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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