Macroeconomics

Lecture 11

Monetary Policy using the IS-LM Model

And
A short discussion on exchange rate
depreciation/appreciation
The basic IS-LM model can be extended to
include variables like:
The basic IS-LM model can be extended to
include variables like
 • Monetary policy is the Central Bank’s actions and
communications to promote maximum employment,
stable prices, and moderate long-term interest rates-the
economic goals generally the Government of the country
mandates the Central Bank to pursue.
What is a
Monetary • In the IS-LM model, the Monetary Policy is modelled as
Policy? the exogenous change in Money Supply by the central
bank.

• The central bank can control the supply of money by

Open Market Operations (OMOs)
What are Open Market Operations?
• Open Market Operations is a traditional tool of monetary policy management by a
central bank
• Open market operations are the purchase and sales of government bonds by the
central bank.
• When the central bank wants to increase the money supply , it uses money to buy
government bonds from the public. As these money leaves the central bank and enter
the hands of the public, the purchase of bonds by the central bank increases the
quantity of money in circulation
• Conversely, when the central bank wants to decrease the money supply, it sells
some government bonds from its own portfolio. This open market sell of bonds take
some money out of the hands of the public and thus decreases the quantity of money
in circulation.
A Central Bank can control money supply using various tools:
Example of RBI Monetary Policy Tools

Repo

Reverse Repo/
1
Standing Deposit
facility
Policy Rates
Instruments of Marginal Standing
Monetary Policy Facility
2

Reserve Ratios Bank Rate

CRR
Open Market
3 Operations

SLR
Signaling, managing expectations

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Open Market
Operations

FOMC = Federal
Open Market
Committee
What happens to the
economy when the central
bank buys
bonds/government
securities?
Expansionary Monetary Policy
• Now consider the effects of an increase in the money
supply (an expansionary monetary policy).

• This shifts the LM curve out.

• The increased money supply causes interest rates to

fall in order to bring the demand for money in line
with the new higher supply.

• This fall in interest rates encourages investment,

leading ultimately to an increase in GDP.

• Thus, interest rates are lower, and GDP is higher.

• The linkage from a change in the money supply to

GDP is known as the monetary transmission
mechanism.
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Monetary Policy: An increase in M (1 of 6)

An increase in the
money supply shifts
the LM curve
downward. The
equilibrium moves from
point A to point B.
Income rises from Y1 to
Y2, and the interest
rate falls from r1 to r2.
Monetary Policy: An increase in M

And the interest

rate falls from r1
to r2.
Note that:
• An expansionary fiscal policy increases Y and increases r
• An expansionary fiscal policy affects demand directly and through the multiplier
effect

• An expansionary monetary policy increases Y but reduces r

• An expansionary monetary policy affects demand through the rate of interest
channel

• The government and the central bank can cooperate to undertake fiscal and monetary
policies to achieve specific targets of Y and r

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What is the Fed’s policy instrument? Part 1

• The news media commonly report the Fed’s policy

changes as interest rate changes, as if the Fed has direct
control over market interest rates.
• In fact, the Fed targets the federal funds rate—the
interest rate banks charge one another on overnight
loans.
• The Fed changes the money supply and shifts the LM
curve to achieve its target.
• Other short-term rates typically move with the federal
funds rate.
What is the Fed’s policy instrument? Part 2

Why does the Fed target interest rates instead of the money
supply?
1. They are easier to measure than the money supply.
2. They are easier to convey as a part of central bank
signalling
3. Overall money supply is difficult to control as there are
behavioral factors involved
What Is the Central Bank’s Policy Instrument—The Money
Supply or the Interest Rate?...The US FED story

• Our analysis of monetary policy has been based on the assumption that the Fed influences the
economy by controlling the money supply. By contrast, when the media report on changes in Fed
policy, they often just say that the Fed has raised or lowered interest rates. Which is right? Even
though these two views may seem different, both are correct, and it is important to understand
why.

• In recent years, the Fed has used the federal funds rate--the interest rate that banks charge one
another for overnight loans--as its short-term policy instrument. When the Federal Open Market
Committee meets every six weeks to set monetary policy, it votes on a target for this interest rate
that will apply until the next meeting. After the meeting is over, the Fed's bond traders in New
York are told to conduct the open-market operations necessary to hit that target. These open-
market operations change the money supply and shift the LM curve so that the equilibrium
interest rate (determined by the intersection of the IS and LM curves) equals the target interest
rate that the Federal Open Market Committee has chosen.

http://gregmankiw.blogspot.com/2006/05/is-lm-model.html 16
What Is the Central Bank’s Policy Instrument—The Money
Supply or the Interest Rate?...The US FED story

• As a result of this operating procedure, Fed policy is often discussed in terms of

changing interest rates. Keep in mind, however, that behind these changes in
interest rates are the necessary changes in the money supply.

• A newspaper might report, for instance, that "the Fed has lowered interest rates."
To be more precise, we can translate this statement as meaning "the Federal
Open Market Committee has instructed the Fed bond traders to buy bonds in
open-market operations so as to increase the money supply, shift the LM curve,
and reduce the equilibrium interest rate to hit a new lower target."

http://gregmankiw.blogspot.com/2006/05/is-lm-model.html 17
What Is the Central Bank’s Policy Instrument—The Money
Supply or the Interest Rate?...The RBI story

• The RBI does fix the Repo rate and the IS-LM model may not exactly represent that behaviour where ‘interest rate’ is the policy
variable

• However, RBI also changes money supply using OMOs and reserve requirements (CRR). In these cases the LM can capture those
policy changes

• The main difference comes from the fact that many Central Banks now have gone into an ‘inflation targeting’ mode which is not
captured by the IS-LM mode well because of the assumptions of the model.

• There are alternative models to capture these new trends, but the IS-LM model remains the most intuitive model to capture
impacts of macroeconomic events.

• More on these later….

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Monetary policy: An interest rate hike

1. Rate of interest is
pushed up r
LM2
2. This acts as a
LM1
contraction in Ms, LM
shifts up r2
3. …the increase in rate of r1
interest contracts
aggregate demand IS
(through its impact on Y
Y2 Y1 That’s the cost of
investment) controlling
inflation using
4. The decline in aggregate demand may help check the Monetary
inflationary pressures but it also leads to a decline in Y Policy
22
Liquidity trap and unconventional monetary policy
• Liquidity trap: A situation where interests rates have fallen to
zero, and therefore, it is possible that (conventional) monetary
policy is no longer effective. At times referred to as the “zero
lower bound”
• Unconventional monetary policies:
• Forward guidance: a policy of announcing future monetary actions,
for example, “we expected… to maintain [low interest rates] until labor
market conditions have reached levels consistent with maximum
employment…”
• Quantitative easing (QE): buying of long-term government debt,
mortgage-backed securities, corporate debt, state and local debt, etc.
Liquidity Trap and the LM Curve

The liquidity trap refers to a state in which the nominal

interest rate is close or equal to zero and the monetary
authority is unable to stimulate the economy with
monetary policy.

In such a situation, because the opportunity cost of

holding money is zero, even if the monetary authority
increases money supply to stimulate the economy, people
hoard money. Consequently, excess funds may not be
converted into new investment. A liquidity trap is usually
caused by, and in turn perpetuates, deflation Liquidity trap visualized in the context of the
IS–LM model: A monetary expansion (the shift
from LM to LM') has no effect on equilibrium
interest rates or output. However, fiscal
expansion (the shift from IS to IS") leads to a
higher level of output (from Y* to Y") with no
change in interest rates. And, ostensibly, since
interest rates are unchanged, there is no
crowding out effect either.
 When an economy enters a liquidity trap,
unconventional monetary policy like the
Quantitative Easing comes into play…

Please also read: http://assets.press.princeton.edu/chapters/reinert/6article_ito_liquidity.pdf

What is quantitative easing?
Quantitative Easing is an example of an unconventional monetary policy

Quantitative easing is when a central bank creates new money electronically to make large purchases of assets. Central banks
make these purchases from the private sector, for example from pension funds, commercial banks and non-financial firms.
Most of these assets are government bonds (also known as gilts). They also buy private debt like corporate bonds.

As more of these other assets are bought, their prices rise because of the increased demand. This pushes down on yields in
general. The companies that have issued these bonds or shares benefit from cheaper borrowing because of these lower
yields, encouraging them to spend and invest more.

This is aimed at making it easier for companies to raise money in capital markets to invest in their business. Those selling
assets to us have more money in their bank accounts as a result. Commercial banks can use these new funds to finance new
loans, encouraging more spending and investment.

Quantitative easing also reduces the riskiness of the private sector by allowing them to sell some of their more toxic assets to
the central bank.

https://www.economist.com/the-economist-explains/2015/03/09/what-is-quantitative-easing https://www.bankofengland.co.uk/monetary-policy/quantitative-easing
Asset Purchase Programmes (APPs):
• APPs involve the outright purchase of assets (mainly government
bonds) by central banks and have long been a feature of their RBI buys long term bonds to
liquidity management operations; however, these have been used Yield (%) increase long term bond prices
more extensively after the GFC and especially in response to and bring down the yield of
COVID-19, leading to large expansion of central bank balance these bonds
sheets.
Original
Yield
Curve
• While a quantity target is commonly referred to as quantitative
Target yield curve
easing (QE), a price target is known as yield curve control (YCC).

• Under yield curve control (YCC), the Central Bank would target
some longer-term rate and pledge to buy enough long-term bonds
to keep the rate from rising above its target. This would be one way
for the Central Bank to stimulate the economy if bringing short- RBI sells short term bonds to
term rates to zero isn’t enough. decrease short term bond
prices and push up the yield of
these bonds

• Operation Twist is an example of yield curve control. The rationale

behind Operation Twist is to push up-the short-term yields and drag
down the long term yields. With this, the gap between the short
term and long term will reduce. Maturity in years

See the uploaded paper- Unconventional Monetary Policy in Times of COVID-19

Interaction between monetary and fiscal policy
• The policy changes discussed above took the form of an
exogenous change in one policy, holding all other exogenous
variables constant.

• In reality, monetary and fiscal policy do not exist in isolation

from each other. The Federal Reserve and the fiscal
authorities both pursue policy goals that may or may not be
compatible.

• Here we note simply that the ultimate effects of a fiscal-

policy change depend upon how the monetary authorities
react to that change.

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Interaction between monetary and fiscal policy

• Model:
• Monetary and fiscal policy variables (M, G, and T) are
exogenous.
• Real world:
• Monetary policymakers may adjust M in response to
changes in fiscal policy or vice versa.
• Such interactions may alter the impact of the original
policy change.
The Fed’s response to ΔG > 0

• Suppose Congress increases G.

• Possible Fed responses:
1. Hold M constant
2. Hold r constant
3. Hold Y constant
• In each case, the effects of ΔG are different . . .
Response 1: Hold M constant

An increase in G
shifts the IS
curve out. The
Fed holds the
money supply
constant, and
therefore, the LM
curve stays the
same. Both
income and the
interest rate rise.
Response 2: Hold r constant

An increase in G
shifts the IS
curve out. To
keep r constant,
the Fed then
increases the
money supply.
Income
increases by
more than if the
Fed held M
constant.
Response 3: Hold Y constant

An increase in G
shifts the IS
curve out. To
keep Y constant,
the Fed then
decreases the
money supply.
Uses of Monetary and Fiscal Policy measures to attain the desired policy goal
Output Goal Interest Rate Goal Policies
Increase Increase Expansionary Fiscal Policy
Increase Decrease Expansionary Monetary Policy
Increase No Change Expansionary- Fiscal and
Monetary Policy

Decrease Decrease Contractionary- fiscal

Policy

Decrease Increase Contractionary Monetary Policy

Decrease No Change Contractionary- Fiscal and
Monetary Policy

No Change Increase Expansionary Fiscal and

contractionary Monetary Policy

No Change Decrease Contractionary Fiscal and

expansionary Monetary Policy

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NOW YOU TRY
Analyze shocks with the IS–LM model
Use the IS–LM model to analyze the effects of
1. a housing market crash that reduces consumers’
wealth
2. consumers using cash in transactions more
frequently in response to an increase in identity theft
For each shock,
a. use the IS–LM diagram to determine the effects on Y
and r.
b. figure out what happens to C, I, and the
unemployment rate.
NOW YOU TRY
Analyze shocks with the IS–LM model, answer, part 2
LM shifts left,
causing r to rise
and Y to fall.
C falls due to lower
income.
I falls because r is
higher.
u rises because Y
is lower.
(Okun’s law)
Shortcomings of the IS-LM model
• First is the fact that the IS–LM model is a static model. With no reference to time, the IS–LM model
restricts in important ways the behavior of some of the variables within the model.
• For example, money is postulated to act as a medium of exchange. Without a reference to time, the effects of the
“store of value” function of money cannot be represented properly in an IS–LM model.

• Many policies work with significant and varying time lags. This aspect is not captured in the IS-LM model

• Its structural equations are postulated and are not derived from utility or profit maximization
• Though these can be incorporated from empirical studies/estimations

• Assumption of fixed price and short-run application may restrict its usefulness

• It is alleged that the model mixes up stocks (Money supply, the LM side) and flows (Investment, saving,
the IS side)

• Role of expectations are not explicitly incorporated in the model

https://www.stlouisfed.org/publications/regional-economist/2023/may/examining-long-
variable-lags-monetary-policy
Reading
• Chapter 13 of your textbook
• Textbook supplement on IS-LM model (uploaded)
• Suggested reading on Monetary Policy (uploaded)
The Choice between Domestic
Goods and Foreign Goods
• When goods markets are open, domestic consumers must
decide not only how much to consume and save, but also
whether to buy domestic goods or to buy foreign goods.

• Central to the second decision is the price of domestic

goods relative to foreign goods, or the exchange rate.

40
 • An exchange rate can be defined as a price
of one country’s money in terms of
another country.

What is an • Each country measures the price of its

exchange goods and services using a particular scale
of measurement.
rate?
• The exchange rate provides a conversion
tool which allows expressing prices of one
country in terms of the units of
measurement of the other country.
Nominal Exchange Rates
• Nominal exchange rates between two currencies can be
quoted in one of two ways:

• As the price of the domestic currency in terms of the

foreign currency.

• As the price of the foreign currency in terms of the

domestic currency.

• Note that both the conventions are used in textbooks. In

India, we generally express it as INR/$ terms

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Nominal Exchange Rates:
Appreciation and Depreciation
• The nominal exchange rate is the price of the foreign
currency in terms of the domestic currency.

• An appreciation of the domestic currency is an increase in

the price of the domestic currency in terms of the foreign
currency, which corresponds
to a increase in the exchange rate.

• A depreciation of the domestic currency is a decrease in

the price of the domestic currency in terms of the foreign
currency, or a decrease in the exchange rate.

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Nominal Exchange Rates:
Revaluations and Devaluations

When countries operate under fixed exchange

rates, that is, maintain a constant exchange rate
between them, two other terms used are:
Revaluations, rather than appreciations, which
are decreases in the exchange rate, and

Devaluations, rather than depreciations, which

are increases in the exchange rate.

44
 • A depreciation of the home currency causes foreign goods to become
more expensive (in terms of home currency), reducing consumption of
imports relative to domestic alternatives.

Exchange • A depreciation makes the home country’s exports cheaper (in terms of
foreign currency), so the trading partner switches expenditure towards
Rate and home products.

Depreciation • This process is called expenditure switching

• Whether expenditure switching will lead to an improvement in the

home country’s current account will depend upon the price elasticities
of demand for imports and exports

45
Exchange Rate and
Depreciation
• Depreciation is a decrease in the value of a currency relative to another currency.

• A depreciated currency is less valuable (less expensive) and therefore can be exchanged for
(can buy) a smaller amount of foreign currency.

• If the exchange rate moves from Rs 40/$ to Rs 50/$ it means that the INR has depreciated
relative to the Dollar. It now takes Rs 50 to buy one US$, so that the INR is less valuable.

• The dollar has appreciated relative to the INR: it is now more valuable.

• Nowadays we tend to use terms ‘devaluation’ and ‘depreciation’ interchangeably. However,

strictly speaking, devaluation happens w.r.t. gold and depreciation happens w.r.t other
currencies.

46
Exchange Rate and Depreciation…Scenario 1

Cost of Export
production Volume of Export Revenue Import Import Volume of Trade
Rs/$ (in Rs) Price in $ exports Revenue ($) (in Rs) Price in $ price in Rs imports Import cost Balance

40 200 5 100 500 20,000 10 400 50 20,000 0

50 200 4 150 600 30000 10 500 30 15000 15000

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Exchange Rate and Depreciation…Scenario 2

Cost of Export
production Volume of Export Revenue Import Import Volume of Trade
Rs/$ (in Rs) Price in $ exports Revenue ($) (Rs) Price in $ price in Rs imports Import cost Balance

40 200 5 100 500 20000 10 400 50 20000 0

50 200 4 110 440 22000 10 500 48 24000 -2000

48
Exchange Rate and Depreciation…3

Cost of Export
production Volume of Export Revenue Import Import Volume of Trade
Rs/$ (in Rs) Price in $ exports Revenue ($) (in Rs) Price in $ price in Rs imports Import cost Balance

40 200 5 100 500 20,000 10 400 50 20,000 0

50 200 4 150 600 30000 10 500 30 15000 15000

Cost of Export
production Volume of Export Revenue Import Import Volume of Trade
Rs/$ (in Rs) Price in $ exports Revenue ($) (Rs) Price in $ price in Rs imports Import cost Balance

40 200 5 100 500 20000 10 400 50 20000 0

50 200 4 110 440 22000 10 500 48 24000 -2000

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 Marshall-Lerner Condition

Marshall-Lerner condition states that a depreciation of domestic

currency can improve a country’s balance of payments only when
the sum of the price elasticity of demand of exports and the price
elasticity of demand for imports exceeds unity.

 x + m  1
 • A depreciation of the home currency causes foreign goods to
become more expensive (in terms of home currency),
reducing demand of imports relative to domestic alternatives.

• A depreciation makes the home country’s exports cheaper

Exchange Rate than other suppliers in the foreign market (in terms of foreign
currency). So, in the foreign market it draws demand away
from foreign suppliers
and
Depreciation • This process is called expenditure switching

• Whether expenditure switching will lead to an improvement

in the home country’s current account will depend upon the
price elasticities of demand for imports and exports

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Other Effects of depreciation
• But for the home country, depreciation can
also be inflationary
• More expensive imports
• Increased aggregate demand may become
inflationary if capacity constraints exist

• What happens if a country is highly import

dependent for its exports?
• Impact of depreciation is less

Cost of Export
production Volume of Export Revenue
Rs/$ (in Rs) Price in $ exports Revenue ($) (in Rs)

40 200 5 100 500 20,000

50 240 4.8

If imported inputs are used, then a depreciation can increase cost of 52

production as imported inputs become more expensive
Other Effects of depreciation
• But for the home country, depreciation can
also be inflationary
• More expensive imports
• Increased aggregate demand may become Therefore, any decision to devalue a currency must depend on
inflationary if capacity constraints exist the estimated net effect on depreciation.
The channels are:
 Impact through exports and its price elasticities
• Sometimes devaluation is called “beggar thy  Impact through imports and its price elasticities and import
neighbour” policy intensity of domestic economy
• But what happens if every country  Impact on foreign debt held by domestic players
devalues?  Possible retaliation by competing countries

• depreciation increases external debt

burden of domestic players in terms of
domestic currency
Impact on external Commercial Borrowing
(What is a natural hedge?)

53
Summing up
If the Marshal-Lerner conditions are satisfied, an exchange rate
depreciation can improve a country’s trade balance

However, the positive impact of depreciation on exports will be less if

there are imported inputs in the production of exports

A depreciation can be inflationary as it increases the prices of imported

goods. These increases may have an impact on cost push inflation.

Also, a domestic inflation (due to say, expansionary monetary or fiscal

policy) can affect a country’s competitiveness in the export market

Because of these, policymakers often track both nominal exchange rate

and real exchange rate of a country

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