Monetary Policy in IS-LM
framework
Monetary policy
• RBI is the authority to conduct monetary policy
• Monetary policy regulates the supply of money
and the cost and availability of credit in the
economy.
• Objectives of monetary policy:
– Maintain price stability
– Full employment and economic growth
– Exchange rate stability
– Financial market stability
Impact of Monetary expansion (increase in money supply)
Interest, i
LM1
Net effect in
the short run
LM2 Output rises
i1 Interest falls
i2
IS1
Y1 Y2 Income, Y
Impact of monetary contraction (decrease in
money supply) in the short run: Do it yourself.
* Output falls
* Interest rises
How monetary policy works?
Change Portfolio adj. Spending Output
in leads to adjusts to adjusts to the
money change in changes in change in
supply asset prices interest AD
Asset market adjustment Goods market adjustment
Reluctance to lend/ Borrow
For the mechanism to work, banks should be willing to lend
at lower rates/ firms should be willing to borrow. If they are
reluctant mechanism fails - Case of Japan in 1990s
Liquidity trap
Liquidity trap
• Liquidity trap concept is due to Keynes. According to
him, money demand is infinitely elastic at low rates of
interest.
• When interest rates are close to zero people prefer to
hold cash. They do not buy other interest bearing
assets. Transmission mechanism fails.
• Monetary policy is ineffective but fiscal policy is
effective when economy is in liquidity trap.
Japanese Interest Rates
Keynesian case: Liquidity trap
Monetary policy under liquidity trap
i
i M0/P M1/P
Net effect in
the short run
LM0 No change in
output and
L i0 interest
IS0
Y0 Income, Y
L, M/P
Keynesian case: Liquidity trap
Fiscal policy under liquidity trap
Interest, i
IS1
Net effect in
the short run
Output rises
i0 LM0
No change in
Interest
IS0
Y0 Y1 Income, Y
Classical Case
Money demand is not a function of interest rate -
Monetary policy
LM0 LM1
i
Monetary policy
is effective
i0
i1
IS0
Y0 Y1 Income, Y
Classical Case
Money demand is not a function of interest rate - Fiscal
policy
LM0
i
Fiscal policy is
i1 ineffective
i0
IS1
IS0
Y0 Income, Y
Control of money stock/ interest?
• Central banks can control either money stock or
interest rate not both.
• If central bank fixes money supply, changes in
money demand will result in changes in interest
rate
• If it pegs interest rate, changes in money demand
will have to be accommodated through changes in
money supply.
Which target for the central bank?
Instruments of Intermediate tgt.
Ultimate tgt. (Goal)
monetary policy Money
Growth
CRR Interest
Inflation
Repo (disc.) rate Credit
Unemployment
OMO Exchange rate
Some countries have adopted inflation targets: ECB, New Zealand.
Now India too has adopted inflation target (goal/ ultimate target).
Intermediate target is interest.
Ultimate tgt. (Goal)
Instruments Intermediate tgt. Inflation
Repo (disc.) rate Interest (Call) Growth
Employment
Why have intermediate tgt?
• Decisions are made under uncertainty – about the
economy, the transmission of policy effects.
• Having a target – guides the day-to-day functioning of
central bank
• Gives clarity to the general public about the policy
• Accountability – whether targets have been achieved.
Money and interest tgt.
• Some economists argue against interest rate
target – lose control on money supply – can
lead to inflation.
• On a day-to-day basis targeting interest is
easier as it can be easily monitored
• Over a year or so money stock growth can
be regulated.
Money and interest tgt.
Interest target does not mean that it is constant all the
time, it is fine tuned according to the economic
situation – inflation, unemployment, GDP growth
MONETARY POLICY IN
ACTION
• US - RECESSION IN 2001
• US - SUB PRIME CRISIS
The 2001 Recession in USA
The Federal Reserve Bank cut interest rate in response to
response to recession in March 2001.
NASDAQ
Slow down had set in earlier following .com bubble
burst in 2000
2001 recession & Fed policy
Interest target is changing with economic conditions
Origin of 2008 subprime crisis in USA was ultra lose monetary
policy implemented in the USA post 9/11 and persisting with it well
into 2004
QUANTITIVE EASING (QE)
• “A policy strategy of seeking to reduce
long-term interest rates by buying large
quantities of financial assets when the
overnight rate is zero.” - James Bullard,
president of the Federal Reserve Bank of St.
Louis
• The Fed bought T-bills, all kinds of debts of
U.S. government agencies and massive
amounts of securities backed by private
mortgages.
