Lecture Notes: IS-LM Model and Macroeconomic Policy

Overview

• Recap of setting up the IS-LM model.
• Using the IS-LM model to discuss macroeconomic policy responses during the COVID-19 recession.

IS-LM Model Recap

• IS Curve: Represents combinations of output and interest rates that achieve equilibrium in the goods market.
  • Investment is increasing in output (sales) but decreasing with interest rates.
  • The curve traces equilibrium where output and interest rates are consistent.
• LM Curve: Addresses the need for equilibrium in financial markets.
  • Central banks typically set interest rates, making the LM curve horizontal.

Policy Response Framework

• Fiscal Policy: Involves changes in taxes and government spending.
  • Example: Contractionary fiscal policy (increasing taxes or reducing spending) shifts the IS curve left.
  • Expansionary fiscal policy does the opposite, shifting the IS curve right.
• Monetary Policy: Involves central bank actions to influence interest rates.
  • Expansionary policy decreases interest rates, increasing aggregate demand and output.
  • Implemented through open market operations (e.g., buying bonds to inject money).

Modern Monetary Policy

• Central banks now target interest rates directly rather than money supply.
• Interest rate changes require adjustments in money supply to maintain equilibrium.
• Concepts such as quantitative easing (QE) and unconventional monetary policies are used when interest rates are near zero (liquidity trap).

COVID-19 and Policy Responses

• During the COVID-19 recession, aggressive monetary and fiscal policies were used globally.
• Central banks reduced interest rates to zero and engaged in QE.
• Massive fiscal expansions occurred, with government spending increasing significantly.

Policy Mix Examples

• All-in Approach: Simultaneous expansionary fiscal and monetary policies used during severe recessions.
• Contractionary Fiscal, Expansionary Monetary: Used to consolidate fiscal deficits without triggering a recession.
• Expansionary Fiscal, Contractionary Monetary: Situations where fiscal expansion is met with higher interest rates to control overheating.

Implications and Challenges

• Monetary policy effects are delayed, taking quarters to impact fully.
• Achieving economic balance involves understanding long and variable lags in policy impacts.

Conclusion

• Understanding the IS-LM framework is crucial for analyzing macroeconomic policy decisions and their effects on the economy.
• Policies need to be coordinated to appropriately address economic conditions, such as recessions or inflation.