Macroeconomic equilibrium in the commodity market. Macroeconomic Equilibrium in Commodity and Money Markets: TS-LM Model
As a result of studying this chapter, a student should:
know
- aggregate demand components and planned costs;
- a mechanism for achieving equilibrium production in the Keynesian model of "income - expenses";
- concepts of inflationary and recessionary gaps;
be able to
- determine the factors affecting the macroeconomic equilibrium in the model of "income - expenses";
- calculate the average and marginal propensity to consume and save, cost multiplier, accelerator;
own
- skills of graphic representation of the model “income - expenses”;
- the ability to identify factors that ensure macroeconomic equilibrium in the model of "income - expenses";
- skills in analyzing public policy measures based on the income-expenditure model.
The balance of the commodity market in the model of "income - expenses"
Another model that reflects the ratio of aggregate demand to aggregate supply is the Keynesian model of income - expenses, which is also called the Keynesian cross. It is built on the assumption of fixed prices, which differs from the AD - AS model.
Note the main provisions of Keynesian theory, which for several decades of the XX century. lay the basis of macroeconomic policies of the leading states of the world:
- not aggregate supply determines demand, but aggregate demand determines the level of economic activity, i.e. aggregate supply and employment rate;
- salaries and prices are not completely flexible;
- the interest rate does not equalize the volume of savings and investments;
- full employment ns is achieved automatically, government intervention in economic processes is necessary.
In the Keynesian model, aggregate demand depends on the functions of consumption and savings. In contrast to the classical economic theory, according to which the main factor determining the dynamics of savings and investments is the interest rate, according to Keynes both consumption and savings are income functions.
The factors that determine the dynamics of consumption and savings include:
- household income;
- wealth accumulated by households;
- price level;
- economic expectations;
- amount of consumer debt;
- level of taxation.
The values \u200b\u200bof consumption and savings, provided that the state does not take special actions to change them, are relatively stable. Current consumption is less than the amount of income by the amount of savings. Therefore, to maintain balance, it is necessary that savings have transformed into investments. It should be noted that the investment activity of business entities is very variable.
We list the factors that determine the dynamics of investments:
- expected net profit margin;
- real interest rate;
- level of taxation;
- changes in production technology;
- cash fixed capital;
- economic expectations;
- dynamics of total income.
To achieve equilibrium at full employment, according to Keynesian theory, the state must stimulate aggregate demand. Therefore, this theory is often called the theory of aggregate demand. The lack of aggregate demand is due to two main reasons.
1. The main psychological law, according to which, as income grows, people increase the share of income that goes into savings: “The psychology of society is such that with an increase in total real income, total consumption also increases, but not to the same extent as income grows” . To describe this pattern, indicators of the average and marginal propensity to consume and to save are used.
Average propensity to consume APC \u003d C / Y shows what proportion of income goes to consumption.
Average propensity to save APS \u003d S / Y characterizes the share of income that is saved.
Marginal propensity to consume IFA = AC / AY shows the change in consumption depending on the change in income.
Marginal propensity to save Mps = AS / AY determines the change in the value of savings depending on the change in income.
2. The low rate of return on capital due to the high level of interest (this reduces investment demand from firms).
Under these conditions, the state’s task is to compensate for the fall in aggregate demand with government spending.
In the Keynesian model of "income - expenses" the equilibrium of the market is achieved when the total (planned) costs AE(i.e. the amount that business entities plan to spend on the purchase of goods and services) are equal to total income N1 (national income) - the real costs that the company, and N1 \u003d DI (disposable income). N1 = DIdenote Y. The expense stream represents aggregate demand, and the income stream represents aggregate supply. To build the model, it is necessary to write the following equalities:
From G and Exp (demand from the state and the external market) at this stage of the study, we abstract.
Hence,
We build the coordinate system (Fig. 5.1). To determine the equilibrium point, it is necessary to draw a line of iodine at an angle of 45 °. All points of this line are in equilibrium: expenses are equal to income (AE \u003d Y). To find the balance point we need to build a consumption line.
In Keynesian theory, as mentioned in the previous chapter, the main factor determining the dynamics of consumption and savings is the amount of disposable household income. The consumption function has the form
where With a - autonomous, i.e. consumption independent of income change (let's say it will be equal to 100 units); IFA - marginal propensity to consume (we take it for 0.8); Y - disposable income (income after tax).
Fig. 5.1.
Build a line WITH. We take U for zero. Then WITH will equal With a (100). Let us give, for example, the value of 200 units. Then WITH \u003d 100 + + 0.8 x200 \u003d 260.
At the intersection of direct consumption with the line at an angle of 45 °, all income is consumed. With consumption values \u200b\u200babove this point, part of the income goes to savings. If consumption exceeds disposable income (the area to the left of the critical point), then it is partly due to previous savings.
Now you need to build a line of savings and find the point where investment is equal to savings. Building a line of savings
where S a - autonomous savings S a = -C a; MPS - marginal propensity for savings.
At Y \u003d 0, this line will go through the point (-100), since all the savings will go to consumption. Where the point of intersection of the line at an angle of 45 ° and the consumption function is projected onto the axis OH, savings are zero (S \u003d 0).
Now you need to find the intersection of the savings line with the investment line.
Investments are autonomous and induced (stimulated). Autonomous investments do not depend on the level of income; they are determined by external circumstances (mineral reserves, foreign markets, etc.). Investments are called induced if their value increases as GDP grows, i.e. their cause is a steady increase in demand for goods. Induced investments, superimposed on autonomous, enhance economic growth.
The investment function has the form
where e + 1 (f) - investments independent of total income; e -autonomous investments determined by external economic factors; / (g) is the real interest rate; / (Y) - induced investment.
Investment demand is volatile enough, but in our example, we will assume that investment demand is 50 units. at all income levels. Projecting the point of intersection of the line S and lines I to the line at an angle of 45 °, we will find the equilibrium point. Straight AE = WITH + / will also pass through this point (parallel to line C).
The determination of the point of general equilibrium is necessary for predicting the development of the economy. If at the moment the actual Y less equilibrium, which means that firms produce less than buyers are willing to purchase (AD\u003e AS), and it can be assumed that the economy will expand. If the size of the national income exceeds the equilibrium level, i.e. buyers purchase less goods than firms produce (A9 AD), increase inventory, and firms reduce production.
The equilibrium level of output fluctuates in accordance with changes in the components of total costs (C, I, G, Exp) moreover, the increment of expenses causes a multiple increase in income.
The question arises: by what amount will national income change due to changes in spending?
Standalone Cost Multiplier- this is the ratio of the change in the equilibrium volume of national production to the change in any component of autonomous costs. It shows how many times the total increase (decrease) in total income exceeds the initial increase (decrease) in autonomous expenses:
where MULT - multiplier of autonomous expenses; A Y - a change in the equilibrium volume of national production; AL - change in autonomous costs, independent of the dynamics of U.
Simple Multiplier Formula
Consider the process of multiplication with a simple example.
Example. Suppose that the growth of autonomous investments in society amounted to 1,000 units. On the one hand, these are expenses. On the other, revenues. This money materializes in the form of labor, equipment, raw materials and other goods. The owners of these factors of production will receive an income equal to 1000 units. At MPC \u003d 0.75 they will direct for consumption of 750 units, and for savings - 250 units. 750 units also for someone they will become expenses, and for someone they will become incomes (Table 5.1).
Table 5.1
Multiplication process
As a result, the initial investment of 1000 units. led to an increase in national income to 4000 units. (with a multiplier of 1 / 0.25 \u003d 4, 1000 4 \u003d 4000).
Thus, the effect of the multiplier, which repeatedly increases the consequences of changes in autonomous expenses, is a factor enhancing government stimulation of aggregate demand. However, it can exacerbate economic instability. Therefore, the task of the government is to create a system of built-in stabilizers that weaken fluctuations in business activity.
As was shown above, the equality between aggregate demand and aggregate supply requires compliance with the equal volumes of savings and investments: I \u003d S. Since investment is a function of interest, and savings is a function of income, the problem of finding their equality is very complex.
The lack of balance between the planned investments and savings can lead to two negative effects for the functioning of the economy:
- inflation gap;
- deflationary gap.
The inflation gap is a situation in the economy in which the planned costs (E along the vertical axis) exceed the potential level of total output, or the planned investments exceed the savings (/\u003e 5) corresponding to the full-time situation, i.e. the supply of savings by the household sector lags behind the investment needs of firms (Figure 5.2).
Fig. 5.2.
In this situation, the population will direct most of the income to consumption, demand in the markets for goods and services will increase, which will increase the price growth rate, i.e. will cause inflation. Thus, the economy of the NS will be able to independently come to a state of equilibrium corresponding to the point Y 0, and the inflationary gap will increase due to the multiplier effect.
To bridge the inflationary gap, it is necessary to restrain aggregate demand and move equilibrium to a point E (. The decrease in equilibrium total income should be
A recessionary (deflationary) gap is a situation in the economy in which the planned costs are less than the potential level of total output or the planned investments are less than the savings (/ S) corresponding to the full-time situation, i.e. the supply of savings by the household sector outpaces the investment demand of firms.
In the conditions of the recession gap, the population will save most of the income, demand in the markets for goods and services will decrease, which will cause overproduction and lower prices, as well as a subsequent decline in production and the dismissal of workers. A decrease in employment and a decrease in income in the economy will continue until the effect of the multiplier ends. Thus, the recession gap will gradually narrow, the economy will independently come to a state of equilibrium corresponding to the point E b however, this will be accompanied by a decline in production and unemployment.
To overcome the consequences of the recession gap and ensure full employment of resources, it is necessary to stimulate aggregate demand (total expenditures) to a point so that the equilibrium moves to a point E 2. The increment of the equilibrium income will be equal to
To eliminate or reduce the recession gap, Keynes suggested:
- implement government revenue redistribution policies to increase consumer demand;
- reduce the real interest rate to increase investment demand;
- increase government spending.
To eliminate or reduce the inflation gap by reducing the components of planned total expenditures (aggregate demand), Keynes proposed increasing taxes and cutting government spending.
It should be noted that the principle of animation has a two-way effect. The increase in the population’s savings in conditions of underemployment and insufficient demand creates a “thrift paradox” - it reduces savings and investments in society as a whole. Even a small reduction in investment gives the opposite multiplier effect - a multiple decrease in national income is that an increase in savings at the macro level (increase MPS) may hamper economic growth. Indeed, the Keynesian cross shows that an increase in savings and a corresponding reduction in consumer spending reduces the equilibrium level of GDP. The mechanism of this phenomenon is simple: a reduction in consumption will cause overstocking of warehouses with unsold goods, a reduction in the income of entrepreneurs will lead to curtailing investments and reducing production.
However, the growth of savings can play a positive role in the economy, but only if the money market quickly and sufficiently completely turns them into investments, then there will be no overall reduction in total expenditures, and the structure of the economy will change in the direction of increasing the accumulation rate, which may lead to faster economic growth.
- Keynes, J .. M. General Theory of Employment, Interest, and Money. Anthology of economic classics. M .: 1993.Vol. 2.P. 155.
Theoretical task:
1) Describe the equilibrium models of the commodity market;
2) How do the differences between the classical and Keynesian models in the understanding of investment and savings affect the results of economic analysis?
3) What are the assumptions that significantly limit the reality of the implementation of the conclusions obtained in the framework of Keynesian theory?
4) How do life cycle and constant income hypotheses resolve the contradictions that have arisen regarding the consumption function of J. M. Keynes?
1. Briefly describe the equilibrium models of the product market.
Macroeconomic or General Economic Equilibrium- This is the state of the national economy when there is a balance between aggregate demand and aggregate supply.
The equilibrium of the commodity market is ensured by the ratio of aggregate demand for goods and services (AD) and aggregate supply of goods and services (AS).
There are two approaches to explaining the equilibrium of the commodity market: classical and Keynesian.
Classic approach
The economy is divided into two sectors: real and monetary, which in macroeconomics was scientifically called "classical dichotomy" ie the money market does not affect real indicators, which is called the principle of neutrality of money. This principle means that money does not affect the situation in the real sector and all prices are relative.
There is perfect competition in all real markets.
Since perfect competition exists in all markets, all prices are flexible, i.e. prices change, adapting to changes in the ratio of aggregate demand and aggregate supply, and ensure the restoration of disturbed equilibrium in any of the markets and, moreover, at the level of full employment of resources
Since prices are flexible, equilibrium in the markets is established automatically
Since equilibrium is ensured by an automatic market mechanism, no external force should interfere with the functioning and regulation of the economy. So the classics justified state non-interference in the economy
The main problem of the economy is the limited resources, so all resources are fully used and the economy is always in a state of full employment of resources, i.e. the most effective use of them, so the volume of output is always at the level of potential
Limited resources make the problem of production the main one in the economy, i.e. the problem of aggregate supply, therefore, the classical model is a model that studies the economy from the side of aggregate supply
The problem of limited resources is being solved slowly, so the classical model is a model that describes a short-term period
Keynesian approach
In the mid 30-ies of XX century. a new employment model was formulated. Its ancestor was John Maynard Keynes, who in 1936 published a book, The General Theory of Employment, Interest, and Money, which laid out the fundamental concepts of new employment. J. Keynes completely rejected the classical theory of employment, arguing that the capitalist market economy does not have at all any mechanism for regulating employment, and that with a certain regulatory role of the state, a balanced economy can be achieved with a significant level of unemployment and significant inflation. It turned out that full employment of the population is an absolute coincidence, and not regularity and capitalism cannot be any self-regulating system capable of infinite prosperity, it is a system that requires constant control and regulation by the state. Unemployment and inflation were considered by Keynes as the natural properties of capitalism, which the state can smooth out by regulating the savings of the population and entrepreneurial investments. He argued that under capitalism, as a rule, a decrease in prices is accompanied by a decrease in wages, which means that consumer profitability decreases and there is no and cannot be elasticity between pricing, primarily for food products and services.
Keynesian employment model rejected Say's law in that the savings of the population through bank interest rates are in accordance with the investment activities of entrepreneurs. No, Keynes said, it is not necessary for entrepreneurs to increase investment if the population accumulates savings. In turn, falling prices for goods not only do not stimulate investment, but, on the contrary, inhibits entrepreneurial activity. Therefore, the subjects of savings and investors are not synchronous groups of the population, but completely independent, independent from each other market entities, developing plans for their savings and investments on different grounds. Keynes argued that the level of savings is weakly correlated with the rate of bank interest, moreover, reasons and examples can be given when the savings are inversely related to the level of the interest rate. Thus, savings can be made in order to make a large purchase over time (for example, a car), sometimes savings are made for convenience (to buy when you want or become possible), savings can be made just like that, for no reason.
In turn, the interest rate does not have a strong synchronous relationship with investments. Here, the norm of profit is usually the more effective factor, and in the case of lower prices for products, it usually decreases.
Macroeconomic equilibrium in the commodity market (IS model)
Model IS (investment - savings) is a theoretical equilibrium model of only commodity markets with fixed prices. It reflects the relationship between the interest rate ( r) and the value of national income ( Y), which is determined by Keynesian equality.
In the analysis presented by J. M. Keynes and the Stockholm School of Economics, aggregate demand equals demand for consumer and investment goods:
And the aggregate supply is equal to national income ( Y), which is used for consumption and savings:
The equilibrium in the commodity markets for the whole economy will look like: or, from here:
That is, savings and investments depend on income and interest rates, respectively.
The obtained Keynesian equilibrium condition admits a plurality of equilibrium states of commodity markets, since the conditions of interest rates and income in the economy can constantly change.
To determine this set of equilibrium states of commodity markets, the English economist John Hicks used the "investment - savings" model ( IS) This model allows you to find in each case the ratio between the interest rate ( r) and national income ( Y), in which investments are equal to savings with the constancy of other factors.
Model IS considered in the short term, when the economy is outside the state of full employment of resources, the price level is fixed, the value of total income ( Y) and interest rates ( r) are mobile.
The investment-savings model - IS is of great practical importance, since it can be used to show how much the interest rate needs to be changed when national income changes in order to maintain equilibrium in commodity markets. For example, if you reduce the interest rate, then investments will increase, which will lead to an increase in planned expenses and an increase in national income. In turn, the growth of national income will cause an increase in savings in society and vice versa.
Fig. 3
macroeconomic equilibrium commodity market
If we depict these processes graphically, we obtain a decreasing curve IS (fig. 3).
Curve IS is the geometric locus of the points characterizing all combinations Y and rwhich simultaneously satisfy the identity of income with the functions of consumption, savings and investment.
Curve IS divides the economic space into two areas: at all points above the curve IS the supply of goods exceeds the demand for them, that is, the volume of national income is greater than planned expenses (stocks accumulate in the company). At all points below the curve IS there is a shortage in the commodity market (society lives in debt, stocks are reduced).
Investments are inversely related to interest rates. For example, at a low rate of interest, investments will grow. Accordingly, revenue will increase Y and some increase in savings S, and the percentage rate will decrease to stimulate the transformation S at I. Hence, the slope of the curve depicted in (Fig. 3) IS.
This is explained by the fact that in the first case, at a higher interest rate and a certain level of income, people prefer not to consume, but to deposit money in a bank, i.e. save, which reduces investment and aggregate demand. In the second case, at a low interest rate, society lives in debt and prefers consumption, thereby increasing investment in the economy and its total costs.
If you change the factors that were previously considered unchanged, for example, government spending ( G) or taxes ( T), then the curve IS will shift right up or left down depending on the changes in the named indicators.
For example, if government spending increases, and taxes remain unchanged when conducting fiscal stimulus policies, then the curve IS shift right up. If taxes increase, and government spending remains unchanged when a fiscal restraint policy is pursued, then the curve IS shift left down.
Thus, the model IS can and is used in business practice to illustrate the impact on the national income of the fiscal (fiscal) policy of the state.
Curve IS - equilibrium curve in the commodity market. It is a geometric place of points characterizing all combinations Y and Rwhich simultaneously satisfy the identity of income, the functions of consumption, investment and net export. At all points of the curve IS Equality of investments and savings. Term IS reflects this equality ( Investment \u003d Savings).
The simplest graphical curve output IS associated with the use of the functions of savings and investments (see. Fig. 2).
The analysis of equilibrium in the national market is carried out by combining in the same coordinate axis the graphs of aggregate demand and aggregate supply. The market system will be located inequilibriumif, at the current price level in the economy, the value of the estimated volume of production in the economy is equal to the value of aggregate demand.
The intersection of the curves of aggregate demand and aggregate supply will thus determinethe equilibrium real volume of domestic production and the equilibrium price level in the economy. The presence on the graph of the aggregate supplythree specific sites slightly complicates the analysis. Consider the situation of establishing macroeconomic equilibrium in each particular section of the AS chart.
The first case is intersection of aggregate demand and aggregate supply graphs in the intermediate section of the latter. This case is a common option, when a change in the price level in the economy virtually eliminates overproduction and underproduction.
Macroeconomic equilibrium will be reached at point E with the following parameters: PE - the equilibrium price level in the economy; QE is the equilibrium volume of production in the economy.
If the price level is above equilibrium, then surplus products will appear on the national market. The presence of surplus (excess supply) will push prices down to the level corresponding to PE in the figure above. The opposite situation occurs if the price level in the economy is less than the equilibrium. In this case, the economy will face a problem of deficit in the national market. The shortage of products will allow prices to rise to the initial level, i.e., to PE. The possibility of changing the price level in the economy practically reduces to zero the situation of overproduction and underproduction, this allows the market system to self-regulate and be in balance.
The next equilibrium of aggregate demand and aggregate supply will be considered on the Keynesian section of the AS graph (Figure below). A feature of this variant of macroeconomic equilibrium is that the price level for the entire Keynesian segment is unchanged and is equal to RE. This means that prices, unlike the case considered above, here cannot be an instrument of influence on the market situation. If we assume that the economy produces a larger volume of output than is demanded by the market, for example, QA (QA\u003e QE), then the economy will face an increase in unsold inventories (by (QA - QB)), which will not be accompanied by fluctuations in price levels .
In response to the growth of inventories, entrepreneurs will reduce production volumes, gradually bringing them to a level corresponding to point E. If the volume of production in this economy is less than equilibrium, for example, QB, there will be a reduction in normal inventories. For manufacturers, this will be a signal of the need to increase production volumes, and the process of expanding production volumes will continue until the situation normalizes, i.e. will not return to point E. All of the above allows us to conclude that in the Keynesian segment AS it is precisely the state of inventories and their dynamics that act as a kind of indicator of the situation on the national market. We note that in both the first and second cases, macroeconomic equilibrium is achieved under underemployment and equilibrium GDP is less than potentialGDP.
And finally, the last case -balance of aggregate supply and demand in the classic section of the AS chart. This option means that macroeconomic equilibrium is achieved in conditions of full employment of economic resources.
The real volume of domestic product here corresponds to the potential GDP, i.e., GDP in full employment (Qmax). Full employment in the economy eliminates overproduction and underproduction.
The situation of stable market equilibrium at the level of the entire national economy is rather an exceptionthan the rule, and is rare enough, since aggregate supplyand aggregate demandsubject to many factors.
And the market for goods is illustrated model IS-LM.
The IS line got its name on the basis that in an equilibrium state in the market for goods, investments (I) are equal to savings (S). In turn, in the money market (which is reflected by the LM line) in equilibrium, the demand for money (L) is equal to their supply (M).
The basic equations of the IS-LM model:
- Y \u003d C + I + G + Xn - The main macroeconomic identity.
- C \u003d a + b (Y-T) - consumption function, where T \u003d Ta + tY.
- I \u003d e - di - investment function.
- Xn \u003d g - m "Y - n" i - net export function.
- M / P \u003d kY - hi - the function of demand for money.
Internal variables of the model: Y (income), C (consumption), I (investment), Xn (net export), i (interest rate).
External model variables: G (government spending), MS (money supply), t (tax rate).
The empirical coefficients (a, b, e, d, g, m ", n, k, h) are positive and relatively stable.
The model is considered at a constant price level (P \u003d const); output or income (Y), and hence the supply of goods is absolutely elastic, i.e. entrepreneurs are able to offer as many domestic goods as they are requested; consumption (C) depends on income; investments (I) are a simple function of the interest rate (i); nominal wages are considered constant, and since prices (P) are unchanged, real wages are also constant; there is a sufficient amount of unoccupied resources (including human). Therefore, changes in income in the IS-LM model lead to significant fluctuations in the level of resource use; exports, imports and the public sector are excluded from the field of analysis.
IS-LM Joint Equilibrium Model (or Hicks Model) - Specification of the AD-AS Model. It allows one to find such combinations of the nominal interest rate (R) and income (Y) at which equilibrium is achieved at the same time both in the market of goods and in the money market.
The IS line characterizes the goods market. Here, interest rate changes (i) affect the investment. But, on the other hand, the interest rate plays an important role in the money market, which, in turn, is represented by the LM line. The IS-LM model will allow us to study the fundamental differences between monetary (credit and monetary) and fiscal (tax and credit) policies, as well as their compatibility with various conditions of the economic situation.
IS line offset. The type and inclination of IS is determined by the position of the investment function and the savings function, i.e. depends on the marginal propensity to invest at the interest rate (ΔI / Δi), as well as on the marginal propensity to save (MPS \u003d Sy).
The shift of the IS line is a consequence of changes in parameters that are not related to changes in either the interest rate or the propensity to consume or save.
The deterioration of the economic situation in the capital market will lead to the fact that the expectations of investors' profit at a given interest rate reduce real investments, i.e. shift the line of investment to the left. The concrete result of this will be the shift of the IS line, also to the left. In this case, the drop in investment occurred at a single interest rate due to the deterioration of investment expectations. That is, the shift of the IS line can be caused by the following main reasons: a shift in the savings function (S), or a shift in the investment function (I), or their simultaneous shift.
The IS line is not able to demonstrate the full picture of an equilibrium economy. The interest rate (K) depends on the level of income (Y), and also determines the transaction demand for money. In turn, the transactional demand for money depends on the amount of income. The combination of transactional and speculative demand for money, as well as the supply of money determines the equilibrium interest rate. The interest rate affects savings and investments, and, accordingly, the level of income. Thus, a simple economic model can be represented as an interconnected system of joint equilibrium, in which the interaction of the market and money creates a single level of interest and income rates.
The LM line reflects all possible combinations of the interest rate (i) and income (Y), at which the total demand for money is equal to the total money supply (M). Thus, these combinations correspond to equilibrium in the money market.
Shifts of the LM line. A shift in the LM line can be caused by a variety of factors: any change in the transaction demand for money, an increase in the amount of money. The LM line configuration changes with every change in the slope and elasticity of speculative demand (Ls). That is, the LM line shape is a reflection of the speculative money demand curve (Ls).
Joint equilibrium is a balance in the market of goods and the market of money, i.e. it is a balance in two markets. General equilibrium - This is a balance in all four macroeconomic markets (goods, money, securities, labor).
Combining the IS and LM lines into one system gives a graphical representation of the IS-LM model. Simultaneous equilibrium in the goods market and in the money market can exist only at the intersection of the IS and LM curves. This is nothing but an equilibrium combination of income and interest rate in the market of goods and in the market of money.
The intersection point of the IS and LM curves is the point of general economic equilibrium, in which, firstly, there is no shortage and excess of cash in circulation and, secondly, all free money is connected and actively invested.
In turn, at points above or below the equilibrium point on the IS and LM curves, we can only talk about the state of partial economic equilibrium, achieved either in the commodity markets (on the IS curve) or on the money (financial) market (on the curve LM).
The IS-LM model allows you to determine the relative effectiveness of fiscal and monetary policy.
Fiscal expansion. The growth of government spending and tax cuts leads to crowding out, which significantly reduces the effectiveness of stimulating fiscal policies. If government spending G increases, then total spending and income increase, which leads to an increase in consumer spending C. Increasing consumption, in turn, increases total spending and income Y, with a multiplier effect. An increase in Y contributes to an increase in demand for money MD, as more transactions are made in the economy. An increase in the demand for money with their fixed supply causes an increase in the interest rate i. An increase in interest rates reduces the level of investment I and net exports Xn. The fall in net exports is also associated with an increase in total income Y, which is accompanied by an increase in imports. As a result, the growth in employment and output, caused by stimulating fiscal policies, is partially eliminated by crowding out private investment and net exports.
Monetary expansion. An increase in money supply allows for short-term economic growth without crowding out, but has a contradictory effect on the dynamics of net exports.
An increase in the money supply Ms is accompanied by a decrease in interest rates I, since the resources for lending expand and the price of credit decreases.
This contributes to the growth of investments I. As a result, total expenditures and income Y increase, causing an increase in consumption C. The dynamics of net exports Xn is influenced by two opposing factors: the growth of total income Y, which is accompanied by a decrease in net exports, and a decrease in the interest rate, which is accompanied by growth. The specific change in Xn depends on the magnitude of the changes in Y and i, as well as on the values \u200b\u200bof the marginal propensity to import.
And fiscal and monetary expansion causes only a short-term effect of increasing employment and output, without contributing to the growth of economic potential. The task of ensuring long-term economic growth cannot be solved with the help of policies for regulating aggregate demand. Incentives for economic growth are linked to aggregate supply policies.
Key concepts
Curve "investment - savings" (IS). The liquidity preference curve is money (LM). Model IS-LM. Joint equilibrium. General equilibrium. Fiscal expansion. Monetary expansion. The effect of crowding out.
test questions
- What internal variable factors determine the IS-LM model?
- What external variable factors determine the IS-LM model?
- What fixed factors determine the economy of underemployment in the short run?
- What variable factors determine the short-term economy of underemployment?
- How to draw the IS curve using the graphical method, having the savings function and the investment function?
- How to use the Keynes cross to derive the IS curve?
- Under what conditions is the IS curve more gentle?
- Under what conditions is the LM curve relatively flat?
- What is the essence of fiscal expansion?
- How is the essence of monetary expansion manifested?
- Under what conditions is the crowding out effect relatively small? In what conditions is it significant?
- What needs to be done to make fiscal policy effective?
- When is fiscal policy relatively ineffective?
- How can a monetary policy stimulus be achieved?
- When is monetary policy the least effective?
- Give the equation of aggregate demand.
- What fiscal policy should be when the price level changes?
- What monetary policy compensates for price changes?
- What will happen to the interest rate, income, consumption and investment in accordance with the IS-LM model if:
a) the central bank reduces the supply of money;
b) the state reduces the purchase of goods and services;
c) the state reduces taxes;
d) the state reduces purchases and taxes by the same amount. - Explain why the effects of any changes in fiscal policy depend on how the central bank responds.