Question

In the IS LM model discuss the effects of expasionary monetary policy, making clear the mechaisms through which monetary policy operates

Answer 1

The IS-LM model is the basic model of aggregate demand that incorporates the money market as well as the goods market. It lays particular stress on the channels through which monetary and fiscal policy affect the economy. The IS-LM model is a standard tool of macroeconomic that demonstrates the relationship between interest rates and real output in the goods and services market and the money market. The intersection of the IS and LM curves is the "General Equilibrium" where there is simultaneous equilibrium in both markets.

EQUILIBRIUM IN A CLOSED ECONOMY

The general equilibrium model of the economy comprises of the two parts. The first part brings together the determinants of equilibrium in the real sector or the goods market of the economy. The second part brings together the determinants of equilibrium in the money market or the monetary sector of the economy. The equilibrium in the real sector is defined in terms of the equality between the aggregate saving and aggregate investment corresponding to that aggregate real income where aggregate saving equals the aggregate Investment (S=I), the aggregate demand for goods just equals the aggregate supply of goods in the economy, i.e. C+I=Y thus, the economy's real sector is in equilibrium at this level of aggregate real income. The equilibrium of the economy's money market requires equality between the total supply of money and the total demand for money. The equality between the total supply of and demand for money furnishes us with the equilibrium rate of interest. Thus, the monetary sector of the economy will be in equilibrium at that rate of interest corresponding to which the total demand for money equals the total supply of money, i.e. where Md=Ms.

The equilibrium aggregate income corresponding to which the aggregate saving equals the aggregate investment, i.e., S=I, partly depends, on the conditions in the monetary sector. Similarly the equilibrium rate of interest at which the total demand for money and the total supply of money are in equilibrium, i.e., Md=Ms , partly depends on the conditions in the real sector or the goods market.

Goods Market Equilibrium: IS Curve

The goods market includes trade in all goods and services that the economy produces at a particular point in time. If the real commodity markets are in equilibrium, the investment demand for internal and external funds and the internal and external supply of saving, both in real terms, must also be equal to each other. This equilibrium condition in the commodity markets may be summarized in an IS schedule. The IS curve is the schedule of combinations of the interest rate and level of income such that the goods market is in equilibrium. The goods market is in equilibrium whenever the quantity of goods and services demanded equals the quantity supplied, or when injections into the system equal leakages. Increases in the interest rate reduce aggregate demand by reducing investment spending. Thus, at higher interest rates, the level of income at which the goods market is in equilibrium is lower. The IS curve relates different equilibrium level of national income with various rates
of interest. The IS curve is negatively sloped because an increase in the interest rate reduces planned investment spending and therefore reduces aggregate demand, thus reducing the equilibrium level of income.

In the IS curve (Fig.1) relates different equilibrium levels of national income with various rates of Interest. The goods market is in equilibrium whenever the quantities of goods and services demanded and supplied are equal. The IS curve describes equilibrium points in the goods market. The combinations of aggregate output and interest rate for which aggregate output produced equals aggregate demand.

Factors Causing a Shift in IS Curve

The IS curve shifts whenever a change in autonomous factors occurs that is unrelated to the interest rate. The IS curve is shifted by changes in autonomous spending. An increase in autonomous spending, including an increase in government purchases, shifts the IS curve out to the right.

The IS curve will shift from IS1 to IS2 (Fig. 2) as a result of i) an increase in autonomous consumer spending, ii) an increase in planned investment spending due to business optimism, iii) an increase in government spending, iv) a decrease in taxes, or v) an increase in net exports that is unrelated to interest rates. These changes shift the aggregate demand function or IS curve upward and raise equilibrium output from Y1 to Y2 .

Money Market Equilibrium : LM Curve

The LM curve shows combinations of interest rates and levels of output such that money demand equals money supply. Money is demanded for transactions and speculative purposes. The transaction demand for money consists of the active working balances held for the purpose of making business payments as they become due. The transaction demand for money is positively related to the level of national income. The speculative demand for money arises from the desire to hold money balances instead of interest- bearing securities. However, the higher the rate of Interest, the smaller is the quantity of money demanded for speculative or liquidity purposes because the cost of holding inactive money balances is greater.

The condition for monetary equilibrium is that the demand for money is equal to the supply of money. The supply of money is assumed by some monetary theorists to be exogenously determined by the central bank. When the money market is in equilibrium, the demand for money and the supply of money are equal to each other and may be shown as an LM schedule. This LM schedule relates different rates of interest and different levels of national income where the demand and supply of money are in equilibrium.

The LM curve is positively sloped. Given the fixed money supply, an increase in the level of income, which increases the quantity of money demanded, has to be accompanied by an increase in the interest rate. This reduces the quantity of money demanded and there by maintains money market equilibrium.

The LM curve (Fig.3) 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 money market is in equilibrium whenever the quantity of money demanded for transactions and speculative purposes is equal to the given supply of money. The LM curve describes the equilibrium points in the market for money- the combinations of aggregate output and interest rate for which the quantity of money demanded equals the quantity of money supplied.

Factors Causing a Shift in LM Curve

The LM curve is shifted by changes in the money supply. An increase in the money supply shifts the LM curve to the right. Only two factors can cause the LM curve to shift. Autonomous changes in money demand and changes in the money supply. 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.

The LM curve (Fig. 4) shifts to the right from LM1 to LM2 when the money supply increases because, at any given level of aggregate output i.e. Y1 , the equilibrium interest rate falls (Pt. A to A1 ). The LM curve shifts to the left if the stock of money supply is reduced.

The LM curve (Fig.5) shifts to the left from LM1 to LM2 when money demand increases because, at any given level of aggregate output i.e. Y1, the equilibrium interest rate rises (Pt. A to A1 ) Thus, the LM curve- which summarizes all the combinations of Y and I that are consistent with money market equilibrium.

Equilibrium in the Goods and Money Markets

The IS and LM schedules summarize the conditions that have to be satisfied in order for the goods and money markets, respectively, to be in equilibrium. For simultaneous equilibrium, interest rates and income levels have to be such that both the goods market and the money market are in equilibrium.

This condition is satisfied at point E (Fig.6). The equilibrium interest rate is therefore I0 and the equilibrium level of income is Y0, given the exogenous variables, in particular, the real money supply and fiscal policy. At point E, both the goods market and the money market are in equilibrium. Thus, the IS- LM curve model is based on : i) The investment – demand function, ii) the consumption function, iii) the money demand function, and iv) the quantity of money. Therefore, 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 and supply of money play a part in the joint determination of the rate of interest and the level of income.