Monetary And Fiscal Policy

under IS-LM Framework

Kishor Bhanushali
IBS - Ahmedabad
 General Equilibrium – IS-LM Framework
i
I LM

ESG
ESM
II EDG
i ESG IV
ESM
EDM

EDG
EDM
III IS

O Y
Y
Region Goods Market Money Market
Disequilibrium Output Disequilibrium Output
I ESG Falls ESM Falls
II EDG Rises ESM Falls
III EDG Rises EDM Rises
IV ESG Falls EDM Rises
 IS-LM Framework- Monetary Policy
i
LM  Increase in real money supply
 Shift in LM curve
LM’  Portfolio dis equilibrium
 Buying of financial assets – and
declining yields
 Fall in interest rate (i2)
 Increase in investments
i0 E  Increase in consumption
 Increase in aggregate demand
i1 E’  Increase in income (Y1)
 Increase in interest rate from initial
i2 E1 high level
 New equilibrium
IS

Y
0
Y0 Y1
 IS-LM Framework- Fiscal Policy
i  Increase in government spending
LM  Increase in aggregate demand (IS’)
 Increase in income (Y1)
i1  Money market dis equilibrium
E’ (EDM)
i0  Increase in demand for money
E E”  Increase in interest rate
 Decrease in investment
 Decrease in aggregate demand from
IS’ initial high level
IS  Decrease in income (Y0’)

Y
O
Y0 Yo’ Y1
 IS-LM Framework- Crowding Out
i
 Increase in government
LM spending crowds out
investment spending
LM’  Crowding out occurs when
expansionary fiscal policy
causes interest rates to rise,
thereby reducing private
E” spending, particularly private
i0 investment
 Crowing out can be reduced by
i1 E E’ following a policy of
increasing money supply along
with increased government
E1
spending
IS’

IS Y
0
Y0 Y” Y1
 The Keynesian Approach to Demand for Money

 According to classical view, transaction demand is the only motive for

holding money. Money is demanded only for spending
 According to Keynes , money is demanded for transaction,
precautionary and speculative motive
 Transaction demand for money depends on (1) level of income
(frequency with which income is received (3) frequency with which
expenditures are made
 Precautionary demand for money depends on (1) level of income (2)
availability of overdraft facilities (3) uncertainty of receipts and
payments
 Speculative demand for money depends on (1) price of securities (2)
earning possibilities (3) interest rates
 Other Factors for Demand for Money
 The wealth of the community
 The ease and certainty of securing credit
 Expectations of future income recepits
 Expectations of prices
 The nature and variety of substitute assets
 The system of payments in the community
 Aggregate Demand Curve
i LM

LM’
 Aggregate demand
E LM = M/P0 curve shows the
LM’ = M/P1
E’
combinations of the
price level and the
level of output at
IS which the goods and
money markets are
0 Y
Y Y’ simultaneously in
equilibrium
P

AD

0 Y’ Y
Y
 Aggregate Demand Curve – Fiscal Policy
i LM

E’
I1
E
I0 -Initial equilibrium E
IS’
-Increase in government
IS
spending
-Shift in IS curve
Y
0 Y0 Y’ -At given price there is
high income and high
interest rate at new
equilibrium point E’
P E’ -Shift in AD curve
E

AD’
AD

0 Y0 Y’ Y
 Aggregate Demand Curve – Monetary Policy
i LM

LM’

I0 E -Increase in
E’
I1 nominal stock of
money
IS
-Shift in LM curve
Y
0 Y0 Y’ -Increase in real
income Y
-Shift in AD curve
P1 K
P P0 E’
E

AD’
AD

0 Y0 Y’ Y
 Aggregate Supply Curve
 In the short run, the interaction between aggregate demand and
aggregate supply determines the level of output, employment and
capacity utilization as well as the price level (the source of
inflation)
 In the long run a decade or more say, aggregate supply is
considered as the major factor behind economic development as
well being of a nation.
 Aggregate Supply in the Short Run
 Production take place in the business sector on the basis of expected
price of its output
 Costs are incurred in anticipation of sales.
 If the actual prices are higher than expected price, firms will
experience a higher level of profit and this will encourage an increase
in production
 This implies that short run supply curve slopes upward from left to
right for part of its range because at any point in time there us a limit
on the output of goods and services
 This limit increase with increased production, the availability of ideal
resources and this limit is reached when the production reaches full
employment level of output
 When the resources available are fully employed the short run
aggregate curve will become vertical.
 At this point, further increase in price level will have no effect on
output
 Aggregate Supply in the Long Run
 In the long run , if all other things remain the same, the higher
price level will come to be accurately expected by firms,
narrowing down the difference between expected and actual
price levels.
 In the long run cost incurred by the firms rise as economic
agents react to higher prices
 As soon as cost increases in line with final prices, the incentives
to produce higher level of output disappear and production
reverts to its original level
 Factors responsible for changes in aggregate
demand

 A change in income
 Rate of interest
 Government policy
 A change in exchange rate
 Change in the expected rate of inflation
 Change in business expectations
 Factors responsible for changes in aggregate
Supply

 Change in costs of production

 Supply shocks or supply disturbances
 Investment spending and technological changes
 Availability of raw materials
 Supply of labour
 Human capital
 incentives
 The Classical Aggregate Supply Model
Classical aggregate supply model is based on number of
relationships
- Production function
- Demand for labour function
- Supply of labour function
 Production Function
 Production function is technological relationship between
the rates of inputs of productive resources and the
maximum rate of output that can be had from this inputs,
given the technology of prodcution
 Given the nation’s land, natural resources, and technology,
the economy’s output is a function of the economy’s
capital stock and the amount of labour employed
 Y = f (K, N)
 Output is positively related to the capital stock of the
economy and the amount of labour employed
 Diminishing returns with regard to factors of production so
than increase in employment with capital stock constant,
increases the output but at a diminishing rate
 Production Function
Output

 With increase
Y2
Y = f (N)
in the level of
Y1 employment ,
Yo
the level of
output
increases but
at a
diminishing
rate

0 No N1 N2 Employment
 The Demand for Labour Function
 Under a condition of perfect competition, a profit
maximizing firm hires workers until the average wages
is equal to the general price level multiplied by the
marginal product of labour
 W = P * MPL
 So long as the cost of hiring additional workers is less
than the revenue gained, firm will demand additional
workers.
 As firm hires additional workers, the marginal product
of labour declines
 W/P (Real wage) = MPL (Marginal product of labour)

 The Demand for Labour Function
 Demand for labour function is a
W/P
relationship between real wage and
the amount of labour demanded
Real
Wages  The amount of labour demanded is
inversely related with real wages
(W/P)0 A
 Marginal product of labour curve is
derived from the production function,
it shifts with shift in production
B
(W/P)1 function

O N0 N1 Employment
 The Supply of Labour Function
 Supply of labour depends on real wages (W/P)
 The amount of labour supplied is assumed to be positively related to
real wages so that increase in real wages results in increase in the
amount of labour supplied.

Ns = f (W/P)

(W/P)1

(W/P)0

O Employment
N0 N1
 W/P

O N

Employment

Output

O
N
Employment

Aggregate Supply Curve

Price Level

O Output
Y
 The Keynesian Aggregate Supply Model

 Unrealistic assumptions of classical – wage price flexibility –

voluntary unemployment
 Perfect efficient wage-price flexibility is far from reality world
 Wage rates changes slowly
 Keynesian aggregate supply curve is based on the assumption
that wages does not change much
 Unemployment is real situation and not full employment
 Unemployment in Keynesian model is caused by demand
deficiency
 Keynesian theory of unemployment suggest that government
can play active role in the economy by adjusting the level of
aggregate demand through fiscal and monetary instruments
Price Level AS Curve

P4’
AD
P4
AD

P3

P2 AD
AD

AD AD

Output - Y
O Y Y1 Y2 Y3 Y4
 The Keynesian Aggregate Supply Model

 The important contribution of the Keynesian aggregate

supply model is that different prices, including money
wages adjust at different speeds implying a much broder
range of supply response.
 If you are interested in what happens to the economy
following a change in aggregate demand, it is essential to
know where the economy is in equilibrium on different
segments of the aggregate supply curve