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Monetary Policy (LM-IS curves)

 
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arthur
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PostPosted: Sat Sep 18, 2004 5:46 pm    Post subject: Monetary Policy (LM-IS curves) Reply with quote

The LM (Liquidity Preference-Money Supply) curve and IS (Investment-Saving) curve shift over time. The LM curve reflects monetary policy and represents the money market and the IS curve reflects fiscal policy and represents the goods market. Interest rates (r) is on the vertical axis and output (Y) is on the horizontal axis. The equilibrium point is where the two curves intersect (see graph below).



An expansionary monetary policy causes r (interest rates) to fall and Y (output) to rise (a rightward shift in the LM curve). A contractionary monetary policy causes r to rise and Y to fall (a leftward shift in the LM curve). An expansionary fiscal policy causes both r and Y to rise (a rightward shift in the IS curve). A contractionary fiscal policy causes both r and Y to fall (a leftward shift in the IS curve).

In my previous economics article (Two Powerful Opposing Forces), I stated that interest rates have less of an effect on consumption and production. Therefore, either the LM curve or IS curve or both have become steeper. Consequently, changes in monetary or fiscal policies or both have become more powerful, i.e. the curves are less responsive to interest rates, which imply changes in monetary or fiscal policies or both will have a more powerful effect on output than (market) interest rates (for example, a leftward shift of a vertical LM curve results only in a contraction in Y with r unchanged).

I will only explain the effects of monetary policy, because the Fed has begun a tightening cycle, and fiscal policy is out of play, except if the tax cuts become permanent (if Bush wins) or if taxes are raised (if Kerry wins). Monetary policy has generally been a more powerful tool than fiscal policy in the U.S. economic structure (i.e. the LM curve has been much steeper than the IS curve).

A contraction in the steeper LM curve will have a greater effect on reducing Y (which is why the Fed chose a "measured" pace of tightening). Moreover, when M / P (money supply divided by the price level) falls (through the Fisher Equation of Exchange: MV = PT; or M = P or M / P = 1 in the long-run), then the LM curve contracts. The U.S. had the fastest growth in 20 years over a three quarter period in late 2003 and early 2004 when there were concerns about disinflation turning into deflation. However, inflation has risen over the past year, although it currently remains tame. A falling money supply with rising inflation will lead to a greater contraction in Y.

There are two types of money, transaction demand for money and investment demand for money. With debt levels high, employment growth slow, contractionary money, and rising inflation, more money will go for transaction demands (to maintain autonomous consumption) than for investment demands (e.g. for the stock market). So, the pace of the tightening cycle and the extent of inflation, over time, will influence the magnitude of the negative effect on the stock market. I tend to believe the effect will be moderately to severely negative for the stock market next year.
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