unit 2 economy in the short run is-lm framework · 1.7 self assessment questions 1.8 suggested...

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Unit – 2

Economy in the Short Run – IS-LM Framework

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LESSON 1

EQUILIBRIUM DETERMINATION AND MULTIPLIER

1. STRUCTURE

1.1 Objective

1.2 Introduction

1.3 Equilibrium in Two and Three Sector Economy

1.4 Concept of Multiplier

1.5 Automatic Stabilizers

1.6 Summary

1.7 Self Assessment Questions

1.8 Suggested Readings

1.1 OBJECTIVE

After reading this lesson, you should be able to

a) Explain different types of Economy – Open and Closed

b) Understand the concept of Equilibrium using AD-AS and S-I Approach

c) Differentiate between different types of multipliers.

d) Analyze Automatic Stabilizers

e) Explain and analyze the changes in Equilibrium

1.2 INTRODUCTION

Economics has two diverse fields – Micro and Macro. While Micro is concerned with analysis of

a particular unit, macro economics is concerned with the aggregate or the total. In macro

economics, the economies can be classified as Open and closed economy, a closed economy is

one where there is no interaction with the external economies having no export and import. An

open economy on the other hand is one where the economies are interlinked because of export

and import of goods and services. Further there can be two sector, three sector or four sector

economies. In two sector there are Households and Firms. In three sector along with the above

two there is also Government. Four sector comprises of external sector too along with export and

import in addition to above three sectors.

Household: A sector that makes the expenditure for own consumption. The entire expenditure by

this sector can be clubbed under the consumption function which is explained as follows:

C = Ĉ + cY (Linear Consumption function)

Where Ĉ = Autonomous Consumption that is the level of consumption which is fixed

irrespective of the level of income. It is there even at zero level of income. This is the

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consumption that households derive out of past savings. It thus determines the intercept of

consumption function.

c = Slope of consumption function which shows change in consumption because of change in

income. It is shown by MPC (marginal propensity to consume) = ∆C/∆Y. In a linear

consumption function MPC is constant that is the slope is same everywhere on the consumption

curve. In non linear consumption function however the marginal propensity to consume

decreases with increase in income. For simplicity we assume that the consumption function is

linear with constant MPC.

Y = Real Income or total output of the economy.

Linear consumption function can be plotted as:

Figure 1: Linear Consumption Curve

Here consumption function is a straight line starting from an intercept shown by Ĉ showing the

level of consumption which is there even at zero level of income which is being supported by

past savings. The slope is given by MPC (Marginal Propensity to consume).

Firm: This is the second component of macroeconomics. It shows all expenditure done by the

private enterprises that spend so that goods or services can be manufactured and sold further. For

simplicity it is assumed that it is constant or fixed. This assumption would be relaxed in the next

chapter when we discuss the concept of IS-LM curves. It is shown by

I = Ȋ that is autonomous investment or fixed investment

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Figure 2: Investment Curve

Investment by private enterprises is fixed irrespective of the level of income or rate of interest in

the economy. This assumption would however be relaxed later in the IS-LM model.

Government: This is the third component in macroeconomics. Government has mainly three

functions – imposition of tax, granting of subsidy, and government expenditure also called

government purchases.

External Sector: The last component of open economy that includes export and import of goods

and services.

1.3 EQUILIBRIUM IN TWO SECTOR AND THREE SECTOR ECONOMY

Equilibrium is a state of rest where there is no tendency to change. An economy is said to be in

equilibrium when the total output (real disposable income) is equal to the total or aggregate

demand as shown by:

Y = AD where AD = C + I (in 2 sector economy) and C + I + G (in 3 sector economy).

If Y ≠ AD there is disequilibrium and it leads to unplanned inventory which is calculated as:

IU = Y – AD

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If Y > AD, there is accumulation of inventory as total output being produced is more than the

total demand in the economy leading to increase in the unplanned stock and IU > 0 whereas

If Y < AD, there is depletion of inventory as total output being produced in the economy is less

than the total demand and hence the excess demand is met out of the stock that reduces the

existing stock and IU < 0.

Equilibrium in Two Sector Economy

A two sector economy is one where there is presence of households and private firms and there

is neither government nor the external sector. It can also be called a closed economy as there is

no interaction with the outside world in the form of exports and imports. A two sector economy

would be in equilibrium when the total output is equal to aggregate demand by the households

and firms as shown below:

Y = AD, Y = C + I, Y = Ĉ + cY + Ȋ, Y = Ᾱ + cY

Where Ᾱ = Ĉ + Ȋ its autonomous spending

Y – cY = Ᾱ, Y(1-c) = Ᾱ, Y = Ᾱ/(1-c). Thus the equilibrium condition is

Y = Ᾱ / (1-c)

Equilibrium is thus dependent on autonomous spending and marginal propensity to consume. If

any or both of them changes there is change in the equilibrium level of output.

Equilibrium can also be attained using an alternative approach as shown below:

Y = C + S (As households can either consume the income or save it). Thus total income is spent

on either the consumption or saving.

S = Y – C, S = Y – (Ĉ + cY), S = – Ĉ + (1- c) Y,

In equilibrium Y = AD (C +I). So from above two equations we get

C + S = C + I, S = I.

Here savings are the leakages from the economy and investment is the injection in the economy.

Thus according to this approach equilibrium is where leakages and injections are equal.

Both the above equilibriums can be presented in the following figure:

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Figure 3: Equilibrium in 2 sector economy

Equilibrium in two sector economy can be achieved by using two approaches that is Y = AD

approach also called Keynesian cross or Savings and Investment approach which is derived from

the above approach only. In the figure above there is a 45 degree guideline that shows that any

point on this guideline is the equilibrium as the values on X axis ans Y axis are equidistant on the

guideline. Thus equilibrium would always be on this line. Then there is consumption function

that is shown by C which is the linear consumption function with slope ‘c’ and AD is the

aggregate demand curve that is parallel to C. The point where guideline and consumption

function intersect is the break even point where savings are zero and Y = C. It is shown by point

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B at Y1 level of income. Equilibrium is where guideline and AD intersect which is at point E in

the Keynesian cross and E* in the panel below and equilibrium level of output is Y2.

Equilibrium in Three Sector Economy

A three sector economy is one where there is presence of government in addition to the

households and firms. Households spend on consumption, Firms spend on Investment and

Government performs three functions – Government expenditure called government purchases

which is assumed to be autonomous, collect taxes (it can be fixed or proportionate tax) and

provides transfer payments which is also assumed to be constant. The equilibrium thus can be

attained in two ways:

When there are Fixed Taxes

Equilibrium condition is

Y = AD,

Now here aggregate demand comprises of consumption which is dependent on disposable

income and not only income as was in two sector income as income and disposable income are

different because of presence of taxes and transfer payments in case of three sector economy

whereas in two sector economy the disposable income and income were one and the same.

Y = C + I + G, Y = Ĉ + cYd + Ȋ + Ḡ, Y = Ĉ + c(Y – TA + TR) + Ȋ + Ḡ

Where TA and TR are assumed to be constant in addition to Investment and government

Y = Ᾱ + cY, Y = Ᾱ /1-c (Equilibrium Condition)

Figure 4: Equilibrium in 3 sector using Fixed Taxes

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When there are proportionate taxes

Y = AD, Y = C + I + G, Y = Ĉ + cYd + Ȋ + Ḡ, Y = Ĉ + c(Y – tY + TR) + Ȋ + Ḡ

Where TR is assumed to be constant in addition to Investment and government purchases and tax

rate is fixed as a proportion of Y.

Y = Ᾱ + c (1-t)Y, Y = Ᾱ /1-c(1-t) (Equilibrium Condition)

Figure 5: Equilibrium in 3 sector using Proportionate Taxes

Both the cases above consider Yd as compared to Y used in two sector economy. Yd is the

disposable income that is the income available in the income after deduction of taxes and

addition of transfer payments. In fixed tax the slope of aggregate demand function is given by

MPC (c) which is same as that of two sector economy as impact of taxes and transfer payments

is considered in autonomous spending. On the other hand slope of aggregate demand function

with proportionate taxes is c (1-t). Thus aggregate demand curve becomes flatter as slope of AD

reduces. The difference between the two equilibrium outputs would be shown under automatic

stabilizers.

1.4 CONCEPT OF MULTIPLIER

The change in equilibrium level of output because of change in autonomous spending by 1 Re is

known as multiplier. As shown above the equilibrium output in a two sector economy is given by

the following equation:

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Y = Ᾱ / (1-c) where Ᾱ = Autonomous spending that includes fixed consumption by the

households and autonomous investment by private firms.

c = Marginal Propensity to consume (MPC).

From the above equation the value of multiplier can be obtained as:

∆Y = ∆Ᾱ / (1-c), ∆Y = 1 / (1-c). ∆Ᾱ

Thus the change in equilibrium level of output is more than the change in autonomous spending

because of presence of multiplier shown by the 1 / (1-c).

Example 1: Let Autonomous spending increases by Re 1 and MPC is 0.8 then value of

multiplier would be: 1 / (1-0.8) = 5 times that is change in equilibrium level of output is more

than change in autonomous spending.

The value of multiplier depends on the value of ‘c’ and as ‘c’ varies from 0 to 1 so the value of

multiplier also varies from 1 to infinity as shown below:

Example 2: Calculate value of multiplier in the following cases: a) MPC = 0 b) MPC = 1, c)

MPC = 0.2 d) MPC = 0.8

Solution: a) 1 / (1-0) = 1 times so no multiplier effect. ∆Y = ∆Ᾱ

b) 1 / (1-1) = Infinity

c) 1 / (1-0.2) = 1.25 times ∆Y > ∆Ᾱ

d) 1 / (1-0.8) = 5 times, ∆Y > ∆Ᾱ

Thus it shows that multiplier has a direct relation with MPC, the greater is MPC the higher is the

value of multiplier.

Graphical derivation of Multiplier

Figure 6: Multiplier in Two Sector Economy

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The figure above shows original Aggregate demand curve with an intercept equal to autonomous

spending and slope equal to MPC. Equilibrium is where the AD intersects the guideline shown

by Y1 level of output. If there is an increase in autonomous spending by ∆Ᾱ, the aggregate

demand curve shifts parallel up by the same amount as slope is still the same (c). The new

equilibrium is at Y2 level of output. The increase in output from Y1 to Y2 is the change in

equilibrium level of output shown by the horizontal and vertical arrows whereas the distance

between the two aggregate demand curves is ∆Ᾱ. Thus graphically also it shows that ∆Y > ∆Ᾱ

because of multiplier.

To show the impact of MPC on multiplier we can take the following two cases that show that as

MPC increases multiplier also increases:

Figure 7 (a): Multiplier and Marginal Propensity to Consume

Figure 7 (b): Multiplier and Marginal Propensity to Consume

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Figure in panel (a) shows aggregate demand curve corresponding to a MPC of ‘c’ which is less

than MPC (c’) exhibited by panel (b). Thus the slope of aggregate demand curve of panel (a) is

less than that of panel (b). The intercept in both the cases is shown by autonomous spending an

increase with initial equilibrium at Y1 level of output in panel (a) and Y1’ in panel (b). With an

increase in autonomous spending by ∆Ᾱ in both the cases the equilibrium is at Y2 in panel (a)

and Y2’ in panel (b). the change in output is greater in case of higher MPC shoeing that there is a

direct relation between MPC and multiplier which is because of the fact that aggregate demand

curve is steeper in the second case as compared to the first one.

Multiplier in case of Three Sector Economy

Figure 8: Multiplier in Three Sector Economy

The figure above shows original Aggregate demand curve in case of three sector economy with

proportionate tax with an intercept equal to autonomous spending and slope equal to c(1-t).

Equilibrium is where the AD intersects the guideline shown by Y1 level of output. If there is an

increase in autonomous spending by ∆Ᾱ, the aggregate demand curve shifts parallel up by the

same amount as slope is still the same c(1-t). The new equilibrium is at Y2 level of output. The

increase in output from Y1 to Y2 is the change in equilibrium level of output shown by the

horizontal and vertical arrows whereas the distance between the two aggregate demand curves is

∆Ᾱ. Thus graphically also it shows that ∆Y > ∆Ᾱ because of multiplier.

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The above discussion thus shows that the economy moves to a new level of equilibrium output

when there is change in the autonomous spending, the quantum of change depends on the

marginal propensity to consume and also on the taxation system being applicable in the economy

(fixed or proportionate tax). However ever economy tries not to deviate too much from the initial

equilibrium and there are certain forces imbibed in the economy itself that prevents a drastic

change which are known as the automatic stabilizers. It is being taken up in the next heading:

1.5 CONCEPT OF AUTOMATIC STABILIZER

Automatic stabilizers offset fluctuations in economic activity without direct intervention by

policymakers. When incomes are high, tax liabilities rise and eligibility for government benefits

falls, without any change in the tax code or other legislation. Conversely, when incomes slip, tax

liabilities drop and more families become eligible for government transfer programs, such as

food stamps and unemployment insurance that help buttress their income.

Two examples of Automatic stabilizers are:

Proportionate Tax – The presence of proportionate tax reduces the multiplier effect thereby

bringing a lesser diversion in the equilibrium income as compared to fixed tax. This is because in

case of proportionate taxes whatever is the change in income because of change in the

autonomous spending a part of it goes to the government in form of taxation and hence

disposable income is less as compared to fixed taxes. This can be illustrated using the following

example and figure:

Example 3: If MPC is 0.8 and tax rate is 0.5 in case of proportionate tax. The effect of automatic

stabilizer can be shown as:

Slope of AD in case of fixed Tax = c = 0.8

Slope of AD in case of Proportionate Tax = c (1-t) = 0.8 (1-0.5) = 0.4

Thus AD is flatter in case of proportionate tax as compared to fixed tax and change in

equilibrium using above data can be shown as:

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Figure 9 (a): Change in Equilibrium Output in case of Proportionate Tax

Figure 9 (b): Change in Equilibrium Output in case of Fixed Tax

Thus in case of Fixed Tax the change in equilibrium level of output is greater as multiplier effect

is more as can be shown mathematically too:

Multiplier Effect in case of Fixed Tax: 1/1-c = 1/1-0.8 = 5 times

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Multiplier Effect in case of Proportionate Tax: 1/1-c (1-t) = 1/1-0.8(1-0.5) =1.67 times

Thus it is visible that multiplier effect weakens in case of proportionate tax because of reduction

in disposable income as with every increase in income a part of it goes towards payment of taxes

and hence less is available with the households for consumption as compared to fixed tax where

tax is fixed irrespective of the level of income and hence disposable income is greater that

provides greater change in the output.

Unemployment Benefits – The change in equilibrium output reduces if government provides

unemployment benefits to the households thus acting as a stabilizing agent.

Impact of Fiscal Policy on the Equilibrium Level of Output

Fiscal policy refers to change in the government policy with respect to change in government

expenditure or taxation policy. There are two types of Fiscal policy – Expansionary fiscal policy

where there is either increase in Government purchases or decrease in taxes and contractionary

fiscal policy where the government reduces the government purchases or increases the tax. The

former brings and upward shift in the aggregate demand curve causing a change in the

equilibrium level of output as shown below:

Figure 10: Effect of Fiscal policy on Equilibrium

The figure above shows that original equilibrium is at Y1 level of output where AD is

intersecting the guideline. With an increase in government purchases there is an increase in

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autonomous spending as government purchases is a part of autonomous spending. This shifts the

AD curve parallel up and new equilibrium is at Y2. The change in equilibrium level of output

from Y1 to Y2 is because of fiscal policy. This change is more than change in government

purchases because of presence of government multiplier.

1.6 SUMMARY

Micro Economics and macro economics are two parts that are studied in Economics. While

micro economics deals with an individual unit – its equilibrium determination, pricing decisions

and policies. Macro economics is wider in sense as it covers all the components of an economy.

The equilibrium condition in both the economics is broadly the same that is where demand and

supply are equal and there is neither excess demand nor excess supply. In macro we just change

the demand to aggregate demand and supply to total output or total income. Macro Economics

can be a two sector economy comprising of only households that spend on consumption

expenditure and private firms that go for investment expenditure, a three sector economy having

Government in addition to the above two sectors that spends on purchases, collect taxes and

provides subsidies and a four sector economy that is also called open economy as it includes the

external sector too in addition to above three, it makes expenditure on imports and earns though

exports. Equilibrium condition is where total output produced in an economy is exactly equal to

the total demand by the different sectors and in case the two are not equal there are changes in

the unplanned inventory and automatic forces that bring the economy back to equilibrium.

Further once equilibrium is attained it may change over a period of time if any component of

autonomous spending changes but the change in equilibrium level of output is more than the

change in autonomous spending and this is because of the presence of multiplier which is

dependent on marginal propensity to consume and/or proportionate taxes. This change in the

equilibrium level of output should not be very large as that can be destabilizing for the economy

so there are some automatic stabilizers in the economy that prevents the economy from moving

too far off from the initial equilibrium. There are two main stabilizers that is proportionate tax

and unemployment benefits that help in reducing the gap between original and new equilibrium

level of output.

1.7 SELF ASSESSMENT QUESTIONS

Check your progress

Exercise 1: True and False

(a) Macro Economics is narrower as compared to Micro Economics

(b) Both micro and macro economics attain equilibrium when demand and supply are equal.

(c) A two sector Economy is also called open economy.

(d) Taxes in a three sector economy are always assumed to be autonomous.

(e) Multiplier shows the change in equilibrium level of output because of change in autonomous

spending.

(f) Equilibrium level of output depends on the slope of Aggregate demand curve

Ans. 1(F), 2(T), 3(F), 4(F), 5(T), 6(T)

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Exercise 2: Fill in the Blanks

(a) A three sector economy has three components namely _ _ _ _ _ _ _ _ _ .

(b) If MPC is 1 then value of multiplier is _ _ _ _ _ _ _ _ _ .

(c) The two automatic stabilizers are _ _ _ _ _ _ _ _ _ .and _ _ _ _ _ _ _ _ _.

(d) An open economy is one where there is _ _ _ _ _ _ _ in addition to households, firms and

government purchases.

Ans 1. Households, Firms and Government 2. Infinity 3. Proportional Tax and Unemployment

Benefits 4. External Sector.

Exercise 3: Questions

1. Explain the equilibrium in case of two sector Economy.

_ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _

_ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _

2. Why the change in equilibrium level of output is greater than change in autonomous

spending.

_ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _

_ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _

3. How is equilibrium attained in case of three sector economy with proportionate tax.

_ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _

_ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _

4. Explain the concept of automatic stabilizers by giving suitable example.

_ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _

_ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _

5. Explain how fixed taxes bring more change in equilibrium as compared to proportionate

tax.

_ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _

_ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _

6. Explain the concept of multiplier in a two sector economy.

_ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _

_ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _

7. What is the effect of expansionary fiscal policy on the equilibrium level of output.

_ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _

_ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _

8. What is the role of government in a three sector economy.

_ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _

1.8 SUGGESTED READINGS

Mankiw, N. Gregory, Macro Economics, Macmillan Worth Publishers New York, Hampshire

U.K..

Dornbusch, Rudiger and Stanley, Fischer, Macro Economics Theory, McGraw-Hill

Barro Robert J., Macroeconomics Theory and Applications, MIT Press.

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LESSON 2

IS-LM DETERMINATION

2. STRUCTURE

2.1 Objective

2.2 Introduction

2.3 Derivation of IS curve

2.4 Derivation of LM curve

2.5 Numerical on IS-LM

2.6 Summary



2.1 OBJECTIVE


a) Explain derivation of equilibrium in goods and money market

b) Understand the concept of simultaneous equilibrium

c) Differentiate between fiscal and monetary policy multipliers.

d) Analyze Aggregate Demand curve.

e) Explain and analyze the changes in Aggregate Demand curve

2.2 INTRODUCTION

The previous chapter discussed about how equilibrium is obtained in a two sector and three

sector economy and what is the change in output because of change in the autonomous spending.

This chapter would discuss about how the goods market and money market are in equilibrium

and how both achieve the simultaneous equilibrium. For explaining the equilibrium in Goods

market IS curve would be derived where I stands fro investment and S stands for saving.

Equilibrium in Money market would be explained through LM curve (L stands for demand of

real money and M stands for supply of real money). IS-LM analysis was introduced by Prof.

Hicks in 1937 to explain the short run phenomenon. It would further explain the relationship

between price level and equilibrium level of output through the aggregate demand curve and

changes in the aggregate demand curve because of fiscal or monetary policy multiplier. The

fiscal policy explains the change in the government expenditure or taxation policy to bring a

change in the equilibrium level of output whereas monetary policy shows change in the money

supply to bring a change in the level of income. There are certain assumptions on which the

whole IS-LM model is based like constant price level, firms willing to supply any amount of

quantity at the given price and the short run aggregate supply curve is flat.

2.3 DERIVATION OF IS CURVE

IS and LM curve analysis is applicable in the short run where the price level is assumed to be

constant.

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IS curve shows different combinations of real interest rates and equilibrium level of output where

goods market is in equilibrium. Derivation of IS curve can be established through the following

two steps:

Derivation of Investment Function: Investment is the total expenditure done by the private firms.

It is an important component of aggregate demand function. Earlier investment was assumed to

be autonomous but now it would be explained as follows:

I = Ȋ + ar

Where Ȋ = Autonomous investment which is not related to rate of interest

a = Sensitivity of Investment to real rate of interest

r = Real rate of interest

There is inverse relation between rate of interest and level of investment as if rate of interest

increases there is decrease in investment because it is expensive for the firms to borrow and

invest whereas a lower interest rate increases the amount of borrowing and investment by the

firms. But how sensitive is the investment to rate of interest depends on ‘a’ which shows the

sensitivity of investment to interest.

Investment function can be shown graphically as:

Figure 1: Investment Function

Panel (a) shows a steeper investment curve which shows a lesser value of ‘a’ that is investment is

not that sensitive to rate of interest showing that when rate of interest reduces investment

expands but by a smaller quantum whereas in panel (b) the curve is flatter because of greater ‘a’

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and higher sensitivity of investment to rate of interest showing that reduction in rate of interest

increases the investment by a greater amount.

After getting the investment function the equilibrium in goods market can be attained as follows:

Equilibrium is when the economy which is a three sector economy and in the short run has its

output and aggregate demand in equilibrium

Y = AD, Y = C + I + G, Y = Ĉ + cYd + Ȋ - ar + G,

Y = Ĉ + c(Y – tY + TR) + Ȋ - ar + G,

Y = A + (1-t) Y – ar, Y = A-ar/1- c (1-t) (Equilibrium condition)

Thus here the equilibrium is the same as in case of three sector economy with proportionate tax

with an addition of ‘ar’. The IS can be derived graphically as:

Figure 2: IS Curve

IS curve is derived from the Keynesian cross in figure above in the upper part. When interest rate

is r1 the investment is I1 where the corresponding aggregate demand curve is AD and equilibrium

level of output is Y1. If rate of interest reduces investment increases and there is a parallel

upward shift in the AD curve with a new equilibrium level of output Y2. Thus there is an inverse

relation between real rate of interest and equilibrium level of output as shown in the figure

above. It is because when rate of interest reduces, investment increases and it being a part of AD

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the aggregate demand increases. In the equilibrium Y should be equal to AD and when AD

increases Y also has to increase to retain the equilibrium, thus bringing an inverse relation

between rate of interest and equilibrium level of output. Now moving to derivation of slope and

position of IS curve.

Modifying above equation we get:

Y = A-ar/1- c (1-t), r = A/a – Y/mga where mg = 1/1- c (1-t),

Thus slope of the IS curve is -1/ mga and position of IS curve depends on autonomous spending

that is A. The negative sign in the slope shows that IS curve is downward sloping. The slope in

turn depends on government multiplier ‘mg’ which in turn depends on MPC (c) and sensitivity of

investment to rate of interest ‘a’. The slope of IS can be shown as follows:

Let us elaborate taking two different MPC c1 = 0.2 and c2 = 0.8. Assuming proportionate tax to

be 0.5 we calculate government multiplier. In the first case mg1 would be 1/1-0.2(1-0.5) = 1.11

and in the second case it is mg2 = 1/1-0.8(1-0.5) = 1.67. Thus it shows that higher the MPC

higher is the government multiplier and lower would be the slope and flatter would be the IS. It

can be shown graphically as:

Figure 3: Slope of IS Curve

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Above figure shows how different Marginal Propensity to Consume have different impact on the

slope of the IS curve. the slope of aggregate demand curve in a two sector economy is given by

MPC only but in three sector economy with proportionate tax the slope changes to MPC(1-tax

rate). Taking this further we would show how there can be different slope of IS because of

different government multiplier which in turn depends on MPC. Initially the aggregate demand

curve is AD having an intercept of A-ar1 and as MPC is 0.2 which is lesser than MPC of 0.8 so

this AD is flatter. It gives equilibrium of Y1. Now if interest rate reduces the AD curve shifts

parallel up and provides a new equilibrium at Y2 level of income. Joining the two combinations

we get the IS curve corresponding to c1 level of marginal propensity to consume. Now similarly

if we draw IS curve corresponding to a higher level of MPC (0.8) we get a flatter IS’ curve

whose slope is lesser than the previous IS because of the government multiplier being large and

hence slope being less.

Similarly the component that affects the intercept or position of the IS curve is given by

autonomous spending (A) In case of three sector economy Autonomous spending comprises of

autonomous consumption, autonomous investment by private firms, fixed government purchases

and a part of fixed transfer payments. If any of these components of ‘A’ changes there is a shift

in the IS curve as can be shown below:

Figure 4: Position of IS Curve

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The above panel shows Keynesian cross that shows equilibrium using a 45 degree guideline and

derivation of equilibrium. Initially at ‘r’ rate of interest and ‘A’ autonomous spending

equilibrium output is Y1. This shows one combination of IS curve where IS passes through ‘r’

and ‘Y1’. Now if autonomous spending increases to A’ there is a parallel upward shift in the AD

curve as slope is still the same. The new equilibrium is at Y2 level of output. Thus there is a

parallel shift in the IS curve to the right showing the change in the position or the intercept of the

IS. The figure above shows that it is the change in the autonomous spending that affects the

intercept/position of the IS curve. Thus fiscal policy by government would bring a shift in the IS

if there is change in autonomous government purchases and if tax rate changes then there would

be change in the slope of IS as change in proportionate tax rate would change the slope of

aggregate demand curve in the Keynesian cross thereby changing the equilibrium level of output.

2.4 DERIVATION OF LM CURVE

LM curve shows different combinations of real interest rates and equilibrium level of output

where money market is in equilibrium. Derivation of LM curve can be established through the

following two steps:

Derivation of Money Demand: Demand for money is demand for transactionary purposes that is

demand for real balances. It is the money that people hold and does not provide any return.

Demand for money can be shown using the following equation:

L = kY – hr

Where L = demand for real money, Y = national income, r = real interest rate, k = sensitivity of

demand to real income and h = sensitivity of money demand to real interest rate of interest.

Demand for money can be plotted as:

Figure 5: Demand of Money

If there is a change in the real rate of interest then there is a movement up or down on the

demand curve whereas with a change in the income the curve shifts to right or left.

23

Equilibrium in Money Market: Money market is in equilibrium when money demand is equal to

money supply. It can be shown as:

kY – hr = M/P

Where M = Nominal money supply which is fixed by the central bank and P = Price level in the

economy. For derivation of LM we assume that central bank keeps the nominal money supply

fixed and P the price level is also fixed as IS-LM is a short run phenomenon where price level is

constant. LM thus can be derived as:

Figure 6: Derivation of LM Curve

LM curve shows equilibrium in the money market and hence it shows the combinations of

different real interest rates and income. Initially the demand curve is shown by kYI-hr1 where

money demand and supply are equal and rate of interest is r1 and corresponding equilibrium

output is Y1. If rate of interest reduces to r2 then money supply being fixed there is excess

demand of money that leads to disequilibrium and restore the equilibrium level of output has to

be reduced which shifts the demand curve of money to left as income reduces and new

equilibrium is at reduced rate of interest and reduced level of income. Both the combinations are

shown in the right hand side diagram. Joining the two combinations we get the upward sloping

LM curve which shows direct relation between rate of interest and equilibrium level of output.

Now to derive the slope and position of LM, the above equilibrium equation can be modified as:

r = 1/h (kY-M/P)

24

Slope of LM is thus k/h that is dependent on sensitivity of demand to real income and rate of

interest and position is dependent on the money supply. The changes in slope and position can be

interpreted as:

Slope of LM curve:

1) If ‘k’ is more the slope is more and LM is steeper

2) If ‘k’ is less the slope is less and LM is flatter

3) If ‘h’ is more the slope is less and LM is flatter

4) If ‘h’ is less the slope is more and LM is steeper

Position of LM curve:

The position of LM curve depends on the nominal money supply keeping price level constant.

This is because if money supply changes there is a change in the equilibrium and shift in the LM.

It can be explained with the diagram below:

Figure 7: Position of LM Curve

Initially the equilibrium is at r1 rate of interest corresponding to a demand curve of money and

real money supply (M as nominal supply and P the price level). The corresponding LM curve is

shown in the right panel. Now if central bank increases the nominal money supply to M1 the new

equilibrium rate of interest reduces to r2 at the same level of equilibrium output. Thus the LM

curve shifts parallel to right to LM1. The shift in LM is thus because of change in the money

supply. If money supply increases LM shifts parallel to right and if money supply reduces then

LM shifts parallel to left.

25

Simultaneous Equilibrium

Simultaneous equilibrium is where both the goods market and money market are in equilibrium.

Any point on the IS curve shows that Goods market is in equilibrium and any point on LM

represents equilibrium in money market. The simultaneous equilibrium is shown in figure below:

Figure 8: Simultaneous Equilibrium

Impact of fiscal Policy on the simultaneous equilibrium

Fiscal policy means change in government expenditure and/or taxes to bring changes in the

equilibrium level of output. If government follows an expansionary fiscal policy and increases

the government expenditure then the autonomous spending would increase and it would bring an

upward parallel shift in the AD curve that would increase the equilibrium level of output at the

same rate of interest. Thus new goods market equilibrium would be at same rate of interest and

higher level of output that would bring a rightward shift in the IS and hence increased level of

output and at that point money market would be in disequilibrium so to bring it to equilibrium

rate of interest would finally increase because of decrease in price level because of increase in

income. It can be shown below:

26

Figure 9: Impact of Fiscal Policy on Equilibrium

Similarly an expansionary monetary policy would increase the money supply and shift LM curve

to right that too would increase the equilibrium level of output and reduce real rate of interest.

Thereby bringing a new simultaneous equilibrium.

2.5 NUMERICAL ON IS-LM

Question 1. Find out IS and LM equation in the following three sector economy

C = 100 + 0.8 Yd

I = 1000 – 5i

G = 80

T = 0.25 Y

L = 0.8Y-0.2i

M = 200

P = 2

27

Solution: Equilibrium in goods market is when Y = AD

Y = C + I + G

Y = 100 + 0.8 (Y-0.25Y) + 1000-5i + 80, 1180 + 0.8*0.75Y-5i , 1180 + 0.6Y-5i

0.4Y = 1180 – 5i, Y = 2950 – 12.5i IS equation

Equilibrium in Money Market is where Money demand = Money supply

0.8Y-0.2i = 200/2, 0.8Y = 100 + 0.2i, Y = 125 – 0.25i LM equation

Question 2 C = 100 + 0.9 Yd, I = 600 – 30r, G = 300, T = 1/3Y, Md = 0.4Y – 50r

M = 1040, P = 2

Full Employment level of equilibrium is 2500.

a) Derive IS and LM equations and compute equilibrium.

b) Explain change in slope and position of IS and LM if MPC changes to 0.6.

Solution: a) Equation of IS curve is Y = AD

Y = 100 + 0.9(Y-1/3Y) + 600 – 30r + 300, Y = 1000 + 0.6Y – 30r, 0.4Y = 1000-30r

Y = 2500 – 75r

Equation of LM curve is Md = Ms

0.4Y – 50r = 1040/2, Y = 1300 + 125r

Solving above IS and LM curve we get the following

2500 – 75r = 1300 + 125r, Y = 2050, r = 6%

b) Impact of MPC is only on the slope of IS curve as it is a part of slope of IS curve

Old Slope = 1/mga = 1/[1/1-0.9(1-1/3)].30 = 0.0133

New Slope = 1/mga = 1/[1/1-0.6(1-1/3)].30 = 0.02

Thus the slope of IS has increased when MPC changes to 0.6

Question 3 (Practice question) C = 100 + 0.8Yd, I = 150 – 6i, G = 100, T = 0.25Y

Md = 0.2Y – 2i, Ms = 300, P = 2

Calculate equilibrium level of output and rate of interest. Also if government spending are raised

from 100 to 150 find the shift in the IS curve.

28

2.6 SUMMARY

The previous chapter talked about how equilibrium is attained in case of two sector and three

sector economy using the concept of Keynesian cross. This chapter talked about attainment of

equilibrium in Goods market and Money market using the concept of IS and LM curves. Where

IS curve gave different combinations of real rate of interest and equilibrium output where goods

market is in equilibrium, the LM curve provided different combinations of the same where

money market achieves its equilibrium. Both IS and LM curves are based on certain assumptions

through which they get their downward or upward sloping slopes and once these assumptions are

relaxed there is a change in the slope and/or position of the two curves. For an economy to be in

total equilibrium both goods and money market should be in equilibrium such that simultaneous

equilibrium is when IS and LM intersects. There can be changes in this simultaneous equilibrium

once achieved by a change in the fiscal or monetary policy as simultaneous equilibrium is based

on IS and LM and if either of them changes there is anew equilibrium. A change in the fiscal

policy brings a new IS curve and a change in the monetary policy changes the LM curve thus

changing the final equilibrium of the economy. While doing IS-LM we assumed that price level

is constant as it is a short run phenomenon but price level usually changes in the long run.

Further IS-LM analysis will be used to derive relation between Price level and equilibrium level

of output known as aggregate demand curve and it would be taken up in the next chapter. As

discussed in the chapter that an increase the government purchases brings a parallel shift in the

IS curve, government increases the purchases to bring an increase in the equilibrium level of

output but while doing so government does not take into consideration the simultaneous increase

in the real rate of interest which in turn reduces the private investment leading to crowding out

and it would be studied in detail in the next chapter.


Check your progress


(a) IS curve shows equilibrium in money market.

(b) LM curve shows different combinations of rate of interest and equilibrium level of output

where money market is in equilibrium.

(c) A two sector economy does not differentiate between Gross income and Disposable income.

(d) Fiscal policy refers to change in government expenditure or change in taxes.

(e) Multiplier shows the change in equilibrium level of output because of change in autonomous

spending.

(f) Aggregate demand curve shows relation between price level and equilibrium level of output.

(g) Proportionate Tax is zero when income is zero.

(h) If the expenditure of the government is more than the revenue of the government it is called

surplus budget.

Ans. 1(F), 2(T), 3(T), 4(T), 5(T), 6(T), 7(T), 8(F)

29


(a) Government has three roles to perform in an economy _ _ _ _ _ _ _ _ _ .

(b) If MPC is 0 then value of multiplier is _ _ _ _ _ _ _ _ _.

(c) The slope of IS curve depends on _ _ _ _ _ _ _ and_ _ _ _ _ _ _ _ .

(d) Slope of LM is _ _ _ _ _ _ _ related to ‘k’ that is sensitivity of demand of money to real

income.

(e) Fiscal Policy means changes in _ _ _ _ _ _ . or _ _ _ _ _ _ .

(f) The shift in the IS curve because of change in government spending can be measured by _ _ .

(g) Monetary policy includes changes in _ _ _ _ _ _ _. in the short run.

(h) The relation between Price level and equilibrium level of output is shown by _ _ _ _ _ _ _ _ .

Ans 1. Government Purchases, Tax collection and Transfer Payment 2. Unity

3. Government Multiplier and Sensitivity of Investment to rate of interest. 4. Directly. 5.

Government Purchases or taxes. 6. Government Multiplier. 7. Money Supply 8. Aggregate

Demand Curve


1 Explain the equilibrium in case of three sector Economy.

_ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _

_ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _

2. Explain the derivation of IS curve and how is its slope and position derived

_ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _

_ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _

3. How is equilibrium attained in case of three sector economy with proportionate tax.

_ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _

_ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _

4. Explain the concept of shift in IS and LM curves.

_ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _

_ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _

5. Explain how the Aggregate demand curve is derived

_ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _

_ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _

6. What is the reason for inverse relation between real rate of interest and equilibrium

level of output in case of IS curve.

_ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _

_ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _

7. What is the effect of increase in nominal money supply on the LM curve in the

money market

_ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _

_ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _

8. What is the role of price level in case of money market equilibrium.

_ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _

30

_ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _



U.K..


Barro Robert J., Macroeconomics Theory and Applications, MIT Press

31

LESSON 3

CROWDING OUT AND DIFFERENT CASES OF LM

3. STRUCTURE

3.1 Objective

3.2 Introduction

3.3 Derivation of Aggregate Demand Curve

3.4 Derivation of Fiscal and Monetary Policy Multiplier

3.5 Crowding Out

3.6 Summary



3.1 OBJECTIVE


a) Explain derivation of Aggregate Demand Curve

b) Understand the concept of crowding out

c) Differentiate between fiscal and monetary policy multipliers.

d) Analyze shift in Aggregate Demand curve

e) Difference between different types of multipliers

3.2 INTRODUCTION

The previous chapter talked about equilibrium in macro economy that comprises of two sector,

three sector economy with presence of fixed and proportionate tax. It also showed how change in

the autonomous spending brings a change in the equilibrium level of output. The present chapter

goes ahead and talks about the derivation of aggregate demand curve that is basically a long run

phenomenon as it shows relation between price level and equilibrium level of output. The shift in

the aggregate demand curve can be because of shift in either the IS or the LM curve and the

change in the equilibrium level of output and this is shown by the fiscal and monetary policy

multipliers respectively which would be studied in this chapter. Another important topic of

discussion is the crowding out effect that shows how because of increase in the government

spending the rate of interest increases and leads to decrease in the private investment that reduces

the desired effect expected by government. This too would be shown using concept of multiplier

in the present chapter.

3.3 DERIVATION OF AGGREGATE DEMAND CURVE

The concept of IS-LM curve as given by Hicks was based on Short run whereby prices were

assumed to be constant. But here in aggregate demand curve the relation is shown between price

level and equilibrium level of output as it’s a long run phenomenon. The AD curve is derived

from simultaneous equilibrium that is IS-LM curve intersections. It is being shown in figure

below:

32

Figure 1: Derivation of AD curve

Upper panel shows simultaneous equilibrium derived from IS-LM curve. As every LM is

corresponding to a price level. So the initial price level is P where equilibrium output is Y1 and

equilibrium rate of interest is r1. This gives a combination for the AD curve drawn in the panel

below. Now if price level reduces to P1 then real money supply increases assuming nominal

money supply to be constant which shifts the LM curve parallel to right providing a new

equilibrium at r2 and Y2 level of income. This provides second combination for the AD curve

which shows that at reduced price level equilibrium level of national income increases showing

33

inverse relation between price level and equilibrium level of output and thereby providing a

downward sloping AD curve.

3.4 MONETARY AND FISCAL MULTIPLIER

In previous two chapters we discussed about the concept of multiplier that shows change in the

equilibrium level of output because of change in autonomous spending. This can be applied in

case of two sector, three sector economies. The multiplier in three sector economy with

proportionate tax shows what is the desired change in the equilibrium level of output if

government increases its purchases assuming that it has no impact on the interest rates. However

it shows a shift in the IS curve and hence at the new equilibrium only goods market is in

equilibrium. But this is not the equilibrium of the economy as money market is in disequilibrium.

So in this entire process there is increase in the interest rates that crowds out the private

investment and hence actual change in te equilibrium is less than the desired change. While

desired change is shown by the government multiplier, the actual change is shown by fiscal

multiplier. It can be presented diagrammatically as:

34

Figure 2: Fiscal Multiplier and its impact on the AD curve

Panel above shows that initially the Goods equilibrium is shown by IS curve and money market

equilibrium is shown by LM curve which is corresponding to a particular price level that is P*

where simultaneous equilibrium level of output is Y1 and real rate of interest is r1. The panel

below shows that corresponding to Price level P* and Y1 level of output there is an aggregate

demand curve AD. Now if government increases its purchases and expects that the output would

increase to Y2 at the same rate of interest but here the goods market is in equilibrium as this is a

point on the IS curve but money market is not in equilibrium as the point is not on the LM curve.

The new simultaneous equilibrium where both money market and goods market is in equilibrium

is at r2 rate of interest and Y3 level of output which is less than what is expected by the

government. This change from Y1 to Y3 is the fiscal multiplier. It is shown by a parallel

rightward shift in the aggregate demand curve showing that at the same price level because of

increase in government purchases the equilibrium level of output also increases though not in the

same quantum as was expected. The opposite would hold if there is decrease in the government

purchases as aggregate demand curve would shift parallel to left.

Similarly we can show the concept of money multiplier which shows the change in equilibrium

level of output when there is increase in the nominal money supply keeping the price level

constant. When there is increase in the nominal money supply the LM curve shifts to the right as

with increase in money supply there is a reduction in the rate of interest that increases the money

demand to bring the money market to equilibrium again. It can be shown using the following

diagram

Figure 3: Monetary Multiplier and its impact on the AD curve

35

The two panels above show how an increase in the nominal money supply shifts the LM curve to

the right in the above panel that brings a reduction in the real rate of interest and increase in the

equilibrium level of output. This increase in the equilibrium level of output is shown by the

monetary policy multiplier which shows how much is the change in the equilibrium level of

output if nominal money supply changes keeping constant the price level and other factors

impacting the simultaneous equilibrium. An increase in nominal money supply brings a

rightward parallel shift in the aggregate demand curve as shown by the panel below. The reverse

would happen with reduction in the price level.

The concept of Fiscal and Monetary policy multiplier can also be shown mathematically as

follows:

Goods Market is in equilibrium when total output produced is equal to the aggregate demand of

the economy

IS equilibrium Equation is:

Y = Ĉ + cYd + Ȋ - ar + G,

Y = Ĉ + c(Y – tY + TR) + Ȋ - ar + G,

Y = A + (1-t) Y – ar, Y = A-ar/1- c (1-t), Y = mg ( A – ar) ………….(1)

LM equilibrium Equation is:

r = 1/h [ KY – M/P] ………….(2)

Substituting value of interest rate in equation (1) we get

Y = mg [A – a/h (KY – M/P)], Y = mg [ A – aKY/h + Ma/Ph]

Y = mgA – mgaKY/h + mgMa/Ph, Y = mgAhP/Ph – mgaKYP/Ph + mgMa/Ph

YPh = mgAhP – mgaKYP + mgMa

YPh + mgaKYP = mgAhP + mgMa, Y (Ph + mgaKP) = mgAhP + mgMa

Y = mgAhP/ (Ph + mgaKP) + mgMa/(Ph + mgaKP)

Y = mgAh/ (h + mgaK) + mgaM/P(h + mgaK)

Substituting α = hmg/h+Kamg we get

Y = αA + [αa/h] [M/P]

Here Fiscal multiplier shows change in equilibrium level of output because of change in

autonomous spending that includes government expenditure and other components but we

assume that the major component here is government purchases and thus fiscal multiplier shows

the impact of changed government expenditure on equilibrium level of output. Thus ‘α’ shows

how much is the change or shift in the equilibrium when there is a change in government

purchases. Similarly change in the equilibrium level of output because of change in the money

supply is shown by Monetary policy Multiplier that shows by how much there is change in the

equilibrium level of output if nominal money supply changes keeping the price level constant.

Graphically it is shown by a shift in the LM curve as the slope has not changed and only the

36

position is being changed because of the change in the nominal money supply. Thus the two

multipliers that shows the impact of two government policies namely fiscal and monetary policy

are the monetary and fiscal multiplier.

3.5 CROWDING OUT

Gross Domestic Product or national income shows how much production is taking place in any

economy. If the government expects that the production is less than what it should be then it goes

for expansionary fiscal policy where it increases the government purchases assuming that there

would not be any change in the other variables (also the interest rate) and the output would

increase by government multiplier multiplied by change in the government expenditure.

However this is not true as with an increase in the government purchases the aggregate demand

in an economy increases and money supply being constant the real rate of interest increases

because of which the private investment is bound to decrease as there is inverse relation between

rate of interest and private investment. Thus the change in output is less than what is expected by

the government. However whether there can be increase in output or not depends on whether the

economy is operating at full employment that is output is already at potential output and no

further increase in output is possible. Another case can be when the current output is less than the

full employment level and with government policy it is possible to bring an increase in the actual

output. The last case can be when government does not want any crowding out or decrease in

private investment and there by increases the government expenditure by printing of currency

and increasing the money supply simultaneously. All the three cases are shown using the

following diagrams:

Figure 4 (a) Crowding Out – Full Employment

Here IS is the original goods market curve and LM is the original Money market curve where the

simultaneous equilibrium is at the intersection of the two. Now if it is already at the full

37

employment Y* then with an increase in the government spending the IS curve shifts to the right

but because of the full employment output there is a corresponding increase in the rate of interest

that shifts the LM curve to the left. Thus there is hundred percent crowding out of private

investment as there is no actual change in the output.

Figure 4 (b) Crowding Out – Less than Full Employment

In case output is less than the full employment then an increase in the government spending

brings a simultaneous rightward parallel shift in the IS curve. Though government intended that

output would increase from Y1 to Y2 but in this process the real rate of interest increased and the

actual change in output is from Y1 to Y3. The reduction in private investment from Y2 to Y3

because of increase in the real rate of interest is known as partial crowding out.

Figure 4 (c) Crowding Out – Monetary Accommodation of Fiscal Expansion

38

The third case also known as monetizing fiscal deficits means printing of currency by the

government to finance its increased government expenditure. Thus there is rightward shift in the

IS as well as LM curve and no corresponding increase in the real rate of interest thus the

intended change in output and the actual change in output are equal with no crowding out.

3.6 SUMMARY

The previous chapter discussed about how goods market and money market are simultaneously

in equilibrium which is shown using the concept of Aggregate Demand curve which shows

inverse relation between price level and equilibrium level of output. The chapter further

discussed how changes in fiscal and monetary policy have an impact the real rate of interest in

the economy and hence the simultaneous equilibrium. There are three situations of crowding out

with it ranging from zero percent crowding out to full crowding out depending on the level of

output where the economy is operating that is at full employment, less than full employment.

There is also an extreme situation where government finances its spending by printing of

currency known as monetary accommodation of fiscal expansion.


Check your progress


(a) AD curve is a short run phenomenon.

(b) Crowding Out happens because of Monetary Policy.

(c) A two sector economy does not differentiate between Gross income and Disposable income.

(d) Fiscal policy refers to change in government expenditure or change in taxes.

(e) Monetizing Fiscal deficit is another name of Monetary Accommodation of Fiscal Expansion

(f) Aggregate demand curve shows relation between price level and equilibrium level of output.

(g) There is no crowding out when output is at full employment level.

(h) Fiscal multiplier shows change in simultaneous equilibrium because of change in government

expenditure.

Ans. 1(F), 2(F), 3(T), 4(T), 5(T), 6(T), 7(F), 8(T)


(a) IS-LM is a _ _ _ _ _ _ _ _ _run phenomenon.

(b) Aggregate Demand shows relation between _ _ _ _ _ _ _ _ _ and _ _ _ _ _ _ _ .

(c) AD shows _ _ _ _ _ _ _ equilibrium.

39

(d) Crowding out shows _ _ _ _ _ _ _ in private investment.

(e) Monetary Policy means changes in _ _ _ _ _ _ .

(f) Monetary Accommodation of Fiscal Expansion means _ _ _ _ _ _ _ of currency to __ _ _ _ _

_ _ Government expenditure.

Ans 1. Short 2. Price Level and Equilibrium Level of Output 3. Simultaneous. 4. Decrease. 5.

Nominal Money Supply. 6 Printing of currency, finance.


1.Explain the derivation of simultaneous equilibrium.

_ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _

_ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _

2. What is Crowding Out.

_ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _

_ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _

3. Explain derivation of Aggregate Demand Curve.

_ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _

_ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _

4. How do monetary and Fiscal multipliers have an impact on the simultaneous

equilibrium.

_ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _

_ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _

5. What happens when there is full employment in the economy and government

increases its purchases.

_ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _

_ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _

6. Derive monetary and Fiscal multiplier mathematically.

_ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _

_ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _

7.What happens when government increases its money supply to fund its additional

expenditure.

_ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _

_ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _



U.K..


Barro Robert J., Macroeconomics Theory and Applications, MIT Press

unit 2 economy in the short run is-lm framework · 1.7 self assessment questions 1.8 suggested...

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