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IS/LM curve analysis & Affects of monetary/fiscal policy on the general equilibrium level

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IS/LM curve analysis & Affects of monetary/fiscal policy on the general equilibrium level

  1. 1. IS/LM curve analysisAffects of monetary/fiscal policy on the general equilibrium level
  2. 2. Fiscal policyIn economics, fiscal policy is the use of government expenditureand revenue collection (taxation) to influence the economy.Stances of fiscal policyThe three possible stances of fiscal policy are neutral, expansionaryand contractionary.The simplest definitions of these stances are as follows:•A neutral stance of fiscal policy implies a balanced economy. Thisresults in a large tax revenue. Government spending is fully fundedby tax revenue and overall the budget outcome has a neutral effecton the level of economic activity.•An expansionary stance of fiscal policy involves governmentspending exceeding tax revenue.•A contractionary fiscal policy occurs when government spending islower than tax revenue.
  3. 3. Instruments of Fiscal Policy Taxes Direct (income, wealth) Indirect (VAT, Excise, Tariff and duties) Subsidies (consumption and production) Spending Pure Public goods ( defence, law and order, roads) Semi-public goods (education, health, sanitation) Debt Borrowing from the private sector -Crowding Out From the central banks -inflationary tax
  4. 4. What is Monetary Policy? The term monetary policy refers to actions taken by the State bank to affect monetary variables or other financial conditions. Monetary Policy operates on monetary variables such as money supply, interest rates and availability of credit. Monetary Policy ultimately operates through its influence on expenditure flows in the economy.
  5. 5. Instruments of Monetary Policy Variations in Reserve Ratios - Banks are required to maintain a certain percentage of their deposits in the form of reserves with the State Bank. In Pak. About 5 % as of 2010. Discount Rate (Bank Rate)- Discount rate is the rate of interest charged by the State bank for providing funds or loans to the banking system. Open Market Operations (OMOs)- OMOs involve buying and selling of govt. securities by the State bank, from or to the public and banks.
  6. 6. The short-run equilibriumThe short-run equilibrium isthe combination of r and Ythat simultaneously satisfies r LMthe equilibrium conditions inthe goods & money markets:Y C(Y T ) I (r ) G IS M P L (r ,Y ) Equilibrium Equilibrium Y interest level of rate income
  7. 7. IS Curve ShiftersVariable Increases IS Curve ShiftsNet Exports RightWealth RightGovernment Spending RightTaxes LeftChanges in ‘r’ Leads to movement along the I.S. curve
  8. 8. Shifting the IS curve E =Y E =C +I (r )+GAt any value of r, E 1 2 G E Y E =C +I (r1 )+G1…so the IS curveshifts to the right.The horizontal Y1 Y2 r Ydistance of theIS shift equals r1 Y 1 G Y 1 MPC IS1 IS2 Y1 Y2 Y
  9. 9. LM Curve ShiftersVariable Increases LM Curve ShiftsNominal Money Supply RightPrice Level LeftNominal interest rate on Rightmoney imAnything Else Increasing Move along the L.M curvethe Demand for Money provided that both ‘r’ and ‘Y’ change
  10. 10. Shifting the LM curve (a) The market for (b) The LM curve real money balancesr r LM2 LM1r2 r2r1 L (r , Y1 ) r1 M2 M1 M/P Y1 Y P P
  11. 11. Macroeconomic equilibrium and policyInterest rate i The intersection of IS and LM LM represents the simultaneous equilibrium on the goods and the money market… …For a given value of i* government spending G, taxes T, Investment I , money supply M and IS prices P Y* Income, Output Y
  12. 12. Macroeconomic equilibrium and policy IS-LM can be used to assess the impact of exogenous (External) shocks on the endogenous (internal) variables of the model (interest rates and output) One can also evaluate the effectiveness of the policy mix, i.e. the combination of:  Fiscal policy: changes to government spending and taxes  Monetary policy: changes to money supply
  13. 13. Macroeconomic equilibrium and Fiscal policy 1. An increase in spending ΔG pushes IS to the right …Interest rate i 2. … By an amount: 1 LM G 1 c But as Y increases (multiplier effect), so does money demand. The interest rate i2 must increase to compensate, which discourages investment i1 IS’ IS The difference between Yk and YIS-LM is the crowding out effect Y1 YIS-LM Income, Output Y
  14. 14. Macroeconomic equilibrium and Monetary policy 1. An increase in money supply shifts LM to the right ….Interest rate i LM 2. …Which reduces the rate of interest... LM’ 3. …And increases output by stimulating investment. i1 i2 IS Y1 Y2 Income, Output Y
  15. 15. Macroeconomic equilibrium and policy Monetary policy affects the equilibrium in the money market, via changes in M.  We’ve seen that this influences the LM curve. As for fiscal policy changes in Fiscal variables, affects both endogenous variables (output and interest rate).  Money is not neutral !! (meaning changes in money supply leads to changes in output)  This is one of the central contributions of Keynes