Name; Vithya Nandakumar
SOAS ID; 652295
Course Title; South Asian Culture with Economics
Assignment; AS2
Tutor; Simone Gasperin
Title; Derive the IS-LM framework and use the framework to discuss the effects of different ways in which an increase in government expenditure can be financed.
Word count;
Introduction
The IS-LM model is regarded as one of the most crucial element that represents the association between real outcomes, interest rate, money market and the market for services and products. It is an essential method to determine the policy concerning the economy, and therefore, it is one of the basic and most considered frameworks in macroeconomics (Singh, 2013). An exemplary graph of the model is below:
In the graph of this framework, the X-axis represents GDP or the income level of the company as denoted by Y. On the other hand, the Y-Axis represents country’s rate of interest that is denoted by a small r. In addition to this, the curve of IS denotes the points of equilibrium in services and products market, which are referred to as their respective saving or investment terms. While the LM curve represents Money supply (M) and Liquidity (L) and the money market equilibrium (Woodford, 2010). Hence, the framework indicates that the equilibrium lies in the intersection of both the curves mentioned earlier, thus, forming the market balance between the two.
It has been evident that the model of IS-LM is considered as a significant tool in analysing economic statistics, making it one of the most vital elements in making monetary, fiscal or economic policies. It has been indicated in the research of Serrano and Summa (2015) that the curve of LM represents the points that combine income level of market, rate of interest and real money in the form of equilibrium. The purpose of this research is to represent the impact of fiscal policy, tax reduction and monetary policy on the government expenditure under the framework of IS-LM framework.
Effect of National Income
It has been noted in the research of Young and Zilberfarb (2012) that fiscal policy plays a vital role in increasing the expenditure of government through generating finance from national income (Wu, Tang and Lin, 2010). The effect can be reflected through the IS-LM model as well. The autonomous nature of increasing expenditure of government also increase the demand of services and produces, that inclines the IS curve for an outward shift, suggesting the shift to IS2 from IS1 in the figure below.
Here, it can be observed that the distance between the curves of IS horizontally reflects the rise of expenditure of government which is multiplier, hence, generating the formula of ΔG x 1/1-MPC. It implies that the increase in interest rate can reflect through the IS curve right shift, which can potentially cause the decline in investments being made privately (Boustan et al, 2013). Given that the LM curve is considered to be unchanged in this situation, the point B gets intersected by IS2 in the LM curve. Therefore, it can be said that the government expenditure, which is denoted by ΔG increases under the IS-LM model that shifts the equilibrium from point E to point B, hence, rising the interest rate go r2 from r1 while representing the shift of income level from Y2 to Y1.
The income point CK is removed because of the increase of the interest that further decreases the amount of investments made privately. Moreover, the same line also represents the crowding effect, considering the increase of government expenditure. Therefore, it can be observed that the fiscal policy indicates the increase of interest rate, income level and the government expenditure (Alesina and Ardagna, 2010). In addition to this, the model of IS-LM considers the difference between increase in interest rate and the decrease in private investment as the source of increasing the government expenditure. Therefore, it can be observed that the decline in expenditure of government is likely to cause the IS curve to shift towards left, while the LM curve remains in the same position. The change is likely to decrease the income level and the interest rate, both (Itzetzki et al, 2013). However, the research of Fontana and Setterfield (2016) observes that the government most often reduces is expenses in order to control the economic inflation.
Effect of Reduction in Taxes
The reduction of taxes also contributes in the governmental expenditure and can be used as an alternative tool to increase the consumption demand of citizens by increasing their disposable income. The reduction of taxes results in the right shift of IS curve to IS2 from IS1. However, it has also been observed that the model of Keynesian multiplier indicates that the shift experienced in the curve of IS, is based on the taxes reductions multiplied by the value of taxes (Kriesler and Nevile, 2016). It is denoted with the ΔT. It is further evaluated through the equation ΔT x MPC/1-MPC, which reflects on the change of income level through E and H.
(Itzetzki et al, 2013)
Based on the framework represented, the curve shift of IS2 from IS1 can be observed through the tax reductions, which as a result causes the shift of equilibrium point of economy from E to the point D.It also indicates the rise of income level to Y2 from Y1 and interest rate to r2 from r1. In addition to this, it can be observed that the LH income level is eliminated because of the crowding-out effect that has been imposed on private investments, which will consequently increase the rate of interest (Itzetzki et al, 2013). However, it has been noted that the interventions posed by government on the economy in order to decrease the pressure of inflation will result in the increase of taxes and reduction of disposable income. Moreover, the increase in taxes will result in the reduction of collective demand; hence, inflation can be controlled through this, as observed in the research of Arnold et al (2011)
Effect of Monetary Policy
It has been evident through the research of Woodford (2011) that the appropriate changes by the government on monetary policies have the significant influence economic activity level. The nature of these monetary policies can either be contractionary or expansionary, which is based on the way an economy prevails in the country (Guajardo, Leigh and Pescatori, 2014). In order to understand the way it influences the governmental expenditure, the model of IS-LM has been used for reflection. It has been found that the shift in the LM curve can be caused because of the change in money supply. While the rise of money supply shifts the curve to right, the decrease in the same variable shifts it on the left (Arnold et al, 2011).
Considering that the economic conditions are suffering through recession, the Central Bank can make the best use of expansionary monetary policy to improve the economic conditions (Davig and Leeper, 2011). Hence, it can be used to boost the money supply within the economy. Moreover, it has been observed that the interest rate is likely to decline with the increase of money supply, given that the demand for money and state of liquidity remains unchanged. In addition to this, the more businessmen are likely to make investment if the interest rate is lower. It will result in the rise of income as well as the aggregate demand, shifting the LM curve to right.
Furthermore, it has been made evident that that the curve in the above model indicates that the money supply expansion results in the rise of aggregate demand of services and products in the market. On the other hand, it has been evident that lower interest rate is a result of heightened money supply, creating an atmosphere that demands more investment. Therefore, it can be observed that the demand for increased investments can be led through multiplier process, which results in increase of national income and aggregate demand (Davig and Leeper, 2011).
It has been noted in the research of Woodford (2011) that the government is responsible to control the inflation affecting economy, along with the Central Bank that is required to monitor and impose strict contractionary monetary policy. The inflation can be controlled through decreasing the money supply through promoting government securities or selling bonds to seek funds from the buyers (Guajardo, Leigh and Pescatori, 2014). The purpose of choosing such methods is to reduce the liquidity that exists in the banking systems. In addition to this, Central Bank can increase the ratio of cash reserves in the banks in order to lower the money supply, which will result in the low inflation rate. Furthermore, it can be observed that the higher ratio of cash reserve equates to the notion that banks are compelled to keep the cash reserve, resulting in them falling short on the cash and being forced to bind a credit contract. On the other hand, it is observed that the investment demand will be reduced as the rate of interest will increase, thus, lowering the consumption demand.
Conclusion
The importance of money in any given economy can be reflected through the positive slope, which indicates that the higher rate of interest promotes the concept of investment, thus increasing the GDP of the country, with a right shift representation in the graph. Moreover, the low rate of interest reflects decrease in the investments that further decreases the income and lowering the economy. The research concludes that fiscal policy, reduction of taxes and monetary policies tend to impact the government, as reflected through the IS-LM model framework.