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Macroeconomics & The Global
Economy -Term III
Ace Institute of Management
Chapter 10: Keynesian Model and ISLM curves
(Based on Macroeconomic Analysis: Edward ShapiroChap. 8,9,12 and Macroeconomics by N. G. Mankiw)
Instructor
Sandeep Basnyat
[email protected]
Mobile: 9841 892281
Classical approach-a reminder
 Stable equilibrium in all sectors through market
mechanism
 The interaction between demand and supply forces in a
long run.
 Even wage rate and prices moves both ways –
upward and downward – adjusting with the change
in demand and supply in an economy.
 No economy would suffer from over production, as
supply will automatically create its own demand.
 No government intervention
Theories didn’t work with the Great Depression of 1930s
The great Depression of 1930s
Very High
Production
after WW1
Oversaw actual
economic demand
Decrease in
price of
goods
and services
Could not
stimulate
Demand
Number of
Industries
suffered
Under
Production /
GDP fell
Mass layoff
Didn’t improve
employment
Huge Wage cut
Didn’t increase
demand
High
unemployment
Big question- Why was economy sluggish?
Evolution of Keynesian Theory
British Economist John Maynard Keynes
analyzed economic issues in a different way
through his world famous book – A General
Theory of Employment, Interest and Money
Basic Concepts:
Effective demand
Aggregate Demand and
Aggregate Supply
Keynesian Macroeconomics
 His arguments were:
 Due to the presence of strong labor union wage cut is not
possible. Therefore Wage is sticky downwards and flexible
upwards
 Economy, thus, does not operate at full employment level,
but at less than full employment level.
The great Depression of 1930s
Very High
Production
after WW1
Oversaw actual
economic demand
Decrease in
price of
goods
and services
Could not
stimulate
Demand
Number of
Industries
suffered
Under
Production /
GDP fell
Mass layoff
Didn’t improve
employment
Huge Wage cut
Didn’t increase
demand
High
unemployment
Big question- Why was economy sluggish?
Keynesian Macroeconomics
 His arguments were:
 Due to the presence of strong labor union wage cut is not
possible. Therefore Wage is sticky downwards and flexible
upwards
 Economy, thus, does not operate at full employment level, but at
less than full employment level.
 Role of government is crucial because its policy decisions
can affect level of aggregate demand, which in turn affects
economic growth, employment and general price level
J.M. Keynes: Equilibrium in the Economy
 For equilibrium, Planned Exp. = Actual Exp.
 Planned Exp. Comes from Aggregate Demand (AD) where as
Actual Exp. Comes from Aggregate Supply (AS) or National
Income (Y)
Therefore, AD = Y or,
 For Eg: Two sector equilibrium: C+I =Y
 The equilibrium is known as Keynesian Cross
 Case 1: Y > C + I -> (Actual investment > planned investment)
 Case 2: C + I > Y -> (Actual investment < planned investment)
Note: Investment is an expenditure on expected demand
Components of Aggregate Demand
 There are four types of demands in an
economy
 Consumption Demand (C)
 Investment Demand (I)
 Demand for Government Expenditure (G)
 Demand for Foreign Trade (X-M)
Consumption Demand (C)
 Reminder,. Y = C +S where,
C = f (Yd) and S = f (Yd)
 Marginal Propensity to Consume (mpc): The portion of any
increase in disposable income that goes towards consumer
spending.
mpc = Change in Consumption Expenditure
Change in Disposable Income
= ∆C / ∆Yd
 Marginal Propensity to Save (mps): The portion of any
increase in disposable income that is saved.
Change in Savings
= ∆S / ∆Yd
mps =
Change in Disposable Income
If, mpc + mps = 1, then mpc = 1- mps;
Consumption function and equation
 Mathematically, C = Ca + bY….consumption equation
 Consumption demand has two components - autonomous
consumption and induced consumption that is dependant on
income and mpc.
 Autonomous consumption are those spent mostly on
sustenance and are independent of level of income.
 Induced consumption depends on the level of income, mostly
on comfort and luxurious goods
 Ca is the autonomous consumption, b is mpc and Y is the
total income (or total output of the economy).
Consumption Demand (continued ….)
 With the help of consumption equation we can construct
hypothetical income-consumption schedule
 Let Ca=50, b = 0.75). Using, C = Ca + bY
Income (Y)
0
100
200
300
400
Consumption (C)
C
50
125
200
275
350
Y
The functional relationship between Income and Consumption
demand is the consumption function as drawn before.
Consumption Function
Y
AGGREGATE
INCOME
(Billions of
Dollars)
-
C
=
AGGREGATE
CONSUMPTION
(Billions of
Dollars)
S
AGGREGATE
SAVING
(Billions of
Dollars)
0
80
100
200
100
160
175
250
-100
-80
-75
-50
400
400
0
600
800
1,000
550
700
850
50
100
150
Investment Demand (I)
 Spending by businesses on capital goods—factories,
machinery, and other aids to production.
 2 influences on the economy:
 Helps determine the economy’s level of total output and total
employment
 Critical determinant of the economy’s rate of growth as it
enlarges the economy’s stock of capital goods and thereby helps
increase the economy’s capacity to produce goods and services
 There are 3 forms of investment.
 Business Fixed Investment
 Residential Fixed Investment and
 Inventory Investment.
Investment Demand contd..
 Mathematically, I = Ia + eY
 e is the marginal propensity to invest and Ia is the autonomous
investment
 As similar to consumption demand, investment demand can
also be autonomous and/or induced
 Autonomous investment are carried out to maintain the basic
growth requirement. This is independent of level of income.
 Induced investment depends on income level
Equilibrium Aggregate Output (Income)
(All Figures in Billions of Dollars)
(1)
(2)
(3)
(4)
(5)
(6)
UNPLANNE
PLANNED
D
AGGREGATE
AGGREGATE
AGGREGATE
INVENTORY
OUTPUT
PLANNED
EXPENDITURE (AE)
EQUILIBRIUM?
CONSUMPTION
CHANGE
(INCOME) (Y)
INVESTMENT (I)
C+I
(Y = AE?)
(C= 100+.75Y)
Y - (C + I)
100
175
25
200
- 100
No
200
250
25
275
- 75
No
400
400
25
425
- 25
No
500
475
25
500
0
Yes
600
550
25
575
+ 25
No
800
700
25
725
+ 75
No
1,000
850
25
875
+ 125
No
Effect of Change in spending
Y=AD
AD, C, I
Final
equilibrium
C+I+I
C+I
E1
E
Initial
equilibrium
I
Y > I
Y
Y
Y1
Y2
Y
Note: Small changes in spending are magnified into larger changes in income
and output—the multiplier effect.
The Multiplier
 The ratio of change in total output to the change in total spending.
Mathematically,

When initial earning of Rs. 10,000 produces total output of Rs. 50,000,
the multiplier is 5 .






Y
I
Assume that mpc is .80, i.e., people spend 80% of the earnings.
Initial earning of Rs. 10,000 incur initial spending of Rs. 8000
Since this Rs. 8000 is earning for someone else, the overall economy’s
output increases by Rs. 8000.
Now, Rs. 8000 incur further spending of Rs. 6400 as mpc = 0.8
Now the economy’s total output is 10000+8000+6400+…= 50,000.
Multiplier depends on the value of marginal propensity to consume (b)
.
The Multiplier
How much is the
multiplier here?
The Multiplier Equation-Two Sectors
 Households and Business firms only.
 Assume a small increase in overall income of an economy
 Increase in income will form a part of consumption and investment.
 Y = C + I. Dividing both sides by Y, we get
Y
Y
=
C
I
+
Y Y
or, 1 =
C
I
+
Y Y
C 1 mpc
I
= 1
=
or,
Y
Y
1
Y
Since Y is the Multiplier by definition,
=
I
I
1 - mpc
1
1
Since, mps (s) = 1-b
Multiplier (k) =
=
b
1
1 - mpc
1
1
Multiplier (k) = s =
1- b
or,
Finding equilibrium in 2 sector economy
 For equilibrium, Y = C+I
Let us assume that all investment is autonomous,
So, I = Ia (Remember I = Ia + eY)
Then, Y = Ca + bY + Ia
or
Y – bY = Ca + Ia
or
(1-b)Y = Ca + Ia
or
Y = [1/(1-b)](Ca + Ia)
Hence, equilibrium output is [1/(1-b)] (Ca + Ia)
As, [1/(1-b)] is the multiplier and is denoted by k,
equilibrium output will be Y = k (Ca + Ia)
Effect of Change in Investment
What happens if there is an increase in investment?
 Let I be increased by I. This will subsequently
increase the output by Y
 New investment will be I +I and corresponding
output will be Y +Y
Hence, Y+ Y = k (Ca + Ia+I)
or Y = k (Ca + Ia) + kI – Y = Y + kI – Y
Y = k I
This shows that an increase in investment by I will
increase the output by k I.
Basic Keynesian Model-3 sectors economy
 The aggregate demand of an economy will be total
demand created by three sectors namely,
household, business and government.
 Government spending (G): purchases of goods and
services by government
 Cases:
What happens to equilibrium when government uses
its fiscal policies?
Note:
 Increase in ‘G’ increases total output
 Increase in Revenue through tax decreases total output
 Works with Multiplier effect
Government In The Economy-Equilibrium
Fiscal Policy At Work: Multiplier Effects:
Case 1 – No tax model
Fiscal Policy At Work: Multiplier Effects:
Case 1 – ‘G’ Increases (but No Tax) model
 Y = AD
=C+I+G
 As stated earlier, C = Ca + bY,
 For a simplest analysis of three-sector Keynesian Model we
assume Investment demand as autonomous and Government
Expenditures are constant. Thus, I = Ia and G is constant
Equation (iii) can now be written as
Y
= Ca + bY + Ia + G
or
Y-bY
= Ca + Ia + G
or
(1-b)Y = Ca + Ia+ G
or
Y
= 1/1-b(Ca + Ia+ G)
 Here, value of simple multiplier in a three sector Economy is
1/1-b.
Multiplier Effects: Case 2 – Tax imposed by the govt.
 When tax is imposed, the disposable income of a consumer
decreases by Y-T.
C = Ca + bY= Ca + b(Y-T)
Assume, I = Ia and G is constant
Y = Ca + b(Y-T) + Ia + G
or
Y – bY = Ca + Ia + G – bT
or
(1-b)Y = Ca + Ia + G – bT
or
Y = 1/1-b(Ca + Ia + G – bT)
Keynesian Economics-Four Sector
(Open) Economy




Export and Import are included in a four sector
economy.
Exports depend on the income of foreigners and
therefore it is exogenously determined in the
home country.
Import on the other hand is a function of level of
income.
Import is given by M = Ma + mY

Ma = Autonomous Import and mY = Induced Import
Four Sector Economy- Case 1: Simple Keynesian
model including the external sector
 Y = AD = C + I + G + (X-M)
Where C = Ca + bY and M = Ma + mY
 I is autonomous and G and X are exogenously
determined
 Now, putting these values in Y,
Y = Ca + bY + I + G + X – Ma – mY
or
Y – bY + mY = Ca + I + G + X – Ma
or
(1-b+m)Y = Ca + I + G + X – Ma
or
Y = (1/1-b+m)(Ca + I + G + X – Ma)
So, Equilibrium Output:
Y = (1/1-b+m)(Ca + I + G + X – Ma)
Value of Multiplier: 1/1-b+m
Keyne’s explanation on-The Recessionary
and Inflationary
 S = National Saving
 I = National Investment
 S – I = Saving investment gap
 If S > I, National Surplus
 Govt. can utilize the surplus if, G > T. How much,
 G-T = Expenditure revenue gap
 For an economy to be in equilibrium,
S – I = G-T
The Recessionary and Inflationary Gaps
The Recessionary Gap
 (C + I)1 = economy’s total expenditure
function and existing level of
equilibrium GDP
Desired
Equilibrium at Full
Employment
(C+I)2
 (C + I)2 = full-employment output—the
e1
level of output that allows to achieve
target rate of unemployment.
 Recessionary Situation—a period of
Recessionary
Gap
e
weak economic activity and relatively
high unemployment.
 Recessionary Gap =The amount by
which the equilibrium GDP falls short
of full-employment, or potential, GDP
 Causes a recession? Keynes: too
little spending. (G-T < S-I)
 Solution: Increase level of planned
expenditure (Remember 1930s
case?)
(C+I)1
Actual
Equilibrium
Y1
Y
Reduction in
output
Two Gaps Model-The Recessionary and Inflationary
Gaps
The Inflationary Gap
 (C + I)1 = economy’s planned expenditure
function and existing level of equilibrium GDP
Desired
Equilibrium at Full
Employment
 (C + I)2 = full-employment output—the level of
(C+I)1
output that allows to achieve target rate of
unemployment.
e
 If the economy is operating in full employment
level, the economy cannot provide more than
Y1 level of goods and services.
Inflationary
Gap
e1
 If consumers and investors attempt to
purchase more output than the economy is
capable of producing, higher prices result as
prospective buyers bid against one another.
 But Real GDP will not increase. Only money
GDP
 Inflationary Gap =The amount by which the
equilibrium GDP exceeds full-employment, or
potential, GDP (G-T > S-I)
 Solution: Decrease level of planned
expenditure.
(C+I)2
Actual
Equilibrium
Y1
Y
Increase in
potential GDP
Paradox of thrift
 Where higher savings become
disincentive in an economy when it
leads to reduction in national output.
S1 S
 Shift of savings curve towards left
results a shift in equilibrium point
 Given an unchanged Investment
I
curve, the shift in savings curve
towards left decreases output
subsequently from “Y” to “Y1”.
 Thriftiness (increased desire to save)
without support from other economic
variables can have undesired
consequences
Y1
Y
One Big Question !
How would the market be in
equilibrium?
• Develop Goods market and money market
• Check how goods market and money
market interact to determine the level of
output and the interest rate.
The Goods Market and the Money Market
Goods market: in which goods and services are
exchanged
 Equilibrium level of price of a product is
determined by the demand and the supply of
the product
Money market : The market in which financial
instruments are exchanged
 Equilibrium level of the interest rate is
determined by the supply of money and the
demand for money
The Goods Market Equilibrium
 In two sector economy, equilibrium level of
goods market is given by Y = C + I (Keynes)
 Similarly, We know, Y = C+S.
 So, C + I = C + S or S = I
 Therefore, in two sector economy, goods market
is also in equilibrium if S = I (financial market)
How will the Goods Market be in equilibrium?
The Goods Market Equilibrium
 We know that,
 Savings is the positive function of Income
S = f(Y)
 Investment is the inverse function of rate of
interest
I = f(r);
Goods Market Disequilibrium
r
S>I
Y>C+I
E
8
7
G
S>I
Y>C+I
..
..
Disequilibrium Point
F
I>S
C+I>Y
IS
60 100
Y
Money Market Equilibrium
MD = MS
Keyne’s 3 Determinants of Demand for money:
 Transaction Demand
 Precautionary Demand
 Speculative Demand
1. Transaction Demand: The main reason that people hold money—to
buy things.
 As the income level increases people want to spend more
money.
 So, Transaction Demand is the direct function of Income.
DT = f (Y)
Money Market Equilibrium
Precautionary Demand for Money


People hold money to meet emergencies and unexpected
contingencies
As in the case of transaction demand, it is some fraction of total
income and is positively related with the changes in money
income
DP = f (Y)
Note: In most of cases precautionary demand is combined with transaction
demand.
Money Market Equilibrium
Speculative Demand for Money



Speculative demand for Money refers to demand for holding
certain amount of cash in reserve to make speculative gain out
of purchase and sale of bonds and securities.
The amount people prefer to maintain idle cash balance for
speculative purpose depends on the rate of interest in the
economy
There is an inverse relationship between speculative demand
for money and rate of interest
DSP = f (r)
Now Total Money Demand, MD = DT + DSP
Money Market Equilibrium
Supply of Money
 Money Supply is exogenously determined – that is from
outside this model
 The central monetary authority fixes the level of nominal stock
of money supply.
 For equality in money market, Money Demand must be equal
to Money supply
MD = MS
Since, Total Money Demand, MD = DT + DSP
Now Total Money Supply, Ms = DT + DSP
Money Market Equilibrium-Liquidity Preference Theory
The money market is in equilibrium when Md = Ms
The equilibrium interest rate is
the point at which the quantity
of money supplied equals the
quantity of money demanded.
If the interest rate is initially high enough
to create an excess supply of money,
the interest rate will immediately fall,
discouraging people from moving out of
money and into bonds.
If the interest rate is initially low enough
to create an excess demand for money,
the interest rate will immediately rise,
discouraging people from moving out of
bonds
and into money.
Money Market Equilibrium
An LM curve illustrates
the positive
relationship between
the equilibrium value
of the interest rate and
aggregate output
(income) (Y) in the
money market.
High level of income
calls for relatively
large transaction
balances, which, with
a given supply of
money can be drawn
out of speculative
balances only by
pushing up the
interest rates.
Transaction Demand
Money Supply
DT
DT
DT = f (Y)
Total Ms =$100
$60
$60
$50
MS = DT + DSP
$50
$100 $120
DSP
Y r
r
Assume
Total Ms
=$100
LM curve
6
6
5
DSP = f (r)
5
$100
$120
Money Market Equilibrium
Ms = Md
Y
$40
$50
Speculative Demand
DSP
Money Market Disequilibrium
r
LM
Ms > Md
Md > Ms
For any combination
located in the space to
the right of the LM curve,
there is a disequilibrium
in which Md > Ms.
6
5
F
E
4
100 120
For any combination located in the space to the
left of the LM curve, there is a disequilibrium in
which Ms > Md.
Y
Two Market Equilibrium-The Goods
and Money Markets
r
LM
re
IS
Ye
Y
Two Market Equilibrium and Disequilibrium
S>I and MD<MS
r
LM
I>S and MD<MS
re
S>I and MD>MS
IS
I>S and MD>MS
Ye
Y
A numerical example
. Consider the economy of Nepal.

The consumption function is given by C = 250+0.75(Y-T). The
investment function is I = 200-25r, where r is the interest rate.
Government purchases and taxes are both 100. For this
economy, find the IS equation.

The money demand function in Nepal is (M/P)d = Y -100r. The
money supply Ms is 1,000 and the price level is 2. For this
economy, find the LM equation.

Find the equilibrium interest rate and the equilibrium level of
income. Assume that r =1 is equal to r =1%.

Suppose that the government purchases are raised from 100 to
150. How much does the IS curve shift? What are the new
equilibrium interest rate and level of income?

With the initial values of monetary and fiscal policies, What are
the new equilibrium interest rate and level of income when:


a) money supply doubles in the economy
b) price level rises from 2 to 4. What happens?
A numerical example
The consumption function is given by C = 250+0.75(Y-T). The investment
function is I = 200-25r, where r is the interest rate. Government purchases
and taxes are both 100. For this economy, find the IS equation.
Solution:
Consumption: C = 250 + 0.75(Y − T)
Investment: I = 200 − 25r
Balanced budget: T = G = 100
IS equation?
We know in three sector economy, the IS equation is
Y = C + I + G.
A numerical example
The consumption function is given by C = 250+0.75(Y-T). The investment
function is I = 200-25r, where r is the interest rate. Government purchases
and taxes are both 100. For this economy, find the IS equation.
Solution:
Now substituting the value of C, I and G.
Y = 250 + 0.75(Y −T )+ 200 − 25r +100
or, Y = 250 + 0.75Y – 0.75T + 200 – 25r + 100
or, Y – 0.75Y = 550 – 0.75x100 - 25r
or, 0.25Y = 550 – 75 - 25r = 475 - 25r
or,
Y = 1900 – 100r …………………(i)
A numerical example
. Consider the economy of Nepal.

The consumption function is given by C = 250+0.75(Y-T). The
investment function is I = 200-25r, where r is the interest rate.
Government purchases and taxes are both 100. For this
economy, find the IS equation.

The money demand function in Nepal is (M/P)d = Y -100r. The
money supply Ms is 1,000 and the price level is 2. For this
economy, find the LM equation.

Find the equilibrium interest rate and the equilibrium level of
income. Assume that r =1 is equal to r =1%.

Suppose that the government purchases are raised from 100 to
150. How much does the IS curve shift? What are the new
equilibrium interest rate and level of income?

With the initial values of monetary and fiscal policies, What are
the new equilibrium interest rate and level of income when:


a) money supply doubles in the economy
b) price level rises from 2 to 4. What happens?
A numerical example
b) Solution:
 The money demand function (M/P)d = Y -100r.
 Money Supply (Ms) = 1000 and
 Price Level (P) = 2
LM equation?
Money market equilibrium, Ms = Md
Substituting the value of Ms and Md,
1000 = Y −100r
Or,Y = 1000 + 100r or …………..(2)
or, r = - 10 + 0.01Y
A numerical example
. Consider the economy of Nepal.

The consumption function is given by C = 250+0.75(Y-T). The
investment function is I = 200-25r, where r is the interest rate.
Government purchases and taxes are both 100. For this
economy, find the IS equation.

The money demand function in Nepal is (M/P)d = Y -100r. The
money supply Ms is 1,000 and the price level is 2. For this
economy, find the LM equation.

Find the equilibrium interest rate and the equilibrium level of
income. Assume that r =1 is equal to r =1%.

Suppose that the government purchases are raised from 100 to
150. How much does the IS curve shift? What are the new
equilibrium interest rate and level of income?

With the initial values of monetary and fiscal policies, What are
the new equilibrium interest rate and level of income when:


a) money supply doubles in the economy
b) price level rises from 2 to 4. What happens?
A numerical example
Here,
IS Equation: Y = 1900 – 100r and
LM Equation: Y = 1000 + 100r
Solving IS-LM Equation,
Therefore,
Y = 1450
Substituting the value of Y in r
r = - 10 + 0.01Y = -10 + 0.01 x 1450 = -10 + 14.5 = 4.5
Therefore,
r = 4.5%
A numerical example
. Consider the economy of Nepal.

The consumption function is given by C = 250+0.75(Y-T). The
investment function is I = 200-25r, where r is the interest rate.
Government purchases and taxes are both 100. For this
economy, find the IS equation.

The money demand function in Nepal is (M/P)d = Y -100r. The
money supply Ms is 1,000 and the price level is 2. For this
economy, find the LM equation.

Find the equilibrium interest rate and the equilibrium level of
income. Assume that r =1 is equal to r =1%.

Suppose that the government purchases are raised from 100 to
150. How much does the IS curve shift? What are the new
equilibrium interest rate and level of income?

With the initial values of monetary and fiscal policies, What are
the new equilibrium interest rate and level of income when:


a) money supply doubles in the economy
b) price level rises from 2 to 4. What happens?
A numerical example
d) Given, Government purchases (G) raised
From 100 to 150. (no more balanced budget !)
Our original equation,
Y=C+I+G
Y = 250 + 0.75(Y − T) + 200 − 25r +150
Y -0.75 Y = 600 – 0.75T – 25r
0.25Y = 600 – 0.75 x 100 – 25r
0.25Y = 600 – 75 – 25r = 525 – 25r
Y = (525 – 25r) / 0.25 = 2100 – 100r
A numerical example
Therefore new IS equation is
Y = 2100 – 100r
LM curve remains the same:
Y = 1000 + 100r
Solving above equations,
Therefore, Y = 1550
Substituting the value of Y in above equation
1550 = 2100 – 100r => r = (1550 – 2100) / -100
r = -550 / -100 = 5.5
Therefore, r = 5.5%
Conclusion: When Aggregate demand increases (increase in C, I
or G), interest rate increases and Total Output (Y) increases.
A numerical example
. Consider the economy of Nepal.

The consumption function is given by C = 250+0.75(Y-T). The
investment function is I = 200-25r, where r is the interest rate.
Government purchases and taxes are both 100. For this
economy, find the IS equation.

The money demand function in Nepal is (M/P)d = Y -100r. The
money supply Ms is 1,000 and the price level is 2. For this
economy, find the LM equation.

Find the equilibrium interest rate and the equilibrium level of
income. Assume that r =1 is equal to r =1%.

Suppose that the government purchases are raised from 100 to
150. How much does the IS curve shift? What are the new
equilibrium interest rate and level of income?

With the initial values of monetary and fiscal policies, What are
the new equilibrium interest rate and level of income when:


a) money supply doubles in the economy
b) price level rises from 2 to 4. What happens?
A numerical example-Ms doubles
b) Given,
The money demand function (M/P)d = Y -100r.
 Since Ms doubles Ms = 2000
 Now New LM curve is,
2000 = Y -100r. New LM Equation is,
Y = 2000 + 100r
Solving new LM and old IS curve
r = 0.5%
Y = 2050
Conclusion: When Money Supply increases, interest rate
decreases and Total Output (Y) increases.
A numerical example-P increases
from 2 to 4
b) Given,
The money demand function (M/P)d = Y -100r.
 Since (M/P) = Ms,
Any increase in “M” increases Ms and any increase in
“P” decreases Ms.
 When P = 2, Ms = 1000
So, when, P = 4, Ms = 500
Now, original equation becomes,
500 = Y -100r =>
New LM Equation is
Y = 500 + 100r or, r = -5 + 0.01Y
A numerical example-P increases
from 2 to 4
Original IS equation remains the same:
Y = 1900 -100r
Solving original IS equation and New LM equation:
Therefore, Y = 1200
Substituting value of Y in r equation, r = -5 + 0.01 x 1200 =
7%
Therefore r = 7%
A numerical examplePrice Level changes-graphical presentation
LM1
r
LM
7%
4.5%
IS
Y
1200 1450
How do government policies affect the
market?
 Monetary policy
 Fiscal Policy
IS and LM and Monetary-Fiscal
Policies
r
LM Curve
r5
Classical
Range
r4
r3
r2
Intermediate
Range
r1
Keynesian
Range
Y
Different policies have different effects
on different ranges
Use of Fiscal and Monetary Policies
r
Assume
Very LowClose to
Zero
LM1
IS1
IS2
LM2
Liquidity
Trap- Central
Bank’s
liquidity can
not increase
further
output
r1
Y
Y1 Y2
Keynesian Range- as
observed by Keynes
Keynesian Range-Liquidity Trap Situation
 Liquidity Trap- a situation when the nominal

interest rate is close or equal to zero and the
monetary authority is unable to stimulate the
economy with traditional monetary policy tools
(failure of monetary policy).
People do not expect high returns on physical or
financial investments, so they keep assets in
cash bank accounts.
Use of Fiscal and Monetary Policies
Assume
Very High
r
IS1
IS2
LM1
LM2
Classical
Range- as
observed by
classical
theorists
r1
Y
Y1 Y2
Monetary and Fiscal Policy-The Intermediate
Range-Shift in IS curve
LM
r
IS’2
r3
IS2
r2
r1
Y2 Y3
The more closer is the equilibrium towards
Keynesian range, more effective the fiscal
policy is.
Monetary and Fiscal Policy-The Intermediate RangeShift in LM curve.
LM1 LM2
r
IS
r2
r1
Y1
Y2 Y
The more closer is the equilibrium towards
classical range, more effective the monetary policy
is.
Effectiveness of Monetary and Fiscal
Policies-General Conclusion
Range
Keynesian
Range
Intermediate
Range
Classical
Range
Most
Effective
Effective
Ineffective
Effective
Most
Effective
Policy
Fiscal Policy
Monetary
Policy
Ineffective
Try it !
 Money Demand: Md = Y (0.2-i) where i is the rate
of interest and Y is the income. Nominal Income
Y = 2000 and Money Supply (Ms) = 300
 Find Md for i = 10 % (or 0.1) and i = 5 % (or
0.05)
 What is the relation between i and Y
 Graph Ms and Md and Calculate the
equilibrium i.
 Central bank increases the Money Supply by
50. What happens to money market
equilibrium? (solve and graph)
Try it !
 Find the simultaneous equilibrium for the
goods and money market when C = 100 +
0.80Yd; I = 150 – 6i; T = 0.25Y; G = 100; Md =
0.2 Y-2i and Ms = 150.
 Calculate equilibrium rate of interest and
output if C = 100 + 0.8Y, I = 150 - 6i, M = 150
and L = 0.20Y – 4i
Thank You
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