IS-LM-BP model

The IS-LM-BP model (also known as IS-LM-BoP or Mundell-Fleming model) is an

extension of the IS-LM model, which was formulated by the economists Robert
Mundell and Marcus Fleming, who made almost simultaneously an analysis of open
economies in the 60s. Basically we could say that the Mundell-Fleming model is a
version of the IS-LM model for an open economy. In addition to the balance
in goods and financial markets, the model incorporates an analysis of the balance of
payments.

Even though both economists researched about the same topic, at about the same
time, both have different analyses. Mundell’s paper “Capital Mobility and Stabilization
Policy under Fixed and Flexible Exchange Rates”, 1963, analyses the case of
perfect mobility of capital, while Fleming´s model, depicted in his article “Domestic
Financial Policies under Fixed and under Floating Exchange Rates”, 1962, was more
realistic as it assumed imperfect capital mobility, and thus made this one a more
rigorous and comprehensive model. However, nowadays, his model has lost cogency,
as the actual world situation has more resemblance with total capital mobility, which
corresponds better to Mundell’s view.

In order to understand how this model works, we’ll first see how the IS curve, which
represents the equilibrium in the goods market, is defined. Secondly, the LM curve,
which represents the equilibrium in the money market. Thirdly, the BP curve, which
represents the equilibrium of the balance of payments. Finally, we’ll analyse how the
equilibrium is reached.

IS curve: the market for goods and services

In an open economy, the equilibrium condition in the market for goods is

that production (Y), is equal to the demand for goods, which is the sum
of consumption, investment, public spending and net exports. This relationship is called
IS. If we define consumption (C) as C = C(Y-T) where T corresponds to taxes, the
equilibrium would be given by:

Y = C(Y-T) + I + G + NX
We consider that investment is not constant, and we see that it depends mainly on two
factors: the level of sales and interest rates. If the sales of a firm increase, it will need to
invest in new production plants to raise production; it is a positive relation. With regard
to interest rates, the higher they are, the more expensive investments are, so that the
relationship between interest rates and investment is negative. Now, in addition to what
we have in the IS-LM model, since we have net exports, we have also to take into
account the exchange rates, which directly affect net exports. Let’s say e is the
domestic price of foreign currency or, in other words, how many units of our own
currency have to be given up to receive 1 unit of the foreign currency. The new
relationship is expressed as follows (where i is the interest rate):

Y = C (Y- T) + I (Y, i) + G + NX(e)

If we keep in mind the equivalence between production and demand, which

determines the equilibrium in the market for goods, and observe the effect of interest
rates, we obtain the IS curve. This curve represents the value of equilibrium for any
interest rate.

An increasing interest rate will cause a reduction in production through its effect
on investment. Therefore, the curve has a negative slope. The adjacent graph shows
this relationship.

As stated before, we also need to analyse changes in exchange rates (here, e). If

e decreases, then we’ll be able to buy more foreign currency with less of our own
currency. On the other hand, foreigners we’ll need to pay more of their currency to buy
our own. Therefore, when e decreases, also called an appreciation under flexible
exchange rates or a revaluation under fixed exchange rates, domestic residents have
more purchasing power, thus being able to buy the same amount of goods using less
domestic currency. The opposite works in the same way: if e increases (also called a
depreciation under flexible exchange rates or a devaluation under fixed exchange
rates), domestic residents will pay more for the same goods. To sum up, an increase in
e causes net exports to increase (IS curve shifts to the right) and a decrease in e
causes net export to decrease (IS curve shifts to the left).

 LM curve: the market for money

The LM curve represents the relationship between liquidity and money. In an open
economy, the interest rate is determined by the equilibrium of supply and demand for
money: M/P=L(i,Y) considering M the amount of money offered, Yreal income and i real
interest rate, being L the demand for money, which is function of i and Y. Also, the
exchange rate must be analysed since it affects money demand (investors may decide
buy or sell bonds in a country depending on the exchange rate).

The equilibrium of the money market implies that, given the amount of money,
the interest rate is an increasing function of the output level. When output increases, the
demand for money raises, but, as we have said, the money supply is given. Therefore,
the interest rate should rise until the opposite effects acting on the demand for money
are cancelled, people will demand more money because of higher income and less due
to rising interest rates.

The slope of the curve is positive, contrary to what happened in the IS curve.
This is because the slope reflects the positive relationship between output and interest
rates.

 
BP curve: the balance of payments

The BP curve shows at which points the balance of payments is at

equilibrium. In other words, it shows combinations of production and interest rates that
guarantee that the balance of payments is viably financed, which means that the
volume of net exports that affect total production must be consistent with the volume
of net capital outflows. It will usually slope up since the higher the production, the higher
the imports, which will disturb the equilibrium of the balance of payments, unless
interest rates rise (which would cause capital inflows to maintain the equilibrium).
However, depending in how great the mobility of capital is, it will have a greater or
smaller slope: the higher the mobility, the flatter the curve.

Once the BP curve is derived, there is an important thing to know about how to use it.
Any point above the BP curve will mean a balance of payments surplus. Any points
below the BP curve will mean a balance of payments deficit. This is important since
depending where we are, different things may affect the interest rates.

The IS-LM-BP model

In the model we distinguish between perfect and imperfect capital mobility, but also
between fixed and flexible exchange rates. For each of these cases, we’ll see what
happens when both an expansionary monetary and fiscal policy are applied to the
economy. We’ll first review Mundell’s model, which deals with perfect mobility. Then,
we’ll analyse Fleming’s imperfect mobility model.

 
1 Perfect capital mobility

1.1 Fixed exchange rate

An expansionary monetary policy will shift the LM curve to LM’, which makes the
equilibrium go from point E0 to E1. However, since we are below the BP curve, we know
the economy has a balance of payments deficit. Since exchange rates are
fixed, government intervention is required: the government will purchase domestic
currency and sell foreign currency, which will drop the money supply and therefore shift
the LM’ curve to its original position (which makes the equilibrium go to E 2). Monetary
policy has therefore no effect under these circumstances.

An expansionary fiscal policy will shift the IS curve to IS’,

moving the equilibrium form point E0to point E1. Since the economy has now a balance
of payments surplus, and because the exchange rate is fixed, government will intervene
in the exact opposite way: they’ll purchase foreign currency and sell domestic currency.
This will increase the money supply, shifting the LM curve to the right. The final
equilibrium is reached at point E2 where, at the same interest rate, production has
increased greatly: fiscal policy works perfectly under these circumstances.

1.2 Flexible exchange rate

An expansionary monetary policy will shift the LM curve to

LM’, which makes the equilibrium go from point E 0 to E1. However, since now exchange
rates are flexible, we have a different situation: the balance of payments deficit will
depreciate the domestic currency. This will increase net exports (since foreigners can
now buy more of our products with the same amount of money), which will shift the IS
curve to the right (to IS’). The final equilibrium is reached at point E 2 where, at the same
interest rate, production has increased greatly: monetary policy works perfectly under
these circumstances.

 
 An expansionary fiscal policy will shift the IS curve to IS’,
moving the equilibrium from point E0to point E1. The economy will therefore have a
balance of payments surplus, which in this case of flexible exchange rate will appreciate
the domestic currency. This will decrease net exports, since we are able to import more
goods and services with less money, while foreigners will import less of our products
because of our appreciated domestic currency. This drop in net exports will shift the IS’
curve back to its original position. Since now the final equilibrium E 2 corresponds to the
initial equilibrium, we know fiscal policy is no good in this case.

It is easy to see why Mundell devised what is known as the impossible trinity. In a few
words, no economy can have the following three: perfect capital mobility, fixed
exchange rates and an independent and efficient monetary policy. Under the perfect
capital mobility assumption, and in order to have an efficient monetary policy, exchange
rates must be flexible. Or have fixed exchange rates but assume that monetary policy
won’t be efficient.
2 Imperfect capital mobility

2.1 Fixed exchange rate

Here we have the exact same situation as before: an expansionary monetary policy will
shift the LM curve to LM’, which makes the equilibrium go from point E 0 to E1. However,
since we are below the BP curve, we know the economy has a balance of payments
deficit. Since exchange rates are fixed, the government will purchase domestic currency
and sell foreign currency, which will drop the money supply and therefore shift the LM’
curve to its original position (which makes the equilibrium go to E 2). Monetary policy has
again no effect, no matter how great or small capital mobility is.

An expansionary fiscal policy will shift the IS curve to IS’, moving the equilibrium from
point E0to point E1. Now, depending on capital mobility, we’ll either have a balance of
payments surplus (high capital mobility, BP+ curve) or a balance of payments deficit
(small capital mobility, BP- curve). Since exchange rates are fixed, government will
need to intervene: its acquisitions and disposals of both domestic and foreign currency
will shift the LM curve to either LM’ or to LM* (you can review what happens above: a
balance of payments surplus is the same scenario as in a fiscal policy with perfect
capital mobility and fixed exchange rates, while the balance of payments deficit
corresponds to the monetary policy scenario). Under these circumstances, fiscal policy
is completely efficient. It’s actually the more efficient the higher capital mobility is.

2.2 Flexible exchange rate

An expansionary monetary policy will shift the LM curve to

LM’, which makes the equilibrium go from point E 0 to E1. However, since now exchange
rates are flexible, the balance of payments deficit will depreciate the domestic currency.
This will increase net exports, shifting the IS curve to IS’. Also, since domestic assets
are less expensive, the BP curve will shift to the right (to either BP’+ or BP’-). Therefore,
with high capital mobility, final equilibrium will be at point E 2. Monetary policy works well
under these assumptions. It’s actually the more efficient the higher capital mobility is.

 
An expansionary fiscal policy will shift the IS curve to IS’, moving the equilibrium from
point E0to point E1. Now, depending on capital mobility, we’ll either have a balance of
payments surplus (high capital mobility, BP+ curve) or a balance of payments deficit
(small capital mobility, BP- curve). In the case of a balance of payments surplus, and
considering flexible exchange rates, there will be an appreciation of the domestic
currency. This will decrease net exports, which will shift the IS’ curve to the left. Also,
since domestic assets are more expensive, the BP+ curve will shift to the left. The final
equilibrium will therefore be at point E2. If there is a balance of payments deficit (the
case for the BP- curve), the result will be the same one as in the monetary policy case
(being E2* the final equilibrium). In this scenario, fiscal policy will be more efficient the
smaller capital mobility is.

The Mundell-Fleming model is a very useful tool when dealing with the analysis of open
economies. A great deal of textbooks and papers argue for or against each of these
models. However, there’s no denying the world is moving towards
liberalizing international trade and capital movements (mostly through WTO’s
agreements), which would make us lean towards Mundell’s view. To sum up, under
perfect capital mobility, monetary policy will only work with flexible exchange rates,
while fiscal policy will only work with fixed exchange rates.
Attempts at incorporating the foreign sector into the Keynesian model were pursued
famously by James Meade (1951) and Jan Tinbergen (1952) - largely in response to the
elasticity-absorption debate that was then raging in balance of payments theory.
However, the most successful attempt at integrating the foreign sector into the Neo-
Keynesian system has been the "Mundell-Fleming Model", the outcome of the research
conducted by Robert Mundell (1962, 1963) and J.M. Fleming (1962) while at the
International Monetary Fund (IMF).

The "Mundell-Fleming" model extends of the IS-LM apparatus to incorporate balance of

payments considerations, which has proved quite useful in analyzing international
macroeconomic policy. To begin with, let us take the simplest open economy model. In
this case, aggregate demand can be defined as:

Yd = C + I + G + NX

where NX are net exports (exports minus imports). We can break NX into the following:

NX = X0 - mY

where X0 are exports and mY are imports. This form implies that a particular economy's
exports are exogenous (X0) but that its imports are a function of its own national
income, Y. Note that m is the marginal propensity to import out of income and we
assume that 0 < m < 1. We obtain goods market equilibium when aggregate supply
meets aggregate demand, Y = Yd or, assuming the simplest consumption function C =
C0 + cY, investment function I = I0 + I(r) and assume exogenous government spending
G = G0, we obtain in equilibrium:

Y* = [C0 + I0 + I(r) + G0 + X0]/(1- c + m)

so exports enter as an autonomous term (X0) whereas the marginal propensity to
import is incorporated in the multiplier. In order for this equilibrium to exist, we must
assume that 0 < c - m < 1, so that the sum of the marginal propensity to import and the
marginal propensity to consume is a fraction. Notice that the open economy multiplier,
1/(1-c-m) is smaller than the closed economy one, 1/(1-c). In relative terms, the IS curve
is steeper in an open economy than in a closed economy.

However, these relations are far too simplistic: domestic actions, by affecting interest
rates, exchange rates and foreign income levels, may affect net exports in more ways.
The Mundell-Fleming model incorporates some of these effects into the IS-LM model.
Let us define the balance of payments surplus as the sum of the current account
surplus and capital account surplus, or:

BP = NX + KA

where NX is the current acount (i.e. net exports) and KA is the capital account
(domestic assets owned by foreigners minus foreign assets owned by domestic
citizens). If BP > 0 then we have a balance of payments surplus; conversely, if BP < 0
we have a balance of payments deficit. Balance of payments equilibrium is achieved
when BP = 0.

To enrich the relationships, let us argue that net exports are a function of the real
exchange rate, eP/P* where e is the nominal exchange rate (domestic country's
currency units per foreign country's currency unit, e.g. dollars per yen), P the domestic
price level and P* the foreign/world price level as well as income. Thus we can express
net exports as a function:

NX = T(Y, eP/P*)
thus TY < 0 (as income increases, imports increase and thus net exports fall - effectively
the same as our previous marginal propensity to import), and dT/d(eP/P*) < 0 (as the
real exchange rate rises, net exports fall due to the lower "competitiveness" of exports).
Note that the famous "Marshall-Lerner" conditions must be met in order for this last
statement to be true. Assuming P, P* are fixed then we can write this relationship simply
as NX = T(Y, e).

In contrast, the capital account is a function of the difference between domestic interest
rates and foreign interest rates, specifically:

KA = k(r - r*)

where dk/d(r-r*) > 0 so that if domestic interest rates rise relative to foreign interest
rates, then the domestic capital account increases as the greater relative attractiveness
of domestic assets implies that domestic and foreign citizens will buy up domestic
assets and drop foreign assets.

In Figure 8 we have superimposed the external balance locus BP on the IS-LM model.
Every point on the BP locus represents a balance of payments equilibrium, BP = 0. Let
us assume that exchange rates and price levels are fixed (thus e, P and P* are
exogenous) and foreign interest rates are fixed (r* exogenous). Thus, only r and Y are
allowed to fluctuate. As a result, a given Y will yield a particular NX whereas a given r
will yield a particular KA. So a point on the BP locus is a combination of r and Y that
yields BP = NX + KA = 0.

The reason for the upward sloping shape of the BP curve is the great advance of
Mundell-Fleming model over the older Keynesian model of Meade (1951). Suppose we
begin with BP = 0 at some initial Y and r configuration. If Y increases, then NX falls and
thus BP < 0. Thus, in order for BP to return to zero, it is necessary for KA to rise - thus
domestic interest rates (r) must rise. Thus, there is a positive relationship between Y
and r representing the balance of payments equilibrium. The slope of the BP curve is
positively related to the marginal propensity to import TY and negatively related to the
interest sensitivity of international capital flows, kr. Thus, if there is absolutely no capital
mobility (kr = 0), then the BP curve will be completely vertical whereas if there is perfect
capital mobility (kr = ï½¥ ), then the BP curve will be horizontal.

Under a fixed exchange rate regime, there is no obvious reason that we will necessarily
be at BP = 0. In other words, the IS-LM equations will yield a particular (Y*, r*) that may
or may not be where BP = 0. If equilibrium (Y*, r*) is to the right of the BP curve (e.g. at
point F in Figure 8), then we have a balance of payments deficit (BP < 0); if (Y*, r*) is to
the left of the BP curve (e.g. at point G in Figure 8), then we have a balance of
payments surplus.

The implications for fiscal and monetary policy are obvious. Beginning at the equilibrium
point E in Figure 8 where BP = 0 prevails, we can immediately notice that a monetary
policy expansion (a rightward shift in LM to LMï½¢ ) will yield a new equilibrium F which
is below the BP curve, thus we obtain a balance of payments deficit. In other words,
from the money supply increase, the consequent rise in Y has driven the current
account towards deficit and the fall in r has driven the capital account towards deficit -
thus the balance of payments is now in deficit. In contrast, starting from E, a fiscal policy
expansion (rightward shift in IS to ISï½¢ ) will drive the economy to a balance of
payments surplus at point G. Here the reasoning is more subtle: the rise in Y has driven
the current account towards deficit but the rise in r has driven the capital account
towards surplus. The net result depends on the relative slopes of the LM and BP
curves. If LM is steeper than BP, then the net result is a balance of payments suplus; if
LM is flatter than BP, then the net result is a balance of payments deficit. Thus, the
relative sensitivity of international capital flows and income sensitivity of imports are the
crucial factors in determining whether an expansionary fiscal policy leads to external
deficits or surpluses.

figure8.gif (3459 bytes)

Figure 8 - Mundell-Fleming IS-LM with Fixed Exchange Rates

Although fiscal and monetary policy can lead to balance of payments surpluses and
deficits, the implication of the Mundell-Fleming model is that one can use a combination
of fiscal and monetary policy to increase output without inducing a balance of payments
deficit or surplus. This is obvious again in Figure 8 where beginning at E, we can
undertake both a fiscal and monetary policy expansions (say, IS to ISï½¢ and LM to
LMï½¢ ) in such a manner that the resulting equilibrium will be a balance of payments
equilibrium (e.g. H in Figure 8).

Of course, things are never quite this simple. A balance of payments surplus
corresponds to an excess supply of foreign currency which must be bought by the
Central Bank; similarly, a balance of payments deficit implies there is an excess
demand for foreign currency which must be provided by the Central Bank. However, the
Central Bank pays for its purchase of foreign currency with domestic currency and when
it sells its foreign currency, it withdraws domestic currency from circulation. Thus, a
balance of payments surplus/deficit will increase/decrease the money supply of the
economy because the central bank must purchase/sell foreign exchange. As a result,
balance of payments surpluses and deficits are not sustainable on their own.

For example, suppose there is a monetary policy expansion such that we obtain a
balance of payments deficit (as at point F in Figure 8) and thus an excess demand for
foreign exchange. The consequent fall in the supply of domestic money as the
government sells foreign exchange will gradually shift the LMï½¢ back to LM and thus
equilibrium will return to E. In order to maintain the position at F, the Central Bank must
conduct what are known as "sterilization policies". This means that by open market
operations or some other domestic tool, the Central Bank increases the domestic
money supply exogenously by exactly the same amount as it that money supply was
decreased by the foreign exchange sales required to maintain the balance of payments
deficit. Thus, the Central Bank "sterilizes" the monetary effects of balance of payments
disequilibrium with monetary policy. To sustain a balance of payments surplus, the
Central Bank's sterilization policy works in reverse.
It is important to note the implications of different policies under different degrees of
capital mobility and different exchange rate regimes and sterilization policies. If we
maintain the assumption of fixed exchange rates and no sterilization policies, then it is
obvious that fiscal policy is more effective than monetary policy. To see this, examine
Figure 8 again. Beginning at E, a monetary expansion will shift LM to LMï½¢ and thus
achieve a balance of payments deficit at point F. However, without sterlization, money
supply will decline and consequently LM will shift leftwards back to LM and we return
from F to E. Thus, monetary policy was completely ineffective at increasing output. In
contrast, suppose that, beginning at E, we undertake a fiscal expansion and shift IS to
ISï½¢ and therefore have a balance of payments surplus at point G. Without
sterilization, a balance of payments surplus implies that the money supply will increase,
therefore shifting LM rightwards to LMï½¢ . The new equilibrium, at point H, is the
resulting long-run position. Thus, output has increased tremendously in this case
because the money supply movements in the absence of sterilization reinforce the
original fiscal expansion. Thus, under fixed exchange rates, fiscal policy is highly
effective and monetary policy is ineffective.

Of course, the effectiveness of fiscal policy depends on the degree of capital mobility. If
there is no capital mobility so that BP is a vertical line, then notice that both
expansionary fiscal and monetary policies are completely ineffective in increasing
output. This is because all expansions yield balance of payments deficits and thus lead
to reductions in the money supply that bring output back down. In contrast, under
perfect capital mobility, when the BP curve is horizontal, monetary policy is again
ineffective, but fiscal policy is fully effective, i.e. output rises the full amount of the fiscal
expansion as the consequent increase in money supply in the absence of sterilization
implies that there will be absolutely no rise in interest rates.

We should note here that James Meade (1951) only considered the "no capital mobility"
case (vertical BP). Consequently, in order for fiscal or monetary expansion to affect
output, Meade argued that the BP locus must be shifted outwards by means of a
different and often complicated class of policies seeking to affect net exports, e.g.
exchange rate changes, subsidies, quotas, tariffs, etc. The analysis of the impact of
such "expenditure-switching" policies were pursued by economists in the 1950s,
particularly W.E.G. Salter (1959) and Trevor Swan (1960). It was only in the 1960s,
after the arrival of the Mundell-Fleming model which allowed for more capital mobility,
that economists realized that internal and external balance could be achieved solely by
means of an optimal mix of fiscal and monetary policy without requiring any delicate and
complicated expenditure-switching policies.

The analysis gets quite different under flexible exchange rates. Recall that if the real
exchange rate rises, then NX falls for any level of income. As a result, there are two
effects of a rise in exchange rates: the BP curve shifts upwards and the IS curve shifts
leftwards. Conversely, a fall in the real exchange rate implies a rise in NX and thus a
rightward shift in the BP curve and a rightwward shift in the IS curve. Under a flexible
exchange rate regime, there will be none of the rises and falls in money supply due to
balance of payments surpluses or deficits. Rather, balance of payments
surpluses/deficits result in rises/falls in the real exchange rate and thus movements in
the BP and IS curves rather than the LM curve.

The implications of flexible exchange rates for fiscal and monetary policies can be
visualized in Figure 9. Suppose we begin at E = (r*, Y*) at the intersection of the curves
IS, LM and BP and suppose there is a monetary policy expansion from LM to LMï½¢ .
As a result, we move from E to F, where we are in a balance of payments deficit. At F,
there is excess demand for foreign currency and excess supply of domestic currency on
the foreign exchange market. Under a flexible exchange rate regime, this implies that
the real exchange rate will fall, therefore shifting BP rightwards to BPï½¢ and IS
rightwards to ISï½¢ so that we are now at point J - at a higher equilibrium output level
YJ*. Notice that external and internal balance obtain at point J as we have the
intersection of ISï½¢ , LMï½¢ and BPï½¢ . Thus, under a flexible exchange rate regime
(and unlike a fixed exchange rate regime), monetary policy is quite effective in
increasing output.

figure9.gif (4099 bytes)

Figure 9 - Mundell-Fleming IS-LM with Flexible Exchange Rates

In contrast, fiscal policy under flexible exchange rates is more ambiguous. In Figure 9,
beginning at point E, suppose we have a fiscal policy expansion that drives our IS curve
to ISï½¢ ï½¢ at point G. However, at point G, we have a balance of payments surplus
and thus there will be a rise in the exchange rate which, in turn, shifts BP upwards to
BPï½¢ ï½¢ and IS backwards from ISï½¢ ï½¢ to ISï½¢ . A new equilibrium is achieved
at point K, the intersection of ISï½¢ , LM and BPï½¢ ï½¢ . Obviously, in relative terms,
such a fiscal expansion is less powerful under a flexible exchange rate regime than
under a fixed exchange rate regime.

However, appropriate modifications to this story must be made if fiscal policy

expansions lead to balance of payments deficits rather then surpluses (as would result if
BP was steeper than the LM curve). In this case, an expansionarly fiscal policy would
lead to a deficit and thus a consequent fall in exchange rate, thereby shifting IS and BP
outwards. In this particular case, then, the fiscal policy effect on output would be more
powerful under a flexible exchange rate regime than under a fixed exchange rate
regime.
The classical model:

Determination of Output and Employment • Output and employment are

determined by the production function and the demand for labour and the supply of
labour in the economy. • This is shown in the form of the following production function: •
Q=f (K, T, N) where total output (Q) is a function (f) of capital stock (K), technical
knowledge (T), and the number of workers (N)

Dn • The demand for labour Dn and the supply of labour Sn determine the level
of output and employment • The demand for labour as the function of the real wage
rate: Dn =f (W/P) • Where Dn = demand for labour, W = wage rate and P = price level. •
Dividing wage rate (W) by price level (P), we get the real wage rate (W/P)

Dn • The demand for labour is a decreasing function of the real wage rate, as
shown by the downward sloping Dn curve in Fig. 2. • It is by reducing the real wage rate
that more workers can be employed.

Sn • The supply of labour also depends on the real wage rate: Sn =f (W/P),
where Sn is the supply of labour. • But it is an increasing function of the real wage rate,
as shown by the upward sloping Sn curve in Fig. 2. • It is by increasing the real wage
rate that more workers can be employed.

Equilibrium • When the Dn and Sn curves intersect at point E, the full

employment level Nf is determined at the equilibrium real wage rate W/P0. • If the wage
rate rises from WP0 to WP1 the supply of labour will be more than its demand by ds.

unemployment • Now at W/P1 wage rate, ds workers will be involuntary

unemployed because the demand for labour (W/P1-d) is less than their supply (W/P1-
s). • With competition among workers for work, they will be willing to accept a lower
wage rate. Consequently, the wage rate will fall from W/P1 to W/P0.

• The supply of labour will fall and the demand for labour will rise and the
equilibrium point E will be restored along with the full employment level Nf. • On the
contrary, if the wage rate falls from W/P0 to WP2 the demand for labour (W/P2-d1) will
be more than its supply (W/P2-s1). • Competition by employers for workers will raise the
wage rate from W/ P2 to W/P0 and the equilibrium point E will be restored along with
the full employment level Nf.
 The complete classical model of income and employment determination in an
economy in Fig. 3.7. In panel (a) of this figure labour market equilibrium is shown
wherein it will be seen that the intersection of demand for and supply of labour
determines the real wage rate (W0/P0 ).

At this equilibrium real wage rate the amount of labour employed is N1; and, as
explained above, this is full employment level. As depicted in panel (b) of the figure this
full employment level of labour N1 produces Y1 level of output (or income).

In panel (c) of Figure 3.7 we have drawn 45° line that is used to transfer the level
of output on the vertical axis in panel (b) to the horizontal axis of panel (c). In panel (d)
we have shown the determination of price level through intersection of the curves of
aggregate demand for and aggregate supply of output, as explained by the quantity
theory of money. In the classical theory, aggregate supply curve AS is a vertical straight
line at full-employment level of output YF.

Determination of Income and Employement: Complete Classial Model

Thus, given constant velocity of money V, the quantity of money M0 will

determine the expenditure or aggregate demand equal to M0V according to which
aggregate demand curve (with flexible prices) is AD0. It will be seen from panel (d) of
Fig. 3.7 that intersection of vertical aggregate supply curve AS at fully-employment level
output YF and aggregate demand curve AD0 determines the price level P0. With price
level at P0, the money wage rate is W0 so that W0/P0 is the real wage rate as
determined by the intersection of demand for and supply of labour [see panel (a) of Fig.
3.7].

Now, a relevant question is how this equilibrium level of real wage rate, prices,
employment and output (income) will change following the increase in the quantity of
money. Suppose the quantity of money increases from M0 to M1 with the given capital
stock (as we are considering the short-run case) and the labor force being already fully
employed, the output cannot increase. Therefore, as depicted in panel (d) following the
increase in money supply to M1, aggregate demand or expenditure will increase to M1
V and thereby causing aggregate demand curve to shift to AD1. As a result, price level
rises from P0 to P1.

However, as explained above, with the given money wage rate W0, the rise in
price level from P0 to P1 will cause a fall in real wage rate. As will be seen from panel
(a), with the rise in price level to P1 real wage rate falls to W0/P1.

This will cause temporary disequilibrium in the labour market. At the lower real
wage rate W0/P1, more labour is demanded than is supplied. Given the competition
among the firms, this excess demand for labour will cause the money wage rate to rise
to W1 level so that the real wage is bid up to the original level W1/P1 = W0/P0.