The IS-LM model
Use diagrams to illustrate the construction of the IS and LM curves, and explain what is meant by a general equilibrium in the aggregate goods and services market and the money market. Under what circumstances might fiscal policy be ineffective?
[...] Again, aggregate supply responds passively to a change in APE. Diagram The goods and services market In addition to these movements along the curve, the APE curve can shift due to change in C and G. Indeed, the multiplier effect amplifies any increase in G. The additional revenue is in fact injected in the economy, forming a ripple effect in the economy, thus shifting the APE curve from APE1 to APE2 and increasing real GDP from Y1 to Y2. A tax cut can also increase shift the APE curve upward, though by a smaller amount, by rising firms and households’ disposable income and consequently consumption C. [...]
[...] However, governments might choose to emit more money to finance their deficit. They will thus sell bonds, which will decrease their price and increase r from r2 to r3. This will shift the LM curve leftward, and reduce the effect of fiscal policy (see below). Diagram counter effect of a shift of the LM curve It has been shown how the IS-LM model is built, and how it represents a general equilibrium in the goods/services and money markets. We have also stressed under what circumstances fiscal policy might be ineffective. [...]
[...] See diagram g. See diagram a. We wont go through this process in detail, since we rather focus on fiscal policy. Graph founded on: http://cepa.newschool.edu/het/essays/keynes/hickshansen.htm Parkin, Powell, Matthews, Economics (London, Pearson Education sixth edition published in 2005), p Marginal propensity to consume. Graphically, it is the slope of the APE curve. William l. Silber, Fiscal Policy in IS-LM Analysis, in The Journal of Money Credit (oct. 1988) Government budget is calculated for a given year, so any increase in spending (or decrease in revenue through tax cut) will create a deficit. [...]
[...] The answer lies in the famous IS curve we are looking for. Indeed, ‘interest rates reflect the cost of borrowing in order to finance investment projects’. Hence, as r increases, the quantity of investment plans will decrease, therefore decreasing APE (downward shifts). Contrary to this, a decrease in r would lead to a rise in investment spending and thus an upward shift of the APE curve. For these reasons, the IS curve is downward sloping. In any case, we will have APE = since if I rises, production will increase, because of the passive status of the supply side, to meet the new demand. [...]
[...] Let us first consider the goods market. In a Keynesian approach, the market is driven by demand and prices are fixed. That is to say, to the question how much to produce, the answer is that production should respond passively to aggregate demand. We have therefore in our Keynesian line of attack to focus on the total amount of goods and services demanded in the whole economy, that is, aggregate planned expenditure (APE). To make things a little bit more simple, we are going to assume that there is no international trade. [...]