Limitations of the IS-LM Model

Limitations of the IS-LM Model

There are some limitations with the IS-LM model which we have developed so far. The limitations are connected with the fact that in this model we have assumed money supply to be exogenously determined, we have also looked only at a closed economy and also assumed the price level to be fixed.

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Summary

As a quick summary, we can say that:

Fiscal policy is more effective the flatter is the LM curve and the steeper is the IS curve.

Monetary policy is more effective the steeper is the LM curve and the flatter is the IS curve.

The condition that makes monetary policy most effective makes fiscal policy least effective. The reason for the difference is the differing role of interest rate plays in transmitting the effects of
monetary and fiscal policy .

Monetary Policy

Monetary Policy

Changes in money supply shifts the LM curve. When an expansionary monetary policy is adopted, for example, the LM curve shifts right causing interest rate to fall and income to rise.

The increase in money supply, by creating an excess money supply causes interest rate to fall. The fall in interest rate stimulates investment and this therefore results in an increase in income. A new equilibrium is achieved when the fall in interest rate and the rise in income jointly increase money demand by an amount equal to the increase in money supply. This equilibrium occurs at the point where the new LM curve intersects the IS curve. A decline in money supply has the opposite effect.

Monetary policy is effective provided:

Md must be interest inelastic (insensitive to changes in interest rate- LM steep); and

Investment must be responsive to changes in interest rate (IS relatively flat)

Fiscal policy to be effective

Hence, for fiscal policy to be effective (i.e. give rise to a big change
in T):

Md must be sensitive to changes in interest rate – the responsiveness of the demand for money to interest rate determines the slope of the LM curve; and

Investment must be interest inelastic – the responsiveness of investment to a change in interest rate determines the slope of the IS curve .

Fiscal Policy

Fiscal Policy

The use of fiscal policy shifts the IS curve, thereby affecting the equilibrium income and interest rate. In the case of an expansionary fiscal (when G is increased or T is reduced) for e.g., the IS curve shifts right, resulting in an increase in the equilibrium level of income and interest rate. A contractionary fiscal policy has the opposite effect.

An expansionary fiscal policy causes interest rate to rise (to maintain equilibrium in the money market). The increase in interest rate in turn causes a decline in investment spending. The decline in investment spending will partially offset the increase in aggregate demand resulting from the increase in government spending. Consequently the increase in income less than in the simple Keynesian model which does not take the offsetting effect into account. An expansionary fiscal policy raises interest rate which therefore dampens its expansionary fiscal impact.

The Effectiveness of Fiscal and Monetary Policies

The Effectiveness of Fiscal and Monetary Policies.

Whenever the economy is not operating at full employment, the government can intervene and help bring the economy to its full employment position by adopting appropriate fiscal and monetary policies.

The effectiveness of these policies will depend on the slopes of both the IS and the LM curves. (More of this will be touched upon when we look at the open economy).