Economic Principles Ch18. Applications of the IS-LM model and debates among schools of thought
Chapter 18. Applications of the IS-LM Model and Debates Between Schools of Thought
The IS-LM model learned previously is not merely a tool for drawing graphs. How effective a given policy is depends on the “slope” of each curve, which leads to philosophical differences between economic schools of thought regarding the economy.
1. Policy Effectiveness and the Slopes of the Curves
(1) Effectiveness of Fiscal Policy (IS Shift)
- The more vertical the IS curve (investment is interest-inelastic): The effectiveness of fiscal policy is maximized.
- The more horizontal the LM curve (liquidity trap): The effectiveness of fiscal policy is maximized (because there is no crowding-out effect).
(2) Effectiveness of Monetary Policy (LM Shift)
- The more vertical the LM curve (money demand is interest-inelastic): The effectiveness of monetary policy is maximized (argued by monetarists).
- The more horizontal the IS curve (investment is highly interest-elastic): The effectiveness of monetary policy is maximized.
2. Differences in Perspectives by School of Thought
| Category | Keynesian School | Monetarist (Classical) School |
|---|---|---|
| Key Policy | Emphasizes fiscal policy | Emphasizes monetary policy (rules) |
| IS Slope | Steep (Low interest elasticity of investment) | Flat (High interest elasticity of investment) |
| LM Slope | Flat (High interest elasticity of money demand) | Steep (Money demand is a function of income) |
| Economic Foundation | Unstable (Government intervention required) | Stable (Trust in market self-regulation) |
3. Special Situation: Liquidity Trap
거시경제 IS-LM 모형 시뮬레이터
재정정책(정부지출)과 통화정책(화폐공급) 슬라이더를 조작하여 균형 국민소득(Y)과 균형 이자율(r)의 변화를 관찰하세요.
현재 균형점
A state where the interest rate is so low that the money demand curve becomes horizontal ( is horizontal).
- Phenomenon: No matter how much the money supply increases, the interest rate does not change, having no effect on the real economy.
- Solution: Keynes argued that in this situation, only fiscal policy, where the government directly spends money, is the sole solution.
4. Recalibration of the Crowding-out Effect
A phenomenon where private investment decreases due to rising interest rates during fiscal policy implementation.
- The classical school viewed the crowding-out effect as 100% occurring, thus rendering fiscal policy useless, whereas the Keynesian school counters that the income-increasing effect is larger when there is idle capacity.
5. Conclusion: Pragmatic Policy Mix
Modern economics does not follow only one side’s extreme arguments. Flexible policy selection tailored to the situation is important, such as using fiscal policy in extremely depressed economic conditions (liquidity trap) and monetary policy during moderate fluctuations.
📖 References
- [Macroeconomics] - Byung-ryul Jung: Comparison of policy effectiveness by economic school.
- [A Monetary History of the United States] - Milton Friedman: Logical foundations of monetarism.
Great job. In the next session, we will study the AD-AS Model and Supply-Side Economics, which expand the determinants of national income by taking price level fluctuations into account.
Oiyo
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