Keynesian Theory and IS-LM Model - Research Paper Example

Running head: The Mechanism of IS-LM model The Mechanism of IS-LM Model s The aggregate demand function with Government intervention in absence of foreign trade can be derived as: AD = C+I+G Where aggregate demand is equal to consumption demand C, plus investment demand I plus Government demand G for goods and services. The level of Government spending G is not effected by the increase or decrease in the income and output. Same is the case with consumption demand C and investment demand I. The Government also changes taxes against the facilities it provides to the people and pays transfers. Net taxes are calculated as taxes minus transfer. The imposition of taxes lower the personal disposable income relative to national income and output hence: YD = Y-NT Where YD is disposable income, Y is the national income and NT is the net taxes. Hence when the net tax rate is t, disposable income is related to national income through following relationship YD = Y-NT = Y-tY = Y (1-t) The Marginal Propensity to consume of National income is related to Marginal Propensity to consume of Personal disposable income by the following formula: MPC= MPC x (1-t) Now we will undertake an analysis of the IS/LM model in order to analyse how the fiscal and monetary policy effect the aggregate demand, the level of GDP and also interest rates. In Fiscal policy mechanism the government can control the Aggregate Demand level through changing the level of taxation, transfers and expenditure. Changes in level of taxation, transfers and expenditure can be automatic or arbitrary. Through Monetary Policy mechanism out put is controlled by the central bank through expansion or contraction of the money supply or by controlling the level of interest rates in the economy. Fiscal Policy: Through the increase in government expenditure financed by the sale of additional government bonds the IS curve will shift to right. As the IS curve shifts to the right the goods market will clear on a new equilibrium level E2 increasing the interest rates and the level of income. As the IS-LM model is based on the assumption of continuous market clearance in the assets markets the adjustment path is along the LM curve, as depicted in the figure below. Through the increase in the government expenditure the private investment spending falls since the interest rates get higher changing the formation of output with the increased share of larger public sector. Figure: Increase in Government Expenditure (Bond-Financed) Crowding Out: The decrease in investment spending with an increment in the government expenditure is regarded as the notion of crowding out. With more crowding out the fiscal policy becomes more ineffective. This can be understood as, the more interest rates rise in response to the increase in government spending the more crowding out will occur and the less effective fiscal policy will be in expanding the economy. This can be graphically understood as the steeper the LM curve the greater the crowding out effect. As we know that the slope of LM curve shows the interest elasticity of the demand for money. A steeper LM curve shows that the increase or decrease in the rate of interest does not effect the demand for the real balances. For instance, the less responsive the demand for real balances to changes in interest rates the steeper the LM curve. This leads to a conclusion that in case of significant crowding out the demand for money is not affected by increase or decrease in interest rates. In this particular situation the Government can increase spending by financing it through lower the price of its bonds and hence raising the interest rate. The slope of the IS curve also depicts the effects of expansionary fiscal policy. The effects of expansionary fiscal policy also depends on the size of the shift in the IS curve arising from the government spending increase. Complete Crowding Out A vertical LM curve depicts the complete crowding out. When the LM curve is completely vertical it means that the demand for money is not responsive to interest rate. This is shown in the figure below, which shows that the fiscal expansionary policy has increased the interest rates from r1 to r2 without effecting the income/output. For such limiting case assumed as unlikely by most of the economists, fiscal policy loses its effectiveness as it fails to boost or reduce aggregate demand and output. Figure 2-2: Complete Crowding Out Crowding Out according to Classicals and Keynesians: In the Post Industrial Revolution era, the economies of many countries have experienced tremendous growth, which has resulted in shape of economic strength and high living standards in the countries such as United States, United Kingdom and Japan. Despite the tremendous progress the economies of these countries also face periodical economic shocks. The time span of these shocks is normally short and the economies revive back to their position. The continuation of this expansion and contraction trend in the economy is known as business cycle. The subject matter of macroeconomic theory mainly constitutes the business cycle theory. The effects of the declining trends in economy expand to all the areas such as production, income, consumption and employment level. Therefore it has been an important issue for the economists of all eras to study the main concerns such as the causes of the business cycle and the responsive behaviour needs to be adopted by the policy makers. Despite many explanations provided by the economists the questions remain still controversial. The main groups of economists involved in the controversy are the Keynesian economists and the classical economists. According to the classical point of view the business cycles are the result of disturbances in the production and spending. The classical economists do not find the need of government action in order to counter the recessions in the economy. On the other hand according to the Keynesian economists the wages and the prices do not respond very quickly to the disturbances in the production level and the employment level. Therefore the Governmental action is needed in order to deal with the situation. In the next section the essay will further elaborate the debate between the two school of thoughts. The Real Business cycle theory is the extended version of the classical theory, which sees business cycle as the result of the productivity shocks. According to the Real business cycle theory the reduction in the productivity at temporary basis creates a declining effect on the real wages, employment level and output and increase the interest rate and the prices. The RBC theory finds a positive relation ship between the business cycle and the level of real wage, prices and the overall productivity level of Labour. On the other hand the theory asserts a negative relation ship between the price level and the business cycle. The anti-cyclical trend of price level is taken as failure by many of the critics of the theory. Except the productivity shocks the increase in the Government purchase also increase the employment level, the interest rate and the price level. Hence the classical model undertake the study of both fiscal factors and the productivity shocks. Although the fiscal policy can play its part in order to improve employment level and output but the classical economists do not support the role of Government action and states that the invisible hand can adjust the market to the most efficient level. The role of money in the RBC is neutral. RBC theorists suggest that increasing or decreasing the nominal money supply can effect the price level but cannot effect the output level, employment and interest rate. The statement of money being neutral by the classical economists has been a failure. It has been proven several times that the role of money supply is not neutral and the money supply has been used in many countries as the policy measure for stabilising the economy. In the case of the extended classical theory i.e. misperceptions theory the sudden change in the in the money supply can affect the output. If the consumers can make rational forecasts regarding the macroeconomic variables the such as money supply the Government regulating bodies cannot surprise the consumers since the will make the judgement regarding the actions of the regulating body. Hence according to the classical economists the fiscal policy cannot be used in shape of changing money supply to control the output. According to the Keynesian theory the business cycle fluctuation is the result of demand shocks. These are the shocks which shift either the IS curve or the LM curve resulting in shape of affecting the aggregate demand for output. The basic difference in the classical and Keynesian Attribute of business cycle that the Keynesian view the business cycle fluctuation as "not enough demand for goods" on the other hand the classical economists see recession as "not enough supply of goods" The Keynesians see unemployment as the result of mismatch between workers and jobs. Also it is caused because of above the level wage rigidity at which the labour supply and demand are equal. In the Keynesian theory the price and the wages not flexible. The firms do not change their prices in the short run with the change in the demand and supply of their goods. In the Keynesian model the money is not neutral in short run. The increase in the money supply shifts the LM curve down and to the right raising output and lowering the interest rate. In the long run the money is neutral. Through monetary expansion the price level also increase which has no real effect in long run. According to the Keynesians economists the monetary and fiscal policies can be used to smooth the business cycle. The Keynesian business cycle theory emphasises the pro-cyclical behaviour of employment, money, inflation and investment. Although the Keynesian theory has to undertake the assumption that the firms employ more labour than demanded during the recession period. The Keynesian theory suggest that the fiscal and monetary policy can be used to stabilise the economy while taking into consideration the type and extent of the problem needs to be addressed and the level of measure needs to be taken. These policy measures can lead to higher price level in the absence of policy changes. After the oil price shocks in 1970's the Keynesian theory was confined to the supply shocks. The notion of stagflation was also introduced being the combination of inflation and recession compounding the stabilisation policy difficulties. Before that the supply shocks were insignificant and the demand side analysis was used effectively. But the 1970's supply shocks were of major level and the Keynesians and the demand side theorists failed to analyse and explain the contemporary increase in the inflation and output level. The Keynesian theory was criticised due to the shift in the correlation mechanism with the change in the nature of shocks. The demand side analysis and theory failed to analyse the 1970's supply shocks and to present any solution on the basis of theory. On the other hand the RBC theory is based on the following major implications which are not consistent with the real world conditions. According to the RBC theorists both the short and long run analysis are same. The RBC theorists do not see the monetary policy as an effective tool of maintaining equilibrium in market. According to them the employment level is dependant upon the voluntary substitution between leisure and the number of hours workers wish to work stating that the wage is pro cyclical. Furthermore the prices are flexible and labour substitution clears the market. The notion of money neutrality is also not accepted by some of the RBC theorists such as Mankiw as it does not explain the Philip curve in short run. The intertemporal leisure substitution and the voluntary unemployment received severe criticism and the Keynesians rejected them on grounds of microfoundations. References Kaboub, F., New Classical and Real Business Cycle Theories Understanding the Business Cycles, available at http://k.faculty.umkc.edu/kaboubf/WP/RBC.html King Robert G. "Will the New Keynesian Macroeconomics Resurrect the IS-LM Model" Journal of Economic Perspectives 7, no. 1 (winter 1993): 67-82. S. Ahmed, B. W. Ickes, P. Wang, and B. S. Yoo, "International business cycles," American Economic Review, vol. 83, pp. 335--359, June 1993. Read More