Monetary And Fiscal Policy

Monetary And Fiscal Policy under IS-LM Framework Kishor Bhanushali IBS - Ahmedabad

General Equilibrium – IS-LM Framework i

I

LM

ESG ESM II

i

EDG ESM

ESG EDM

IV

EDG EDM III O

IS 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

 

LM’    

E

i0 i1

 

E’

 

i2

E1 IS

0



Increase in real money supply Shift in LM curve Portfolio dis equilibrium Buying of financial assets – and declining yields Fall in interest rate (i2) Increase in investments Increase in consumption Increase in aggregate demand Increase in income (Y1) Increase in interest rate from initial high level New equilibrium

Y Y0 Y1

IS-LM Framework- Fiscal Policy i LM

  

i1 i0



E’ E



E”

  

IS’ IS O



Increase in government spending Increase in aggregate demand (IS’) Increase in income (Y1) Money market dis equilibrium (EDM) Increase in demand for money Increase in interest rate Decrease in investment Decrease in aggregate demand from initial high level Decrease in income (Y0’)

Y Y0 Yo’ Y1

IS-LM Framework- Crowding Out i



LM LM’



E” i0 

i1

E’

E E1

IS’

IS 0

Y0

Y”

Y1

Y

Increase in government spending crowds out investment spending Crowding out occurs when expansionary fiscal policy causes interest rates to rise, thereby reducing private spending, particularly private investment Crowing out can be reduced by following a policy of increasing money supply along with increased government spending

The Keynesian Approach to Demand for Money 

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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 LM

i

LM’ LM = M/P0 LM’ = M/P1

E E’

IS 0

Y

Y

Y’

P

AD 0

Y

Y’

Y



Aggregate demand curve shows the combinations of the price level and the level of output at which the goods and money markets are simultaneously in equilibrium

Aggregate Demand Curve – Fiscal Policy LM

i E’

I1 E I0

IS’ IS 0

Y

Y0 Y’

E’

P

E AD’ AD 0

Y0 Y’

Y

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

Aggregate Demand Curve – Monetary Policy LM

i

LM’ I0

E E’

I1 IS 0

P1 P

P0

Y

Y0 Y’

K E’ E AD’ AD

0

Y0 Y’

Y

-Increase in nominal stock of money -Shift in LM curve -Increase in real income Y -Shift in AD curve

Aggregate Supply Curve 

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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 

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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 

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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 

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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

 Y2 Y = f (N) Y1 Yo

0

No

N1

N2

Employment

With increase in the level of employment , the level of output increases but at a diminishing rate

The Demand for Labour Function 

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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  W/P Real Wages



(W/P)0

A

B

(W/P)1

O



N0

N1

Demand for labour function is a relationship between real wage and the amount of labour demanded The amount of labour demanded is inversely related with real wages Marginal product of labour curve is derived from the production function, it shifts with shift in production function

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

N0

N1

Employment

W/P

O

N Employment

Output

O

N Employment Aggregate Supply Curve

Price Level

O

Y

Output

The Keynesian Aggregate Supply Model 

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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

AS Curve

Price Level P4’ AD

P4

AD P3 AD

P2 AD AD

O

Y

Y1

AD

Y2

Y3

Y4

Output - Y

The Keynesian Aggregate Supply Model 

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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