The IS-LM Curve Model
(Explained With Diagram)
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The IS-LM Curve Model (Explained With
Diagram)!
The Goods Market and Money Market: Links between Them:
The
Keynes in his analysis of national income explains that national income is
determined at the level where aggregate demand (i.e., aggregate expenditure)
for consumption and investment goods (C +1) equals aggregate output.
In
other words, in Keynes’ simple model the level of national income is shown to
be determined by the goods market equilibrium. In this simple analysis of
equilibrium in the goods market Keynes considers investment to be determined by
the rate of interest along with the marginal efficiency of capital and is shown
to be independent of the level of national income.
The
rate of interest, according to Keynes, is determined by money market
equilibrium by the demand for and supply of money. In this Keynes’ model,
changes in rate of interest either due to change in money supply or change in
demand for money will affect the determination of national income and output in
the goods market through causing changes in the level of investment.
In
this way changes in money market equilibrium influence the determination of
national income and output in the goods market. However, there is apparently
one flaw in the Keynesian analysis which has been pointed out by some
economists and has been a subject of a good deal of controversy.
It
has been asserted that in the Keynesian model whereas the changes in rate of
interest in the money market affect investment and therefore the level of
income and output in the goods market, there is seemingly no inverse influence
of changes in goods market i.e., (investment and income) on the money market
equilibrium.
It
has been shown by J.R. Hicks and others that with greater insights into the
Keynesian theory one finds that the changes in income caused by changes in
investment or propensity to consume in the goods market also influence the
determination of interest in the money market.
According
to him, the level of income which depends on the investment and consumption
demand determines the transactions demand for money which affects the rate of
interest. Hicks, Hansen, Lerner and Johnson have put forward a complete and
integrated model based on the Keynesian framework wherein the variables such
as investment, national income, rate of interest, demand for and supply of
money are interrelated and mutually interdependent and can be represented by
the two curves called the IS and LM curves.
This
extended Keynesian model is therefore known as IS-LM curve model. In this model
they have shown how the level of national income and rate of interest are
jointly determined by the simultaneous equilibrium in the two interdependent
goods and money markets. Now, this IS-LM curve model has become a standard tool
of macroeconomics and the effects of monetary and fiscal policies are discussed
using this IS and LM curves model.
Goods Market Equilibrium: The Derivation of the is Curve:
The
IS-LM curve model emphasises the interaction between the goods and money
markets. The goods market is in equilibrium when aggregate demand is equal to
income. The aggregate demand is determined by consumption demand and investment
demand.
In
the Keynesian model of goods market equilibrium we also now introduce the rate
of interest as an important determinant of investment. With this introduction
of interest as a determinant of investment, the latter now becomes an
endogenous variable in the model.
When
the rate of interest falls the level of investment increases and vice versa.
Thus, changes in the rate of interest affect aggregate demand or aggregate
expenditure by causing changes in the investment demand. When the rate of
interest falls, it lowers the cost c’ investment projects and thereby raises
the profitability of investment.
The
businessmen will therefore undertake greater investment at a lower rate of
interest. The increase in investment demand will bring about increase in
aggregate demand which in turn will raise the equilibrium level of income. In
the derivation of the IS Curve we seek to find out the equilibrium level of
national income as determined by the equilibrium in goods market by a level of
investment determined by a given rate of interest.
Thus
IS curve relates different equilibrium levels of national income with various
rates of interest. As explained above, with a fall in the rate of interest, the
planned investment will increase which will cause an upward shift in aggregate
demand function (C + 7) resulting in goods market equilibrium at a higher level
of national income.
The
lower the rate of interest, the higher will be the equilibrium level of
national income. Thus, the IS curve is the locus of those combinations of rate
of interest and the level of national income at which goods market is in
equilibrium.
How the IS curve is derived is illustrated in Fig. 24.1. In
panel (a) of Fig. 24.1 the relationship between rate of interest and planned
investment is depicted by the investment demand curve II. It will be seen from
panel (a) that at rate of interest Or0 the planned investment
is equal to OI0. With OI0 as the amount of
planned investment, the aggregate demand curve is C + I0 which, as will be seen
in panel (b) of Fig. 24.1 equals aggregate output at OY1 level of national
income.
Therefore, in the panel (c) at the bottom of the Fig. 24.1,
against rate of interest Or2, level of income
equal to OY0 has been plotted. Now,
if the rate of interest falls to Or2 the planned investment
by businessmen increases from OI0 to OI1 [see panel (a)]. With
this increase in planned investment, the aggregate demand curve shifts upward
to the new position C + 11 in panel (b), and the goods market is in equilibrium
at OY1 level of national
income. Thus, in panel (c) at the bottom of Fig. 24.1 the level of national
income OY1 is plotted against the
rate of interest, Or1.
With further lowering of the rate of interest to Or2, the planned investment increases to OI2 (see panel a). With
this further rise in planned investment the aggregate demand curve in panel (b)
shifts upward to the new position C + I2 corresponding to which
goods market is in equilibrium at OY2 level of income.
Therefore, in panel (c) the equilibrium income OY2 is shown against the
interest rate Or2.
By
joining points A, B, D representing various interest-income combinations at
which goods market is in equilibrium we obtain the IS Curve. It will be
observed from Fig. 24.1 that the IS Curve is downward sloping (i.e., has a
negative slope) which implies that when rate of interest declines, the
equilibrium level of national income increases.
Why does IS Curve Slope Downward?
What
accounts for the downward-sloping nature of the IS curve. As seen above, the
decline in the rate of interest brings about an increase in the planned
investment expenditure. The increase in investment spending causes the
aggregate demand curve to shift upward and therefore leads to the increase in
the equilibrium level of national income. Thus, a lower rate of interest is
associated with a higher level of national income and vice-versa. This makes
the IS curve, which relates the level of income with the rate of interest, to
slope downward.
Steepness
of the IS curve depends on (1) the elasticity of the investment demand curve,
and (2) the size of the multiplier. The elasticity of investment demand
signifies the degree of responsiveness of investment spending to the changes in
the rate of interest.
Suppose
the investment demand is highly elastic or responsive to the changes in the
rate of interest, then a given fall in the rate of interest will cause a large
increase in investment demand which in turn will produce a large upward shift
in the aggregate demand curve.
A
large upward shift in the aggregate demand curve will bring about a large
expansion in the level of national income. Thus when investment demand is more
elastic to the changes in the rate of interest, the investment demand curve
will be relatively flat (or less steep). Similarly, when investment demand is
not very sensitive or elastic to the changes in the rate of interest, the IS
curve will be relatively more steep.
The
steepness of the IS curve also depends on the magnitude of the multiplier. The
value of multiplier depends on the marginal propensity to consume (mpc). It
may be noted that the higher the marginal propensity to consume, the aggregate
demand curve (C + I) will be more steep and the magnitude of multiplier will
be large.
In
case of a higher marginal propensity to consume (mpc) and therefore a higher
value of multiplier, a given increment in investment demand caused by a given
fall in the rate of interest will help to bring about a greater increase in
equilibrium level of income.
Thus,
the higher the value of multiplier, the greater will be the rise in equilibrium
income produced by a given fall in the rate of interest and this makes the IS
curve flatter. On the other hand, the smaller the value of multiplier due to
lower marginal propensity to consume, the smaller will be the increase in
equilibrium level of income following a given increment in investment caused by
a given fall in the rate of interest. Thus, in case of smaller size of
multiplier the IS curve will be more steep.
Shift in IS Curve:
It
is important to understand what determines the position of the IS curve and
what causes shifts in it. It is the level of autonomous expenditure which
determines the position of the IS curve and changes in the autonomous
expenditure cause a shift in it. By autonomous expenditure we mean the
expenditure, be it investment expenditure, the Government spending or
consumption expenditure which does not depend on the level of income and the
rate of interest.
The
government expenditure is an important type of autonomous expenditure. Note
that the Government expenditure which is determined by several factors as well
as by the policies of the Government does not depend on the level of income and
the rate of interest.
Similarly,
some consumption expenditure has to be made if individuals have to survive
even by borrowing from others or by spending their savings made in the past
year. Such consumption expenditure is a sort of autonomous expenditure and
changes in it do not depend on the changes in income and rate of interest.
Further, autonomous changes in investment can also occur.
In
the goods market equilibrium of the simple Keynesian model the investment
expenditure is treated as autonomous or independent of the level of income and
therefore does not vary as the level of income increases. However, in the
complete Keynesian model, the investment spending is thought to be determined
by the rate of interest along with marginal efficiency of investment.
Following
this complete Keynesian model, in the derivation of the IS curve we consider
the level of investment and changes in it as determined by the rate of interest
along with marginal efficiency of capital. However, there can be changes in
investment spending autonomous or independent of the changes in rate of
interest and the level of income.
For
instance, growing population requires more investment in house construction,
school buildings, roads, etc., which does not depend on changes in level of
income or rate of interest. Further, autonomous changes in investment spending
can also take place when new innovations come about, that is, when there is
progress in technology and new machines, equipment, tools etc., have to be
built embodying the new technology.
Besides,
Government expenditure is also of autonomous type as it does not depend on
income and rate of interest in the economy. As is well- known government
increases its expenditure for the purpose of promoting social welfare and
accelerating economic growth. Increase in Government expenditure will cause a
rightward shift in the IS curve.
Money Market Equilibrium: Derivation of LM Curve:
Derivation of the LM Curve:
The
LM curve can be derived from the Keynesian theory from its analysis of money
market equilibrium. According to Keynes, demand for money to hold depends upon
transactions motive and speculative motive.
It
is the money held for transactions motive which is a function of income. The
greater the level of income, the greater the amount of money held for
transactions motive and therefore higher the level of money demand curve.
The
demand for money depends on the level of income because they have to finance
their expenditure, that is, their transactions of buying goods and services.
The demand for money also depends on the rate of interest which is the cost of
holding money. This is because by holding money rather than lending it and
buying other financial assets, one has to forgo interest.
Thus demand for money (Md) can be expressed as:
Md
– L(Y, r)
Where Md stands for demand for
money, Y for real income and r for rate of interest. Thus, we can draw a family
of money demand curves at various levels of income. Now, the intersection of
these various money demand curves corresponding to different income levels with
the supply curve of money fixed by the monetary authority would gives us the LM
curve.
The
LM curve relates the level of income with the rate of interest which is
determined by money-market equilibrium corresponding to different levels of
demand for money. The LM curve tells what the various rates of interest will be
(given the quantity of money and the family of demand curves for money) at
different levels of income.
But the money demand curve or what Keynes calls the liquidity
preference curve alone cannot tell us what exactly the rate of interest will
be. In Fig. 24.2 (a) and (b) we have derived the LM curve from a family of
demand curves for money.
As income increases,
money demand curve shifts outward and therefore the rate of interest which
equates supply of money, with demand for money rises. In Fig. 24.2 (b) we
measure income on the X-axis and plot the income level corresponding to the
various interest rates determined at those income levels through money market
equilibrium by the equality of demand for and the supply of money in Fig. 24.2
(a).
As income increases,
money demand curve shifts outward and therefore the rate of interest which
equates supply of money, with demand for money rises. In Fig. 24.2 (b) we
measure income on the X-axis and plot the income level corresponding to the
various interest rates determined at those income levels through money market
equilibrium by the equality of demand for and the supply of money in Fig. 24.2
(a).
Slope of LM Curve:
It will be noticed from Fig. 24.2 (b) that the LM curve
slopes upward to the right. This is because with higher levels of income,
demand curve for money (Md) is higher and
consequently the money- market equilibrium, that is, the equality of the given
money supply with money demand curve occurs at a higher rate of interest. This
implies that rate of interest varies directly with income.
It is important to know the factors on which the slope of the
LM curve depends. There are two factors on which the slope of the LM curve
depends. First, the responsiveness of demand for money (i.e., liquidity preference)
to the changes in income. As the income increases, say from Y0 to Y1 the demand curve for
money shifts from Md0 to Md1 that is, with an
increase in income, demand for money would increase for being held for
transactions motive, Md or L1 =f(Y).
This
extra demand for money would disturb the money market equilibrium and for the
equilibrium to be restored the rate of interest will rise to the level where
the given money supply curve intersects the new demand curve corresponding to
the higher income level.
It
is worth noting that in the new equilibrium position, with the given stock of
money supply, money held under the transactions motive will increase whereas
the money held for speculative motive will decline.
The greater the extent to which demand for money for
transactions motive increases with the increase in income, the greater the
decline in the supply of money available for speculative motive and, given the
demand for money for speculative motive, the higher the rise in tie rate of
interest and consequently the steeper the LM curve, r = f (M2 L2) where r is the rate of interest, M2 is the stock of money
available for speculative motive and L2 is the money demand or
liquidity preference for speculative motive.
The
second factor which determines the slope of the LM curve is the elasticity or
responsiveness of demand for money (i.e., liquidity preference for speculative
motive) to the changes in rate of interest. The lower the elasticity of
liquidity preference for speculative motive with respect to the changes in the
rate of interest, the steeper will be the LM curve. On the other hand, if the
elasticity of liquidity preference (money demand-function) to the changes in
the rate of interest is high, the LM curve will be flatter or less steep.
Shifts in the LM Curve:
Another
important thing to know about the IS-LM curve model is that what brings about
shifts in the LM curve or, in other words, what determines the position of the
LM curve. As seen above, a LM curve is drawn by keeping the stock or money
supply fixed.
Therefore,
when the money supply increases, given the money demand function, it will lower
the rate of interest at the given level of income. This is because with income
fixed, the rate of interest must fall so that demands for money for speculative
and transactions motive rises to become equal to the greater money supply. This
will cause the LM curve to shift outward to the right.
The
other factor which causes a shift in the LM curve is the change in liquidity
preference (money demand function) for a given level of income. If the
liquidity preference function for a given level of income shifts upward, this,
given the stock of money, will lead to the rise in the rate of interest for a
given level of income. This will bring about a shift in the LM curve to the
left.
It
therefore follows from above that increase in the money demand function causes
the LM curve to shift to the left. Similarly, on the contrary, if the money
demand function for a given level of income declines, it will lower the rate of
interest for a given level of income and will therefore shift the LM curve to
the right.
The LM Curve: The Essential Features:
From our analysis of the LM curve, we arrive at its following
essential features:
1.
The LM curve is a schedule that describes the combinations of rate of interest
and level of income at which money market is in equilibrium.
2.
The LM curve slopes upward to the right.
3.
The LM curve is flatter if the interest elasticity of demand for money is high.
On the contrary, the LM curve is steep if the interest elasticity demand for
money is low.
4.
The LM curve shifts to the right when the stock of money supply is increased
and it shifts to the left if the stock of money supply is reduced.
5.
The LM curve shifts to the left if there is an increase in the money demand
function which raises the quantity of money demanded at the given interest rate
and income level. On the other hand, the LM curve shifts to the right if there
is a decrease in the money demand function which lowers the amount of money
demanded at given levels of interest rate and income.
Simultaneous Equilibrium of the Goods Market and Money Market:
The IS and the LM curves relate the two variables:
(a)
Income and
(b)
The rate of interest.
Income and the rate of interest are therefore determined
together at the point of intersection of these two curves, i.e., E in Fig.
24.3. The equilibrium rate of interest thus determined is Or2 and the level of
income determined is OY2. At this point
income and the rate of interest stand in relation to each other such that (1)
the goods market is in equilibrium, that is, the aggregate demand equals the
level of aggregate output, and (2) the demand for money is in equilibrium with
the supply of money (i.e., the desired amount of money is equal to the actual
supply of money). It should be noted that LM cur/e has been drawn by keeping
the supply of money fixed.
Thus, the IS-LM curve
model is based on:
Thus, the IS-LM curve
model is based on:
(1)
The investment-demand function,
(2)
The consumption function,
(3)
The money demand function, and
(4)
The quantity of money.
We
see, therefore, that according to the IS-LM curve model both the real factors,
namely, saving and investment, productivity of capital and propensity to
consume and save, and the monetary factors, that is, the demand for money
(liquidity preference) and supply of money play a part in the joint
determination of the rate of interest and the level of income. Any change in
these factors will cause a shift in IS or LM curve and will therefore change
the equilibrium levels of the rate of interest and income.
The
IS-LM curve model explained above has succeeded in integrating the theory of
money with the theory of income determination. And by doing so, as we shall
see below, it has succeeded in synthesising the monetary and fiscal policies.
Further, with the IS-LM curve analysis, we are better able to explain the
effect of changes in certain important economic variables such as desire to
save, the supply of money, investment, demand for money on the rate of interest
and level of income.
Effect of Changes in Supply of Money on the Rate of Interest
and Income Level:
Let us first consider what will happen if the supply of money
is increased by the action of the Central Bank. Given the liquidity preference
schedule, with the increase in the supply of money, more money will be
available for speculative motive at a given level of income which will cause the
interest rate to fall. As a result, the LM curve will shift to the right.
With this rightward
shift in the LM curve, in the new equilibrium position, rate of interest will
be lower and the level of income greater than before. This is shown in Fig.
24.4 where with a given supply of money, LM and IS curves intersect at point E.
With this rightward
shift in the LM curve, in the new equilibrium position, rate of interest will
be lower and the level of income greater than before. This is shown in Fig.
24.4 where with a given supply of money, LM and IS curves intersect at point E.
With
the increase in the supply of money, LM curve shifts to the right to the
position LM’, and with IS schedule remaining unchanged, new equilibrium is at
point G corresponding to which rate of interest is lower and level of income
greater than at E. Now, suppose that instead of increasing the supply of money,
Central Bank of the country takes steps to reduce the supply of money.
With
the reduction in the supply of money, less money will be available for
speculative motive at each level of income and, as a result, the LM curve will
shift to the left of E, and the IS curve remaining un-changed, in the new
equilibrium position (as shown by point T in Fig. 24.4) the rate of interest will
be higher and the level of income smaller than before.
Changes in the Desire to Save or Propensity to Consume:
Let us consider what happens to the rate of interest when
desire to save or in other words, propensity to consume changes. When people’s
desire to save falls, that is, when propensity to consume rises, the aggregate
demand curve will shift upward and, therefore, level of national income will
rise at each rate of interest.
As a result, the IS
curve will shift outward to the right. In Fig. 24.5 suppose with a certain
given fall in the desire to save (or increase in the propensity to consume),
the IS curve shifts rightward to the dotted position IS’. With LM curve
remaining unchanged, the new equilibrium position will be established at H
corresponding to which rate of interest as well as level of income will be
greater than at E.
As a result, the IS
curve will shift outward to the right. In Fig. 24.5 suppose with a certain
given fall in the desire to save (or increase in the propensity to consume),
the IS curve shifts rightward to the dotted position IS’. With LM curve
remaining unchanged, the new equilibrium position will be established at H
corresponding to which rate of interest as well as level of income will be
greater than at E.
Thus,
a fall in the desire to save has led to the increase in both rate of interest
and level of income. On the other hand, if the desire to save rises, that is,
if the propensity to consume falls, aggregate demand curve will shift downward
which will cause the level of national income to fall for each rate of interest
and as a result the IS curve will shift to the left.
With
this, and LM curve remaining unchanged, the new equilibrium position will be
reached to the left of E, say at point L (as shown in Fig. 24.5) corresponding
to which both rate of interest and level of national income will be smaller
than at E.
Changes in Autonomous Investment and Government Expenditure:
Changes
in autonomous investment and Government expenditure will also shift the IS
curve. If either there is increase in autonomous private investment or
Government steps up its expenditure, aggregate demand for goods will increase
and this will bring about increase in national income through the multiplier
process.
This
will shift IS schedule to the right, and given the LM curve, the rate of
interest as well as the level of income will rise. On the contrary, if somehow
private investment expenditure falls or the Government reduces its expenditure,
the IS curve will shift to the left and, given the LM curve, both the rate of
interest and the level of income will fall.
Changes in Demand for Money or Liquidity Preference:
Changes
in liquidity preference will bring about changes in the LM curve. If the
liquidity preference or demand for money of the people rises, the LM curve
will shift to the left. This is because, greater demand for money, given the
supply of money, will raise the rate of interest corresponding to each level of
national income. With the leftward shift in the LM curve, given the IS curve,
the equilibrium rate of interest will rise and the level of national income
will fall.
On
the contrary, if the demand for money or liquidity preference of the people
falls, the LM curve will shift to the right. This is because, given the supply
of money, the rightward shift in the money demand curve means that
corresponding to each level of income there will be lower rate of interest.
With rightward shift in the LM curve, given the IS curve, the equilibrium level
of rate of interest will fall and the equilibrium level of national income will
increase.
We
thus see that changes in propensity to consume (or desire to save), autonomous
investment or Government expenditure, the supply of money and the demand for
money will cause shifts in either IS or LM curve and will thereby bring about
changes in the rate of interest as well as in national income.
The
integration of goods market and money market in the IS-LM curve model clearly
shows that Government can influence the economic activity or the level of
national income through monetary and fiscal measures.
Through
adopting an appropriate monetary policy (i.e., changing the supply of money)
the Government can shift the LM curve and through pursuing an appropriate
fiscal policy (expenditure and taxation policy) the Government can shift the IS
curve. Thus both monetary and fiscal policies can play a useful role in
regulating the level of economic activity in the country.
Critique of the IS-LM Curve Model:
The
IS-LM curve model makes a significant advance in explaining the simultaneous
determination of the rate of interest and the level of national income. It
represents a more general, inclusive and realistic approach to the determination
of interest rate and level of income.
Further,
the IS-LM model succeeds in integrating and synthesising fiscal with monetary
policies, and theory of income determination with the theory of money. But the
IS-LM curve model is not without limitations.
Firstly,
it is based on the assumption that the rate of interest is quite flexible, that
is, free to vary and not rigidly fixed by the Central Bank of a country. If the
rate of interest is quite inflexible, then the appropriate adjustment explained
above will not take place.
Secondly,
the model is also based upon the assumption that investment is
interest-elastic, that is, investment varies with the rate of interest. If
investment is interest-inelastic, then the IS-LM curve model breaks down since
the required adjustments do not occur.
Thirdly,
Don Patinkin and Milton Friedman have criticised the IS-LM curve model as being
too, artificial and over-simplified. In their view, division of the economy
into two sectors – monetary and real – is artificial and unrealistic. According
to them, monetary and real sectors are quite interwoven and act and react on
each other.
Further,
Patinkin has pointed out that the IS-LM curve model has ignored the possibility
of changes in the price level of commodities. According to him, the various
economic variables such as supply of money, propensity to consume or save,
investment and the demand for money not only influence the rate of interest and
the level of national income but also the prices of commodities and services.
Patinkin
has suggested a more integrated and general equilibrium approach which
involves the simultaneous determination of not only the rate of interest and
the level of income but also of the prices of commodities and services.
IS-LM Curve Model: Explaining Role of Government’s Fiscal and
Monetary Policies:
With the help of IS-LM curve model we can explain how the
intervention by the Government with proper fiscal and monetary policies can
influence the level of economic activity, that is, income and employment level.
We explain below the impact of changes in fiscal and monetary policy on the
economy in the IS-LM model.
Effect of Fiscal
Policy:
Effect of Fiscal
Policy:
Let us first explain how IS-LM model shows the effect of
increase in Government expenditure on level of income. This is illustrated in
Fig. 24.6. As explained above, 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, as is shown in Fig. 24.6 where increase in
Government expenditure leads to the shift in IS curve from IS1to IS2Note that the
horizontal distance between the two IS curves is equal to ∆G x 1/1 –MPC which
shows the increase in income that occurs in Keynes’s multiplier model.
It will be seen from Fig. 24.6 that with the LM curve
remaining unchanged, the new IS2curve intersects
LM curve at point B. Thus, in IS-LM model with the increase in Government expenditure
(AG), the equilibrium moves from point E to B and with this the rate of
interest rises from r1 to r2 and income level from
Y1 to Y2. Thus, IS-LM model shows that expansionary fiscal
policy of increase in Government expenditure raises both the level of income
and rate of interest.
It is worth noting that in the IS-LM model increase in national
income by Y1Y2 in Fig. 24.6 is less
than EK which would occur in Keynes’s model. This is because Keynes in his
simple multiplier model (popularly called Keynesian cross model) assumes that
investment is fixed and autonomous, whereas 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, increase in Government
expenditure crowds out some private investment.
Likewise, it can be illustrated that the reduction in
Government expenditure will cause a right- ward shift in the IS curve, and
given the LM curve unchanged, will lead to the fall in both rate of interest
and level of income. It should be noted that Government often cuts expenditure
to control inflation in the economy.
Reduction in Taxes:
Reduction in Taxes:
An alternative measure of expansionary fiscal policy which
may be adopted is the reduction in taxes which 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. 24.7,
from IS1 to IS2. It may however noted that in the Keynesian
multiplier model, the horizontal shift in the IS curve is determined by the
value of tax multiplier which is equal to ∆T x MPC/1 – MPC and causes level of
income to increase by EH.
However, in the IS-LM model, with the shift of the IS curve
from IS1 to IS2 following the
reduction in taxes, the economy moves from equilibrium point E to D and as is
evident from Fig. 24.7, rate of interest rises from r1 to r2 and level of income
increases from Y1 to Y2.
On
the other hand, if the Government intervenes in the economy to reduce
inflationary pressures, it will raise the rates of personal taxes to reduce
disposable income of the people. Rise in personal taxes will lead to the
decrease in aggregate demand. Decrease in aggregate demand will help in
controlling inflation. This case can also be shown by IS-LM curve model.
Impact of Monetary Policy:
Through
making appropriate changes in monetary policy the Government can influence the
level of economic activity. Monetary policy may also be expansionary or
contractionary depending on the prevailing economic situation. IS-LM model can
be used to show the effect of expansionary and tight monetary policies. As has
been explained above, a change in money supply causes a shift in the LM curve;
expansion in money supply shifts it to the right and decrease in money supply
shifts it to the left.
Suppose
the economy is in grip of recession, the Government (through its Central Bank)
adopts the expansionary monetary policy to lift the economy out of recession.
Thus, it takes measures to increase the money supply in the economy. 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. 24.8.
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 the expansion in money
supply lowers interest rate and raises income.
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 the expansion in money
supply lowers interest rate and raises income.
We
have also indicated what is called monetary transmission mechanism, that is,
how IS-LM curve model shows the expansion in money supply leads to the increase
in aggregate demand for goods and services. We have thus seen that increase in
money supply lowers the rate of interest which then stimulates more investment
demand. Investment demand through multiplier process leads to a greater
increase in aggregate demand and national income.
If
the economy suffers from inflation, the Government will like to check it. Then
its Central Bank should adopt tight or contractionary monetary policy. That
is, it should reduce the money supply. IS-LM model can be used to show, as we
have seen above in case of expansionary monetary policy, that reduction in
money supply will cause a leftward shift in LM curve and will lead to the rise
in interest rate and fall in the level of income.
