ASSIGNMENT

On

Monetization of Fiscal Expansion

Course Title : Macro Economic Theory

Course Code : BUS-505

Slot : F2

Submitted To : Professor Dr. S. M. Ikhtiar Alam.

Professor, IBA-JU.

Submitted By

Name : Md. Shahed Monsur Rakib

ID : 201902036

E-mail : s.m.rakib09@gmail.com

Phone : 01521439603

Semester : 4th

Batch : 21st

Date of Submission: 18-12-2020

 IS Equation

Ā
b

𝟏 ̶ 𝒄 (𝟏 ̶ 𝒕)
Slope = −
𝒃

𝑰𝑺 𝑪𝒖𝒓𝒗𝒆

𝟎 ̅
𝐀 Y
𝟏 ̶ 𝒄 (𝟏 ̶ 𝒕)

̅.
We know that, AD = C + I + 𝑮
Here,
C = 𝐂̅ + c [Y ̶ t x Y+𝑻𝑹
̅̅̅̅] [⸪YD =Y-txY+𝑻𝑹
̅̅̅̅]

=> C = 𝐂̅ + c Y ̶ c x t x Y+ c̅̅̅̅̅
𝑻𝑹.
=> C = 𝐂̅ + c Y ̶ c x t x Y + c̅̅̅̅̅
𝑻𝑹
=> C = 𝐂̅ + Y [c ̶ c x t] + c̅̅̅̅̅
𝑻𝑹
=> C = 𝐂̅ + Y [c (1 ̶ t)] + c̅̅̅̅̅
𝑻𝑹.
Again,

I = I̅ ̶ b x ί [where b is the slope of investment demand curve and ί is the interest rate]
And
̅ . It will not change. It is autonomous.
The last one is 𝑮
Now the Equation is,
̅.
 AD = C + I + 𝑮
 AD = 𝐂̅ + Y [c (1 ̶ t)] + c𝑻𝑹 ̅.
̅̅̅̅ + 𝐼 ̅ ̶ b x ί + 𝑮
 AD = Ā + Y [c (1 ̶ t)] ̶ b x ί. [Here, 𝐂̅ + c𝑻𝑹 ̅ = Ā]
̅̅̅̅ + ̅𝑰 +𝑮

We know, each point on the IS curve represents the product market equilibrium. Where AD=Y. In
equilibrium,
 Y = AD
 Y = Ā + Y [c (1 ̶ t)] ̶ b x ί
 Y ̶ Y [c (1 ̶ t)] = Ā ̶ b x ί
 Y [1 ̶ c (1 ̶ t)] = Ā ̶ b x ί
Ā ̶ 𝒃𝒊
 Y=
𝟏 ̶ 𝐜 (𝟏 ̶ 𝒕)

Ā 𝒃
 Y= − x ί. [This is the IS Equation]
𝟏 ̶ 𝐜 (𝟏 ̶ 𝒕) 𝟏 ̶ 𝐜 (𝟏 ̶ 𝒕)
𝟏
 Y= (Ā − 𝒃)𝒙 ί.
𝟏−𝐜(𝟏−𝒕)
𝟏
So, in this equation is the National Income Multiplier and the slope of IS Equation is
𝟏−𝐜(𝟏−𝒕)
𝒃
− .
𝟏 ̶ 𝐜 (𝟏 ̶ 𝒕)

In the IS diagram we can see,

Ā Ā
If Y = 0, ί = , and if ί=o, then Y = .
𝒃 𝟏 ̶ 𝐜 (𝟏 ̶ 𝒕)
 𝒊

Ā′
b

̅↑
𝑮
Ā
b

𝟎 ̅
𝐀 ̅
𝐀′ Y
𝟏 ̶ 𝒄 (𝟏 ̶ 𝒕) 𝟏 ̶ 𝒄 (𝟏 ̶ 𝒕)

In Ā there is c̅̅̅̅̅
𝑻𝑹. If c increases, then Ā slightly increases. Thus, the IS curve shifts a bit and then rotate.
We generally ignore it for policy implications.
If any component of Ā↑, then IS curve will shift upward and vice versa. But its slope will not change.
So, the shift is always parallel. If, for instance, ̅
𝑮 ↑ then IS curve will shift upward as shown in the
diagram.
 LM Equation

LM Curve

0
Y

𝟏 𝐌̅
𝐱
𝐤 𝐏
𝟏 ̅
𝑴
ꟷ( 𝒙 )
𝒉 𝑷

̅ is the total money supply. If general price level is P, then real money supply
In this diagram, 𝑴
̅
𝐌
is .
𝐏

Money market equilibrium is achieved when demand for money is equal to supply of money.
We know, demand for money, MD = k Y ꟷ h × ί.

Therefore, in money market equilibrium:

̅
𝑴
 MD = ( 𝑷 )
̅
𝑴
 k Y ꟷ h × ί = (𝑷)
̅
𝑴
 h × ί = k Y ꟷ (𝑷)
𝟏 𝟏 ̅
𝑴
 ί= k Y ꟷ(𝒉 𝒙 𝑷 ).
𝒉

This is LM Equation. It represents the money market equilibrium.

So, in the LM diagram we can see,
𝟏 ̅
𝑴 𝟏 ̅
𝑴 𝟏 ̅
𝑴
If Y = 0, then ί = ꟷ(𝒉 𝒙 𝑷 ), and when ί = 0, Y =𝒌 𝒙 𝑷 . Here, ꟷ(𝒉 𝒙 𝑷 ) is the intercept of LM
𝟏 ̅
𝑴
curve and 𝒌 𝒙 𝑷 is the point on Y axis. Now we will connect these two points to get the LM curve.

𝑳𝑴𝟎
i ̅
𝟏 𝐌
𝐱 𝑳𝑴𝟏
𝐤 𝐏 ̅ ↑
𝑴

0
Y
𝟏 ̅𝐌′
̅̅̅
𝐱
̅
𝐤 𝐏
𝟏 𝑴
ꟷ( 𝒙 )
𝒉 𝑷

𝟏 ̅̅̅̅
𝑴′
ꟷ( 𝒙 )
𝒉 𝑷

̅ increases (𝑴
If 𝑴 ̅ ↑), the LM curve will shift to right and vice versa. Government can change 𝑴
̅
to shift LM curve upward or downward, given the price level.
 IS-LM Equilibrium

𝑷𝟎
IS Curve LM Curve
̅
𝑨
𝒃

𝑷𝟎
𝒊𝟎 A

𝟏 𝑴̅ ̅
𝑨
− × 𝒀𝟎 Y=
𝒉 𝑷𝟎 𝟏−𝒄(𝟏−𝒕)

𝟏 𝑴̅′
− ×
𝒉 𝑷𝟎

̅ will change but P is constant.

Diagram: Shifting LM Curve when 𝑴

LM Curve represent money market equilibrium. If M̅ (Money Supply) increases then LM curve will
shift to down-right side. So, the upper & lower LM curve intercept IS curve into point A & Y
respectively. And there create a range between A & Y. LM curve should be between this range
(point A & Y), this is called Monetary Policy Range. LM curve can’t goes up from point-A and can’t
goes down from point-Y. Govt. must maintain this range either to increase or to decrease in
money supply in the economy. Otherwise, the economy will not be equilibrium at all.
 𝐏𝟎
LM Curve

̅
𝐀 IS Curve
𝐏𝟏
𝐛

IP Curve IY Curve
𝐚
𝒃
𝒊𝟎

0
𝐏𝟎 𝒄 ̅
𝐀
𝐘𝟎 𝐘𝟏 =
𝟏 − 𝐜(𝟏 − 𝐭)

𝐏𝟎 AD Curve

𝟒𝟓𝐨 line

0 P=0 ̅
𝐀
𝐘𝟎 𝐘𝟏 =
𝟏 − 𝐜(𝟏 − 𝐭)

̅ is constant.
Diagram: Shifting LM Curve when P will change but 𝑴

So, in the diagram we see, IS and LM curve (𝐏𝟎 ) intercept each other in the point a. “a” is the equilibrium
point. In the equilibrium we get 𝒊𝟎 & 𝐘𝟎 . Also IS and LM equilibrium point creates two more curve which is IP
curve “0b” and I-y curve “bc”. IP and I-y curve intercept each other on point “b”. In this point “b”, we get the price
𝐏𝟎 . So, the highest interest rate and price is 𝒊𝟎 & 𝐏𝟎 .

In the same way, from 𝐏𝟏 LM curve, we get the interest rate i=0 and price P=0. So, the distance between 𝐏𝟎 to P=0
is the AD curve which is also a part of IS curve.
 ̅ Increase)
IS-LM Equilibrium (if 𝑮

IS Curve

𝐏𝟎

̅
↑𝐆
̅
𝐀
𝐏𝟏
𝒃 𝐛 e
𝐢𝟏

𝐚
𝐢𝟎

𝐢𝟐

0 ̅ ̅′
𝐀
𝐏𝟐 𝒄 𝐘𝟎 𝐀 𝐘𝟑 =
𝐏𝟎 𝐏𝟑 𝐘𝟏 =
𝟏 − 𝐜(𝟏 − 𝐭) 𝟏−𝐜(𝟏−𝐭)

𝐏𝟑 t

High hill
𝐏𝟎 s v

𝟒𝟓𝐨 line

0 ̅
𝐀 ̅′
P=0 𝐘𝟎 𝐘𝟏 = 𝐀
𝟏 − 𝐜(𝟏 − 𝐭) 𝐘𝟑 =
𝟏−𝐜(𝟏−𝐭)

̅, then the IS curve will shift from left to right upward parallel. And that new IS
If govt. increases 𝐆
curve will create a new equilibrium point “e”. Shifting IS curve will also increase the IP curve from
point-a to point-b. So, the interest rate will increase from 𝐢𝟎 to 𝐢𝟏 . New equilibrium point will also
create a new I-y Curve bc. So, IP & I-y curve intercept eachother in point-b. In this point the price
will also go up from 𝐏𝟎 to 𝐏𝟑 . According to IP curve, if interest rate goes up then price will also go
up.

In the same way, from 𝐏𝟏 LM curve, interest increase from i=0 to 𝐢𝟐 and price P=0 to 𝐏𝟐 . So the distance
between 𝐏𝟐 to 𝐏𝟑 is the AD curve which is also a part of IS curve. And the high hill is the distance from p=0 to
𝐏𝟐 which is v𝐘𝟑 line.
 Monetization of Fiscal Expansion

P0

̅
↑G P𝑟
Inflation ̅
A
P1
b
i1

i0 P𝑞

i2

0 P𝑘 Y0
̅
𝐀
P2 P0 Pm P3 P4 𝐘𝟏 =
𝟏 − 𝐜(𝟏 − 𝐭)

P4 Choke Price
NO HH

P3
Pm

P0

P2
o
45 line

0 ̅
A ̅′
A
P=0 Y0 Y1 =
1 − c(1 − t) Y3=
1−c(1−t)

Fiscal expansion happened when govt. increases 𝑮 ̅ . If govt. increases money supply then LM curve will
shift to downward. Shifting downward of LM curve will decrease interest rate and value of money
(cause interest and price has positive relationship). But, if govt. artificially controls the interest rate,
then the 𝐏𝟎 LM curve will shift to the 𝐏𝒓. Due to high inflation the value of the money will decrease and
interest rate falls down. And I-S curve will reduce its length and will shift to the right which will indicate
higher price. But I-Y curve becomes shorter in length and will fixed in position.

So it creates maximum interest rate 𝐢𝟎 and minimum is i=0. At 𝐢𝟎 the price is 𝐏𝟒 and at i=0 the price is
𝐏𝒎 . So the new AD curve will be between 𝐏𝒎 & 𝐏𝟒 . there is no high hill in this AD curve.
If the price continuously increases due to inflation, the price will reach to the point 𝐏𝒌 . This point is
called “Choke Price”. At this price level there will be no demand of the food. Because the price is very
high.

If inflation continuous, purchasing power will fall down, rich will make more money and poor will
become poorer. This will destroy social norms, values, honesty, humanity etc. These are known as SIX-
FACTOR MODEL:

• Political Distortion (Autocracy);

• Bureaucratic/Administrative Distortion (Bribery and Nepotism);
• Judicial Distortion (Dependence of judiciary on autocratic govt.),
• Economic Distortion (income Inequality and Poverty);
• Socio-cultural Distortion, and
• Honesty Distortion (Lack of Honesty).

∆𝐘 𝟏
=
̅ 𝟏−𝐜(𝟏−𝐭)
∆𝐆

𝟏
 ∆𝒀 = ̅
X ∆𝐆
𝟏−𝐜(𝟏−𝐭)

If ∆𝐆̅ is 10000tk , then

= 2.7 X 10000 = 27000.
 Short-Run Phillips Curves
It is a graphical chart of describing the opposite relationship between inflation rate and
unemployment rate.

P, 𝛑 LRAS
𝛑

SRSC

8% 8%
5.5%
5.5%
5%
5%
3% 3%

2% 2%
𝐀𝐃𝟏 0 8% 10% 13% 15% 18% 𝐔𝐧𝐞𝐦𝐩𝐥𝐨𝐲

-1% -1% 𝐦𝐞𝐧𝐭 𝐑𝐚𝐭𝐞

𝐀𝐃𝟎

w
SRPC

18%
13% 10% 8%
15%
Yf
𝑼𝒏𝒆𝒎𝒑𝒍𝒐𝒚𝒎𝒆𝒏𝒕 𝑹𝒂𝒕𝒆
0

Short-run Philips curves indicates that there is a opposite relation between unemployment and
inflation rate in the short run. This relationship either convex or linear. Also, it can be statistical
zigzag. If inflation (𝝅) increases then unemployment will decrease and vice-versa.

In this graph, NRU (National Rate of Unemployment) = 10%, where 𝑨𝑫𝟎 curve and SRSC intercept each
other, and inflation rate is 3%. When AD curve shift to upward, the inflation will increase to 5% and
unemployment rate will decrease to 8%. If AD curve shift to downward, the inflation will decrease to -
1% and unemployment rate will increase to 15%. If we add all the combination of AD curve changes it
will create a downward slope. This slope is called Short-Run Phillips Curve (SRPC).

So, we can see that, this model is also supports the opposite/inverse relationship between inflation
rate and unemployment rate in the short run.