Outline The Joint Determination Of The Level Of Income And The Rate Of Interest By The Demand Side O Essay, Research Paper
One way to explain
the determination of the level of income and the rate of interest is IS/LM
analysis.? IS/LM analysis is designed to
show the relationship between output and income, the rate of interest, the
goods market, and the money market.? The
IS curve represents all the points at which investment is equal to saving, i.e.
all the points at which the goods market is in equilibrium.? The LM curve likewise represents all the
points where money supply is equal to money demand, i.e. all the points at which
the money market is in equilibrium.?
When these two curves are plotted together on a graph of output/income
and rates of interest, it can be seen that there is an equilibrium point of
both goods and money markets together, and that there is therefore a relationship
between income and rates of interest, determined by the point of equilibrium
between the goods and money markets.The IS schedule is
derived by first drawing a normal graph of aggregate demand, as shown
below.? We know that a change in interest
rates will affect the height of the aggregate demand curve, since interest
rates affect investment.? With a lower
rate of interest, the aggregate demand schedule will be higher, and with a
higher rate of interest the aggregate demand schedule will be lower.? Knowing this, it is possible to plot an
aggregate demand curve for any given rate of interest, and show the different
equilibrium points.? Several aggregate
demand curves are shown on the graph below.Since we know the
rate of interest which produced the aggregate demands curves AD0, AD1 and AD2,
we also know the rates of interest which produced the incomes E0, E1 and
E2.? We can therefore plot rates of
interest against income, which will give us the IS schedule shown below.The LM curve is
similarly derived, beginning from a graph of the money demand schedule.? We know that for any given level of income
there will be a certain amount of money demand, which will depend on the
interest rate.? A change in the level of
income will lead to a change in height of the money demand schedule.? If income rises, money demand will be
higher.? If income falls, money demand
will be lower.? Money demand depends to
a large extent on the interest rate; if interest rates are low, then more money
is demanded.? The graph below shows several
money demand curves. Since we know the
level of income which generated curves L0, L1 and L2, we also know the level of
income which is associated with each of the equilibrium rates of interest, r0,
r1 and r2.? Therefore, it is possible to
plot income against interest ratesfor the money market, giving an LM schedule
like the one below. The IS and LM
schedules can then be plotted on the same axes to show the levels of income and
interest which will lead to equilibrium in both the money market and the goods
market.? On this graph, an example of
which is shown below, it is shown that the goods market is in equilibrium at
any point on the IS schedule and the money market is in equilibrium at any
point on the LM schedule, but there is only one point, E, where both are in
equilibrium. What are the
mechanisms for controlling these variables by fiscal and monetary policy?Government has
several ways to control income and interest rates, which can be divided into
two broad groups, fiscal policy and monetary policy.? Fiscal policy involves managing demand on the goods market, and
includes the raising or lowering of government expenditure and the raising or
lowering of taxes.? By raising the
amount of government expenditure or lowering taxes, governments increase the
circular flow and therefore aggregate demand.?
In relation to the IS/LM model, since anything (other than interest
rates) which affects aggregate demand has a similar effect on the IS curve, we
would expect a rise in government expenditure or a cut in taxes to move the IS
curve to a higher position.Some have
criticised this use of fiscal policy on practical grounds.? The main difficulty with it is the time lags
involved.? If government reacts to
counter the effects of a recession by increasing government expenditure and
therefore raising demand, it is quite possible that by the time this policy has
been implemented and has worked its way through the system the recession will
have ended, and therefore the increase in demand caused by the spending will
come at an undesirable time.? This is
one of the reasons why fiscal policy is no longer widely used in the UK as a
tool for controlling interest rates and income.We can show the
effect of fiscal policy in terms of the IS/LM analysis.? The graph below shows the effect of an
increase in government expenditure, assuming that the money supply is kept
constant.Here an
expansionary fiscal policy, accompanied by a constant and unchanged money
supply, has led to an increase in income from Y0 to Y1.? However, there has also been a rise in
interest rates, from r0 to r1, because of the upward shift in the equilibrium
point.At this point, it
becomes important to consider monetary policy.?
In the example above, a tight monetary policy has been exercised, and
the money supply has been kept constant.?
However, an expansionary fiscal policy undertaken under this monetary
policy will inevitable lead to higher demand for money (because of the higher
income), and therefore rises in interest rates.? Rises in interest rates will in turn lead to the phenomenon of
crowding out, whereby investment demand is reduced.? From this two things are apparent.? Firstly, fiscal policy is not a very efficient tool for
stimulating demand, because of crowding out, and secondly, fiscal policy cannot
be considered in isolation from monetary policy.Monetary policy
aims to increase income, and therefore aggregate demand, by controlling the
money supply and interest rates.? An
increase in the money supply will naturally lead to less demand for money, and
therefore a lower LM curve.? This means
lower interest rates, because lower interest rates are needed to encourage
people to hold this real money supply rather than less liquid assets.? Lower interest rates make assets less
attractive and liquidity more attractive.?
The effect of increasing the real money supply whilst maintaining a
strict fiscal policy is shown on the graph below.However, it is
often desirable to maintain interest rates at a fairly constant level, so this
use of monetary policy would be less than useful.It is clear that
monetary and fiscal policy can be used to compliment each other, with the rise
in interest rates caused by an easy fiscal policy being offset by the falls in
interest rates associated with an increase in the money supply.? An increase in income can be achieved either
by having a tight fiscal policy and an easy monetary policy or an easy
fiscal policy and a tight monetary policy, but is best achieved by a careful
combination of fiscal and monetary policy.How useful is
this representation of the macro economy?Although the IS/LM
model provides a very useful way of looking at the determination of interest
rates and incomes, it has several weaknesses.?
Firstly, the model does not provide a complete picture of the macro
economy.? For example, inflation is not
considered in this model, but it is inflation which is a major influence on
policy makers when they are considering what monetary policy to pursue.? It is generally feared that an easy monetary
policy, which would increase the real money supply, would lead to inflation,
and therefore this is avoided.Secondly, IS/LM
does not provide an error-free analysis of the economy.? Very often it is difficult to see what exact
effect a fiscal policy might have, for example.? It might be difficult to estimate the extent of crowding
out.? Also, the time lags involved mean
that the model can only be used as a rough guide for what will happen in the
real economy in relation to a specific fiscal or monetary policy.
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