MACROECONOMICS – NOTES – B.Com 2nd Semester (CBCS)
Unit II
Economy in the short run
IS-LM Framework
Investment-saving (IS) Function
The IS function depicts investment and saving function. It relates to goods market, the goods market is in equilibrium when saving and investment are equal or aggregate demand for goods is equal to aggregate supply of goods. If the amount of savings exceeds investment or aggregate supply is greater than aggregate demand the level of income in the community will have a tendency to decline. Lf the level of investment exceeds savings or aggregate demand for goods is greater than aggregate supply the level of income tends to increase. The IS curve is a downward slopping curve. This is depicted in the diagram below:
Liquidity Preference or Money Supply (LM) Function
The money market is in equilibrium when demand for money is equal to supply of money.
MD = MS where MD implies demand for money and MS implies supply of money.
If the demand for money is greater than its supply the rate of interest has a tendency to increase due to increase in speculative motive of the people. On the other hand if supply of money increases over demand there will be a tendency to fall in the rate of interest.
The LM curve has a positive slope; it slope upward from left to right. This is shown in the following diagram:
IS-LM Framework
The IS-LM model was given by Hicks and Hansen to determine simultaneously equilibrium income and rate of interest. The goods market equilibrium is shown by the IS curve which depicts various combinations of income and rate of interest at which saving and investments are in equilibrium. Similarly the money market gives such combinations of income and rate of interest where demand for money and supply of money is in equilibrium. The intersection of the IS and LM curve gives the general equilibrium where both the goods market and money market are in equilibrium simultaneously. This is shown in the following diagram:
Fiscal and Monetary Policy
Fiscal policy and IS-LM model
Fiscal policy like changes in government spending and taxes can shift the IS curve to the right. On the other hand an increase in taxes and reduction in government spending can shift the IS curve to the left. Suppose the economy is facing depression, as a result the government will increase spending to revive the economy and reduce taxes. This will lead to a rise in equilibrium income and rate of interest. On the other hand if the economy is in inflation, the government will try to counteract the excess demand through reduction in government spending and increase in taxes. This will lead to a fall in income and the IS curve will shift to the left. But fiscal policy cannot affect the LM curve. This is shown in the diagram below:
In the diagram, the equilibrium is at point E. if the government takes expansionary fiscal policy the IS curve will shift to the right to IS1. It intersects the LM curve to determine a higher level of income Y2 and higher rate of interest r2. If the government takes a contractionary monetary policy the IS curve will shift to the left to IS2 and the equilibrium rate of interest is r1 and income Y1.
Monetary policy and IS-LM model
Monetary policy implies the variations in supply of money brought about by the central bank of a country to achieve certain economic goals. Suppose an economic system is faced with the condition of recession, the monetary authority of the country to tackle the situation by an expansion in the supply of money and credit and lowering down the rate of interest. The monetary policy measures will result in a shift in the LM curve to the right. But monetary policy cannot affect the IS curve. If the economy faces inflation, the monetary authority will reduce the supply of money and credit and raise the structure of the rate of interest. This will result in a fall in income and a rise in the rate of interest and LM curve will shift to the left. This is shown in the following diagram:
In the diagram, the initial equilibrium is at point E. if the economy faces recession the central bank increases the money supply and credit and the LM curve will shift to the right to LM1. If there is inflation in the economy the central bank reduces the supply of money and credit and the LM curve shifts to the left to LM2.
Determination of Aggregate Demand (AD)
Demand in economics implies demand for goods and services which is backed by money supply. It merely means the willingness and ability to buy the goods and services. Effective demand refers to the total spending of the community. It implies the aggregate amount spent on goods and services by the whole community during a period of time. There are two determinants of effective demand i.e. Aggregate Demand (AD) and Aggregate Supply (AS).
Aggregate Demand (AD) refers to the sale proceeds expected by the producers at varying level of employment. It is the amount of money expected by the entrepreneur through the sale of their goods produced at a specific level of employment. Keynes define aggregate demand function relates any given level of employment to the expected proceeds from that volume of employment.
According to Harvey and Johnson, “The receipts, which entrepreneurs as a whole, expect to obtain can be termed as aggregate demand.”
The aggregate demand function shows the functional relationship between the level of employment (N) and expected Proceeds or Aggregate Demand (AD).
AD = f (N). There is a direct relationship between aggregate demand and the level of employment. As employment rises, aggregate demand or expected proceeds also increases and vice-versa.
Shift in Aggregate Demand (AD)
During the period of expansion the entrepreneur expects to receive larger amounts by the sale of outputs at the same level of employment. It means the aggregate demand function shifts upward to AD1, on the other hand when there is contraction or depression, the entrepreneur expects lower sales at the same level of output. In such a situation the aggregate demand function shifts downward to AD2. This is shown in the following diagram:
Thus, in the diagram it is shown that aggregate demand function can shift in the short run due to entrepreneurs expectations.
Determination of Aggregate Supply (AS)
According to Keynes, aggregate supply price of the output of a given amount of employment is the expectation of proceeds which will just make its worth the while of the entrepreneurs to give in an employment.
The aggregate supply function relates different amounts of minimum expected proceeds in aggregate supply prices to different levels of employment. It shows the functional relationship between aggregate supply price or cost of the level of employment. The aggregate supply function is shown in the following diagram:
In the diagram ASF is the aggregate supply function curve which initially slopes upward from left to right and at the level of full employment it becomes parallel to the vertical scale because the aggregate supply price alone now rises, while the level of employment remains fixed. The ASF is more elastic before full employment and becomes perfectly inelastic after full employment.
Keynes regards aggregate supply function as fixed in the short run because supply is affected by such factors as machinery, equipment, organization and techniques of production, which can undergo changes only in the long run.
Equilibrium or Effective Demand
The effective demand shows the short run equilibrium between aggregate demand and aggregate supply. The equilibrium point of effective demand is determined by the intersection between Aggregate Demand Function (ADF) and Aggregate Supply Function (ASF). This is shown in the following diagram:
In the diagram, employment is measured along the horizontal axis and expected proceeds along the vertical axis. The ADF becomes perfectly elastic at the full employment level ON2. If employment is ON 1 the aggregate demand price is more than aggregate supply price. Therefore entrepreneurs will tend to expand employment. When ON2 workers are employed the aggregate supply price is greater than aggregate demand price. Since the entrepreneurs in this case expect losses, they will tend to reduce employment. When ON the amount of workers employed then aggregate demand price is equal to aggregate supply price. Since entrepreneurs neither expect profits nor losses.
The point of intersection E is the point of effective demand and its equilibrium level of employment is ON.
