Unit I-V

UNIT II
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.
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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)
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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.
24
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:
25
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
26
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.
27
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)
28
(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.
__________________________________________
__________________________________________
29
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.

__________________________________________
_______________________________________________

U.K..
Barro Robert J., Macroeconomics Theory and Applications, MIT Press
30
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:
31
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
32
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:
Figure 2: Fiscal Multiplier and its impact on the AD curve

33
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
34
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
35
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
36
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
37
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.
38
(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
39
UNIT III
INFLATION AND UNEMPLOYMENT
41
LESSON 1
INFLATION AND UNEMPLOYMENT
1. STRUCTURE
1.1 Objective
1.2 Introduction
1.3 Inflation and Interest Rates- Fisher Equation
1.4 Social Cost of Inflation
1.5 Concept of Unemployment
1.6 Summary
1.1 OBJECTIVE

a) Explain the concept of Inflation and Unemployment
b) Understand the different costs associated with Inflation
c) Differentiate between different types of Unemployment.
d) Analyze strategies to reduce inflation
e) Explain and analyze the wait unemployment
1.2 INTRODUCTION
A situation that affects all the economies of the world is the changes in the price level which can
be either increase or decrease in prices. The former one where there is persistent and
considerable increase in the prices is known as inflation. It affects the standard of living of the
people of an economy as it reduces there real income or the purchasing power. Some percentage
of inflation is bound to exist in an economy that is expanding or growing. Its opposite is known
as Deflation which means a reduction in the price level in an economy. One should not be
confused between deflation and Disinflation as the latter one means there is inflation in the
economy but its rate has reduced. Various economists have tried to analyse the relation between
inflation and interest rates and one equation which is of utmost importance is given by Fisher
that would be taken up in the chapter. Another feature that is common in all the economies of the
world is the problem of unemployment. It refers to a situation where people who are able and
willing to work are unable to find a job at the prevailing wage rates. Again some percentage of
unemployment is bound to be present in all the economies because of people changing jobs and
other reasons. But still if unemployment is huge and chronic it is devastating for any economy.
So the various types and causes of unemployment too would be taken up in this chapter.
42
1.3 INFLATION AND INTEREST RATES- FISHER EQUATION
Fisher effect is a theory propounded by economist Irvin Fisher that explains the relation between
inflation and interest rates – both real and nominal. Nominal interest rate is the rate that prevails
in the market whereas real interest rate shows change in the purchasing power. Fisher provided
that expected real interest rate can be calculated by deducting the expected rate of inflation from
the expected nominal rate of interest. For example, if the nominal interest rate on a savings
account is 6% and the expected rate of inflation is 3%, then the money in the savings account is
really growing at 3%. The smaller the real interest rate the longer it will take for savings deposits
to grow substantially when observed from a purchasing power perspective. It can be presented in
the following equation:
re = i - πe
Where re = Expected Real interest rate
i = Nominal rate of interest and
πe = Expected rate of inflation

This equation holds in the short run as the changes in nominal rate of interest takes place because
of changes in real interest rate and expected inflation. In the long run however if the real interest
rate is assumed to be constant and expected inflation is equal to actual inflation because the
economy is operating at full employment level of output the above equation changes as:
r* = i - π
Where r* = Given real interest rate
i = Nominal rate of interest and
π = Actual rate of inflation

Thus in the long run the changes in inflation are shown in the nominal rate of interest. It is called
Fisher’s Effect. The Fisher effect is more than just an equation: It shows how the money supply
affects nominal interest rate and inflation rate
1.4 SOCIAL COST OF INFLATION
Inflation refers to persistent and considerable increase in the prices in an economy such that the
real income of the people of that economy reduces. However if there is an increase in price
which is either not significant or not continuous then it cannot be termed as inflation. Inflation
can be of various degrees depending upon its intensity like:
1. Creeping, Mild or Low Inflation: It is the mildest form of inflation where rate of increase in
prices is very low that is not more than 3% per annum then it is called creeping inflation.
43
2. Chronic or Secular Inflation: When creeping inflation continues for a long period of time it
takes the form of chronic inflation. It is named chronic because if an inflation rate continues to
grow for a longer period without any downturn, then it possibly leads to Hyperinflation.
3. Walking or Trotting Inflation: When the rate of increase in prices is more than 3% per annum
but less than 10% per annum it is termed as walking inflation. It should be corrected in time as
otherwise it may lead to serious consequences.
4. Moderate Inflation: Prof. Samuelson clubbed together concept of Creeping and Walking
inflation into Moderate Inflation. It happens when prices rise by less than 10% per annum (single
digit inflation rate). According to him, it is a stable inflation and not a serious economic problem.
5. Running Inflation: When prices rise at a fast rate that is more than 10% per annum it is termed
as running inflation as rate of increase in prices is in double digits which is not good for the
economy.
6. Galloping or Jumping Inflation: According to Prof. Samuelson, if prices rise by dual or triple
digit inflation rates like 30% or 400% or 999% yearly, then the situation can be termed as
Galloping Inflation. When prices rise by more than 20%, but less than 1000% per annum (i.e.
Between 20% to 1000% per annum), Galloping Inflation occurs. Jumping Inflation is its another
name.
7. Hyperinflation: When rate of increase in prices takes an alarming situation it is termed as
hyperinflation and it is beyond the corrective action of any government. When prices rise above
1000% per annum (quadruple or four-digit inflation rate), it is termed as Hyperinflation. During
a worst-case scenario of hyperinflation, the value of the national currency (money) of an affected
country reduces almost to zero. Paper money becomes worthless, and people start trading either
in gold and silver or sometimes even use the old barter system of commerce. Two worst
examples of hyperinflation recorded in the world history are of those experienced by Hungary in
the year 1946 and Zimbabwe during 2004-2009 under Robert Mugabe's regime.
Inflation which is a general and persistent rise in the prices over a considerable period of time
can be divided into perfectly anticipated inflation and imperfectly anticipated inflation. The types
of inflation based on the expectation or predictability:
Anticipated Inflation: If the rate of inflation corresponds to what the majority of people are either
expecting or predicting, then is called Anticipated Inflation. Expected Inflation is it’s another
name.
Unanticipated Inflation: If the rate of inflation corresponds to what the majority of people are
neither anticipating nor predicting, then is called Unanticipated Inflation. Unexpected Inflation is
it’s another name.
Costs of Perfectly Anticipated Inflation
1. Shoeleather Cost: A high anticipated inflation means a higher nominal rate of interest as
shown by the above Fisher equation which means people hold less money with them as
the opportunity cost of holding money is quite high thus making frequent visits to the
44
banks. This inconvenience of reducing money holding is called the shoe-leather cost of
inflation. This cost of wearing out of one’s shoes while making frequent trips to banks
because of reduced money holding is called the shoe leather cost of inflation.
2. Menu costs: When inflation is high then it increases the cost of production of the firms
which forces the firms to change their prices often which is costly as it involves printing
of new catalogues, packaging that has prices printed on them. This increased cost of
frequent printing of menus is known as menu cost that arises because of high anticipated
inflation.
3. Microeconomic Inefficiencies: As the firms’ menu changes frequently because of
changes in the prices the variability in relative prices is quite high and it bring difficulty
in market allocations as it is based on relative prices thus bringing inefficiency in the
resource allocations.
4. Tax Issues: Inflation affects the tax liability of individuals and companies that are not
taken care of in the tax rules. As inflation changes the nominal income there is change in
the tax liability irrespective of the fact whether real income has changed or not. Thus it
again brings inefficiency if it is not taken care of in the tax rules.
5. Inconvenience: Money is common measure of value, it is the yardstick to measure
economic transactions but when the worth of the yardstick itself is changing it brings
distortions in measuring the economic worth or value of different transactions
6. Reduced Purchasing Power: If nominal income changes at the same rate as that of the
inflation then there is no change in the real income as shown by Fisher equation in the
long run, however if inflation and nominal income do not keep pace then there might be a
reduction in the purchasing power.
7. Fiscal Drag: With rising income because of inflation more people fall in the higher tax
brackets, thus the amount of tax per person increases and they are dragged into tax
payments because of higher inflation.
If inflation is unanticipated (e.g. people expect a lower inflation rate) then the costs will be
more serious than if the inflation rate was expected. It is unanticipated inflation that can
negatively impact on a firm’s costs.
Costs of Unanticipated Inflation
Unanticipated inflation has effects that are far worse then the inflation which was correctly
anticipated in advance. Unanticipated inflation arbitrarily redistributes income and wealth among
individuals. This brings losses to one and gains to other and it is something which was not
expected in advance, it can be understood with a simple loan example where the interest rates
were fixed in advance which was based on an anticipated inflation rate. The ex post real return
that the debtor pays to the creditor differs from what both parties anticipated. Now here if
inflation is higher than what was anticipated the debtor is at a gain as he pays a lesser sum in
terms of real balances as interest rate was fixed based on a lower anticipated inflation rate and
45
creditor loses as he gets less. The opposite would be true if the actual inflation is les than the
anticipated inflation. Thus it brings wealth distribution distortions.
1.5 CONCEPT OF UNEMPLOYMENT
Unemployment is a situation where a person who is able and willing to work is unable to find a
work at the prevailing wage rate. Unemployment is considered to be a measure that reflects the
health of an economy. There are various types of unemployment that are prevalent. They have
been defined as:
1. Voluntary Unemployment: When unemployment arises out of individual’s own choice
and not because there no jobs available in the economy, it is known as voluntary
unemployment. The reason can be search of better job prospects. Here the reservation
wage rate of the worker (the minimum price that a worker desires to get) is more then the
prevailing wage rate. Such people are not included in the labour force of the economy as
they are finding the suitable work but still not willing to work.
2. Involuntary Unemployment: when a person is willing to work at the prevailing wage rate
but is still unable to find a job it is termed as involuntary unemployment. These people
are physically and mentally fit to do a job and ready to accept the prevailing wage rates
but still out of work force because of low demand of labour.
3. Frictional Unemployment: Sometimes workers leave their present job to find a better one
and for a temporary period when they are unemployed it is called frictional
unemployment. It can be a voluntary one or also a termination though the previous one is
more common. Some percentage of unemployment in the form of frictional is always
present in all the economies. Though it is short term but is usually unavoidable. Frictional
unemployment usually reduces in times of recession as the basic reason behind friction is
better job prospects but during recession as already fewer jobs are there so workers are
contend with their present jobs.
4. Cyclical Unemployment: Every economy goes through boom, recession, recovery etc.
When there is unemployment in the economy because of downturn in the business cycle
which can be measured by reduction in GDP it is called cyclical unemployment. It is
usually a long term phenomenon. It's known as “cyclical” because it’s tied to the business
cycle. It is one of the major reasons behind high unemployment in any economy.
5. Structural Unemployment: The unemployment that arises because a type of technology
becomes outdated and employees are unemployed. Structural unemployment is a
permanent level of unemployment that's caused by forces other than the business cycle. It
occurs when an underlying shift in the economy makes it difficult for some groups to find
jobs. There is a mismatch between the jobs available and the skill levels of the
unemployed. It is harder to correct than other types of unemployment.
6. Disguised unemployment: This type of unemployment is usually found in agriculture
where more people are unemployed then are actually efficiently required, though it
appears that they all are employed but the marginal productivity of many is either zero or
46
negative and hence it called disguised unemployed as on the face of it they seem to be
employed.
7. Natural Rate of Unemployment: Some unemployment is bound to be there in every
economy because of frictional unemployment or structural unemployment. This is known
as natural rate of unemployment. The Natural Rate of Unemployment is sometimes
known as the Non accelerating inflation rate of Unemployment NAIRU. This is because
when unemployment is at natural rate there is no tendency for inflation to increase.
8. Wait Unemployment: Unemployment caused when workers are rigid about wages which
are above the equilibrium wage rate. It can be explained with the following figure:
Figure 1
Here DL is the demand curve of labour which is downward sloping showing inverse relation
between wage rate and demand of labour by the firms. SL is the supply curve of labour
which here is assumed to be constant showing full employment level as per classical theory.
Now as per the equilibrium achieved by intersection of demand and supply curve of labour
the wage rate that should prevail is W1 but if the workers are rigid about wages at W* then at
increased wage rate the demand for labour would be more than the supply of labour and it
leads to wait unemployment arising because of rigid wages.
Various causes that can be associated with Wait employment are:
1. Minimum Wage Laws – Government of various countries impose a floor price on the
wages that can be paid to the workers of the economy. These wages are usually above the
equilibrium wage rate. It reduces the demand of workers thereby creating an excess
47
supply and leading to wait unemployment because of rigidity of wages. Another reason
for this type of unemployment can be presence of trade unions.
2. Trade Unions: Presence of trade unions also leads to wage rigidity and hence wait
unemployment this is because trade unions often bargain for a higher wage rate then the
equilibrium wages and it also creates excess supply and wait unemployment.
Exercise 1: What are the determinants of Unemployment.
Solution: Let E = Total workers Employed
U = Total workers unemployed
L = Total Labour force that includes both employed and unemployed
If we assume that there is steady state of employment then people who are leaving the jobs in
search of new jobs should be exactly equal to those who are finding the jobs such that:
fU = sE where
f is rate of job finding and U is unemployed workers so fU is total number of workers finding
the job out of the unemployed pool. Similarly s = rate of job separation that is people who are
leaving the job out of those who are employed
So to be in steady state they should both match each other..Thus the equation that we get is:
L=E+U
E=L-U
Also fU = sE, fU = s (L – U)
Dividing both sides by L we get
fU/L = s (L – U)/L
fU/L = s (1- U /L)
fU/L + sU/L = s, U/L (f + s) = s, U/L = s/s+f
Above equation shows relation between unemployment rate that is U/L and rate of job
separation and job finding. Following results are obtained
1. Unemployment rate is directly related to job separation that is higher the job separation or
frictional unemployment higher is the unemployment.
2. Unemployment rate is inversely related to job finding that is higher the job finding lower
is the unemployment
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1.6 SUMMARY
Two major issues that every economy faces today are that of unemployment and inflation. These
are two issues that every government wants to reduce that is to have lower unemployment and
lower inflation. However there is a trade off between the two so the government has to accept
one of the evils. Inflation means persistent and considerable increase in the prices that reduce the
purchasing power of money whereas unemployment refers to a situation where able and willing
people are unable to find a job at the existing wage rates. There are various types of
unemployment that prevail in any economy at a point of time, some of them being short term
while others are chronic or long term in nature. Some causes of unemployment can be slow
economic growth where economy is growing at a slower rate as compared to growth in the
working population leading to surplus labour force being unemployed, joint family system
provides support to the family members who are unemployed thereby reducing the urge amongst
others to work, slow growth of industries also contribute to the unemployment as industries are
unable to add enough jobs to support the growing population, less savings and investment leads
to reduction in capital formation that aggravates the problem of unemployment. Though it is
impossible to have zero level of unemployment but still it should be reduced to the bare
minimum to make efficient use of the human resource of an economy.
Check your progress

(a) Unemployment means hundred percent employment.
(b) Disguised unemployment means more people working than are actually required.
(d) There is a trade off between unemployment and inflation.
(e) Frictional unemployment is chronic unemployment.
Ans. 1(F), 2(T), 3(F), 4(T), 5(F), 6(T)
(a) Cyclical unemployment occurs because of _ _ _ _ _ _ _ _ _ .
(b) If unemployment is high inflation would be _ _ _ _ _ _ _ _ _ .
(c) Unemployment present in every economy is _ _ _ _ _ _ _ _ .
(d) Fisher effect shows relation between _ _ _ _ _ _ and _ _ _ _ _ _ .
Ans 1. Business Cycles 2. Low 3. Natural Rate of Unemployment 4. Inflation and Interest Rate
49
1. Explain the Fisher. effect both in short term and long term
__________________________________________
__________________________________________
2. What are the different types of Unemployment.

__________________________________________
__________________________________________
3. What are the main causes of Wait unemployment

__________________________________________
__________________________________________

__________________________________________
__________________________________________
5. Explain the relation between inflation and unemployment.

__________________________________________
__________________________________________
6. Explain the concept of Natural rate of Unemployment.

__________________________________________
__________________________________________
7. What is the difference between voluntary and involuntary unemployment.

__________________________________________
__________________________________________
8. How can unemployment be reduced in an economy.

__________________________________________
_______________________________________________
U.K..
50
LESSON 2
INFLATION AND UNEMPLOYMENT (PART 2)
2. STRUCTURE
2.1 Objective
2.2 Introduction
2.3 Philips Curve and Modern Philips Curve
2.4 Aggregate Supply Curve and Dynamic Aggregate Supply Curve
2.5 Neutrality of Money
2.6 Dynamic aggregate Demand Curve
2.7 Gradualism and Cold Turkey
2.8 Summary
2.1 OBJECTIVE

a) Explain the relation between unemployment and wage inflation
b) Explain the relation between price level and equilibrium level of output
c) Analyze the impact of expected inflation on output
d) Examine the relation between inflation and equilibrium level of output
e) Show the impact of monetary expansion on real money supply
2.2 INTRODUCTION
The previous chapter talked about relation between interest and inflation both in the short run
and long run using Fisher equation. It also discussed various types of unemployment present in
an economy, their causes and effects. The present chapter would focus on different types of
theories given by different economists showcasing relation between inflation, employment,
unemployment and equilibrium level of output. A.W Philips started out with explaining why
there is inverse relation between unemployment and growth rate in wages which was further
extended to explain the relation between unemployment and price inflation. Later other
economists added the concept of expected inflation to explain the relationship when the previous
one was not sufficient to explain different relationships. The chapter also discusses about why an
increase in nominal money supply has no impact on the real money balances in the long run
showing that money is neutral in the long run. Lastly the chapter would discuss two important
techniques used by government to reduce the level of expected inflation namely Gradualism and
Cold Turkey.
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2.3 PHILIPS CURVE AND MODERN PHILIPS CURVE
Philips curve was given by economist A.W. Philips to establish the relationship between level of
unemployment in an economy and growth rate in wages. Phillips analyzed annual wage inflation
and unemployment rates in the UK for the period 1860 – 1957, and then plotted them on a scatter
diagram. The data appeared to demonstrate an inverse and stable relationship between wage
inflation and unemployment. Later on it was used to explain the relation between unemployment
and general price inflation instead of wage inflation. Normally an economy desires to have low
unemployment and low inflation but this curve showed that there is a trade off that is if there
high unemployment then there would be reduction in wages and reduced wage inflation and vice
versa. Thus Philips curve helps an economist in deciding the different combination of inflation
and interest rate that it can have. It can be derived mathematically as:
Growth rate in wages: Gw = W-W-1/W-1
Also there being inverse relation between growth rate in wages and unemployment it can be
rewritten as:
Gw = -θ (u – u*) where Gw = Growth rate in wages, θ = Functional relationship between wage
inflation and unemployment, u = actual unemployment and u*= natural rate of unemployment.
Equating above two equations we get:
W-W-1/W-1 = -θ (u – u*), W = W-1 [1- θ (u – u*)]
Philips curve depicted that wages and prices adjust slowly to changes in demand in the economy
that is prices and wages are sticky in the short run. The relationship can be shown
diagrammatically as:
Figure 1: Philips Curve
52
The above curve thus shows different combinations of unemployment and wage inflation than an
economy can opt for, there being a trade off between the two.
The above relation can also be extended to show the relation between employment and growth
rate in wages. As there is inverse relation between unemployment and wage inflation there is
bound to be direct relation between wage inflation and employment which can be shown
mathematically as:
Rate of unemployment, u – u* = E* - E/E* where E* = Full employment level and
E= Actual employment , substituting value of unemployment in Philips curve equation above we
get:
W = W-1 [1- θ (E* - E/E*)], W = W-1 [1 + θ (E – E*/E*)],
Thus it shows there is direct relation between change in the wages and employment.
When the above Philips curve was applied to economies like United States and Britain it was
found that it failed to be tested empirically and hence economists thought of something that was
missing in the original Philips curve. The missing link was found out to be expected inflation.
Friedman and Phelps introduced an adjustment in Phillips curve with respect to anticipated or
expected inflation (πe) as a factor influencing the growth rate of money wage. As the modern
Phillips curve incorporates the expected inflation, therefore, when workers and firms enter into
wage negotiations while fixing the wage and price they bargain over the real wages, and both
sides are willing to adjust nominal wage for any inflation expected during the contract period.
Thus Modern Philips curve shows that actual inflation is actually effected by expected inflation
as well as unemployment level. It states that workers are not concerned about nominal wages but
real wages and want them to be constant such that any change in actual or expected inflation is
shown in the nominal inflation so that there purchasing power is constant. So modifying the
original Philips curve equation to include expected inflation we get the following equation:
Gw = -θ (u – u*) + πe as wages would grow by an equal amount as the changes in inflation so G w

= π, the above equation can be rewritten as:
π = πe - θ (u – u*) Thus the modern Philips curve in the short run can be drawn as:
53
Figure 2
The above figure shows that if actual unemployment is equal to natural rate of unemployment
then actual inflation is equal to expected inflation. M1 is drawn corresponding to an expected
inflation which is low whereas M2 is drawn with an expected inflation that is more. Thus higher
expected inflation means a greater intercept and lower expected inflation means a lower curve. a
point where there is high expected inflation and high unemployment is known as stagflation
which is shown by a point towards the right of u* and on M2 curve.
2.4 AGGREGATE SUPPLY CURVE AND DYNAMIC AGGREGATE SUPPLY

CURVE
The curve that shows the relation between price level and equilibrium level of output is known as
the aggregate supply curve. It can be derived mathematically as:
Let the production function is given by:
Q = pE where Q = Total Output, p = efficiency of labour and E = total employment
Now to establish the price we add profit margin to the unit cost and assuming that labour cost is
the major cost, we get the following:
P = (1+z)W/E where Z is the mark up cost and W is the current periods wages.
Now substituting the above in the Philips curve equation we get:
W = W-1 [1 + θ (E – E*/E*)], P = (1+z)/E W-1 [1 + θ (E – E*/E*)]
54
P = P-1 [1 + θ (E – E*/E*)], P = P-1 [1 + θ (Q – Q*/Q*)], P = [1 + α ( Q-Q* )]
This is the equation of the aggregate supply curve showing positive relation between equilibrium
level of output and current price level. It can be plotted as follows:
Figure 3
There can be three situations here; if actual output is equal to full employment level of output
then the current price would be equal to previous period’s price level. If however the output is
more than the full employment level then current price level would be more than the previous
period’s prices and there would be a movement to point B in the short run whereas in the long
run the aggregate supply curve would shift upwards. The opposite would happen if the actual
output is less than the full employment level of output. The slope of the aggregate supply curve
is dependent on the slope variable given by ‘α’. The position depends on the past periods price
level. There were certain limitations in the aggregate supply curve hence it laid way for the
modified aggregate supply curve which took into consideration the expected inflation too.
Inflation that is π can be calculated as:
π = P – P-1/P-1
So the above aggregate supply equation can be rewritten as:
π = α ( Q – Q*) This is the modified aggregate supply curve which shows relation between
inflation and output. If expected inflation is added to it then it becomes expectations augmented
aggregate supply curve or dynamic aggregate supply curve which can be written as:
π = α ( Q – Q*) + πe
55
The equation above shows that actual inflation is dependent on not only the level of output but
also on the expected inflation and there is one to one relation between the expected inflation and
actual inflation apart from the level of output. This is dynamic aggregate supply curve.
2.5 NEUTRALITY OF MONEY
Neutrality of money shows how expansion in money supply impacts the equilibrium level of
output in the short run, medium term and long term. Money supply has an impact on the output
in the short term but not in the long term it is because changes in the money supply growth will
lead to changes in the GDP growth only when there is no change in the price level and as per
Philips curve prices are sticky in the short run, thus nominal money supply change lead to real
money supply change which then stimulates the output. In the long run, however, prices adjust
and three is no impact on real money supply and real GDP. In other words, money has neutral
impact on all real macro variables. It can be shown graphically as:
Figure 4
Original aggregate demand curve is AD and aggregate supply curve is AS where original
equilibrium is at E having full employment level of equilibrium and current price is equal to past
periods prices. Now if there is an increase in money supply then aggregate demand curve shifts
to right and new equilibrium is at E’ where output becomes more than the full employment level
in the short run and price level also increases. This process cannot continue in the long as output
56
cannot be more or less than the full employment level. So in the medium term the adjustment
process would start and there would be an increase in the prices that reduces the aggregate
supply and AS curve shifts up to the left with new equilibrium at lesser output and increased
prices, this process continues in the long run till the prices have increased to such an extent that
the output comes back to Y* and there is no change in the real money supply as price level has
increased by the same proportion as the money supply thereby having the same level of real
money supply and making money neutral in the long run having no impact on the level of output.
It shows that though in the short run and medium run the money supply is not neutral it impacts
the output; in the long run money supply has no impact on real variables.
2.6 DYNAMIC AGGREGATE DEMAND CURVE
In unit 2 of IS-LM model we talked about derivation of aggregate demand curve that showed
relation between price level and equilibrium level of output such that both the goods market and
money market are in equilibrium but now here we are going to explain the derivation of dynamic
aggregate demand curve that talks about relation between inflation rate and equilibrium level of
output. It can be derived from IS-LM equations as follows:
Equilibrium in Goods market is when Y= AD which can be further elaborated as:
Y = mg (A – ai) where mg = Government multiplier, A = Autonomous spending, a = sensitivity
of investment to rate of interest and i = real rate of interest
Also i = r – π , substituting this in equation above we get:
Y = mg [A – a (r– π)], Y = mg [A – ar + aπ)],
Money market is in equilibrium when money demand = money supply
r = 1/h [kY – M/P], Simultaneous equilibrium is when IS = LM
Y = mg [A – a/h (kY – M/P) + aπ)], Above equation shows that the output is affected because of
autonomous spending, real money supply and inflation rate.
Above equation can be modified to explain the aggregate demand equation as:
∆Y = αf + φ (m – π) or Y – Y-1 = αf + φ (m – π), Y = αf + φ (m – π) + Y-1
π = m – 1/ φ [ Y – Y-1 ]
It shows inverse relation between inflation and equilibrium level of output keeping the nominal
money supply and lagged output as constant. It can be plotted as:
57
Figure 5
DAD is the original demand curve which is at a lower intercept because of lower money supply
and lagged level of output. If there is a change in either of the two variables then the DAD curve
shifts and it would shift up with an increase in nominal money supply.
2.7 GRADUALISM AND COLD TURKEY
Inflation is steady and persistent increase in the prices of the commodities that reduces the
purchasing power in an economy. Though some percentage of inflation is bound to be present in
any economy but still every economy wants it to be in a certain limit. If inflation goes above that
there are two strategies that government can adopt which can be called gradualism or cold
turkey. In gradualism government cuts the nominal money supply by a small amount whereas in
cold turkey the cut in the money supply is drastic. The cut being small in gradualism there is
unemployment and recession but it is not that huge whereas in cold turkey the unemployment
and recession is quite large. Gradualism is mainly adopted by the economies because of its lesser
serious impacts as compared to cold turkey. Both can be presented diagrammatically as:
58
Figure 6: Gradualism
Initial dynamic aggregate demand curve and dynamic aggregate supply curve intersect at e
where actual inflation is much higher then the expected inflation of π’. If government wants to
reach the expected inflation it cuts the money supply by a small amount such that DAD shifts
leftwards with new equilibrium at lower inflation and a new output. With reduction in inflation
the SAS also shifts to right, the process keeps on repeating till the inflation is reduced to the
expected one and output is at full employment level.
Figure 7: Cold Turkey

59
Initial dynamic aggregate demand curve and dynamic aggregate supply curve intersect at e
where actual inflation is much higher then the expected inflation of π’. If government wants to
reach the expected inflation it cuts the money supply by a drastic amount such that DAD shifts
leftwards by a huge amount as compared to small magnitude in gradualism with new equilibrium
at lower inflation and a new output. With reduction in inflation the SAS also shifts to right, the
process keeps on repeating till the inflation is reduced to the expected one and output is at full
employment level. Here the expected inflation is reached earlier as compared to gradualism as
the money supply is cut by a huge amount.
2.8 SUMMARY
In the previous chapter we discussed about unemployment its different types and problems
associated. One major problem with unemployment is that it brings changes in prices that bring
changes in inflation. This chapter talked about impact of inflation on unemployment and
employment. Philips curve showed the impact of unemployment on growth rate in wages which
was later changed to price inflation. It stated that prices and wages are sticky in the short run. It
also laid foundation for the development of aggregate supply curve that showed the relation
between price level and equilibrium level of output. However modern economists modified both
the Philips curve and aggregate supply curve to include the component of expected inflation that
was missing in the original research. This is known as expectations augmented Philips curve and
expectations augmented Aggregate Supply Curve. The chapter also discussed about how money
is neutral in the long run having no impact on the real output level as price level increases by the
same quantum by which the money supply increased thereby having no impact on the real GDP.
Every economy in the world wants to attain low level of unemployment and low inflation but
there is a trade off between the two where it has to accept one of the two evils. Though there are
certain strategies that can help in the reduction of the inflation namely gradualism and cold
turkey. Both are different in their approach and impact as the prior one brings smaller changes in
money supply to reduce inflation gradually the second one is concerned about huge changes in
money supply that drastically reduces the inflation and unemployment.
Check your progress

(a) Unemployment and growth rate in wages have inverse relationship.
(b) Dynamic aggregate Supply curve shows vertical curve.
(c) Philips curve is flatter at the bottom
(d) There is a trade off between unemployment and inflation.
(e) Money is neutral in the long run but not in short term.
Ans. 1(T), 2(T), 3(T), 4(T), 5(T), 6(T)
60
(a) Philips curve shows _ _ _ _ _ _ _ _ _ relation between unemployment and growth rate in
wages.
(b) If unemployment is high inflation would be _ _ _ _ _ _ _ _ _ .
(c) Cold Turkey means _ _ _ _ _ _ _ _ reduction in money supply.
Ans 1. Inverse 2. Low 3. Drastic 4. Inflation and Interest Rate
1. Explain the derivation of dynamic demand curve.
__________________________________________
__________________________________________
2. What are the different ways to reduce inflation.

__________________________________________
__________________________________________
3. What are the ways through which investors estimate expected inflation
__________________________________________
__________________________________________

__________________________________________
__________________________________________
5. Explain the relation between inflation and employment.
__________________________________________
__________________________________________
6. Differentiate between Cold Turkey and Gradualism.
__________________________________________
__________________________________________
7. Derive modified Philips curve from the traditional Philips curve and comment why they are
different.
__________________________________________
__________________________________________
8. Derive expectations augmented aggregate supply curve from the modified aggregate supply
curve.
__________________________________________
_______________________________________________
61
U.K..
62
UNIT IV
OPEN ECONOMY
63
64
LESSON 1
OPEN ECONOMY – LARGE AND SMALL
3. STRUCTURE
3.1 Objective
3.2 Introduction
3.3 Small Open Economy and Large Open Economy
3.4 Effect of Policies on small and large open economy
3.5 Exchange rate determination
3.6 Summary
3.1 OBJECTIVE
After reading this lesson, you should be able to:

a) Explain the concept of small and large open economy.
b) Effect of policies on small and large open economy and how they differ.
c) Determination of exchange rate using fixed exchange rate and flexible exchange rate
regime.
d) Analyze the impact of exchange rate variation on the small and open economy
e) Examine the relation between exchange rate and equilibrium output
3.2 INTRODUCTION
Unit two discussed derivation of IS-LM curves in a closed economy but there is no economy in
the world today that can be called a closed economy, hence to make the model more realistic this
unit would talk about IS-LM model in an open economy system. There are basically two types of
open economies – small and large open economy that would be discussed in the chapter and how
different policies have different impact on the output depending upon the fact whether it is an
open economy or a closed economy. In the IS-LM determination the model being closed one
there was no discussion about the exchange rate impact on the various variables but that is an
important component of this unit as it talks about open economy where exchange rate is an
important variable. IS-LM model showed relation between different levels of real rate of interest
and equilibrium level of output whereas open economy IS-LM model also known as Mundell-
Fleming model shows relation between exchange rate and equilibrium level of output which is
derived from the IS-LM model itself. This is because of the fact in an open economy exchange
rate is one such important variable that has an impact on all the policies and the equilibrium
output.
65
3.3 SMALL OPEN ECONOMY VS LARGE OPEN ECONOMY
The aggregate demand as done in unit two included consumption expenditure by the households,
investment expenditure by private firms and government expenditure. The aggregate demand
however in an open economy is more than that as it includes one more variable namely the net
exports which is exports minus imports. Now an open economy can be a small open economy or
a large open economy based upon two characteristics:
1. If the real interest rate in the world economy can be impacted by our economy it is known as
the large open economy whereas if the world interest rate is not influenced by domestic interest
rate and domestic interest rate always equates itself to the world interest rate then it is called a
small open economy.
4. The second point of difference comes from the flow of capital, if there is free flow of
capital in and out of the domestic economy it is called a small open economy however in
large open economy there are restrictions on the free flow of capital may be because of
domestic investment preference or other reasons.
To establish the equilibrium in an open economy we proceed with the mathematical derivation
as:
Equilibrium in goods market is when Y = AD or Y = C + I + G + NX. To prove this we assume
that the total output produced in an economy is Y which would be distributed amongst
households, firms, government and what is left is exported.
Y = Cd + Id + Gd + X . . . . . . . (1)
Also Total consumption of the households of an economy includes consumption of domestically
produced goods as well as foreign goods. Thus it can be written as:
C = Cd + Cf or Cd = C - Cf
Similarly Total investment of the private firms of an economy includes consumption of
domestically produced goods as well as foreign goods. Thus it can be written as:
I = Id + If or Id = I - If
Similarly total expenditure by the government sector of an economy includes consumption of
domestically produced goods as well as foreign goods. Thus it can be written as:
G = Gd + Gf or Gd = G - Gf
Substituting these in the equation (1) above we get:
Y = C - Cf + I - If + G - Gf + X
Y = C + I + G + X – (Cf + If + Gf )
Y=C+I+G+X–M
66
Y = C + I + G + NX or NX = Y – ( C + I + G ) . . . . . . (2)
Where Y = Total output
C = Total consumption by the domestic households whether on domestically produced goods or
foreign goods
I = Total expenditure by the domestic private firms whether on domestically produced goods or
foreign goods
G = Total expenditure by the domestic government whether on domestically produced goods or
foreign goods
NX = Net exports that is exports minus imports
Equation (2) can be further modified as:
Y – C – G = I + NX
Y – C – G + T – T = I + NX, (Y – T – C) + ( T - G ) = I + NX,
S = I + NX or S - I = NX . . . (3)
As Y – C – G refers to savings by private households and T – G refers to public savings. Thus
total Y – C – G + T – G refers to national savings.
Where S – I refers to net capital outflow and NX is net exports or trade balance.
Thus from equation (2) and (3) there can be three situations:
1) If Y = C + I + G then it means that NX = 0. It is a situation of trade balance as domestic
output is equal to domestic spending. Also from equation (3) if NX = 0 then S = I. That is
domestic savings are enough to fund domestic investment and hence there is no need to
borrow or lend from or to abroad.
2) If Y > C + I + G then it means that NX > 0. It is a situation of trade surplus as domestic
output is more than the domestic spending. Also from equation (3) if NX > 0 then S > I.
That is domestic savings are more than enough to fund domestic investment and hence
there is a need to lend to foreigners abroad.
3) If Y < C + I + G then it means that NX < 0. It is a situation of trade deficit as domestic
output is less than the domestic spending. Also from equation (3) if NX < 0 then S < I.
That is domestic savings are not enough to fund domestic investment and hence there is
need to borrow from foreigners abroad.
3.4 EFFECTS OF POLICIES ON REAL INTEREST RATE IN SMALL OPEN

ECONOMY
Now to establish equilibrium rate of interest in small open economy and to show the effects of
different policies on interest rates in a small open economy we make the following assumptions:
Total output that is Y is constant, also output depends on disposable income and interest rate
depends on real interest rate. Using these we get the following figure:
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Figure 1: Equilibrium rate of interest in small open economy
In small open economy the real interest rate in the domestic economy is equal to real interest rate
in the world economy. If worlds interest rate is r* then the domestic interest rate is also the same.
And here savings is equal to investment or there is balanced trade as net exports are zero. If
world interest rate increases to r1* then interest rate in the domestic economy also increases to r1
and here investment reduces as there is inverse relation between rate of interest and investment
however savings are constant so at increased interest rate savings become more than investment
hence there is trade surplus and the small open economy lends to the foreigners as savings are
more than investment. If world interest rate decreases to r2* then interest rate in the domestic
economy also decreases to r2 and here investment increases as there is inverse relation between
rate of interest and investment however savings are constant so at decreased interest rate savings
become less than investment hence there is trade deficit and the small open economy borrows
from the foreigners as savings are less than investment.
The impact of three different policies on the interest rate in the small open economy would be
shown as follows:
Expansionary Fiscal Policy at Home
When government of domestic economy which is a small open economy goes for expansionary
fiscal policy that is either increases its government expenditure or reduces the taxes with an
incentive to increase the level of output the impact can be shown as:
68
Figure 2: Impact of Expansionary Fiscal Policy at home (small open economy)
In the figure above investment function is downward sloping showing inverse relation between
real rate of interest and investment by private firms. Savings are fixed as all the components of
savings are assumed to be constant for simplicity. Initially if we assume that rate of interest
prevailing in the outside world is r* then the real interest rate in the small open economy too
would be fixed at r which is equal to r* and it would change only when world interest rate
changes. So initial equilibrium is at point ‘A’ in figure above where we assume there is balanced
trade as savings and investment are equal and there is no lending or borrowing from the outside
world. Now if small open economy goes for expansionary fiscal policy then national savings
reduce as expenditure of government increases or tax revenue decreases, there is tus a leftward
shift in the savings function. If the economy would have been a large open economy the rate of
interest would have increased but it cannot happen in a small open economy as the rate of
interest is constant at r = r*. Thus at the same interest rate equilibrium is now at point ‘B’ where
savings are less than investment and hence there is trade deficit in the economy. The small open
economy has to borrow from the outside world to finance its deficit investment.
Expansionary Fiscal Policy Abroad.
Now if there is expansionary fiscal policy in the world economy which we assume e home
economy which to be a large open economy the impact on the home economy which is a small
open economy would be different as can be seen from the figures below:
69
Figure 3: Impact of Expansionary Fiscal Policy abroad (large open economy)
Here initially we assume that the equilibrium is where saving curve shown by ‘S’ and investment
function intersect giving the equilibrium interest rate of r* which has to be accepted by the small
open economy as it is. Now if there is expansionary fiscal policy in the large open economy then
savings function shift to the left and rate of interest increases to r1* which raises the interest rate
in the small open economy too which is shown in figure below.
70
Figure 4: Impact of Expansionary Fiscal Policy abroad on the home economy (small open
economy)
Here initially the rate of interest is r* which is given by the large open economy where the small
open economy is at balanced trade. Now because of the action of large open economy when rate
of interest increases to r1* the rate of interest increases in small open economy too. Thus at
increased rate of interest investment falls and savings are fixed which means investment
becomes less than savings leading to trade surplus and small open economy becomes net lender
to the world economy.
Increase In Investment Demand
If there is a shift in the investment demand and it shifts to the right may be because of credit
given by government on investment or anything else, it leads to a rightward shift in the
investment function as at every rate of interest there is now increased investment which can be
shown as:
Figure 5: Impact of Investment credit at home (small open economy)

Here original investment curve is I and savings curve is fixed at S there by at given interest rate
of r = r* which is given by world economy. We assume that originally the economy is at trade
balance where savings and investment are equal. Now if investment credit is given then there is
rightward shift in the investment curve so at every rate of interest now the investment is more as
compared to previous level. At interest rate of r* the investment now is more than the savings
which leads to trade deficit and small open economy becomes net lender to the world economy.
71
3.5 EXCHANGE RATE DETERMINATION
In an open economy exchange rate is one important factor that influences the equilibrium
situation. Exchange rate can be defined as the rate at which residents of a country trade with the
residents of another country. It can be divided into two types:
Nominal exchange rate: The nominal exchange rate is defined as the number of units of the
domestic currency that can purchase a unit of a given foreign currency. A decrease in this
variable is termed nominal appreciation of the currency. An increase in this variable is termed
nominal depreciation of the currency.
Real Exchange rate: The real exchange rate is defined as the ratio of the price level abroad and
the domestic price level, where the foreign price level is converted into domestic currency units
via the current nominal exchange rate. Formally, R = (E.P*)/P, where the foreign price level is
denoted as P* and the domestic price level as P. A decrease in real exchange rate is termed
appreciation of the real exchange rate, an increase is termed depreciation. The real rate tells us
how many times more or less goods and services can be purchased abroad (after conversion into
a foreign currency) than in the domestic market for a given amount.
Relation Between Real Exchange Rate And Nominal Exchange Rate
RER = NER * Price of Domestic Good/Price of Foreign good
A high (low) real exchange rate implies that foreign goods are relatively cheap (expensive) and
domestic goods are relatively expensive (cheap).
Thus if real exchange rate is high then domestic goods being expensive there would be less
exports from the domestic economy and more imports in the domestic economy that leads to less
net exports. Thus there is inverse relation between real exchange rate and net exports and it can
be shown graphically as:
Figure 6: Relation between real exchange rate and net exports

72
Figure above shows inverse relation between real exchange rate and net exports. A vertical
straight line in the middle shows the level of trade balance that is when real exchange rate is at
this level then exports and imports are equal and hence the net exports are zero. However if real
exchange rate is less than this then net exports are negative as real exchange rate is high enough
such that the exports are less than the imports and net exports are negative. Also if real exchange
rate is more than this then net exports are positive as real exchange rate is low enough such that
the exports are more than the imports and net exports are positive. To find out how this real
exchange rate is established in reality the following figure has been drawn. We know that
S – I = NX
1) If Y = C + I + G then it means that NX = 0. It is a situation of trade balance as
domestic output is equal to domestic spending. Also from equation (3) if NX = 0
then S = I. That is domestic savings are enough to fund domestic investment and
hence there is no need to borrow or lend from or to abroad.
2) If Y > C + I + G then it means that NX > 0. It is a situation of trade surplus as
domestic output is more than the domestic spending. Also from equation (3) if
NX > 0 then S > I. That is domestic savings are more than enough to fund
domestic investment and hence there is a need to lend to foreigners abroad.
3) If Y < C + I + G then it means that NX < 0. It is a situation of trade deficit as
domestic output is less than the domestic spending. Also from equation (3) if NX
< 0 then S < I. That is domestic savings are not enough to fund domestic
investment and hence there is need to borrow from foreigners abroad.
Figure 7: Relation between real exchange rate and net exports
73
Figure above shows a vertical line showing the savings and investment difference or the net
capital outflow. It is a vertical line as neither the savings nor the investment is a function of real
exchange rate. Net exports is a downward sloping curve showing inverse relation between net
exports and real exchange rate. Equilibrium is when both these curves intersect and there is trade
balance in the economy. This is the real exchange rate that would prevail in the economy.
3.6 SUMMARY
All the economies in the world can be divided into two types that is closed economy which does
not have any interaction with the rest of the world and open economy which is integrated with
the other economies of the world. Though there is no such economy which can be called purely a
closed economy. Further there can be two types of open economy – small open economy and
large open economy. The small open economy is one where there is no restriction on capital
movement and the world interest rate determines the real interest rate prevalent in the small open
economy. In the latter that is large open economy there are certain restrictions on the capital
movement in and out of the economy which can be because of investors’ preference for domestic
investment or government restrictions on free mobility. Also the world interest rate can be
influenced by the real interest rates prevailing in the large open economy. An important concept
that is needed in the open economy which was not there in the closed economy is the concept of
exchange rate as the capital movements, the movement of goods and services in and out of an
economy to a great extent depends on the exchange rate of the two countries. The impacts of
various policies are seen not only on the interest rates but also on the exchange rates in an open
economy.
Check your progress

(a) Large open economy can influence the world interest rate.
(b) When savings are more than the investment it means we are lending funds to the foreigners.
(d) Fiscal policy in the home country which is a small open economy has no impact on the
interest rates.
(e) Small open economy has unrestricted capital flows in and out of the economy.
Ans. 1(T), 2(T), 3(F), 4(T), 5(T), 6(T)
74
(a) An economy with households, firms, government and external sector is termed as _ _ _ _ _ _
___.
(b) If there is expansionary fiscal policy in rest of the world it _ _ _ _ _ _ _ _ _ the interest rate in
the small open economy.
(c) Exchange rate is the rate at which currency of one country is exchanged for currency of _ _ _
_ _ _ _ _ country .
Ans 1. Open economy 2. Increases 3. Another 4. Inflation and Interest Rate
1. Differentiate between small open and large open economy.
__________________________________________
__________________________________________
2. What is the impact of contractionary fiscal policy in the small open economy on the
equilibrium?
__________________________________________
__________________________________________
3. Explain the concept of exchange rate.

__________________________________________
__________________________________________
4. Differentiate between nominal and real exchange rate.

__________________________________________
__________________________________________
5. Net foreign investment always equals the trade balance in a small open economy. Elaborate
__________________________________________
__________________________________________
6. Explain the concept of Natural rate of Unemployment.
__________________________________________
__________________________________________
7. What is the difference between investment credit and fiscal policy on the equilibrium in a
small open economy.
__________________________________________
__________________________________________
8. Why is world interest rate equal to interest rate in the small open economy.
__________________________________________
_______________________________________________
75
U.K..
76
LESSON 2
OPEN ECONOMY- MUNDELL FLEMING MODEL
2. STRUCTURE
2.1 Objective
2.2 Introduction
2.3 Equilibrium in Large open economy
2.4 Mundell – Fleming Model
2.5 Impact of policies on equilibrium
2.6 Summary
2.1 OBJECTIVE

a) Differentiate between small and large open economy.
b) Effect of policies on large open economy and how they differ.
c) Determination of IS-LM Mundell Fleming model
d) Analyze the impact of exchange rate variation on the small and open economy
e) Examine the relation between various policy changes and equilibrium
2.2 INTRODUCTION
The earlier chapter talked about small open economy where there is no restriction on the
capital flows in and out of the economy, this chapter would focus on large open economy
and the impact of various policies on the equilibrium in large open economy. The chapter
would also discuss the IS-LM model applicable in case of a small open economy. The IS-
LM model that was discussed in unit two was operative in a closed economy where there
was no external sector and no imports or exports. A large open economy has capital
movements in and out of the economy but there is not an absolute free movements as
investors prefer domestic investment rather than outside investment. This fact is reflected
in the difference in the real interest rates that prevail in the domestic economy and world
economy.
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2.3 EQUILIBRIUM IN LARGE OPEN ECONOMY
A large open economy has the following two features:
1. Real interest rate in the domestic large open economy is not equal to the world real
interest rate
2. There are restrictions on the capital movements in and out of the large open economy
as investors have preference for the local economy rather than the rest of the world.
To attain the equilibrium in a large open economy two markets are to be studied
simultaneously that is market for loanable funds where the real interest rates are
determined and then the market for foreign exchange where the equilibrium exchange
rate is determined. It can be shown using the following diagrams:
Figure 1: Equilibrium Real interest rate
Figure above shows that the savings of an open economy can be used either for domestic
investment or for lending abroad. That is S = I + CF. Also savings are constant as it is not
dependent on the real interest rate whereas investment and net capital outflow both are
inversely related to the real interest rate. Hence the curve is downward sloping.
Equilibrium is when savings and investment and net capital outflows care equated. It
provides ‘r’ as the real interest rate that would prevail in the large open economy.
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Figure 2: Equilibrium Exchange rate
The derivation in the previous chapter showed that S – I = NX, also CF = NX. Thus
equilibrium is where the net exports which is inversely related to real exchange rate and
net capital outflow which is independent of real exchange rate are equal. This gives ‘E’ as
the equilibrium exchange rate.
2.4 MUNDELL – FLEMING MODEL
Mundell Fleming model is an extension of the closed economy IS-LM model as Mundell
Fleming model is applicable in an open economy and that too a small open economy and
hence it is also called balance of payment IS-LM model. Here we derive IS* and LM* to
attain the simultaneous equilibrium.
Derivation of IS*: Equilibrium in the goods market in an open economy is when
Y = AD, Y = C + I + G + NX
Y = C (Yd) + I ( r = r*) + G + NX (e)
It shows that in a small open economy model aggregate demand is a combination of
consumption function which is a function of disposable income, investment which is a
function of real interest rate prevalent in the domestic economy which in turn is
dependent on the world real interest rate, government expenditure which is taken to be
constant and net exports which is a function of nominal exchange rate. Earlier inverse
relation was shown between real exchange rate and net exports but here as it is a model
applicable in short run so price levels are constant in both the domestic economy and
world economy and hence nominal exchange rate has been used in place of real exchange
rate. The graphical derivation can be shown as follows:
79
Figure 3: Mundell Fleming IS* curve
To derive IS* curve which shows goods market equilibrium in a small open economy
there are three figures that are two figures that are required simultaneously to derive the
relation between nominal exchange rate and equilibrium level of output. In figure A the
net exports curve has been drawn showing inverse relation between nominal exchange
rate and net exports. Initially the nominal exchange rate is e1 where net exports is NX1.
Corresponding to this net exports in fig B there has been drawn the Keynesian cross
showing the AD curve corresponding to NX1 level of net exports and equilibrium output
at this level is Y1. Dragging e1 from fig A and Y1 from fig B we get a point of IS* in fig
C. Now if nominal exchange rate falls to e2 then there being inverse relation between
exchange rate and net exports the net exports increases to NX2. With an increase in net
exports the aggregate demand curve shifts parallel upwards where the new equilibrium
output also increases to Y2. Dragging the new nominal exchange rate and corresponding
equilibrium level of output at which goods market is in equilibrium there is a new
combination of the IS*. Joining the two there is downward sloping IS* curve showing
inverse relation between nominal exchange rate and equilibrium level of output.
IS* curve shows different combinations of nominal exchange rate and equilibrium level
of output where the goods market in a small open economy is in equilibrium. It is a
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downward sloping curve as it shows that there is an inverse relation between the
exchange rate and income level. The reason is that when nominal exchange rate reduces
the aggregate demand in the economy increases because exports increase leading to an
increase in net exports and to establish the equilibrium the increased aggregate demand
has to be matched by an increase in the corresponding level of output which gives the IS*
curve its downward slope.
Now we derive the equilibrium in the money market that is shown by LM* curve as
follows:
Derivation of LM*: Equilibrium in the money market in an open economy is when
money demand is equal to money supply.
Md = Ms, kY – hr = M/P where money demand is shown by kY – hr that is it is directly
related to income and inversely related to real rate of interest. Money supply is shown as
the ratio between nominal money supply and price level and being a short run model
price level is constant. Now none of the variables of money demand or money supply is
related to nominal exchange rate and hence LM* would be a vertical straight line parallel
to Y axis at a level where real interest rate and LM curve intersects as shown below:
Figure 4: Mundell Fleming LM* curve
81
To derive the LM* curve there are two panels required, in the above part there is LM
curve of a closed economy showing relation between real interest rate and equilibrium
level of output. Assuming the world real interest rate to be r* the domestic interest rate
would be equal to that such that the LM curve intersects the r* line which is dragged
below to get the LM* curve of an open economy. It is a vertical straight line showing that
there is no specific relation between nominal exchange rate and equilibrium level of
output. If there is any change in the world interest rate then there is a corresponding shift
of the LM curve and hence the LM* curve.
Simultaneous equilibrium in small open economy from IS* and LM* curve can be shown
as follows:
Figure 5: Simultaneous equilibrium in small open economy
Any point on the IS* curve shows equilibrium in the goods market of a small open
economy while any point on the LM* curve shows equilibrium in the money market in
the small open economy. For an economy to be in simultaneous equilibrium the point
should be on both the IS* and LM* curve which occurs at ‘E’ in the figure above
showing that the equilibrium nominal exchange rate is e* and equilibrium level of output
is Y*.
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2.5 IMPACT OF DIFFERENT POLICIES ON SMALL AND LARGE
OPEN ECONOMY
Case 1: Impact of Expansionary Fiscal and monetary policy on Mundell Fleming
Equilibrium under Fixed and Floating Exchange rate: Floating exchange rate means
exchange rate that can change depending upon the market conditions whereas fixed
exchange rate is one where central bank fixes and exchange rate and it might be more or
less than the equilibrium exchange rate that market forces determine. But the arbitrageurs
make sure that their buying and selling action keeps the exchange rate as that fixed by the
central bank. Thus in fixed exchange rate the exchange rate is fixed at the central banks’
rate and exchange rate is not allowed to fluctuate.
a) Expansionary Fiscal Policy in case of floating Exchange Rate
Figure 6: Expansionary Fiscal Policy: Floating Exchange Rate
Here IS* is the original goods market curve and LM* is the original money market
curve. The original equilibrium exchange rate is e1. Now if there is expansionary
fiscal policy in the small open economy then IS* shifts parallel to right to IS’*. The
83
new equilibrium exchange rate is e2 that is there is appreciation of domestic currency
because of which net exports falls and hence the equilibrium output is at same level
because the increase in aggregate demand because of increase in government
expenditure is offset by decrease in net exports. Hence the new equilibrium is at
higher exchange rate but at same level of equilibrium level of output.
b) Expansionary Monetary Policy in case of floating Exchange Rate
Figure 7: Expansionary Monetary Policy: Floating Exchange Rate
Here IS* is the original goods market curve and LM* is the original money market
curve. The original equilibrium exchange rate is e1. Now if there is expansionary
monetary policy in the small open economy then LM* shifts parallel to right to LM’*.
The new equilibrium exchange rate is e2 that is there is depreciation of domestic
currency because of which net exports rises and hence the equilibrium output is at
increased level. Hence the new equilibrium is at lower exchange rate and at increased
level of equilibrium level of output.
84
c) Expansionary Fiscal Policy in case of fixed Exchange Rate
Figure 8: Expansionary Fiscal Policy: Fixed Exchange Rate
This is the case of a fixed exchange rate regime where the central bank has fixed the
exchange rate at e1, now if the government of the small open economy goes for an
expansionary fiscal policy then the IS* curve shifts to right to IS’*, now if the
exchange rate would have been floating then exchange rate would have appreciated to
e2. But it being a fixed exchange rate scenario, the moment exchange rate in the
foreign exchange market increases to e2, arbitragers come into force and increase the
money supply of domestic currency till the exchange rate in the foreign exchange
market also comes down to the rate fixed by central bank.. Hence LM* also shifts to
the right and at new equilibrium the exchange rate is same but equilibrium output has
increased unlike fixed exchange rate policy where there was a change in exchange
rate and no change in equilibrium output.
d) Expansionary Monetary Policy in case of fixed Exchange Rate
85
Figure 9: Expansionary Monetary Policy: Fixed Exchange Rate
This is the case of a fixed exchange rate regime where the central bank has fixed the
exchange rate at e2, now if the government of the small open economy goes for an
expansionary monetary policy then the LM* curve shifts to right to LM’*, now if the
exchange rate would have been floating then exchange rate would have depreciated to
e1. But it being a fixed exchange rate scenario, the moment exchange rate in the
foreign exchange market decreases to e1, arbitragers come into force and decrease the
money supply of domestic currency till the exchange rate in the foreign exchange
market also comes to the rate fixed by central bank. Hence LM* also shifts to the left
and at new equilibrium the exchange rate as well as output is same.
Case 2: Impact of Expansionary Fiscal and Monetary policy on Large open

economy.
a) Effect of Expansionary Fiscal Policy
86
Figure 10: Expansionary Fiscal Policy: Large open economy
In a large open economy the equilibrium in the goods and money market is obtained
when following condition holds good
Y = AD, Y = C (Yd) + I(r) + G + NX(e) that is consumption is a function of disposable

income, investment is a function of real interest rate prevailing in the domestic economy,
government spending which is assumed to be autonomous and net exports which is a
function of nominal exchange rate (as it is a short run policy change so taken nominal
exchange rate and not real exchange rate).
In a large open economy there is one more condition that is NX(e) = CF(r) that is net
exports which is a function of nominal exchange rate and net capital outflow which is a
function of real interest rate should be equal. Thus substituting this in equation above we
get:
Y = C (Yd) + I(r) + G + CF (r)
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So the equilibrium in goods market has two factors namely investment and net capital
outflow that are inversely related to real interest rate and hence IS curve here is more
flatter. To show the impact of Expansionary fiscal policy there are three figures that have
to be drawn simultaneously, the first one shows simultaneous equilibrium where IS and
LM intersect and original equilibrium rate of interest is ‘r’ and equilibrium output is ‘Y’.
With an increase in fiscal policy IS curve shifts parallel to right and equilibrium rate of
interest increases which brings a decrease in the net capital outflow in the second panel as
it is inversely related to rate of interest. In the last panel is the curve showing relation
between net exports and net capital outflow. Initial equilibrium is when CF and NX curve
intersects. Now when CF shifts to left the new equilibrium is at NX1. Thus at new
equilibrium the exchange rate has appreciated and net exports reduced with an increase in
the equilibrium level of output and increase in real interest rate.
b) Effect of Expansionary Monetary Policy
Figure 11: Expansionary Monetary Policy: Large open economy
To show the impact of Expansionary monetary policy there are three figures that have to
be drawn simultaneously, the first one shows simultaneous equilibrium where IS and LM
intersect and original equilibrium rate of interest is ‘r’ and equilibrium output is ‘Y’.
With an increase in monetary policy LM curve shifts parallel to right and equilibrium rate
of interest decreases which brings an increase in the net capital outflow in the second
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panel as it is inversely related to rate of interest. In the last panel is the curve showing
relation between net exports and net capital outflow. Initial equilibrium is when CF and
NX curve intersects. Now when CF shifts to right the new equilibrium is at NX’. Thus at
new equilibrium the exchange rate has depreciated and net exports increased with an
increase in the equilibrium level of output and decrease in real interest rate.
1.6 SUMMARY
In an open economy with the presence of external sector there can be either a small open
economy or a large open economy with the basic difference lying in the fact as to how
free is the capital movement in and outside the economy and how the interest rates in the
domestic economy are being impacted by the rest of the world. While in a small open
economy there are no restrictions on the capital movements but the interest rates ie n the
small open economy is determined by the world interest rate and the changes in the
interest rate in the small open economy have no impact on the world interest rate. A large
open economy on the other hand has certain restrictions on the capital movements as
investors here prefer domestic investments rather than outside investment. IS-LM model
as studied in unit 2 was about goods and market equilibrium in a closed economy with
just households, firms and government. Mundell and Fleming gave an extension of the
goods and market equilibrium by extending it to the open economy. It is known as IS*-
LM* model that studies relationship between nominal exchange rate and equilibrium
level of output where both the goods and money market are in equilibrium in an open
economy. It also showed how various policies have an impact on the large and small
open economy in the presence of fixed and floating exchange rate.
Check your progress
(a) Small open economy can influence the world interest rate.
(b) Mundell Fleming is a short run model.
(c) A four sector Economy is also called open economy.
(d) Fiscal policy in the home country which is a small open economy has no impact on
the interest rates.
(e) In fixed exchange rate policy monetary policy has no impact on the equilibrium in
small open economy.
(f) Equilibrium level of output depends on the slope of Aggregate demand curve.
89
Ans. 1(F), 2(T), 3(T), 4(T), 5(T), 6(T)
(a) An economy with households, firms, government and external sector is termed as _ _
_______.
(b) If there is expansionary fiscal policy in a small open economy with fixed exchange
rate it brings an _ _ _ _ _ _ _ in the output.
(c) Exchange rate is the rate at which currency of one country is exchanged for currency
of _ _ _ _ _ _ _ _ country .
(d) Expansionary Fiscal Policy leads to _ _ _ _ _ _ in net exports.
Ans 1. Open economy 2. Increases 3. Another 4. Decrease
1. Differentiate between small open and large open economy.

__________________________________________
__________________________________________
2. What is the impact of expansionary fiscal policy in the small open economy on the
equilibrium?
__________________________________________
__________________________________________
3. Explain the equilibrium in large open economy.

__________________________________________
__________________________________________
4. How does fixed exchange system operate when equilibrium exchange rate is more
than the fixed exchange rate..
__________________________________________
__________________________________________
5. Net foreign investment always equals the trade balance in a small open economy.
Elaborate
__________________________________________
__________________________________________
90
6. Explain the concept of floating and fixed rate system
__________________________________________
__________________________________________
7. How Is* and LM* are derived using mundell fleming model.
__________________________________________
__________________________________________
8. Derive aggregate demand curve in a small open economy.
__________________________________________
_______________________________________________
Mankiw, N. Gregory, Macro Economics, Macmillan Worth Publishers New York,

Hampshire U.K..
91
UNIT V
INVESTMENT SPENDING AND DEMAND AND SUPPLY OF MONEY
93
94
LESSON 1
INVESTMENT SPENDING AND DEMAND AND SUPPLY OF MONEY
1. STRUCTURE
1.1 Objective
1.2 Introduction
1.3 Concept of Investment Spending
1.4 Theories of Money Demand
1.5 Supply of Money
1.6 Summary
1.1 OBJECTIVE
a) Differentiate between different types of investment spending.
b) Determine demand of money using different theories.
c) Determination of money supply.
d) Analyze how money supply is created by banks
e) Examine the relation between various monetary policies and its impact on money supply
1.2 INTRODUCTION
The equilibrium in macro economics is when aggregate demand and aggregate supply are equal
and aggregate demand in a macro economics consists of consumption by households, investment
by the firms, expenditure by government and net exports. The previous chapters have talked
about consumption, government expenditure and net exports and investment was assumed to be
autonomous in all the previous chapters. This chapter discusses about different forms of
investment and factors on which investment depends. Equilibrium in the money market is when
money demand and money supply are equal. To explain the concept of money demand it
explains various theories that help in determining the demand of money. It also explains how
banks help in creation of money through credit creation process and various monetary policies of
the central bank that have an impact on the money supply.
1.3 CONCEPT OF INVESTMENT SPENDING

Expenditures made by the business sector on final goods and services, or gross domestic product,
especially the purchase of productive capital goods. It can be broadly divided into three types:
Business Fixed Investment: It is the most common form of investment that includes
expenditure by firms’ on the fixed investment that is capital goods like machinery, equipments,
building for factory etc. It is one of the main contributors to economic growth and one of the
most crucial decisions that have to be undertaken. While deciding about whether to go ahead
with a particular investment or not firms use discounted techniques which is because of the fact
that the revenues take place in the future whereas costs are usually incurred in the present, to
calculate the viability the future stream of revenue has to be discounted to get its present value.
95
These decisions are very crucial because of the fact the once started it is very difficult to reverse
them without incurring any costs.
Residential Investment: It includes expenditures on houses, buildings, and similar types of
shelter. Residential fixed investment includes structures built, owned, and occupied by
individuals and it also includes residential places developed by businessman whose business is to
sell or give on rent such property. To decide whether to go for this type of investment or not the
benefits and costs associated with it has to be seen. Benefits include the imputed rent if the house
is being used for self accommodation or earned rent if it has been rented out and the capital gain
(or loss) because of change in the value of the investment. Cost includes the interest payments if
investment has been taken on loan and depreciation or annual expenditure on maintenance. If
benefits outweigh the cost the investment should be done otherwise it should not be.
Inventory Investment: Firms not only invest in fixed assets but also in raw materials, work in
progress and finished goods that are kept in the stock in anticipation of to be sold in the future.
Firms usually keep a ratio of inventory to the sales to ensure they do not lose out any opportunity
in the market. Although inventories are a relatively small portion of the overall investment
sector, inventories are a critical component of changes in GDP over the business cycle. If the
economy is slowing down then inventories and that too unexpected inventory would pile up and
if there is boom in the economy then inventories would come down. Thus changes in the
inventory determine the production level of the firm whether it needs to increase the production
or reduce it.
1.4 THEORIES OF MONEY DEMAND
Money demand and money supply needs to be understood to establish the money market
equilibrium. Money demand refers to demand for real money that is demand of money for
transactionary purposes. People hold money with them because they need to enter into
transactions and for that liquidity is needed. Demand of money for transactionary purpose is
directly related to income level and inversely related to real rate of interest. This is the simplest
theory of money demand as was also done in LM or money market equilibrium. Other motive for
holding money is for precautionary motive and speculative motive.
Tobin’s Portfolio Theory: Portfolio refers to a mix or combination of different assets that
people hold in with them to satisfy their requirements. The different proportions of assets that
individuals hold depends on the risk and return of different assets and the total wealth that they
have. So the demand function can be written as:
(M/P)d = f(rs, rb, πe, W)
Where (M/P)d refers to real demand of money for transactionary purpose.
rs = Expected real return on stocks
rb = Expected real return on stocks
πe = Expected Inflation rate
W = Real Wealth
An increase in real return on stocks or bonds reduces the demand for real money as the
opportunity cost of holding money increases and stocks and bonds become more attractive. an
increase in expected inflation also reduces demand of real money. An increase in wealth
however increases the demand of real money. Thus this theory emphasize that demand function
of money should include expected returns on other assets too. However the theory is applicable
96
only if M2 measure of money is considered and fails if M1 is taken into consideration. There is
another theory by Tobin which takes into consideration behaviour of individual wealth holder
and assumes only two components to be a part of the portfolio - money and bonds. The expected
proportion of money and bond that an individual would hold depends on expected gain and
expected risk of the portfolio. Earlier theory ignored the determination of the transactions
demand for money and considered only the demand for money as a store of wealth. Here the
focus is on an individual’s portfolio allocation between money-holding and bondholding, subject
to the wealth constraint. The theory is based on certain assumptions like:
1. Wealth is considered as an economic good and risk is an economic bad
2. In case of money there is no return or risk.
3. The expected capital gain on bonds is zero. This is because the individual investor expects
capital gains and losses to be equally likely.
4. Bonds pay an expected return of interest, but they are a risky asset. Their actual return is
uncertain due to the fact that the market rate of interest fluctuates even in the short run.
The theory can be explained using the following figure:
Figure 1: Tobin’s Portfolio Theory
Here W is the initial wealth that the individual has which has to be divided between money and
bonds. If the individual holds the entire wealth in form of money then after a year his wealth
would be the same as money earns neither any return nor any risk. However if the investor
invests entire wealth in the bond with an expected real interest rate of r% the wealth after a year
would be w(1+r) and the risk as measured by standard deviation is max shown by R1. But the
portfolio that investor chooses depends upon the point of tangency between indifference curve
and the budget constraint where the highest possible indifference curve is tangent to the budget
constraint it is the equilibrium showing the proportion of wealth between money and bonds. The
shape of the indifference curve is such that because on x axis there is an economic bad and on y
axis there is economic good. If there is change in the interest rate the budget constraint would
97
change and the portfolio of the investor would also change depending upon whether the investor
is risk averse, risk neuter or risk lover. It can be shown as follows:
Figure 2: Tobin’s Portfolio Theory: Risk Neuter Investor
A risk neuter is one who is indifferent towards risk and is only concerned about return, so with
increase in the rate of interest the risk neuter brings no change in the proportion as he gets more
return now with the same portfolio because of increase in the rate of interest.
Figure 3: Tobin’s Portfolio Theory: Risk Lover Investor
A risk lover is one who seeks risk and is willing to take more risk. Thus with an increase in the
rate of interest on bonds the risk lover increases his holding of bonds such that both the risk and
return increases and the investor is satisfied because of higher risk. Thus he moves to a higher
indifference curve which is to the right showing greater proportion of bonds as compared to
previous portfolio.
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Figure 4: Tobin’s Portfolio Theory: Risk Averse Investor
A risk averse investor is one who prefers less risk and tries to avoid risk. Thus with an increase
in rate of interest as he can earn the same wealth by investing less in bonds, so a risk averse
investor reduces the proportion of bonds in his portfolio to reduce the overall risk and to keep the
return constant. Thus there is a leftward shift in the indifference curve. Though he is on a higher
indifference curve because of increased satisfaction due to reduced risk his return is the same as
earlier.
Baumol-Tobin Model of Cash Management: This theory focuses on the transactionary

function of money as people hold money worth them because they need to enter into transactions
and to maintain liquidity cash is needed. The amount of money that people will hold with them
depends on the cost associated with holding money which involves the interest foregone on the
money being held with the individual. The benefit includes the convenience as there is no need
of going to banks to acquire money for entering into transactions. Thus taking into consideration
the cost and benefit involved the investor has to decide the optimum sum that he needs to hold
with them such that the cost is minimum. Let us assume that investor requires ‘Y’ sum of money
to enter into transactions for the whole year and he withdraws this at the beginning of the year
and then uses it and by the year end it becomes zero. Thus it can be presented diagrammatically
as:
99
Figure 5: One trip to Bank
The figure shows that in the beginning of the year itself individual withdraws ‘Y’ amount of
money that is needed for the transaction in the whole year. This money is then spent evenly
throughout the year such that by the year end it becomes zero. So the average holding throughout
the year is ‘Y/2’ that is opening + closing balance divided by 2. Now if we assume that investor
makes two trips to bank then the above figure would change as:
Figure 6: Two trips to Bank
The figure shows that in the beginning of the year itself individual withdraws ‘Y/2’ amount of
money that is half the amount needed for the transaction in the whole year. This money is then
spent evenly throughout the half year such that by the end of six months it becomes zero and
then again he makes a visit to the bank and withdraws Y/2 such that by the year end it again
becomes zero. So the average holding throughout the year is ‘Y/4’ that is opening + closing
balance divided by 2.
100
The above figure can be expanded to show what will happen if he makes ‘N’ trips to bank.
Figure 7: N trips to Bank

The figure shows that in the beginning of the year itself individual withdraws ‘Y/N’ amount of
money that is one by Nth of the amount needed for the transaction in the whole year. This money
is then spent evenly throughout the 1 by Nth of the year such that by the end of it, it becomes
zero and then again he makes a visit to the bank and withdraws Y/N such that by the period end
it again becomes zero. This process continues for the whole year such that by the year end it is
again zero and the transactionary need of the whole period has been met by making ‘N’ trips to
the bank. So the average holding throughout the year is ‘Y/2N’ that is opening + closing balance
divided by 2.
Now to decide how many trips to make to bank we need to use the following derivation:
To minimize cost to the banks we have to do the following derivation:
Total cost = Interest foregone + Costs of trips to bank
TC = iY/2N + FN where i is the rate of interest and F is the cost of per trip to bank.
dC/dN = -iY/2N2 + F = 0 , N = √iY/2F
Average cash holding is directly related to the income level (Y) and (F) but indirectly related
interest rate (i) If F is greater or Y is the greater or i is lower (where Y is the expenditure), then
the individual holds more money, that is, demand for money depends positively on expenditure
(Y) and negatively on the interest rate.
101
Figure 8: Minimum cost at optimal number of trips
Failure of the Model:

1. The Model failed because some people have less discretion over their money holdings than the
model assumes
2. Empirical studies of money demand find that the income elasticity of money demand is greater
than half and the interest elasticity of money demand is less than half. Thus, the model is not
completely correct.
1.5 SUPPLY OF MONEY

Credit creation which is the most important function of banks refers to the power of the banks to
expand or contract demand deposits through the process of more loans, advances and
investments. It is based on certain assumptions like all the receipts and payments in the economy
are done through the banking system and all the deposits that are made in the banks are not given
out as loan but a part of it is reserved with the banks in the form of legal reserve ratio and the rest
is lent out. Let us take an example that there is LRR requirement of 20% and bank receives
initial deposit of Rs 1000 so banks keep Rs 200 with them and give away Rs 800 as loan. Now
the bank that receives this Rs 800 would keep Rs 160 with them as reserve and give away Rs 640
as loan. This process would continue till money supply of 1/0.20 * 1000 that is Rs 5000 is
created with just an initial money supply of Rs 1000. Thus how much money is created is
inversely related to the legal reserve ratio. the above process can also be shown as:
Balance Sheet of Bank "1"

Liabilities Amount Assets Amount
A's deposits 1000 Cash Reserve 200
Loan to "B" 800
Total 1000 Total 1000
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Now suppose that money that borrowed from bank "1" is paid to individual "C" in settlement of
his past debts. The individual "C" deposits the money in his bank say, bank 2. Now bank 2
carries out its banking transaction. It keeps a cash reserve to the extend of 20%, that is Rs. 160 and
lend Rs. 640 to a borrower D. at the end of the process the balance sheet of Bank 2 would look like:-
Balance Sheet of Bank "2"
Liabilities Amount Assets Amount
B's deposits 800 Cash Reserve 160
Loan to "C" 640
Total 800 Total 800
The amount advanced to D will return ultimately to the banking system, as described in case of B
and the process of deposits and credit creation will continue until the reserve with the banks is
reduced to zero. The final picture that would emerge at the end of the process of deposit & credit
creation by the banking system is presented in the consolidated balance sheet of all banks are as
under:-
The combined Balance sheet of Banks

Bank Liabilities Assets Credits Reserve Total Assets
Deposits
Bank 1 1000 800 200 800
Bank 2 800 640 160 640
Bank 3 640 512 128 512
- - - - -
- - - - -
Bank n 00 00 00 00
Total 5000 4000 1000 4000
It can be seen from the combined balance sheet that a primary deposits of Rs. 100 0 in a bank 1
leads to the creation of the total deposit of Rs. 5,000. The combined balance sheet also shows that
the banks have created a total credit of Rs. 4,000. And maintained a total cash reserve of
Rs.1000.Which equals the primary deposits. The total deposit created by the commercial banks
constitutes the money supply by the banks.
There are various instruments through which the central bank can control the money supply in an
economy like open market operations where the central bank buys and/or sells the government
securities in the open market to reduce or increase the money supply in the economy, reserve
requirements that is cash reserve ratio that is the proportion of net demand and time liabilities
that banks are required to keep with the central bank or statutory liquidity ratio that refers to the
proportion of net demand and time liabilities that banks are required to buy the government
securities, discount rate that is the rate of interest charged by the central bank to the banks on the
loans being made. There are other measures also like moral suasion and selective credit controls
that also helps in determining the money supply in the economy.
103
1.6 SUMMARY
In macro economics equilibrium is when aggregate demand and aggregate supply are equal.
Aggregate demand consists of expenditure by households in the form of consumption which is a
function of disposable income, expenditure by private firms in the form of investment, by
government in the form of receipt of taxes, expenditure on transfer payments and government
purchases and external sector’s exports and imports. This chapter talks about investment
expenditure which can be broadly divided into residential fixed investment, business fixed
investment and inventory investment. Various theories have been given that explain the demand
and supply of money like Tobin’s portfolio theory which determines how an individual forms his
portfolio and determine the proportion of different assets to hold. Similarly Baumol explained
how much money an investor would hold which depends on the transactionary need of the
investor and a comparison between the holding cost and carrying cost. Similarly money supply is
determined by the central bank and it takes various policies that is quantitative and qualitative to
alter the money supply as and when required. The most important function of the banks that
leads to money supply in the economy is the process of credit creation through which money
supply is created in the economy. This process in turn depends on the legal reserve requirement
that is mandatory for the banks to hold and is a combination of cash reserve ratio and statutory
liquidity ratio in our country. Thus in this manner equilibrium is attained in the money market
when money demand and money supply become equal.

Check your progress
(a) Demand of money means demand for transactionary purpose.
(b) Risk is measured by standard deviation in Tobin’s Portfolio.
(c) Tobins theory is successful in case of M1 measure but not M2.
(d) Credit creation by banks is dependent on the legal reserve requirement of banks.
(e) High powered money includes cash and reserves.
Ans. 1(T), 2(T), 3(F), 4(T), 5(T)
(a) Demand of money means demand for _ _ _ _ _ _ _ _ _ .
(b) Bonds have expected return which is equal to zero because _ _ _ _ _ _ .
(c) Exchange rate is the rate at which currency of one country is exchanged for currency of _ _ _
_ _ _ _ _ country .
(d) Monetary policy includes _ _ _ _ _ _ and _ _ _ _ _ _ _ measures.
Ans 1. Transactionary, speculative and precautionary motive 2. Expected gains and losses are
equal 3. Another 4. Qualitative and quantitaive
1. Differentiate between Tobin and Baumol’s theory
__________________________________________
__________________________________________
2. What is the process of credit creation by banks.

__________________________________________
__________________________________________
104
3. Explain the concept of money multiplier.
__________________________________________
__________________________________________
4. How does central bank affects money supply in the economy.

__________________________________________
__________________________________________
5. Explain qualitative measures of monetary policy.
__________________________________________
__________________________________________
6. Explain the concept of floating and fixed rate system
__________________________________________
__________________________________________
7. Explain the various components of investment.
__________________________________________
__________________________________________
8. Derive aggregate demand curve in a small open economy.
__________________________________________
_______________________________________________

U.K..
105

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UNIT II

ECONOMY IN THE SHORT RUN – IS-LM FRAMEWORK

EQUILIBRIUM DETERMINATION AND MULTIPLIER

After reading this lesson, you should be able to

Figure 1: Linear Consumption Curve

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 in Two Sector Economy

Figure 4: Equilibrium in 3 sector using Fixed Taxes

Figure 5: Equilibrium in 3 sector using Proportionate Taxes

1.4 CONCEPT OF MULTIPLIER

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

Graphical derivation of Multiplier

Figure 6: Multiplier in Two Sector Economy

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

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

Figure 8: Multiplier in Three Sector Economy

1.5 CONCEPT OF AUTOMATIC STABILIZER

Automatic stabilizers offset fluctuations in economic activity without direct intervention by

Two examples of Automatic stabilizers are:

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

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

Figure 10: Effect of Fiscal policy on Equilibrium

1.7 SELF ASSESSMENT QUESTIONS

1.8 SUGGESTED READINGS

After reading this lesson, you should be able to

2.3 DERIVATION OF IS CURVE

Figure 1: Investment Function

Figure 3: Slope of IS Curve

Figure 4: Position of IS Curve

2.4 DERIVATION OF LM CURVE

Figure 5: Demand of Money

Figure 6: Derivation of LM Curve

Figure 7: Position of LM Curve

Figure 8: Simultaneous Equilibrium

Impact of fiscal Policy on the simultaneous equilibrium

2.5 NUMERICAL ON IS– LM

2.7 SELF ASSESSMENT QUESTIONS

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

5. Explain how the Aggregate demand curve is derived

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

2.8 SUGGESTED READINGS

After reading this lesson, you should be able to

3.3 DERIVATION OF AGGREGATE DEMAND CURVE

3.4 MONETARY AND FISCAL MULTIPLIER

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

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

3.5 CROWDING OUT

Figure 4 (a) Crowding Out – Full Employment

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

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

3.7 SELF ASSESSMENT QUESTIONS

Check your progress

3. Explain derivation of Aggregate Demand Curve.

3.8 SUGGESTED READINGS

After reading this lesson, you should be able to

i = Nominal rate of interest and