Class Materials for Lecture 12

Brief Outline of Topics Covered in Lecture 12

Chapter 20 The IS-LM Model [cont.]

• The liquidity trap

Equilibrium

Chapter 21 Monetary and Fiscal Policy in the IS-LM Model

Changes in the equilibrium values of output and the interest rate

• Monetary policy in the IS-LM model
• Fiscal policy in the IS-LM model

Effectiveness of Monetary and Fiscal Policy Graphically and Intuitively

• Responsiveness of money demand to the interest rate (including liquidity trap)
• Responsiveness of investment to the interest rate

Video:

Additional Reading

• A comprehensive solution to combustible markets - Barney Frank
• Talking about Tomorrow’s Monetary Policy Today - FRBSF Economic Letter
• Bernanke Learns Flexibility in the Debate Over Fed’s Role - NYTimes.com
• Banks bill seeks to strip Fed of powers - FT.com
• Will rising oil prices derail the recovery? - Econbrowser
• Politicizing the Fed? - washingtonpost.com
• Yellen Is More Worried About Disinflation - Real Time Economics

Application:

Depression multipliers, by Paul Krugman: Barry Eichengreen and Kevin O’Rourke have lately been scoring a series of research coups, based on the combination of historical perspective and a global view. Most famously, they showed that on a global basis the first year of the current crisis was every bit as severe as the first year of the Great Depression.

Now they and collaborators have a new piece on policy effects, especially fiscal multipliers.

The background here is that there are two problems with estimating multipliers relevant to our current situation. First, you need to look at what happens under liquidity-trap conditions — and except in Japan,these haven’t prevailed anywhere since the 1930s. The second is that in the United States, fiscal policy was never forceful enough to provide a useful natural experiment. We didn’t have a really big fiscal expansion until World War II; and WWII isn’t a good experiment because the surge in defense spending was accompanied by government policies that suppressed private demand, such as rationing and restrictions on investment.*

What E&R do here is use a broad international cross-section to overcome this problem. This works because a number of countries had major military buildups during the 1930s — fiscal expansions that can be regarded as exogenous to the economic situation, since they were

driven above all by Hitler’’s rearmament programmes and other nations’’ efforts to match the Nazis in this sphere, and by one-off events like Italy’’s war in Abyssinia.

What do E&R find? Initial fiscal multipliers of 2 or more, although they shrink over time. Yes, fiscal expansion is expansionary.

* I really, really don’t understand why this point has been so hard to get across.