Government Spending and Price Levels Contents ISLM Model 3 Keynesian model of cross planned expenditure 5 Phillips Curve 7 Imperfect Information 8 Monetary effects on output, work, and investment 13 References 15 ISLM Model The total supply of goods in the economy is denoted by Y…
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A part of the consumer’s income is taxed. Let the fixed rate of tax be t. Then the savings can be written as S = (1-t)Y-C+ tY-G. Consumption can be written as C=c(1-t)Y, c is the marginal propensity to consume. Therefore, S=(1-c)(1-t)Y-tY-G. Let us concentrate on the monetary side. The assumption here is that the supply of money (M) is determined by the central bank. The consumer’s decision on their holdings is the sole driving force behind the demand for money. The consumers allocate a part of their wealth as currency and the remaining part in the form of bonds. It is expected that an increase in the interest rate will induce consumers to keep a smaller proportion of their income as currency which, in turn, reduces the demand for money. An expansionary monetary policy will reduce the interest rate and increase output in the short run while an expansionary fiscal policy will do just the opposite (Weins, n.d.). A reduction in marginal propensity to save will increase the rate of interest along with the output. A shock of drop in consumer’s confidence will have its effects on savings, investment, money supply and demand assuming rate of interest and output remains constant. (Massachusetts Institute of Technology, 2009, p. 1) The original point A is still equilibrium of the money market. Therefore, the LM curve must include point A. But investment is same as before but savings has increased. So the point A which originally was in the IS curve is now a point where S>I. If there is movement to the right from A, then interest rates and investments are same and savings increases due increase in output. This will make the savings even bigger and so the actual movement should have been to the left of A. (Massachusetts Institute of Technology, 2009, p. 1) An increase in money supply will have no effect on savings and investment or demand for money. Therefore, savings and investment will remain the same and so IS curve must include point A. Keynesian model of cross planned expenditure The cross planned expenditure is given by Ep. Ep= C+I+G. Investment Demand Schedule (Cooke, 2010, p. 10) Ip is planned investment. Ep=E(Y,r,G,T)=C(Y-T)+Ip(r)+G Keynesian Cross (Cooke, 2010, p. 12) Government Spending (Cooke, 2010, p. 13) Phillips Curve The relationship between inflation and unemployment is represented through Phillip’s curve. There is a relation between the prices charged by the company and the wages. (Hoover, n.d.) Suppose the government plans for an expansionary fiscal and monetary policy in order to bring the unemployment below the natural rate. This results in increase in demand conditions. The firms are encouraged to raise the prices. The rate of increase in prices is faster than that anticipated by the workers. Workers in this situation are likely to suffer from money illusion. They witness a rise in the wage rate and thereby supplies more labor. This results in fall unemployment rate (Liaudes, 2005, p. 31). Imperfect Information The real economy is significantly affected by monetary policy in the short run. The non-neutral effects of monetary policy rise because of temporary nominal price rigidities. The short term interest rate is taken as the instrument of monetary policy. The Central Bank should adjust the nominal rate so that it cannot offset the movement in expected inflation. The nature of the disturbances has a role to play in this part. The Central Bank may not
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