Answer to Q-1 A closed economy is the one which doesn t have any commercial activities with other countries and all the trade happens within the diffe

Transcription

1 Economics IS-LM

2 Answer to Q-1 A closed economy is the one which doesn t have any commercial activities with other countries and all the trade happens within the different parties in the country itself. In a closed economy in order to increase the output of the economy, it can be done either through use of expansionary monetary policies which increases the money supply in the market which in turn induces increase in demand of goods or through use of expansionary fiscal policies which include increasing government expenditure and reducing the taxes which also increases demand of goods. When any one of the measures is taken by the government alone, it has effect on the interest rates in the economy with increase in output (Heijdra and Ploeg, 2002). It can be seen in the below diagram when use of expansionary monetary policy results in shifting of LM curve and thus reducing the interest rate at the new equilibrium which got reduced from i0 to i1 with increase in output from Y0 to Y1. It can also be seen in the below diagram when use of expansionary fiscal policy results in shifting of IS curve and thus increasing the interest rate at the new equilibrium which got increased from i0 to i1 with increase in output from Y0 to Y1.

3 Thus it can be seen that in a closed economy, any of the expansionary monetary policy or the expansionary fiscal policy is used alone, there is an increase in output of the economy but with simultaneous effect on the interest rate in the economy. In order to increase the output of the economy, without effecting the interest rate in the economy, it is important that both the curves, IS curve and LM curve shift. The IS curve need to shift outwards while the LM curve needs to shift inwards. This can be seen in the diagram below where when the IS curve shifts to IS curve and LM curve shifts to LM curve, the equilibrium interest rate remains unchanged to i* and output of the economy increases from Y to Y. This outward shift of the IS curve can be obtained by using expansionary fiscal policy and the inward shift of the LM curve can be obtained by use of expansionary monetary curve. (Case and Fair, 1999) Thus it is important that in a closed economy, the policy mix which the policymakers must use is use of expansionary monetary and expansionary fiscal policy together to increase the output of the economy without changing the interest rate in the economy. This is difficult for the policymakers as it is not easy to use both expansionary monetary and expansionary fiscal policy together at the same time, but in a closed economy, if the policymakers want to increase the output of the economy without changing the interest rate, then this solution has to be implemented by them.

4 Answer to Q-2 a) Elasticity of money demand means the sensitivity of change in any particular factor on the demand of the money in the economy. It can also be defined as the percent change in the money demand due to one percent change in the factor under consideration (Campbell and Brue, 1990). Income elasticity of money demand thus means the sensitivity of demand of the money in the economy on income of consumers of economy. It can also be defined as the percent change in the money demand due to one percent change in the income of consumers of economy. Interest elasticity of money demand on the other hand means the sensitivity of demand of the money in the economy on interest rates in the economy. It can also be defined as the percent change in the money demand due to one percent change in the interest rates in economy. b) I agree with the statement that The effect of an expansionary fiscal policy on the output level in a closed economy is very large when income elasticity of money demand is relatively high and interest elasticity of money demand is relatively low. It is generally observed that the income elasticity of money demand is positive because people tend to demand more money when there is increase in their income. It is also observed that the interest elasticity of money demand is negative because with increase in interest rates, people tend to demand less money. With higher value of income elasticity of money demand, the slope of the IS curve is also higher which means the LM curve is more slanted towards x axis and with lower value of income elasticity of money demand the slope of the LM curve is less. With higher value of interest elasticity of money demand, the slope of the LM curve is also higher and with lower value of the interest elasticity of money demand the slope of the LM curve is less which means the LM curve is more slanted towards x axis. This means with use of expansionary fiscal policy, there is shift IS curve. The change in output gets magnified when there is high income elasticity of money demand and low interest elasticity of money demand (Henderson and Quandt, 1980). This can be seen in the two diagrams below. The first diagram shows the situation when there is low income elasticity of money demand and high interest elasticity of money demand which means both IS and LM curve

5 are straighter and less slanted towards x axis. The increase of output from y0 to y1 is smaller in this case when expansionary fiscal policy is used and IS curve shifts to IS. The second diagram shows the situation when there is higher income elasticity of money demand and low interest elasticity of money demand which means both IS and LM curve are less straight and more slanted towards x axis. The increase of output from y0 to y1 is higher in this case when expansionary fiscal policy is used and IS curve shifts to IS.

6 Answer to Q-3 The effect of increased government spending or fiscal expansion gets amplified in case of open economy with fixed exchange rate in comparison to closed economy. This is due to the fact that the federal bank also needs to meet the exchange rate target in such a case. When the government spending increases, it causes a pressure in the economy which tries to increase the interest rate and also causes the appreciation of the domestic currency. This appreciation makes the federal bank to take steps through which it tries to purchase foreign currency from the domestic currency which causes the LM curve to shift outwards and increase in money supply in the economy (Gärtner, 2006). It can be seen in the diagram below where in an open economy with fixed exchange rate, where due to expansionary fiscal policy, the IS curve shifts to IS and due to increase in money supply the LM curve shifts to LM. This means that the output of the economy increases from Y to Y and also the interest rate and the exchange rate in the economy remain unchanged. The effect of the same expansionary fiscal policies in a closed economy is not as pronounced as in the open economy with fixed exchange rate. This is because in a closed economy, the upwards pressure on the interest rate causes rise in interest rate as there is no exchange rate mechanism through which the pressure on the interest rate can be released. With increase in interest rate, people tend to reduce their spending which means that the private spending in the economy reduces and thus the output of the economy doesn t get increased to the same level as would have been in the case of open economy with fixed exchange rate (Gärtner, 2006). This can be seen in the diagram below where although increase government spending has shifted the IS curve

7 to IS but when the economy reaches equilibrium, the interest rate in the economy increases from i0 to i1 and the output of the economy increases from Y0 to Y1. If however it was a fixed exchange rate economy, the LM curve to would have shifted to LM as shown in previous diagram which would have resulted in amplification of increase in the output of the economy and the interest rate in the economy remaining unchanged.

8 References Campbell, R. and Brue, S.L., (1990). Economics: Principles, Problems, and Policies (11th ed.). New York: McGraw-Hill. Case, K. and Fair, R. (1999). Principles of Economics (5th ed.). Prentice-Hall. Gärtner, M. (2006), Macroeconomics, Pearson Education Limited. Heijdra, B. J. and Ploeg, F. (2002), Foundations of Modern Macroeconomics, Oxford University Press. Henderson, J. and Quandt, R.E. (1980). Microeconomics Theory- A Mathematical Approach, McGraw Hill