Question

Suppose the demand for real money balances is Md/P = L(Y, i), where L(Y, i) is an increasing function of income Y and a decreasing function of the nominal inter- est rate i. Assume that the interest elasticity of money demand is infinite when the nominal interest rate is zero. Money-market equilibrium is represented by the equation Ms/P = L(Y, i), where Ms is the money supply controlled by the central bank and P is the price level. The LM curve relationship between Y and i repre- sents money-market equilibrium for given values of Ms and P. In the IS-LM model, the price level P is assumed to be fixed in the short run.

The IS curve represents goods-market equilibrium. Consumption depends posi- tively on disposable income; investment depends negatively on the real interest rate; tax and government spending are exogenous.

Following a large negative shock to confidence, investment demand falls and the IS curve shifts to the left, intersecting the LM curve at i = 0.

Use the IS-LM model to analyse the effects on GDP of each of the following policy options. Which policies does the model predict are effective in avoiding a recession?

1. The central bank increases the money supply by buying more short-term government bonds (‘quantitative easing’);

2. Higher government expenditure paid for by increasing taxes;

3. A tax cut paid for by printing money (a ‘helicopter drop’ of money);

4. The central bank raises its inflation target (assume this is credible and increases inflation expectations πe).

Answer 1

In the given situation, the IS curve has shifted leftwards, causing the output to decline. In order to avoid this decline in output, the policy should either shift the LM curve rightwards or the IS curve rightwards. The first option and third options state policies which will shift the LM curve rightwards. The second option also states a policy that will be effective in avoiding recession. This will be the case because the increase in consumption due to an increase in government spending will be higher than the decrease in consumption due to the increase in taxes, because tax multiplier is lower than the government spending multiplier.

Therefore, the first, the second, and the third options are correct.