David K.H. Begg, Gianluigi Vernasca-Economics-McGraw Hill Higher Education (2011)

20.2 The IS-LM model
Until 2008 monetary policy had successfully stabilized most countries close to the trend level of normal
output. There was little discrepancy between actual and cyclically-adjusted budgets, because the business
cycle had largely been eliminated. The evolution of the budget position was therefore due to changes in fiscal
policy - decisions about tax rates and spending levels - not fluctuations in output.
For example, in the UK, after 2000 the government embarked on a substantial increase in government
spending, especially on health care. Since tax rates were not raised in line, both the actual and the cyclicallyadjusted
budget deficit increased. Chancellor Gordon Brown was finding it harder and harder to live up to his
claim of fiscal responsibility.
In the years leading up to 2008, the Spanish budget surplus was steadily increasing, and that of Italy was
essentially flat. Italy and Spain were not on a course of fiscal recklessness. Since Greece has subsequently
admitted that all of its official statistics were wrong, changes in Greece probably had more to do with changes
in reporting than in underlying reality.
All four charts confirm that large falls in output in 2009 had immediate and adverse effects on budget deficits.
Not merely did banks require bailouts, but tax revenues fell as activity fell. There are reasons to hope that both
may be reversed as output recovers. Tax revenue will improve and governments may recoup some of the
bailout funds as banks become healthier.
None of this detracts from the fact that substantial tax rises and spending cuts will still be required. Some of the
bank assets are permanently bad, governments have to pay interest on the debts they have issued in the meantime,
and projected output paths (and hence tax revenues) are lower than we had previously been projecting.
All of this affects the decision of when to tighten fiscal policy. If interest rates could be reduced further, fiscal
policy could be tightened immediately without threatening the output recovery. But interest rates are already
close to rock bottom, If fiscal policy is tightened too much too soon, output recovery will stall, tax revenues
will not materialize, and the desired improvement in government finances will be frustrated. However, if
fiscal tightening is postponed too long, government debt will have mushroomed to levels that will then be
very hard to repay. Nobody said economic policy was supposed to be easy.
The LM schedule: money market equilibrium
Pursuing a monetary target, the central bank endeavours to fix the money supply
itself. In Figure 20.2, along the LM schedule, the demand for money (or liquidity,
hence L) equals the given supply of money (hence M). Hence the shorthand LM.
The quantity of money demanded rises with output Y but falls with the interest
rate r. In money market equilibrium, money demand equals the given money
supply. Hence if output rises from Y0 to Y 1 - tending to raise the quantity of money
demanded - money market equilibrium is restored only if interest rates rise from
r0 to rl> thereby reducing money demand back to the level of the given money
The LM schedule shows
combinations of interest rates
and income-yielding money
market equilibrium when the
central bank pursues a given
target for the nominal money
supply.
supply. Figure 20.2 shows the upward-sloping schedule LM describing money market equilibrium. Higher
output and income are accompanied by higher interest rates.
The slope of the schedule
The LM schedule slopes up. Following a monetary target, higher output induces a higher interest rate to
keep money demand in line with money supply. The more sensitive is money demand to income and output,
the more the interest rate must change to maintain money market equilibrium, and the steeper is the LM
schedule. Similarly, if money demand is not responsive to interest rates, it takes a big change in interest
rates to offset output effects on money demand, and the LM schedule is steep. Conversely, the more money
demand responds to interest rates and the less it responds to income, the flatter is the LM schedule.
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