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Well I'm reading a book on the IS-LM model. At the end of the chapter, page 125 in my edition, the author presents one paper showing some graphs where the monetary policy (monetary contraction - increasing 1% of the federal funds rate) influencing output, but with its greatest impact only being felt after 4 quarters, and continues well into the 8th quarter. At the same time, when the impact of the monetary policy is the greatest, is when the price level also begins to noticeably change.

According to the author, since in the IS-LM model we've assumed that the price level is given, the fact that the price level only begins changes at 4th quarter, is a good support for our assumption.

Well, my question then is, why should we study the monetary policy as if it had the same time to impact as fiscal policy in the short-run, when the graphs support more the medium-run impact? Or is it a matter of magnitude of the policy at hand?(The Central Bank can move the interest rate with a lot more leeway than just a 1%)

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It is one point in time, when the effects of a policy can be measured. It may be an earlier, point in time when these effects start their workings.
Assume that monetary policy does affect output, and prices take some time to respond. Assume that we observe that output and prices appear to respond at the same point in time. But hey, if prices change, why after all, output responds?

In normal times with not much productive factors lying idle, expanding output means new investments. This takes time, to actually complete these investments and make them productive. Decisions on investments are made "now", but actual final production increase appears "later". In the first stage one should expect an increase of output only in those sectors whose services are required to build machinery etc, and it is only in the second stage that we will see final output increase. This can account for why "monetary policy's greatest impact is only felt after 4 quarters".

This of course makes actual empirical macroeconomic models much more complicated than what we see in textbooks. The "size" of the policy also matters of course. But the message is there: price sluggishness may make monetary policy effective on output.

In my opinion, at the textbook level, segmenting time in a more accurate way would not be fruitful for educational purposes -it would create a more complicated picture which, although truer to the real world, it would weaken the lesson of "what to look for" -when eventually one will be confronted with the latter.

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  • $\begingroup$ Alecos, but wouldn't fiscal policy also encounter similar obstacles that would slow the appearance of its impact? Also, do you know of some model that studies this in more detail? $\endgroup$
    – An old man in the sea.
    Sep 7, 2015 at 22:05
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    $\begingroup$ @Anoldmaninthesea. It depends on how it is conducted. For example if we apply fiscal policy by increasing demand of the public sector, this could be satisfied immediately by running down inventories. $\endgroup$
    – Alecos Papadopoulos
    Sep 7, 2015 at 23:18
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In an IS-LM model, expansionary monetary policy increases output and decreases the interest rate. Expansionary fiscal policy increases output and increases the interest rate, so the two types of policies are not equivalent.

Furthermore, monetary policy does not work in the long-run. See an AS-AD model for more details on that. The only reason monetary policy actually works, is because of the fixed prices and their slowly changing (increase) in the medium run. Otherwise inflation would rise immediately in response thereby making monetary policy not have any effect on real GDP.

To really get to the medium run you have to understand the short run first. Effects observed in the actual economy often are not as quick as in our models and take time. I wouldn't consider 4-8 quarters the medium run.

Hope this helps.

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  • $\begingroup$ I've reread my text and changed it a bit. I didn't mean to say fiscal and monetary policies were equal. What I meant was that we study in the book as if both type of policies took the same time to impact. If monetary only happens at medium run, then there seems no point to study it as if it had a considerable impact in the short-run $\endgroup$
    – An old man in the sea.
    Aug 28, 2015 at 16:34

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