Lecture - 56

Hi everyone, welcome. In this session, in addition to continuing what we have discussed in the previous session of shift in L and curve and IS curve, we will discuss the fiscal policy and monetary policy multiplier. And subsequently, we also discuss the derivation of aggregate demand curve from ISLM model. So, let us continue begin with the discussion that we started in the previous class. In the previous class, we started how GDP that aggregate demand or the income is going to change when there is increase in money supply. And subsequently, we started with fiscal policy that means increase in government expenditure or increase in tax how is going to affect income in the macroeconomy. So, this one I have shown you in the previous session that means when there is increase in government expenditure, we have seen that the IS curve will be shifting rightwards. This is that this distance is the full Keynesian multiplier that simple Keynesian multiplier. However, because the reason that we have outlined in the previous session, rate of interest increase from r 0 to r 1 and the as a result, instead of increase in output till from y 0 to y epsilon 1, the increase in output is going to be only this much that the y 0 to y 1 distance. So, because the new equilibrium position is at B. So, what we have seen here is that due to increase in government expenditure, we can see that the rate of interest has risen from r 0 to r 1. So, as a result, because of the increase in rate of interest, it discourages private investment that means a kind of a crowding out effect happen. That means increase in government expenditure increases rate of interest which further decrease or crowd out private investment. So, as a result, we can see that which is our supposed to be increase income was this much, but actually increase in income was only y 0 to y 1. So, this is due to the crowding out effect of government expenditure on private investment. Subsequently, what if there is increase in tax. So, increase in tax, the initial equilibrium position is here, look at here, initial equilibrium position. So, the IS curve shift leftwards, then as a result, you can see that this is the full negative impact supposed to happen due to increase in tax. However, since due to decrease in tax that means is also you can say that look like you can interpret it as decrease in government expenditure as well. So, here you can see that the rate of interest decrease from r 0 to r 1 and as a result, supposed to be this much decrease in output is supposed to happen, but due to the decline in rate of interest, we can see that decline in output is only this much del y is this much that the y 1 y 0 distance. Suppose, when there is government expenditure that the increase in government expenditure, we have seen that the rate of interest increase and as a result, the increase in output is only this much. Here only actually this one only y epsilon 1, the main reason for this one that we have seen that because of the crowding out effect on private investment because increase in rate of interest. So, in order to compensate that the one option normally what if when there is an increase in government expenditure, obviously, there will be budget deficit. So, in order to monetize that in order to raise finance for that sometime, a policy mix happen that means an equivalent amount of money supply is injected into the economy that means increase in money supply happen in order to finance the budget deficit. So, as a result, initially suppose that IS curve shifted from left to right that means IS t 0 to t 1. So, that shifted to here and this is the new equilibrium position. But if suppose there is a policy mix that means an accommodative monetary policy that means when government expenditure increase in order to finance that when money supply also increase and more the budget deficit is monetized, then you can see that the LN curve will be shifting rightwards. So, when the LN curve is shifting rightwards that means you can see rate of interest will come down. Initially rate of interest increase is impact is neutralized by increase in money supply. So, this actually in order to overcome the crowding out effect, if there is equivalent increase in money supply, then you can see that output is going to increase to y 1. So, this is the initial equilibrium position A, B and finally C that means initially increase in government expenditure equilibrium going to happen from A to B with increase in rate of interest. But if there is equivalent increase in money supply LN curve shift rightwards and the C is going to be the new point of equilibrium and rate of interest will be restored at the initial position and here output increase to from y naught to y 1. So, del y is this much. So, in this case it is also related to one kind of interest rate targeting. Suppose, when the policy makers do not want to see that rate of interest increase or decrease, if they want to see a constant rate of interest, then in this case this kind of policy is also called as interest rate targeting rule. And in this case, if that is the scenario is suppose if they do not want to see the rate of interest increasing at all or no change in interest rate and for example, if they want to see interest rate for example, 5 percentage at a constant rate of 5 percentage and in that case they have to increase money supply in the same proportion. And similarly, if they want to see rate of interest at 7 percentage, then they will be increasing money supply at the 7 percentage rate. So, that means in order to ensure that the rate of interest is constant accordingly money supply will be adjusted. So, in this case, you can say that if they want clearly a particular rate of interest, then in this case you can see that the L-N curve, L-N curve is going to be horizontal. This is the L-N curve, if they clearly want the rate of interest is at a fixed rate, that means for example, 5 percentage. So, in this case it is going to be perfectly elastic curve. In contrast to this, if they want to allow some flexibility, so in that case there is some range, there is some confidence interval at the lower and upper level, that means they are not looking for a point interest rate targeting instead with a confidence interval. In this case, that is the case the L-N curve is going to be like this, L-N 1 or if range is very low, then the curve is going to be little bit more flat, right. So, that means if they use a range of interest rate target, then it is going to be more flat, it is going to be flat. And if they do point interest rate target, then L-N curve is going to be perfectly elastic. Now, let us proceed with deriving fiscal policy multiplier and monetary policy multiplier. This is the ISLM, from the ISLM we have derived when equating the equilibrium income and equilibrium rate of interest, we have derived this equation from IS equation and from LM equation. So, finally we got this equation, that means Y is equal to this, the left hand side, first left hand side is called the multiplier component and the other side is the autonomous component and this one is further due to the money market in the picture. So, here what we are going to do here is, what if the government expenditure is increased by for example 100 million. So, you know for example, see government expenditure is going to be for example 100 million, then we see that output also increase but how much. If output increase, for example, if the output has been increased by 200 million due to increase in government expenditure, then in this case we can see that the multiplier, the government expenditure multiplier is going to be 2, government expenditure multiplier is going to be 2 here because 200 divided by 100, so we are going to get 2, that is the multiplier. So, what does it mean that, when government expenditure with the 100 million, we can see that there is 2 times increase in output. So, this is the basic induction behind the multiplier idea. So, in the ISLM framework, let us see what are the factors that determine the values of government expenditure multiplier. So, here the expenditure multiplier, we are going to see to what the effect of, what is the quantitative effect of government expenditure on del y, keeping other exogenous variables constant. So, you can look at change in GDP output due to change in government expenditure, if you take the first derivative, you are going to get this value. So, that means, this is the fiscal expenditure that the fiscal policy or government expenditure multiplier from here, this is the government expenditure multiplier. So, in the simple Keynesian model, without money market, the government expenditure, the government expenditure multiplier was del y by del g is 1 by 1 minus b. That means, there is no, that is full multiplier in the simple Keynesian model. But since we know that due to the crowding out effect, we can say that increase in output or del y due to del g is less than in the ISLM model as compared to the simple Keynesian model. So, the government expenditure in, government expenditure multiplier in ISLM is less than the simple Keynesian multiplier. That means, we can see, this is going to be del y due to simple Keynesian multiplier time minus del y loss due to crowding out effect due to increase in interest rate that we have seen in the previous diagram as well. So, that means, here we need to add this component also in the fiscal policy multiplier in the ISLM model. In the simple Keynesian model, we have only this much. Then coming to the tax multiplier, we are going to see what is the effect on del t on del y. Here, the formula is that you can take the first derivative of del y, del g with respect to del y. So, you are going to get this value. That means, this is the tax multiplier. In the simple Keynesian model, the tax multiplier was simple Keynesian model, tax multiplier was only 1 minus b, 1 minus b, right. But in the ISLM model, we are going to get the crowding out, the negative effect. Actually, the value is here negative. You can see that because of tax, the output is going to decline. But in the simple Keynesian model, there is huge large decline in output. But in the ISLM model, there will not be large, it will be less than, the decline in output in ISLM model is less than that of simple Keynesian model because you can see that because of the money market effect, when government, when there is increase in tax, you can see that there will be decline in the rate of interest that will induce private investment. As a result, the expected decline in del y is less than that of, in ISLM model is less than that of the simple Keynesian model. So, look at this. This is the government expenditure multiplier, fiscal policy multiplier. So, here what I am showing you is that when there is increase in government expenditure, the IS curve shift from here to, from here, it shift to, from left to right. You can see, it is shifting from left to right. So, the new equilibrium position with the intersection between IS curve and LM curve is going to happen at this point. And you know that as per, if there was no LM, money market at all, then the increase in government expenditure would result in increase in GDP from y naught to y 1, y epsilon 1. But due to money market, that money market, the rate of interest will increase due to the expansionary fiscal policy. So, as a result, the actual increase in, actual increase in output is only y naught y 1, right. So, that means this much loss in GDP, this much loss in GDP is due to crowding out effect. So, the actual increase, this distance, that the y naught to y 1, this y naught to y 1, this happen with this value, this times del G, this times del G. This is the increase in, this much increase in that del y, this is equal to del G times this fiscal policy multiplier. Let us now talk the monetary policy multiplier. In the monetary policy multiplier, again, let us start using the ISLM combined equation, ISLM equation, combined equation. So, del y, so let us see, del y due to change in money supply. So, when you take the first derivative, you are going to get this value. This means, this is the monetary policy multiplier. So, monetary policy multiplier is this one. This is the, for the simplified version, that means the monetary policy multiplier. So, that means due to change in money supply, due to change in money supply, GDP will increase, output will increase, this times multiplied by del m s is equal to the del y. This is the multiplier effect of the monetary policy in a macroeconomy in the ISLM framework. So, presenting this one graphically, we can see that this distance, this del y is due to monetary policy. So, this that we are going to get, del y is equal to the multiplier, the money multiplier, monetary policy multiplier that we derived, monetary policy multiplier that we derived, this monetary policy multiplier that we derived in the previous slide, times del m s. So, this is going to be this value. So, you can see that, because of increase in money supply, output increase to, from y naught to y 1, this del y, this is the s multiplier times, this multiplier times money supply. So, this is the summary of the effects of monetary and fiscal policy variables, starting with the effect of, this is money supply, this is government expenditure, this is tax. Suppose, there is increase in money supply, you can see that effect on y, first start with the effect on y, this will increase, y will increase, but rate of interest will decrease. Similarly, increase in government expenditure, you can say that output will increase, rate of interest also will increase. So, similarly, in contrast, you can see that increase in tax, it will reduce output, it will reduce rate of interest as well. So, this is the larger picture, the structure of ISLM model. So, what we have discussed so far, putting in the ISLM model, plugging or introducing monetary and fiscal policy, these are the two important component of economic policy. So, the monetary policy affects in this way, that means, it will affect money market, that means, it also affect bond market, this has an implication on industry. Similarly, and this would further affect aggregate demand, right, that is about the goods market. This further lead to increase in income and further again, increase in income have impact on goods market as well as assets market as well. Similarly, fiscal policy is going to directly impact the goods market, then it will increase the income in the economy and then you can see that because of the increase in income, we can say that it has impact on money market and bond market. So, we have seen the change in interest rate, that actually coming from fiscal policy in this way, that means, increase in income for a transaction demand for money assuming money supply is constant, then you can see that rate of interest is going to increase. Again, increase in change in rate of interest, it will have further impact on output, right. So, this is the broader picture. We can further present this one in this way, that means, the ISLM model is real sector and the money market, that is the IS curve and LM curve, that is ISLM model. This is going to affect aggregate demand and subsequently, actually mainly the ISLM models impact this on the aggregate demand curve, not on the aggregate supply curve and then the macroeconomic equilibrium, you can see that aggregate demand should be equal to aggregate supply, so that macroeconomy is at equilibrium. So, this actually used for as an explanation for short run fluctuations in the macroeconomy. So, in that way to understand the macroeconomic fluctuation at the short run and as well as to influence, you know, in order to adjust, in order to, as a risk management, in order to correct the economy or restore the economy back to its initial equilibrium, in the short run, the IS curve and LM curve, we can use it as a tool to understand as well as, especially how different policy, especially to understand the policy effects, particularly fiscal and monetary policy effects in the macroeconomy in the short run. So, actually in the ISLM model is short run, used to understand the short run fluctuations in the economy, especially the policy effects in the short run. So, let us now move to the further related topic in the ISLM. So, what we have been keep on telling in this session and last previous session, suppose, if there is increase in government expenditure, we have seen that there is increase in income. Similarly, when there is increase in money supply, that means, an expansionary monetary policy, there also we have seen, there is increase in income. But actually what I meant there is actually, I meant increase in income means actually increase in aggregate demand. So, that means, increase in income means aggregate demand. So, equivalently we also mentioned increase in aggregate output, aggregate income or aggregate demand. But actually what we meant here is aggregate demand. We did not discuss, we did not mention aggregate supply, because aggregate supply, that is the productive sectors of the economy has to produce goods and services. It depends on so many other factors. What we meant here is that the demand for goods and services from the economy, that means, increase in C plus I plus D. That is what we meant when we say that when there is increase in income. So, let us elaborate this point further. In the IS schedule, our one of the IS and LM schedule, one of our assumption was that price remaining constant, price remaining constant and similarly, money supply also remaining constant. So, in the IS schedule, we mentioned it like this, that means, investment is a function of rate of interest and saving is a function of y. In LM schedule also we mentioned, that means, money supply, we assume that price remain constant, money supply also remain constant. So, the demand for money is a function of income and rate of interest. So, when we discuss that money supply, we meant real money supply, that means, money supply divided by the price level. So, what if we change the price level, what if price level changes, that means, increases from P naught to P 1 to P 2 like that, keeping the nominal money supply fixed, the money supply by the central bank fixed. And what if we change price level, that means, increase, for the sake of simplicity, let us increase price level from P naught to P 1, then P 1 to P 2, then how does it affect our IS LM model. So, in this case, when there is increase, suppose the money supply is fixed, assume that money supply is M naught, when price level is increased from, from price level is increased from P naught to P 1 and further P 1 to P 2, what we can see that, suppose this is the initial situation, that the price level is P naught and keeping money supply this one at fixed level, when price level is increased, then you can see that the nominal terms money supply remaining same, but in real terms money supply has decreased, because the purchasing power of money has declined, because the price level has increased. So, similarly, when price level further increased to P 2, keeping the initial, the nominal money supply same, then you can further see that in real terms money supply has decreased. So, translating this one in a figure, look at this, here throughout, look at this, the initial equilibrium position, where IS curve, because IS curve, this is the initial IS curve and this is the initial LM curve and the money market and goods market is at equilibrium. So, this is the condition, when we assume that the price level remaining same. But now, let us change the price level from P naught to P 1 and to P 2, but we assume, take the money level, money supply, that in nominal terms we assume this remaining constant. That means, if price level is increased, we will discuss how price level will increase. For the time being, for this slide, assume that we are deliberately, arbitrarily increasing the price level. When the price level is increased, then you can see that the same fixed money supply, when the price level is increased to P 1, then that means, real money supply declines, right. There is a decline or fall in the real money supply. We have seen in the previous session, that when there is increase or decrease in money supply, LM curve shift. When increase in money supply, we have seen that LM curve shift rightwards. But here, since there is decrease in money supply, then you can say that LM curve will be shifting leftwards. So, that means, when the price level is P naught, equilibrium position is A. When the price level increase, keeping the nominal money supply constant, that means, real money supply decrease, new equilibrium position is B. That means, this is at a price level P 1, right. This is at a price level P naught. Further, if we increase the price level to P 2, keeping nominal money supply M naught constant, then you can see that further the LM curve will be shifting further leftwards. Then you can see that this is going to be the new equilibrium. So, that means, at each, then you can also see that the rate of interest is increasing from R naught to R 1 and R 1 to R 2. So, taking this price level on the y-axis in the part B diagram, in the part A diagram what we just discussed now, taking this one in the part B diagram, keeping price level on the y-axis, you can see that at P naught price, you can see this is the output, corresponding output is here. When the price level is increased, the equilibrium position, you can see that point equilibrium position B and equilibrium position C. So, here what we are seeing that, on the right-hand side we are having output, that is aggregate demand, aggregate demand at the, when the, at money supply M naught, nominal money supply at M naught. And at a different price level, you can see that output is declining. When the price level increases, the demand decreases. That means, we are seeing an inverse relationship between price level and aggregate demand. So, this is actually, this is the way that we can derive an aggregate demand curve from the ISLM model. That means, when we take a flexible prices, when we increase price, then you can see ln curve is shifting leftwards. That means, new equilibrium position. So, accordingly putting this one, translating this one to part B diagram, you can see that at increasing price level, there is decrease. Increase in price level, there is decrease in output. Otherwise, decrease in price level, you can say there is increase in output. For example, if the price level is decreased further, you can see that, you can see that ln curve will be shifting rightwards. So, this is going to be further equilibrium position. So, that means, what we have seen here is that, the inverse relationship between price and quantity demanded at aggregate level, this is nothing but the aggregate demand curve. So, we can derive aggregate demand curve from this diagram. Let us discuss this in for more details in the next session. Then, there we will be seeing that what one assuming price change, then subsequently there is increase in government expenditure and similarly, increase in money supply, how does it affect aggregate demand, etc. Thank you. Thank you so much. See you in the next session.