INCOME DETERMINATION MODEL INCLUDING MONEY

AND INTEREST

Session Outline

• Equilibrium in the Goods and Money Markets (Simultaneous Equilibrium)

• Monetary and Fiscal Policy

• The Transmission Mechanism

• Crowding Out

Equilibrium in the Goods and Money Markets (Simultaneous

Equilibrium)• Simultaneous equilibrium in the goods and

money markets is possible only at the point where the IS and the LM curves intercept each other.

• At any point other than E, we have equilibrium only in the goods market, or equilibrium only in the money market, or no equilibrium in either market

i0

Interest Rate

Y0

E

Income and Output (Y)

LM

IS

Continued…..

• It is worth recalling our assumptions and the meaning of equilibrium at point E. The important assumption that we made here is that price level is constant and firms are willing and able to supply any amount of output demanded at that price level.

Characteristics of Points that do not lie on the IS and LM Curves

III

II

ESM

i0

ESG

ESM

Interest Rate

Y0

E

EDM

Income and Output (Y)Figure 1.9

LM

EDM

EDG

ESGEDG

I

IV

IS

Characteristics of Points that do not lie on the IS and LM Curves

• Let us discuss the characteristics of points that do not lie on the IS and the LM curves. We have seen that points above the IS curve indicate excess supply of goods (ESG) and below it indicate excess demand for goods (EDG).

• Similarly, points above the LM curve indicate excess supply of money (ESM) and below it indicate excess demand for money (EDM).

• The intersection of the IS and LM curve, thus, leads to four zones with different characteristics. The four zones are shown in figure 1.9. Except for point E, all other points are disequilibrium points.

Region Goods Market Money Market

Disequilibrium

Output Disequilibrium

Interest Rate

I ESG Falls ESM Falls

II EDG Rises ESM Falls

III EDG Rises EDM Rises

IV ESG Falls EDM Rises

The above table shows what happens if the economy is at different

disequilibrium points.

Changes in the Equilibrium Levels of Income and the Interest Rate

• A shift in the IS curve or LM curve would shift the equilibrium levels of income and the interest rate.

• For example, increase in autonomous investment would shift the IS curve to the right, leading to increase in interest rate and income. Similarly increase in autonomous spending of government, G also leads to increase in interest rate and income.

• On the other hand, a change in real money supply shifts the LM curve.

• An increase in real money supply shifts the LM curve down and to the right, leading to increase in income, but decrease in interest rate.

Monetary and Fiscal Policy

• We now discuss how the IS-LM model can be used in understanding the working of monetary and fiscal policy.

• Fiscal and monetary policies are two important macroeconomic tools the government uses to keep the economy growing at a reasonable rate, with low inflation.

• While fiscal policy has its initial impact on the goods market, monetary policy affects the assets market initially.

• But, because of close proximity between goods and assets market, both monetary and fiscal policies have effects on both the output level and the interest rates

Monetary Policy• Let the initial equilibrium be at point E, where the LM

schedule intercepts IS schedule. The corresponding real money supply to the initial LM curve is . Suppose the RBI increases the nominal money supply, say through open market operation*, the real money supply also increases, given the price level.

• With the increase of real money supply, the LM curve shifts down and to the right, say to LM1 (see figure 1.10). Consequently, the equilibrium changes to E1 with a lower rate of interest and a higher level of income. The equilibrium level of income increases because the investment spending increases with the fall in interest rate in the economy.

• If the demand for real money is extremely sensitive to interest rate (represented by a relatively flat LM curve), a change in the money supply will be absorbed in the assets markets and there will be only a very small change in the rate of interest. Consequently, the investment spending

LM1

E1

E1

i1

i0

Interest Rate

Y0

E

Income and Output (Y) Figure 1.10

LM

IS

Y1

Impact of monetary policy

Impact of monetary policy

• If the demand for real money is extremely sensitive to interest rate (represented by a relatively flat LM curve), a change in the money supply will be absorbed in the assets markets and there will be only a very small change in the rate of interest.

• Consequently, the investment spending would also be small. Conversely, when the money demand is insensitive (represented by a relatively steeper LM curve), a change in the money supply causes a great change in the interest rate, and thereby has a greater impact on investment demand

adjustments during monetary expansion

• When money supply is increased, the LM curve shifts to the right. Consequently, the equilibrium point changes to E1. But the economy is at the initial equilibrium point E. At point E, the increase in money supply creates an excess supply of money in the market which makes people to buy more financial assets.

• As demand increases for financial assets, asset prices increase and yields decline. The adjustment process in the assets market is much more rapid than that in the goods market and, therefore, we move immediately to point E1 when the money supply increases.

Adjustment continued….

• At point E1, the demand for real balances increases as the interest rate has declined significantly. However, at point E1, there is excess demand for goods. This excess demand leads to increase in output and thereby income. As output expands, the interest rate (after immediate decline in interest rate when money supply is increased) rises because increase in output and income raises the demand for money. Ultimately, the equilibrium in money market is reached at point E1. (Note: rise in interest rate would be less than the initial fall in interest rate. Hence, an increase in the money supply leads to overall decline in interest rate).

• Thus, rise in money supply leads to decline in interest rates, which in turn leads to increase in aggregate demand and thereby output and income.

The Transmission Mechanism• The mechanism by which the changes in monetary policy

affect aggregate demand is called Transmission Mechanism. Two steps are involved in the process of Transmission mechanism

• Step one: when there is a change in real money supply, portfolio adjustments lead to change in the prices of assets and interest rates. For example, if real money supply increases, people hold more money than they want. People reduce their money holdings by buying financial assets; thereby leading to increase in asset prices and decline in yields (i.e. interest rates).

• Step two: Changes in interest rates affect aggregate demand and ultimately output and income. Thus, in our above example, fall in interest rates lead to increase in aggregate demand which in turn increases output and income in the economy.

Tabular presentation of Transmission Mechanism

The Transmission Mechanism

Step One Step Two

Change in real money supply

Adjustments in the portfolio, leading to a change in asset prices and interest rates

Changes in interest rates lead to change in aggregate demand

Change in aggregate demand results in adjustments in output and income.

Fiscal Policy

• While changes in monetary policy affect the LM curve, fiscal policy changes affect the IS curve. Let us see how changes in the government spending influence the level of income and interest rates in the economy. When government spending (G) increases, the aggregate demand increases

• given the interest rates. To meet the increased demand for goods, output must rise as shown by a shift in the IS schedule in figure 1.11. For example, if government spending increases by 100, the income increases by 400 at each level of interest rate, given the multiplier as 4. Thus, the IS curve shifts up to the right by 400.

Impact of changes in govt. spending

• When the government spending increases by 100, the economy would move to point E11 from initial equilibrium point E, given the interest rates remain same at i0. The corresponding income level is Y11 which is more than Y0 by 400. At E11, the goods market is in equilibrium, but the money market is not. At point E11, the goods demanded equals goods supplied, but there is excess demand for money in the market because of lower interest rate

Continued….

• When income increases, the quantity of money demanded goes up. Consequently, the interest rate rises. Firms reduce their planned investment spending at higher rate of interest and the aggregate demand falls from the high level it reaches immediately on increase in the government spending. However, the economy finally reaches a new equilibrium at point E1 where both goods and asset markets are in equilibrium.

• Thus, an increase in government spending would lead to an increase in the income level and increase in interest rates.

Policy Effects on Income and Interest Rates

Policy Equilibrium Income

Equilibrium Interest Rate

Expansionary Monetary Policy

Increase Decrease

Expansionary Fiscal Policy Increase Increase

Note that expansionary policy (fiscal or monetary) is aimed at increasing income. Expansionary monetary policy, thus, includes increasing money supply in the economy, while expansionary fiscal policy involves increasing government spending and reducing taxes. We discuss these aspects in detail in the later chapters.

Crowding Out

• Crowding out is the phenomenon where increase in interest rates due to increase in government spending crowds out the private investment spending, leading to decline in aggregate demand.

• Recall that when government spending increases, the income increases only to Y1, although it may have increased initially to Y11. This is so because an increase in interest rates in the market from i0 to i1 reduces the level of private investment spending (called crowding out), leading to drop in aggregate demand and income.

I0

IS1

E E11

i1

Intere

st R

ate

Y0

E1

Income and Output (Y)Figure 1.12

LM

IS

Y1 Y11

LM1

Crowding out of private investment

Crowding out effect

• crowding out of private investment that is caused by the expansionary fiscal policy

• To prevent such crowding out, interest rates should be prevented from rising by increasing the money supply in the economy.

• Thus, an expansionary monetary policy can be used to prevent crowding out caused by an expansionary fiscal policy.

A fiscal expansion

• A fiscal expansion shifts the IS curve to IS1 and moves the equilibrium of the economy from E to E1, as shown in figure 1.12. At E1, both the income and the IS1 interest rate are also higher than at E (i.e. i1 > i0).

• This higher interest rate would crowd out investment spending. But an increase in money supply shifts the LM curve to LM1 and helps the economy to at reach E11 (where the equilibrium income is higher, but interest rate is lower at i0) by keeping the interest rate at its initial level, i0.