Question

1. Choose a diagrammatic device such as IS-LM and demonstrate your use of it to show policy effects.

Answer 1

Fiscal Policy and IS-LM Curve Model

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 where increase in Government expenditure leads to the shift in IS curve from IS₁ to IS₂. the horizontal distance between the two IS curves is equal to the increase in government expenditure times the government expenditure multiplier, that is, ΔG x 1/1-MPC which shows the increase in national income equal to the horizontal distance EK that occurs in Keynes’ multiplier model. However, in IS-LM model actual increase in national income is not equal to EK caused by the working of Keynesian multiplier. This is because with the rightward shift in IS curve rate of interest also rises which causes reduction in private investment. It will be seen from Fig that, with the LM curve remaining unchanged, the new IS₂ curve intersects LM curve at point B. Thus, in IS-LM model with the increase in Government expenditure (ΔG), 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.Income equal to CK has been wiped out because of rise in interest causing a decline in private investment. Thus CK represents crowding-out effect of increase in government expenditure 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 Y₁ Y₂ in Fig is less than EK which would occur in Keynes’ model. This is because Keynes in his simple multiplier 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 leftward 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.