macro-economics project

80
Government advisors Submitted To Prof. Ramji Narayanan on 3 rd April, 2010 As a term paper in MACRO ECONOMIC POLICY & ANALYSIS By Anupam Arora Srishti Batra Anand Behl Vivek Verma Ayush Gupta Rancee Sood Sheenam Sachdeva Prateek Negi Gaurav Choudhary Arpan Majumdar

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Page 1: Macro-Economics project

Government advisors

Submitted To Prof. Ramji Narayanan

on 3rd April, 2010

As a term paper in

MACRO ECONOMIC POLICY & ANALYSIS

By

Anupam Arora Srishti BatraAnand Behl Vivek VermaAyush Gupta Rancee SoodSheenam Sachdeva Prateek Negi Gaurav Choudhary Arpan Majumdar

Page 2: Macro-Economics project
Page 3: Macro-Economics project

Contents

ACKNOWLEDGEMENT

PREFACE

OBJECTIVE OF THE PROJECT

ASSUMPTIONS

METHODOLOGY USED

IS-LM FRAMEWORK

AD-AS FRAMEWORK

CONTROLLING THE PRICE LEVEL

REDUCING UNEMPLOYMENT

PROMOTING GROWTH

REDUCING FISCAL DEFICIT

PROMOTING HEALTHY BANKING PRACTICE

CONCLUSION

Page 4: Macro-Economics project

Acknowledgement

We wish to extend our sincere gratitude to Dr. Ramji Narayanan who helped us to understand the intricacies and ideas by providing ingenuous insights, valuable inputs, suggestions, and constructive criticism throughout the pursuit of the project.

It has been a learning experience to understand the analytical tools and to look at their applicability in the various scenarios. We are thankful that he painstakingly guided us during our endeavour and it is due to his cooperation and suggestions that we are able to present this project.

Submitted to Dr. Ramji Narayanan

Department of Financial Studies, Delhi University South Campus

Page 5: Macro-Economics project

e’

PREFACE

This project aims to analyze and critically examine the steps that the IndianGovernment and Reserve bank can take to stimulate economic growth keeping price level, unemployment level and fiscal deficit in control. In our analysis, we use the IS LM and the AD AS supply framework. The IS curve ‐ ‐gives the combination of interest rate at which the goods and services market is in equilibrium. The LM curve gives the level of interest rate at which the money and the bonds market is in equilibrium. The intersection of both the curves gives the macroeconomic equilibrium in the economy.

i LM

IS

O y* y

The fiscal and monetary policy undertaken by the government and the Reserve bank shift the IS and the LM curves out of the old equilibrium into the new equilibrium. We attempt to reach the new equilibrium such that the new equilibrium corresponds to our goal of increased income andemployment, reduced budget deficit and reduced price level. We are mindful of the fact that there is always a trade off between macroeconomic variables. But ‐we attempt to present an optimum policy solution to reach the desired objectives.

i’’

I0

Page 6: Macro-Economics project

OBJECTIVES

The objective of this project is to advice the Government to take fiscal and monetary measure in order to:

Control Price Level

Stimulate Growth

Promote High Level of Employment

Reduce Fiscal Deficit

Promote Healthy Banking Practice Through Monetary Policy

Page 7: Macro-Economics project

ASSUMPTIONS IN THE ANALYSIS

The following assumptions have been made for working out Analysis.

1) The economy is assumed to be a closed economy i.e. our analysis comprises of the following economic agents: domestic firms, domestic households, the domestic government and financial institutions.

2) It is in the realm of the short run model that we find the greatest role for ‐government policy and hence we consider the impact of our policy measures in the short run.‐

3) The economy has achieved full employment.4) Firms passively produce whatever is demanded.

5) There is no expected inflation; hence nominal rate of interest is equal to the real rate of interest.

6) Capital and Technology are given and cannot be changed.7) Labour market is imperfectly competitive; there is the influence of trade

unions8) Output is a function of employment Y = f (n) and employment in turn is a

function of real wages n = g (ω – p).9) Investments are assumed to be an inverse function of rate of interest ‘I’.

I = I (r) Investments as a function of real assets have been ignored.10) There are 2 types of assets: Money and Bonds; the investor has the

choice to invest in either of the two.11) Consumption expenditure is assumed to be a function of personal

disposable income and consumption as a function of real assets has been ignored.

12) Savings is assumed to be a function of personable disposable income and not of real assets.

13) The present level IS & LM curves are ‘IS’ & ‘LM’. Correspondingly, the aggregate demand and aggregate supply curves are ‘AD’ and ‘AS’. The current general price level is P0.

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METHODOLOGY USEDIn order to achieve the aforesaid objectives, a judicious mix of the following tools has been used:

FISCAL POLICY

According to Arther Simithies fiscal policy is a policy under which government uses its expenditure and revenue programme to produce desirable effects and avoid undesirable effects on the national income, production and employment. Fiscal policy is used by governments to influence the level of aggregate demand in the economy, in an effort to achieve economic objectives of price stability, full employment and economic growth. Keynesian economics suggests that adjusting government spending and tax rates, are the best ways to stimulate aggregate demand. This can be used in times of low economic activity as an essential tool in providing the framework for strong economic growth and working toward full employment.

Government can make use of various instruments of fiscal policy:‐

Public Expenditure Taxes Public Debt

Changes in the above instruments can have an impact on the following variables in the economy:

Aggregate demand and the level of economic activity The pattern of resource allocation The distribution of income

Types of Fiscal Policy

The government can have the following policies -

Expansionary (or loose) Fiscal Policy.

This involves -

Increasing the government spending.Lower taxes which will increase consumers spending because they have more disposable income.

Page 9: Macro-Economics project

This will worsen the govt budget deficit

Deflationary (or tight) Fiscal Policy

This involves -

Decreasing the government spending.

Increasing the taxes as higher taxes will reduce consumer spending. This will lead to an improvement in the government budget deficit.

MONETARY POLICY

Monetary Policy regulates the supply of money and the cost and availability of credit in the economy. It is the process by which the government, central bank, or monetary authority manages the nominal supply of money. Monetary policy rests on the relationship between the rates of interest in an economy, that is the price at which money can be borrowed, and the total supply of money. Monetary policy uses a variety of tools to control one or both of these, to influence outcomes likeeconomic growth, investments, price level, and unemployment.The central bank is responsible for formulating and implementing Monetary Policy. It can make use of various monetary policy instruments:‐

A. Quantitative measures:

Open Market operations: Here, the central bank enters into sale and purchase of government securities and treasury bills. So it can inject money into economy by buying back the securities and vice versa.

Bank rate policy: Popularly known as repo rate and reverse repo rate, it is the rate at which the central bank lends and accepts short term advances from other banks in the economy. This results into the flow of bank credit and thus affects the money supply.

Cash Reserve ratio (CRR)/ Statutory Liquidity Requirement (SLR): This is the percentage of total deposits that the banks have to keep with central bank. And this instrument can change the money supply overnight.

B. Qualitative measures:

Page 10: Macro-Economics project

Credit rationing: Imposing limits and charging higher/lower rates of interests in selective sectors.

Moral Persuasion

Monetary policy is referred to as either being an expansionary policy, or a contractionary policy, where an expansionary policy increases the total supply of money in the economy, and a contractionary policy decreases the total money supply. Expansionary policy is traditionally used to increase employment in the economy by lowering interest rates, while contractionary policy involvesraising interest rates in order to combat price level rise.Various measures can be taken towards the attainment of the objectives stated above. The measures may be fiscal or monetary meaning efforts can be made towards changing the government spending or tax as a part of fiscal measure or supply of money can be regulated as desired (Monetary measure). A fiscal or monetary method can be taken to achieve goals like to encourage consumer spending government may reduce taxes or it may increase the supply ofmoney. But both, fiscal & monetary measures are usually taken in tandem to obtain the best possible results in the quickest possible time.

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IS-LM FRAMEWWORK

IS CURVE

Aggregate demand in a closed economy can be written as the sum of Consumption expenditure (C), Investment expenditure (I) and Government Expenditure (G). Therefore, the national income will be, Y = C+I+G

When taxes are deducted from income we get disposable income (Yd). Y T = Y‐ d

Some part of this disposable income is consumed by the households and the firms. The remaining part constitutes the savings portion in the economy,Yd – C = S

Assuming that the consumption, investment, and tax functions are linear:C=co + cy(y – t),here co is autonomous consumption and cy is marginal propensity to consume current disposable income: 0 < cy <1;

t = tyY,………………….................... (Tax function)here 0 < ty < 1.

If we substitute the tax function into the consumption function and rearrange the terms, the consumption function is:c = co + cy (1 t‐ y) Y……….….. (Consumption function)

The investment function isI = A – ar………..…………. (Investment function)here ‘a’ measures sensitivity of investment to changes in interest rates.

In goods market equilibrium, y = yD = co + cy (1 – ty) Y+ A – ar + g

Solving for y gives:Y= (co + A + g)/ (sy + cyty) ( ) [a/ (s‐ y + cyty)]*r…………………………. (IS Curve)

The IS curve is downward sloping because a low interest rate generates high investment which will be associated with high output. Also we see from the above equation the negative relationship between the Income and Interest rate.

A change in the component or autonomous spending, i.e. an increase in autonomous consumption, investment or government spending shift the IS curve with no change in slope. An increase shifts it towards right and vice versa for decrease. The extent of shift is (Multiplier)*change in autonomous variable. For e.g.: For government spending: dY= k dG , where k is the multiplier.

Page 12: Macro-Economics project

LM CURVE

LM curve deals with asset markets as stocks at a point in time. As per Keynes, in the short run price level and nominal wages are fixed and national income adjusts to clear the commodity market. Also, the monetary influences determine the rate of interest. Keynes visualized that people hold cash balances for transactions purposes because of their immediate liquidity needs and because of the non‐synchronization of payments and receipts.People demand money for speculative purposes as well. If interest rates are high and its expected to fall in near future (bond prices are expected to rise), it would be rational for an investor to buy more bonds and reduce the demand for money. Analogously, when interest rates are low and people expect the rates to rise and bond prices to fall and will therefore tend to sell the bonds to make capital gains. In this process they will increase their demand for money. Therefore the demandfor money for speculative purposes depends negatively on the interest rate.

Therefore, the aggregate demand for money can be written as L(r,y).

Equilibrium in the money market is given by:L (r.y) = M/P (4)here M is the nominal stock of money supply and P is the aggregate price level. M/P therefore is the real value of cash balances.

Assuming that the demand for money function is linear and writing it in real terms:Ms/P = l l‐ ie + [1/vT]*y

Solving for i gives,

i = (l – Ms/P)/li + [1/vTli]*y………………….. (LM Curve)

1. A rise in the transaction velocity of circulation makes the LM curve flatter.

2. A rise in interest sensitivity of the demand for money makes the LM curve flatter.

3. A rise in money supply shifts the LM curve rightwards with no change in slope. The size of the shift is dy = v. dM/P.

4. A rise in the price level shifts the LM curve leftwards with no change in the slope of the curve. The size of the shift is dy = v. M/sp here ‘v’ is the transaction velocity of money.

Page 13: Macro-Economics project

AS-AD FRAMEWORK

AGGREGATE DEMAND SCHEDULE

At all the points on the aggregate Demand Curve the goods and money market are in equilibrium. We start at point E0 where the IS and LM curve intersect. Now at this point holding the nominal money supply constant, we decrease the price level. This increases the supply of real balances. As a result people have too much money. This pushes up the bond prices and lowers the interest rate. This moves the economy into a new equilibrium at E1 with a higher output. Mapping the equilibrium points of E0 and E1 into the output –price schedule, we see that with lower price, the output is greater. Hence we have achieved a downward sloping Demand Curve

AGGREGATE SUPPLY SCHEDULE

The AD curve, by itself, cannot determine Price level and Y, to complete the system we introduce an aggregate supply schedule. The derivation of the AS schedule, which shows combinations of Price and Y consistent with production conditions in the labor market, has two key elements :

(i) an aggregate production function relates total output produced to labor input, and

(ii) labor market supply and demand conditions relating labor supply and demand to the real wages.

The short run aggregate supply curve is upward sloping. In the medium run we assume the supply curve to be perfectly inelastic or vertical at the full employment level of output.

WAGE SETTING

Under Imperfect Competition, there is an upward sloping wage setting (WS) ‐curve that is the counterpart of the labour supply curve in the competitive model. Because of labour market imperfections, the wage setting curve lies above the labour supply curve. Conditions in the labour market are the key determinant of the ‘wage setting real wage’. In terms of money wages, the wage setting equation is: W = P. b(E) ………………………………………………Wage Equationhere P is the Price level, E is the level of employment and b is a rising function of employment.

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When wages are set by unions, employers, or through bargaining, it is the nominal (i.e. money) wage that is fixed. However, workers will evaluate wage offers in terms of the real wage that they are expected to deliver – i.e. it is the money wage relative to the expected consumer price level that affects the standard of living and hence the worker’s utility.

Assuming that the actual and expected price level is equal, the wage equation can be written in terms of real wages to define the upward sloping wage setting ‐ ‐curve in the labour marketWws = b(E) ………………………………..Wage Setting real wage‐here Wws = W/P

The excess of the real wage on the WS curve above that on the labour supply curve at any level of employment is the mark up per worker(in real terms) ‐associated with labour market imperfections. Two common interpretations of this mark up, both relying on imperfect competition, are Wage setting by unions and ‐Efficiency wage setting by firms.

PRICE SETTING

Under perfect competition, the real wage implied by competitive pricing by firms is the marginal product of labour (or labour demand) curve. Firms take the market price, P, and set it equal to their marginal cost.P = MC= W/MPL= W/P = MPLBy contrast, under imperfect competition, firms set a price to maximise profits. The mark up on marginal cost will depend on the elasticity of demand: as the ‐elasticity of demand rises, the mark up falls until comes a special case of perfect ‐competition where the elasticity of demand is infinite.

Page 15: Macro-Economics project

CONTROLLING THE PRICE LEVELIntroductionIt is imperative for an economy to keep the price levels under control. However, this entails a cost in the form of loss of output and employment. Thus, the government must attain a trade off between the conflicting objectives.

ObjectiveThe objective of the following section is to advise the Government of India to reduce the

price level in the economy maintaining the same output level and employment.

Strategy

Case 1:Reduce government expenditure as well as the nominal money supply in the economy

in equal proportion to control prices.

ExplanationThe IS curve is the locus of combinations of the interest rate and output level at which

there is equilibrium in the goods market, while LM curve is the locus of combinations of

interest rate and income which keep the money market is in equilibrium.

The short run equilibrium level of output and interest rate is determined by the

intersection of IS and LM curve.

IS curve can be written as-

yd=c0+c y (1−t y ) y+A−ar+g1

Where ‘g’ is government spending

c0 is autonomous consumption

(1−t y ) y is the disposable income

c y is the marginal propensity to consume

Page 16: Macro-Economics project

ais the interest rate sensitivity of investment

The equation of LM curve initially is: i=1l1×[ yv +l−Ms

P ] Where ‘Ms’ represents the money supply in the market at a given price level of ‘P’.

Every point of the Aggregate Demand curve (AD) is a point of intersection of IS and

LM. In the medium run (before reducing money supply and government expenditure)

when the market is in equilibrium the real wages prevalent in the market is given byw0.

This we get by intersection of WS (wage setting) and PS (price setting curve), as shown

in the figure.

Rearranging the above given IS curve by using the fact that in goods market equilibrium

yd=y we get the IS curve as:-

y= 11−c y(1−t y)

⌊c0+( A−ar )+g1 ⌋

Where 1

1−c y (1−t y ) represent the multiplier.

Any change in government expenditure ‘g’ (reduction in our case) will cause the IS

curve to shift leftwards by the change in autonomous spending times the multiplier.

Similarly on reducing the money supply in the market the LM curve will shift upwards to

the extent of ¿

Shifting of IS and LM curves will cause the Aggregate demand curve to shift downwards

to AD ' from AD. Due to shift in aggregate demand curve we will see that level of output

will also decreased from y0 toy1. Due to the decrease in level of demand, the firms will

require lesser labour to provide the output required. Thus, the level of employment will

fall from E0 toE1.

Now in the first period due to decrease in output two main events will take place-

Page 17: Macro-Economics project

a) Output decreases, so requirement of labour in the firms decreases. Supply of

labour remaining the same, unions will become less powerful and labour will

accept to work at lower nominal wages. Price level remaining the same, the real

wages would fall below w0 . This effect is shown by ∝ in the WS-PS graph where

w1 represents the real wages at which labour are ready to work (below the

equilibrium level of real wage ofw0), which ultimately causes the prices to fall.

b) Now due to less labour working in the firms marginal product of labour i.e. MPL

will increase, which causes marginal cost, MC to fall. The fall in the cost of

production would be translated into a proportionate fall in the price of product. To

compensate for that real wages must rise (this effect will be shown by β in the

figure).

So in both cases we have seen that price must fall. Real wages will remain at PS line.

We will see that now the short run aggregate supply curve (SAS) will cut the new

aggregate demand curve at ‘A’. Here prices have fallen to P1 from initial equilibrium

price level ofP0. Corresponding to this price level, labour will be ready to work at lower

wage rate which are less thatw2, but real wages will follow the PS curve only.

When prices fall, the real balances in the economy rise causing the LM curve to shift to

the right. This leads to a fall in the interest rates. Projects which were not viable earlier

become favourable now and hence the level of investment rises. This causes the

Aggregate demand to rise.

In the next period, the labour will enter into wage contracts asking for lower nominal

wages. Firms on finding that the cost of production has decreased will further reduce

prices. Thus the same output is supplied at lower prices causing the SAS curve to shift

downwards. This new short run aggregate supply curve will cuts the AD ' curve at ‘B’,

now at point B we will see that prices will again fall to P2 and real wages on the PS

curve will reduce further. At point ‘B’ we will again see that more output can be

produced, we will again get a new short run aggregate supply curve asSAS2. This curve

will cut the AD ' curve at ‘C’. Now this process will keeps on occurring in short run till the

real wages get back tow0. As we know that any changes in money market is reflected

Page 18: Macro-Economics project

quickly while goods and service market reflects late for any changes, we will see that for

every intersection point of SAS curves and AD ' our LM curve will shift to right wards as

LM ', LM ' ', LM ' ' ' till it reaches LM f .

Page 19: Macro-Economics project

e0 e1

B

SAS2

i1

AD

AD’

i LM’ LM

LM’’ LM’’’

LMf

i0

IS’ IS

y

P AS SAS

SAS1

SASf

y1 y0 y

w

w2 WS

β

w0

α

w1

PS

O E1 E0 E

A

if

P0

P2

P2

P3

Pf

P

Page 20: Macro-Economics project

CASE 2We will try to reduce the price level by reducing government expenditure as well as the

nominal money supply in the economy. We will reduce the money supply more than the

government expenditure i.e. in unequal proportion.

As we know that short run equilibrium level of output and interest rate is determined by

the intersection of IS and LM curve.

IS curve can be written as- yd=c0+c y (1−t y ) y+A−ar+g1

Where ‘g’ is government spending

The equation of LM curve initially is: i=1l1×[ yv +l−Ms

P ] Where ‘Ms’ represents the money supply in the market at a given price level of ‘P’.

Intersection of IS and LM curve gives us the Aggregate demand curve (see figure)

denoted by AD.

In the medium run (before reducing money supply and government expenditure) when

the market is in equilibrium the real wages prevalent in the market is given byw0. This

we get by intersection of WS (wage setting) and PS (price setting curve), as shown in

the figure.

Rearranging the above given IS curve by using the fact that in goods market equilibrium

yd=y we get the IS curve as:-

y= 11−c y(1−t y)

⌊c0+( A−ar )+g1 ⌋

Where 1

1−c y (1−t y ) represent the multiplier effect.

Any change in government expenditure ‘g’ (reduction in our case) will cause the IS

curve to shift leftwards by the change in autonomous spending times the multiplier.

Page 21: Macro-Economics project

Similarly on reducing the money supply in the market the LM curve will shift upwards to

the extent of ¿

Now in our case reduction in money supply is more than the reduction in government

expenditure and hence shift in LM curve is higher than the shift in IS curve. Due to

higher shift in LM curve than the IS curve we will get the new equilibrium point ate1.

Shifting of IS and LM curves will cause the Aggregate demand curve to shift downwards

to AD ' from AD. Due to shift in aggregate demand curve we will see that level of output

will also decreased from y0 toy1. Decrease in level of output will cause the level of

employment to fall from E0 toE1.

Now in the first period due to decrease in output two main events will take place-

a) Output decreases, so requirement of labour in the firms decreases. Now due to

no change in labour supply labour will accept to work at lower nominal wages.

This effect is shown by in the WS-PS graph where w1 represents the real

wages at which labour are ready to work (below the equilibrium level of real

wage ofw0), which ultimately causes the prices to fall.

b) Now due to less labour working in the firms marginal product of labour i.e. MPL

will increase, which causes marginal cost MC to fall. Due to which cost of

production and price of product will also falls and to compensate for that real

wages must rise (this effect will be shown by β in the figure).

So in both cases we have seen that price must fall. Real wages will remain at PS line.

We will see that now the short run aggregate supply curve (SAS) will cut the new

aggregate demand curve at ‘A’. Here prices have fallen to P1 from initial equilibrium

price level ofP0. Corresponding to this price level labour will be ready to work at lower

wage rate which are less thatw2, but real wages will follow the PS curve only.

Now we will see that at price level of P1 we can still produce more to reach the

equilibrium level of output of y0 i.e. we can supply more and hence we will get a new

SAS curve as SAS1. This new short run aggregate supply curve will cuts the AD ' curve

Page 22: Macro-Economics project

at ‘B’, now at point B we will see that prices will again fall to P2 and real wages on the

PS curve will further reduces. At point ‘B’ we will again see that more output can be

produced, we will again get a new short run aggregate supply curve asSAS2. This curve

will cut the AD ' curve at ‘C’.

Now this process will keeps on occurring in short run till the real wages get back tow0.

As we know that any changes in money market is reflected quickly while goods and

service market reflects late for any changes, we will see that for every intersection point

of SAS curves and AD ' our LM curve will shift to right wards as LM ', LM ' ', LM ' ' ' till it

reaches LM f .

Page 23: Macro-Economics project

e0

e1

A B

LM’ LM’’ LM

i LM’’’

LMF

i1

i0

i3

IS

IS’

0 y1 y0 y

P AS SAS SAS1

SAS2

SASf

AD

AD’

0 y1 y0 y

w

WS

w2

w0 β

α

w1

PS

0 E1 E0 E

P0

P1

P2

Pf

Pf

P

Page 24: Macro-Economics project

CASE 3We will now attempt to reduce the government expenditure more than the nominal

money supply i.e. in unequal proportionate to control prices.

As we know that short run equilibrium level of output and interest rate is determined by

the intersection of IS and LM curve.

IS curve can be written as- yd=c0+c y (1−t y ) y+A−ar+g1

Where ‘g’ is government spending

The equation of LM curve initially is: i=1l1×[ yv +l−Ms

P ] Where ‘Ms’ represents the money supply in the market at a given price level of ‘P’.

Intersection of IS and LM curve gives us the Aggregate demand curve (see figure)

denoted by AD.

In the medium run (before reducing money supply and government expenditure) when

the market is in equilibrium the real wages prevalent in the market is given byw0. This

we get by intersection of WS (wage setting) and PS (price setting curve), as shown in

the figure.

Rearranging the above given IS curve by using the fact that in goods market equilibrium

yd=y we get the IS curve as:-

y= 11−c y(1−t y)

⌊c0+( A−ar )+g1 ⌋

Where 1

1−c y (1−t y ) represent the multiplier effect.

Any change in government expenditure ‘g’ (reduction in our case) will cause the IS

curve to shift leftwards by the change in autonomous spending times the multiplier.

Similarly on reducing the money supply in the market the LM curve will shift upwards to

the extent of ¿

Page 25: Macro-Economics project

Now in our case reduction in government spending is more than the reduction in money

supply and hence shift in IS curve is much higher than the shift in LM curve. Due to

higher shift in IS curve than the LM curve we will get the new equilibrium point ate1.

Shifting of IS and LM curves will cause the Aggregate demand curve to shift downwards

to AD ' from AD. Due to shift in aggregate demand curve we will see that level of output

will also decreased from y0 toy1. Decrease in level of output will cause the level of

employment to fall from E0 toE1.

Now in the first period due to decrease in output two main events will take place-

c) Output decreases, so requirement of labour in the firms decreases. Now due to

no change in labour supply labour will accept to work at lower nominal wages.

This effect is shown by in the WS-PS graph where w1 represents the real

wages at which labour are ready to work (below the equilibrium level of real

wage ofw0), which ultimately causes the prices to fall.

d) Now due to less labour working in the firms marginal product of labour i.e. MPL

will increase, which causes marginal cost MC to fall. Due to which cost of

production and price of product will also falls and to compensate for that real

wages must rise (this effect will be shown by β in the figure).

So in both cases we have seen that price must fall. Real wages will remain at PS line.

We will see that now the short run aggregate supply curve (SAS) will cut the new

aggregate demand curve at ‘A’. Here prices have fallen to P1 from initial equilibrium

price level ofP0. Corresponding to this price level labour will be ready to work at lower

wage rate which are less thatw2, but real wages will follow the PS curve only.

Now we will see that at price level of P1 we can still produce more to reach the

equilibrium level of output of y0 i.e. we can supply more and hence we will get a new

SAS curve as SAS1. This new short run aggregate supply curve will cuts the AD ' curve

at ‘B’, now at point B we will see that prices will again fall to P2 and real wages on the

PS curve will further reduces. At point ‘B’ we will again see that more output can be

Page 26: Macro-Economics project

produced, we will again get a new short run aggregate supply curve asSAS2. This curve

will cut the AD ' curve at ‘C’.

Now this process will keeps on occurring in short run till the real wages get back tow0.

As we know that any changes in money market is reflected quickly while goods and

service market reflects late for any changes, we will see that for every intersection point

of SAS curves and AD ' our LM curve will shift to right wards as LM ', LM ' ', LM ' ' ' till it

reaches LM f .

Page 27: Macro-Economics project

e0

e1

A

B

i LM’ LM

LM’’ LM’’’

LMF

i0

i1 i2 IS’ IS

0 y

P AS SAS SAS1

SAS2

SASF

AD

AD’

0 y1 y0 y

w

w1 WS

w0 β

α

w2

PS

0 E1 E0 E

P0

P2

P2

P3

Pf

P

Page 28: Macro-Economics project

ConclusionCase1:

Both government expenditure and nominal money supply have been decreased

in the economy.

Prices have fallen from P0 to Pf while the level of output and employment have

remained at y0 andE0.

Real wages have also remained at w0.

Real money supply in the economy has ultimately increased due to fall in the

price level. This in-turn has caused nomin al interest rate to fall and fall in

government spending is covered up by rise in investments.

Case2:

Both government expenditure and nominal money supply have been decreased

in the economy.

Prices have fallen from P0 to Pf while the level of output and employment have

remained at y0 andE0.

Real wages have also remained at w0.

Real money supply in the economy has ultimately increased due to fall in the

price level. This in-turn has caused nominal interest rate to fall to if and fall in

government spending is covered up by rise in investments.

Case 3:

Both government expenditure and nominal money supply have been decreased

in the economy.

Prices have fallen from P0 to Pf while the level of output and employment have

remained at y0 andE0.

Page 29: Macro-Economics project

Real wages have also remained at w0.

Real money supply in the economy has ultimately increased due to fall in the

price level. This in-turn has caused nominal interest rate to fall to if and fall in

government spending is covered up by rise in investments.

Page 30: Macro-Economics project

REDUCING UNEMPLOYMENT

Definition

The unemployment rate is the % of people in the labour force without a job but registered as being willing and available for work. The natural rate of unemployment is defined as the equilibrium rate of unemployment i.e. the rate of unemployment where real wages have found their free market level and where the aggregate supply of labour is in balance with the aggregate demand for labour. At the natural rate, all those wanting to work at the prevailing real wage rate have found employment and thus there is assumed to be no involuntary unemployment. There remains some voluntary unemployment as some people remain out of a job searching for work offering higher real wages or better conditions.

ObjectiveThe objective of the following section is to advise the Government of India to increase

employment level in the economy. However, there is a trade-off between reducing the level of

unemployment and reducing the price level. Thus, providing employment opportunities entails a

cost.

Possible strategiesThe government could use the fiscal policy, the monetary policy or an interplay of both to promote employment.

Strategy Adopted

Case 1:We will try to achieve the objective by increasing government expenditure and nominal money

supply in the economy. We propose to increase nominal money supply as much as increase in

the government expenditure i.e. in equal proportion.

Page 31: Macro-Economics project

ExplanationIn the short run equilibrium level of output and interest rate is determined by the intersection of

IS and LM curve.

IS curve can be written as- yd=c0+c y (1−t y ) y+A−ar+g1

Where:

g is government spending

C is the marginal propensity to consume

T represents government taxes

Co is that part of consumption financed from wealth and future stream of income

a is the interest sensitivity of investment

r is the real rate of interest

The equation of original LM curve is: i= 1l1×[ yv +l−Ms

P ]

Where ‘Ms’ represents the money supply in the market at a given price level of ‘P’.

Intersection of IS and LM curve gives us the Aggregate demand curve (see figure) denoted by

AD.

Initially in the medium run when the market is in equilibrium the real wages prevalent in the

market is given byw0. This we get by intersection of WS (wage setting) and PS (price setting

curve), as shown in the figure.

Page 32: Macro-Economics project

Rearranging the above given IS curve by using the fact that in goods market equilibrium yd=y

we get the IS curve as:-

y= 11−c y(1−t y)

⌊c0+( A−ar )+g1 ⌋

Where 11−c y (1−t y )

represent the multiplier effect.

Any change in government expenditure ‘g’ (increase in our case) will cause the IS curve to shift

rightwards by the change in autonomous spending times the multiplier.

Shift in IS curve = ___∆g___ 1-c(1-t)Similarly on increasing the money supply in the market the LM curve will shift rightwards to the

extent of ¿

Shifting of IS and LM curves will cause the Aggregate demand curve to shift upwards from AD

to AD '. Due to shift in aggregate demand curve we will see that level of output increases from

y0 toy2. This will cause the level of employment to rise from E0 toE2.

To meet the excess demand the firms require more labour which is equal to OE’. OE’ labour

won’t be forthcoming unless real wages ↑ from w◦ to w1

Initially, w = W◦ / Po

Since the power of the unions increase, they demand higher nominal wages, leading to higher

real wage.

Page 33: Macro-Economics project

Thus, w1 = W1 / P◦

Hence the cost of labour increases which results in firms increasing the price accordingly. This

is denoted by ‘α’

Further, in the medium run, capital is fixed. So ↑in labour results in ↓ in MPL. Fall in marginal

product causes the marginal cost MC to rise. Thus, the cost of production and this is translated

into a rise in prices. The real wages thus fall.

This ↑ in price by the firms still further. This is denoted by ‘β’

P = MC

MC = w◦ / MPL

As MPL ↓, MC ↑, hence P ↑

Therefore w2 = W◦ / P2

Thus in both cases price must increase. Real wage will remain at the price setting curve

because the percentage increase in the nominal wages is equal to the increase in price level.

Hence real wages would remain at w◦

Here, employment has increased, but the economy pays a price in the form of higher prices.

Now, in the money market, the rise in the price levels causes the real balances to fall and thus

the LM curve would shift to the left, intersecting at a lesser level of output. We will see that now

the short run aggregate supply curve (SAS) will cut the new aggregate demand curve at ‘A’.

Here prices have risen to P1 from initial equilibrium price level ofP0. Corresponding to this price

level labour will be ready to work at lower wage rate which are less thatw2, but real wages will

follow the PS curve only.

Now we will see that at price level of P1 we still have excess supply till the original equilibrium

level of output of y0 i.e. supply has to be reduced and hence we will get a leftward shift of SAS

Page 34: Macro-Economics project

curve. This new short run aggregate supply curve will cut the new aggregate demand curve,

AD ', at a point corresponding to higher price level.

Now this process will keep on occurring in short run till price level is P2 and real wages get back

tow0.

Any changes in money market is reflected quickly while goods and service market reflects late

for any changes, we will see that for every intersection point of SAS curves and AD ', our LM

curve will shift left wards till it reaches LM ' ' '.

Page 35: Macro-Economics project

e’

LM’

IS’

IS

O y◦ y1 Y2 Fig(1) y

AS SAS

α+β

AD’

AD

O y◦ y1 Y2 Fig(2) y

WS

W1

W0 α+β

W2

PS

O E0 E1 E2 Fig(3) E

P2

P

W

e

P1

P0

LM’’’

LM’’’ LM

I2

I1

I0

i

SAS1

Page 36: Macro-Economics project

Case 2:Alternately, we can try to achieve objective by increasing government expenditure and nominal

money supply in the economy wherein the increase in government expenditure is more

than the increase in the nominal money supply.

In the short run equilibrium level of output and interest rate is determined by the intersection of

IS and LM curve.

IS curve can be written as- yd=c0+c y (1−t y ) y+A−ar+g1

Where ‘g’ is government spending

The equation of LM curve initially is: i=1l1×[ yv +l−Ms

P ] Where ‘Ms’ represents the money supply in the market at a given price level of ‘P’.

Intersection of IS and LM curve gives us the Aggregate demand curve (see figure) denoted by

AD.

Initially in the medium run when the market is in equilibrium the real wages prevalent in the

market is given byw0. This we get by intersection of WS (wage setting) and PS (price setting

curve), as shown in the figure.

Rearranging the above given IS curve by using the fact that in goods market equilibrium yd=y

we get the IS curve as:-

y= 11−c y(1−t y)

⌊c0+( A−ar )+g1 ⌋

Where 1

1−c y (1−t y ) represent the multiplier effect.

Any change in government expenditure ‘g’ (increase in our case) will cause the IS curve to shift

rightwards by the change in autonomous spending times the multiplier.

Similarly on increasing the money supply in the market the LM curve will shift rightwards to the

extent of ¿

Page 37: Macro-Economics project

In this case increase in government spending is more than the increase in money supply and

hence shift in IS curve is much higher than the shift in LM curve and a new equilibrium point is

established at pointe1.

Shifting of IS and LM curves will cause the Aggregate demand curve to shift upwards from AD

to AD '. Due to shift in aggregate demand curve we will see that level of output increases from

y0 toy2. This will cause the level of employment to rise from E0 toE2.

Now in the first period due to increase in output two main events will take place-

Again and explain the cause of the price change.

Real wages will remain at PS line. We will see that now the short run aggregate supply curve

(SAS) will cut the new aggregate demand curve at ‘A’. Here prices have risen to P1 from initial

equilibrium price level ofP0. Corresponding to this price level labour will be ready to work at

higher nominal wage rate, but real wages will follow the PS curve only.

Now we will see that at price level of P1 we still have excess supply till the original equilibrium

level of output of y0 i.e. supply has to be reduced and hence we will get a leftward shift of SAS

curve. This new short run aggregate supply curve will cut the new aggregate demand curve,

AD ', at a point corresponding to higher price level.

Now this process will keep on occurring in short run till price level is P2 and real wages get back

tow0.

Any changes in money market is reflected quickly while goods and service market reflects late

for any changes, we will see that for every intersection point of SAS curves and AD ', our LM

curve will shift left wards till it reaches LM ' ' '.

Page 38: Macro-Economics project

e’

i

IS

O y◦ y1 Y2 Fig(1) y

AS SAS

α+β

AD’

AD

O y◦ y1 Y2 Fig(2) y

WS

W1

W0 α+β

W2

PS

O E0 E1 E2 Fig(3) E

I0

P

W

e

I1

I2

I3

LM LM’

LM’’ LM’’’

P0

P2

P1

IS’

SAS1

Case

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3:

Another scenario is where the government increases the nominal money supply more than it

increases in the government expenditure i.e. in unequal proportionate. In this case, again, an

increase in employment would only be temporary or in the short period. (refer to diagram on

next page).

Page 40: Macro-Economics project

e’

i LM’’’ LM LM’’

LM’

IS’

IS

O y◦ y1 Y2 Fig(1) y

AS SAS

α+β

AD’

AD

O y◦ y1 Y2 Fig(2) y

WS

W1

W0 α+β

W2

PS

O E0 E1 E2 Fig(3) E

i’’

P

W

e

I0

I3

SAS1

I2

i’’

P2 P1 P0

I1

Page 41: Macro-Economics project

If the government wishes to implement only an expansionary fiscal policy to attain higher

employment levels, it would fail. The economy would settle at a less than full employment level

of output. Government expenditure would not work to its full potentials under variable prices.

The variable price dampens the effect of the fiscal policy. Similarly, a monetary policy would be

less effective with flexible prices.

ConclusionIncrease in government expenditure is equal to fall in real money supply in the

economy.

Prices have risen from P0 to P2 while the level of output and employment have

remained at y0 andE0.

Real wages have also remained at w0.

Employment in economy did increase but only in the transitionary period

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PROMOTING GROWTH

DefinitionEconomic growth is the term used to indicate increase in per capita GDP or other measures of aggregate income. It refers to permanent increase in goods and services in the economy. By permanent increase we mean an increase in output in not just one period but a continuous increase in output over more than one period. This increase in real GDP means there is an increase in the value of national output / national expenditure.

BenefitsThe Benefits of economic growth include:

Higher Incomes This enables consumers to enjoy more goods and services Lower unemployment With higher output firms tend to employ more workers creating more employment. Lower Government borrowing Economic growth creates higher tax revenues and there is less need to spend money on benefits such as unemployment benefit. Improved public services With increased tax revenues the government can spend more on the NHS and education etc.

Possible strategiesPotential growth can increase due to the following reasons:

Increased Capital e.g. investment in new factories or investment in infrastructure such as roads and telephones.Increase in Labour productivity, through better education and trainingTechnological improvements to improve the productivity of Capital and labour e.g. Microcomputers and the internet have both contributed to increased economic growth

Strategy AdoptedWe suggest increasing capital investment to promote growth in the economy.

Now, investment can be expressed as a function as:

I(A,r)= A-ar

Page 43: Macro-Economics project

Where A = encompasses business outlook and technology etc

a = interest sensitivity to investment

r = rate of interest

such that,

I α A I α 1/r

Therefore to increase investment we need to reduce the rate of interest.

When rate of interest decreases, the cost of borrowing decreases. Projects which were unviable

earlier become favorable and hence investment increases.

Even if the firms choose to use its own funds in investment, the interest rate represents the

opportunity cost of investing those funds rather than lending out that money for interest.

In order to decrease rate of interest to stimulate investment, the strategies we are adopting are-

Increase in money supply by the central bank that causes LM curve to shift

downwards and rightwards.

Decrease in government spending which causes IS curve to shift leftwards and

downwards.

ExplanationIn the short run equilibrium level of output and interest rate is determined by the intersection of IS and LM curve.

IS curve can be written as- yd=c0+c y (1−t y ) y+A−ar+g1 Where ‘g’ is government spending

Page 44: Macro-Economics project

The equation of LM curve initially is: i= 1l1×[ yv +l−Ms

P ] here ‘Ms’ represents the money supply in the market at a given price level of ‘P’.

Intersection of IS and LM curve gives us the Aggregate demand curve (see figure) denoted by

AD.

Initially in the medium run when the market is in equilibrium the real wages prevalent in the

market is given byw0. This we get by intersection of WS (wage setting) and PS (price setting

curve), as shown in the figure.

Rearranging the above given IS curve by using the fact that in goods market equilibrium yd=y

we get the IS curve as:-

y= 11−c y(1−t y)

⌊c0+( A−ar )+g1 ⌋

Where 11−c y (1−t y )

represent the multiplier effect.

SHIFTS-

Shift in LM curve = 1l1×d (MP )

This shift in the LM curve would be caused by a change in money supply.Shift in IS curve = ∆ g

1−c (1−t 1 )

This shift in the IS curve is caused by a change in government spending.

Page 45: Macro-Economics project

CASE 1 When increase in money supply > decrease in government spending

i.e magnitude of rightward shift in LM curve > leftward shift in IS curve

IS LM FRAMEWORKInitially economy is at equilibrium at E.

Due to ↑ in money supply and ↓ in government spending, we would move to E’ which would be

the new equilibrium level. This is the point of intersection of LM’ and IS’.

E’ corresponds to

Lower rate of interest, i3

Higher level of output/ income, y1

AS-AD FRAMEWORKAt the existing price level P0, there is an increase in Y resulting in the shift of AD curve to the

right. The new aggregate demand curve is AD’.

Due to ↑ in the aggregate demand the price level increases to P1. This ↑ in price level is

because of 2 reasons:

To meet the excess demand the firms require more labour which is equal to OE1. OE1

labour won’t be forthcoming unless real wages ↑ from w0 to w1

Thus initially w = w◦ / P0

To ↑ real wage rate at the existing price level P0, the labour asks for a higher nominal wage

i.e W1

Thus w1 = W1 / P0

Hence the cost of labour increases which results in firms increasing the price accordingly. This

is denoted by ‘α’

Page 46: Macro-Economics project

In short to medium run, capital is fixed. So ↑in labour results in ↓ in MPL.

This results in ↑ in price by the firms still further. This is denoted by ‘β’

P = MC

MC = w◦ / MPL

As MPL ↓, MC ↑, hence P ↑

Therefore w2 = W0 / P2

Thus in both cases price must increase. Real wage will remain at the price setting curve

because the percentage increase in the nominal wages as well as the price level is the same

resulting in the real wage to be w0

Now, in the money market, the rise in the price levels causes the real balances to fall and thus

the LM curve would shift to the left, intersecting at a lesser level of output. We will see that now

the short run aggregate supply curve (SAS) will cut the new aggregate demand curve at ‘A’.

Here prices have risen to P1 from initial equilibrium price level ofP0. Corresponding to this price

level labour will be ready to work at lower wage rate which are less thatw2, but real wages will

follow the PS curve only.

Now we will see that at price level of P1 we will produce less to reach the equilibrium level of

output of y0 i.e. we can supply less and hence we will get a new SAS curve as SAS1. This new

short run aggregate supply curve will cuts the AD ' curve at a point corresponding to new price

level P1.

Now this process will keeps on occurring in short run till the real wages get back tow0 and price

level rises to P2.

Any changes in money market is reflected quickly while goods and service market reflects late

for any changes, we will see that for every intersection point of SAS curves and AD ', our LM

curve will shift to leftwards till it reaches LM ' ' '.

Page 47: Macro-Economics project

e’

i LM LM’’’ LM” LM’

IS’ IS

y◦ y2 y1 Fig(1) y

AS SAS

α+β

AD’

AD

y◦ y2 Y1 Fig(2) y

WS

W1

W0 α+β

W2

PS

0 E◦ E2 E1 Fig(3) E

P

W

e

I2 I3

I1

0

0

I0

P0 P1 P2

SAS1

Page 48: Macro-Economics project

CASE 2When increase in money supply = decrease in government spending

i.e magnitude of rightward shift in LM curve = leftward shift in IS curve

LM-IS FRAMEWORKInitially economy was at equilibrium at E. Due to an increase in money supply and decrease in

government spending by an equal amount, the economy would move to a new equilibrium point

E’.

The new equilibrium point is the point of intersection of LM’ and IS’.

E’ corresponds to

A lower rate of interest, i’

The same level of output / income, y

AS-AD FRAMEWORKAt the existing price level P0, there is no shift in the AD curve

In the second panel, the intersection of SAS and AD gives the equilibrium level of output.

Since there is no change in the aggregate demand, the equilibrium level of employment

remains the same i.e OE

Thus the real wage rate remains the same at w0

Page 49: Macro-Economics project

i LM

LM’

i0 e

i’ e’

IS’ IS

y₀ y Fig(1)

P

AS

SAS

P₀

AD

y₀ y Fig(2)

W

WS

w₀

PS

E₀ E Fig(3) Case

Page 50: Macro-Economics project

3:When decrease in government spending > increase in money supplyi.e magnitude of leftward shift in IS curve > rightward shift in LM curve

IS LM FRAMEWORKInitially economy is at equilibrium at E.

Due to ↑ in money supply and ↓ in government spending, we would move to E’ which would be

the new equilibrium level. This is the point of intersection of LM’ and IS’.

E’ corresponds to

Lower rate of interest, i1

Lower level of output/ income, y0

AS-AD FRAMEWORKAt the existing price level P0, there is a decrease in Y resulting in the shift of AD curve to the

left. The new aggregate demand curve is AD’.

Due to in the aggregate demand the price level decreases to P1. This in price level is

because of 2 reasons:

To meet the deficit demand the firms require less labour which is equal to OE0. OE0

labour would be willing to accept low wages w2

Thus initially w = w◦ / P0

To real wage rate at the existing price level P0, the labour asks for a lower nominal wage i.e

W2

Thus w2 = W2 / P0

Hence the cost of labour falls which results in firms reducing the price accordingly. This

is denoted by ‘α’

Page 51: Macro-Economics project

In short to medium run, capital is fixed. So in labour results in in MPL.

This results in in price by the firms still further. This is denoted by ‘β’

P = MC

MC = w◦ / MPL

As MPL , MC , hence P

Therefore w2 = W0 / P2

Thus in both cases price must fall. Real wage will remain at the price setting curve because the

percentage decrease in the nominal wages as well as the price level is the same resulting in the

real wage to be w0

Now, in the money market, the fall in the price levels causes the real balances to rise and thus

the LM curve would shift to the right, intersecting at a higher level of output. We will see that

now the short run aggregate supply curve (SAS) will cut the new aggregate demand curve at a

point corresponding to reduced price level P1. Corresponding to this price level labour will be

ready to work only at higher wage rate but real wages will follow the PS curve only.

Now we will see that at price level of P1 we will produce more to reach the equilibrium level of

output of y0 i.e. we can supply more and hence we will get a new SAS curve as SAS1.

Now this process will keeps on occurring in short run till the real wages get back tow0 and price

level falls to P2.

Any changes in money market is reflected quickly while goods and service market reflects late

for any changes, we will see that for every intersection point of SAS curves and AD ', our LM

curve will shift rightwards till it reaches LM ' ' '.

Page 52: Macro-Economics project

e’

i LM LM’’’ LM” LM’

IS’ IS

y◦ y2 y1 Fig(1) y

AS SAS

α+β

AD’

AD

y◦ y2 Y1 Fig(2) y

WS

W1

W0 α+β

W2

PS

0 E◦ E2 E1 Fig(3) E

P

W

e

I2 I3

I1

0

0

I0

P0 P1 P2

SAS1

Page 53: Macro-Economics project

CONCLUSION

CASE 1There is a decrease in the rate of interest which stimulates investment and hence

promotes growth

In the short to medium run there is an increase in level of output, income and hence

employment.

CASE 2There is a decrease in the rate of interest promoting growth.

In the short to medium run there is an increase in output, hence income.

Correspondingly the level of employment remains the same.

CASE 3Fall in government expenditure is equal to increase in real money supply in the

economy.

Prices have fallen from P0 to P2 while the level of output and employment have

remained at y0 andE0.

Real wages have also remained at w0.

Real money supply in the economy has ultimately increased due to fall in the price

level. This in-turn has caused nominal interest rate to fall to i3 and fall in government

spending is covered up by rise in investments.

Page 54: Macro-Economics project

REDUCING FISCAL DEFICITDefinitionFiscal deficit is an economic phenomenon, where the Government's total expenditure surpasses its revenue. It is the difference between the government's total receipts (excluding borrowing) and total expenditure.

Reasons for an increased fiscal deficit The fiscal deficit increases mainly due to following reasons:

1. Actual tax collection < target tax collections2. Government spending > government receipts

In 2008-09 governments around the world incurred huge fiscal deficits due to stimulus packages undertaken in order to counter slowdown in economy. To spur economic activity, they had initiated various measures like massive spending programme and slashed taxes, levies and duties. The slash in duties resulted in a decrease in the revenue generation for the country and thereby increasing the fiscal deficit.

ObjectiveThe objective of the following section is to advise the Government of India about how to

reign in fiscal deficit.

Strategy to reign in Fiscal deficit Fiscal deficit arises when a government's total expenditures exceed the revenue that it

generates; taxes form a major portion of government’s revenue.

FD = G – T -------------------- (1)

FD: Fiscal Deficit

G: Government Expenditure

T: Taxes collected by the government

From equation 1 it can be ascertained that fiscal deficit can be reduced by decreasing

the amount of government spending (G) and increasing the amount of tax collected (T).

The amount of tax collected can be increased by increasing the applicable tax rate. The

Page 55: Macro-Economics project

short run equilibrium level of output and interest rate is determined by the intersection of

IS and LM curve. (Refer to figure No 1 & 2).

The equation of IS curve initially is: i=C0+A+g1

a− y [ 1−C (1−t 1 )

a ] (IS1)

The equation of LM curve initially is: i=1l1×[ yv +l−M 1

P1 ] (LM1)

To determine the equilibrium level of output and interest rate the aforementioned

equations of IS1 and LM1 are solved. The two unknown variables in these equations are

i and y.

After solving the equilibrium level of output (y1) obtained is:

y 1=

C0+A+g1

a− ll 1

+ M 1P1∗l 1

1l1∗v

+[ 1−C (1−t 1 )a ]

And equilibrium level of interest rate (i1) obtained is

i1=1l 1 [ l1 (C0+A+g1 )−a(l−M 1

P1 )a+l 1∗v [1−C (1−t 1 ) ]

+l−M 1P1 ]The government spending is now reduced to

g2 (Refer to figure No 3) and the applicable tax rate is increased to t2 (Refer to figure No

4). The aforementioned changes would ramify into the IS curve (IS1) shifting left and

inverting inwards. The IS curve will invert inwards because of the increase in tax rate to

t2. It will cause the value of the multiplier to decrease thereby increasing the absolute

value of the slope (i.e. the slope will become steeper).

The extent of leftward shift of the IS curve is given by ∆g

1−c (1−t 1)

The equation of the IS curve after the aforementioned changes is:

i=C0+A+g2

a− y [ 1−C (1−t 2 )

a ] (IS2)

Page 56: Macro-Economics project

Slope of IS2: [ 1−C (1−t 2 )a ] the slope of IS2 is steeper because of higher tax rate t2.

At this juncture the nominal money supply in the economy is increased to M2; this level

of nominal money supply will cause the LM curve to shift rightwards or downwards to

the extent so that the level of output where LM2 and IS2 intersect is the same as

equilibrium level of output which prevailed in the first place (y1). Increasing the nominal

money supply to M2 will cause the equilibrium level of rate of interest to fall to i2 (Refer to

figure No 5). This fall in interest rate will stimulate private investments; increase in

investments will be exactly equal to fall in government expenditure, thus ensuring there

is no change in aggregate demand, price level and employment level even in the short

run. (Refer to figure No 6, 7& 8).

Reason for increasing the money supply If the money supply is not increased, the LM

curve will shift rightwards to a lesser extent in the short term which will cause a

decrease in the level of employment and price. In order to obviate such a scenario in

which there is a decrease in the level of employment in the intermediate term, the

nominal supply of money has been increased.

The LM curve will shift downwards to the extent of −1l 1×d(MP )

The equation of LM curve after the shift is i=1l1×[ yv +l−M 2

P1 ] (LM2)

To determine the new equilibrium level of output equations IS2 and LM2 are solved

simultaneously.

After solving the equilibrium level of output (y2) obtained is:

y 2=

C0+A+g2

a− ll1

+ M 2P1∗l 1

1l1∗v

+[ 1−C (1−t 2 )a ]

Page 57: Macro-Economics project

y1 y

IS1

i

SAS

AD

P

y

P1

LM11

i1

y1

Fig (1)Fig (1)

Fig (2)

Page 58: Macro-Economics project

AD

y1

P1

P

SAS

WS

AD

w

w1

y1

i

y

IS1

IS2

LM1

LM2

i1

i2

α

β

E1 E

Fig (7)

Fig (8)

Fig (6)

y

Page 59: Macro-Economics project

i

y

IS1

IS2

LM1

i

y

IS1

IS2

LM1

i2

i

y

IS1

IS2

LM1

LM2

i1

y1

Fig (4)

Fig (3)

Page 60: Macro-Economics project

The new equilibrium level of output should be equal to y1.

y2=y1

On solving the value of M2 is determined as

M 2=[ y1× {a+l 1×v (1−c(1−t 2)) }−l 1v {C0+A+g2}+l×a×v ]

a×v

And equilibrium level of interest rate (i2) obtained is

i2=1l 1 [ l1 (C0+A+g2 )−a(l−M 2

P1 )a+ l1∗v [1−C (1−t 2 ) ]

+l−M 2P1 ]

Conclusion1. Fiscal deficit has been reduced as there has been a reduction in Government

spending(G) and an increase in tax collected by the government through an

increase in applicable tax rate(t1 to t2).

2. The level of output and the price level has not been affected in both short and

medium term

3. Interest rates have decreased from i1 to i2. The magnitude of the decrease in

interest rates is i1-i2. The reduction in interest rates will stimulate investment as

the level of investment in the economy is inversely related to the level of real

interest rates in the economy.

4. The level of employment will be unaffected in the short and medium term.

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Promotion of Healthy Banking Practice through Monetary Policy Measures

To initiate a change in LM curve, central bank has to change the amount of nominal money supply (i.e. liquidity of money) in the economy. This can be achieved through open market operations or by changing statutory reserve ratios.

In open market operations the central bank enters into sale and purchase of government securities and treasury bills. By selling the bonds, money liquidity in the economy is reduced as the central bank keeps the proceeds with itself. Also, bonds prices fall and yield (nominal interest rates) rises. If bonds are bought by central bank, they would be using their money reserves to pay for the proceeds and hence enhance money liquidity in the economy. Also, bond prices rise due to increase in their demand and yield (nominal interest rates) falls.These transactions are done with mostly financial institutions and other banks in the country.

Another way to change nominal money supply is to change statutory reserve ratios. These ratios are Cash Reserve Ratio and Statutory Liquidity Ratio. Banks have to keep a certain portion of their total deposits with the central bank in the form of cash and government bonds. An increase in the ratio requirement by central bank raises the amount of cash and bonds that banks have to keep with central bank and thereby reduce nominal money supply in the economy. It also raises the demand for bonds, raising their prices and reducing nominal interest rates. A decrease in reserve requirements would result in injection of money liquidity in economy, fall in bond demand and its prices and a rise in yield (nominal interest rates).

Both measures mentioned above have an impact on the deposit and lending interest rates of the banks. A reduction in liquidity increases their cost of funds and thus they increase both deposit and lending rates being offered to the public. But an increase in liquidity brings down the cost of bank’s funds and in turn reduces the deposit and lending rates offered to the public in the economy.

Hence, central bank can use monetary policy measures to ensure healthy banking practices are being followed in the economy.

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Strategy’s Result Summary

Strategy Benefitted Objectives Tick the Best onesIncrease Money Supply > Decrease Government Expenditure

Stimulate Growth Promote High Level

of Employment Reduce Fiscal Deficit

Increase Money Supply < Decrease Government Expenditure

Stimulate Growth Reduce Fiscal Deficit Control Price Level

Increase Money Supply = Decrease Government Expenditure

Stimulate Growth Reduce Fiscal Deficit

Strategy Benefitted Objectives Tick the Best onesDecrease Money Supply > Decrease Government Expenditure

Stimulate Growth Reduce Fiscal Deficit Control Price Level

Decrease Money Supply < Decrease Government Expenditure

Stimulate Growth Reduce Fiscal Deficit Control Price Level

Decrease Money Supply = Decrease Government Expenditure

Stimulate Growth Reduce Fiscal Deficit Control Price Level

Strategy Benefitted Objectives Tick the Best onesIncrease Money Supply > Increase Government Expenditure

Promote High Level of Employment

Increase Money Supply < Increase Government Expenditure

Promote High Level of Employment

Increase Money Supply = Increase Government Expenditure

Promote High Level of Employment

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Further, it can be seen that the objectives are conflicting in nature. Attaining one objective requires compromising the other. The government would choose a point on its indifference curve which maximizes its satisfaction. Thus, choosing the best strategy is very subjective and depends on the governments taste and preferences.