Shift in IS- LM Model in closed

Economy: Role of fiscal and

monetary policy
Chandan Adhikari

"For making soap,

..oil is required.
But to clean oil,
..soap is required”.
 Learning Objectives
• After studying this topic, you should be able to
understand:
• The effect of expansionary fiscal policy due
increase in government expenditure and
reduction in tax (fiscal variables) on interest
rate and national income. (Md, Ms, CRR, SLR
etc. are monetary variables).
• How increase in Government expenditure and
reduction in tax rates crowds out some private
investment.
 Learning objectives
• The effect of expansionary monetary
policy due to increase in government
expenditure and reduction in tax on
interest rate and national income.
• How increase in Government
expenditure and reduction in tax rates
crowds out some private investment.
 What is Fiscal Policy
• Fiscal policy relates to the utilisation of
government expenditure and taxation to
achieve some well defined objectives
related to growth, employment and
many others.
• It has three instruments: Taxes,
government expenditure and
borrowings. (fiscal variables)
 Effect of Fiscal Policy: Expansionary FP

• Let us first explain how IS-LM model shows the effect

of expansionary fiscal policy of increase in
Government expenditure on level of national income.
• G↑→ AD & Y↑→ Md & r↑→I and Y ↓ (When Ms is
given)
• Increase in Government expenditure which is of
autonomous nature raises aggregate demand for
goods and services and thereby causes an outward
shift in IS curve.
• Fig. 20.6 shows increase in Government expenditure
leads to the shift in IS curve from IS1 to IS2.
 Govt. multiplier
• The national income equilibrium can be
determined with the help of following
equation: when there is lump sum tax an GE
• Y = 1/1-b (a – bT + I + G) (1)
• Y + ΔY= 1/1-b (a – bT + I + G + ΔG) (2)
• By subtracting equation (1) from (2), we get:
• ΔY= 1/1-b (ΔG)
• The government expenditure multiplier can
be calculated by the following formula:
• Gm = ΔY/ΔG = 1/1-b
• Where Gm is the government expenditure
multiplier.
Shift in IS due to GE, r , National
income and crowding out effect
 Contd..
• Shift in IS curves is equal to the increase in
government expenditure times the government
expenditure multiplier which is ΔG x 1/1-MPC.
• Increase in national income equals to the horizontal
distance EK through Keynes’ multiplier model.
• However, in IS-LM model actual increase in national
income is not equal to EK rather it is EC.
• When G increases, AD increases which leads to an
increase in demand for real money balances and
given the real money supply fixed, interest rate rise
which causes reduction in private investment.
• LM curve remaining unchanged, the new IS2 curve
intersects LM curve at point B.
 Contd..
• It can be seen from the diagram that in the IS-LM
model increase in national income by Y1 Y2
• Increase in national income by Y1 Y2 is less than EK
which would occur in Keynes’ model.
• This is because Keynes in his simple multiplier model
assumes that investment is fixed and autonomous.
• IS-LM model takes into account the fall in private
investment due to the rise in interest rate that takes
place with the increase in Government expenditure.
• That is how increase in Government expenditure
crowds out some private investment due to which CK
level of income is crowded out.
 Crowding out and crowding in
• Crowding out is a situation which arises when
an expansionary fiscal policy for example, an
increase in government expenditure leads to an
increase in the rate of interest, thus leading to a
decrease in private investment.
• Crowding in is an economic principle in which
private investment increases as debt-financed
government spending increases. This is caused
by government spending boosting the demand
for goods, which in turn increases private
demand for new output sources, such as
factories. Infra spend also encourages pvt invt.
 Expansionary Fiscal Policy:
Reduction in Taxes
• Reduction in taxes through increase in
disposable income of the people raises
consumption demand of the people.
• As a result, cut in taxes causes a shift in the
IS curve to the right as is shown in Fig. 20.7
from IS1 to IS2.
• Keynesian multiplier model, the horizontal
shift in the IS curve is determined by the
value of tax multiplier times the reduction in
taxes (ΔT), that is, ΔT x MPC/1-MPC and
causes level of income to increase by EH
 Tax multiplier
• Y = 1/1-b (a -bT + I + G)
• Let there be change in tax ΔT, hence we get,
Y + ΔY = 1/1-b [a – bT + b ΔT + I + G ] (2)
• By subtracting equation (1) from equation
(2), we obtain:
• ΔY= 1/1-b (-b ΔT)
• ΔY = bΔT/1-b or Tm= ΔY/ ΔT= -b/1-b
• The tax multiplier (Tm) can be calculated
by using the above equation:
 Shift of the IS curve from IS1 to IS2 due to reduction in taxes
Equilibrium of the economy moves from point E to D.
Rate of int. rises from r1 to r2, income increases from Y1 to Y2.
Income equal to LH has been wiped out because of crowding-
out effect on private investment as a result of rise in interest
rate. Just opposite happens when taxes are increased.
 Effectiveness of Fiscal Policy
• It depends upon on how strong/weak is the
link between each of the four parts of the
fiscal policy transmission mechanism.
• If government expenditure multiplier is large
and productive, FP will be more effective
and vice versa.
• Financial sophistication through e-money will
decide the demand for real money balances.
E-money will leave less idle money and
thereby lower demand for money and hence
less increase in interest rate and crowding
out will be less.
 Contd..
• Responsiveness of demand for money to
rate of interest. A small increase in interest
rate will be necessary to bring the money
market into equilibrium. Again the crowding
out will be less.
• How responsive is the private sector
investment to change in interest rate. If the
nature of investment is autonomous,
crowding out will be less.
 Monetary Policy
• Monetary policy refers to various
monetary policy instruments which are
used to attain certain objectives such as
regulating money supply, changes in
interest rate, regulating exchange rate
etc. to achieve growth, employment and
other objectives.
 Effect of expansionary and tight monetary
policies through IS-IM Curve Model
● A change in money supply causes a shift in the LM curve.
● Expansion in money supply shifts LM Curve to the right
and contraction in money supply shifts it to the left.
● The increase in money supply, state of liquidity preference
or demand for money remaining unchanged, will lead to the
fall in rate of interest.
● At a lower interest there will be more investment by
businessmen.
● More investment will cause aggregate demand and income
to rise.
● This implies that with expansion in money supply LM curve
will shift to the right as is shown in Fig. 20.8.
 As a result, the economy will move from equilibrium
point E to D and with this the rate of interest will fall from
r1 to r2 and national income will increase from Y1 to Y2.
Thus, IS-LM model shows that expansion in money
supply lowers interest rate and raises income.
 Monetary Transmission mechanism.
• IS-LM curve model shows the expansion in
money supply leads to the increase in
aggregate demand for goods and services.
• Increase in money supply lowers the rate of
interest which then stimulates more
investment demand.
• Increase in investment demand through
multiplier process leads to a greater increase
in aggregate demand and national income.
Effectiveness of MP
 Contd..
• The LM curve has three stages:
• (i) Liquidity trap region where the LM curve is
horizontal (also known as the Keynesian region),
• (ii) The classical region where the LM curve is
vertical, or perfectly inelastic, interest elasticity
of national income is infinite
• (iii) The intermediate region where the LM curve
is positively sloped. E >0
• In the liquidity trap region or extreme Keynesian
range, monetary policy is totally ineffective in
stimulating income. Despite an increase in money
supply, LM curve does not change its position.
 Contd…
• An increase in money supply cannot cause the
interest rate to fall below the rate given by the
liquidity trap. Equilibrium income then remains
unchanged at OY0.
• As was believed by Keynes during the Great
Depression years of the 1930s that the economy
was caught in the trap region then he
recommended for the use of unorthodox fiscal
policy. In other words, monetary policy was to
be discarded during the early 1930s as it would
be grossly ineffective in stimulating the
economy.
 Contd..
• The essence of the argument is that since government is
helpless in raising income/output level through monetary
policy, the government has to employ the fiscal policy.
Anyway, it must be said that the liquidity trap is an
extreme case.
• Secondly, in the classical region, where the LM curve is
vertical and E=0 or perfectly inelastic, monetary policy
becomes completely effective as speculative demand for
money becomes zero
• As the LM curve shifts to LM1, rate of interest declines
more this time from Or4 to Or3. This causes income to
rise by a larger amount from OY3 to OY4. In view of this,
classicists favour monetary policy.
 Contd..
• But Keynesians reject monetary policy during
depression when rate of interest reaches a floor
level. Thus, in the classical range, monetary
policy is completely effective in contrast to the
Keynesion or liquidity trap region in which
monetary policy is totally ineffective, (i.e., the
LM curve is perfectly elastic).
• Finally, in the intermediate range where the LM
curve is positive sloping, an increase in money
supply shifts the LM curve from LM to LM1.
Consequently, interest rate declines to Or 1 and
income rises from OY to OY .
 Contd..
• Thus, monetary policy is effective. To be more
specific, monetary policy is found to have a
degree of effectiveness but not the complete
effectiveness as we see in the classical region.
• In general, the closer the equilibrium (of IS and
LM curves) is to the classical region, the more
effective monetary policy becomes, and the
closer the equilibrium is to the Keynesian range,
the less effective monetary policy becomes.
 Fiscal Policy
• Fiscal policy also attempts to influence aggregate
demand in an economy by influencing tax-expenditure
programme of the government. A cut in taxes or an
increase in government spending causes a shift in the IS
curve in the rightward direction.
• In Fig. 3.34, the IS curve intersects the LM curve at its
horizontal portion (i.e., liquidity trap region). In this
region, as the IS curve shifts from IS to IS1, the
equilibrium level of income rises from OY0 to OY1.
Thus, fiscal policy is completely effective in stimulating
aggregate income in the depressionary phase without
having any effect on interest rate.
 Contd…
• Secondly, in the classical range, fiscal policy is
completely ineffective since it fails to stimu­late
aggregate demand and, hence, aggregate income.
Fig. 3.34 says that the increased gov­ernment
expenditure and/or decreased taxes shifts the IS
curve in the classical region (where the LM curve
is vertical) from IS4 to IS5.
• This causes equilibrium intersection to shift up.
This results in an increase in the interest rate only
from Or3 to Or4, keeping income level unchanged
at OY4.
 Contd..
• Finally; fiscal policy is partly effective in the
normal intermediate range where both interest
rate and income rise. Fiscal measures that shift
the IS curve from IS2 to IS3 in the section
between Keynesian and classical section, called,
intermediate section, raises the level of income
from OY2 to OY1 and the rate of interest from Or1
to Or2.
 Fiscal Policy
• Thus, fiscal policy is found to have a degree
of effectiveness in this region. It may be
concluded that in general fiscal policy
becomes more effective the closer the IS-
LM intersection or equilibrium lines to the
Keynesian or liquidity trap region and less
effective the closer equilibrium resides to
the classical region.
 Contd..
• Thus, fiscal policy may be employed in
depression years. This is the Keynesian argu­
ment. It is argued that these results concern­ing
monetary policy are the opposites of the results
obtained under fiscal policy regime.
 Contd..
• Thus, one can conclude that the effective­ness of
monetary policy depends on (i) the interest-
elasticity of the demand for money, and (ii) the
interest elasticity of investment. These two
aspects can be illustrated in terms of Fig 3.35.
Contd..
 Contd..
• If the LM curve is vertical (pure classical case), monetary
policy becomes highly effective in raising equilibrium
income [Fig. 3.35(a)]. Consequent upon an increase in
money supply, the LM curve shifts from LM to LM1.
Equilibrium interest rate now declines from Or1 to Or2
and equilibrium income rises from OY1 to OY2.The
biggest effect of monetary policy can be felt if the IS
curve is perfectly elastic [Fig. 3.35(b)]. Note that
following a shift in the LM curve from LM to LM1
national income rises from OY1 to OY2 without
influencing the interest rate that remains at Or1.
 Contd..
• On the other hand, if the LM curve is horizontal
(pure Keynesian range) and if the IS curve is
vertical, monetary policy becomes ineffective
completely [Figs. 3.35 (c) and (d)]. Fig. 3.35 (c)
says that a downward shift in the horizontal LM
curve from LM to LM1 along with the vertical IS
curve, income remains unchanged at OY1 while r
declines to Or2.
 Contd..
• Thus, monetary policy does not have any
influence in stimulating an economy in
depression. Again, monetary policy fails to boost
income/output of an economy if the positive
sloping LM curve shifts from LM to LM1,
though interest rate declines from Or1 to Or2
following an increase in money supply.
 Contd..
• Likewise, the effectiveness of fiscal policy depends on the slopes
of the IS curve and the LM curve. The more interest-inelastic is
the investment, the more effective is fiscal policy (Fig. 3.36(b).
Likewise, the flatter the LM curve, greater the effectiveness of
fiscal policy (Fig. 3.36 (c). Fiscal policy is completely in­effective
in Fig. 3.36(a).
 Inflation and monetary policy.
• Reduction in money supply through open market
operations by selling bonds or government
securities in the open market
• RBI gets currency funds from those who buy the
bonds. In this way liquidity in the banking system
can be reduced.
• Increase in cash reserve ratio of the banks is
another method of reducing money supply.
• The higher cash reserve ratio implies that the
banks have to keep more cash reserve with the
Central Bank. As a result, the cash reserves with
the banks fall which force them to contract credit.
With this money supply in the economy declines.
 IS-LM model and reduction in money supply. When
LM shifts leftward shift in LM curve, IS curve
remaining the same, interest rate rises which causes
reduction in investment demand and consumption
demand and help in controlling inflation. This is
shown in Fig. 20.9.