Tuesday, May 17, 2011

Part IV- Shifts of IS and LM Curves

Synthesis of Monetary and Income Analysis - Part IV

Any fiscal policy change shifts the IS Curve, and any monetary policy change shifts the LM Curve.
a) Shift of the IS Curve due to changes in fiscal policy

The IS Curve shifts to the right to I'S' due to expansionary fiscal policy. Expansionary fiscal policy may be adopted through

i) Cut in taxes
ii) Increase in government expenditure
These are basically called real disturbances in the economy.

H becomes the new equilibrium position. When government spends more, there is an increase in income due to the operation of the multiplier. So the income increases to Yc from Ye. If national income increases, the demand for money also increases. This leads to an increase in the rate of interest, which now goes up to rc.

A cut or fall in taxes lead to an increase in the disposable income (Yd). Similarly this also leads to an increase in the rate of interest. Yd = Y - Tax.

The opposite thing will happen if the national income falls. The demand for money will fall. This would lead to a fall in the rate of interest.

b) Shift of the LM Curve due to changes in monetary policy

An increase in money supply or adoption of an expansionary monetary policy leads to a fall in the price of money, namely the rate of interest. This is basically called a monetary disturbance in the economy. Rate of Interest falls from re to rd. This shifts the LM Curve downward to L'M'. E' becomes the new equilibrium position. Due to a fall in the rate of interest, investment increases in the commodity market. Change in investment will increase the national income because ΔY = m(ΔI). National Income increases from Ye to Yd.

Thus, an increase in money supply leads to
a) Fall in the demand for money
b) Fall in the rate of interest
c) Rise in investment
d) Rise in the level of income

Similarly, a decrease in money supply leads to
a) Rise in the demand for money
b) Rise in the rate of interest
c) Fall in investment
d) Fall in the level of income

Any change in consumption function, investment function, government expenditure or taxes Shifts the IS Curve. Upward or downward shift depends upon whether the effect is expansionary or contractionary.

Any change in the demand for money, supply of money (or price level) Shifts the LM Curve. Again, upward or downward shift depends upon whether the effect is expansionary or contractionary.

c) There will be a number of possibilities if both the curves shift, due to simultaneous changes in monetary policy and fiscal policy.

If the IS Curve shifts to the right and the LM Curve to the left, the rate of interest increases from ro to r1, but income remains unchanged at Yo.
If both the curves shift to the right, the rate of interest remains unchanged at ro, but the level of income increases from Yo to Y1.
Various combinations of expansionary and contractionary monetary and fiscal policies may be adopted by the government to bring about the desired change in the economy.

Part IV of IV

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