CH 10 Money Interest Income is-LM Model

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Coursework: Macroeconomics

IMT Ghaziabad
By
Dr. Manas Paul
Term I PGDM 2023-25
Explain these scenarios
 Explain the impact of COVID pandemic on economy…
 Explain the impact of demonetization?
 Explain a temporary adverse supply shock say adverse monsoon
 Explain impact of a wave of credit card fraud increases…..
 Explain impact of a Rapid rise in ATMs
 Explain the impact of Stock market crash….in IS-LM framework
 Explain the impact of Improvements in business and consumer confidence

 Explain the impact of Corporate accounting scandals like Enron, Worldcom etc
What we intend to do?
 Now Investments is no more autonomous but depends on interest rates in
aggregate demand

 Three segments of the economy – Goods market, Money Market & asset market
….i.e. introduction of money into model

 Equilibrium output determined in the goods market while interest rate in


Money Market

 In goods market “interest rate” is given while “Y” gets determined

 In money market “Y” is given while “interest rate” gets determined

 Taking the two markets together we have joint determination of equilibrium


output and interest rates
Introduction
• Money plays a central role in the determination of income and
employment
– Interest rates are a significant determinant of aggregate
spending  Related to central bank (RBI) action
– The stock of money, interest rates, and the RBI were noticeably absent
from the model developed in the simple Keynesian theory of income
distribution of the previous chapter
• This chapter
 introduces money and monetary policy
builds an explicit framework of analysis within which to
study the interaction of goods markets and assets market
What determines interest rates?
What is the role of interest rates in the business cycle?
A relatively holistic view – interaction of both goods and asset markets

IS-LM model is the core of short-run macroeconomics

Maintains the details of earlier model, but adds the interest rate as an additional
determinant of aggregate demand Includes the goods market and the money market, and
their link through interest rates and income.
The Goods Market and the IS Curve
• The IS curve shows combinations of interest rates
and levels of output such that planned spending
equals income
– Derived in two steps:
1. Link between interest rates and investment
2. Link between investment demand and AD

• Investment is no longer treated as exogenous, but


dependent upon interest rates (endogenous)
– Investment demand is lower the higher are interest rates
• Interest rates are the cost of borrowing money
• Increased interest rates raise the price to firms of borrowing for
capital equipment  reduce the quantity of investment demand
Investment and the Interest Rate
• The investment spending [Insert Figure 10-4 here]
function can be specified as:
I  I  bi where b > 0 (1)
– i = rate of interest
– b = the responsiveness of
investment spending to the
interest rate
– I = autonomous investment
spending
• Figure on the right illustrates
the investment schedule of
equation (1)
– Negative slope reflects
assumption that a reduction in i
increases the quantity of I
AD curve modified
• Need to modify the AD function of the last chapter
to reflect the new planned investment spending
schedule
AD  C  I  G  NX
 
 C  cT R  c(1  t )Y  ( I  bi )  G  N X
 A  c(1  t )Y  bi

An increase in i reduces AD for a given level of income


At any given level of i, can determine the equilibrium
level of income and output the equation above…
remember ‘i’ gets determined in the money market
hence appear as given for goods market…
A change in i will change the equilibrium
The Interest Rate and AD: The IS Curve
AD  A  c(1  t )Y  bi
[Insert Figure 10-5 here]
• Derive the IS curve using
figure
 For a given interest rate, i1, the
last term in equation above is
constant  can draw the AD
function with an intercept of
A  bi1
 The equilibrium level of
income is Y1 at point E1
 Plot the pair (i1, Y1) in the
bottom panel as point E1  a
point on the IS curve
 Combination of i and Y that
clears the goods market
The Interest Rate and AD: The IS Curve

• We can apply the same [Insert Figure 10-5 here again]


procedure to all levels of i to
generate additional points on
the IS curve
– All points on the IS curve
represent combinations of i and
income at which the goods
market clears  goods market
equilibrium schedule
• Figure alongside shows the
negative relationship
between i and Y
– Downward sloping IS curve
Derivation of : The IS Curve
• We can also derive the IS curve using the goods market equilibrium
condition:
Y  AD  A  c(1  t )Y  bi
We can solve LHS equation for i:
Y  c(1  t )Y  A  bi
Y   G ( A  bi )

Y (1  c(1  t ))  A  bi Y   G A   G bi

Y   G ( A  bi ) Y  G A
i
  Gb
A Y
For a given change in Y, the i 
associated change in ‘i’ will be b  Gb
larger in size as ‘b’ is smaller
and as the multiplier is smaller.
1
where   (1  c(1  t )) is the multiplier we derived in the previous
G

chapter
10-11
IS curve shifts -The Role of Multiplier
• Figure alongside shows the [Insert Figure 10-6 here]
AD curves corresponding to
different multipliers
– The coefficient c on the solid
black AD curve is smaller than
that on the dashed AD curve 
multiplier larger on the dashed
AD curves
• A given reduction in i, from i1
to i2 raises the intercept of
the AD curves by the same
vertical distance
– Because of the different
multipliers, income rises to Y2’
on the dashed line and Y2 on the
solid line
IS Curve shifts on change in “A”
• Figure alongside shows two [Insert Figure 10-7 here]
different IS curves  differ by
levels of autonomous
spending
– Initial AD with A and i1 
corresponding point E1 on IS
curve in Figure in panel (b)
– If autonomous spending
increases to A  , equilibrium
level of income increases at i1
 point E2 in panel (b), shifting
out IS
• The change in income as a
result from a change in
autonomous spending is
Y  G A
The Money Market and the LM Curve
• The LM curve shows combinations of interest
rates and levels of output such that money
demand equals money supply  equilibrium in
the money market
• The LM curve is derived in two steps:
1. Explain why money demand depends on interest rates and
income
– Theory of real money balances, rather than nominal
2. Equate money demand with money supply, and find
combinations of income and interest rates that maintain
equilibrium in the money market
– (i, Y) pairs meeting this criteria are points on a given LM curve
Demand for Money
• The demand for money, is a demand for real
money balances
– People are concerned with how much their money
can buy, rather than the number of dollars in their
pockets
• The demand for real balances depends on:
Real income: people hold money to pay for their
purchases, which, in turn, depend on income
Interest rate: the cost of holding money
The higher the interest rate, the more expensive it is to hold
money, and the less cash will be held at each level of income
• The demand for money is defined as: L  kY  hi
Demand for Money Function
L  kY  hi [Insert Figure 10-8 here]
• The parameters k and h
reflect the sensitivity of the
demand for real balances to
the level of Y and i
• The demand function for real
balances implies that for a
given level of income, the
quantity demanded is a
decreasing function of i
– Figure alongside illustrates the
inverse relationship between
money demand and i  money
demand curve
Money Market Equilibrium & LM Curve
• The nominal quantity of money supplied, M, is controlled by the central
bank
– Real money supply is M , where M and P are assumed fixed
P
• The figure below shows combinations of i and Y such that the demand
for real money balances exactly matches the available supply

[Insert Figure 10-9 here]

Money market equilibrium implies that an increase in the interest


rate is accompanied by an increase in the level of income.
Money Market Equilibrium, and the
LM Curve derivation
• The LM curve can be obtained directly by
combining the demand curve for real balances
and the fixed supply of real balances
– For the money market to be in equilibrium, supply
must equal demand: M  kY  hi
P

1 M
– Solving for i:i   kY  
h P
The relationship (7a) is the LM curve.
The relationship above is the LM curve.

10-18
The Slope of the LM Curve
• The steeper the LM curve:
– The greater the responsiveness of the demand for
money to income, as measured by k
– The lower the responsiveness of the demand for
money to the interest rate, h
These points can be confirmed by experimenting with
Figure or examining equation,
1 M
i   kY  
h P
A given change in income has a larger effect on i, the larger
is k and the smaller is h
The Position of the LM Curve
• If real money balances increases, the money supply curve shifts
to the right
– To restore equilibrium at the income level Y1, the i must decrease to i2
• The new equilibrium is at point E2
– In panel (b), the LM curve shifts to the down and to the right
• At each level of income, the equilibrium interest rate has to be lower to
induce people to hold the larger real quantity of money

[Insert Figure 10-10]


Equilibrium and the Goods
and Money Market
• The IS and LM schedules [Insert Figure 10-11 here]
summarize the conditions that
have to be satisfied for the
goods and money markets to
the in equilibrium
– How are they brought into
simultaneous equilibrium?
 Satisfied at point E in the
adjacent figure
corresponding to the pair (i0,
Y0)
• Assumptions:
– Price level is constant
– Firms willing to supply whatever
amount of output is demanded at
that price level Flat SRAS curve
Pulls and Pushes in IS-LM framework
Y

Y
i
i
Y

i
Y
Impact of multiplier and interest rate
sensitivity
• What does a higher Keynesian multiplier imply for IS curve
slope?

• Does interest rate sensitivity affect AD and hence the IS


curve in any way?

• …if it does then does it have implications for responsiveness


of equilibrium output to changes in monetary policy?
The following equations describe an economy. (Think of C,I,G, etc as being
measured in INR billion at constant prices and ‘i’ as a percentage; a 5% interest
rate implies i=5):
𝐶 = 0.8 1 − 𝑡 𝑌
𝑡 = 0.25
I = 900 -50i
𝐺ҧ = 800
𝐿 = 0.25𝑌 − 62.5𝑖
𝑀ഥ
=500
𝑃ത

a. What is the equation that describes the IS curve?


b. What is the general definition of IS curve?
c. What is the equation of LM curve?
d. What is the general definition of LM curve?
e. What are the equilibrium levels of income and interest rates?
f. What would be the value of the Keynesian multiplier?
g. By how much does an increase in govt spending ∆𝐺ഥ increase the level of income in
this model which includes money market? Explain the change if any…
h. By how much does the change in government spending ∆𝐺ഥ affect equilibrium interest
rates?
IS-LM impact of autonomous spending

on equilibrium
Suppose there is a rise in autonomous
component of spending? [Insert Figure 10-12 here]
• i.e. autonomous G, I or NX has changed…
• Impact on AD curve?
• Impact on eqlm output in Keynesian
multiplier model?
• Will it be the same in IS-LM model? Explain
• Adjustment path?

Autonomous Investment  ==>


Y  ==> the IS-curve shifts right
==> md 
==> i 
Y  AD  A  c(1  t )Y  bi
==> I 
A Y
==> Y  from level of initial rise IS _ Curve : i  
b  Gb

CROWDING OUT EFFECT & flatter IS and steeper LM curve


IS-LM impact of tax policy cut

Tax policy: A tax cut IS


LM
i
• Will eqlm income in IS-LM model i
be same as in model of Keynesian
multipliers?
Y Y Y’
• What will be the impact
on AD curve?
Consumers save a part of the
• What will be the impact tax cut, so the initial boost in
spending is smaller for the tax
on IS curve?
cut than for an increase in G.
• Will the impact on output
due to tax cut be same as Y  AD  A  c(1  t )Y  bi
that of increase in G? A Y
IS _ Curve : i  
• What would the adjustment b  Gb
path be?
IS-LM impact of money supply on equilibrium
Monetary policy: An increase in M
i
1. ΔM > 0 shifts the LM curve down
(or to the right)
(i/k)Δ (M/P)
2. …causing the interest rate to fall i1

3. …which increases investment, causing i2


output & income to rise.

4. What would the adjustment process be?


Ms  ==> the LM-curve shifts right
==>i  M
 kY  hi
==> I  P
==> Y 
==> md  1 M
i   kY  
==> i  from the initial level of the fall h P
Policy choice: Money supply Vs setting
Interest rate
Choice between i & M are equivalent if => Positions of LM & IS curves are known
Why????

Suppose target interest rate is i*


Given the IS curve we get Y* plugging that value of i* in IS equation
Since we have i* & Y* then from the LM equation we can get
corresponding level of money supply
Suppose IS curve shifts up due an increase in autonomous spending
IS (position) changes i.e. new equation
In the new IS equation we can plug in the value of i* to get Y’
Plugging i* & Y’ in the LM equation we get the level of money supply to maintain i at i*
IS IS
LM LM
I’
i* i*

Y* Y* Y’
1. Assume the following IS-LM model:
expenditure sector: money sector:
AD = C + I + G + NX M = 500
C = 110 + (2/3)YD P =1
YD = Y - TA + TR md = (1/2)Y + 400 - 20i
TA = (1/4)Y + 20
TR = 80
I = 250 - 5i
G = 130
NX = -30

a. Calculate the equilibrium values of private domestic investment (I), tax revenues
(TA), and real money demand (md).
b. b. How much of private domestic investment (I) will be crowded out if government
purchases are increased by G = 100?

AD = C + I + G + NX = 110 + (2/3)(Y - TA + TR) + 250 - 5i + 130 – 30 = 500 + (1/2)Y - 5i


In eqlm. Y = AD ==> Y = 500 + (1/2)Y - 5i ==>Y = 2(500 - 5i)
==> Y = 1,000 - 10i IS-curve
From (M/P) = md ==> 500/1 = (1/2)Y + 400 - 20i ==> (1/2)Y = 100 + 20i
==> Y = 200 + 40i LM-curve
Eqlm: i = 16 ==> Y = 840
==> I = 250 - 5*16 = 170 & TA = (1/4)840 + 20 = 230
Since (M/P) = md ==> md = 500
Check: md = (1/2)840 + 400 - 20*16 = 500
b. How much of private domestic investment (I) will be crowded out if government
purchases are increased by G = 100?

If government purchases are increased by G = 100, the IS-curve will shift by

IS = α(∆G) = 2*100 = 200, and the new IS-curve is of the form Y = 1,200 - 10i

LM curve remains the same

New values for i & Y : ==> i = 20 ==> Y = 1,000


Since i = 4 ==> I = - 4*5 = - 20
2. Assume that the money sector can be described by the equations:

money supply: ms = 600 and money demand: md = (1/4)Y + 400 - 15i.

The expenditure sector can be described by the equation:

intended spending: AD = C + I + G + NX = 400 + (3/4)Y - 10i.

Calculate the equilibrium levels of Y and i, and indicate by how much the central bank
will have to change money supply if its goal is to keep interest rates constant after
government purchases are increased by G = 50. (Show your solutions graphically and
mathematically).
ms = md ==> 600 = (1/4)Y + 400 - 15i ==> (1/4)Y = 200 + 15i
==> Y = 4(200 + 15i) ==> Y = 800 + 60i LM-curve

Y = C + I + G + NX ==> Y = 400 + (3/4)Y - 10i ==> Y = 1,600 - 40i IS-curve

From IS = LM: ==> i = 8 ==> Y = 1,280

If government purchases increase by G = 50…


….the IS-curve will shift to the right by IS = 4*50 = 200. {Multiplier 1/((1-(3/4)) = 4}
new IS-curve is: Y = 1,800 – 40i.
Interest rate is kept constant at previous level i.e. new i = 8
Given i = 8 from new IS-curve “Y = 1,800 – 40i” we can get “new Y”
plugging i=8 in IS curve
new Y = 1800-40*8 = 1480
Given “new Y” we can find the “new ms” from the LM curve
ms = md = (1/4)Y + 400 - 15i = (1/4)*1480 +400 -15*8 = 650
“old ms = 600 & “new ms =650” from the LM curve
Money supply should increase by 50
3. Assume the equation for the IS-curve is: Y = 1,200 – 40i
and the equation for the LM-curve is: Y = 400 + 40i.
a. Determine the equilibrium value of Y and i.
b. If this is a simple model without income taxes, by how much will these
values change if the government increases its expenditures by G = 400, financed by
an equal increase in lump sum taxes (TAo = 400)?

Solving the IS & LM curve we have: i = 10 & Y = 800

According to the balanced budget theorem, the IS-curve will shift horizontally by the
increase in government purchases, that is, IS = G = TAo = 400

Therefore the new IS-curve is of the form: Y = 1,600 - 40i.

Solving the new IS and the given LM Curve :


New eqlm i = 15 & New eqlm Y = 1,000
Why interest rate not money supply?
Easier to measure

Central Banks belief about prevalence of LM


shocks
..hence interest rates stabilizes income better than
targeting money supply

Strictly for use of students of IMT only and


not for any other purpose
Monetary Transmission Mechanism
1. Central Bank announces short term interest rate that
depends upon its objectives and state of the economy
2. Central Bank undertakes daily operations to meet its
interest-rate target
3. Central Bank’s new interest rate target and market
expectations about future financial conditions help
determine the entire spectrum of short and long term
interest, asset prices and exchange rates
4. Changes in interest rate, credit conditions, asset prices,
and exchange rates affect investment, consumption and
net exports
5. Changes in investment, consumption, and net exports
affect the path of output and inflation through AS-AD
mechanism
Impediments To:
Monetary Policy Transmission in India
 Statutory SLR
 Lazy Banking
 Low credit demand
 Rising NPA’s
 Fiscal dominance
 Small savings schemes
Post office deposits, PPF, Savings Certificates
 Interest rate subventions, debt waiver/relief
 Tax saving mutual funds
Strictly for use of students of IMT only and
not for any other purpose
Vertical LM curve?
Vertical LM:
LM LM
 Can happen only if money demand is a function of income i
alone…. (1/k)Δ (M/P)
• Implies whatever be the interest rate, only certain
amount of money would be demanded (Classical View ) IS
• Quantity of money has the maximal effect on income
 LM curve will have to shift if there is any change in Y
…but the change happens through either a change in Y
Money supply or price level.
M
 kY  hi
1. What does it mean for the effectiveness of monetary P
policy??
1 M
With respect to monetary policy, this implies that any change in i   kY  
the money supply will lead to the rise in Y to the full extent of the h P
effective change in real balance.
putting _ h  o
2. What does it mean for the effectiveness of fiscal policy??
M  kP Y
- Full Crowding out effect (in short-run)
Quantity theory of money
Can IS curve become horizontal?
Horizontal IS:
LM
i LM
 Can happen if either one or both of these two (i/k)Δ (M/P)
happens:
• Value of “multiplier” and/or interest rate IS
sensitivity “b” are infinite (difficult to find
meaningful explanation)
Y
 Nonetheless, what would infinite multiplier mean for Y  AD  A  c(1  t )Y  bi
the slope of aggregate demand curve?
A Y
IS _ Curve : i  
b  Gb
What does it mean for the effectiveness of monetary
policy??
M
Though infinite value of “multiplier” or “b” are difficult  kY  hi
P
to find, what this means qualitatively is that …… higher
the multiplier and or interest rate sensitivity of 1 M
i   kY  
investment, higher the effectiveness of monetary h P
policy.
What does Vertical IS imply?
LM
Vertical IS: IS
 IS curve is independent of interest rate i LM
(i/k)Δ (M/P)
 Aggregate demand is insensitive to interest
rate
• What would be the value of interest rate
responsiveness of investment “b”?

• Would that affect the slope of IS curve or its intercept? Y

 Such a phenomenon looks a bit weird but can it happen when?

 Lack of businesses’ willingness to undertake investments irrespective


of the level of interest rate? When does it happen? Y  AD  A  c(1  t )Y  bi

 In literature this is known as investment insufficiency A Y


IS _ Curve : i  
b  Gb

What does it mean for the effectiveness of monetary policy?


What does it mean for the effectiveness of fiscal policy?
Impact of monetary policy in LR
Full Crowding
IS
Ms 
LM LM1
==>i 

I’ ==> I 
i*
==> Y  ==> the LM-
curve shifts right

Here P  (Why???) ==>


M/P 

O LM shifts back raising


Y(Full Emp) interest rate until  in
agg demand is fully
crowded out
Monetary Fiscal Policy mix
Policy Mix to prevent crowding
out
IS IS’
LM LM1

I’ Would such “Prevention of


i*
Crowding out effect” through
policy mix be possible in the
medium term?

O
Y* Y’ Y’
IS-LM monetary & fiscal policy interaction
Monetary & fiscal policy variables: (M, G, and T ) are exogenous.

In Real world: Monetary policymakers may adjust M in response to changes in fiscal


policy, or vice versa.

• Such interactions may alter the impact of the original policy change.

RBI Holds M constant RBI Holds i constant RBI Holds Y constant


i i i

i3
i2 i2
i2

i1 i1 i1
Solution of IS-LM model
IS curve from real economy LM curve from money mkt
Y  AD  A  c(1  t )Y  bi M
 kY  hi
P
A Y
IS _ Curve : i   1 M 
b  Gb LM _ curve : i   kY  
h P 

Two equations & two unknowns ‘i’ & ‘y’ hence equation system solvable
Y* 
Incorporating the value of ‘i’ from LM curve into IS curve we can solve for eqlm Y*

h G A b G M
Y*   *[ 0 ]
h  kb G h  kb G P

Incorporating the value of ‘Y*’ into IS curve we can solve for r*

k G A 1 M
i*   *[ 0 ]
h  kb G h  kb G P

Derive the fiscal & money multiplier & relate it to the of IS & LM slopes discussed earlier
Explain these scenarios
 Central banks setting interest rates and money supply … are they equivalent?
 Why do central banks choose to set interest rate than money supply?
 Explain differences in economic adjustments due crowding out effect in short run
and long run
 Explain the impact of demonetization in the IS-LM framework?
 Explain a temporary adverse supply shock say adverse monsoon in IS-LM
framework
 Explain impact of a wave of credit card fraud increases…..in IS-LM framework
 Explain impact of a Rapid rise in ATMs….in IS-LM framework
 Explain the impact of Stock market crash….in IS-LM framework
 Explain the impact of Improvements in business and consumer confidence … in
IS-LM framework
 Explain effectiveness of monetary and fiscal policy in a deflationary situation
 Explain the impact of Corporate accounting scandals like Enron, Worldcom etc in
IS-LM framework
Demonetization Impact
• LM impact • IS impact
• A certain sum of currency in • Reduced consumption and
circulation (estimate of black investment on complications
money in circulation) was not to carry out transaction due to
expected to return back to the the arrival of Rs. 2000 notes
banking system and their distribution
• To that extent RBI’s liability • Decline in consumer
would reduce… confidence on govt.
• …implies reduction in broad or announcement of heavy
high powered money…. i.e. penalties can affect
∆𝑀 <0 investment as well
• Reduced wealth of which
destroyed or unused cash was
a part
Example: Assume that an economy is characterized by the following equations:
C = 100 + (2/3)*(Disposable income)
T = 600
G = 500
I = 800 – (50/3)r
Md/P = 0.5Y – 50r
The money supply M is 1,200 and the price level P is 1.
Aggregate Demand & Aggregate Supply
• The AS/AD model is the basic macroeconomic tool for
studying output fluctuations and the determination of the
price level and the inflation rate

• AS upward sloped

• AD downward sloping = Why?


– Wealth effect
– Interest effect
– Net export effects (operates through exchg rate)
Deriving Aggregate Demand Schedule
Interaction of asset market and goods market
M
• Real money supply is written as , where M is the nominal
P
money supply, and P is the price level

M
P    i   I   AD 
P

&
M
P     i   I   AD 
P

Inverse relationship between P and Y  downward sloping AD curve


Deriving the AD Schedule
• The AD schedule maps out [Insert Figure 10-13 here]
the IS-LM equilibrium holding
autonomous spending and
the nominal money supply
constant and allowing prices
to vary
– Suppose prices increase from P1
to P2
• M/P decrease from M/P1 to
M/P2  LM decreases from
LM1 to LM2
• Interest rates increase from
i1 to i2, and decreased
output from Y1 to Y2
• Corresponds to lower AD
10-49
Deriving Aggregate Demand Schedule
Considering asset market alone
• Money demand function:
• L = kY – hi with k > 0 and h > 0

• But what if money demand is no more a function of interest rate


L = kY
• In eqlm: M/P = kY

• We can write: M V  P  Y Quantity Theory of Money


(where V = I/k)

• V = velocity of circulation of money = total number of times the


average rupee changes hands in a year
AD from Asset Mkt alone
• Quantity Theory of Money: M V  P  Y

• If M & V are assumed constant


• Then inverse reln btwn P & Y i.e. –vely sloped aggregate demand fn

• If V & Y are constant then it implies “neutrality of money”


• i.e. , changes in money supply will change the nominal variables in a
proportionate manner, but leave the real variables unchanged
Equilibrium: AD = AS
• Equilibrium output is Y0

• Equilibrium price level is P0


Shifts in AD: Impact on prices & output
• Anything that shifts IS curve
would shift AD curve in a
‘similar’ way ( like G, TA, TR)

• Anything that shifts LM curve


will shift AD curve in a
‘similar’ way (…like changes
in MS)

• Resulting changes in Eqlm ‘P’


& ‘Y’ would depend on
– Slope of AS
– Slope of AD
– Extent of shift in AD & AS
AS: Keynesian & Classical
• Keynesian AS:
• firms will supply whatever amount of
goods is demanded at the existing price
level (Fig a)

• Why is it horizontal?
– Keynesian Economics evolved
during great depression
– High unemployment, idle
Capacity
• Firms could increase
production without
increasing P by putting idle
K (i.e., capital) and N (i.e.,
labor) to work
AS: Classical
• Classical AS:
• Full employment of resources (Fig b)

• Vertical AS?

• Given the all available


resources are employed… any
attempts by firms to increase
output would only lead to
increase in P due to rise in
cost of K (i.e., capital) and N
(i.e., labor)
Frictional Unemployment &
Natural level of unemployment
• Natural rate of unemployment is the rate of
unemployment arising from normal labor market
frictions that exist when the labor market is in
equilibrium

• In reality there is always some unemployment due to


frictions in the labor market (Ex. Someone is always moving
and looking for a new job)

• The unemployment rate associated with the full


employment level of output is the natural rate of
unemployment
Fiscal and Monetary Policy with Keynesian
and Classical Supply Conditions
EFFECTS OF FISCAL EXPANSION
Interest Real
Aggregate Supply output prices
rate Balance

Keynesian + + 0 0
Classical 0 + + -

EFFECTS OF MONETARY EXPANSION


Keynesian + - 0 +
Classical 0 0 + 0
EFFECTS OF FISCAL EXPANSION
Interest Real
Aggregate Supply output prices
rate Balance

Keynesian + + 0
Classical 0 + + -
Intermediate + + + -

EFFECTS OF MONETARY EXPANSION


Keynesian + - 0 +
Classical 0 0 + 0
Intermediate + - + +
Supply Side Economics
• Supply side economics focuses on AS as the driver in the economy
• Supply side policies are those that encourage growth in potential
output  shift AS to right
– Such supply side policy measures include:
• Investing for augmenting productive capacity (i.e., capital
accumulation)
• Inducing technological progress
• Removing unnecessary regulation and bringing about market friendly
and growth friendly economic reforms
• Maintaining efficient legal system and institutions which are market
friendly and growth friendly
• Politicians sometimes use the term supply side economics in reference to the
idea that cutting taxes will increase AS enough so that tax collections will
actually increase, rather than fall
• Many economists too support cutting taxes for the incentive effect => Shift in
the AS curve
Supply Side Economics
• Supply side policies are crucial for maintaining medium and long-
term growth in an economy
– Only supply side policies can permanently increase
output
– Demand side policies are useful for managing cyclical
fluctuations in the short run (which is what we have done
for this course)
http://www.slideshare.net/luxminy/islm-analysis

Understanding financial crisis:

http://www.finance-watch.org/hot-topics/understanding-finance/1229-
bank-capital

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