Closed Economy Policy Analysis Flashcards
Basic Closed Economy Equilibrium
- At e, IS = LM
- > ī - Y(1-c) / b = KY - L (M/P) / h
Solve for Y, steps: 1) Remove fractions by cross multiplying 2) Group like terms (All terms with Y) 3) Divide both sides by square brackets 4) hī - Yh (1-c) = b KY - b (m/p) 5) hī + b(m/p) = Y [bk+h(1-c)] 6) Y = h (ī + G) + b (m/p) / (h (1 - c) + bk) This is graphically point where IS-LM intersect
Fiscal Multiplier
1 / (1 - c) + bk / h > 0
- Smaller than basic fiscal multiplier due to bk/h on bottom, this captures effect of asset market interaction
- ↑ G ⇒↑ Y ⇒ L > M ⇒↑ i ⇒↓ I ⇒↓ Y
Money Multiplier
1 / ((h/b)(1 − c) + k) > 0
- Smaller than basic money multiplier due to extra term (h/b) (1-c), takes interaction with goods market into account
- ↑ M ⇒ M > L ⇒↓ i ⇒↑ I ⇒↑ Y
Closed economy AD curve
- Shows relationship between price and income
when the asset and goods markets are in simultaneous equilibrium - To find, set IS-LM equal and solve for P instead of Y
- P = bM / Y(h(1 − c) + bk) − h(ī + G)
↑ P ⇒ (M/P) < L ⇒↑ i ⇒↓ I ⇒↓ Y
What determines effectiveness of fiscal & monetary policy in a closed economy?
1) Interest sensitivity of investment - b
2) Interest sensitivity of money demand - h
Look at extreme values of each, as they tend toward infinity or 0 and see effect of fiscal & monetary in each scenario
Shown on pages 35,36 online textbook
What does the IS-LM Model
Keynsian model that attempts to explain a way to keep the economy in balance through an equilibrium of money supply versus interest rates
IS downward sloping showing as when R is lower, less savings more investment
LM curve shows money market, upward sloping as when economy expands, institutions need funds to support extra investment
IS-LM Model limitations
- Lacks a formal budget constraint on G.
- Endogenous Money: Central banks today in most advanced economies prefer to control interest rates on the open market—for example, through sales of securities and bonds. This would mean instead of an LM curve it could be replaced with a horizontal MP curve at whatever rate was set. Expansionary monetary policy could be represented by a downward movement of the MP curve.
- Assumes fixed prices, 0 inflation. This assumes economy below full capacity or AS is flat. If have downwards AD and flat AS, means any expansionary policy has no impact on the price level, this is not often the case in reality. However, do this to simplify analysis, also in developed economics inflation is close to 0 anyway due to independent central bank.
The IS-LM model is a great way to explain Keynes’s ideas about how monetary systems, markets, and governmental actors can work together to drive economic growth. However, as a practical model to advise on fiscal or spending policy, it falls short.
Financing G
1) Taxes Today
2) Issuing Bonds (Taxes Tomorrow as have to be repaid)
3) Seignorage: Printing money - Government revenue is augmented but at cost of erosion of real income by inflation, inflation tax
Effect of G financing on IS Curve
- Addition of tax T t rate t, consumption function must now be a function of disposable income Yd (Y-T)
- C = cYd = c(Y-T) = (Y-tY) = (c-ct)Y
Substitute this consumption function to revise the IS Curve, gives us:
Y = ī + G - Y (1-c+ct) / b
- IS curve stays the same except tax rate becomes another determinant of the position of the curve, a rise in T shifts IS down
Basic Tax Multiplier & Finding & Effect on graph
- Shows effect of change in income tax rate t on income Y
- To find basic tax mulitplier (considers goods market alone), rearrange goods market e making Y the subject:
Y = AE
= (c-ct)Y + ī - bi + G
Y (1 - c + ct) = ī + G - bi
Y = (ī + G -bi) / (1 - c + ct)
Then partially differentiate with respect to t
∂Y/∂t < 0 - Is negative, increase in t lowers Y
- Increase in t rotates IS curve inwards
