Question

Discuss different impacts on the interest rate and GDP under the same shift of aggregate demand curve (the shift of IS and LM) under different slopes of AS. Under what conditions that monetary and fiscal policy will have greater impact on interest rate and GDP ?

Answer 1

The IS-LM model

· The Interest Savings [IS] and Liquidity preference Money supply [LM], a Keynesian macroeconomic model depicts the interaction of the market for economic goods [IS] with the money market [LM].

· The intersection of the IS and LM curves gives the short run equilibrium between interest rates and output

· The three external variables in this model are investment, consumption and liquidity.

· The liquidity is determined by the size and velocity of money supply whereas the investment and consumption are determined by decisions of individuals in the market.

Graphical Analysis

· GDP is placed on the horizontal axis and increases towards the right and the interest rate is depicted in the vertical axis.

· The IS curve depicts he interest rates and the GDP a which investment equals savings. At lower interest rates, investment is higher and thus results in more GDP outcome which causes the IS curve to slope towards the right.

· The LM curve represents the income and interest rate at which money supply equals money demand. Higher income levels induces increased demand and induces higher interest rates to keep the money supply and liquidity in equilibrium and the LM curve slopes upward.

· When the IS and LM curves intersect, the point of intersection gives the equilibrium point of interest rate and output and thus represents the equilibrium case of money market and real economy.

Shifts in the curve

· Higher demand for spending results in shifting the IS curve to the right which indicates, lower taxes, higher government spending and improvements in the business.

· Lower consumer responses in the market results in shifting the IS curve to the left

· When GDP goes up, the demand for money raises and equilibrium can only be restored only via higher interest rates which causes the LM curve to slope up.

· The higher money supply requires a higher demand for money and we need higher levels of GDP to generate this extra demand. Thus, the LM curve shifts out.

· Considering the supply side economics, higher prices raises the demand for money and the GDP must be now lower to maintain the equilibrium. Thus, the LM curve shifts in

· The AD curve is a set of price-GDP combination consistent with IS-LM equilibrium for a fixed money supply.

· At IS-LM equilibrium with higher output for a given price level will shift the AD curve to the left, which indicated increased money supply, increased government expenditure and increased consumption.

· In short-run AS with fixed prices, right shift in the AD curve indicated higher output.

Effect of Fiscal and Monetary policy

· Fiscal policy is set by the government and monetary policy by the central bank or the Federal reserve.

· At times of externalities like increased inflationary or deflationary situations, contractionary and expansionary fiscal and monetary policies can be implemented so as to bring back stability in the AD-AS and IS-LM curves and thus attain stability in the economy.

· Thus, both these policies will have higher impacts when there is a shift in the curve thus to bring back stability to the economy.