9. Sensitivity of the Results to the Interest Elasticity of the Demand for Money
It is well known that the properties of the IS/LM model depend on the interest elasticity of the demand for money. If the demand for money is highly elastic, the LM curve is very flat, and if the demand for money is highly inelastic, the LM curve is very steep. Given this, it is of interest to see how sensitive the properties of a model like the US model are to the elasticity of the demand for money.

There are two key demand for money equations in the model, equation 9 explaining MH and equation 17 explaining MF. MH is the level of demand deposits and currency holdings of the household sector, and MF is the same for the firm sector. The interest rate in both equations is RS, the three month Treasury bill rate.

We have seen in Chapter 5, Experiment 5.1, how the economy responds to a decrease in COG when the money supply is held constant. We now examine the question of how the results change when the demand for money is less elastic than is estimated in the model. We will make the coefficient of RS in equation 9 smaller in absolute value and then rerun Experiment 5.1 for this version of the model.

Experiment 9.1: Experiment 5.1 with a less Interest Elastic Demand for Money

  • Change the fourth coefficient in equation 9 to be one half its size in absolute value. Solve the model for the forecast period. Call this dataset BASEA. Take BASEA as your base dataset, and change COG by -20 in each quarter of the forecast period. Take M1 to be exogenous. Solve the model for the forecast period. Call this dataset NEWA. Answer the following questions by comparing NEWA to BASEA.
  1. Note that a new base dataset had to be created because a coefficient was changed. The predictions of the new version of the model are not the same as the predictions in BASE, and so a new base dataset had to be created. It is not of interest to compare the predicted values in BASEA with the values in BASE. They differ, but only because a coefficient estimate has been arbitrarily changed. Make sure you understand what is going on here.
  2. Compare these results to those of Experiment 5.1. Explain carefully the differences. Do these differences square your knowledge of the IS-LM model?

There are many other experiments of this type that you can perform. You can change the interest rate coefficient in the other main demand for money equation, equation 17. You can change the coefficients on the transactions variables in the two demand for money equations. You can also run different experiments once you have your new version of the model. Be sure each time you change a coefficient that you get a new base dataset (like BASEA above).