Using the IS-LM framework - Essay Example

? IS/LM MODEL IS-LM graphical model remains a very important part in explaining the changes that occur in various macroeconomic factors after a change in the independent macroeconomic variables. The model was developed by Keynes and remains an integral part of Keynesian macroeconomic model till date. IS/LM stands for Investment-Saving/Liquidity Preference-Money Supply. The model shows the changes in interest rate and output of goods and services produced in an economy over a period of time following a shift in government spending. The model is represented in the form of a graph. The horizontal axis represents the national income or Gross Domestic Product (GDP) of an economy. The vertical axis represents the variable “i” which denotes the prevailing interest rates in the economy. The model achieves equilibrium at a point where “IS” curve intersects the LM curve. Inflation is considered as an exogenous factor in this model in the short run. This means that in the short-run real and nominal interest rates are same and any changes in the nominal interest rates affect the demand for money in the economy. (Lipsey & Chrystal 2003) IS curve is drawn just like a conventional demand curve. The independent variable of this curve is the interest rate and the dependent variable is the national income of the economy which is denoted by “Y”. The curve is a downward sloping line. The reason for the downward or negative slop of the curve is the fact that at lower interest rates demand for money “Y” is high. At higher interest rate levels, the demand drops down. This is in line with the rational behavior of consumers, institutions, businesses and governments. Since interest rate is a cost of money, many people would demand more money when it is being offered at cheaper rates. Similarly businesses will demand more money when the interest rates are low which lowers down their cost of doing business. Governments and other institutions will also borrow when the interest rate is low because of the fact that they will have to give lower amount to the party lending the fund, for the use of funds. In other words opportunity cost of borrowing is low when interest rates are low and high when interest rates are higher. All the parties needing money borrow more at lower interest rates unless the demand for money is inelastic. (Brue & McConnell 2006) IS Curve can be mathematically explained by the following equation: In the above equation, C(Y-T(Y)) represents the consumer spending part of the function. I(r) represent the investment function which is affected by the interest rates. It must be remembered that the relationship between investment and interest rate is negatively proportional at all times. G represents the government spending part which is exogenous or given. No factor affects the government spending and since it is solely determined by the government’s own policy hence it is considered as an exogenous factor. The last part of the function is related to international trade. NX(Y) represents the net import minus exports and denotes the net international trade as a function of real income. It must be remembered that the relationship between the international trade and disposable income is positive all the times. This makes sense as it tells the readers that the more income the people have, more they will be willing to spend. (Anabtwi & Smith 1994) In the diagram “Figure 1”, it can be seen that the IS curve is downward sloping. In other words, the relationship between national income (GDP) and interest rate is negatively correlated. Any fall in interest rate increases the national income and any rise in interest rate decreases the national income (GDP). The relationship is more explicitly point out in numerical figures. The rise in interest rates from 4 percent to 5 percent has resulted in the fall in national income from $700 to $600. The relationship between these two variables is negative. The relationship makes sense because of the opportunity cost of money as discussed above. (Anderson 1998) The second important part of the IS/LM model is the LM curve. LM curve represents two variables just like the IS curve. LM curve is quite similar to IS curve, but the nature of the variables used in the curve design is different from the IS curve. In LM curve, income becomes the independent variable and Interest rates become the dependent variable. In other words, any change in income causes the interest rates to fluctuate. LM curve is drawn like a conventional supply curve. It is an upward sloping curve. It reflects that the relationship between the two variables is positively correlated. Any increase in income cause the national income to rise which will eventually result in increasing interest rates. However, the curve is more complex than it first looked. LM curve represents two complex calculations. Liquidity Preference and Money Supply are two important measures used in the drawn of the LM curve (Chang & Smyth 1970). The curve represents the points at which Liquidity Preference and Money Supply curves meet. Liquidity Preference curve is downward sloping. Liquidity preference represents the transaction demand for money and speculation demand for money. Transaction demand for money is a sum of money a person needs to hold and money help for emergencies. Similarly speculative demand for money is the money help for making profit on the money by trading it in FX markets or any other business that will increase the value of money. Money Supply is determined by the central banks and hence it is represented by a vertical line denoting that it does not change with nominal interest rate, GDP or any other factor (Findlay 1999). The LM curve can be represented mathematically by the following function: In the above equation M/P represents the real supply of money. P represents the price level and is a factor that translates nominal demand of money into real demand for money. L represents the demand for money which is affected by the interest rates and national income. The diagram above the shows the upward sloping LM curve. It shows that any increase in thee income level pushes up the interest rates and vice versa. Since any increase in the income results in people becoming more conscious about their standard of living and hence they demand more money. Businesses demand more money because they have made a lot of money in the fiscal year which is reflect in the increase in the GDP of an economy (Hicks 2000). GDP is nothing but sum of all the income earned in an economy over a period time (taken as one fiscal year). Therefore any increase in the national income shows improved performance of households, businesses, government and institutions. Since these players in the market are performing well therefore they need more money to finance them and this pushes up the interest rates because the demand for money in the economy has suddenly increased. The entire relationship is aptly explained in the “Figure 2”. IS-LM equilibrium is achieve where IS curve intersects the LM curve. They are drawn together on the same graph and the equilibrium is achieved where these two curves intersect each other. It is the point that represents the interest rates in an economy and the total GDP of the same country. (Kennedy & Tower 1999) The diagram “Figure 3” shows that IS/LM equilibrium is achieved where the IS curve intersect the LM curve. The equilibrium output of this economy would also be the point where the two curves meet and the interest rates in the economy would be the point of intersection of the two curves. (King 1993) The government spending is nothing but an increase in the money supply in an economy. It is a way of pumping money into the economy. The increase of government spending in the economy is going to shift the IS curve rightward. This means that at every interest rates level there would now be higher GDP or national income in the economy. Therefore, it can be said that any increase in the government spending in an economy also increases the GDP or output of goods and services produced in an economy over a given fiscal period. This can be mathematically proven by considering the equation derived earlier in the paper. Since it is known that government spending (G) is an autonomous factor and it is not affected by any factor, we can rewrite the equation as: Y = X + G Where x represents C(Y-T(Y) + I(r) + NX(Y) In order to prove the increase in Y as a result of change in government spending, it must be tested by keeping x in the equation as constant. Support that x is $250 and government spending (G) in the economy is also $250. This will produce an output of $500. Now if the government spending increases to $300, the output will be greater than $550. The reason for this is that there is going to be an increase in consumer spending in the economy, investment is going to increase and as a result of pumping money into the economy the international trade is going to be increased since all of these factors are functions of the national income. Therefore, the aggregated result will always be greater than the initial government spending. This shift in the IS curve is going to increase the demand of money in the economy and will increase the level of interest rates in the economy. (Wrightsman 1999) If the government is financing this investment through different means then the output and interest rates might not fluctuate as they would if other factors are held constant. Any increase in the government spending as a result of increase in taxes will dampen out the effect of increase in government spending and the multiplier effect of initial government expenditure would be far lower than established previously. Similarly if the increase government spending is a result of domestic borrowing than this would curb the consumer spending and GDP would not be as high as first though. Similarly if international funds have been borrowed to increase the government spending then the importing partners would be left with limited money and the increase in international trade might not occur and this would not enlarge “Y” (GDP) much. All of these factors would not increase the demand of money in the economy and hence there would be no increase in the interest rate levels of an economy. The things would stay pretty much stagnant if the wrong sources of funding are used to finance the government investment and if the money demand in the economy is not increased by as much as first though, there would be no increase in the interest rates which would not encourage any new investment and the size of Y would remain very small even after the increase in the exogenous factor in the IS model. (Silber 1970) The government can use the strategy of financing its expenditure in the economy using a host of strategies other if it wants to show the artificial increase or change in the size of the economy. Not much will occur if the financing is done through any other factor in the IS model, but the GDP figure is going to inflate and the economy conditions will look better without any threat of inflation or any other macroeconomic ailment. Since, any rise in interest rates is a signal of inflation in the economy, therefore by keeping interest rates in control through financing the expenditure by various means of financing the government is achieving its dual targets of economic growth and keeping inflation under control This strategy would be beneficial for the economy in the long run as it will attract the interest of foreign investors and would achieve growth without hurting the other important macroeconomic aims of the economy. All of this will result in better and more rewarding future for the economy. References Anabtwi, I. & Smith, G., 1994. Modelling of Money, Credit and Banking. Eastern Economic Journal, vol 20, no. 3, pp. 275-290. Anderson, W.,. 1998. A Pedagogical Note on the Open Economy IS-LM Model. The Journal of Economic Education, vol 19, no. 1, pp. 82-86. Brue, S. & McConnell, C., 2006. Economics. McGraw-Hills, New York. Chang, W. & Smyth, D., 1970. Stability and Instability of IS-LM Equilibrium. Oxford Economic Papers, vol 24, no. 3, pp. 372-384. Findlay, D., 1999. The IS-LM Model: Is There a Connection between Slopes and the Effectiveness of Fiscal Policy. The Journal of Economic Education, vol 30, no. 4, pp. 370-380. Hicks, J., 2000. IS-LM: An Explanation. Journal of Post Keynesian Economics, vol 3, no. 2, pp. 143-164. Is, Lbaassoteaamd, 1998. Chen, Chau-Nan. Southern Economic Journal, vol 40, no. 1, pp. 34-98. Kennedy, P. & Tower, E., 1999. Excess Demand in the IS-LM Model. Eastern Economic Journal, vol 1, no. 16, pp. 43-53. King, R., 1993. Will the New Keynesian Macroeconomics Resurrect the IS-LM Model? The Journal of Economic Perspective, vol 7, no. 1, pp. 66-80. Lipsey, A. & Chrystal, M., 2003. Economics. Oxford University Press, Oxford. Silber, W., 1970. Fiscal Policy in IS-LM Analysis: A Correction. Journal of Money, Credit and Banking, vol 2, no. 4, pp. 24-34. Sloman, J., 2003. Economics. Prentice, New York. Wrightsman, D., 1999. IS, LM, and External Equilibrium: A Graphical Analysis. The American Economic Review, vol 60, no. 1, pp. 203-210. Read More