3. Putting the IS and the LM Relations Together
The equilibrium values of i and Y are those that satisfy simultaneously the goods market equilibrium
condition (equation (5.2)) and the money market equilibrium condition (equation (5.3)). Graphically,
these values are determined by the point of intersection of the IS and LM curves, as illustrated in Figure
5-5.
Changes in the equilibrium values of output and the interest rate (Y* and i*) can be brought about only as
the result of shifts in the IS curve, the LM curve, or both. An increase in the money supply, which shifts
the LM curve down, increases equilibrium output and reduces the equilibrium interest rate. An increase in
taxes (or a reduction in government spending), which shifts the IS curve to the left, reduces equilibrium
output and reduces the equilibrium interest rate. An increase in taxes has an ambiguous effect on
investment, since the output effect tends to reduce investment, but the interest rate effect tends to increase
it. More generally, although deficit reduction increases public (government) saving, it does not
necessarily increase investment, because private saving is endogenous.
Fiscal expansions (i.e. lower taxes or higher government spending) shift the IS curve to the right and
result in higher output. In contrast, fiscal contractions (i.e. higher taxes or lower government spending)
shift the IS curve to the left and result in lower output. See Figure 5-6.
Changes in monetary policy shift the horizontal LM curve up or down as the central bank increases or
decreases interest rates through changes in the money supply. A monetary expansion lowers the interest
rate and shifts the horizontal LM curve down resulting in higher output. See Figure 5-7. In contrast, a
monetary contraction increases interest rates and shifts the LM curve upward resulting in lower output
(Y).
4. Using a Policy Mix
The text considers the consequences of combinations of fiscal and monetary policy through two
examples: the recession of 2001 and the deficit reduction during President Clinton’s first term. A box in
the text argues that the proximate cause of the recession of 2001 was a drop in (nonresidential) investment
spending and that the policy response—a sharp cut in interest rates by the Fed and large tax cuts
spearheaded by the Bush administration—lessened the severity of the recession. Although the tax cuts
provided useful stimulus, they also played the major role in creating large budget deficits in the United
States. Many economists worry about these deficits, and argue that the tax cuts should not have been
made permanent. Long after the recession of 2001, the loss of tax revenue associated with the Bush tax
cuts continues to affect government finances.
During the recession of 2001, monetary and fiscal policy both became more expansionary. In the
President Clinton’s first term, by contrast, fiscal policy became more contractionary while monetary
policy became more expansionary. The Federal Reserve supported the Clinton deficit reduction policy (a
fiscal contraction) with a monetary expansion, and interest rates fell. As a result, there was a deficit
reduction without a slowdown in growth. In fact, there was a large economic expansion—an outcome
supported by the policy mix but also aided by other factors.
5. How Does the IS-LM Model Fit the Facts?
So far, the discussion has ignored dynamics. In fact, it takes some time for consumption, investment, and
output to adjust to an economic disturbance. How long is an empirical question. To discuss this question
and to provide evidence of the empirical relevance of the IS-LM model, the text describes the results
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