The IS LM model or the Hicks –Hansen model is the macroeconomic tool that shows the relationship between the interest rates and the real output of goods and services and the money market. The intersection of the investment - saving curve or the IS curve and liquidity preference curve or the money supply curve is the general equilibrium in both the markets .This model explains the changes in the national income when the price level is fixed in the short run and also shows the reason for the shift in the aggregate demand curve. It was first developed by Hicks and then by Hansen as a mathematical representation if the Keynesian macroeconomic theory.
The Keynesian income expenditure analysis developed in the General Theory of Employment Interest and money offered an alternative approach to the interpretation of changes in the money income that emphasized the relation between money income and investment are autonomous expenditure rather than the relation between money, income and the stock of money. According to Keynes whether an increase in the quantity of money will lead to an increase in the price level does not depend what happens to the aggregate demand curve but depends on the shape of the aggregate supply curve.
In the Keynesian system the equilibrium price level is determined at the intersection of aggregate demand and aggregate supply curves. When the supply of money increases the aggregate demand curve shifts to the right. Now the effect of an increase in the quantity of money on the equilibrium price levels depends on two things. Firstly it depends on the extent by which aggregate demand curve shifts to the right. Secondly it depends on the shape of the aggregate supply curve. If the productive capacity of the economy is employed the supply of output will be completely inelastic and any increase in demand will lead only o an increase in the price level . On the other hand if there is unused capacity at levels of production a rise in effective demand leads to an increase in production and supply keeping prices unchanged. Again, when the economy approaches full utilization of capacity (i.e. when firms operate in a region of rising the marginal cost) a rise in effective demand leads to rise in output and a simultaneous increase in prices. Thus the effect of an increase in the effective demand on prices depends entirely on the initial position of the economy. In other words, in case of full employment the aggregate supply curve is a vertical straight line. The unused capacity of the aggregate supply curve is a horizontal straight line. Lastly, when the economy approaches full utilization of capacity the aggregate supply curve is upward rising(Dornbusch,334).
Let us see how a change in the quantity of money leads a change in the effective demand. In the Keynesian theory of income and employment we know that when there is an increase in the quantity of money this will lead to the lowering of the interest rate. A fall in the inertest rate will lead to the increase in the rate of investment. The increase in the rate of investment will increase the effective demand through the multiplier process. Thus the effect of the change in quantity demand depend on three factors:
First, the extent by which the rate of interest falls as the quantity of money is increased which in turn depends on the slope of liquidity preference schedule.
Second, the extent by which investment rate will be stimulated due to a fall in the rate of interest. i.e. interest elasticity of investment.
Third, the extent by which the effective demand will increase as the rate of investment increases i.e. the size of investment multiplier which again depend on the propensity to consume.
There are two special cases when an increase in the money supply will not lead to increase in effective demand. The first case is the case of liquidity trap or the absolute liquidity preference where the preference schedule becomes absolutely elastic. The second is the complete inelasticity of investment. According to Keynesian model the price level changes in these situations even if there is an increase in the quantity of money but only in the case of full employment. In case of full employment an increase in aggregate demand leads to an increase in the quantity of money which will again lead to an increase in price level
The IS curve slopes downward because a decrease in the interest rates increases the investment spending thereby increasing the aggregate demand and the level of output at which the goods market is in equilibrium. The fiscal expansion shifts the IS curve to the right. Both government spending and the tax rate affect the IS schedule (Dornbusch, 261).
The figure shows that an expansionary fiscal policy raises the income and the interest rate. At The figure shows that an expansion fiscal policy raises the income and the interest rate. At unchanged interest rates the higher levels of government spending increases the level of aggregate demand that causes shift in the IS schedule. At each level of interest rate the equilibrium income is raised by increase in government spending. The rising national income follows the increased aggregate demand which also increases the transaction demand for money. But with money supply fixed and rising interest rates will motivate people to hold less cash. This is because the opportunity cost of holding wealth in the form of cash rises when interest rises. The increase in interest rate causes reduction on private investment which offsets some of the rise in government spending . This is known as financial crowding effect. The increase in interest rate that follow the rise in government spending crowd out other interest sensitive components of aggregate demand. The investment is the sum of purchase of newly produced capital goods , changes in inventories known as inventory investments and purchases of new residential building. The increase in interest rate which will offset private investment will choke off the residential spending. That means that the real estate market will incur loss (Dornbusch, 263).
Monetary policies operate by stimulating the interest responsive components of aggregate demand , primarily investment spending. When the central bank like Federal reserve pays for the bonds it buys with money then it reduces the quantity of bond available in the market thereby increasing their prices or lowering their yield only. But at lower interest rate the public buy the wealth in the form of bonds or holds larger fraction in the form of money. In open market purchase the LM curve shifts below. The increase in the nominal quantity of money given the price level shits the LM curve and a new equilibrium is reached with a lower interest rate and higher level of income. The steeper the LM curve the larger is the change in income. If money demand is very sensitive to interest rate then a given change in the money stock can be absorbed in the asset market with only a small change in the interest market.
Answer 2.
According to Keynes theory of saving and investment in equilibrium planned saving is equal to planned investment. This applies to the economy where there is no government or no foreign trade. So from national income accounting equation,
Y= C+S .
It means income is either spent or saved. Without government and foreign trade aggregate demand equals consumption plus investment
Y= C+I. S putting together C+S = C+I or S = I.
If the economy moves from the state of equilibrium then what will happen .Inventory investment takes place when firms increase their inventories. The increase in inventory happens in two situations. First, when the sales of firms are unexpectedly low and it is found that unsold inventories are accumulating on the shelves. This is unanticipated inventory. In some cases the inventory investment can be high when firms plan to build up inventories and this is anticipated investment. Unanticipated inventory investment is a result of unexpected low aggregate demand. But planned inventory investment adds to aggregate demand. Thus rapid accumulation of inventories are associated with either rapidly declining aggregate demand or rapidly increasing aggregate demand (Dornbush,324).
In the simple Keynesian model of income determination the equilibrium level of income is determined by the equality of intended saving and intended investment. The equilibrium level of income thus determined may be of full employment or one of less than full employment. Keynes produced an aggregate general equilibrium model where money influence real variables. He also explained that the horizontal LM curve is due to liquidity trap. The other reason is the inadequate interest elasticity in the savings and investment functions even when the interest fell to zero i.e. inelastic IS curve or such that the highest attainable level of income is below full employment. The Pigou effect reintroduced the cash balance mechanics and argued that the slope of the IS curve depend on the people's real wealth. A falling price level shifts the IS cure rightward so that the economy goes back to full employment. Pigou argued that the rate of interest can either be zero or negative .In that case saving and investment would always be at a positive rate of interest. When people save even at negative interest rate then they save for other reasons. The dependence of the saving function on the real value of cash balances is the "Pigou" or wealth effect. It states that the consumption expenditure of the economy is related to the volume of wealth such that as total wealth increases total consumption expenditure also increase. In case of full employment as consumption expenditure increases, saving decrease. So saving in inversely related to the volume of wealth (Dornbusch, 336).
Works Cited
Dornbusch, Rudiger. Macro economics. New Delhi: Tata McGraw-Hill, 2005
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