This shifts the IS curve outwards due to an increase in G
Would be disappointed if a rise in government spending doesn't lead to an increased output
Government spending (G) only affects the IS curve
Money supply (M) affects the LM curve
What happens if you increase money supply (M) ?
M0 - M1
Only changes the LM curve
A rise in M shifts the LM curve in a positive direction
An expansionary money policy leads to an increase in GDP (similar to fiscal policy).
In a recession you need to boost government spending and money supply
Money policy is effective but leads to a fall in interest rates. This is neither good nor bad globally it depends on the person in the situation
what happens when b tends to infinity ?(Monetary policy)
Flat IS as b is tending to infinity
Monetary policy is very effective and there is no change in interest rate
What happens when b tend 0 ?(Monetary policy)
Vertical IS
Interest rate has fallen however there is no change in output this means that this monetary policy is ineffective
What happens what b tends to infinity ? (fiscal policy)
Flat IS
Fiscal policy is ineffective
What happens when b tends to 0? (Fiscal policy)
Vertical IS
Fiscal policy is effective when it is vertical subject to the normal caveat of the crowding out effect.
What happens when h tends to infinity ? Monetary policy
Flat LM
Monetary policy is ineffective (liquidity trap)
Zero - lower bound problem
What happens when h tends to 0 ? Monetary policy
Vertical LM
Output increases and has the normal falling interest rates so it is effective (classical view)
What happens when h tends to infinity ? Fiscal policy
Flat LM
Not only is there an increase in output but there is also no crowding out (keynesian view)
What happens when h tends to 0 ? Fiscal policy
Vertical LM
Output has no change and all the government spending has passed through to the interest and then us complete crowding out. (classical view) Ineffective
Limitations
Fixed prices - inflation assumed to be zero π = inflation
r = i - π
As inflation is 0 then the equation is r = i
This is so we can draw IS and LM on the same diagram (i on the vertical axis)
fe = full employment
Yfe = output at full employment (the maximum a country can actually produce)
Counterargument to if fixed prices are a limitation
There are independent central banks which target inflation
It is based on the Taylor rule:
this says that if inflation increases higher than 2% then they will look at increasing interest rates.
This bank will look at the economy to see whether increasing interest rates is suitable
If there is no interaction with the money market (no exchange in interest rate then we can see that it is a basic multiplier )(didn't take into account that the LM curve will move)
Nominal exchange rate - the price of one unit of foreign currency in terms of the domestic currency - E
Uk - Norway. E = 0.08. costs 8 pence to buy 1 krone
(UK / US media: often use inverse definition)
1/E = 12 12 kroners to £1
Real exchange rate (R)
R = EP^w / P
nominal x relative price level
Purchasing power parity (PPP) - R = 1
Rise and falls
appreciation fall in E
Real appreciation fall in R
A fall in R is the domestic currency is "less competitive" ("stronger")
[fix : revaluation]
depreciation rise in E
Real depreciation rise in R
This means the the domestic currency is "more competitive" (weaker)
[fix : devaluation]
Imports (IM)
IM = m,Y
m = marginal propensity to import MPM
m2R - real exchange rate sensitivity of imports
Decrease in R is less competitive (our goods more expensive compared to foreign goods) - increase IM
Exports (EX)
EX = x1Y* + x2R
x2R - real exchange rate sensitivity of exports - increase in EX
Increase R more competitive (i.e cheaper than others)
Balance of payments
BP = CA + CP + OR
current account + capital account + official reserves