As the consequence of recession in 2008, most of the central banks in the world became more and more worried that the traditional instrument of monetary policy-controlling interest rate was insufficient to stimulate the demand (Sloman and Wride, 2012, pp. 618). The alternative of monetary policy considered was to increase the money supply, which is also known as quantitative easing. This process would be predicted to have numerous complex effects on both goods and financial markets. In order to generalize and examine the specific influences of the monetary policy on the interest rate and real output (or national income), John Hicks (1937) had developed his simple model, the IS-LM, by taking both markets into account simultaneously. The intersection of the IS and the LM curves (or IS-LM) is a general equilibrium in the goods and financial markets. According to Gregory Mankiw (2012), the IS-LM model is an excellent interpretation to analyse any changes in the level of income when the price is unchanged in the short-run. Therefore, this essay is written on purpose of illustrating and explaining deeply how the money supply is working and also points out some circumstances in which this process cannot affect the level of income based on the IS-LM framework.
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The IS-LM model is a macroeconomic tool that interprets the link between the interest rate and the real level of income in the goods and financial market (Robert Gordon, 2009). In the goods market, the IS curve is derived from the Keynesian injection and withdrawals model.
From the four-quadrant diagram 1 that at the level of income Y in the 1stquadrant, there is a specific investment I in the 2ndquadrant. As for simplicity, it is assumed that the investment I is only injection and savings S is only leakage so that the equilibrium is in position I=S. At I level of investment, the interest rate is set at r in the 3rdquadrant, and the first point on the IS curve is at level Y of income and r of interest rate. Since the interest rate decreases up to r1 in the 3rdquadrant, investment will increase to I1 and savings will rise to S1 in the 2ndquadrant. The increasing level of saving shows the higher level of income at Y1, so the second point of the IS curve is defined at Y1 national income and r1 of interest rate in the 4thquadrant. Connecting two points in the 4thquadrant, the IS curve is derived with the downward sloping.
Similarly, the LM curve in the money market is concerned with the combination of the interest rate (r) and the level of income (Y), where demand for money (L) is equal to the supply (Ms). From diagram 2, the LM curve is derived in which a rise in national income from Y to Y1 in the first quadrant will encourage people more transaction demand for money from TD to TD1 and less on speculative ones such as government bonds so the AD reduces to AD1 in the 2ndquadrant. The decreasing demand for bonds will cause their price to fall, which will then lead to an increase in the interest rate from r to r1 in the 3rdquadrant. Thus, the level of income rises, the interest rate rises as well, and the LM curve is described as an upward sloping curve in the 4thquadrant.
Taking both the IS and LM curves in the same diagram, the equilibrium of the IS-LM model is known as “r” interest rate and “Y” level of income. There is an assumption with the IS-LM model that the price is fixed, therefore, the changes in the money supply will influence the level of income. In particular, it will result in a fall of interest rate, and, eventually, the growth of national income.
Firstly, the effect of the money supply on an increase in the level of income can be explained by the transmission mechanism of asset purchase. In fact, the money supply involves an aggressive version of open-market operations, where the central bank purchases the range of assets from the commercial banks or financial institutions, such as long-term government bonds (Sloman and Wride, 2012, pp. 619). The purpose is to pump large amounts of additional money into the financial market to stimulate the demand and increase the broad money through the process of credit creation.
The increase in the money supply is, therefore, illustrated by the shift outward from Ms1 to Ms2 as well as LM1 to LM2 in diagram 3. Because of assets purchase, there is a rise of demand for bonds in the market, which shows AD1 increasing to AD2 and then the bonds’ prices are beginning to go up, making them more expensive to buy (BBC, 2013). Thus, this will depreciate interest rate from r1 to r3 in the 3rdquadrant and lead to a new equilibrium in LM2 as point “B,” where the national income is Y1 and the interest rate is r3 in the 4thquadrant. In theory, the fall in interest rate will stimulate investment and consumption because of lower returns and savings, respectively, which, thus, rises in the injection. In the Keynesian income-expenditure model, any changes in injection will reflect a national income change, too. Finally, the level of income, in this case, will be boosted from Y1 to Y3 because of increasing investment.
Afterward, it is clear from the 4thquadrant diagram that the market is not in equilibrium (LM#IS), and hence, both markets should be automatically adjusted to gain the new equilibrium of point “C“. Because of the increase in national income at Y3, people are willing to increase their consumption and broad money to pay for these. It also means that they will demand more money. However, there will be an excess of demand for money because people prefer to consume at Y3 while the liquidity preference is only available at lower level of Y1. When the demand for money is higher, it will lead to higher interest rates, too. Indeed, the excess of demand can be only eliminated by an increase in interest rate from r3 to r2, which then results in less investments as well as a fall in injection. The decrease in injection shows a reduction in the level of income from Y3 to Y2. Here, the market reaches the equilibrium as point “C” in which the interest remains “r2” and the national income is “Y2“. Consequently, the rise in the money supply will cause a fall in interest rate and an increase in the level of income.
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However, there are some arguments in which the effect of monetary policy might be determined by some factors. For example, Keynesians figure out that the monetary policy will not work effectively on the level of income. In other words, the money supply cannot increase the national income because of “animal spirit” and “liquidity trap“. The first situation is illustrated as the IS curve is vertical. This case is known as an “animal spirit” which refers to the importance of instincts, proclivities and emotions in human behaviours on future decisions, and can be measured in terms of consumer and business confidence (John Maynard Keynes, 1936). Keynesians argue that the IS curve is likely to be inelastic because the investment and savings are mainly determined by factors such as an animal spirit rather than changes of interest rate. The lack of sensitiveness of investment leads to no changes in the level of income, even when the interest rate is falling.
From diagram 4, the IS curve is extremely inelastic (or vertical). Since an expansionary monetary policy applied, the money supply increases, which also means the LM curve is shifting outward from LM1 to LM2. To eliminate this excess of money, the theory of liquidity preference says that the interest rate has to fall, and hence, interest rate decreases from r1 to r2 (Begg and Vernasca, 2011). By contrast, the reduction in interest rate cannot stimulate investments as the theory in diagram 1, because investors are currently unconfident and pessimistic on the future business prospects, they are not willing to invest even a fall in interest rate. Thus, the injection and level of income cannot be affected and remained at point Y as no changes of investment. In a summary, Keynesian suggested that the human behaviours do play a vital role in the effectiveness of monetary policy. Furthermore, it is one of the elements causing liquidity trap that is an issue of the current economy after the recession in 2008.
In fact, the central bank had decreased interest rates from 5% in 2008 to 0.5% in 2009, and remained at that level to date. However, the economic growth was still in a recession, and the unemployment was growing because the confidence of both businesses and consumers was severely depressed in 2011 (BBC, 2014). Furthermore, the second circumstance is believed as the extreme effect of monetary policy (Economics Help, 2009). It shows that when the market operates in the case of a liquidity trap, the monetary policy cannot affect the level of income because it is ineffective in changing the interest rate. Generally, a “liquidity trap” is a situation in which people are likely to hoard cash rather than non-liquidity assets since they feel afraid of an adverse event, such as deflation, insufficient aggregate demand, or war that are expected in the future.
A common characteristic of a liquidity trap is defined as the interest rate being close to zero or even zero percent (0%), and people are unwilling to forego the benefits of holding cash by investing in bonds (Krugman Paul, 2008). According to Krugman Paul (2008), when the monetary policy is carried out through the open market of asset purchase, there will be an injection of broad money into the private bank system since the commercial banks are selling bonds in order to get “new” money (BBC, 2013). However, the process of the money supply fails to decrease the interest rate which main purpose is to stimulate investment and consumption since the interest rate is at its lowest in the liquidity trap. Moreover, bonds will pay little or no interest at this period, meaning that bonds are nearly equivalent to cash. When people may not gain higher returns from bonds, they do not want to purchase bonds, therefore, any attempt by an expansionary monetary policy to encourage people to hold non-liquidity assets in the form of consumption will not be useful. Overall, the interest rate is unchanged so that it is unable to increase in investment, injection and, the level of income finally (Economics Help, 2012).
From diagram 5, at the close-to-zero interest rate, the demand for money will become extremely elastic, meaning that the left part of the LM curve must be flat. Then, it is assumed that the market is working in a liquidity trap case so the equilibrium A lies on the horizontal line of the LM curve with the very low interest rate r and level of income Y (Paul Krugman, 1998). The monetary policy is implemented so that the vertical part of the LM curve shifts from LM1 to LM2. However, the IS are working in the horizontal part of LM, which shows that people feel either pessimistic or unconfident to spend at very low interest rate. Then, there is no movement along the IS curve following the change in the LM curve as well as in the money supply. The interest rate and national income are finally unchanged at r and Y.
There are some empirical experiences of how the monetary policy was implemented in a period of a liquidity trap. In the case of the UK economy, the interest rate was cut to 0.5% in March 2009, as mentioned above. Helped by quantitative easing, there was a weak recovery in 2010. According to Michael Joyce (2011), the first round of quantitative easing by £200bn from the central bank had helped to raise the annual economic growth between 1.5% and 2%. Conversely, the rate of UK economic growth was generally falling in 2011 and 2012, which is a good example of a liquidity trap period. In particular, it revealed that there was slow growth in 2012, and business and consumer confidence declined rapidly since firms and consumers were highly indebted and they decided to cut spending to pay down debt. Moreover, as they are expected an increase in interest rate, the price of government bonds fell, and hence, investors were willing to keep cash savings rather than bonds. Therefore, even though the bank of England had injected £275bn into the economy until 2012, there was still a majority of Monetary Policy Commitment (MPC) voting for £50bn more quantitative easing in order to boost the demand (BBC, 2012). Although Keynesians supported fiscal policy as government spending is essential for a liquidity trap, the monetary policy was stated as an important role to save the economy from a credit-led depression (BBC, 2013).
In conclusion, based on the IS-LM framework, the expansionary monetary policy, particularly in quantitative easing, has been described regarding its effect on increasing the level of income. On the other hand, the effectiveness of the policy depends on the slope of the IS and LM curves, as well as how much the money supply increases. For example, the flatter the IS curve, the steeper the LM, and when quantitative easing is bigger, the growth of the national income will be larger (Sloman and Wride, 2012). Additionally, there are two circumstances in which the monetary policy is failing to affect the level of income. Keynesians argued that since the “animal spirit” and “liquidity trap” were derived in the UK economy after the Great depression in 2008, the monetary policy of quantitative easing is ineffective. Once there, Paul Krugman (1998) had viewed the argument against the quantitative easing based on Japan’s experience in the 1990s: “no matter how much the monetary base increase, as long as expectations are not affected it will simply be swap of one zero- interest asset for another, with no real effects.” This argument implied that the central bank is unable to affect the broad monetary aggregate while the expectations still did not change.