MACROECONO

MIC MODELS
DR. SEEMA SHARMA
DEPARTMENT OF MANAGEMENT STUDIES
IIT DELHI-110016
 Introduction

 What is Economics?
 Economic Problems in Long Run
 Economic Problems in Short Run
 Economic Systems
 Business Cycles
 Stabilization Policies
History of Economic
Thought
 Mercantilism
 Classical
School of Thought
 Keynesian School of
Thought
Classical Model
 Classical economists believed that because of the following:
 Say’s Law
 Flexible interest rates
 Flexible prices
 Flexible wages

There would be enough spending to maintain full emp.

P2
P1

P0

Full Employment Output

According to classicals, increase in MS has a direct relationship with

Prices. Hence an increase in MS will increase the prices.

Reduction in wages led to decline in AD levels and plunged the economy

in deeper depression
Great Depression
 John Maynard Keynes

 Keynes's magnum opus, The General Theory of Employment,

Interest and Money, published in 1936.
 Keynes argued that Aggregate demand, instead of
Aggregate Supply, determines the overall level of economic
activity
 Inadequate aggregate demand could lead to prolonged
periods of high Unemployment.
 He advocated that the use of Fiscal and monetary policies
can mitigate the adverse effects of economic recessions and
Depressions.
Keynes gave Income Model based on effective
demand. Also gave concepts:
•Paradox of Thrift
•Liquidity Trap
 Keynesian Model

Full Employment Output

The General Theory of Employment, Interest and Money (1936)

• Effective Demand: Economy generally operates at less than

full employment.
• There is indirect relationship between MS and Price level.
• Government must behave as investor to revive the economy in bad times.
 Keynesian Model
Equilibrium in the economy:
AD= AS
E=Y
C+I = C+S
AD: Aggregate Demand, AS: Aggregate Supply,

E: Total Expenditure, Y: Total Income,

C = Consumption, I: Investment, S: Savings

 Investment Multiplier

Multiplier
mpc of poor people is high hence, in depression, purchasing
power of poor people should be increased.
IS LM Framework
 IS LM Analysis

 Given by Hicks and Hansen (1937)

 GeneraL EQUILIBRIUM of Product and money market
 IS: Investment (I) and Saving (S)
 LM: Demand for Money(L) and Supply of Money (S)
 Product Market Equilibrium

Y = C+I+G
C+I+G = C+S+T
Hence S = I (Desired S and I)

S = f(Y); positive relationship

I = f(r); negative relationship,
r: interest rate

IS curve shows combinations of r & Y where S & I are equal.

Derivation of IS Curve

IS Curve: There is
negative relationship
between r and output.

Changes in Y caused
by changes in r are
reflected as
movements along the
IS curve. When
interest rates
decrease, spending
rises and as a result,
output increases as
well. When interest
rates increase,
spending falls and as
a result output
decreases as well.
Shifts in IS curve: Changes in Y due to factors
other than r

Change Shift
Increase in investment right

Increase in Govt. Spending Right

Increase in consumption Right

Reduction in saving Right
Reduction in Taxes Right
Investment falls Left
increase in Savings Left
Increase in Taxes Left
 Money market Equilibrium
LM
 L= LT+Ls
LT: Transactions demand for money
Ls: Speculative demand for money

LT =f(Y), positive relationship

Ls= f(r), negative relationship

 M
Money Supply is assumed fixed as set by RBI in India and
Federal reserve in US
LM curve shows all combinations of r & Y at which demand
for money and supply of money is equal.
 Shifts in LM curve
Change Shift

Increase in Money supply Right

Decrease in demand for money Right

Decrease in Money supply Left

Increase in demand for money Left

IS LM General Equilibrium
IS-LM and Policy Analysis: Fiscal Policy and
Monetary Policy

(Govt. Expenditure, Taxation and Money Supply are policy variables)

Expansionary Fiscal Policy: Crowding Out Effect

Public investment crowds out the private investment.

 Expansionary Monetary Policy

Open Market Operations: The Central Bank buys G-Secs & increases the money supply.
This injection of liquidity lowers the interest rate in the money market. The reduced
interest rate induces increased investment, and equilibrium output consequently
increases. The LM curve shifts to the right and equilibrium output increases. Because of
the increased income demand for money increases (transactions), and this increases the
interest rate. The economy eventually settles down at a new simultaneous equilibrium.

MS ↑ ⇒ r↓ ⇒ I↑ ⇒Y↑ ⇒MD ↑ ⇒ Net reduction in r overall and higher income.

Simultaneous use of Expansionary Fiscal &
Monetary Policy to avoid Crowding Out
 Mundell-Fleming model

 Also known as the IS-LM-BP model is an extension

of the IS-LM model given by Robert Mundell and
Marcus Fleming in 60s.
 The traditional model is applicable to a closed
economy. Whereas this model is applicable to an
open economy.
 The problem of Trinity was also given by them.
Balance of Payments
Exchange Rate
BOP Equilibrium
 The equilibrium condition In an open economy, in the goods market is
that Y (Supply/production/income) is equal to the demand for goods
i.e., consumption expenditure, investment spending, Government
spending and net exports.

Y = C(Y-T) + I + G + NX

Now, let us examine impact of changes in exchange rate(ER) on goods

market and money market.
 The Goods Market

 If ER decreases (An appreciation under flexible exchange rates or a revaluation under fixed
exchange rates), then we’ll be able to buy more foreign currency with less of our own currency.
Therefore, when ER decreases domestic residents have more purchasing power, thus being able to
buy the same amount of goods using less domestic currency. Hence Net Exports will come down.

 If ER increases (depreciation under flexible exchange rates or a devaluation under fixed exchange
rates), the net exports will increase.

 In case of increase in ER, IS curve shifts to the right, and in case of decrease in ER causes net export
to decrease and hence the IS curve shifts to the left.
 The Money Market
 The equilibrium of the money market implies that, given the amount of
money, the interest rate is an increasing function of the output level. When
output increases, the demand for money raises, but, as we have said, the
money supply is given. Therefore, the interest rate should rise until the
opposite effects acting on the demand for money are cancelled, people will
demand more money because of higher income and less due to rising
interest rates. The slope of the curve is positive, contrary to what happened in
the IS curve. This is because the slope reflects the positive relationship
between output and interest rates.
IS-LM-BP Model: BP Line
The Balance of Payments
Shift in BP Curve
Equilibrium in IS-LM-BP Model
Scenario 1: Fixed Exchange Rates, Perfect Capital Mobility, Increase in
Money Supply

The increase in the Money supply shifts

the LM curve to the right, the economy
goes from point A to point B. At B, there
are infinite capital outflows as domestic
investors seek to purchase higher
returning foreign assets. For foreign
exchange, the investors will exchange
INR into dollars. The RBI has agreed to
maintain the exchange rate stability, and
therefore sells foreign exchange. As the
RBI supplies the dollars and takes back
INR, the money supply is decreased: the
LM curve moves to the left, coming to
rest at its initial position. The economy
moves back to A. There is no change in
Y or r from this monetary policy.
Finding: Monetary policy is ineffective in
altering the level of domestic output under
fixed exchange rates and perfect capital
mobility.
 Scenario 2: Fixed Exchange Rates, Perfect Capital Mobility, Increase in
Govt. Spending (G)
Finding: Fiscal policy is extremely effective
in altering the level of domestic output
under fixed exchange rates and perfect
capital mobility
The increase in G means an
increase in Total Expenditures,
therefore the IS curve shifts to the
right and the economy goes from
point A to point B. At B, there are
infinite capital inflows as foreign
investors seek to purchase higher
returning domestic assets. These
investors are exchanging their
foreign currency for dollars. The
RBI has agreed to maintain the
exchange rate stability, and
therefore buys up the unwanted
foreign exchange. hence the
Money supply in INR is increased:
the LM curve moves to the right
and the economy goes from point
B to point C. There is a large
change in Y from this fiscal
expansion.
 Scenario 3: Flexible Exchange Rates, Perfect Capital Mobility,
Increase in Money Supply
The increase in the Money supply shifts the LM
curve to the right, the economy goes from point A to
point B. At B, there are infinite capital outflows as
domestic investors seek to purchase higher returning
foreign assets. The INR depreciates, ER increases).
As ER increases, Net Exports increase. As NX
increases, Total Expenditures rise and the IS curve
shifts to the right. The exchange rate will continue to
depreciate, and the IS curve will continue to shift to
the right until the capital outflow is halted (i.e. until
the domestic interest rate equals the foreign interest
rate). The new equilibrium is at C, where domestic
output has increased.

In abbreviated notation this would be: ↑MS → LM

right: A to B

At B: infinite capital outflows: ↑ER (INR

depreciates) → ↑NX → ↑TE → IS right: B to C. ↑Y
Finding: Monetary policy is extremely effective from Y0 to Y1.
in altering the level of domestic output under
flexible exchange rates and perfect capital
mobility
 Scenario 4: Flexible Exchange Rates, Perfect Capital Mobility,
Increase in G

The increase in Government spending means there's

an increase in Total Expenditures, therefore the IS
curve shifts to the right and the economy goes from
point A to point B. At B, there are infinite capital
inflows as foreign investors seek to purchase higher
returning domestic assets. INR appreciates, Net
Exports decrease. As NX decreases, Total
Expenditures fall and the IS curve shifts to the left.
The exchange rate will continue to appreciate, and
the IS curve will continue to shift to the left until the
capital inflow is halted (i.e., until the domestic
interest rate equals the foreign interest rate). The
new equilibrium is at the same level of output as the
initial level: the economy moves back to A.

Finding: Fiscal policy is ineffective in altering the

level of domestic output under flexible exchange
rates and perfect capital mobility.