IS-LM Model: Fiscal and Monetary Policy Effects
Monetary and Expansionary Fiscal Policy
In our simplified model, we assume constant prices, which isn’t always true in reality. Implementing both monetary and expansionary fiscal policies can significantly increase aggregate demand, potentially causing prices to rise sharply.
Achieving Income Stability and Investment Growth
If monetary authorities aim to keep income stable while increasing investment, a combined approach is needed. An expansionary monetary policy should be paired with a restrictive fiscal policy. The former increases bond prices, lowering interest rates and boosting investment. The latter reduces income through decreased government spending or increased taxes. The net effect is increased investment due to lower interest rates, with income remaining steady.
Expansionary Fiscal Policy (Increased Government Spending)
An increase in government spending (G) boosts aggregate demand (AD) and, consequently, income. This initial income increase raises money demand, leading economic agents to sell bonds, which lowers bond prices and increases interest rates. This, in turn, reduces investment, aggregate demand, and ultimately, income. In short, short-term income increases, but medium-term income decreases.
Driving Economic Growth
The most direct way to stimulate economic growth is by increasing investment in stocks, equipment, and industrial plants.
Interest Rate and Investment Demand
The interest rate is a key determinant in investment demand because it influences the profitability of investment projects. Higher interest rates make bond purchases more attractive than capital investment, while lower rates favor investment.
High Interest Rates and High Investment
High interest rates and high investment can coexist for two primary reasons: strong economic expectations that make investment attractive, and high inflation rates that lower the real interest rate, making investment more profitable.
Restrictive Monetary Policy Effects
A shrinking money supply creates a shortage relative to money demand. This lack of liquidity forces economic actors to sell bonds, lowering their prices and increasing interest rates. Consequently, investment becomes less attractive, reducing aggregate demand and production.
Expansionary Fiscal Policy (Reduced Direct Taxes)
Lower direct taxes initially increase consumption and, therefore, income. This rise in income increases money demand, which raises interest rates. This increase impacts both the asset and real markets. In the asset market, money demand decreases until equilibrium is reached. In the real market, investment decreases, reducing income, which in turn causes a fall in money demand to reach equilibrium. Crowding out occurs when increased consumption comes at the expense of investment.