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Keynesian Theory and IS-LM Model - Research Paper Example

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The paper "Keynesian Theory and IS-LM Model" discusses that 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 the short run…
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Keynesian Theory and IS-LM Model
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Download file to see previous pages 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 government expenditure, the private investment spending falls since the interest rates get higher changing the formation of output with the increased share of the larger public sector.
The decrease in investment spending with an increment in 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 the 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 affect the demand for 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 an 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 depend 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 the interest rate.   ...Download file to see next pages Read More
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