Question

In response to the decline in aggregate income due to the COVID-19 pandemic, Indian central bank has expanded money supply significantly, but the government of India has left its fiscal expenditure unchanged. In the context of IS-LM model, the pandemic had shifted the IS curve to the left, and the central bank’s response has rotated the LM curve downward. This is in contrast with the situation in other countries that launched expansionary fiscal as well as monetary policies. In other words, after experiencing a leftward shift in the IS curve due to the pandemic, other countries employed fiscal policies to shift IS curve to the right at the same time that their monetary policies flattened their LM curve. Assume that the pandemic effects and the policy responses are all temporary. In the following questions, please compare the macroeconomic outcomes of India’s current policies with the hypothetical situation where, like other countries, India had used an expansionary fiscal policy in addition to the monetary policy that it adopted.

(a) How would the interest rate and aggregate income in India have been different from the current outcome if India had added expansionary fiscal policy to its pandemic response?:

(b) How would the rupee exchange rate and net exports in India have been different from the current outcome if India had added expansionary fiscal policy to its pandemic response?

(c) How would investment and household consumption in India have been different from the current outcome if India had added expansionary fiscal policy to its pandemic response?

Answer 1

Lets start by sumarizing the situation as an IS-LM model. Initially IS-LM curves are IS0 and LM0 at equilibrium e0. The pandemic shifts IS0 curve left to IS1. The interest rate falls from r0 to r' and Y falls to Y' from Y0 at e'. Now monetary policy is used and LM shifts from LM0 to LM1. This raises back output from Y' to initial level Y0 and causes interest rate to fall further to r1. Now if fiscal policy is also applied, the IS curve would shift back up to IS0 from IS1. This would shift equilibrium to e'' at the intersection of IS0 and LM1. This would increase interest rates to r' level and increase output to Y''.

a) So India who did not use fiscal policy in this hypothetical situation would have no increase in aggregate income(Y0) from the pre-pandemic levels(Y0) while if it had employed both policies it would increase aggregate income(Y''). The interest rate however will be lower when when only monetary policy(r1) is employed. If both policies were used then they would have had a higher interest rate(r') but it will be lower than the pre-pandemic interest rate(r0).

b) Since India did not employ expansionary fiscal policy like other nations, India will have a lower interest rate than other nations. Lower interest rate discourage investors to invest in India and hence they demand less amount of Rupees. This means demand for rupee has fallen. This will reduce rupee exchange rate. A decrease in exchange rate would encourage exports (as our goods are cheaper to foreigners) and decrease imports (as foreign goods have become costlier). Hence Net exports would rise. On the contrary if India has employed both policies then the interest rate levels would have been same for India and the other nations. This would cause no relative change in rupee exchange rate and hence net exports would not change.

c) Interest rates are lower when only monetary policy is used. Hence consumption and investment would increase strongly due to due to real interest rate effect (large fall in r) and a weak multiplier effect(Y adjusts to inital levels only). If fiscal policy was also applied than it would decrease the real interest rate effect (as r would rise back from r1 to r') of the LM curve and there will be increase in consumption and investment through a weak real interest rate effect. While due to fiscal policy output has increased further than the pre-pandemic level. The fiscal policy wpild have a strong multiplier effect and would increase consumption and investment through mpc and mpi. Here if we consider that the strong r effect + weak Y effect = strong Y effect + weak r effect then there is no change in consumption and Investment based on the policy mix.

Note that depending on the magnitudes of the two forces there can also be an ambiguous effect on C & I.