Classical Theory of Income and Employment

RAU'S IAS
STUDY CIRCLE
BLUE WORKBOOKS
ECONOMICSby Dr. J.C. Sharma

OPTIONAL
SUBJECT
UNIT-2 : ADVANCED MACRO ECONOMICS

1. Classical Theory: An Economy in the Long Run
2. Short Term Fluctuations in Output and Employment:
3. The Model of Aggregate Supply and Aggregate Demand
4. Keynesian Theory of Output, Income & Employment
5. Alternative Theories of Rate of Interest
6. Building the IS–LM Model: Interaction between Real and
Financial Sectors for Simultaneous Determination of Level
of Income and Rate of Interest
7. Analysis of Economic Fluctuations in an Open Economy:
The Mundell–Fleming Model
8. Aggregate Supply and the Short-Run Trade-off Between
Inflation and Unemployment
INDEX
ECONOMICS (OPTIONAL)
PAPER - I
UNIT – II : ADVANCED MACROECONOMICS

The syllabus of the Unit is prescribed as below:
 Approaches to Employment; Income and Interest rate Determination;
 Classical Theory of Income and Employment
 Keynes and Neo-Classical Theories of Interest Rate Determination
 Keynes Theory of Income And Employment
 Synthesis of Classical and Keynes Theories(IS-LM Analysis)
 Interest Rate Structure (covered in the Notes on Money, Banking and Finance)
The syllabus, keeping in the view the previous years question papers, has been
organized in following Chapters:
INDEX
CHAPTER TITLE OF THE CHAPTER PAGE NO.
Chapter 1 Classical Theory: An Economy in the Long Run 1-25

Chapter 2 Short Term Fluctuations in Output and Employment: 26-34
The Model of Aggregate Supply and Aggregate Demand
Chapter 3 Keynesian Theory of Output, Income & Employment 35-59
Chapter 4 Alternative Theories of Rate of Interest 60-76
Chapter 5 Building the IS–LM Model: Interaction between Real and 77-119
Financial Sectors for Simultaneous Determination of Level of
Income and Rate of Interest
Chapter 6 Analysis of Economic Fluctuations in an Open Economy: The 120-135
Mundell–Fleming Model
Chapter 7 Aggregate Supply and the Short-Run Trade-off Between 136-146
Inflation and Unemployment
1 Classical Theory: The
CHAPTER Economy in the Long Run
What Macroeconomists Study?
Why have some countries experienced rapid growth in incomes over the past century while others stay mired in
poverty? Why do some countries have high rates of inflation while others maintain stable prices? Why do all
countries experience recessions and depressions—recurrent periods of falling incomes and rising unemployment—
and how can government policy reduce the frequency and severity of these episodes? Macroeconomics, the study
of the economy as a whole, attempts to answer these and many related questions.
Because the state of the economy affects everyone, macroeconomic issues play a central role in national political
debates. Although the job of making economic policy belongs to world leaders, the job of explaining the workings
of the economy as a whole falls to macroeconomists. Toward this end, macroeconomists collect data on incomes,
prices, unemployment, and many other variables from different time periods and different countries. They then
attempt to formulate general theories to explain these data. Macroeconomists observe that economies differ across
countries and that they change over time. These observations provide both the motivation for developing
macroeconomic theories and the data for testing them. While the basic principles of macroeconomics do not
change from decade to decade, the macroeconomist must apply these principles with flexibility and creativity to
meet changing circumstances.
Macroeconomists study many facets of the economy. For example, they examine the role of saving in economic
growth, the impact of minimum-wage laws on unemployment, the effect of inflation on interest rates, and the
influence of trade policy on the trade balance and exchange rate. Economists use models to address all of these
issues, but no single model can answer every question. Just as carpenters use different tools for different tasks,
economists use different models to explain different economic phenomena. Students of macroeconomics, therefore,
must keep in mind that there is no single “correct’’ model that is always applicable. When using a model to address
a question, the economist must keep in mind the underlying assumptions and judge whether they are reasonable for
studying the matter at hand.
Microeconomic Thinking and Macroeconomic Models
Microeconomics is the study of how households and firms make decisions and how these decision makers interact
in the marketplace. A central principle of microeconomics is that households and firms optimize—they do the best
they can for themselves given their objectives and the constraints they face. In microeconomic models, households
choose their purchases to maximize their level of satisfaction, which economists call utility, and firms make
production decisions to maximize their profits. Because economy-wide events arise from the interaction of many
households and firms, macroeconomics and microeconomics are inextricably linked. When we study the economy
as a whole, we must consider the decisions of individual economic actors. For example, to understand what
determines total consumer spending, we must think about a family deciding how much to spend today and how
much to save for the future. To understand what determines total investment spending, we must think about a firm
deciding whether to build a new factory. Because aggregate variables are the sum of the variables describing many
individual decisions, macroeconomic theory rests on a microeconomic foundation. Although microeconomic
decisions underlie macroeconomic phenomena, macroeconomic models do not necessarily focus on the optimizing
behavior of households and firms, but instead sometimes leave that behavior in the background.
RAU’S IAS STUDY CIRCLE | ECONOMICS OPTIONAL | PAPER – I | UNIT-2 1

CLASSICAL THEORY: THE ECONOMY IN THE LONG RUN
Classical Theory: The Economy in the Long Run
The most important macroeconomic variable is gross domestic product (GDP), which measures both a nation’s
total output of goods and services and its total income. Therefore, four groups of questions about the sources and
uses of a nation’s GDP need to be addressed:

How much do the firms in the economy produce? What determines a nation’s total income?

Who gets the income from production? How much goes to compensate workers, and how much goes to
compensate owners of capital?

Who buys the output of the economy? How much do household do purchase for consumption, how much do
households and firms purchase for investment, and how much does the government buy for public purposes?

What equilibrates the demand for and supply of goods and services? What ensures that desired spending on
consumption, investment, and government purchases equals the level of production?
To answer these questions, we must examine how the various parts of the economy interact. Figure 3.1 more
accurately reflects how real economies function. It shows the linkages among the economic actors— households,
firms, and the government—and how flow among them through the various markets in the economy. Households
receive income and use it to pay taxes to the government, to consume goods and services, and to save through the
financial markets. Firms receive revenue from the sale of goods and services and use it to pay for the factors of
production. Households and firms borrow in financial markets to buy investment goods, such as houses and
factories. The government receives revenue from taxes and uses it to pay for government purchases. Any excess of
tax revenue over government spending is called public saving, which can be either positive (a budget surplus) or
negative (a budget deficit). In this part, we develop a basic classical model to explain the economic interactions
depicted in Figure 7.1.
We begin with firms and look at what determines their level of production (and, thus, the level of national income).
Then we examine how the markets for the factors of production distribute this income to households. Next, we
consider how much of this income households consume and how much they save. In addition to discussing the
demand for goods and services arising from the consumption of households, we discuss the demand arising from
investment and government purchases. Finally, we come full circle and examine how the demand for goods and
services (the sum of consumption, investment, and government purchases) and the supply of goods and services
(the level of production) are brought into balance.
What Determines the Total Production of Goods and Services?
An economy’s output of goods and services—its GDP—depends on (1) its quantity of inputs, called the factors of
production, and (2) its ability to turn inputs into output, as represented by the production function. Factors of
production are the inputs used to produce goods and services. The two most important factors of production are
capital and labor. We use the symbol K to denote the amount of capital and the symbol L to denote the amount of
labor. We assume that the economy’s factors of production are fixed and assumed as given. We also assume here
that the factors of production are fully utilized—that is, that no resources are wasted.

Figure 7.1: Circular Flow of Income in an Economy
The available production technology determines how much output is produced from given amounts of capital and
labor. Economists express this relationship using a production function. Letting Y denote the amount of output,
we write the production function as
Y = F(K, L)
This equation states that output is a function of the amount of capital and the amount of labor. The production
function reflects the available technology for turning capital and labor into output. Thus, techno-logical change
alters the production function. Many production functions have a property called constant returns to scale. A
production function has constant returns to scale if an increase of an equal percentage in all factors of production
causes an increase in output of the same percentage. If the production function has constant returns to scale, then
we get 10 percent more output when we increase both capital and labor by 10 percent. Mathematically, a
production function has constant returns to scale if for any positive number z.
zY = F(zK, zL)
This equation says that if we multiply both the amount of capital and the amount of labor by some number z, output
is also multiplied by z. Under classical theory, the assumption of constant returns to scale has an important
implication for how the income from production is distributed. We can now see that the factors of production and
the production function together determine the quantity of goods and services supplied, which in turn equals the
economy’s output. To express this mathematically, we write
Y=F(K,L)=Ӯ
How National Income Distributed to Factors of Distribution?
Because the factors of production and the production function together determine the total output of goods and
services, they also determine national income. The circular flow diagram in Figure 7.1 shows that this national
income flows from firms to households through the markets for the factors of production. In this section we
continue to develop our model of the economy by discussing how these factor markets works. It is based on the
classical (eighteenth-century) idea that prices adjust to balance supply and demand, applied here to the markets for
the factors of production, together with the more recent (nineteenth-century) idea that the demand for each factor of

production depends on the marginal productivity of that factor. This theory, called the neo-classical theory of
distribution, is accepted by most economists today as the best place to start in understanding how the economy’s
income is distributed from firms to households. The distribution of national income is determined by factor prices.
Factor prices are the amounts paid to the factors of production. In an economy where the two factors of
production are capital and labor, the two factor prices are the wage workers earn and the rent the owners of capital
collect.
As Figure 7.2 illustrates, the price each factor of production receives for its services is in turn determined by the
supply and demand for that factor. Because we have assumed that the economy’s factors of production are fixed,
the factor supply curve in Figure 7.2 is vertical. Regardless of the factor price, the quantity of the factor supplied to
the market is the same. The intersection of the downward-sloping factor demand curve and the vertical supply
curve determines the equilibrium factor price.
Figure 7.2: How a Factor of Production is Compensated
Assuming that the firm is a competitive firm, the firm’s manager knows that if the extra revenue P × MPL exceeds
the wage W, an extra unit of labor increases profit. Therefore, the manager continues to hire labor until the next
unit would no longer be profitable—that is, until the MPL falls to the point where the extra revenue equals the
wage. The competitive firm’s demand for labor is determined by P × MPL = W. We can also write this as
MPL = W/P.
W/P is the real wage—the payment to labor measured in units of output rather than in dollars. To maximize profit,
the firm hires up to the point at which the marginal product of labor equals the real wage. Figure 7.2 shows how the
marginal product of labor depends on the amount of labor employed (holding the firm’s capital stock constant).
That is, this figure graphs the MPL schedule. Because the MPL diminishes as the amount of labor increases, this
curve slopes downward. For any given real wage, the firm hires up to the point at which the MPL equals the real
wage. Hence, the MPL schedule is also the firm’s labor demand curve.
The firm decides how much capital to rent in the same way it decides how much labor to hire. The marginal
product of capital (MPK ) is the amount of extra output the firm gets from an extra unit of capital, holding the
amount of labor constant: MPK = F(K + 1, L) − F(K, L). To maximize profit, the firm continues to rent more
capital until the MPK falls to equal the real rental price:
MPK = R/P.
The real rental price of capital is the rental price measured in units of goods rather than in dollars. To sum up, the
competitive, profit-maximizing firm follows a simple rule about how much labor to hire and how much capital to

rent. The firm demands each factor of production until that factor’s marginal product falls to equal its real factor
price.
The Division of National Income
Having analyzed how a firm decides how much of each factor to employ, we can now explain how the markets for
the factors of production distribute the economy’s total income. If all firms in the economy are competitive and
profit maximizing, then each factor of production is paid its marginal contribution to the production process. The
real wage paid to each worker equals the MPL, and the real rental price paid to each owner of capital equals the
MPK. The total real wages paid to labor are therefore MPL × L, and the total real return paid to capital owners is
MPK × K. The income that remains after the firms have paid the factors of production is the economic profit of the
owners of the firms. Real economic profit is
Economic Profit = Y − (MPL × L) − (MPK × K )
Because we want to examine the distribution of national income, we rearrange the terms as follows:
Y = (MPL × L) + (MPK × K ) + Economic Profit.
Total income is divided among the return to labor, the return to capital, and economic profit. If the production
function has the property of constant returns to scale, as is often thought to be the case, then economic profit must
be zero. That is, nothing is left after the factors of production are paid. This conclusion follows from a famous
mathematical result called Euler’s theorem, which states that if the production function has constant returns to
scale, then
F(K, L) = (MPK × K) + (MPL × L).
If each factor of production is paid its marginal product, then the sum of these factor payments equals total output.
In other words, constant returns to scale, profit maximization, and competition together imply that economic profit
is zero.
If economic profit is zero, how can we explain the existence of “profit” in the economy? The answer is that the
term “profit” as normally used is different from economic profit. We have been assuming that there are three types
of agents: workers, owners of capital, and owners of firms. Total income is divided among wages, return to capital,
and economic profit. In the real world, however, most firms own rather than rent the capital they use. Because firm
owners and capital owners are the same people, economic profit and the return to capital are often lumped together.
If we call this alternative definition accounting profit, we can say that
Accounting Profit = Economic Profit + (MPK × K)
Under our assumptions—constant returns to scale, profit maximization, and competition—economic profit is zero.
If these assumptions approximately describe the world, then the “profit” in the national income accounts must be
mostly the return to capital. Each factor of production is paid its marginal product, and these factor payments
exhaust total output. Total output is divided between the payments to capital and the payments to labor, depending
on their marginal productivities.
What Determines the Demand for Goods and Services?
We now continue our tour of the circular flow diagram, Figure 6.1, and examine how the output from production is
used. We know that there are four components of GDP:

Consumption (C )

Investment (I )

Government purchases (G)

Net exports (NX )

The circular flow diagram contains only the first three components. For now, to simplify the analysis, we assume
our economy is a closed economy—a country that does not trade with other countries. Thus, net exports are always
zero. A closed economy has three uses for the goods and services it produces. These three components of GDP are
expressed in the national income accounts identity:
Y=C+I+G
Households consume some of the economy’s output; firms and households use some of the output for investment;
and the government buys some of the out-put for public purposes. We want to see how GDP is allocated among
these three uses.
Consumption
When we eat food, wear clothing, or go to a movie, we are consuming some of the output of the economy. All
forms of consumption together make up about two-thirds of GDP. Because consumption is so large,
macroeconomists have devoted much energy to studying how households decide how much to consume.
Households receive income from their labor and their ownership of capital, pay taxes to the government, and then
decide how much of their after-tax income to consume and how much to save. The income that households receive
equals the output of the economy Y. The government then taxes households an amount T. (Although the
government imposes many kinds of taxes, such as personal and corporate income taxes and sales taxes, for our
purposes we can lump all these taxes together.) We define income after the payment of all taxes, Y − T, to be
disposable income. Households divide their disposable income between consumption and saving. We assume that
the level of consumption depends directly on the level of disposable income. A higher level of disposable income
leads to greater consumption. Thus,
C = C(Y − T)
This equation states that consumption is a function of disposable income. The relationship between consumption
and disposable income is called the consumption function. The marginal propensity to consume (MPC) is the
amount by which consumption changes when disposable income increases by one dollar. The MPC is between zero
and one: an extra dollar of income increases consumption, but by less than one dollar. Thus, if households obtain
an extra dollar of income, they save a portion of it. For example, if the MPC is 0.7, then households spend 70
percent of each additional rupee of disposable income on consumer goods and services and save 30 percent.
Figure 7.3 illustrates the consumption function. The slope of the consumption function tells us how much
consumption increases when disposable income increases by one rupee. That is, the slope of the consumption
function is the MPC.
Figure 7.3: Consumption Function

Investment
Both firms and households purchase investment goods. Firms buy investment goods to add to their stock of capital
and to replace existing capital as it wears out. Households buy new houses, which are also part of investment. Total
investment in the India averages about 28 percent of GDP. The quantity of investment goods demanded depends on
the interest rate, which measures the cost of the funds used to finance investment. For an investment project to be
profitable, its return (the revenue from increased future production of goods and services) must exceed its cost (the
payments for borrowed funds). If the interest rate rises, fewer investment projects are profitable, and the quantity of
investment goods demanded falls.
When studying the role of interest rates in the economy, economists distinguish between the nominal interest rate
and the real interest rate. This distinction is relevant when the overall level of prices is changing. The nominal
interest rate is the interest rate as usually reported: it is the rate of interest that investors pay to borrow money.
The real interest rate is the nominal interest rate corrected for the effects of inflation. If the nominal interest rate
is 8 percent and the inflation rate is 3 percent, then the real interest rate is 5 percent. At the moment, it is sufficient
to note that the real interest rate measures the true cost of borrowing and, thus, determines the quantity of
investment. We can summarize this discussion with an equation relating investment I to the real interest rate r:
I = I(r)
Figure 7.4 shows this investment function. It slopes downward, because as the interest rate rises, the quantity of
investment demanded falls.
Figure 7.4: Investment Function
Government Purchases
Government purchases are the third component of the demand for goods and services. The Union government buys
guns, missiles, and the services of government employees as well as spends on infrastructure services, social and
economic services for the welfare of the people. Local governments buy library books, build schools, and hire
teachers. Governments at all levels build roads and other public works. Therefore, they are not included in the
variable G.
If government purchases equal taxes minus transfers, then G = T and the government has a balanced budget. If G
exceeds T, the government runs a budget deficit, which it funds by issuing government debt—that is, by borrowing
in the financial markets. If G is less than T, the government runs a budget surplus, which it can use to repay some

of its outstanding debt. We assume that government purchases and taxes as exogenous variables. To denote that
these variables are fixed outside of our model of national income, we write
We do, however, want to examine the impact of fiscal policy on the endogenous variables, which are determined
within the model. The endogenous variables here are consumption, investment, and the interest rate. To see how
the exogenous variables affect the endogenous variables, we must complete the model.
What Brings the Supply and Demand for Goods and Services into Equilibrium?
We have now come full circle in the circular flow diagram, Figure 7.1. We began by examining the supply of
goods and services, and we have just dis-cussed the demand for them. How can we be certain that all these flows
balance? In other words, what ensures that the sum of consumption, investment, and government purchases equals
the amount of output produced? We will see that in this classical model, the interest rate is the price that has the
crucial role of equilibrating supply and demand. There are two ways to think about the role of the interest rate in
the economy. We can consider how the interest rate affects the supply and demand for goods or services. Or we
can consider how the interest rate affects the supply and demand for loanable funds. As we will see, these two
approaches are two sides of the same coin.
Equilibrium in the Market for Goods and Services: The Supply and Demand for the Economy’s Output
The following equations summarize the discussion of the demand for goods and services:
The demand for the economy’s output comes from consumption, investment, and government purchases.
Consumption depends on disposable income; investment depends on the real interest rate; and government
purchases and taxes are the exogenous variables set by fiscal policymakers. To this analysis, let’s add the supply of
goods and services wherein the factors of production and the production function determine the quantity of output
supplied to the economy:
Now let’s combine these equations describing the supply and demand for output. If we substitute the consumption
function and the investment function into the national income accounts identity, we obtain
Y = C(Y − T) + I(r) + G
Because the variables G and T are fixed by policy, and the level of output Y is fixed by the factors of production
and the production function, we can write
This equation states that the supply of output equals its demand, which is the sum of consumption, investment, and
government purchases. Notice that the interest rate r is the only variable not already determined in the last
equation. This is because the interest rate still has a key role to play: it must adjust to ensure that the demand for
goods equals the supply. The greater the interest rate, the lower the level of investment, and thus the lower the
demand for goods and services, C + I + G. If the interest rate is too high, then investment is too low and the
demand for output falls short of the supply. If the interest rate is too low, then investment is too high and the
demand exceeds the supply. At the equilibrium interest rate, the demand for goods and services equals the supply.
To understand how the interest rate gets to the level that balances the supply and demand for goods and services,
let us consider how financial markets fit into the story.
Equilibrium in the Financial Markets: The Supply and Demand for Loanable Funds
Because the interest rate is the cost of borrowing and the return to lending in financial markets, we can better
understand the role of the interest rate in the economy by thinking about the financial markets. To do this, rewrite
the nation-al income accounts identity as
Y–C–G=I
The term Y − C − G is the output that remains after the demands of consumers and the government have been
satisfied; it is called national saving or simply saving (S). In this form, the national income accounts identity

shows that saving equals investment. To understand this identity more fully, we can split national saving into two
parts — one part representing the saving of the private sector and the other rep-resenting the saving of the
government:
S = (Y – T − C) + (T − G) = I
The term (Y − T − C) is disposable income minus consumption, which is private saving. The term (T − G) is
government revenue minus government spending, which is public saving. (If government spending exceeds
government revenue, then the government runs a budget deficit and public saving is negative). National saving is
the sum of private and public saving. The circular flow diagram in Figure 3.1 reveals an interpretation of this
equation: this equation states that the flows into the financial markets (private and public saving) must balance the
flows out of the financial markets (investment). To see how the interest rate brings financial markets into
equilibrium, substitute the consumption function and the investment function into the national income accounts
identity:
Y − C(Y − T) − G = I(r)
Next, note that G and T are fixed by policy and Y is fixed by the factors of production and the production function:
The left-hand side of this equation shows that national saving depends on income Y and the fiscal-policy variables
G and T. For fixed values of Y, G, and T, national saving S is also fixed. The right-hand side of the equation shows
that investment depends on the interest rate. Figure 7.5 graphs saving and investment as a function of the interest
rate. The saving function is a vertical line because in this model saving does not depend on the interest rate (we
relax this assumption later). The investment function slopes downward: as the interest rate decreases, more
investment projects become profitable.
Figure 7.5: Saving, Investment, and the Interest Rate
From a quick glance at Figure 7.5, it may be observed that saving and investment can be interpreted in terms of
supply and demand. In this case, the “good” is loanable funds, and it price is the interest rate. Saving is the supply
of loanable funds—households lend their saving to investors or deposit their saving in a bank that then loans the
funds out. Investment is the demand for loanable funds—investors borrow from the public directly by selling
bonds or indirectly by borrowing from banks. Because investment depends on the interest rate, the quantity

of loanable funds demanded also depends on the interest rate. The interest rate adjusts until the amount that firms
want to invest equals the amount that households want to save. If the interest rate is too low, investors want more
of the economy’s output than households want to save. Equivalently, the quantity of loanable funds demanded
exceeds the quantity supplied. When this happens, the interest rate rises. Conversely, if the interest rate is too high,
house-holds want to save more than firms want to invest; because the quantity of loan-able funds supplied is
greater than the quantity demanded, the interest rate falls. The equilibrium interest rate is found where the two
curves cross. At the equilibrium interest rate, households’ desire to save balances firms’ desire to invest, and the
quantity of loanable funds supplied equals the quantity demanded.
Changes in Saving: The Effects of Fiscal Policy
We can use our model to show how fiscal policy affects the economy. When the government changes its spending
or the level of taxes, it affects the demand for the economy’s output of goods and services and alters national
saving, investment, and the equilibrium interest rate.
An Increase in Government Purchases: Consider first the effects of an increase in government purchases by an
amount G. The immediate impact is to increase the demand for goods and services by G. But because total output
is fixed by the factors of production, the increase in government purchases must be met by a decrease in some
other category of demand. Disposable income Y – T is unchanged, so consumption C is unchanged as well.
Therefore, the increase in government purchases must be met by an equal decrease in investment. To induce
investment to fall, the interest rate must rise. Hence, the increase in government purchases causes the interest rate
to increase and investment to decrease. Government purchases are said to crowd out investment. To grasp the
effects of an increase in government purchases, consider the impact on the market for loanable funds. Because the
increase in government purchases is not accompanied by an increase in taxes, the government finances the
additional spending by borrowing—that is, by reducing public saving. With private saving unchanged, this
government borrowing reduces national saving. As Figure 7.6 shows, a reduction in national saving is represented
by a leftward shift in the supply of loanable funds available for investment. At the initial interest rate, the demand
for loanable funds exceeds the supply. The equilibrium interest rate rises to the point where the investment
schedule crosses the new saving schedule. Thus, an increase in government purchases causes the interest rate to
rise from r1 to r2.
Figure 7.6: Impact of Reduction Savings
A Decrease in Taxes: Now consider a reduction in taxes of T. The immediate impact of the tax cut is to raise
disposable income and thus to raise consumption. Disposable income rises by T, and consumption rises by an
amount equal to T times the marginal propensity to consume MPC. The higher the MPC, the greater the impact of
the tax cut on consumption. Because the economy’s output is fixed by the factors of production and the level of

government purchases is fixed by the government, the increase in consumption must be met by a decrease in
investment. For investment to fall, the interest rate must rise. Hence, a reduction in taxes, like an increase in
government purchases, crowds out investment and raises the interest rate. We can also analyze the effect of a tax
cut by looking at saving and investment. Because the tax cut raises disposable income by T, consumption goes up
by MPC × T. National saving S, which equals Y − C − G, falls by the same amount as consumption rises. As in
Figure 7.6, the reduction in saving shifts the supply of loanable funds to the left, which increases the equilibrium
interest rate and crowds out investment.
Changes in Investment Demand
So far, we have discussed how fiscal policy can change national saving. We can also use our model to examine the
other side of the market—effects of changes in investment demand. One reason investment demand might increase
is technological innovation. Suppose, for example, that someone invents a new technology, such as the rail-road or
the computer. Before a firm or household can take advantage of the innovation, it must buy investment goods. The
invention of the railroad had no value until railroad cars were produced and tracks were laid. The idea of the
computer was not productive until computers were manufactured. Thus, technological innovation leads to an
increase in investment demand. Investment demand may also change because the government encourages or
discourages investment through the tax laws. For example, suppose that the government increases personal income
taxes and uses the extra revenue to provide tax cuts for those who invest in new capital. Such a change in the tax
laws makes more investment projects profitable and, like a technological innovation, increases the demand for
investment goods. Figure 6.7 shows the effects of an increase in investment demand.
Figure 7.7: An Increase in the Demand for Investment
At any given interest rate, the demand for investment goods (and also for loanable funds) is higher. This increase in
demand is represented by a shift in the investment schedule to the right. The economy moves from the old
equilibrium, point A, to the new equilibrium, point B. The implication of Figure 7.7 is that the equilibrium amount
of investment is unchanged. Under our assumptions, the fixed level of saving determines the amount of investment;
in other words, there is a fixed supply of loanable funds. An increase in investment demand merely raises the
equilibrium interest rate. We would reach a different conclusion, however, if we modify our simple consumption
function and allowed consumption (and its flip side, saving) to depend on the interest rate. Because the interest rate
is the return to saving (as well as the cost of borrowing), a higher interest rate might reduce consumption and
increase saving. If so, the saving schedule would be upward sloping rather than vertical. With an upward-sloping
saving schedule, an increase in investment demand would raise both the equilibrium interest rate and the
equilibrium quantity of investment. Figure 7.8 shows such a change. The increase in the interest rate causes
households to consume less and save more. The decrease in consumption frees resources for investment.

Figure 7.8: An Increase in Investment Demand When Saving Depends on the Interest Rate
In this classical theory, we have developed a model that explains the production, distribution, and allocation of the
economy’s output of goods and services. The model relies on the classical assumption that prices adjust to
equilibrate supply and demand. In this model, factor prices equilibrate factor markets, and the interest rate
equilibrates the supply and demand for goods and services (or, equivalently, the supply and demand for loanable
funds). Because the model incorporates all the interactions illustrated in the circular flow diagram in Figure 7.1, it
is some-times called a general equilibrium model. The model can explain how income is divided among the factors
of production and how factor prices depend on factor supplies. We have also used the model to discuss how fiscal
policy alters the allocation of output among its alternative uses—consumption, investment, and government
purchases—and how it affects the equilibrium interest rate.
Assumptions of the Classical Theory
At this point it is useful to review some of the simplifying assumptions we have made under this theory:

Laissez-faire Approach
This approach states that there is no interference of the government in the economic activity. The law assumes that
if government intervenes in the self-adjusting economy, then it would create the state of disequilibrium. In the
absence of government intervention, the condition of disequilibrium would be for a shorter duration and tend to be
solved by the free implication of market forces. Therefore, government should not create hurdles in the normal
working of an economy. It implicitly assumes that the government should balance its income and expenditure. The
classical economists advocated that the government should follow the laissez-faire approach of economy.

Flexible Prices
The first assumption of classical economics is that prices are flexible. Price flexibility means that markets are able
to adjust quickly and efficiently to equilibrium. While this assumption does not mean that every market in the
economy is in equilibrium at all times, any imbalance (shortage or surplus) is short lived. Moreover, the adjustment
to equilibrium is accomplished automatically through the market forces of demand and supply without the need for
government action. The most important macroeconomic dimension of this assumption applies to resource markets,
especially labor markets. The unemployment of labor, particularly involuntary unemployment, arises if a surplus
exists in labor markets. With a surplus, the quantity of labor supplied exceeds the quantity of labor demanded--at
the exist price of labor (wages). With flexible prices, any surplus is temporary. Wages fall to eliminate the surplus
imbalance and restore equilibrium--and achieve full employment. If, for example, aggregate demand in the
economy takes a bit of a drop, then production also declines (temporarily) and so too does the demand for labor,
creating a surplus of labor and involuntarily unemployed workers. However, flexible prices mean that wages
decline to eliminate the surplus.

Say's Law

The second assumption of classical economics is that the aggregate production of good and services in the
economy generates enough income to exactly purchase all output. This notion commonly summarized by the
phrase "supply creates its own demand" is attributed to the Jean-Baptiste Say, a French economist who helped to
popularize the work of Adam Smith in the early 1800s. Say's law was a cornerstone of classical economics, and
although it was subject to intense criticism by Keynesian economists, it remains relevant in modern times and is
reflected in the circular flow model. Say's law actually applies to aggregate, economy-wide supply and demand. A
more accurate phrase is "aggregate supply creates its own aggregate demand". This interpretation means that the
act of production adds to the overall pool of aggregate income, which is then used to buy a corresponding value of
production--although most likely not the original production. This law, first and foremost, directed attention to the
production or supply-side of the economy. That is, focus on production and the rest of the economy will fall in line.
Say's law further implied that extended periods of excess production and limited demand, the sort of thing that
might cause an economic downturn, were unlikely. Economic downturns could occur, but not due to the lack of
aggregate demand.

Saving-Investment Equality
This implies that saving by the household sector exactly matches investment expenditures on capital goods by the
business sector. A potential problem with Say's law is that not all income generated by the production of goods is
necessarily spent by the household sector on consumption demand--some income is saved. If this happens, then
producers reduce production and lay off workers, which causes a drop in income and induces a decline in
consumption, which then triggers further reductions in production, employment, income, and consumption in a
contractionary downward spiral. A match between saving and investment is assured in classical economics through
flexible prices. However, in this case price flexibility applies to interest rates. Should saving not match investment,
then interest rates adjust to restore balance? In particular, if saving exceeds investment, then interest rates fall,
which stimulates investment and curtails saving until the two are once again equal.

Assumption of the Neutrality of Money and Classical Dichotomy
The classical theory of output and employment is that changes in the quantity of money affect only nominal
variables (i.e. money wages, nominal GNP, money balances), and have no influence whatsoever on the real
variables of the economy such as real GNP (i.e. output of goods and services produced), level of employment (i.e.
number of labour – hours or number of workers employed), real wage rate (i.e. wage rate in terms of its purchasing
power). In fact, according to classical theory, the nominal variables move in proportion to changes in the quantity
of money, while real variables such as GNP, employment, real wage rate, real rate of interest remain unaffected.
Classical economists explained that real variables such as GNP, employment, and real wage rate are determined by
real factors such as stock of capital, the state of technology, marginal physical product of labour, households’
preferences regarding work and leisure. In the classical model based on flexibility of prices and wages, changes in
money supply only affect the price level and nominal magnitudes (i.e. money wages, nominal interest rate), while
the real variables such as levels of labour employment and output, saving and investment, real wages, real rate of
interest remain unaffected. This independence of real variables from changes in money supply and nominal
variables is called classical dichotomy.
The neutrality of money is graphically illustrated in figure 7.9. Suppose to begin with, the stock of money in the
economy is equal to M0. With this, as will be seen from Panel (d) of Figure 7.9, aggregate demand curve for output
is AD0 which with interaction with aggregate supply curve AS determines price level P0. Given the price level P0,
labour-market equilibrium determines money wage rate W0 and real wage rate equal to W0/P0 and level of
employment Nf in Panel (a) of Figure. The level of employment Nf given the production function, determines
aggregate output Yf in Panel (b) of Figure 6.9. Now suppose there is expansion in money supply from M0 to M1
which causes an upward shift in the aggregate demand curve from AD0 to AD1 [see Panel (d)]. As a result of this
upward shift in the aggregate demand curve from AD0 to AD1 price level rises from P0 to P1 Now, as will be seen
from Panel (a), with money wage rate W0 and price level equal to P1, real wage rate falls to W0/ P1 at which
demand for labour exceeds supply of labour. This will cause, according to classical theory, money wage rate to rise
to W1 in equal proportion to the rise in price level so that real wage is restored to the original level (W1/P1 = W0/P0)
and labour-market equilibrium determines the original level of employment N f. With the same level of labour
employment aggregate output (i.e. GNP) will not be affected. Thus, we see that with the expansion in money
supply, nominal wage rate and price level have risen, but real wage rate, level of employment and output remain
constant. Hence it shows that money is neutral in its effect on real variables.

With the same level of labour employment, aggregate output (i.e. GNP) will not be affected. Thus, we see that with
the expansion in money supply, nominal wage rate and price level have risen, but real wage rate, level of
employment and output remain constant. Hence it shows that money is neutral in its effect on real variables.
Changes in Money Supply, Saving-Investment Equilibrium and Neutrality of Money: According to the classical
theory, money performs the function of merely a medium of exchange of goods and services and is therefore
demanded only for transaction purposes. This means alternative to holding money is the purchase of goods and
services. Therefore, demand for and supply of money in the classical system does not determine the rate of interest.
When the quantity of money increases, it will leave the real rate of interest unchanged and hence the amount of
output saved and allocated to investment (i.e., real saving and investment) will remain the same as shown in Figure
7.10. This means the increase in money supply does not disturb the capital market equilibrium or saving-
investment equality and consequently the continuation of full-employment equilibrium. However, it may be noted
that the higher level of prices of commodities would mean that investment expenditure in money terms will
increase in the same proportion as the rise in prices even though the output of commodities allocated for
investment purposes remains the same.
Figure 7.9: Classical Dichotomy and Determination of Income and Employment
Figure 7.10: Capita Market Equilibrium

But this increase in monetary expenditure for investment is matched by the equal increase in monetary saving
brought about by the rise in prices. The higher prices of commodities also mean a proportionate increase in the
amount of money received from the sale of commodities so that savers are willing to provide proportionately larger
amount of saving at a given rate of interest. Thus, with the increase in quantity of money, the supply curve of
nominal saving and investment demand curve will shift to the right as shown by dotted S’S’ and IT curves by the
same proportion so that the same real rate of interest is maintained and the same amounts of real saving and
investment in terms of commodities are made at the higher price level. A serious limitation of the classical concept
of neutrality of money is that it is based on flexibility of prices and wages. If increase in money supply and
consequent rise in prices has no real effects, then inflation would not be a matter of concern.

Capital stock, the labor force, and the production technology are fixed.

Short-run sticky prices will not change the basic outcome of the classical theories.
The Open Economy Model
The key macroeconomic difference between open and closed economies is that, in an open economy, a country’s
spending in any given year need not equal its output of goods and services. A country can spend more than it
produces by borrowing from abroad, or it can spend less than it produces and lend the difference to foreigners. To
understand this more fully, let’s extend the national income accounting little bit further to incorporate the
transactions of a country with the rest of the world.
The Role of Net Exports
Consider the expenditure on an economy’s output of goods and services. In a closed economy, all output is sold
domestically, and expenditure is divided into three components: consumption, investment, and government
purchases. In an open economy, some output is sold domestically and some is exported to be sold abroad. We can
divide expenditure on an open economy’s output Y into four components:
Cd = consumption of domestic goods and services,
Id = investment in domestic goods and services,
Gd = government purchases of domestic goods and services, X = exports of domestic goods and services.
The division of expenditure into these components is expressed in the identity
Y = C d + I d + G d + X.
The sum of the first three terms, Cd + Id + Gd, is domestic spending on domestic goods and services. The fourth
term, X, is foreign spending on domestic goods and services. Note that domes-tic spending on all goods and
services equals domestic spending on domestic goods and services plus domestic spending on foreign goods and
services. Hence, total consumption C equals consumption of domestic goods and services C d plus consumption of
foreign goods and services Cf; total investment I equals investment in domestic goods and services Id plus
investment in foreign goods and services I f; and total government purchases G equals government purchases of
domestic goods and services Gd plus government purchases of foreign goods and services G f. Thus,
= C d + C f,
= I d + I f,
=Gd+Gf
We substitute these three equations into the identity above:
Y = (C − C f) + (I − I f) + (G − G f) + X
We can rearrange to obtain
Y = C + I + G + X − (C f + I f + G f)
The sum of domestic spending on foreign goods and services (C f + I f + G f) is expenditure on imports (IM). We
can thus write the national income accounts identity as

Y = C + I + G + X − IM
Because spending on imports is included in domestic spending (C + I + G), and because goods and services
imported from abroad are not part of a country’s out-put, this equation subtracts spending on imports. Defining net
exports to be exports minus imports (NX = X − IM), the identity becomes
Y = C + I + G + NX
This equation states that expenditure on domestic output is the sum of consumption, investment, government
purchases, and net exports. The national income accounts identity shows how domestic output, domes-tic spending,
and net exports are related. In particular,
NX = Y − (C + I + G)
Net Exports = Output − Domestic Spending.
This equation shows that in an open economy, domestic spending need not equal the output of goods and services.
If output exceeds domestic spending, we export the difference: net exports are positive. If output falls short of
domestic spending, we import the difference: net exports are negative.
International Capital Flows and the Trade Balance
In an open economy, financial markets and goods markets are closely related. To see the relationship, we must
rewrite the national income accounts identity in terms of saving and investment. Begin with the identity
Y = C + I + G + NX
Subtract C and G from both sides to obtain
Y – C – G = I + NX
As Y − C − G is national saving S, which equals the sum of private saving, Y − T − C, and public saving, T − G,
where T stands for taxes. Therefore,
S = I + NX
Subtracting I from both sides of the equation, we can write the national income accounts identity as
S – I = NX
This form of the national income accounts identity shows that an economy’s net exports must always equal the
difference between its saving and its investment. The left-hand side of the identity is the difference between
domestic saving and domestic investment, S − I, which is normally net capital outflow or net foreign investment.
Net capital outflow equals the amount that domestic residents are lending abroad minus the amount that foreigners
are lending to us. If net capital outflow is positive, the economy’s saving exceeds its investment, and it is lending
the excess to foreigners. If the net capital outflow is negative, the economy is experiencing a capital inflow:
investment exceeds saving, and the economy is financing this extra investment by borrowing from abroad. Thus,
net capital outflow reflects the international flow of funds to finance capital accumulation. The national income
accounts identity shows that net capital outflow always equals the trade balance. That is,
Net Capital Outflow = Trade Balance
S−I = NX
If S − I and NX are positive, we have a trade surplus. In this case, we are net lenders in world financial markets,
and we are exporting more goods than we are importing. If S − I and NX are negative, we have a trade deficit. In
this case, we are net borrowers in world financial markets, and we are importing more goods than we are exporting.
If S − I and NX are exactly zero, we are said to have balanced trade because the value of imports equals the value
of exports.
The national income accounts identity shows that the international flow of funds to finance capital accumulation
and the international flow of goods and services are two sides of the same coin. If domestic saving exceeds
domestic investment, the surplus saving is used to make loans to foreigners. Foreigners require these loans because
we are providing them with more goods and services than they are providing us. That is, we are running a trade
surplus. If investment exceeds saving, the extra investment must be financed by borrowing from abroad. These
foreign loans enable us to import more goods and services than we export. The following table summarizes these
outcomes in an open economy:
Saving and Investment in a Small Open Economy

If the real interest rate does not adjust to equilibrate saving and investment in this model, what does determine the
real interest rate? We answer this question here by considering the simple case of a small open economy with
perfect capital mobility. By “small’’ we mean that this economy is a small part of the world market and thus, by
itself, can have only a negligible effect on the world interest rate. By “perfect capital mobility’’ we mean that
residents of the country have full access to world financial markets. In particular, the government does not impede
international borrowing or lending. Because of this assumption of perfect capital mobility, the interest rate in our
small open economy, r, must equal the world interest rate r*, the real interest rate prevailing in world financial
markets:
r = r*
Residents of the small open economy need never borrow at any interest rate above r*, because they can always get
a loan at r* from abroad. Similarly, residents of this economy need never lend at any interest rate below r *
because they can always earn r* by lending abroad. Thus, the world interest rate determines the interest rate in our
small open economy.
The Model
To build the model of the small open economy, we make three assumptions:
(a) The economy’s output Y is fixed by the factors of production and the production function. We write this as
(b) Consumption C is positively related to disposable income Y − T. We write the consumption function as
C = C (Y − T)
(c) Investment I is negatively related to the real interest rate r. We write the investment function as
I = I(r)
The accounting identity and write it as
NX = (Y – C − G) − I
NX = S − I

Substituting the Chapter 3 assumptions recapped above and the assumption that the interest rate equals the world
interest rate, we obtain
This equation shows that the trade balance NX depends on those variables that determine saving S and investment
I. Because saving depends on fiscal policy (lower government purchases G or higher taxes T raise national saving)
and investment depends on the world real interest rate r* (a higher interest rate makes some investment projects
unprofitable), the trade balance depends on these variables as well. Figure 7.11 graphed the savings and investment
in a small open economy.
Figure 7.11: Saving and Investment in a Small Open Economy
In the small open economy, as we have assumed, the real interest rate equals the world real interest rate. The trade
balance is determined by the difference between saving and investment at the world interest rate.
How Policies Influence the Trade Balance
Suppose that the economy begins in a position of balanced trade. That is, at the world interest rate, investment I
equal saving S, and net exports NX equal zero. Let’s use our model to predict the effects of government policies at
home and abroad.
Fiscal Policy at Home: Consider first what happens to the small open economy if the government expands
domestic spending by increasing government purchases. The increase in G reduces national saving, because S = Y
C − G. With an unchanged world real interest rate, investment remains the same. Therefore, saving falls below
investment, and some investment must now be financed by borrowing from abroad. Because NX = S − I, the fall in
S implies a fall in NX. The economy now runs a trade deficit. The same logic applies to a decrease in taxes. A tax
cut lowers T, raises disposable income Y − T, stimulates consumption, and reduces national saving. (Even though
some of the tax cut finds its way into private saving, public saving falls by the full amount of the tax cut; in total,
saving falls.) Because NX = S − I, the reduction in national saving in turn lowers NX. Figure 7.12 illustrates these
effects. A fiscal policy change that increases private consumption C or public consumption G reduces national
saving (Y − C − G) and, therefore, shifts the vertical line that represents saving from S1 to S2. Because NX is the
distance between the saving schedule and the investment schedule at the world interest rate, this shift reduces NX.
Hence, starting from balanced trade, a change in fiscal policy that reduces national saving, leads to a trade deficit.
Fiscal Policy Abroad: Consider now what happens to a small open economy when foreign governments increase
their government purchases. If these foreign countries are a small part of the world economy, then their fiscal
change has a negligible impact on other countries. But if these foreign countries are a large part of the world

economy, their increase in government purchases reduces world saving. The decrease in world saving causes the
world interest rate to rise, just as we saw in our closed-economy model.
Figure 7.12: A Fiscal Expansion at Home in Small Open Economy
The increase in the world interest rate raises the cost of borrowing and, thus, reduces investment in our small open
economy. Because there has been no change in domestic saving, saving S now exceeds investment I, and some of
our saving begins to flow abroad. Because NX = S − I, the reduction in I must also increase NX. Hence, reduced
saving abroad leads to a trade surplus at home. Figure 7.13 illustrates how a small open economy starting from
balanced trade responds to a foreign fiscal expansion. Because the policy change is occurring abroad, the domestic
saving and investment schedules remain the same. The only change is an increase in the world interest rate from r*1
to r*2. The trade balance is the difference between the saving and investment schedules; because saving exceeds
investment at r*2, there is a trade surplus. Hence, starting from balanced trade, an increase in the world interest rate
due to a fiscal expansion abroad leads to a trade surplus.
Figure 7.13: A Fiscal Expansion Abroad in a Small Open Economy
Shifts in Investment Demand: Consider what happens to our small open economy if its investment schedule shifts
outward—that is, if the demand for investment goods at every interest rate increases. This shift would occur if, for
example, the government changed the tax laws to encourage investment by pro-viding an investment tax credit.
Figure 7.14 illustrates the impact of a shift in the investment schedule.

Figure 7.14: A shift in the Investment Schedule in a small Open Economy
At a given world interest rate, investment is now higher. Because saving is unchanged, some investment must now
be financed by borrowing from abroad. Because capital flows into the economy to finance the increased
investment, the net capital outflow is negative. Put differently, because NX = S − I, the increase in I implies a
decrease in NX. Hence, starting from balanced trade, an outward shift in the investment schedule causes a trade
deficit.
Evaluating Economic Policy
The model of the open economy shows that the flow of goods and services measured by the trade balance is
inextricably connected to the international flow of funds for capital accumulation. The net capital outflow is the
difference between domestic saving and domestic investment. Thus, the impact of economic policies on the trade
balance can always be found by examining their impact on domes-tic saving and domestic investment. Policies that
increase investment or decrease saving tend to cause a trade deficit, and policies that decrease investment or
increase saving tend to cause a trade surplus. Evaluating economic policies and their impact on the open economy
is a frequent topic of debate among economists and policymakers. When a country runs a trade deficit,
policymakers must confront the question of whether it represents a national problem. Most economists view a trade
deficit not as a problem in itself, but perhaps as a symptom of a problem. A trade deficit could be a reflection of
low saving. In a closed economy low saving leads to low investment and a smaller future capital stock. In an open
economy, low saving leads to a trade deficit and a growing foreign debt, this eventually must be repaid. In both
cases, high current consumption leads to lower future consumption, implying that future generations bear the
burden of low national saving.
Yet trade deficits are not always a reflection of an economic malady. When poor rural economies develop into
modern industrial economies, they sometimes finance their high levels of investment with foreign borrowing. In
these cases, trade deficits are a sign of economic development. For example, South Korea ran large trade deficits
throughout the 1970s, and it became one of the success stories of economic growth. The lesson is that one cannot
judge economic performance from the trade balance alone. Instead, one must look at the underlying causes of the
international flows.
Exchange Rates
Having examined the international flows of capital and of goods and services, we now extend the analysis by
considering the prices that apply to these transactions. The exchange rate between two countries is the price at
which residents of those countries trade with each other. We first examine precisely what the exchange rate
measures, and then discuss how exchange rates are determined.
Nominal and Real Exchange Rates

Economists distinguish between two exchange rates: the nominal exchange rate and the real exchange rate. The
nominal exchange rate is the relative price of the currencies of two countries. For example, if the exchange rate
between the U.S. dollar and the Indian rupee is 70 rupee per dollar, then you can exchange one dollar for 70 rupee
in world markets for foreign currency. When the domestic currency appreciates, it buys more of the foreign
currency; when it depreciates, it buys less. An appreciation is sometimes called a strengthening of the currency,
and depreciation is sometimes called a weakening of the currency.
The real exchange rate is the relative price of the goods of two countries. That is, the real exchange rate tells us
the rate at which we can trade the goods of one country for the goods of another. The real exchange rate is
sometimes called the terms of trade.
To see the relation between the real and nominal exchange rates, consider a single good produced in many
countries: cars. Suppose an American car costs $10,000 and a similar Japanese car costs 2,400,000 yen. To
compare the prices of the two cars, we must convert them into a common currency. If a dollar is worth 120 yen,
then the American car costs 1,200,000 yen. Comparing the price of the American car (1,200,000 yen) and the price
of the Japanese car (2,400,000 yen), we conclude that the American car costs one-half of what the Japanese car
costs. In other words, at current prices, we can exchange 2 American cars for 1 Japanese car. At these prices and
this exchange rate, we obtain one-half of a Japanese car per American car. More generally, we can write this
calculation as
Nominal Exchange Rate × Price of Domestic Good
𝑅𝑒𝑎𝑙 𝐸𝑥𝑐ℎ𝑎𝑛𝑔𝑒 𝑅𝑎𝑡𝑒 =
Price of Foreign Good
The rate at which we exchange foreign and domestic goods depends on the prices of the goods in the local
currencies and on the rate at which the currencies are exchanged. Let e be the nominal exchange rate (the number
of yen per dollar), P be the price level in the United States (measured in dollars), and P* be the price level in Japan
(measured in yen). Then the real exchange rate ԑ is
Real Exchange Rate = Nominal Exchange Rate × Ratio of Price Levels
ԑ = e × (P/P*)
The real exchange rate between two countries is computed from the nominal exchange rate and the price levels in
the two countries. If the real exchange rate is high, foreign goods are relatively cheap, and domestic goods are
relatively expensive. If the real exchange rate is low, foreign goods are relatively expensive, and domestic goods
are relatively cheap.
The Determinants of the Real Exchange Rate
The real exchange rate is related to net exports. When the real exchange rate is lower, domestic goods are less
expensive relative to foreign goods, and net exports are greater. The trade balance (net exports) must equal the net
capital outflow, which in turn equals saving minus investment. Saving is fixed by the consumption function and
fiscal policy; investment is fixed by the investment function and the world interest rate.
Figure 7.15: Net Exports and the Real Exchange Rate

Figure 7.15 illustrates these two conditions. The line showing the relationship between net exports and the real
exchange rate slopes downward because a low real exchange rate makes domestic goods relatively inexpensive.
The line representing the excess of saving over investment, S − I, is vertical because neither saving nor investment
depends on the real exchange rate. The crossing of these two lines determines the equilibrium real exchange rate.
Figure 6.15 in fact represent the supply and demand for foreign-currency exchange. The vertical line, S − I,
represents the net capital outflow and thus the supply of dollars to be exchanged into foreign currency and invested
abroad. The downward-sloping line, NXe, represents the net demand for dollars coming from foreigners who want
dollars to buy our goods. At the equilibrium real exchange rate, the supply of dollars available from the net capital
outflow balances the demand for dollars by foreigners buying our net exports.
How Policies Influence the Real Exchange Rate
Fiscal Policy at Home: What happens to the real exchange rate if the government reduces national saving by
increasing government purchases or cutting taxes? This reduction in saving lowers S – I gap and thus NX. That is,
the reduction in saving causes a trade deficit. Figure 7.16 shows how the equilibrium real exchange rate adjusts to
ensure that NX falls. The change in policy shifts the vertical S − I line to the left, lowering the supply of dollars to
be invested abroad. The lower supply causes the equilibrium real exchange rate to rise from e1 to e2 —that is, the
dollar becomes more valuable. Because of the rise in the value of the dollar, domestic goods become more
expensive relative to foreign a goods, which causes exports to fall and imports to rise. The change in exports and
the change in imports both act to reduce net exports.
Figure 7.16: The Impact of Expansionary Fiscal Policy at Home on the Real Exchange Rate
Fiscal Policy Abroad: What happens to the real exchange rate if foreign governments increase government
purchases or cut taxes? This change in fiscal policy reduces world saving and raises the raises S − I and thus NX.
That is, the increase in the world interest rate causes a trade surplus. Figure 7.17 show that this change in policy
shifts the vertical S − I line to the right, raising the supply of dollars to be invested abroad. The equilibrium real
exchange rate falls. That is, the dollar becomes less valuable, and domestic goods become less expensive relative to
foreign goods.
Shifts in Investment Demand: What happens to the real exchange rate if investment demand at home increases? At
the given world interest rate, the increase in investment demand leads to higher investment. A higher value of I
means lower values of S − I and NX. That is, the increase in investment demand causes a trade deficit. The increase
in investment demand shifts the vertical S − I line to the left, reducing the supply of dollars to be invested abroad.
The equilibrium real exchange rate rises.

Figure 7.17: The Impact of Expansionary Fiscal Policy Abroad on the Real Exchange Rate
The Effects of Trade Policies

Now that we have a model that explains the trade balance and the real exchange rate, we have the tools to examine
the macroeconomic effects of trade policies. Trade policies, broadly defined, are policies designed to influence
directly the amount of goods and services exported or imported. Most often, trade policies take the form of
protecting domestic industries from foreign competition— either by imposing a tariff or restricting the amount of
goods and services that can be imported (a quota).
As an example of a protectionist trade policy, consider what would happen if the government prohibited the import
of foreign cars. For any given real exchange rate, imports would now be lower, implying that net exports (exports
minus imports) would be higher. Thus, the net-exports schedule shifts outward, as in Figure 7.18. To see the effects
of the policy, we compare the old equilibrium and the new equilibrium. In the new equilibrium, the real exchange
rate is higher, and net exports are unchanged. Despite the shift in the net-exports schedule, the equilibrium level of
net exports remains the same, because the protectionist policy does not alter either saving or investment.
This analysis shows that protectionist trade policies do not affect the trade balance. Because a trade deficit reflects
an excess of imports over exports, one might guess that reducing imports—such as by prohibiting the import of
foreign cars—would reduce a trade deficit. The model shows that protectionist policies lead only to an appreciation
of the real exchange rate. The increase in the price of domestic goods relative to foreign goods tends to lower net
exports by stimulating imports and depressing exports. Thus, the appreciation offsets the increase in net exports
that is directly attributable to the trade restriction. Although protectionist trade policies do not alter the trade
balance, they do affect the amount of trade. As we have seen, because the real exchange rate appreciates, the goods
and services we produce become more expensive relative to foreign goods and services. We therefore export less in
the new equilibrium. Because net exports are unchanged, we must import less as well. (The appreciation of the
exchange rate does stimulate imports to some extent, but this only partly offsets the decrease in imports due to the
trade restriction.) Thus, protectionist policies reduce both the quantity of imports and the quantity of exports. This
fall in the total amount of trade is the reason economists almost always oppose protectionist policies. International
trade benefits all countries by allowing each country to specialize in what it produces best and by providing each
country with a greater variety of goods and services. Protectionist policies diminish these gains from trade.
Although these policies benefit certain groups within society—for example, a ban on imported cars helps domestic
car producers — society on average is worse off when policies reduce the amount of international trade.

Figure 7.18: The Impact of Protectionist Trade Policies on the Real Exchange Rate
The Special Case of Purchasing-Power Parity

A famous hypothesis in economics, called the law of one price, states that the same good cannot sell for different
prices in different locations at the same time. The law of one price applied to the international marketplace is called
purchasing-power parity. It states that if international arbitrage is possible, then a dollar (or any other currency)
must have the same purchasing power in every country. The argument goes as follows. If a dollar could buy more
wheat domestically than abroad, there would be opportunities to profit by buying wheat domestically and selling it
abroad. Profit-seeking arbitrageurs would drive up the domestic price of wheat relative to the foreign price.
Similarly, if a dollar could buy more wheat abroad than domestically, the arbitrageurs would buy wheat abroad and
sell it domestically, driving down the domestic price relative to the foreign price. Thus, profit-seeking by
international arbitrageurs causes wheat prices to be the same in all countries. We can interpret the doctrine of
purchasing-power parity using our model of the real exchange rate. The quick action of these international
arbitrageurs implies that net exports are highly sensitive to small movements in the real exchange rate. A small
decrease in the price of domestic goods relative to foreign goods—that is, a small decrease in the real exchange
rate—causes arbitrageurs to buy goods domestically and sell them abroad. Similarly, a small increase in the
relative price of domestic goods causes arbitrageurs to import goods from abroad. Therefore, as in Figure 7.19, the
net-exports schedule is very flat at the real exchange rate that equalizes purchasing power among countries: any
small movement in the real exchange rate leads to a large change in net exports. This extreme sensitivity of net
exports guarantees that the equilibrium real exchange rate is always close to the level that ensures purchasing-
power parity.
Purchasing-power parity has two important implications. First, because the net-exports schedule is flat, changes in
saving or investment do not influence the real or nominal exchange rate. Second, because the real exchange rate is
fixed, all changes in the nominal exchange rate result from changes in price levels.

Figure 7.19: Purchasing-Power Parity
Is this doctrine of purchasing-power parity realistic? Most economists believe that, despite its appealing logic,
purchasing-power parity does not provide a completely accurate description of the world. First, many goods are not
easily traded. A haircut can be more expensive in Tokyo than in New York, yet there is no room for international
arbitrage because it is impossible to transport haircuts. Second, even tradable goods are not always perfect
substitutes. Some consumers prefer Toyotas, and others prefer Fords. Thus, the relative price of Toyotas and Fords
can vary to some extent without leaving any profit opportunities. For these reasons, real exchange rates do in fact
vary over time. Although the doctrine of purchasing-power parity does not describe the world perfectly, it does
provide a reason why movement in the real exchange rate will be limited. There is much validity to its underlying
logic: the farther the real exchange rate drifts from the level predicted by purchasing-power parity, the greater the
incentive for individuals to engage in international arbitrage in goods. We cannot rely on purchasing-power parity
to eliminate all changes in the real exchange rate, but this doctrine does provide a reason to expect that fluctuations
in the real exchange rate will typically be small or temporary.

Short Term Fluctuations in Output and
2 Employment: The Model of Aggregate
CHAPTER Supply and Aggregate Demand
In this Chapter, we introduce the model of aggregate supply and aggregate demand, which economists use to
explain short-run fluctuations. Before we start building the model, however, let’s step back and ask a fundamental
question: Why do economists need different models for different time horizons? This question generally arises as it
is widely believed that classical macroeconomic theory applies to the long run but not to the short run. But why is
this so?
Time Horizons in Macroeconomics
Most macroeconomists believe that the key difference between the short run and the long run is the behavior of
prices. In the long run, prices are flexible and can respond to changes in supply or demand. In the short run, many
prices are “sticky’’ at some predetermined level. Because prices behave differently in the short run than in the long
run, various economic events and policies have different effects over different time horizons. To see how the short
run and the long run differ, consider the effects of a change in monetary policy. Suppose that the RBI suddenly
reduces the money supply by 5 percent. According to the classical model, the money supply affects nominal
variables—variables measured in terms of money—but not real variables. As the theoretical separation of real and
nominal variables is called the classical dichotomy, and the irrelevance of the money supply for the determination
of real variables is called monetary neutrality. Most economists believe that these classical ideas describe how the
economy works in the long run: a 5-percent reduction in the money supply lowers all prices (including nominal
wages) by 5 percent while output, employment, and other real variables remain the same. Thus, in the long run,
changes in the money supply do not cause fluctuations in output and employment. In the short run, however, many
prices do not respond to changes in monetary policy. A reduction in the money supply does not immediately cause
all firms to cut the wages they pay, all stores to change the price tags on their goods, all mail-order firms to issue
new catalogs, and all restaurants to print new menus. Instead, there is little immediate change in many prices; that
is, many prices are sticky. This short-run price stickiness implies that the short-run impact of a change in the
money supply is not the same as the long-run impact.
A model of economic fluctuations must take into account this short-run price stickiness. We will see that the failure
of prices to adjust quickly and completely to changes in the money supply (as well as to other exogenous changes
in economic conditions) means that, in the short run, real variables such as output and employment must do some
of the adjusting instead. In other words, during the time horizon over which prices are sticky, the classical
dichotomy no longer holds: nominal variables can influence real variables, and the economy can deviate from the
equilibrium predicted by the classical model.
The Model of Aggregate Supply and Aggregate Demand
How does the introduction of sticky prices change our view of how the economy works? We can answer this
question by considering economists’ two favorite words—supply and demand. In classical macroeconomic theory,
the amount of output depends on the economy’s ability to supply goods and services, which in turn depends on the
supplies of capital and labor and on the available production technology. This is the essence of the basic classical
model of income and employment as well as of the Solow growth model. Flexible prices are a crucial assumption
of classical theory. The theory posits, sometimes implicitly, that prices adjust to ensure that the quantity of output
demanded equals the quantity supplied.
The economy works quite differently when prices are sticky. In this case, as we will see, output also depends on
the economy’s demand for goods and services. Demand, in turn, depends on a variety of factors: consumers’
confidence about their economic prospects, firms’ perceptions about the profitability of new investments, and
monetary and fiscal policy. Because monetary and fiscal policy can influence demand, and demand in turn can

SHORT TERM FLUCTUATIONS IN OUTPUT AND EMPLOYMENT: THE MODEL OF AGGREGATE SUPPLY AND AGGREGATE DEMAND
influence the economy’s output over the time horizon when prices are sticky, price stickiness provides a rationale
for why these policies may be useful in stabilizing the economy in the short run.
The basic model to start with is the model of supply and demand, which offers some of the most fundamental
insights in economics and shows how the supply and demand for any good jointly determine the good’s price and
the quantity sold, as well as how shifts in supply and demand affect the price and quantity. We now introduce the
“economy-size” version of this model—the model of aggregate supply and aggregate demand which allows us to
study how the aggregate price level and the quantity of aggregate output are determined in the short run. It also
provides a way to contrast how the economy behaves in the long run and how it behaves in the short run. The goal
of this chapter is to explain the model fully with its key elements and illustrate how it can help explain short-run
economic fluctuations.
Aggregate Demand
Aggregate demand (AD) is the relationship between the quantity of output demanded and the aggregate price
level. In other words, the aggregate demand curve tells us the quantity of goods and services people want to buy at
any given level of prices. We examine the theory of aggregate demand with the help of the quantity theory of
money to provide a simple derivation of the aggregate demand curve.
The Quantity Equation as Aggregate Demand
The quantity theory says that
MV = PY
Where M is the money supply, V is the velocity of money, P is the price level, and Y is the amount of output. If the
velocity of money is constant, then this equation states that the money supply determines the nominal value of
output, which in turn is the product of the price level and the amount of output. The quantity equation can be
rewritten in terms of the supply and demand for real money balances:
M/P = (M/P)d = ky
where k = 1/V is a parameter representing how much money people want to hold for every dollar of income. In this
form, the quantity equation states that the supply of real money balances M/P equals the demand for real money
balances (M/P)d and that the demand is proportional to output Y. The velocity of money V is the “flip side” of the
money demand parameter k. The assumption of constant velocity is equivalent to the assumption of a constant
demand for real money balances per unit of output. If we assume that velocity V is constant and the money supply
M is fixed by the central bank, then the quantity equation yields a negative relationship between the price level P
and output Y.
Figure 8.1 graphs the combinations of P and Y that satisfy the quantity equation holding M and V constant. This
downward-sloping curve is called the aggregate demand curve.
Figure 8.1: The Aggregate Demand

As a strictly mathematical matter, the quantity equation explains the downward slope of the aggregate demand, i.e.
the money supply M and the velocity of money V determine the nominal value of output PY. Once PY is fixed, if P
goes up, Y must go down. The economic intuition that lies behind this mathematical relationship is that we have
assumed the velocity of money is fixed; the money supply determines the rupee value of all transactions in the
economy. If the price level rises, each transaction requires more money, so the number of transactions and thus the
quantity of goods and services purchased must fall. In terms of the supply and demand for real money balances, if
output is higher, people engage in more transactions and need higher real balances M/P. For a fixed money supply
M, higher real balances imply a lower price level. Conversely, if the price level is lower, real money balances are
higher; the higher level of real balances allows a greater volume of transactions, which means a greater quantity of
output is demanded.
Shifts in the Aggregate Demand Curve
The aggregate demand curve is drawn for a fixed value of the money supply. In other words, it tells us the possible
combinations of P and Y for a given value of M. If the RBI changes the money supply, then the possible
combinations of P and Y change, which means the aggregate demand, curve shifts.
Figure 8.2: (a) Inward Shifts in the AD Curve (b) Outward Shifts in the AD Curve
For example, consider what happens if the RBI reduces the money supply. The quantity equation, MV = PY, tells
us that the reduction in the money supply leads to a proportionate reduction in the nominal value of output PY.
For any given price level, the amount of output is lower, and for any given amount of output, the price level is
lower. As in Figure 8.2(a), the aggregate demand curve relating P and Y shifts inward. The opposite occurs if the
RBI increases the money supply as in Figure 8.2(b). The quantity equation tells us that an increase in M leads to an
increase in PY. For any given price level, the amount of output is higher, and for any given amount of output, the
price level is higher. It is however to be noted that fluctuations in the money supply are not the only source of
fluctuations in aggregate demand. Even if the money supply is held constant, the aggregate demand curve shifts if
some event causes a change in the velocity of money.
Aggregate Supply
To accompany the aggregate demand curve, we need another relationship between P and Y that crosses the
aggregate demand curve—an aggregate supply curve. The aggregate demand and aggregate supply curves together
pin down the economy’s price level and quantity of output. Aggregate supply (AS) is the relationship between the
quantity of goods and services supplied and the price level. Because the firms that supply goods and services have
flexible prices in the long run but sticky prices in the short run, the aggregate supply relationship depends on the
time horizon. We need to discuss two different aggregate supply curves:

The long-run aggregate supply curve LRAS and

The short-run aggregate supply curve SRAS.

We also need to discuss how the economy makes the transition from the short run to the long run. The Long
Run: The Vertical Aggregate Supply Curve
Because the classical model describes how the economy behaves in the long run, we derive the long-run aggregate
supply curve from the classical model, i.e. the amount of output produced depends on the fixed amounts of capital
and labor and on the available technology. To show this, we write

According to the classical model, output does not depend on the price level. To show that output is fixed at this
level, regardless of the price level, we draw a vertical aggregate supply curve, as in Figure 8.3. In the long run, the
intersection of the aggregate demand curve with this vertical aggregate supply curve determines the price level.
Figure 8.3: The Long-Run Aggregate Supply Curve
If the aggregate supply curve is vertical, then changes in aggregate demand affect prices but not output. For
example, if the money supply falls, the aggregate demands curve shifts downward, as in Figure 8.4.
Figure 8.4: Shifts in Aggregate Demand in the Long Run
The economy moves from the old intersection of aggregate supply and aggregate demand, point A, to the new
intersection, point B. The shift in aggregate demand affects only prices. The vertical aggregate supply curve
satisfies the classical dichotomy, because it implies that the level of output is independent of the money supply.
This long-run level of output Y, is called the full-employment, or natural, level of output. It is the level of output at
which the economy’s resources are fully employed or, more realistically, at which unemployment is at its natural
rate.
The Short Run: The Horizontal Aggregate Supply Curve
The classical model and the vertical aggregate supply curve apply only in the long run. In the short run, some
prices are sticky and, therefore, do not adjust to changes in demand. Because of this price stickiness, the short-run
aggregate supply curve is not vertical. Suppose that all firms have issued price catalogs and that it is too costly for
them to issue new ones. Thus, all prices are stuck at predetermined levels. At these prices, firms are willing to sell

as much as their customers are willing to buy, and they hire just enough labor to produce the amount demanded.
Because the price level is fixed, we represent this situation in Figure 8.5 with a horizontal aggregate supply curve.
Figure 8.5: The Short-Run Aggregate Supply Curve
The short-run equilibrium of the economy is the intersection of the aggregate demand curve and this horizontal
short-run aggregate supply curve. In this case, changes in aggregate demand do affect the level of output. For
example, if the Fed suddenly reduces the money supply, the aggregate demand curve shifts inward, as in Figure
8.6.
Figure 8.6: Shifts in Aggregate Demand in the Short Run
The economy moves from the old intersection of aggregate demand and aggregate supply, point A, to the new
intersection, point B. The movement from point A to point B represents a decline in output at a fixed price level.
Thus, a fall in aggregate demand reduces output in the short run because prices do not adjust instantly. After the
sudden fall in aggregate demand, firms are stuck with prices that are too high. With demand low and prices high,
firms sell less of their product, so they reduce production and lay off workers. The economy experiences a
recession. Although many prices are sticky in the short run, some prices are able to respond quickly to changing
circumstances. As we will see later, in an economy with some sticky prices and some flexible prices, the short-run
aggregate supply curve is upward sloping rather than horizontal. Figure 8.6 illustrates the extreme case in which all
prices are stuck. Because this case is simpler, it is a useful starting point for thinking about short-run aggregate
supply.
From the Short Run to the Long Run

We can summarize our analysis so far as follows: Over long periods of time, prices are flexible, the aggregate
supply curve is vertical, and changes in aggregate demand affect the price level but not output. Over short periods
of time, prices are sticky, the aggregate supply curve is flat, and changes in aggregate demand do affect the

economy’s output of goods and services. How does the economy make the transition from the short run to the long
run? Let’s trace the effects over time of a fall in aggregate demand. Suppose that the economy is initially in long-
run equilibrium, as shown in Figure 8.7. In this figure, there are three curves: the aggregate demand curve, the
long-run aggregate supply curve, and the short-run aggregate supply curve. The long-run equilibrium is the point at
which aggregate demand crosses the long-run aggregate supply curve. Prices have adjusted to reach this
equilibrium. Therefore, when the economy is in its long-run equilibrium, the short-run aggregate supply curve must
cross this point as well.
Figure 8.7: A Long Run Equilibrium
Now suppose that the Fed reduces the money supply and the aggregate demand curve shifts downward, as in
Figure 8.8. In the short run, prices are sticky, so the economy moves from point A to point B. Output and
employment fall below their natural levels, which means the economy, is in a recession. Over time, in response to
the low demand, wages and prices fall. The gradual reduction in the price level moves the economy downward
along the aggregate demand curve to point C, which is the new long-run equilibrium. In the new long-run
equilibrium (point C), output and employment are back to their natural levels, but prices are lower than in the old
long-run equilibrium (point A). Thus, a shift in aggregate demand affects output in the short run, but this effect
dissipates over time as firms adjust their prices.
Figure 8.8: Reduction in Aggregate Demand
Stabilization Policy
Fluctuations in the economy as a whole come from changes in aggregate supply or aggregate demand. Economists
call exogenous events that shift these curves shocks to the economy. A shock that shifts the aggregate demand
curve is called a demand shock, and a shock that shifts the aggregate supply curve is called a supply shock. These
shocks disrupt the economy by pushing output and employment away from their natural levels. One goal of the
model of aggregate supply and aggregate demand is to show how shocks cause economic fluctuations. Another

goal of the model is to evaluate how macroeconomic policy can respond to these shocks. Economists use the term
stabilization policy to refer to policy actions aimed at reducing the severity of short-run economic fluctuations.
Because output and employment fluctuate around their long-run natural levels, stabilization policy dampens the
business cycle by keeping output and employment as close to their natural levels as possible. We analyze the
stabilization policy using our simplified version of the model of aggregate demand and aggregate supply. In
particular, we examine how monetary policy might respond to shocks. Monetary policy is an important component
of stabilization policy because, as we have seen, the money supply has a powerful impact on aggregate demand.
Shocks to Aggregate Demand
Consider an example of a demand shock: the introduction and expanded availability of credit cards. Because credit
cards are often a more convenient way to make purchases than using cash, they reduce the quantity of money that
people choose to hold. This reduction in money demand is equivalent to an increase in the velocity of money.
When each person holds less money, the money demand parameter k falls. This means that each rupee of money
moves from hand to hand more quickly, so velocity V (= 1/k) rises. If the money supply is held constant, the
increase in velocity causes nominal spending to rise and the aggregate demand curve to shift outward, as in Figure
8.9.
Figure 8.9: An Increase in Aggregate Demand
In the short run, the increase in demand raises the output of the economy—it causes an economic boom. At the old
prices, firms now sell more output. Therefore, they hire more workers, ask their existing workers to work longer
hours, and make greater use of their factories and equipment. Over time, the high level of aggregate demand pulls
up wages and prices. As the price level rises, the quantity of output demanded declines, and the economy gradually
approaches the natural level of production. But during the transition to the higher price level, the economy’s output
is higher than its natural level. With an increase in Aggregate Demand, the economy begins in long-run
equilibrium at point A. An increase in aggregate demand, perhaps due to an increase in the velocity of money,
moves the economy from point A to point B, where output is above its natural level. As prices rise, output
gradually returns to its natural level, and the economy moves from point B to point C.
Shocks to Aggregate Supply
Shocks to aggregate supply can also cause economic fluctuations. A supply shock is a shock to the economy that
alters the cost of producing goods and services and, as a result, the prices that firms charge. Because supply shocks
have a direct impact on the price level, they are sometimes called price shocks. Here are some examples:
A drought that destroys crops. The reduction in food supply pushes up food prices. All these events are adverse
supply shocks, which mean they push costs and prices upward. A favorable supply shock, such as the breakup of
an international oil cartel, reduces costs and prices.

Figure 8.10 shows how an adverse supply shock affects the economy. The short-run aggregate supply curve shifts
upward. (The supply shock may also lower the natural level of output and thus shift the long-run aggregate supply
curve to the left, but we ignore that effect here.) If aggregate demand is held constant, the economy moves from
point A to point B: the price level rises and the amount of output falls below its natural level. An experience like
this is called stagflation, because it combines economic stagnation (falling output) with inflation (rising prices).
Faced with an adverse supply shock, a policymaker with the ability to influence aggregate demand, such as the
RBI, has a difficult choice between two options. The first option, implicit in is to hold aggregate demand constant.
In this case, output and employment are lower than the natural level. Eventually, prices will fall to restore full
employment at the old price level (point A), but the cost of this adjustment process is a painful recession.
Figure 8.10: An Adverse Supply Shock
The second option, illustrated in Figure 8.11, is to expand aggregate demand to bring the economy toward the
natural level of output more quickly. If the increase in aggregate demand coincides with the shock to aggregate
supply, the economy goes immediately from point A to point C. In this case, the Fed is said to accommodate the
supply shock. The drawback of this option, of course, is that the price level is permanently higher. There is no way
to adjust aggregate demand to maintain full employment and keep the price level stable.
Figure 8.11: Accommodating an Adverse Supply
We may conclude AS and AD Analysis, which is based on the assumption that prices are sticky in the short run
and flexible in the long run, which shows how shocks to the economy cause output to deviate temporarily from the
level implied by the classical model. The model also highlights the role of monetary policy. On the one hand, poor

monetary policy can be a source of destabilizing shocks to the economy. On the other hand, a well-run monetary
policy can respond to shocks and stabilize the economy.
We may conclude AS and AD Analysis, which is based on the assumption that prices are sticky in the short run
and flexible in the long run, which shows how shocks to the economy cause output to deviate temporarily from the
level implied by the classical model. The model also highlights the role of monetary policy. On the one hand, poor
monetary policy can be a source of destabilizing shocks to the economy. On the other hand, a well-run monetary
policy can respond to shocks and stabilize the economy.

3 Keynesian Theory of Output,
CHAPTER Income and Employment
The Background
The Great Depression of the 1930s crippled the free enterprise economics of the United Kingdom very badly. At
the bottom of the Depression unemployment in the US reached almost 13 million, estimating to approximately 25
percent of the total labour force of the country. Comparable rates of unemployment exist in the U.K during this
period. Since such a prolonged and deep depression was unthinkable in the classical economics which was
dominant at that time. Many an economist tended to explain away the situation by saying that it was the “world”
and not the theory that was at fault. The prominent classicist of that time, Prof. Arthur Cecil Pigou of England’s
Cambridge University, wrote in his book, titled “The Theory of Unemployment” (1933)”with perfectly free
competition…… there will always be a strong tendency towards full employment. The implication is that such
unemployment as exists at any time is due wholly to the fact that frictional resistances (caused by monopolistic
trade unions and firms maintaining rigid wages and prices) prevent the appropriate wage (and price) adjustments
from being made instantaneously”.
The classical economists contended that a flexible wage and price policy would abolish fluctuations of
unemployment. They strongly adhered to the position that the system automatically tends toward full-employment
equilibrium, and that frictional maladjustments alone are responsible for temporary fluctuations. In reaction to this
general view-and to Prof. Pigou’s book in particular-the eminent British economist John Maynard Keynes
published in 1936 his celebrated volume, ‘The General Theory of Employment, Interest and Money’ in which he
undermined the classical theory and introduced what came to be called the New Economics.
In this book, he not only criticised the classical macroeconomics, but also presented a ‘new’ theory of income and
employment. Keynes’ theory of employment is a demand-deficient theory. This means that Keynes visualised
employment/unemployment from the demand side of the model. His theory is, thus, known as demand-oriented
approach, as opposed to the classical supply side model. According to Keynes, the volume of employment in a
country depends on the level of effective demand of people for goods and services. Unemployment is attributed to
the deficiency of effective demand.
It is to be kept in mind that Keynes’ theory is a short run theory when population, labour force, technology, etc., do
not change. Once Keynes remarked that since “in the long run we are all dead”, it is of no use to present a long run
theory. In view of this, one can argue that the volume of employment depends on the level of national
income/output. Higher (lower) the level of national output higher (lower) is the volume of employment. Thus,
Keynesian theory of employment determination is also the theory of income determination.
Meaning of Effective Demand:
Keynes’ theory of employment is based on the principle of effective demand. In other words, level of employment
in a capitalist economy depends on the level of effective demand. Thus, unemployment is attributed to the
deficiency of effective demand and to cure it requires the increasing of the level of effective demand. By ‘effective’
demand, Keynes meant the total demand for goods and services in an economy at various levels of employment.
Total demand for goods and services by the people is the sum total of all demand meant for consumption and
investment. In other words, the sum of consumption expenditures and investment expenditures constitute effective
demand in a two-sector economy.
In order to meet such demand, people are employed to produce all kinds of goods, both consumption goods and
investment goods. However, to complete our discussion on effective demand, we need another component of
effective demand — the component of government expenditure. Thus, effective demand may be defined as the
total of all expenditures, i.e.

KEYNESIAN THEORY OF OUTPUT, INCOME AND EMPLOYMENT
C+1+G
Where C stands for consumption expenditure, I stand for investment expenditure, and G stands for government
expenditure.
Here we ignore government expenditure as a component of effective demand. According to Keynes, the level of
employment is determined by the effective demand which, in turn, is determined by aggregate demand function or
aggregate demand price and aggregate supply function or aggregate supply price. In Keynes’ words; “The value of
D (Aggregate Demand) at the point of Aggregate Demand function, where it is intersected by the Aggregate Supply
function, will be called the effective demand.”
Aggregate Supply (AS)
Employers hire and purchase various inputs and raw materials to produce goods. Thus, production involves cost. If
sales revenue from the sale of output produced exceeds cost of production at a given level of employment and
output, the entrepreneur would be induced to employ more labour and other inputs to produce more.
At any given level of employment of labour, aggregate supply price is the total amount of money that all
entrepreneurs in the economy expect to receive from the sale of output produced by given number of laborers
employed. For each particular level of employment, there is an aggregate supply price. Here, by ‘price’ we mean
the amount of money received from the sale of output, i.e., sales proceeds.
Thus, aggregate supply price refers to the proceeds from the sale of output at each level of employment and there
are different aggregate supply prices for different levels of employment. If this information is expressed in a
tabular form, we obtain “aggregate supply price schedule” or aggregate supply function. The aggregate supply
function is a schedule of the minimum amounts of proceeds required to induce varying quantities of employment.
Simply, it shows various aggregate supply prices at different levels of employment. Plotting this information
graphically, we obtain aggregate supply curve.
According to Keynes, aggregate supply function is an increasing function of the level of employment. Aggregate
supply (AS) curve slopes upward from left to right because volume of employment increases with the increase in
sale proceeds. But there is a limit to increase output level. This is called full employment level of output beyond
which output cannot be increased; it is because of full employment that AS curve becomes vertical or perfectly
inelastic. This means that the level of employment cannot exceed full employment (LF) level even by increasing
aggregate supply price. This is shown in Figure 9.1.
Figure 9.1: Effective Demand and Determination of Employment

Aggregate Demand (AD):

Aggregate demand or aggregate demand price is the amount of money or price which all entrepreneurs expect to
receive from the sale of output produced by a given number of men employed. Or it refers to the expected revenue
from the sale of output at a particular level of employment. Each level of employment is associated with a
particular aggregate supply price and there are different aggregate demand prices for different levels of
employment.
Like the aggregate supply schedule, aggregate demand schedule shows the aggregate demand price for each
possible level of employment. Plotting the aggregate demand schedule we obtain aggregate demand curve as there
is a positive relation between the level of employment and aggregate demand price, i.e., expected sales receipts.
This is shown in Fig. 8.1 It rises from left to right.
Equilibrium Level of Employment— the Point of Effective Demand:
We have studied separately aggregate demand and aggregate supply as the two determinants of effective demand.
Now we will describe how equilibrium level of employment is deter-mined in an economy by using the concept of
effective demand.
The level of employment in an economy is determined at that point where the aggregate supply price equals the
aggregate demand price. In other words, the intersection of the aggregate supply function with the aggregate
demand function determines the volume of income and employment in an economy.
It is, thus, clear that so long as expected sales receipts of the entrepreneur (i.e., aggregate demand schedule) exceed
costs (i.e., aggregate supply schedule), the level of employment should be increasing and the process will continue
until expected receipts equal costs or aggregate demand curve intersects aggregate supply curve.
Note that the AS curve starts from the origin. If aggregate receipts (i.e., GNP) are zero, entrepreneurs would not
hire workers. Like-wise, AD curve also starts from the origin. The equilibrium level of employment is determined
by the intersection of the AS and AD curves. This is the point of effective demand— point E in Figure 8.1
Corresponding to this point, OLE workers are employed. At the OL1 level of employment, expected receipts
exceed necessary costs by the amount RC. Entrepreneurs will now go on hiring more labour till OLE level of
employment is reached.
At this level of employment, entrepreneurs’ expectations of profits are maximized. Employment beyond OLE is
unprofitable because costs exceed revenue. Thus, actual employment (OLE) falls short of full employment (OLF).
Keynesian system shows two kinds of equilibria—actual employment equilibrium determined by AD and AS
curves and underemployment equilibrium.
Effective Demand and Determination of Employment
Keynes made little emphasis to the aggregate supply function since its determinants (such as technology, supply or
availability of raw materials, etc.,) do not change in the short run. Keynes was examining the possibility of
unemployment in a capitalistic economy against the backdrop of Great Depression of the 1930s.
After diagnosing the problem, Keynes recommended policy prescription so as to create more employment in the
economy. Indeed, for curing unemployment problem, he did not subscribe to the classical ideas—the supply-
oriented policies. Keynes attached great importance to demand-stimulating policies to cure unemployment. In other
words, Keynes paid emphasis on the aggregate demand function. That is why Keynes’ theory is known as a ‘theory
of aggregate demand’.
Figure 8.1 shows the situation of equilibrium at less than full employment level. Actual equilibrium, OLE, is short
of full employment equilibrium, OLE. Thus, the distance OLF – OLE measures unemployment. This is called
involuntary unemployment—a situation at which people are willing to work but do not find jobs. This
unemployment, according to Keynes, is due to the deficiency of aggregate demand. This unemployment can be
removed by stimulating aggregate demand. Aggregate demand is the sum total of consumption and investment
demand or expenditures in the economy. By raising consumption expenditure, level of employment can be raised.

But there is a limit to consumption expenditure. So what is needed is the raising of (private) investment demand.
Anyway, an increase in consumption demand and investment demand will raise the level of employment in the
economy. The point of effective demand has been changed because of the shifting of AD curve from AD to AD1.
New effective demand is now given by E1 Corresponding to this point, equilibrium level of employment is OLF—
the level of full employment. Thus, in Keynes’ theory, unemployment is due to the deficiency of effective demand.
Only by stimulating effective demand can a higher level of employment be achieved. However, Keynes goes on
arguing that equilibrium level of employment will not necessarily be at full employment.
A capitalist economy will always experience underemployment equilibrium—an equilibrium situation less than full
employment. Full employment, according to Keynes, can never be achieved. In Keynes’ scheme of things, both
consumption and investment cannot be raised enough to employ more work force. Therefore, he recommends
government to come forward and take appropriate action to cure unemployment problem.
This means that aggregate demand is now the sum total of all consumption, investment and government
expenditures. It is because of the multiplier effect of both private investment expenditure and government
expenditure, that there will be larger income, output and employment. But equilibrium in the economy will be
established at less than full employment situation because of (i) wage rigidity, (ii) interest inelasticity of
investment, and (iii) liquidity trap.
Keynesian Theory: Fundamental Assumptions
Like any economic theory, Keynesian economics relies on a set of fundamental assumptions. The three most noted
assumptions are inflexible prices, effective demand, and important savings and investment determinants other than
the interest rate. These three assumptions are in direct contrast, and in response, to three assumptions underlying
classical economics-flexible prices, Say's law, and savings-investment equality. Whereas classical economics
assumes that prices are flexible and quickly adjust to equilibrium, Keynesian economics assumes that prices are
inflexible and do not quickly adjust to equilibrium. Whereas classical economics assumes that supply creates its
own demand, termed Say's law, Keynesian economics assumes that demand, especially consumption expenditures,
depends on actual income received by the household sector. Whereas classical economics assumes that saving and
investment achieve equality through flexible adjustment of the interest rate, Keynesian economics assumes that
saving and investment depend on factors other than the interest rate and might not achieve equilibrium.
Highlights of Keynesian economics include:
 One, Keynesian economics offers a theoretical explanation of, and a remedy for, persistent unemployment
problems, especially those occurring during the Great Depression.
 Two, the theoretical structure of Keynesian economics is based on a view that the macro economy is a distinct
entity operating according to a set of principles distinct from those governing microeconomic phenomena. The
macro economy is more than just a collection of markets.
 Three, these macroeconomic principles of Keynesian economics indicate that aggregated markets, especially
resource markets, do not automatically achieve equilibrium, meaning full employment is not guaranteed.
 Four, Keynesian economics indicates that the recommended way to achieve full employment is through
government intervention, especially fiscal policy.
Rigid Prices
The first of three key assumptions underlying Keynesian economics is the presumption that prices are inflexible or
rigid, especially in the downward direction. This price rigidity is fundamental to the Keynesian implication of
sustained unemployment. If prices, especially wages, do not decline, then the resulting labor market surplus means
unemployment.
Rigid prices can exist for a number of reasons. First, producers often have long-term, multi-year contracts with
resource suppliers that specify resource prices. These agreements prevent prices for changing. Second, workers
tend to view wages as an indication of intrinsic self-worth and thus resist attempts to lower wages. Workers might
opt for temporary unemployment, rather than working at lower wages.
Third, the employment and payment system is guided by inertia. Employers are often reluctant to change wages
because doing so can be costly. Fourth, firms often reduce employment rather than wages to "clean house" and get
rid of the least productive workers. Fifth, many firms, especially small ones, are price takers in resource markets.
They have no control over the resource prices set by the market.
Effective Demand
The second key Keynesian assumption is the notion of effective demand, that consumption expenditures are based
on the disposable income actually available to the household sector rather than income that would be available at
full employment. Effective demand means that people spend the income that they actually have not the income that
they could have under other circumstances.
This assumption means that changes in income, especially disposable income, are the prime influence on
consumption expenditures. If the household sector has more income because the economy is expanding, then they
increase consumption expenditures. If the household sector has less income because the economy is contracting
and a large group of workers is unemployed, then they decrease consumption expenditures.
This effective demand proposition is embodied in a key Keynesian principle, termed the consumption function,
which is the relation between household consumption expenditures and household income. More specially, as
specified by the so-called psychological law, the consumption function indicates that people use only a fraction of
any extra income for consumption.
Saving and Investment Determinants
The third important Keynesian assumption is that saving and investment are influenced by factors other than the
interest rate. These other factors can prevent the equality between saving and investment, or perhaps allow
equilibrium only at a negative interest rate. The lack of equality between saving and investment can lead to a
cumulatively reinforcing downward spiral of declining production and income.
The most important non-interest-rate determinant of household saving is disposable income. As the disposable
income changes, not only does the household sector change consumption expenditures, it also changes saving.
Keynesian economics assumes that the relation between saving and income is a great deal more important than that
between saving and the interest rate. Another key non-interest-rate determinant of saving is expectations. That is,
the household is motivated to save in anticipation of future spending (saving for college, saving for retirement,
saving to buy a house, etc.), regardless of the interest rate.
The most important non-interest-rate determinant of business investment is expectations, especially expectations of
future production and profitability. That is, the business sector is primarily motivated to undertake investment
expenditures on capital goods if they anticipate a profitable return. A booming economy can ensure profitable
returns even with a high interest rate. Moreover, a stagnant economy can prevent profitable returns even with a low
interest rate. In fact, the economy might be in such a dismal state that a negative interest rate is needed to entire
enough business investment to achieve equality with saving.
Alternative Expositions to Keynesian Theory of Income and Employment Total Spending and Economic
Activity:
Basically, expansions and contractions in economic activity, or changes in real output, are caused by changes in
total, or aggregate, spending. Total, or aggregate, spending refers to the total spending for all new goods and
services by households, businesses, government units, and foreign buyers combined.
Why do changes in spending cause the level of economic activity to change? In a market economy, buyers, through
their spending decisions, choose goods and services that are produced by sellers. If buyers do not spend their
money on products, sellers will not produce those products for the market. Thus, if total spending were to decrease,
output would decrease; if total spending were to increase, output would increase; and if total spending remained
unchanged, output would not change. When the level of spending goes up and sellers increase production, more
land, labour, capital, and entrepreneurship are required. This means that there will be an increase in the
employment of resources, which will, in turn, enlarge incomes. Thus, increased spending leads to economic

expansion or recovery because it stimulates a growth in output, employment, and income. When spending falls and
sellers reduce their outputs, a cutback occurs in the employment of resources. This cutback in turn leads to a
decrease in resource owners’ incomes. Thus, a reduction in spending leads to a recession or contraction in
economic activity, because of its dampening effect on output, employment, and income.
Because aggregate spending is composed of expenditures by households, businesses, the government, and foreign
buyers, it is necessary examine the spending behaviour of each of these sectors, along with how that behaviour
affects the level of economic activity.
Aggregate Effective Demand:
Keynes’ analysis of general unemployment is based on the concept of aggregate (or total) demand in the economy.
To simplify his analysis, Keynes initially left aside the government sector and foreign trade (or exports). In a
closed economy with no government sector, the two components of aggregate demand are:
 Private consumption expenditure and
 Private investment ex-penditure.

The Household Sector:
In the aggregate, the largest spending group in the economy is households. Households buy far more goods and
services than do businesses, government units, and foreign purchasers combined. Also, over time, household
spending increases at a relatively stable pace. Because individuals do not usually alter their expenditure patterns
from year to year, aggregate house-hold spending on new goods and services, which is technically termed personal
con-sumption expenditures, tends to fluctuate very little as it grows over time.
The Consumption Function:
To construct Keynesian macroeconomic models, it is necessary to have a clear under-standing of the consumption
function. The concept of propensity to consume or the so- called consumption function is based on the—
“fundamental psychological law” which states that — “as a rule and on the average” — as income increases,
consumption increases but the rate of the increase in consumption is less than the rate of increase in income. Thus,
in Keynes’ consumption function, a relation-ship between functions has the following characteristics:
 Consumption is a function of (dispos-able) income, i.e., C = f (Y).
 The relationship between consumption and income is a direct one.
 The rate of increase in consumption is less than the rate of increase in income. In Keynes’ terminology, the
value of the marginal propensity to consume (MPC) is less than one.
The Saving Function:
The portion of income which is not consumed is automatically saved. Thus, saving is the difference between
income and consumption. That is,
S=Y–C
Like consumption function, saving also directly depends or income. To have a clear understanding of the saving
function, we must define Keynes’ four key concepts
 The average propensity to consume (APC): It is the proportion of income which is spent on consumption. It is
worked out by dividing total consumption expenditure (C) by total income (Y) – APC = C/Y.
 The marginal propensity to consume (MPC): It is the proportion of an addition to income that is spent on
consumption. It is expressed as: MPC = ΔC/ΔY, where C denotes the change in consumption and Y is the
change in income.
 The average propensity to save (APS): It is the proportion of income that is saved. It is found out by dividing
total savings (S) by total income (Y) or APS = S/Y.

 The marginal propensity to save (MPS): It is the proportion of an addition to income that is saved – MPS =
ΔS /ΔY, where S is the change in saving.

Relationship between APC and APS and MPC and MPS:
We know that, out of total income, a part is consumed and another part is saved, i.e., Y = C + S. Thus, if we know
APC or MPC, then we can determine APS and MPS in the following way:
APC = C/Y
APS = S/Y = Y – C/Y [As S = Y – C]
Or, APS = 1 – C/Y
Or, APS = 1 – APC.
Thus, APC and APS are complementary concepts. The sum of APC and APS is always equal to one. We know
that, Y = C + S. Dividing both sides of the equation by Y we get,
Y/Y = C/Y + S/Y
Or, 1 = APC + APS
To determine MPS from MPC, let us suppose that both consumption and saving change as income changes. Thus
∆Y =∆C + ∆S. Dividing both sides of the equation by Y we get,
= ∆C/∆Y +
∆Y/∆Y ∆S/∆Y
Or, 1 = MPC + MPS
Or, MPS = 1–MPC
Keynes assumed that, as income rises, the MPC falls. This brings us on to the consumption function, which lies at
the heart of the Keynesian analysis. The consumption function shows the level of consumer’s expenditure at each
level of income. Figure 9.2 represents the linear consumption function (C = a + bY) diagrammatically.
Figure 9.2: Linear Consumption Function
We know that even when income is zero, consumption expenditure is positive. This is known as ‘autonomous
consumption’ and can take place because people draw on past savings to pay for it. Or, some people may depend
on others for survival. This is also known as ‘subsistence consumption’. It has no relation to individual’s (or
society’s) income. As income increases above this zero level, consumption expenditure also increases. In Figure
9.1, when income rises from OY1 or OY2 consumption expenditure increases from OC1 to OC2. However, the

increase in consumption is less than the increase in income — because part of the increase in income is likely to
the saved. The slope of the consumption schedule gives us the MPC. From the Figure, one can establish the
relationship between APC and MPC. At the zero level of income, APC is infinite. However, as income increases,
APC declines. Its value may be greater than, equal to, or less than one. On the other hand, the value of MPC is
always greater than zero but less than one; i.e., 0 < MPC < 1. On a straight line consumption function, the value of
MPC remains constant. Thus, APC should exceed MPC.
Like consumption function, saving function can also be represented with the help of Figure. It starts somewhere
from the vertical axis below the origin (i.e., negative quadrant). This is because, at a very low level of income,
saving may be negative, since consumption is always positive. Consumption expenditure takes place during this
time by drawing down past savings. That is why the saving live starts from the negative axis. But, as income
increases, saving increases, so saving curve must be a rising one. Further, the slope of the saving function is
nothing but the MPS.
Investment
Investment expenditure is the second component of aggregate effective demand. Business investment refers to
expenditure on capital goods such as plant, equipment and machinery (fixed capital) as also stocks (working
capital), i.e., physical or real investment. In economics, the term investment relates specifically to physical
investment. It creates new assets, thereby adding to society’s productive capacity. To be more specific, investment
refers to expenditure on the purchase of physical assets such as plant, machinery and equipment (fixed capital) and
stocks (working capital). Such physical or real investment creates new assets — thereby adding to the country’s
productive capacity, whereas financial invest-ment only transfers the ownership of existing assets from one person
or institution to another. Investment requires that an amount of current consumption is sacrificed (i.e., a portion of
income is saved) so as to release the resources to finance it. It is an injection into the circular flow of national
income. Investment expenditure is normally defined as consisting only of private sector investment spending.
Determinants of Investment
When considering whether to undertake expenditure an entrepreneur will compare the cost of the venture (such as
setting up of a textile mill) and the revenue he expects to get from it. The cost refers to the amount to be paid for
the machine, or any other form of capital, and the rate of interest to be paid on the money borrowed to finance the
expenditure. If the rate of interest falls, one would expect more investment to be undertaken. As Keynes put it:
“The amount of current investment will depend, in turn, on what we shall call the inducement to invest; and the
inducement to invest will be found to depend on the relation between the schedule of marginal efficiency of capital
and the interest rates on comes of various maturities and risks”.
Thus investment decisions are governed by whether the expected rate of return on the machine is greater than the
cost of borrowing the necessary funds, or, if the funds are already available, the cost of the earnings lost by
purchasing the machine rather than by lending out of funds. In short, the inducement to invest depends on the
marginal efficiency of capital (expected return from the investment in future) and the rate of interest r. For an
investment to be worthwhile, MEC must never fall below r. So the desire of on entrepreneur to undertake such
risks will depend on their expectations regarding the future. If their view of future prospects is pessimistic they will
be less willing to spend more on investment. On the other hand, optimism among entrepreneurs can make them
more ready to undertake new investment projects.
The MEC decreases as the amount of investment increases. This is because initial investments are made on the
most productive or profitable projects later investments are made on less productive projects, which yield returns.
We have just mentioned that the demand curve for investment goods depends largely on entrepreneurs’
expectations of the future earnings of these goods. And since expectations are largely uncertain, the demand for
investment goods is likely to fluctuate overtime.
In truth the main factor — which will influence entrepreneurs in making investment decisions—is the level of
consumption. For the demand for investment goods is a derived demand which depends ultimately on current

expenditure on consumption. If current consumption is high, investment will be high too, in as much as
entrepreneurs will be optimistic. If consumption is low, then investment will also be low.
MEC represents the demand for new investment goods. MEC is the yield expected from a new unit of capital. An
entrepreneur, who decides to purchase a new factory or buy a new machine, first of all considers the prospective
yield of the asset in question. He will also have to pay for the asset if it is to be produced. This price is known as
the supply price of the asset or its replacement cost. And the MEC of a particular type of asset shows what the
entrepreneur expects to earn from one more asset of that kind compared with what he has to pay to buy it. Keynes
defines MEC as being equal to that rate of discount which would make the present value of the series of annuities,
given by the returns expected from the capital asset during its life, just equal to its supply price.
In other words, the MEC of a particular type of capital asset is the rate at which the prospective yield expected
from one additional unit of that particular asset must be discounted if it is just to equal the (replacement) cost of the
asset. It shows what the rate of discount must be if some entrepreneur is to be just induced to purchase one more
(marginal) unit of that type of asset.
The rate of return over cost, r, is called the MEC. It can be calculated as follows:
Let R1, R2…, Rn the expected earnings of a new capital asset in years 1, 2, …., n, respectively. Let K be the scrap
value of the machine at the time of replacement, C0 the initial cost of the machine, and e the rate return over cost.
Then
C0 = R1/(1 + e) + R2/(1 + e)2 + … + Rn/(1 + e)n + K/(1 + e)n.
Therefore, if C0, K and R’s are known, e can be calculated.
Illustration: Let us consider a simple case of a machine with an indefinite return R each year. In this case C0 =
R/e, so that, if the machine costs Rs. 1,000 and R is Rs. 100, the expected rate of return over cost of the machine is
10%. If the market rate of interest is 5%, the Rs. 1,000 would bring a return of Rs. 50, if lent in the market. But if
the same Rs. 1,000 is invested in the new machine, the annual return is Rs. 100. Consequently, it pays to invest in
the machine rather than in the bond. Similarly, if the Rs. 1,000 is not available, it would pay to borrow at 5% in
order to purchase the machine on which 10% can be earned. Clearly, if MEC remains constant, the number of new
machines that will be bought in any period depends on the market rate of interest. So the investment demand
function can be written as:
I = f (r).
On the basis of the two factors affecting investment (i.e., MEC and the rate of interest) we can draw the MEC
schedules in Figure 9.4.
Figure 9.4: MEC Schedule

The Marginal Efficiency of Capital Schedule
It is clear that investment will be profitable up to the point where MEC is equal to the rate of interest (which
measures the cost of capital). In Figure 9.4, at an interest rate of r0 (which is, say, 20%) only OI0 amount of
investment is worthwhile. A fall in the rate of interest to r1, (say, 15%), increases the amount of profit investment
to OI1. Investment also depends on expectation of entrepreneurs. If expectations change and investors expect to
receive more return from each investment because of, say, technological progress, then the MEC schedule will
shift from MEC to MEC1. Consequently, at any given rate of interest (such as 20%) more investment will be
undertaken then before. This is indicated by point C in Figure 9.4. A more pessimistic outlook would cause the
MEC curve to shift to the left, e.g., to MEC2 indicating that less investment will be undertaken at any given rate of
interest. The curve is, therefore, likely to shift frequently as and when there is a change in the mood among
entrepreneurs.
Equilibrium Level of Income
There are two alternative ways of stating the equilibrium conditions for national income:

Desired expenditure equals actual output (the income-expenditure approach).

Saving equals investment (the leakages-injections approach).
Both the approaches give the same result. But each has different insights. Thus, it is useful to discuss both.
The Income-Expenditure Approach:
The income-expenditure approach is illustrated in Table 8.1. It is quite obvious that in a modern economy using
money as a medium of exchange all income is generated by production, i.e., the entire national income is paid out
to households, so that the income of the households is exactly equal to the value of output i.e., GNP or GNI.
The Relation between Income and Expenditure:
It is necessary to consider, at the beginning of our analysis, how much expenditure is planned at each level of
national income. Let us assume that business firms are producing an output of Rs. 1600 crores. Income of the
household sector is also Rs. 1600 crores. But, according to Table 9.1 total planned expenditure of households and
firm on C and I is Rs. 1800 crores at that level of income.
If firms continue to produce their current output level of Rs. 1600 crores when planned expenditure is Rs. 1800
crores, one of the following two things must happen: either (1) production plans will be fulfilled and expenditure
plans unfulfilled or (2) expenditure plans will be fulfilled and production plans will be unfulfilled. We may now
consider each of these extreme possibilities in greater detail.
Unfulfilled expenditure plans:
Firstly there is the possibility that households and business firms will not be able to spend Rs. 200 crores in excess
of the value of current output that they plan to spend. There will be excess demand for commodities and shortages
will appear in the market(s). These will provide signals to the firms to increase their output so as to meet the excess
demand by selling more. As and when they do this, national income rises.

Table 9.1: Equilibrium Level of Income: Income Expenditure Approach
Unplanned changes in stocks:

Business firms often hold stocks of finished goods because production and sales do not always coincide. So the
second possibility here is that households and firms will be able to fulfil their expenditure (consumption and
invest-ment) plans by purchasing goods that were produced in the past and held in stock. Since supply =
production ± stocks, the only way to fulfil consumption and investment plans in this case is by purchasing existing
stocks of goods.
Thus, in our example, the stocks of business firms must fall by Rs. 200 crores in order to meet excess demand of
the same amount. It is because the desired expenditure of the community of Rs. 1800 crores is greater than the
current output of Rs. 1600 crores by exactly Rs. 200 crores. This situation will continue as long as stocks last, with
more goods being sold than are currently being produced. However, stocks will get exhausted sooner or later. But
firms will adopt necessary measures to meet the extra demand well in advance. The additional output will then
permit business firms to sell more without a further reduction of stocks. As production increases the demand for
factors will increase and the factor- owners will receive extra income.
Thus, in both the case (i.e., case of unfulfilled expenditure plan and un-planned changes in stocks) the effect of an
excess of planned expenditure over actual output is a rise in GNP or in national income. In each of the two cases
described above the following conclusion will hold at any level of national income or national output at which total
planned (desired) expenditure exceeds total output, national income will have to rise—sooner or later.
Assume that national income is Rs. 3,200 crores. When income reaches this level, the total expenditure of
households and business firms on consumption and investment goods is Rs. 3,000 crores. If firms continue to
produce a total output of Rs. 3,200 crores there will be undesired inventory of Rs. 200 crores, i.e., Rs. 200 crores
worth of goods will remain unsold. This will lead to a rise in the level of stocks of business firms. But this is not
desirable for obvious reasons. Firms will, therefore, not permit their stocks to increase continuously. If they are
forced to hold stocks of finished goods due to low demand, a cutback in production is inevitable. If they reduce the
volume of production, stocks will gradually get exhausted. Consequently output will be equal to cur-rent sales,
sooner or later. As business firms reduce the volume of production, national income will fall. Thus, it is quite clear
that at any level of national income for which total desired (planned) expenditure falls short of total output (GNP),
national output or national income will sooner or later fall.

Equilibrium Income:
Suppose, now national income is Rs. 2,400 crores. At this level, and only at this level, total planned expenditure of
households and business firms is exactly equal to the amount of output produced or income generated by the
economy (i.e. total planned expenditure is equal to national income). Households are just able to buy what they
wish to without causing stocks to rise or fall. Business firms are just able to sell their entire current output, with-out
adding to or subtracting from their stocks. Since current output is just sufficient to meet current demand there is
hardly any incentive for firms to pro-duce more or less. Thus national income remains un-changed. Since there is
neither excess demand nor ex-cess supply there is no upward or downward pressure on national income either.
When national income remains unchanged at a particular level without either increase or fall it is said to be in
equilibrium. Thus, national income reaches its equilibrium level only when aggregate planned expenditure (C + I)
is exactly equal to current total output.
The income-expenditure approach may now be illustrated diagrammatically. In Figure 9.5 the aggregate
expenditure function is E. It is the sum-total of C and I and is obtained by plotting column (iv) of Table 9.1. The
45° line is called the income line (or guideline) because it shows different levels of income. It is obtained by
plotting column (i) of Table 9.1. National income reaches equilibrium at point A where desired expenditure is
equal to national income (out-put). What is the logic of this equilibrium? Below the equilibrium level of income,
the E line lies above the 45° line (labelled E = Y). This shows that total planned expenditure exceeds national
income.
Figure 8.5: Income-Expenditure Approach
When people want to buy more goods than is being produced there will be a pressure on national income to rise, as
is indicated by the arrow to the left of point A. On the other hand, above the equilibrium level of income, the E lie
above the income line. This shows that planned expenditure is less than income. What people express their
desire to buy less than what the economy is currently producing; there is a pressure on national income to fall, as is
indicated by the arrow to the right of point A. Equilibrium is reached at the level of income Ye where the total
expenditure line, E, cuts the income line (or the 45° line). At this level of income desired expenditure, shown on
the vertical axis, it exactly equal to actual national income, shown on the horizontal axis. This is the essence of the
Keynesian theory of income (output) determination. Since income is the result of employment of resources,
including manpower, this theory is also known as the Keynesian theory of income and employment.

Planned and Actual Expenditure:

It was Keynes who first discovered the relation between planned and actual figures. So it is necessary to refer to
the relation between output and planned expenditure on one hand and actual expenditure on the other hand. A
study of national income accounting (estimation) shows that as a matter of definition, the value of the nation’s
output or GNP is equal to actual expenditure on that output and to actual factor incomes generated by producing
that output. These are just three different ways of looking at the same figure, the money value of total output
produced.
But what is relevant for Keynesian theory of income determination is planned or desired expenditure. We have
seen above that an inequality (or imbalance) between planned expenditure and total output creates disequilibrium
in a simple two-sector economy. There is no reason why the planned expenditure of households and firms on
consumption and capital goods should always be equal to the value of total output of such goods. In fact, we have
observed that when these two magnitudes are not the same, national income must rise or fall. We have also noted
that when planned expenditure is equal to total output, national income is in equilibrium. Keynes’ income-
expenditure approach determines the equilibrium level (value) of national income at that point. The implication is
very simple: in a private two-sector economy people wish to buy the total output that firms succeed in producing.
The Leakages-Injections (Saving-Investment) Approach:
It is to be noted, at the outset, that there are both injections into and leakages from the circular flow of income, as
discussed in Chapter 7. An injection or an addition refers to payments received by firms or households that are not
derived from the spending of the other group. Oppositely, a leakage or a subtraction (or withdrawal) refers to
payments received by firms or households that are not passed on through their current expenditure. In a different
language, an injection is an income receipt that did not arise from household spending while a leakage is that
portion of an income receipt which does not lead to further spending (or responding). As R. G. Lipsey and Colin
Harbury have rightly put it: “Leakages are identified by looking forward to see where income goes, while
injections are identified by looking backwards to see where the income came from.” In the simple two-sector
economy we are considering now investment is the only injection and saving is the only leakage.
Saving as a Leakage
In all non-socialist countries the major portion of saving originates from the household sector. Here we assume that
all saving is household saving. This means that business firms do not retain any dividend for reinvestment. They
distribute their entire after-tax profits as dividends. Household saving is income received by households and not
passed on to firms through extra consumption spending. To the extent households save they reduce their
expenditure on consumption goods. The amount that is saved is not passed on to business firms in the form of sales
receipts. So the demand for their products falls. They are forced to cut back production. As a result national income
falls. Hence saving is called a leakage from the circular flow of income.
Investment as an Injection
If a firm makes investment the income of firms producing investment (capital) goods rises. If a textile producing
company places more orders for textile producing machines the industry manufacturing such machines will get
more orders. Thus an act of investment leads to an increase in income of firms that produce capital goods such as
plant, equipment and machinery. Since investment spending creates income, investment represents an injection of
income into the circular flow.
The Relation between Saving and Investment:
Saving is the supply of capital and investment is the demand for capital. Some people save and others invest.
Saving is mainly done by households but in-vestment activities are largely carried out by business firms. Moreover,
the motives for saving and investment are different. While households save for certain personal reasons business
firms invest for making profits. Thus a divergence between saving and investment is a logical possibility. It is quite
possible for business firms to plan to increase their investment spending at a time when households are planning to
reduce their saving (in order to increase consumption). It is also possible for firms to plan to reduce their
investment expenditure at the same time that households plan to increase their saving. No doubt financial

institutions like banks help to channel savings into investment. But since saving and investment decisions are taken
by two different groups of people the planned saving of households are unlikely to be equal to the planned
investment of business firms.
To see how national income equilibrium is achieved through saving and investment we look at Table 9.2. Let us
first consider what would happen if the value of output or national income were Rs. 1,600 crores. At this level of
income, households are desirous or saving only Rs. 100 crores, while business firms wish to invest Rs. 300 crores.
Thus, there is an inconsistency between savings and investment plans. If output is held constant at this level there
are extreme possibilities. Either production plans will be fulfilled and expenditure plans unfulfilled or expenditure
plan fulfilled and production plan unfulfilled.
Table 9.2: Equilibrium Level of Income: Saving-Investment Approach
We may now consider each of the above possibilities. In the first place, households will not be able to buy all that
they want to buy. So they will be forced to save more than what they planned. In other words, households are
forced to save income they originally planned to spend. As a result the business firms will be able to sell more than
what they planned or de-sired. But to be able to sell more, they must produce more. In the second case, the stocks
of finished goods accumulated in the past will get exhausted. They, therefore, find that they end up making
investment of Rs. 300 crores less than what they planned.
They no doubt spend Rs. 300 crores on investment goods but they also have an unplanned (undesired) exhaustion
of stocks. Since total investment includes investment in fixed capital plus changes in stocks, ac-tual total
investment in this example is Rs. 300 crores minus the reduction in stocks. If households’ plan to spend Rs. 200
crores more than current output is fulfilled, stocks will fall exactly by the same amount. Thus actual total
investment would be only Rs. 100 crores, although firms originally planned to invest Rs. 300 crores. This would be
so because the reduction in stocks was unplanned and undesired. Business firms generally do not wish to exhaust
their stocks. So they will increase their production to maintain their level of stocks. In either of the two cases we
observe a tendency for output to rise whenever households wish to with-draw less from the circular flow by saving
than business firms wish to add to it by investing. So it logically follows that whenever planned saving is less than
planned investment, national income tends to rise.
We may now consider an exactly opposite situation. Suppose national income goes above the equilibrium value. If
it is Rs. 3200 crores, planned saving would exceed planned investment. If firms produce output of Rs, 3200 crores,
they will not be able to sell the entire amount of it. Since households wish to buy less than this, firms will be forced
to hold stocks. So stocks will rise. In other words, there will now be unplanned investment in stocks. If firms wish
to reduce stocks at the original level, they have to reduce current production. That is, if business firms try to
eliminate the unplanned increase in stocks, output reduction is inevitable. A fall in output will lead to a fall in
national income. The reason is simple: households wish to withdraw more from the circular flow through saving
than firms wish to add to it by investing. When the level of national income is Rs. 2,400 crores, there is no
inconsistency between saving plans of households and investment plans of business firms.
Since the two groups (i.e., savers and investors) are able to save and invest exactly what they plan to at an
unchanging level of national income, they have no reason to alter their behaviour. Thus it is quite obvious that
national income is in equilibrium when planned saving equals planned investment.
Figure 9.6: Equilibrium National Income: Saving-Investment Approach
The leakage-injection approach is illustrated in Figure 9.6. When actual income is less than equilibrium level, the
investment line lies above the saving line. This indicates that planned investment exceeds planned saving. In the
opposite situation when actual income is greater than equilibrium income, the saving line lies above the investment
line. This indicates that planned saving exceeds planned investment. So it logically follows that national income
reaches its equilibrium level where the saving and investment lines intersect each other. Since at this level of
national income, planned saving is exactly equal to planned investment, neither expenditure plan of the household,
nor production plan of the business firms will be frustrated. Thus there will neither be excess demand (and the
consequent out-put expansion) nor excess supply (and the consequent output contraction). As national output or
national income will be held constant at this level, this is indeed the equilibrium level of income.
Generality of the Results:
From Keynes’ model we have arrived at a general result that national income is in equilibrium where aggregate
planned expenditure is equal to actual output (i.e., actual national income). Graphically this is shown by the
intersection between the aggregate expenditure line and the 45° line. It also follows from the Keynesian model that
national income equilibrium occurs where planned saving equals planned investment. In a two-sector economy
where saving is the only desired leakage and investment is the only desired injection national income is in
equilibrium where leakage equals injection, i.e., where S = I. However, this is not a general result in the sense that
it does not always hold. The saving and investment decisions are made by different groups of people. So there is no
necessary reason why households should decide to save exactly the same amount as firms decide to invest.
However, in the simple Keynesian model, national income is in equilibrium when planned saving is equal to
planned investment. It implies that there is a mechanism that ensures that households end up desiring to save

exactly what firms desire to invest. The mechanism is in the change in national income that occurs when desired
saving is not equal to desired investment.
The explanation of the apparent conflict is the essence of the Keynesian theory of income determination. The
classical economists believed that saving was always equal to investment due to the operation of the Say’s Law of
Markets. But Keynes argued that there was no reason why the amount that households wish to save at any given
level of national income should be equal to the amount that firms wish to invest at the same level of national
income. In this context the following quote from R. G. Lipsey becomes relevant: “These is no reason why desired
saving should equal desired investment at any randomly chosen level of income, but when they are not equal in the
two-sector economy, national income will change until they are brought into equality.” But when the two are not
equal, certain forces in the economy will be at work that cause national income to change in the desired direction.
In fact, income change continues until the two become equal.
However, if the full employment level of income is above equilibrium level, the result is unemployment, while, if
the full employment level is below the equilibrium level, the result is inflation. This is what would happen if there
were no government activity. However, if the government intervened to regulate demand, it could, in the one case,
increase demand in order to reduce unemployment or, in the other, reduce demand in order to reduce inflation.
Keynes, therefore, argued that the only way to avoid high level of unemployment was for the government to
increase aggregate demand.
Changes in Equilibrium Income

The simple Keynesian analysis of income determination tells us something about the causes and direction of
changes in the circular flow of income but nothing about the size of those changes. This latter depends upon the
relative proportions of income withdrawn from the circular flow or passed on through expenditure on consumption.
Thus, if, taken together, the members of a community have, after withdrawals, four-fifths of their income left for
consumption this latter expenditure will become the income of the suppliers of consumer goods and services.
However, Keynes considered it important to analyze the effect on the equilibrium level of income of a change in
planned investment. Keynes realised that an increase in investment will increase the level of income and
employment, and the converse is also true. Modern income analysis shows that an increase in investment will
increase national income by a multiplied amount — by an amount greater than itself. This amplified effect of
investment on income is called the ‘multiplier’ doctrine. The word stands for the numerical coefficient showing
how much above unity is the increase in income resulting from each increase in investment.
An increase in investment will create income for those who produce the capital goods. Part of this income will be
saved, but the rest will be spent, thereby providing income for someone else. That ‘someone else’ will, in turn, save
part of the new income and spend the remainder, so that another person (or persons) will receive additional income.
In this way there is a much larger increase in income than the original increase in investment. The relationship
between an autonomous change in expenditure (in this case, investment) and the resulting change in income is
known as the ‘investment multiplier’ (or simply multiplier).
When an increase in investment creates a larger increase in income, the value of the multiplier is given by the
following formula:
Multiplier = ΔY/ΔI.
Thus, the multiplier is the ratio of an induced change in the equilibrium level of national income to an initial
change in the level of autonomous spending. The ‘multiplier effect’ denotes the phenomenon whereby a small
change (increase or decrease) in autonomous spending (such as investment) brings about a more than proportionate
change in national income (output).

Figure 9.7: Multiplier Effect
In Figure 9.7, we see that a rise in investment from I1, to I2, has caused this equilibrium level of income to rise
from OY1 to OY2. The size of the multiplier is given by FH/JH.
The Multiplier Effect
On what does the value of the multiplier depend? A consideration of our previous example will give us the answer.
The extent to which income increases depends upon the proportion of income which is passed on at each stage of
the process, i.e., the marginal propensity to consumer (MPC). If, for example, investment increases by Rs. 1,000
and the MPC is 4/5, the final increase in income will be Rs. 5,000. This must be so because when the increase in
income reaches Rs. 5,000, the increase in saving will be Rs. 1,000 (since MPS is 1/5. And when the increase in
saving reaches Rs. 1,000 it will be equal to the increase in investment and the economy will again be in
equilibrium. Thus, in this example, the multiplier (∆Y/∆I) is 5. An alternative way of finding the multiplier is to
use the following formula:
Multiplier = 1/1 – b, where b is the MPC. In our example this would be 1/(1 – 4/5) = 5.
Moreover, since MPC + MPS = 1, the multiplier can be found by using following formula:
Multiplier = 1/s, where s is the MPS. In other words, the reciprocal of MPS gives us the numerical value of the
multiplier. This can easily be proved. National income reaches equilibrium when S = 1. So when / increases by ΔI,
S must also increase by ΔS to maintain equilibrium (at a higher level of national income). In Keynes’ model ΔY =
m (ΔI). In Keynes’ theory, the multiplier (m) investment is the number by which the change in interest has to be
multiplied to find out the resulting change in national income (GNP).
or, m = ∆Y/∆I = ∆Y/∆S
= I/(∆S/∆Y) = 1/MPS
= 1/1 – MPC
Thus the multiplier is the reciprocal of the MPS (which is 1 – MPC).
Keynes’ multiplier is known as the investment multiplier, because investment is the key variable in his theory. A
change in investment leads to a change in national income through the multiplier process. According to Keynes
any change in autonomous spending will have a multiplier effect. In Keynes’ two-sector demand-determined
model, investment is the only type of autonomous spending.
Assumptions of the Multiplier:
The Keynesian concept of multiplier is based on the following assumptions:

Autonomous Investment: The Keynesian multiplier comes into operation for any auto-nomous (income-
independent) change in spen-ding.


Lump-sum taxes: The multiplier is derived on the assumption that taxes are lump-sum (once-for-all) only.
If part of economy’s extra income is taxed away by the government, total leakages (i.e., the withdrawals
from the income flow) would rise and the value of the multiplier would be smaller.

Closed economy: It is also assumed that the economy is closed. The multiplier ignores all external
economic transactions that could be significant for a country with foreign sector.
Leakages from the Multiplier:
Anything that leads to a fall in national income through the multiplier is to be considered as a leakage. There are
three such leakages:

Savings,

Taxes, and

Imports.
These are the three deflationary components of national incomes (if consumption can be regarded as fairly stable in
the short run). Two important features of the multiplier are:

It is a cumulative process rather than instantaneous effect. So it can be seen as series of successive ’rounds’
of additions to income.

The value of the multiplier depends on the proportion of extra income that is spent on consumption (the
MPC) at each successive round.
The size of a change in the flow of income initiated by every change in injection or withdrawal, other things
remaining the same, will depend upon the community’s MPC or its counterpart, its marginal propensity to
withdraw income. The larger an increase in consumption from an income increase, the higher the value of the
multiplier. Thus, if MPC = 0.9, and MPS = 0.1, the value of the multiplier is 10; if MPC = 0.75 and MPS = 0.25,
the value is only 4. However, the multiplier process takes time to work itself out. It is not that people receive some
extra income and spend a proportion of it the next day. They may take weeks or months to spend the relevant
proportion of their additional income at each stage of the process. Thus, it will take some time for the full effects of
the multiplier to be felt.
Apparently the above analysis is true at all points of time. Actually there is a time tag between the receipt of
income and its spending in equation (i) and between its spending and subsequent re-emergence as income in
equation (ii). Therefore, the multiplier only tells us the position which will be reached by an economy after a lapse
of time if the rate of injection remains constant. The multiplier concept brings out the fact that income is related to
investment in a definite way. But it is very difficult to measure- its active value in case of a country like India.
Importance of the Multiplier:
The multiplier is one of the most important concepts in the theory of the national income. It offers a means of
numerically measuring or quantifying the impact of changes in aggregate demand and any of its component parts.
For example, surveys of business plans may show that next year business firms expect to increase their investment
spending above this year’s level by say, Rs. 5 crore. With a twelvemonth multiplier of 2, this change would bring
a Rs. 10 crore rise in the value of output in the coming year. Business people and government policymakers can
make use of this information to analyze the effects of the change, forecast its impact on other sectors of the
economy, and take necessary steps to adapt to the new conditions that will prevail. Both corporate and national
planning will be helped.
There is a second way in which the Keynesian multiplier is important. Since the effect of any change is magnified,
it is possible to achieve large results from relatively small beginnings. For example, suppose the economy is
currently operating well below its full employment potential by some Rs. 200 crore and the central government
wants to increase aggregate demand so as to move the GNP upward to the amount. Additional spending will have
to be generated by government directly or by stimulating consumer spending or business investment. Whatever the

path taken, the amount of new spending required to push the national income upward by Rs. 200 crore is only half
that amount when the twelve-month multiplier is 2.
Super Multipliers
Keynes’ theory of income and employment treats the investment (1) as an autonomous variable in that it does not
depend upon income. Instead, it is treated as one of the determinants of aggregate demand (the other being
consumption) and hence of the aggregate income level. Given this assumption the equilibrium level of income is
given by the equation, Y=E, where Y is aggregate income and E is aggregate demand. Aggregate demand (E)
consists of consumption demand (C) and investment demand (I). Thus E = C + I. Consumption is a positive
function of income. It may be written as
C = C0 + bY
Where C0 is autonomous (or basic minimum) consumption irrespective of the level of income, and by is induced
consumption which varies with the level of income in the ratio b, the marginal propensity to consume. Since
investment is assumed to be autonomous, I=Io. Thus in equilibrium
Y= E
= C+I0
= C0 + bY + I0
Y – bY = C0 + I0
(1 – b)Y = C0 + I0
Y = (C0 + I0)/(1 – b)
(∆Y/ ∆I0) = 1/(1 – b)
Last expression 1/(1 – b), is the Keynesian Investment Multipliers. It is often called the simple multiplier to
distinguish it from the super multiplier derived by J.R. Hicks. While the simple multiplier is derived by assuming
that all investment taking place in the economy is autonomous, the super multiplier is derived by making
investment partly autonomous and partly induced. Investment function may be written as
I = I0 + mY,
Where I0 is autonomous investment (of Keynes’ type) and mY is induced investment changes when income, Y
changes. ‘m’ is otherwise called the marginal propensity to investment and it ranges between 0 and 1. The concept
of induced investment is based on the notion that when income increases, people increase their demand for
consumer goods and this in turn increases the demand for investment goods to produce consumer goods. By
incorporating the redefined investment equation, we may rewrite the equilibrium equation as under;
Y =E
= C+I0
= C0 + bY + I0 + mY
Y – bY – mY = C0 + I0
Y – (1 – b – m) = C0 + I0
∴ Y = C0 + I0, and
1–b–m
∆Y/ ∆I0 = 1/(1 – b – m)
The expression (1/(1 – b – m)) is called the super multiplier or compound multiplier. It may be easily seen that the
insertion of the marginal propensity to invest, m, to the multiplier. Let us take a numerical example to substantiate
this difference. Suppose the consumption function is C = 1000 + 0.6y and investment is Rs. 1000. So, the MPC is

0.6y and investment is Rs. 1000. So, the MPC is 0.6 and the investment multiplier, 1/1-b is 2.5. Assuming that
investment is wholly autonomous, the equilibrium income increases by Rs. 5000. That is,
Y = (C0 + I0)/(1 – b) = 2000/(0.4) = 5000. With the same consumption data, assume now that investment is partly
autonomous and partly autonomous and partly induced, so that the investment function is I = 1000 + 0.2y, where
Rs. 1000 is the autonomous investment and 0.2 is the marginal propensity to invest. The super multiplier, 1/1 – b
– m is 10. The equilibrium income is:
Y = (C0 + I0)/(1 – b – m) = 2000/(0.2) = 10,000
This means that a given injection of investment into the economy generates a larger in income when investment is
induced than when it is wholly autonomous.
The concept of super multiplier is more realistic than that of simple multiplier because it recognizes the role of
induced investment in income changes. It reveals that a given change in autonomous investment will result in a
larger change in income than the one implied by simple multiplier. In income will need a smaller increase in
autonomous investment under the impact of the super multiplier than under that of the simple multiplier. It is,
however, not easy to say what part of any given period’s total investment was autonomous investment and what
part was induced investment. Super multiplier can at the most be used as theoretical tool rather than as an empirical
device to study the relationship between investment and income.
The Accelerator Theory of Investment
The Keynesian concept of multiplier which states that as the investment increase, income increases by a multiple
amount. On the other hand, there is a concept of accelerator which was not taken into account by Keynes has
become popular after Keynes, especially in the discussions of theories of trade cycles and economic growth. The
acceleration principle describes the effect quite opposite to that of multiplier. According to this, when income or
consumption increases, investment will increase by a multiple amount.
As income and therefore consumption of the people increases, the greater amount of the commodities will have to
be produced. This will require more capital to produce them if the already given stock of capital is fully used. Since
in this case, investment is induced by changes in income or consumption, this is known as induced investment. The
accelerator is the numerical value of the relation between the increases in investment resulting from an increase in
income. The net induced investment will be positive if national income increases and induced investment may fall
to zero if the national income or output remains constant.
To produce a given amount of output, it requires a certain amount of capital. If Yt output is required to be produced
and v is capital-output ratio, the required amount of capital to produce Yt output will be given by the following
equation:
Kt = vYt
Where, Kt stands for the stock of capital, Yt for the level of output or income, and v for capital-output ratio. This
capital-output ratio v is equal to K/Y and in the theory of accelerator this capital-output ratio is assumed to be
constant. Therefore, under the assumption of constant capital-output ratio, changes in output are made possible by
changes in the stock of capital. Thus, when income is Yt then required stock of capital Kt = vYt when output or
income is equal to then required stock of capital will be Kt-1 = vYt-1.
It is clear from above that when income increases from Yt-1 in period t-1 to Yt in period t, then the stock of capital
will increase from Kt-1 to K. As seen above, Kt-1is equal to vYt-1and Kt is equal to vYt. Hence, the increase in the
stock of capital in period t is given by the following equation:
Kt – Kt-1= vYt – vYt-1
Since increase in the stock of capital in a year (Kt – Kt-1) represents investment in that year, the above equation can
be written as below:
It = vYt – vYt-1

Hence, it is v i.e., capital-output ratio which represents the magnitude of the accelerator. If the capital-output ratio
is equal to 3, then as a result of a certain increase in income, investment will increase three times more i.e.,
accelerator here will be equal to 3. It thus follows that investment is a function of change in income. If income or
output increases over time, that is, when Yt is greater than Yt-1 then investment will be positive. If income declines,
that is, Yt is less Yt-1 then disinvestment will take place. And if the income remains constant, that is, Yt = Yt-1 the
investment will be equal to zero.
Samuelson’s Multiplier Accelerator Interaction Model

The principle of acceleration working by itself is perhaps not much forceful but recently it has attained more
importance in the trade cycle theory by its alliance with the multiplier principle. Professor Samuelson has built a
model of multiplier- accelerator interaction. He could show that the interaction of the accelerator with the
multiplier is capable, under certain circumstances, of generating continuous cyclical fluctuations. After P. A.
Samuelson, J. R. Hicks, R. F. Harrod and A. Hansen have made fairly successful attempts to integrate the two
concepts and thus introduced remarkable improvements in the theory of economic growth. It is, therefore, quite
interesting and useful to analyze the combined (leverage) effects of multiplier and accelerator on national income
propagation.
Paul Samuelson has derived the super multiplier as follows:
Yt = Ct + It ….(1)
Income in period t equals the consumption in period t – 1 plus investment in period t

Yt = bYt-1+ lt ….(2)
Where b is the MPC in period t – 1. Investment in period t is partly autonomous (Ia) and partly induced (Id). The
induced investment depends upon changes in consumption which in turn depend upon changes in income.
Therefore, we can express as
It = Ia+Id
= Ia+V (Ct – Ct–1)
= Ia +V {bYt-1 - bYt-2}
= Ia + V.b (Yt-1 - Yt-2)….(3)

The expression in equation (3) tells us that changes in net investment and hence income for period t can be
estimated as a weighted sum, the weights being the values of b (MFC) and V(the output-capital ratio). Professor
J.R. Hicks has called the joint action of b and V as the super multiplier and used it to build up his theory of the
trade cycle.
That is, the speed with which income increases as a result of accelerator- multiplier interaction depends inversely
on the marginal propensity to save and directly on the value of the acceleration coefficient. The lower is the MPS
and the higher is the value of the accelerator, the greater the speed with which changes in net investment are
multiplied into changes in income. We show the working of the super-multiplier through the Table 11.2 given
hereunder.
The Interaction:

In the Table 9.3 given below, we can easily see the process of income propagation through the multiplier and
acceleration interaction. We assume that (i) MPC = ½ and (ii) Acceleration Coefficient = 2.
Table 9.3: Multiplier and Acceleration Interaction: Effect on Income
In the first period there is an initial outlay of Rs. 10 crores, which does not lead to any induced investment. Hence,
the total rise in national income in the first period is Rs. 10 crores (being equal to the initial outlay of Rs. 10
crores). Since the MPC =1/2, induced consumption in the second period is Rs. 5 crores (shown in the column 3 and
the acceleration coefficient being 2, the induced investment in the second period is Rs. 10 crores, (shown in
column 4) and the total leverage effect (total increase in national income) is Rs. 25 crores (shown in column 5).
Similarly, in the third period we get increased consumption of Rs. 12.50 crores and induced net investment of Rs.
15 crores (being the difference between 12.50 crores and 5 crores in column 3). Thus, total income in the fourth
period has reached the peak level of Rs. 41.25 crores, as a result of the combined multiplier and acceleration
effects i.e. through their interaction also called Super Multiplier. Then, in the fifth period, the marginal income
increase starts falling off. It falls to rock bottom level of 1.2 crores in the 8th period and then again starts rising in
the 9th period from 2 crores to 12 crores.
It goes up to 26 crores in the 11th period, thereby completing a cycle. If we go on calculating the multiplier-
acceleration effects in the various columns we will find that the result is quite a moderate type of recurring cycle
which repeats itself indefinitely. If we show the values of income and the time periods on a graph, we get a regular
trade cycle m n shown in the figure 9.8 given below.
Figure 9.8: Multiplier-Acceleration goes to Generate Trade Cycle

This shows that an MPC of less than unity gives an answer to the crucial question: Why does the cumulative
process come to an end before a complete collapse or before full employment? Hansen says that the rise in income
progressively slows down on account of the fact that a large part of the increase in income in each successive
period is not spent on consumption. This results in a decline in the volume of induced investment and when such a
decline exceeds the increase in induced consumption, a decline in income sets in. “Thus, it is the marginal
propensity to save which calls a halt to the expansion on top of the multiplier process.”
We have in our table above assumed constant values of multiplier and acceleration coefficients but in a dynamic
economy they also vary cyclically. Thus, when we study the results of leverage effects or interaction of multiplier
and acceleration coefficients as they vary cyclically, we find that the levels of income will be subject to various
types of fluctuations depending on the values of the acceleration and the multiplier. Paul A. Samuelson attempted
to combine different values of the multiplier and accelerator to analyze the nature of income streams generated by
them. He found that four different types of fluctuations are obtained when the super multiplier with different values
works (Figure 9.9)
In the analysis of the process of multiplier accelerator working together, the values which we assume are of great
importance. If the values of K and a are high, income would rise continuously at an ever-increasing rate, and there
would be no downturn and therefore no cycle. The path would be similar to curve A in Figure 9.9. At the opposite
extreme, low values of the accelerator will also fail to generate a cycle; income will merely converge to the new
equilibrium level which would have been achieved by the operation of the Multiplier alone, and will stay there; the
accelerator will work to make income grow faster during the initial stage of expansion, but it will not be strong
enough to alter the eventual outcome. Such a path of income is exemplified by curve B in Figure 9.9. If trade
cycles are to be generated, it is necessary that the values of multiplier and accelerator lie between certain upper and
lower extremes.
Figure 9.9: Accelerator-Multiplier Interaction to Produce Fluctuations of Different Types
Three other distinct types of cycles may be generated according to the relative values of accelerator and multiplier.
If accelerator is small relatively to Multiplier the oscillations would be ‘damped’—that is, they would become
weaker and weaker and eventually die away altogether leaving income constant at its central value. Curve C in
Figure 9.9 illustrates this kind of fluctuation. High values of Accelerator give rise to explosive fluctuations (Curve
D), the cycles becoming stronger and stronger. The third type of cycle is a perfectly regular one exemplified by
curve E where the cycle is regular as it is having equal periodicity and amplitude.

Samuelson’s Classification of the Regions of Different Cycles:

We have seen that multiplier and accelerator working together shape the process of income generation. But
Professor P. A. Samuelson went farther and showed that with different combinations of the values of the multiplier
and accelerator, it is possible to get income fluctuations (cycles) of various types. In a much-quoted article,
‘Interaction Between the Multiplier Analysis and the Principle of Acceleration’, he showed that with different
values of the Marginal Propensity to Consume on the one hand and the Accelerator on the other, it is possible from
a continued injection of public investment, to get 5 different types of cycles or fluctuations. If we express MPC as a
(Alpha) and acceleration coefficient as β (Beta), the types of cyclical fluctuations which we can obtain are as
follows.
Figure 9.10: Yypes of Cyclical Fluctuations
 Combination 1, α = 0.5 and β = 0. This gives us purely multiplier effects with income approaching the peak.
Here the acceleration coefficient is zero (Region A in the Figure 9.10). This is the case of fluctuations having
multiplier effects only, where income approaches asymptotic level.
 Combination 2, α = 0.5, β=1. This gives us damped oscillations falling in value as they fluctuate about the
multiplier level, gradually subsiding to that level. (Region B in the figure 9.10).
 Combination 3, 0.5, (i= 2. This gives us regular or continuous cycles about the multiplier levelled more or less
unchanged values repeating themselves indefinitely. (Region C).
 Combination 4, α= 0.6 and/3 = 2. This gives us explosive cycles with variations about the multiplier level
becoming larger and larger. (Region D in Figure 9.10).
We summarise the above results. In Figure 9.10 above: region A shows the multiplier effect only where the value
of b (accelerator) is zero. In this case, with a constant level of public expenditure, the national income would reach
its peak through multiplier only (i.e., 1/1-s) or 1/1-1/2 = 2. Region B shows damped oscillations in value as they
fluctuate about the multiplier level. Region C shows explosive cycles with variations about the multiplier level
becoming larger and larger and region D shows the ever increasing national income approaching a compound rate
of growth.
The essence of the argument is that multiplier-accelerator interaction is capable of generating various types of
cycles and fluctuations: mild, damped and explosive. These cycles of fluctuations are of varying periodicity and
amplitude. If we are able to find out the interacting values of the multiplier and accelerator in practice, we can
ascertain for ourselves the nature of income fluctuations we are likely to experience in the absence of exogenous
restraints. Professor JR. Hicks has used this mechanism for building up a theory of the trade cycle that explains the
behaviour of business cycle around a rising trend of income.
Importance
Thus, we find that the Super-Multiplier (interaction of multiplier and accelerator) assumes great importance in as
much as it tends to speed up the rate at which the national income raises through the multiplier effects. In the first
place, study of interaction of the two principles has paved the way for a more accurate analysis of the nature of the
cyclical processes.

Further, an analysis of the interaction shows that it is possible to explain turning points in business cycle without
resorting to special explanations. These factors are: a marginal propensity to consume of less than one plus the
acceleration effect, the former being perhaps more important. The acceleration principle, before Keynes, was based
on Say’s Law wherein increase in investment and a decrease in the rate of consumption would lead to a similar
decline in investment—i.e., a cumulative expansion or contraction without limit.
Thus, the pre-Keynesian theory of acceleration gave an exaggerated picture of instability in the economy. But with
the introduction of the concept of multiplier and consumption function, the long-sought-for limits to the
fluctuations short of zero were at last found. Keynes’s concept of consumption function has brought forward the
true significance of acceleration principle for business cycle analysis. According to Prof. K. Kurihara, “it is in
conjunction with the multiplier analysis based on the concept of the marginal propensity to consume (being less
than one) that the acceleration principle serves as a useful tool for business cycle analysis and as a helpful guide to
business cycle policy.
Thirdly, it shows that it is a combination of the multiplier and the accelerator which seems to be capable of
producing cyclical fluctuations. The multiplier alone produces no cycles from any given impulse. It only gradually
increases income to a constant level as determined by the propensity to consume. But if the principle of
Acceleration is also introduced, the result is a series of oscillations about what might be called the multiplier level.
The accelerator at first carries total income above this level, but as the rate of increase of income diminishes; the
accelerator induces a downturn which carries total income below the multiplier level, then up again, and so on.
Professor J R. Hicks has used the accelerator multiplier interaction for building up a new theory of the trade cycle
in this context.
Limitations
A casual student of the super-multiplier (multiplier-acceleration principle) might feel that it is very easy to raise the
economy out of the depths of depression simply by having a small increase in autonomous investment. This would
stimulate consumption via the multiplier effects, which would then induce further investment and national income
would continue to grow like a Topsy. In actual practice, the interaction of multiplier and acceleration does not
work for growth; at best, it is responsible for fluctuations on the path of movement of national income to higher
and higher levels; that is, it does not work for growth; at best, it is responsible for fluctuations on the path of
movement of national income from one level to another. The interaction, no doubt, shows significant cyclical
effects but it has overlooked the other factors which work in the actual determination of the total income effect of
the multiplier and acceleration principles.

4 ALTERNATIVE THEORIES OF
CHAPTER RATE OF INTEREST
What do we mean by interest? Interest has been variously defined and interpreted.
Firstly, interest is conceived by economists as the rate of return on capital. Some classical economists distinguished
between the natural or real rate of interest and the market rate of interest. The market rate of interest is the rate at
which funds can be borrowed in the market, while the natural rate of interest is rate of return on capital investment.
When the natural rate of interest is higher than the market rate of interest, then there will be greater investment in
capital with the result that the natural rate of interest (i.e., the rate of return on capital) will fall. The equilibrium
will be established when the natural rate of interest becomes equal to the market rate of interest.
Since physical capital has to be purchased with monetary funds, rate of interest becomes the rate of return over
money invested in physical capital. But since money to be invested in physical capital has to be saved by someone,
interest also becomes rate of return or saving. Thus, there are two concepts of interest which are related to each
other.
 First, the term interest is used to express a rate of return earned on capital as a factor of production.
 The second concept of interest refers to the price which is paid by the borrowers to lenders for the use of their
saving funds. When the borrowers are entrepreneurs or businessmen, who use the saving funds for investment
in capital for them rate of return on physical capital is highly significant.
However when we consider things from the viewpoint of lenders who save money to send it to others, the concept
of interest as a price for borrowed funds is of crucial importance therefore, interest is generally defined as price for
the use of borrowed funds. It is also important to note the difference between the real rate of interest and nominal
rate of interest. The real rate of interest is the nominal rate of interest corrected for inflation (i.e. rise in the general
price level) in the economy. Thus:
Real rate of interest = Nominal rate of interest – rate of inflation

For explaining the determination of rate of interest, the theories have been put forward.
 First theory of interest is Classical Theory of Interest which explains interest as determined by saving and
investment.
 Secondly, neo-classical economists such as Wicksell, Ohlin, Haberler, Robertson, Viner developed what is
known as Loanable Funds or Neo-Classical Theory of interest. These writers consider the interplay of
monetary and non-monetary forces in the determination of the rate of interest. At their hands, interest theory
ceased to be purely real or non-monetary theory. In their view, monetary factors along with the real factors
determine the rate of interest.
 The loanable funds theory is partly a monetary theory of interest. But monetary theory gained more
recognition with the publication of Keynes’ General Theory. According to Keynes, interest is a purely a
monetary phenomenon and as such it is determined by the demand for money (i.e., liquidity preference) and
the supply of money. According to him interest is a price not for the sacrifice of waiting or time preference
but for parting with liquidity. Since he emphasized the role of liquidity preference in the determination of the
interest rate, his theory is known as liquidity preference theory of interest. Keynesian theory is a purely
monetary theory.

ALTERNATIVE THEORIES OF RATE OF INTEREST
 Neo-Keynesian Theory of simultaneous determination of interest rate and level of income (also termed as
modern theory of interest rate) gained much popularity in the form of IS-LM Model, which will be discussed
in detail in the next Chapter.
It is worth noting that all these theories of interest seek to explain the determination of the rate of interest through
the equilibrium between the forces of demand and supply. In other words, all these theories are demand and supply
theories. The difference between the various theories of interest lies in the answer to the question: demand for what
and supply of what. Another point worth mentioning is that a theory of interest has to explain two things. First,
why does interest arise? Secondly, how rate of interest is determined? All the alternative theories mentioned above
explain both these aspects of interest.
Classical Theory of Interest Rate Determination
According to the classical theory, rate of interest is determined by demand for savings to make investment and the
supply of savings. This theory seeks to explain the determination of the rate of interest through the interaction of
the demand for savings to make investment and the supply of savings. Since this theory explains the determination
of the rate of interest by real forces such as thriftiness, time preference and productivity of capital, it is also called
the real theory of interest.
Various classical writers differ a good deal from each other in respect of their views about interest. Some of them
laid emphasis on the forces governing the supply of savings. Thus they considered interest as a price for abstinence
or waiting or time preference. Some others like J.B. Clark and F.H. Knight argue that the marginal productivity of
capital, which is a force that operates on the demand side of savings, determines the rate of interest. Fisher and
Bohm-Bawerk explained the interest with both types of factors.
There is a basic assumption that is common to all classical writers. It is that all of them assume full employment of
resources. In other words, in their models if more resources are to be devoted to investment, that is, to the
production of capital goods, some resources have to be withdrawn from the production of consumers’ goods.
According to this theory, money which is lent out to the entrepreneurs for investment in capital goods is to be made
available by those who save out of their incomes. By abstaining from consumption they release resources for the
production of capital goods. In order to induce people to save and refrain from consuming a part of their incomes,
they must be offered some interest as a reward. To persuade them to save more, the higher rate of interest has to be
offered. So far the various classical economists agreed but they differed in detail about the nature of interest. We
shall discuss below the views of some of them.
Interest is a price for abstinence or waiting
It was Nasau Senior who first pointed out that saving involved a sacrifice of abstinence and interest is a price for
this sacrifice. Anyone who saves some money and is therefore able to lend it to others abstains from consuming a
part of his income and in order to induce him to do so, he must be paid interest by the borrower. Thus, according to
Senior, interest arises because of the abstinence involved in the act of saving. Without giving him the interest as
compensation, the individuals will not like to undergo the sacrifice of abstaining from consumption.
The idea of abstinence was criticised by some economists, in particular by Karl Marx, who pointed out that the rich
people who are the main source of savings are able to save without making any real sacrifice of abstinence. They
save because something is left over after they have indulged in consumption to their heart’s desire. In order to
avoid this criticism Marshall substituted the word waiting for “abstinence”. According to him, when a person saves
money and lends it to others, he does not abstain from consumption for all time; he merely postpones consumption.
But the individual who lends his savings has to wait until he gets back the money. Thus, the person who saves
money and lends it to others undergoes the sacrifice of waiting. To induce people to save and wait some price has
to be paid to them as compensation for making this sacrifice. According to this view, interest is a price for waiting.
Interest is paid because of time preference (Fisher’s Theory)
The views of Irving Fisher, an eminent American economist, are very popular among economists. According to
him, enjoyment interest needs to be paid to the lenders because people prefer present enjoyment of goods to future

of them. Fisher laid greater emphasis on time preference as a cause of interest. But along with time preference he
also considered the role of marginal productivity of capital for which he used the term ‘rate of return over cost’ as a
factor that also determines interest. Rate of interest arises because people prefer present satisfaction to future
satisfaction. They are therefore impatient to spend their incomes in the present. According to Fisher, interest is a
compensation for the time preference of the individual.
The greater the impatience to spend money in the present, that is, the greater the preference of individuals for the
present enjoyment of goods to future enjoyment of them, the higher will have to be the rate of interest to induce
them to lend money. The degree of impatience to spend income in the present depends upon the size of the income,
the distribution of income over time, the degree of certainty regarding enjoyment in the future and the temperament
and character of the individual. The people whose incomes are large are likely to have their present wants more
fully satisfied. Therefore, these rich people will discount the future at a relatively lower rate of interest (that is,
their time preference will be less) and will be required to be paid a relatively lower rate of interest.
As regards distribution of income over time, three kinds of situation are possible.
 The income may be uniform throughout one’s life or may increase with age or decrease with age. If it is
uniform the degree of impatience to spend in the present will be determined by the size of the income and the
temperament of the individual.
 If income increases with age, it means the future is well provided for and the degree of impatience to spend
money in the present (that is, time preference) will be greater. On the other hand, if income decreases with age,
the degree of impatience to spend money at present will be less. As regards certainty of enjoyment in the
future, if the individual is sure of enjoyment of income in the future, other things remaining the same, the
impatience to spend money in the present will be less, that is, the degree of time preference will be smaller.
 Finally, the character and the temperament of the individual will also determine his time preference. A man of
foresight will be less impatient to spend income in the present, that is, his rate of time preference will be less as
compared to that of a spendthrift. The rate of time preference is also influenced by expectation of life. If a man
expects to live long, his preference for spending income in the present will be comparatively low.
It is clear from the above analysis that Fisher, like Bohm Bawerk, regarded the rate of interest as an agio on the
present goods exchanged for future goods of the same kind. Fisher based his explanation of the rate of interest on
his concept of income. According to him, interest is the link between expected future income values and the
present capital values based on them. The present capital value of the stream of expected income in future years
depends on the rate of interest (i.e., rate of time preference) at which they have to be discounted. He says, “The
value of the orchard depends upon the value of its crops and in this dependence lurks implicitly the rate of interest
itself.”
As said above, Fisher also regarded productivity of capital which he called rate of return over cost, as a
determinant of interest. According to him, several different uses of capital which may yield different income
streams are open to the owner of capital. The greater the expected income stream from use of capital, the greater
will be the rate of interest.
Another point worth mentioning is that Fisher introduced risk and uncertainly in his explanation of interest.
According to him, individual has a choice of any one of a number of uncertain income streams so that instead of a
single rate of interest representing the rate of exchange between this year and next year we now find a great variety
of rates according to the risks involved.
Determination of the Rate of Interest in the Classical Theory
According to the classical theory rate of interest is determined by the supply of savings and demand for savings to
invest. We have explained above the forces working on the side of supply of saving. Some classical economists
laid stress on the abstinence or waiting involved in the act of savings and supply of them and some others
emphasized the role of time preference as a determinant of the supply of savings.

According to this theory, the money which is to be used for purchasing capital goods is made available by those
who save from their current income. By postponing consumption of a part of their income they release resources
for the production of capital goods. It is assumed in this theory that savings are interest elastic. The higher the rate
of interest, the more the savings which people will be induced to make. Besides, at higher rate of interest, savings
would be forthcoming from those persons whose rates of time preference are more strongly weighed in favor of
present satisfaction. The supply curve of savings will, therefore, slope upward to the right.
On the other hand, the demand for savings comes from the entrepreneurs or firms which desire to invest in capital
goods. Capital goods are demanded because they can be used to produce further goods which can be sold to earn
income. Thus capital goods have revenue productivity like all other factors. For any given type of capital asset,
e.g., a machine , it is possible to draw a marginal revenue productivity curve showing the addition made to total
revenue by an additional unit of a machine at various levels of the stock of that machine.
As stated above, like other factors of production, capital has marginal revenue productivity. But the marginal
revenue productivity of capital is a more complex concept than that of other factors because capital has a life of
many years. A capital asset continues to yield returns for many years. But the future is quite uncertain. Therefore,
the entrepreneurs have to judge the uncertainties of the future and estimate prospective yield or income from a
capital asset after making allowance for maintenance and operating costs. In other words, they have to find out the
net expected return of a capital asset.
This net expected return is expressed as percentage of the cost of capital asset. The more capital assets of a given
kind there are, the less income will be expected to accrue from a marginal unit of it. Therefore, the marginal
revenue productivity curve of capital slopes downward to the right.
A firm in a perfectly competitive factor market will hire a factor up to the point at which the price of that factor
equals the marginal revenue product of the factor. Now, the marginal revenue product of a capital asset can be
regarded as marginal revenue product of money invested in that capital asset.
The price of money invested in capital assets is the rate of interest which a person has to pay on the borrowed
funds. An entrepreneur will continue making investment in capital assets as long as the expected net rate of return,
or in other words, marginal revenue producer of capital or investment is greater than the rate of interest. He will be
in equilibrium position when marginal revenue product of capital (or expected rate of return) falls to the level of
the rate of interest.
Since the marginal revenue product curve of capital slopes downward, it will become profitable to purchase more
capital goods as the rate of interest falls, i.e., with the fall in the rate of interest more money will be demanded for
investment. Thus, the invest-ment demand curve connecting the rate of interest with the investment demand will be
downward sloping. In other words, investment demand is assumed to be interest-elastic.
Investment Demand Curve
The way in which the investment demand increases as the interest falls is illustrated in Figure 10.1 where II is the
investment demand curve showing the falling marginal revenue productivity of capital which, in other words,
indicates the declining marginal net expected return as more investment is undertaken.

Figure 10.1: Investment Demand Curve
When the rate of interest is Or, the entrepreneurs will make investment up to ON because the marginal net
expected return is equal to Or rate of interest when ON investment is made. Now, if the rate of interest falls to Orʹ,
then more capital projects will become profitable to be undertaken. Therefore, as a result of the fall in the rate of
interest to Orʹ, investment increases to ONʹ. It is clear from the above analysis that investment demand curve slopes
downward to the right. With the change in the rate of interest, investment will change.
Equilibrium between Demand and Supply
According to the classical theory, the rate of interest is determined by the intersection of the investment demand
curve and the supply of savings curve – the curves showing the relation of investment and savings to the rate of
interest. The way in which the rate of interest is determined by the intersection of investment demand and supply of
savings is depicted in Figure 10.2 where II is the investment demand curve and SS is the supply of savings curve.
Investment demand curve II and the supply of savings curve SS intersect at point E and thereby determine Or as
the equilibrium rate of interest. In this equilibrium position, ON is the amount of savings and investment. If any
change in the demand for investment and supply of savings comes about, the curves will shift accordingly and
therefore the equilibrium rate of interest will also change.
Figure 10.2: Classical Theory: Determination of Interest
Critical Appraisal of the Classical Theory of Interest

Classical theory of interest has been criticized on several grounds. J.M. Keynes made a strong attack on this theory
and put forward a new theory of interest called liquidity preference theory. We shall consider below the various
criticisms levelled against the classical theory of interest.

 Full Employment Assumption: Classical theory of interest has been criticized for its assumption of full
employment of resources which is said to be unrealistic. In the case of full employment of resources, more
investment (i.e., production of more capital goods) can take place only by curtailing consumption and there by
releasing resources from the production of consumption goods. Therefore, when full employment of resources
prevails, people have to be paid interest so as to induce them to abstain from consumption so that more
resources should be devoted to the production of capital goods. But, when unemployed resources are found on
a large scale there is no need for paying people to abstain from consumption or to postpone consumption and
wait in order that more savings for undertaking investment should take place. More investment then can be
undertaken by employing the unemployed or unutilized productive resources.
 Changes in Income Level Ignored: By assuming full employment the classical theory has ignored the changes
in income level and their effect on savings and investment. Classical theory establishes a direct functional
relationship between interest rate and the volume of savings. As the rate of interest goes up, more savings will
take place. But at the higher rate of interest investment demand will be less with the result that interest will
tend to fall to the level where savings and investment are in equilibrium. But this is not so realistic firstly,
because the direct functional relationship between savings and the rate of interest is doubtful, and secondly,
because when more savings take place as a result of the rise in the rate of interest, these more savings should
lead to more investment, as according to classical theory investment is governed by savings.
But, in the whole process of adjustment, change in income is not at all considered by the classical theory. As a
matter of fact, when the rate of interest rises and investment shrinks as a consequence, income will decline.
With the decline in income, the savings will decline. Therefore, the equality between savings and investment
are brought about not so much through changes in the rate of interest but through changes in income. Now,
take the opposite case. If the rate of interest falls, according to classical theory, the investment demand will
increase. But because of the lower rate of interest the greater supply of savings would not be forthcoming.
Therefore, in classical theory more investment cannot take place even at lower rates of interest, because of the
paucity of savings at lower rates of interest. But this is not what actually happens. At a lower rate of interest,
more investment will be undertaken and increase in the investment will lead to the increase in income via
multiplier. And out of increased income more would be saved. Again the tendency to equalize savings and
investment is brought about by changes in income. Thus the lower rate of interest through the increase in
investment and income leads to the rise in savings. But this is quite contrary to the classical theory wherein at
the lower rate of interest small savings are made.
From the above analysis it follows that by neglecting the changes in income the classical theory is led into the
error of viewing the rate of interest as the factor which brings about the equality of savings and investment.
The classical theory ignores the changes in income level because it assumes full employment of resources.
 Disincentive Effect of Lesser Consumption on Investment Ignored: According to the classical theory, more
investment can occur only by cutting down consumption. More the reduction in consumption, the greater the
increase in investment in capital goods. But as we know the demand for capital goods is a derived demand; it
is derived from the demand for consumer goods. Therefore, the reduction in consumption, which means
decrease in demand for consumer goods, will adversely affect the demand for capital goods and will thus
reduce the inducement to invest. The disincentive effect of the fall in consumption on investment is glossed
over by the classical theory. As we shall see later, in Keynes’ theory more investment does not occur at the
expense of consumption. In Keynes’ theory, in view of the unemployment of resources, more investment is
possible by utilizing the unemployed and under-employed resources. When investment increases, it leads to
the increase in the income level. With the increase in incomes, people will consume more. Thus in Keynesian
analysis more investment leads to more consumption, or in other words, investment and consumption go
together. Keynesian analysis is more realistic in the context of unemployment of re-sources prevailing in the
economy.
 Independence of Savings Schedule from Investment Schedule Assumed. Another implication of assuming full
employment and constant level of income by classical theory of interest is that investment demand schedule
can change without causing a change in the savings schedule. For instance, according to classical theory, if
investment demand curve II shifts downward because the profit prospects have lessened, then according to
classical theory, the new equilibrium rate of interest is higher where the new investment demand curve IT
intersects the supply curve SS which remains unaltered. But this is quite untenable. As a result of the fall in
investment, income will decline. Since the supply curve of savings is drawn with a given level of income,
when income falls, there will be fewer saving than before and as a result savings curve will shift to the left. But
the classical theory does not take into account changes in the income level as a result of changes in investment
and regards the savings schedule as independent of investment schedule which is not correct and realistic.
 Indeterminateness: Finally, the classical theory, as pointed out by Keynes, is indeterminate. Position of the
savings curve varies with the level of income. There will be different savings schedules for different levels of
income. As income rises, the savings curve will shift to the right and as income falls the savings curve will
shift to the left. Thus, we cannot know the position of the savings curve unless we already know the level of
income, and if we do not know the position of the savings curve, we cannot know the rate of interest. It follows
therefore that we cannot know what the rate of interest will be unless we already know what the income level
is. But we cannot know the income level without already knowing the rate of interest because with the changes
in the rate of interest investment will change which will in turn bring about changes in the income level. The
classical theory, therefore, offers no determinate solution to the problem of interest rate determination and is
indeterminate.
Savings out of current income is not the only source of supply of funds. As we have seen, the classical theory
considered only savings out of current income as constituting the supply of funds in the market. But savings out of
current income is not the only source of capital supply.
People have usually past hoarded savings, which they may dishoard in a period adding to the supply of funds in the
market. Further, now-a-days bank credit has become a very important source of investible funds which are also not
taken into account by the classical theory. We have critically explained the classical theory of interest. Some of the
shortcomings of the classical theory were removed by the loanable funds theory which we now turn to discuss.
Loanable Funds Theory of Interest
Another school of thought developed what is called loanable funds theory of interest. Among the principal
economists who contributed to the development of loanable funds theory mention may be made of Wicksell, Bertil
Ohlin, Robertson, Myrdal, Lindahl, Viner, etc. According to this theory, real forces, such as thriftiness, waiting,
time-preference and productivity of capital alone do not go to determine the rate of interest, monetary forces such
as hoarding and dishoarding of money, money created by banks, monetary loans for consumption purposes also
play a part in the determination of the rate of interest.
Thus the exponents of the loanable funds theory saw the interplay of monetary and non-monetary forces in the
determination of the rate of interest. We, therefore, see that loanable funds theory is a monetary theory of interest,
although it is only partly monetary since it also recognises the importance of real forces such as thriftiness and
productivity of capital in the determination of the rate of interest. According to this theory, rate of interest is
determined by demand for and supply of loanable funds.
The supply of loanable funds consists of savings out of disposable income, dishoarding, money created by the
banks and disinvestment (i.e., disentangling of fixed and working capital). The demand for loanable funds is
composed of the demand for investment, demand for consumption and demand for hoarding money. We shall
discuss below in detail these several sources of supply and demand of loanable funds.
Supply of Loanable Funds
 Savings: Savings by individuals and households constitute the most important source of the supply of loanable
funds. In the loanable funds theory savings are considered in either of the two ways. Firstly, in the sense of ex-
ante savings, that is, savings planned by individuals and households in the beginning of a period in the hope of
expected incomes and anticipated expenditures on consumption, and secondly, in the sense of Robertsonian
savings, that is, the difference between the income of the preceding period (which becomes disposable in the
present period) and consumption of the present period. In both these senses of savings it is assumed that the

amount of savings varies with rate of interest. More savings will be forthcoming at higher rates of interest and
vice versa. It is granted that savings by individuals and households primarily depend upon the size of their
income. But, given the level of income, savings vary with the rate of interest; the higher the rate of interest, the
greater the volume of savings. Therefore, supply curve of savings slopes upward to the right.
 Like individuals, business concerns also save. When the business is of the type of single proprietorship or
partnership, a part of the income from the business is used for consumption purposes and a part is kept for
further expansion of the business. When the business is of the type of joint stock Company, a part of the
earnings is distributed as dividends to the shareholders and a part of the earnings of the company is retained
undistributed which constitutes the corporate savings. Business savings depend partly upon the current rate of
interest. A higher rate of the interest is likely to encourage business savings as a substitute for borrowing from
the loan market. These savings are mostly used for investment purposes by the business firms themselves and,
therefore, most of them do not enter into the market for loanable funds. But these savings influence the rate of
interest since they serve as substitute for borrowed funds and, therefore, reduce the market demand for
loanable funds. In Figure 10.3, the curve labelled as S indicates the supply curve of savings which slopes
upward to the right.
 Dishoarding: Dishoarding of the past accumulated savings constitutes another source of supply of loanable
funds. Individuals may possess idle cash balances hoarded from the incomes of the previous periods which
they may dishoard in a period. When people dishoard, the idle cash balances become active cash balances in
the present period and thus add to the supply of loanable funds People hoard money because of their
preference for liquidity. When the rate of interest or when the prices of securities decline, they may like to take
advantage of these market movements and thus dishoard money for lending it to others or for purchasing
securities. At a higher rate of interest, the individuals possessing idle cash balances will be induced to dishoard
more money. At very low rates of interest, their parting with liquidity will not be rewarded sufficiently and,
therefore, they will hold on to money. It is evident that dishoarding is interest-elastic and, therefore, the curve
of dishoarding slopes upwards to the right as is shown in Fig 9.3 by curve DH.
 Bank Money: The banking system is another important source of the supply of loanable funds. The commercial
banks by creating credit money advance loans to the businessmen and industries for investment. Banks can
also reduce the supply of loanable funds by contracting their lending. Banks also purchase and sell securities
and thereby affect the supply of loanable funds. The supply curve of funds provided by banks is to some
degree interest-elastic. Generally speaking, the banks would like to lend more money at higher rates of interest
than at lower ones. Therefore, supply curve of bank money also slopes upward to the right as is shown by the
curve BM in Figure 10.3.
Figure 10.3: Determination of Rate of Interest

 Disinvestment: Disinvestment is another source of the supply of loanable funds. Disinvestment means
disentangling of the present fixed and working capital. Usually a good amount of depreciation reserves are
kept so as to replace the fixed capital when it is completely worn out. When there is a declining tendency in
certain industries due to some structural changes in the economy, the entrepreneurs may not like to remain tied
to those industries and therefore they may allow the existing stock of machines and other equipment belonging
to those industries wear out without replacement. As a result, they may bring the depreciation reserves in the
market for loanable funds. Similarly, working capital invested in business may be withdrawn gradually and
made available as loanable funds. When disinvestment is decided to be undertaken, then not only the
depreciation reserves but also a part of the revenue earned from the sale of the output instead of going into
capital replacement flows into the market for loanable funds. At higher rates of interest, the entrepreneurs will
generally contemplate a greater amount of disinvestment. It is, therefore, clear that disinvestment curve will
also slope upward to the right, as is indicated by the curve DI in Figure 10.3.
By lateral summation of the curves of savings (S), dishoarding (DH), bank money (BM) and disinvestment (DI) we
get the total supply curve of loanable funds SL which slopes upward to the right showing that a greater amount of
loanable fund will be available at higher rates of interest and vice versa.
Demand for Loanable Funds
Having now explained the sources of supply of loanable funds, we turn to explain the factors which determine the
demand for loanable funds. Loanable funds theory also differs from the classical theory in its explanation of the
demand for funds. Whereas the classical theory considers only the demand for funds for investment purposes, the
loanable funds theory also considers the demand of loans for consumption and demand for hoarding money, apart
from the demand of funds for investment. In considering the hoarding of money, loanable funds theory
incorporates in itself the factor of liquidity preference on which Keynes later laid great stress as an important
determinant of interest. We shall explain below these different sources of demand for loanable funds.
 Investment Demand: Demand for investment constitutes an important factor working on the side of demand for
loanable funds. Investment demand includes businessmen’s borrowings for purchasing or making of new
capital goods including the building up of inventories. The price of obtaining the loanable funds required to
purchase or make in capital goods is obviously the rate of interest. It will pay businessmen to demand and
undertake investment of loanable funds up to the point where the expected net rate of return on investment
equals the rate of interest. In the loanable funds theory, demand for investment depends upon the marginal
revenue productivity of capital (or the marginal rate of return) in the same way as in the classical theory. When
the rate of interest falls, businessmen will find it profitable to increase investment in capital goods with the
result that their demand for loanable funds will raise. We thus see that demand of loanable funds for
investment is interest-elastic; at a low rate of interest, there will be greater investment demand and vice versa.
Therefore, the curve of investment demand for loanable funds slopes downward to the right as is shown by the
curve I in Figure 10.3.
 Consumption Demand: Another important source of demand for loanable funds is the loans desired to be taken
by the people for consumption purposes. Loans for consumption purposes are demanded by the people when
they wish to make purchases in excess of their current incomes and idle cash resources. The loans for
consumption purposes are demanded generally for buying durable use goods such as houses, automobiles,
refrigerators, television sets, air conditioners etc. Whereas a lower rate of interest will induce people to borrow
more for consumption, the higher rates of interest will discourage borrowing for consumption. Therefore,
consumption demand for loanable funds slopes downward to the right and is shown by the curve labelled as
DS in Figure 10.3.
 Demand for Hoarding. Lastly, demand for money to hoard is another important factor determining demand for
loanable funds. Demand for hoarding money arises because of people’s preference for liquidity, i.e., for cash
balances. Hoarded money represents idle cash balances. People save money when they do not spend all their
disposable income on consumption. Now the people can lend out their savings to others or purchase securities
with their savings or invest their savings in real capital assets. Another alternative use of income saved (i.e.,

income not spent on consumption) is to hoard them, that is, to hold them as idle cash balances. People can also
hoard money when they sell securities or assets owned by them and not spending the proceeds obtained
therefrom. Now the question arises as to why people hoard money when they can earn some income by lending
it to others or investing it in securities or capital assets. An important reason for the demand for hoarding
money is that people like to take advantage of the changes in the rate of interest or changes in the prices of
securities in the future. At higher current rates of interest, people will hoard less money because much of the
money will be lent out to take advantage of the higher rates of interest, and people will hoard more money at
lower rates of interest because loss suffered in hoarding money in this case will not be very much. It follows
therefore that the curve of demand for hoarding money will slope downwards as is shown by the curve H in
Figure 9.3. An important point to be noted here is that the person who has a demand for funds to hoard
supplies the funds to himself for that purpose. A saver who hoards savings can be said to be supplying loanable
funds and also demand-ing them to satisfy his liquidity preference.
By adding up horizontally the investment demand curve I, dis-savings or consumption demand curve DS, and the
hoarding demand curve H, we get DL as the total demand curve for loanable funds.
Equilibrium between Demand for and Supply of Loanable Funds:
We have explained above the factors governing both demand for and supply of loanable funds and have also
derived the aggregate demand curve of loanable funds DL and the aggregate supply curve of loanable funds SL.
Now, the rate of interest is determined by the intersection of the demand for loanable funds curve DL and the
supply of loanable funds curve SL, as is illustrated in Figure 10.3. DL and SL curves intersect at point E and
thereby determine the equilibrium rate of interest Or. At the equilibrium rate of interest Or, the loanable funds
supplied and demanded are equal to OM. At any other interest rate either the demand for loanable funds will
exceed the supply of loanable funds or the supply of loanable funds will exceed the demand for loanable funds and
therefore there will be a change in the rate of interest until it reaches the level or where demand for and supply of
loanable funds are equal.
It should be noted that at the equilibrium rate of interest where aggregate demand for and supply of loanable funds
are equal, planned savings and investment may not be equal, as is the case in Figure 10.3. It will be seen from this
figure that at equilibrium rate of interest Or, while investment is equal to rE, the savings are equal to rA.
As a result of investment being greater than savings, income will increase. With the increase in income, the savings
curve S and therefore the aggregate supply curve SL will shift to the right. And this shift in the savings and supply
of loanable funds curve SL will cause a change in the rate of interest.
We thus see that the rate of interest as deter-mined by the demand for and supply of loanable funds will not be a
stable one if there is inequality between savings and investment at that rate. This inequality will bring about a
change in the in-come and thereby a change in the savings and supply of loanable funds. As a result, the rate of
interest will tend to change.
A stable equilibrium rate of interest will be achieved where intersection of the aggregate supply and demand curves
of loanable funds determines the equilibrium rate of interest at which the savings and investment are also equal.
But in a single period, the rate of interest at which demand and supply of loanable funds are equal will prevail in
spite of the inequality of savings and investment, although the equilibrium rate of interest in such a situation will
tend to change over time through changes in income.
We have explained above the various components of demand for and supply of loanable funds and have shown
how the equilibrium rate of interest is determined. We have taken the savings (S) on the supply side, dis-savings
(DS) on the demand side; dishoarding (DH) on the supply side and hoarding (H) on the demand side; investment
(I) on the demand side and disinvestment on the supply side.
We can further simplify our analysis of components of demand for and supply of loanable funds and bring out the
conditions for the equilibrium rate of interest in a better way if we use net of savings (i.e. savings minus
dissaving’s), net of hoarding (i.e. hoarding minus dishoarding) and net of investment (i.e. investment minus
disinvestment). This will become clear from the following:

We know that equilibrium rate of interest is determined where Supply of loanable funds = Demand for loanable
funds or S + DH + BM + DI = I + DS + H
By taking DS to the left hand side and DH and DI to the right hand side we get
(S – DS) + BM = (1- DI) + (H-DH)
Or Net S + BM = Net I + Net H
Or, Net savings + Bank money = Net Investment + Net hoarding
Thus we see that the rate of interest will be at the equilibrium level where the supply of net savings and bank
money will be equal to the demand for investment and net hoarding. This is the essence of the loanable funds
theory of interest.
Critical Evaluation of Loanable Funds Theory
Loanable funds theory is superior to classical theory of interest. It has greatly improved our understanding of the
forces working on the supply of and demands for loanable funds. It makes quite comprehensive analysis of the
determination of the rate of interest and takes into consideration all the relevant factors which have a bearing on the
rate of interest, namely, saving or thriftiness, investment demand, hoarding and bank credit. However, loanable
funds theory has been criticized by Keynes and Keynesians.
 First, it was asserted by Keynes that the concept of hoarding as used in loanable funds theory is quite dubious.
This is so because hoarding simply cannot increase or decrease as long as the amount of money remains the
same. Money in circulation in an economy has to be in somebody’s cash balances at any time. According to
him, if the quantity of money remains the same, then the total amount of cash balances in the beginning and at
the end of a period will be the same; the greater hoarding of money by one person must have been offset by the
dishoarding of any other person. But this criticism of loanable funds theory is misplaced. As a matter of fact,
the effective supply of money in a society does not merely depend upon the quantity of money; it also depends
upon the velocity of circulation of money. And it is this velocity of circulation which changes as a result of
hoarding or dishoarding and, therefore, involves the changes in the effective supply of money, although the
amount of money in existence may have remained the same. Thus, we see that the hoarding can occur even if
the quantity of money in circulation remains constant during a period and, therefore, Keynes’s objection
against the loanable funds theory on this ground is not valid. As a matter of fact, Keynes himself introduced
distinction between ‘active’ and ‘idle’ balances. Now, increase in idle balances at the expense of active
balances is hoarding and results in a reduction in the velocity of circulation of money. If the time duration of
idleness of money (i.e., period of rest between the two transfers) increases, it will mean hoarding which will
reduce the supply of loanable funds in the market and thus affect the determination of the rate of interest.
Keynes also criticized the loanable funds theory on the ground that like classical theory it did not provide a
determinate solution to the interest-rate determination and involved what was called circular reasoning.
According to him, since savings is an important constituent of the supply of loanable funds, the supply of
loanable funds curve will vary with the level of income which determines savings. We, therefore, cannot know
the rate of interest unless we know what the level of income is. And we cannot know the level of income
unless we know the rate of interest since rate of interest affects investment which in turn determines the level
of income. Following Keynes, Hansen also disapproves loanable funds theory and maintains that “the schedule
of loanable funds is composed of savings plus net additions to loanable funds from new money and
dishoarding of idle balances. But since the savings portion of the schedule varies with the level of disposable
income it follows that the total supply schedule of loanable funds also varies with income making the rate of
interest indeterminate.”
 Keynes was correct in criticizing the classical theory for its ignoring the effect of changes in the level of
income upon the supply of savings but his criticism against loanable funds theory is not valid. This is because
loanable funds theory seeks to explain the interest rate determination through period analysis with a lag of one
period, which makes the theory quite determinate. In loanable funds theory, the supply of savings is regarded

as being determined by the income of the preceding period and savings so determined along with other
components of supply and the demand for loanable funds determine the rate of interest in the current period.
The current rate of interest so determined affects the level of income in the succeeding period through
investment. Prof. Halm rightly maintains that “It is not circular reasoning to say that income is influenced by
investment, investment by rates of interest, rates of interest by the supply of loanable funds, the supply of
loanable funds by savings, and savings in turn, by the income received in the last period.” We, therefore,
conclude that charge against loanable fundi theory that it is indeterminate is untenable.
 Another charge against the loanable funds theory is that it is based upon the assumption of full employment
level of income which does not hold in the real world. And the superiority of Keynes’s theory is sought to be
proved on the basis of its being based upon realistic assumption of less than full employment. But this is not
correct interpretation of loanable funds theory. As we have seen above in the explanation of the loanable funds
theory that it takes into account the increases in the level of income as a result of investment and their
influence on savings.
According to loanable funds theory, stable equilibrium regarding rate of interest will be reached at the level where
not only demand for and supply of loanable funds are equal but saving and investment are also equal. As a matter
of fact, loanable funds theory is a synthesis between the classical theory and Keynes’s liquidity preference theory
since it takes into account the savings and investment demand of the classical theory as well as liquidity preference
of Keynes’s theory. By incorporating hoarding and dishoarding it considers the liquidity preference on which
Keynes laid a great stress as an important factor determining the rate of interest.
Keynes’s Liquidity Preference Theory of Interest
In his epoch-making book, “The General Theory of Employment, Interest and Money” J.M. Keynes gave a new
view of interest. According to him, “interest is the reward for parting with liquidity for a specified period.” A man
with a given income has to decide first how much he is to consume and how much to save. The former will depend
on, what Keynes calls, the propensity to consume. Given this propensity to consume, the individual will save a
certain proportion of his given income. He then has to make another decision. Should he hold his savings? How
much of his resources will he hold in the form of ready money (cash or non-interest-paying bank deposits) and how
much will he part with or lend depends upon what Keynes calls his “liquidity preference”. Liquidity preference
means the demand for money to hold or the desire of the public to hold cash.
Demand for Money or Motives for Liquidity Preference
Liquidity preference of a particular individual depends upon several considerations. The question is: Why should
the people hold their resources liquid or in the form of ready money, when they can get interest by lending such
resources? The desire for liquidity arises because of three motives:
(i) The transactions motive,
(ii) The precautionary motive, and
(iii) The speculative motive.
The Transactions Motive: The transactions motive relates to the demand for money or need for cash for the current
transactions of individuals and businessmen. Individuals want to hold cash in order “to bridge the interval between
the receipt of income and its expenditure”. This is called the ‘Income Motive’. Most of the people receive their
incomes by the week or the month, while the expenditure goes on day by day. A certain amount of ready money,
therefore, is kept in hand to make current payments for goods and services to be purchased. This amount will
depend upon the size of the individual’s income, the interval at which the income is received and the methods of
payment prevailing in the society. The businessmen and the entrepreneurs also have to keep a proportion of their
resources in ready cash in order to meet current needs of various kinds. They need money all the time in order to
pay for raw materials and transport, to pay wages and salaries and to meet all other current expenses business. This
Keynes calls the ‘Business Motive’ for keeping money.

It is clear that the amount of money held under this business motive will depend to a very large extent on the
turnover (i.e., the volume of trade of the firm in question). The larger, the turnover, the larger in general, will be the
amount of money needed to cover current expenses.
Precautionary Motive: Precautionary motive for holding money refers to the desire of the people to hold cash
balances for unforeseen contingencies. People hold a certain amount of money to provide for the danger of
unemployment, sickness, accidents, and the other uncertain emergencies. The amount of money held under this
motive will depend on the nature of the individual and on the conditions in which he lives.
Speculative Motive: The speculative motive relates to the desire to hold one’s resources in liquid form in order to
take advantage of market movements regarding the future changes in the rate of interest (or bond prices). The
notion of holding money for speculative motive is a new typically Keynesian idea. Money held under the
speculative motive serves as a store of value as money held under the precautionary motive does. But it is a store of
money meant for a different purpose. The cash held under this motive is used to make speculative gains by dealing
in bonds whose prices fluctuate.
If bond prices are expected to rise, which, in other words, means that the rate of interest is expected to fall,
businessmen will buy bonds to sell when their prices actually rise. If, however, bond prices are expected to fall,
i.e., the rate of interest is expected to rise, businessmen will sell bonds to avoid capital losses. Nothing being
certain in this dynamic world, where guesses about the future course of events are made on precarious basis,
businessmen keep cash balances to speculate on the probable future changes in bond prices (i.e. the rate of interest)
with a view to making profits.
Given the expectations about the changes in the rate of interest in future, less money will be held under the
speculative motive at a higher current or prevailing rate of interest and more money will be held under this motive
at a lower current rate of interest. The reason for this inverse relation between money held for speculative motive
and the prevailing rate of interest is that at a lower rate of interest less is lost by not lending money or not investing
it, that is, by holding on to money, while at a higher rate of interest holders of cash balances would lose more by
not lending or investing.
Thus, the demand for money under speculative motive is a function of the current rate of interest, increasing as the
interest rate falls and decreasing as the interest rate rises. Thus, demand for money under this speculative motive is
a decreasing function of the rate of interest. This is shown in Figure 10.4.
Figure 10.4: Demand for Money
Along the X-axis is represented the speculative demand for money and along the Y-axis the rate of interest. The
liquidity preference curve LP is a downward sloping towards the right signifying that the higher the rate of interest,
the lower the demand for speculative motive, and vice versa. Thus, at the high current rate of interest Or, a very
small amount OM is held for speculative motive. This is because at a high current rate of interest much money
would have been lent out or used for buying bonds and therefore less money will be kept as inactive balances. If
the rate of interest falls to Orʹ, then a greater amount OMʹ is held under speculative motive.

With the further fall in the rate of interest to Oʹʹ, money held under speculative motive increases to OMʹʹ. It will be
seen in Fig 9.4 that the liquidity preference curve LP becomes quite flat i.e., perfectly elastic at a very low rate of
interest. It is horizontal line beyond point Eʹʹ towards the right. This perfectly elastic portion of liquidity preference
curve indicates the position of absolute liquidity preference of the people. That is, at a very low rate of interest
people will hold with them as inactive balances any amount of money they come to have. This portion of liquidity
preference curve with absolute liquidity preference is called liquidity trap by some economists.
Demand for Money
But the demand for money to satisfy the speculative motive does not depend so much upon what the current rate of
interest is, as on expectations of changes in the rate of interest. If there is a change in the expectations regarding the
future rate of interest, the whole curve of liquidity preference for speculative motive will change accordingly.
Thus, if the public on balance expect the rate of interest to be higher (i.e., bond prices to be lower) in the future
than had been previously supposed, the speculative demand for money will increase and the whole liquidity
preference curve for speculative motive will shift upward.
If the total supply of money is represented by M, we may refer to that part of M held for transactions and
precautionary motives as M1, and to that part held for the speculative motive as M2. Thus M = M1 + M2. According
to Keynes, the money held under the transactions and precautionary motives, i.e. M1 is completely interest-inelastic
unless the interest rate is very high. The amount of money held as M1 that is, for transactions and precautionary
motive, is mainly a function of the size of income and business transactions together with the contingencies
growing out of the conduct of personal and business affairs.
We can write this in a functional form as follows:
M1 = L1(Y) …(i)
Where Y stands for income, L1 for liquidity preference function, and Ml for money held under the transactions and
precautionary motive. The above function implies that money held under the trans-action and precautionary motive
is a function of income. On the other hand, money demanded for speculative motives, i.e., M2, as explained above,
is primarily a function of the rate of interest. This can be written as:
M2 = L2(r) …(ii)
Where r stand for the rate of interest, L2 for liquidity preference function for speculative motive. Since total supply
of money M = M1 + M2, we get from (i) and (ii) above
M = L1(Y) + L2(r)
Determination of the Rate of Interest: Interaction of Liquidity Preference and Supply of Money:
According to Keynes, the demand for money, i.e., the liquidity preference and supply of money determine the rate
of interest. It is in fact the liquidity preference for speculative motive which along with the quantity of money
determines the rate of interest.
We have explained above the speculative demand for money in detail. As for the supply of money, it is determined
by the policies of the Government and the Central Bank of the country. The total supply of money consists of coins
plus notes plus bank deposits. How rate of interest is determined by the equilibrium between the liquidity
preference for speculative motive and the supply of money is shown in Figure 10.5.

Figure 10.5: Determination of Rate of Interest and Effect of Expansion in Money Supply
In Fig 10.5, LP is the curve of liquidity preference for speculative motive. In other words, LP curve shows the
demand for money for speculative motive. To begin with, ON is the quantity of money available for satisfying
liquidity preference for speculative motive. Rate of interest will be determined where the speculative demand for
money is in balance or equal to the fixed supply of money ON. It is clear from the figure that speculative demand
for money is equal to ON quantity of money at Or rate of interest. Hence Or is the equilibrium rate of interest.
Assuming no change in expectations, an increase in the quantity of money (say through open market operations by
central bank of a country) for the speculative motive will lower the rate of interest.
In Figure 10.6, when the quantity of money increases from ON to ONʹ, the rate of interest falls from Or to Orʹ
because the new quantity of money ONʹ is in balance with the speculative demand for money at Orʹ rate of interest.
In this case we move down the curve. Thus, given the curve of liquidity preference for speculative motive, an
increase in the quantity of money brings down the rate of interest. But the act of increase in the quantity of money
may cause a change in the expectations of the public and thereby cause an upward shift in liquidity preference
curve for speculative motive bringing the rate of interest up. But this is not certain. New developments may only
cause wide differences of opinion leading to increased activity in the bond market without necessarily causing any
shift in the aggregate speculative demand for money.
It is worth mentioning that shift in liquidity preference schedule or curve can be caused by many other factors
which affect expectations and might take place independently of changes in the quantity of money by the central
bank. Shifts in the liquidity function may be either downward or upward depending on the way in which the public
interprets people a change in events. If some change in events leads the people on balance to expect a higher rate of
interest in the future than they had previously supposed, the liquidity preference for speculative motive will
increase which will bring about an upward shift in the curve of liquidity preference for speculative motive and will
raise the rate of interest.
Figure 10.6: Effect of Increase in the Liquidity Preference on Rate of Interest

In Figure 10.6, assuming that the quantity of money remains unchanged at ON, the rise in the liquidity preference
curve from LP to LʹPʹ, the rate of interest rises from Or to Oh because at Oh, the new speculative demand for
money is in equilibrium with the supply of money ON. It is worth noting that when the liquidity preference for
speculative motive increases from LP to LʹPʹ, the amount of money hoarded does not increase; it remains ON as
before. Only the rate of interest rises from Or to Oh to equilibrate the new liquidity preference for speculative
motive with the available quantity of money ON. Thus we see that Keynes explained interest in terms of purely
monetary forces and not in terms of real forces like productivity of capital and thriftiness times which formed the
foundation-stones of both classical and loanable fund theories.
According to him, demand for money for speculative motive together with the supply of money determines the rate
of interest. He agreed that the marginal revenue product of capital tends to become equal to the rate of interest but
the rate of interest is not determined by marginal revenue product of capital. Moreover, according to
him, interest is not a reward for saving or thriftiness or waiting but for parting with liquidity. Keynes asserted that
it is not the rate of interest which equalizes saving and investment. But this equality is brought about through
changes in the level of income.
Critical Appraisal of Keynes’s Liquidity Preference Theory of Interest:
Keynes Liquidity Preference theory of Interest has also been subjected to some criticism which we discuss below:
 Keynes ignored real factors in the determination of interest: Firstly, it has been pointed out that rate of interest
is not purely a monetary phenomenon. Real forces like productivity of capital and thriftiness or saving also
play an important role in the determination of the rate of interest. Keynes makes the rate of interest
independent of the demand for investment funds. In fact, it is not so independent. The cash-balances of the
businessmen are largely influenced by their demand for capital investment. This demand for capital-investment
depends upon the marginal revenue productivity of capital. Therefore, the rate of interest is not determined
independently of the marginal revenue productivity of capital (marginal efficiency of capital) and investment
demand. When in-vestment demand increases due to greater profit prospects or, in other words, when marginal
revenue productivity of capital rises, there will be greater demand for investment funds and the rate of interest
will go up. But Keynesian theory does not take this into account. Similarly, Keynes ignored the effect of the
supply of savings on the rate of interest. For instance, if the propensity to consume of the people increases,
savings would decline. As a result, supply of funds in the market will decline which will raise the rate of
interest.
 Keynesian theory is also indeterminate: Now exactly the same criticism applies to Keynesian theory itself on
the basis of which Keynes rejected the classical and loanable funds theories. Keynes’s theory of interest is
also indeterminate. According to Keynes, rate of interest is determined by the speculative demand for money
and the supply of money available for satisfying speculative demand. Given the total money supply, we cannot
know how much money will be available to satisfy the speculative demand for money unless we know how
much the transactions demand for money is. And we cannot know the transactions demand for money unless
we first know the level of income. Thus the Keynesian theory, like the classical, is indeterminate. “In the
Keynesian case the supply and demand for money schedules cannot give the rate of interest unless we ahead’
know the income level; in the classical case the demand and supply schedules for saving offer no solution until
the income is known. Precisely the same is true of loanable-fund theory. Keynes’ criticism of the classical and
loanable-fund theories applies equally to his own theory.”
 No liquidity without Savings: According to Keynes, interest is a reward for parting with liquidity and in no
way a compensation and inducement for saving or waiting. But without saving how can the funds be available
to be kept as liquid and how can there be question of surrendering liquidity if one has not already saved
money. Jacob Viner rightly maintains, “Without saving there can be no liquidity to surrender”. Therefore, the

rate of interest is vitally connected with saving which is neglected by Keynes in the determination of interest. It
follows from above that Keynesian theory of interest is also not without flaws. But importance Keynes gave to
liquidity preference as a determinant of interest is correct. In fact, the expo-nents of loanable funds theory
incorporated the liquidity preference in their theory by laying greater stress on hoarding and dishoarding.
Keynes did not forge nearly as new a theory as he and others at first thought. Rather, his great emphasis on the
influence of hoarding on the rate of interest constituted an invaluable addition to the theory of interest as it had
been developed by the loanable funds theorists who incorporated much of Keynes’s ideas into their theory to make
it more complete.

5 BUILDING THE IS–LM MODEL
CHAPTER
Interaction between Real and Financial Sectors for Simultaneous Determination of Level of
Income and Rate of Interest
Keynes proposed that low aggregate demand is responsible for the low income and high unemployment that
characterize economic downturns. He criticized classical theory for assuming that aggregate supply alone—capital,
labor, and technology—determines national income. Economists thereafter reconcile these two views with the
model of aggregate demand and aggregate supply, which was discussed in Chapter 7. In the long run, prices are
flexible, and aggregate supply determines income. But in the short run, prices are sticky, so changes in aggregate
demand influence income. In 2008 and 2009, as the United States and Europe descended into a recession, the
Keynesian theory of the business cycle was in the news and policymakers around the world debated how best to
increase aggregate demand and put their economies on the road to recovery.
In this chapter, we continue our study of economic fluctuations by looking more closely at aggregate demand and
our goal is to identify the variables that shift the aggregate demand curve, causing fluctuations in national income.
We also examine more fully the tools policymakers can use to influence aggregate demand. In Chapter 7, we
derived the aggregate demand curve from the quantity theory of money, and we showed that monetary policy can
shift the aggregate demand curve. In this chapter we see that the governments can influence aggregate demand with
both monetary and fiscal policy.
The model of aggregate demand developed, called the IS–LM model, is the leading interpretation of Keynes’s
theory. The goal of the model is to show what determines national income for a given price level. There are two
ways to interpret this exercise. We can view the IS –LM model as showing what causes income to change in the
short run when the price level is fixed because all prices are sticky. Or we can view the model as showing what
causes the aggregate demand curve to shift. These two interpretations of the model are equivalent as in the short
run when the price level is fixed, shifts in the aggregate demand curve lead to changes in the equilibrium level of
national income.
The two parts of the IS –LM model - IS stands for “investment’’ and “saving,’’ and the IS curve represents what’s
going on in the market for goods and services while LM stands for “liquidity’’ and “money,’’ and the LM curve
represents what’s happening to the supply and demand for money. Because the interest rate influences both
investment and money demand, it is the variable that links the two halves of the IS –LM model. The model shows
how interactions between the goods and money markets determine the position and slope of the aggregate demand
curve and, therefore, the level of national income in the short run.
The Goods Market and the IS Curve
The IS curve plots the relationship between the interest rate and the level of income that arises in the market for
goods and services. To develop this relationship, we start with a basic model called the Keynesian cross. This
model is the simplest interpretation of Keynes’s theory of how national income is determined, which was discussed
in Chapter 9 and is a building block for the more complex and realistic IS–LM model.
It may be recalled that the derivation of the Keynesian cross was based on the distinction between actual and
planned expenditure. Actual expenditure is the amount households, firms, and the government spend on goods and

BUILDING THE IS–LM MODEL
services, and it equals the economy’s gross domestic product (GDP). Planned expenditure is the amount
households, firms, and the government would like to spend on goods and services. The Keynesian cross assumes
that the economy is in equilibrium when actual expenditure equals planned expenditure. This assumption is based
on the idea that when people’s plans have been realized, they have no reason to change what they are doing.
Recalling that Y as GDP equals not only total income but also total actual expenditure on goods and services, we
can write this equilibrium condition as
Actual Expenditure = Planned Expenditure
Y = PE.
The 45-degree line in Figure 10.1 plots the points where this condition holds. With the addition of the planned-
expenditure function, this diagram becomes the Keynesian cross. The equilibrium of this economy is at point A,
where the planned-expenditure function crosses the 45-degree line. In this model, inventories play an important role
in the adjustment process. Whenever an economy is not in equilibrium, firms experience unplanned changes in
inventories, and this induces them to change production levels. Changes in production in turn influence total income
and expenditure, moving the economy toward equilibrium.
For example, suppose the economy finds itself with GDP at a level greater than the equilibrium level, such as the
level Y1 in Figure 11.1. In this case, planned expenditure PE1 is less than production Y1, so firms are selling less
than they are producing. Firms add the unsold goods to their stock of inventories. This unplanned rise in inventories
induces firms to lay off workers and reduce production; these actions in turn reduce GDP. This process of
unintended inventory accumulation and falling income continues until income Y falls to the equilibrium level.
Figure 11.1: The Adjustment to Equilibrium in the Keynesian Cross

Similar but opposite is the process when GDP is at a level lower than the equilibrium level, such as the level Y2 in
Figure 11.1. In this case, Firms meet the high level of sales by drawing down their inventories. But when firms see
their stock of inventories dwindle, they hire more workers and increase production. GDP rises and the economy
approaches the equilibrium. In summary, the Keynesian cross shows how income Y is determined for given levels
of planned investment I and fiscal policy G and T. We can use this model to show how income changes when one of
these exogenous variables changes.
The Interest Rate, Investment, and the IS Curve
The Keynesian cross is only a stepping-stone on our path to the IS –LM model, which explains the economy’s
aggregate demand curve. The Keynesian cross is useful because it shows how the spending plans of households,
firms, and the government determine the economy’s income. Yet it makes the simplifying assumption that the level
of planned investment I is fixed. To add this relationship between the interest rate and investment to our model, we
write the level of planned investment as
I = I(r)
This investment function is graphed in panel (a) of Figure 11.2. Because the interest rate is the cost of borrowing to
finance investment projects, an increase in the interest rate reduces planned investment. As a result, the investment
function slopes downward. To determine how income changes when the interest rate changes, we can combine the
investment function with the Keynesian-cross diagram. Because investment is inversely related to the interest rate,
an increase in the interest rate from r 1 to r2 reduces the quantity of investment from I (r1) to I (r2). The reduction in
planned investment, in turn, shifts the planned-expenditure function downward, as in panel (b) of Figure 11.2. The
shift in the planned-expenditure function causes the level of income to fall from Y1 to Y2. Hence, an increase in the
interest rate lowers income. The IS curve, shown in panel (c) of Figure 11.2, summarizes this relationship between
the interest rate and the level of income. In essence, the IS curve combines the interaction between r and I
expressed by the investment function and the interaction between I and Y demonstrated by the Keynesian cross.
Each point on the IS curve represents equilibrium in the goods market, and the curve illustrates how the
equilibrium level of income depends on the interest rate. Because an increase in the interest rate causes planned
investment to fall, which in turn causes equilibrium income to fall, the IS curve slopes downward.
How Fiscal Policy Shifts the IS Curve

The IS curve shows us, for any given interest rate, the level of income that brings the goods market into
equilibrium. As we learned from the Keynesian cross, the equilibrium level of income also depends on government
spending G and taxes T. The IS curve is drawn for a given fiscal policy; that is, when we construct the IS curve, we
hold G and T fixed. When fiscal policy changes, the IS curve shifts. Figure 11.3 uses the Keynesian cross to show
how an increase in government purchases G shifts the IS curve. This figure is drawn for a given interest rate and
thus for a given level of planned investment. The Keynesian cross in panel shows that this change in fiscal policy
raises planned expenditure and thereby increases equilibrium income from Y1 to Y2. Therefore, in panel (b), the
increase in government purchases shifts the IS curve outward. We can use the Keynesian cross to see how other
changes in fiscal policy shift the IS curve. Because a decrease in taxes also expands expenditure and income, it,
too, shifts the IS curve outward. A decrease in government purchases or an increase in taxes reduces income;
therefore, such a change in fiscal policy shifts the IS curve inward.

Figure 11.2: Deriving the IS Curve

Figure 11.3: An Increase in Government Purchases Shifts the IS Curve
In summary, the IS curve shows the combinations of the interest rate and the level of income that are consistent
with equilibrium in the market for goods and services. The IS curve is drawn for a given fiscal policy. Changes in
fiscal policy that raise the demand for goods and services shift the IS curve to the right. Changes in fiscal policy
that reduce the demand for goods and services shift the IS curve to the left.
The Money Market and the LM Curve

The LM curve plots the relationship between the interest rate and the level of income that arises in the market for
money balances. This relationship is based on a theory of the interest rate, called the theory of liquidity
preference.
The Theory of Liquidity Preference
The theory of liquidity preference posits that the interest rate is one determinant of how much money people choose
to hold. The underlying reason is that the interest rate is the opportunity cost of holding money: it is what you forgo
by holding some of your assets as money, which does not bear interest, instead of as interest-bearing bank deposits
or bonds. When the interest rate rises, people want to hold less of their wealth in the form of money. We can write
the demand for real money balances as
(M/P)d = L(r)
According to the theory of liquidity preference, the supply and demand for real money balances determine what
interest rate prevails in the economy. That is, the interest rate adjusts to equilibrate the money market. At the
equilibrium interest rate, the quantity of real money balances demanded equals the quantity supplied. The
adjustment occurs because whenever the money market is not in equilibrium, people try to adjust their portfolios of

assets and, in the process, alter the interest rate. For instance, if the interest rate is above the equilibrium level, the
quantity of real money balances supplied exceeds the quantity demanded. Individuals holding the excess supply of
money try to convert some of their non-interest-bearing money into interest-bearing bank deposits or bonds. Banks
and bond issuers, who prefer to pay lower interest rates, respond to this excess supply of money by lowering the
interest rates they offer. Conversely, if the interest rate is below the equilibrium level, so that the quantity of money
demanded exceeds the quantity supplied, individuals try to obtain money by selling bonds or making bank
withdrawals. To attract now-scarcer funds, banks and bond issuers respond by increasing the interest rates they
offer. Eventually, the interest rate reaches the equilibrium level, at which people are content with their portfolios of
monetary and nonmonetary assets.
Income, Money Demand, and the LM Curve

Having developed the theory of liquidity preference as an explanation for how the interest rate is determined, we
can now use the theory to derive the LM curve. We begin with a question: how does a change in the economy’s
level of income Y affect the market for real money balances? The answer is that the level of income affects the
demand for money. When income is high, expenditure is high, so people engage in more transactions that require
the use of money. Thus, greater income implies greater money demand. We can express these ideas by writing the
money demand function as
(M/P )d = L(r, Y ).
The quantity of real money balances demanded is negatively related to the interest rate and positively related to
income. Using the theory of liquidity preference, we can figure out what happens to the equilibrium interest rate
when the level of income changes. For example, consider what happens in Figure 11.4 when income increases from
Y1 to Y2. As panel (a) illustrates, this increase in income shifts the money demand curve to the right. With the
supply of real money balances unchanged, the interest rate must rise from r1 to r2 to equilibrate the money market.
Therefore, according to the theory of liquidity preference, higher income leads to a higher interest rate. The LM
curve shown in panel (b) of Figure 11.4 summarizes this relation-ship between the level of income and the interest
rate. Each point on the LM curve represents equilibrium in the money market, and the curve illustrates how the
equilibrium interest rate depends on the level of income. Higher the level of income, the higher the demand for real
money balances, and the higher the equilibrium interest rate. For this reason, the LM curve slopes upward.
Figure 11.4: Deriving the LM Curve

How Monetary Policy Shifts the LM Curve

The LM curve tells us the interest rate that equilibrates the money market at any level of income. Yet, as we saw
earlier, the equilibrium interest rate also depends on the supply of real money balances M/P. This means that the
LM curve is drawn for a given supply of real money balances. If real money balances change— for example, if the
RBI alters the money supply—the LM curve shifts.
We can use the theory of liquidity preference to understand how monetary policy shifts the LM curve. Suppose that
the Fed decreases the money supply from M1 to M2, which causes the supply of real money balances to fall from
M1/P to M2/P.
Figure 11.5: A Reduction in the Money Supply Shifts the LM Curve Upward
Figure 11.5 shows what happens. Holding constant the amount of income and thus the demand curve for real money
balances, we see that a reduction in the supply of real money balances raises the interest rate that equilibrates the
money market. Hence, a decrease in the money supply shifts the LM curve upward.
In summary, the LM curve shows the combinations of the interest rate and the level of income that is consistent
with equilibrium in the market for real money balances. The LM curve is drawn for a given supply of real money
balances. Decreases in the supply of real money balances shift the LM curve upward. Increases in the supply of
real money balances shift the LM curve downward.
The Short-Run Equilibrium
We now have all the pieces of the IS –LM model. The two equations of this model are
Y = C(Y − T) + I(r) + G IS,
M/P = L(r, Y) LM.
The model takes fiscal policy G and T, monetary policy M, and the price level P as exogenous. Given these
exogenous variables, the IS curve provides the combinations of r and Y that satisfy the equation representing the
goods market, and the LM curve provides the combinations of r and Y that satisfy the equation representing the
money market. These two curves are shown together in Figure 11.6.

Figure 11.6: Equilibrium in the IS–LM Model
The equilibrium of the economy is the point at which the IS curve and the LM curve cross. This point gives the
interest rate r and the level of income Y that satisfy conditions for equilibrium in both the goods market and the
money market. In other words, at this intersection, actual expenditure equals planned expenditure, and the demand
for real money balances equals the supply.
The schematic diagram explaining the derivation of IS-LM model is given below:
Explaining Fluctuations with the IS–LM Model

The intersection of the IS curve and the LM curve determines the level of national income. When one of these
curves shifts, the short-run equilibrium of the economy changes and national income fluctuates. We now examine
how changes in policy and shocks to the economy can cause these curves to shift.
How Fiscal Policy Shifts the IS Curve and Changes the Short-Run Equilibrium
We begin by examining how changes in fiscal policy (government purchases and taxes) alter the economy’s short-
run equilibrium. The changes in fiscal policy influence planned expenditure and thereby shift the IS curve. The IS –
LM model shows how these shifts in the IS curve affect income and the interest rate.
Changes in Government Purchases: The government-purchases multiplier in the Keynesian cross tells us that this
change in fiscal policy raises the level of income at any given interest rate by G/ (1 − MPC). Therefore, as Figure
11.7 shows, the IS curve shifts to the right by this amount. The equilibrium of the economy moves from point A to
point B. The increase in government purchases raises both income and the interest rate.

Figure 11.7: An Increase in Government Purchases in the IS–LM Model
The economic process of shifting IS curve goes as: When the government increases its purchases of goods and
services, the economy’s planned expenditure rises. The increase in planned expenditure stimulates the production of
goods and services, which causes total income Y to rise. These effects should be familiar from the Keynesian cross.
Now consider the money market, as described by the theory of liquidity preference. Because the economy’s demand
for money depends on income, the rise in total income increases the quantity of money demanded at every interest
rate. The supply of money has not changed; however, so higher money demand causes the equilibrium interest rate
r to rise. The higher interest rate arising in the money market, in turn, has ramifications back in the goods market.
When the interest rate rises, firms cut back on their investment plans. This fall in investment partially offsets the
expansionary effect of the increase in government purchases. Thus, the increase in income in response to a fiscal
expansion is smaller in the IS –LM model than it is in the Keynesian cross (where investment is assumed to be
fixed). The horizontal shift in the IS curve equals the rise in equilibrium income in the Keynesian cross. This
amount is larger than the increase in equilibrium income here in the IS –LM model. The difference is explained by
the crowding out of investment due to a higher interest rate.
Changes in Taxes: In the IS –LM model, changes in taxes affect the economy much the same as changes in
government purchases do, except that taxes affect expenditure through consumption. Consider, for instance, a
decrease in taxes of T. The tax cut encourages consumers to spend more and, therefore, increases planned
expenditure. The tax multiplier in the Keynesian cross tells us that this change in policy raises the level of income at
any given interest rate by ΔT × MPC/(1 − MPC ). Therefore, the IS curve shifts to the right by this amount. The
equilibrium of the economy moves from point A to point B. The tax cut raises both income and the interest rate.
Once again, because the higher interest rate depresses investment, the increase in income is smaller in the IS –LM
model than it is in the Keynesian cross.
How Monetary Policy Shifts the LM Curve and Changes the Short-Run Equilibrium
We now examine the effects of monetary policy. A change in the money supply alters the interest rate that
equilibrates the money market for any given level of income and, thus, shifts the LM curve. The IS –LM model
shows how a shift in the LM curve affects income and the interest rate.
Consider an increase in the money supply. An increase in M leads to an increase in real money balances M/P,
because the price level P is fixed in the short run. The theory of liquidity preference shows that for any given level
of income, an increase in real money balances leads to a lower interest rate. Therefore, the LM curve shifts
downward, as in Figure 11.8. The equilibrium moves from point A to point B. The increase in the money supply
lowers the interest rate and raises the level of income.

Figure 11.8: An Increase in the Money Supply in the IS–LM Model
Once again, to tell the story that explains the economy’s adjustment from point A to point B, we rely on the
building blocks of the IS –LM model—the Keynesian cross and the theory of liquidity preference. This time, we
begin with the money market, where the monetary-policy action occurs. When the RBI increases the supply of
money, people have more money than they want to hold at the prevailing interest rate. As a result, they start
depositing this extra money in banks or using it to buy bonds. The interest rate r then falls until people are willing to
hold all the extra money that the Fed has created; this brings the money market to a new equilibrium. The lower
interest rate, in turn, has ramifications for the goods market. A lower interest rate stimulates planned investment,
which increases planned expenditure, production, and income Y.
Thus, the IS –LM model shows that monetary policy influences income by changing the interest rate. This
conclusion sheds light on our analysis of monetary policy in Chapter 9. In that chapter we showed that in the short
run, when prices are sticky, an expansion in the money supply raises income. But we did not discuss how a
monetary expansion induces greater spending on goods and services—a process called the monetary transmission
mechanism. The IS –LM model shows an important part of that mechanism: an increase in the money supply
lowers the interest rate, which stimulates investment and thereby expands the demand for goods and services.
The Interaction between Monetary and Fiscal Policy
When analyzing any change in monetary or fiscal policy, it is important to keep in mind that the policymakers who
control these policy tools are aware of what the other policymakers are doing. A change in one policy, therefore,
may influence the other, and this interdependence may alter the impact of a policy change.
For example, suppose government raises taxes. What effect will this policy have on the economy? According to the
IS –LM model, the answer depends on how the central bank responds to the tax increase. Figure 11.9 shows three of
the many possible outcomes.

Figure 11.9: Response of an Economy to Tax Increases
How the economy responds to a tax increase

depends on how the central bank responds. In
panel (a) the RBI holds the money supply
constant. In panel (b) the RBI holds the
interest rate constant by reducing the money
supply. In panel (c) the RBI holds the level of
income constant by raising the money supply.
In each case, the economy moves from point
A to point B.
In panel (a), the RBI holds the money supply constant. The tax increase shifts the IS curve to the left. Income falls
(because higher taxes reduce consumer spending), and the interest rate falls (because lower income reduces the
demand for money). The fall in income indicates that the tax hike causes a recession. In panel (b), the RBI wants to
hold the interest rate constant. In this case, when the tax increase shifts the IS curve to the left, the Fed must
decrease the money supply to keep the interest rate at its original level. This fall in the money supply shifts the LM
curve upward. The interest rate does not fall, but income falls by a larger amount than if the Fed had held the money
supply constant. Whereas in panel (a) the lower interest rate stimulated investment and partially offset the
contractionary effect of the tax hike, in panel (b) the Fed deepens the recession by keeping the interest rate high. In
panel (c), the RBI wants to prevent the tax increase from lowering income. It must, therefore, raise the money
supply and shift the LM curve downward enough to offset the shift in the IS curve. In this case, the tax increase does
not cause a recession, but it does cause a large fall in the interest rate. Although the level of income is not changed,
the combination of a tax increase and a monetary expansion does change the allocation of the economy’s resources.

The higher taxes depress consumption, while the lower interest rate stimulates investment. Income is not affected
because these two effects exactly balance.
From this example we can see that the impact of a change in fiscal policy depends on the policy the central bank
pursues—that is, on whether it holds the money supply, the interest rate, or the level of income constant. More
generally, whenever analyzing a change in one policy, we must make an assumption about its effect on the other
policy.
Shocks in the IS–LM Model

Because the IS–LM model shows how national income is determined in the short run, we can use the model to
examine how various economic disturbances affect income. So far we have seen how changes in fiscal policy shift
the IS curve and how changes in monetary policy shift the LM curve. Similarly, we can group other disturbances
into two categories: shocks to the IS curve and shocks to the LM curve.
Shocks to the IS curve are exogenous changes in the demand for goods and services. Some economists, including
Keynes, have emphasized that such changes in demand can arise from investors’ animal spirits—exogenous and
perhaps self-fulfilling waves of optimism and pessimism. For example, suppose that firms become pessimistic
about the future of the economy and that this pessimism causes them to build fewer new factories. This reduction in
the demand for investment goods causes a contractionary shift in the investment function: at every interest rate,
firms want to invest less. The fall in investment reduces planned expenditure and shifts the IS curve to the left,
reducing income and employment. This fall in equilibrium income in part validates the firms’ initial pessimism.
Shocks to the IS curve may also arise from changes in the demand for consumer goods. Suppose, for instance, that
the election of a popular president increases consumer confidence in the economy. This induces consumers to save
less for the future and consume more today. We can interpret this change as an upward shift in the consumption
function. This shift in the consumption function increases planned expenditure and shifts the IS curve to the right,
and this raises income. Shocks to the LM curve arise from exogenous changes in the demand for money. For
example, suppose that new restrictions on credit-card availability increase the amount of money people choose to
hold.
In summary, several kinds of events can cause economic fluctuations by shifting the IS curve or the LM curve.
Policymakers can try to use the tools of monetary and fiscal policy to offset exogenous shocks. Due to timely
response by policy makers, shocks to the IS or LM curves need not lead to fluctuations in income or employment.
IS–LM as a Theory of Aggregate Demand

We have been using the IS –LM model to explain national income in the short run when the price level is fixed. To
see how the IS –LM model fits into the model of aggregate supply and aggregate demand introduced, we now
examine what happens in the IS –LM model if the price level is allowed to change.
From the IS–LM Model to the Aggregate Demand Curve
The aggregate demand curve describes a relationship between the price level and the level of national income.
Earlier, this relationship was derived from the quantity theory of money. That analysis showed that for a given
money supply, a higher price level implies a lower level of income. Increases in the money supply shift the
aggregate demand curve to the right, and decreases in the money supply shift the aggregate demand curve to the
left.
To understand the determinants of aggregate demand more fully, we now use the IS –LM model, rather than the
quantity theory, to derive the aggregate demand curve. First, we use the IS –LM model to show why national
income falls as the price level rises—that is, why the aggregate demand curve is downward sloping. Second, we
examine what causes the aggregate demand curve to shift.

To explain why the aggregate demand curve slopes downward, we examine what happens in the IS–LM model
when the price level changes. This is done in Figure 11.10.
Figure 11.10: Derivation of Aggregate Demand Curve with IS-LM Model
For any given money supply M, a higher price level P reduces the supply of real money balances M/P. A lower
supply of real money balances shifts the LM curve upward, which raises the equilibrium interest rate and lowers the
equilibrium level of income, as shown in panel (a). Here the price level rises from P1 to P2, and income falls from
Y1 to Y2. The aggregate demand curve in panel (b) plots this negative relationship between national income and the
price level. In other words, the aggregate demand curve shows the set of equilibrium points that arise in the IS–LM
model as we vary the price level and see what happens to income.
What causes the aggregate demand curve to shift? Because the aggregate demand curve summarizes the results
from the IS –LM model, events that shift the IS curve or the LM curve (for a given price level) cause the aggregate
demand curve to shift. For instance, an increase in the money supply raises income in the IS –LM model for any
given price level; it thus shifts the aggregate demand curve to the right, as shown in panel (a) of Figure 11.11.
Similarly, an increase in government purchases or a decrease in taxes raises income in the IS –LM model for a
given price level; it also shifts the aggregate demand curve to the right, as shown in panel (b) of Figure 11.11.
Conversely, a decrease in the money supply, a decrease in government purchases, or an increase in taxes lowers
income in the IS –LM model and shifts the aggregate demand curve to the left. Anything that changes income in the
IS –LM model other than a change in the price level causes a shift in the aggregate demand curve. The factors
shifting aggregate demand include not only monetary and fiscal policy but also shocks to the goods market (the IS
curve) and shocks to the money market (the LM curve).

Figure 11.11: How Monetary and Fiscal Policies Shift the Aggregate Demand Curve
We can summarize these results as follows: A change in income in the IS–LM model resulting from a change in the
price level represents a movement along the aggregate demand curve. A change in income in the IS–LM model for
a given price level represents a shift in the aggregate demand curve.
The IS–LM Model in the Short Run and Long Run

The IS –LM model is designed to explain the economy in the short run when the price level is fixed. Yet, now that
we have seen how a change in the price level influences the equilibrium in the IS –LM model, we can also use the
model to describe the economy in the long run when the price level adjusts to ensure that the economy produces at
its natural rate. By using the IS –LM model to describe the long run, we can show clearly how the Keynesian model
of income determination differs from the classical model.

Figure 11.12: The Short-Run and Long-Run Equilibria
Panel (a) of Figure 11.12 shows the three curves that are necessary for understanding the short-run and
long-run equilibria: the IS curve, the LM curve, and the vertical line representing the natural level of output Y . The
LM curve is, as always, drawn for a fixed price level P1. The short-run equilibrium of the economy is point K,
where the IS curve crosses the LM curve. Notice that in this short-run equilibrium, the economy’s income is less
than its natural level.
Panel (b) of Figure shows the same situation in the diagram of aggregate supply and aggregate demand. At the
price level P1, the quantity of output demanded is below the natural level. In other words, at the existing price level,
there is insufficient demand for goods and services to keep the economy producing at its potential. In these two
diagrams we can examine the short-run equilibrium at which the economy finds itself and the long-run equilibrium
toward which the economy gravitates. Point K describes the short-run equilibrium, because it assumes that the price
level is stuck at P1. Eventually, the low demand for goods and services causes prices to fall, and the economy
moves back toward its natural rate. When the price level reaches P2, the economy is at point C, the long-run
equilibrium. The diagram of aggregate supply and aggregate demand shows that at point C, the quantity of goods
and services demanded equals the natural level of output. This long-run equilibrium is achieved in the IS –LM
diagram by a shift in the LM curve: the fall in the price level raises real money balances and therefore shifts the LM
curve to the right.
We can now see the key difference between the Keynesian and classical approaches to the determination of national
income. The Keynesian assumption (represented by point K) is that the price level is stuck. Depending on monetary
policy, fiscal policy, and the other determinants of aggregate demand, output may deviate from its natural level. The
classical assumption (represented by point C) is that the price level is fully flexible. The price level adjusts to ensure
that national income is always at its natural level.
To make the same point somewhat differently, we can think of the economy as being described by three equations.
The first two are the IS and LM equations:

The IS equation describes the equilibrium in the goods market, and the LM equation describes the equilibrium in the
money market. These two equations contain three endogenous variables: Y, P, and r. To complete the system, we
need a third equation. The Keynesian approach completes the model with the assumption of fixed prices, so the
Keynesian third equation is
P = P1.
This assumption implies that the remaining two variables r and Y must adjust to satisfy the remaining two equations
IS and LM. The classical approach completes the model with the assumption that output reaches its natural level, so
the classical third equation is
This assumption implies that the remaining two variables r and P must adjust to satisfy the remaining two equations
IS and LM. Thus, the classical approach fixes output and allows the price level to adjust to satisfy the goods and
money market equilibrium conditions, whereas the Keynesian approach fixes the price level and lets output move to
satisfy the equilibrium conditions.
Which assumption is most appropriate? The answer depends on the time horizon. The classical assumption best
describes the long run. Hence, our long-run analysis of national income and prices assumes that output equals its
natural level. The Keynesian assumption best describes the short run. Therefore, our analysis of economic
fluctuations relies on the assumption of a fixed price level. We now have the tools to analyze the effects of
monetary and fiscal policy in the long run and in the short run. In the long run, prices are flexible, and we use the
classical analysis and in the short run, prices are sticky, and we use the IS –LM model to examine how changes in
policy influence the economy.
Effectiveness of Monetary and Fiscal Policy

The relative effectiveness of monetary and fiscal policy has been the subject of controversy among economists. The
monetarists regard monetary policy more effective than fiscal policy for economic stabilization.
On the other hand, the Keynesians hold the opposite view. In between these two extreme views are the synthesis’s
who advocate the middle path. Before we discuss them, we study the effectiveness of monetary and fiscal policy in
terms of shape of the IS curve and the LM curve. The IS curve represents fiscal policy and the LM curve monetary
policy.
Monetary Policy
The government influences investment, employment, output and income through monetary policy. This is done by
increasing or decreasing the money supply by the monetary authority. When the money supply is increased, it is an
expansionary monetary policy. This is shown by shifting the LM curve to the right. When the money supply is
decreased, it is a contractionary monetary policy. This is shown by shifting the LM curve to the left.
Figure 11.13 illustrate an expansionary monetary policy with given LM and IS curves. Suppose the economy is in
equilibrium at point E with OY income and OR interest rate. An increase in the money supply by the monetary
authority shifts the LM curve to the right to LM1 given the IS curve. This reduces the interest rate from OR to OR1
thereby increasing investment and national income. Thus the national income rises from OY to OY1. But the
relative effectiveness of monetary policy depends on the shape of the LM curve and the IS curve.

Figure 11.13: Expansionary Monetary Policy
Monetary policy is more effective if the LM curve is steeper. A steeper LM curve means that the demand for
money is less interest elastic. The less interest elastic is the demand for money, the larger is the fall in interest rate
when the money supply is increased. This is because when the demand for money is less elastic to a change in
interest rate, an increase in the money supply is more powerful in the bringing about a large fall in interest rate. A
large fall in the interest rate leads to a higher increase in investment and in national income. This is depicted in
Figure 11.14 where E is the original equilibrium position of the economy with OR interest rate and OY income.
Figure 11.14: Effectiveness of Monetary Policy and Elasticities of LM Curve
When the steep LM1 curve shifts to the right to LMs, the new equilibrium is set at E2. As a result, the interest rate
falls from OR to OR2 and income rises from OY to OY2. On the other hand, the flatter is the LM curve; the less
effective will be monetary policy. A flatter LM curve means that the demand for money is more interest elastic.
The more interest elastic is the demand for money, the smaller is the fall in interest rate when the money supply is
increased. A small fall in the interest rate leads to a smaller increase in investment and income. In Figure 11.14, E
is the original equilibrium position with OR interest rate and OY income. When the flatter LМ2 curve shifts to the
right to LMF the new equilibrium is established at E1 which produces OR1interest rate and OY1 income level. In
this case, the fall in interest rate to OR1 is less than OR2 of the steeper LMs curve and the increase in income OY1 is
also less than OY2 of the steeper curve. This shows that monetary policy is less effective in the case of the flatter
LM curve and more effective in the case of the steeper curve.

If the LM curve is horizontal, monetary policy is completely ineffective because the demand for money is perfectly
interest elastic. This is the case of “liquidity trap” shown in Figure 11.15, where the increase in the money supply
has no effect on the interest rate OR and the income level OY.
Figure 11.15: Horizontal LM Curve Figure 11.16: Vertical LM Curve
On the other hand, if the LM curve is vertical, monetary policy is highly effective because the demand for money is
perfectly interest inelastic. Figure 11.16 shows that when the vertical LM curve shifts to the right to LM with the
Increase in the money supply, the interest rate falls from OR to OR1which has no effect on the demand for money
and the entire increase in the money supply has the effect of raising the income level from OY to OY1.
Now let us take the slope of the IS curve. The flatter is the IS curve, the more effective is the monetary’ policy.
The flatter IS curve means that the investment expenditure is highly interest elastic. When increase in the money
supply lowers the interest rate even slightly, private investment also increases, by a large amount, thereby raising
income much. This is depicted in Figure 11.17 where the original equilibrium is at point E with OR interest rate
and OY income level. When the LM curve shifts to the right to LM1 with the increase in money supply, it intersects
the flatter curve ISF at E2 which produces OR2 interest rate and OY2 income.
Figure 11.17: Slope of IS Curve and Effectiveness of Monetary Policy
If we compare this equilibrium position Е2 with the E1position where the curve ISs is steeper, the interest rate OR1
and the income level OY1 are lower than the interest rate and income level of the flatter ISF curve. This shows that
when the money supply is increased, a small fall in the rate of interest leads to a large rise in private investment
which raises income more (by YY2) with the flatter ISF curve as compared to the steep IS curve (by YY1) thus
making monetary policy more effective.

If the IS curve is vertical monetary policy is completely ineffective because investment expenditure is completely
interest inelastic. With the increase in the money supply, the LM curve shifts to the right to LM1 in Figure 11.18,
the interest rate falls from OR to OR1 but investment being completely interest inelastic, the income remains
unchanged at OY.
Figure 11.18: Vertical IS Curve Figure 11.19: Horizontal Curve
On the other hand, if the IS curve is horizontal, monetary policy is highly effective because investment expenditure
is perfectly interest elastic. Figure 11.19 shows that with the increase in the money supply, the LM curve shifts to
LM1 .But even with no change in the interest rate OR, there is a large change in income from OY to OY1 This
makes monetary policy highly effective.
Fiscal Policy
The government also influences investment, employment, output and income in the economy through fiscal policy.
For an expansionary fiscal policy, the government increases its expenditure or/and reduces taxes. This shifts the IS
curve to the right. The government follows a contractionary fiscal policy by reducing its expenditure or/and
increasing taxes. This shifts the IS curve to the left.
Figure 11.20: Expansionary Fiscal policy with given IS and LM Curves
Figure 11.20 illustrates an expansionary fiscal policy with given IS and LM curves. Suppose the economy is in
equilibrium at point E with OR interest rate and OY income. An increase in government spending or a decrease in
taxes shifts the IS curve upwards to IS which intersects the LM curve at E1 .This raises the national income from
OY to OY1.The rise in the national income increases the demand for money, given the fixed money supply. This, in
turn, raises the interest rate from OR to OR1.The increase in the interest rate tends to reduce private investment
expenditure at the same time when the government expenditure is being increased. If the interest rate had not
changed with the increase in government expenditure, income would have risen to OY2 level. But the actual
increase in income has been less by Y2Y1 due to the increase in the interest rate to OR1 which has reduced private
investment expenditure. The opposite happens in a contractionary fiscal policy.

The relative effectiveness of fiscal policy depends on the slope of the LM curve and the IS curve. Fiscal policy is
more effective, the flatter is the LM curve, and is less effective when the LM curve is steeper. When the IS curve
shifts upwards to IS1with the increase in government expenditure, its impact on the national income is more with
the flatter LM curve than with the steeper LM curve. This is shown in Figure 11.21 where the IS1 curve intersects
the flatter LMF curve at point Е2which produces OY2 income and OR2 interest rate. On the other hand, it intersects
the steeper LMs curve at E1 which determines OY1 income and OR1interest rate. In the case of the steeper curve
LMs, the increase in income to OY1 leads to a large rise in the demand for money which raises the interest rate to a
very high level OR1.
Figure 11.21: Slope of LM Curve and effectiveness of Fiscal policy
The large increase in the interest rate reduces private investment despite increase in government expenditure which
ultimately brings a small rise in income OY1. But in the case of the flatter curve LMF the rise in the interest rate to
OR2 is relatively small. Consequently, it reduces private investment to a lesser degree and its net effect on national
income is relatively large. Thus the increase in national income with the flatter curve LMF is more (YY2> YY1) as
compared with the steeper curve LMs.
Fiscal policy is completely ineffective, if the LM curve is vertical. It means that the demand for money is perfectly
interest inelastic. This is shown in Figure 11.22 where the level of income remains unchanged. When the IS curve
shifts upwards to IS1, only the interest rate rises from OR to OR1 and increase in government expenditure does not
affect national income at all. It remains constant at OY. At the other extreme is the perfectly horizontal LM curve
where fiscal policy is fully effective.
Figure 11.22: Vertical LM Curve Figure 11.23: Horizontal IS Curve
This situation implies that the demand for money is perfectly interest elastic. This is shown in Figure 11.23 where
the horizontal LM curve is intersected by the IS curve at E which produces OR interest rate and OY income. When

the IS curve shifts to the right to IS1, income rises by the full multiplier of the increase in government expenditure.
It rises to OK, but there is no change in interest rate.
Now take the slope of the IS curve. The steeper is the IS curve, the more effective is fiscal policy. The flatter is the
IS curve, the less effective is fiscal policy. These two cases are illustrated in Figure 11.24 where E is the original
equilibrium point with OR interest rate and OY income level.
Figure 11.24: Slope of IS Curve and effectiveness of Fiscal policy
The increase in government expenditure shifts the flatter curve IS1 to ISF so that the new equilibrium with LM
curve at point E1 produces OR1 interest rate and OY1income level. Similarly, the steeper curve IS2 is shifted to ISS
with the increase in government expenditure and the new equilibrium with LM curve at point E2 leads to OR2
interest rate and OY2 income level. The figure shows that the national income increases more with the shifting of
the steeper IS curve than in the case of the flatter IS curve.
It rises by YY2 in the case of the steeper curve ISs and by YY1 in the case of the flatter curve IS1.This is because
investment expenditure is less interest-elastic, when the IS curve is steeper. The increase in the interest rate to OR2
reduces very little private investment with the result that the rise in income is greater. On the other hand, the
increase in income is smaller in the case of the flatter IS curve. This is because investment expenditure is more
interest-elastic. The increase in the interest rate to OR1 reduces large private investment so that the rise in income
is smaller. Thus fiscal policy is more effective, the steeper is the IS curve and is less effective in the case of the
flatter IS curve.
Fiscal policy is completely ineffective, if the IS curve is horizontal. A horizontal IS curve means that investment
expenditure is perfectly interest elastic. This is depicted in Figure 11.25 where LM curve intersects the IS curve at
E. An increase in government expenditure has no effect on the interest rate OR and hence on the income level OY.
Such a situation is not likely to be in practice.
Figure 11.25: Horizontal IS Curve Figure 11.26: Horizontal IS Curve

On the other extreme is the vertical IS curve, which makes fiscal policy highly effective. This is because
government expenditure perfectly interest inelastic. An increase in government expenditure shifts the IS curve to
the right to E1,raises the interest rate to OR1 and income to OY1 by the full multiplier of the increase in government
expenditure, as shown in Figure 11.26. This makes fiscal policy highly effective.
The Synthesit’s View: Three Range Analysis
Economists have explained the effectiveness of monetary and fiscal policies in three ranges in order to reconcile the
extremes of the Keynesian and monetarist (or classical) views. The LM curve slopes upward to the right and has
three segments, as shown in Figure 11.27. Starting from the left it is perfectly elastic. This segment is known as
“the Keynesian range”, reflecting the “liquidity trap”. At the other extreme to the right, the LM curve is perfectly
inelastic. This segment of the curve is known as the classical range,” because the classical believed that money is
held only for transactions purposes and nothing is held for speculative purposes. In between these two segments of
the curve is “the intermediate range”. The Keynesian range represents the fiscalism or Keynesian view, the
classical range the monetarist view, and the intermediate range the synthesist view. We take expansionary monetary
and fiscal policies in order to explain their effectiveness which depends upon the extent to which they affect the
level of income and the rate of interest in the Keynesian, the classical and the intermediate ranges. They, in turn,
are determined by the responsiveness of the demand for money to changes in the interest rate.
Figure 11.27: Effectiveness of Monetary Policicy: Three Range Analysis
Monetary Policy
Monetary policy is explained in Figure 11.27 where the two LM curves LM1 and LМ2 are shown with three IS
curves. The LM2 curve emerges after an increase in the money supply.
The Keynesian Range:
First, consider the Keynesian range where the LM curve is perfectly elastic. This is the Keynesian liquidity trap
situation in which the LM curve is horizontal, and the interest rate cannot fall below OR1. An increase in the money
supply shifts the LM curve from LM1 to LM2. This shift in the curve has no effect on the rate of interest.
Consequently, investment is not affected at all so that the level of income remains unchanged at OY 1 .This is

because at a very low rate of interest such as OR1, people prefer to keep money in cash rather than in bonds (or
securities) in the hope of converting it into bonds when the interest rate rises. Thus under the Keynesian assumption
of the liquidity trap, the horizontal portion of the LM curve is not affected by an increase in the money supply. The
IS curve intersects the LM curve in the flat range at A with little effect on the interest rate, and consequently on
investment and income. Monetary policy is, therefore, totally ineffective in the Keynesian range.
The Classical or Monetarist Range:
Consider the classical range where LM curve is perfectly inelastic. The normal case has already been explained in
terms of Figure 4. In the classical range, the system is in equilibrium at D where the IS3 curve intersects the
LM1curve and the interest rate is OR5 and income level OY4. Suppose the central bank adopts an expansionary
monetary policy which increases the money supply by open market operations. The increase in money supply shifts
the LM1 curve to the right to LM2 position. As a result, the income level increases from OY4 to OY5 and the
interest rate falls from OR5 to OR4 when the IS3.curve crosses the LM2 curve at E.
The increase in the income level and fall in the interest rate as a result of the increase in the money supply is based
on the classical assumption that money is primarily a medium of exchange. When the central bank buys securities
in the market, the security prices are bid up and the rate of interest falls. The wealth holders then find other assets
more attractive than securities.
They, therefore, invest the increased cash holdings in new or existing capital investments which, in turn, raise the
level of income. But as long as wealth holders possess more money balances than are required for transactions
purposes, they will continue to compete for earning assets. Consequently, the interest rate will continue to fall and
investment will continue to rise until the excess money balances are absorbed in such transactions. Ultimately the
equilibrium level of income rises by the full amount of the increase in the money supply. Thus the monetary policy
is highly effective in the classical range when the economy is at high levels of income and interest rate and utilizes
the entire increase in the money supply for transactions purposes thereby raising national income by the full
increase in the money supply.
The Intermediate Range:
Now consider the intermediate range when the initial equilibrium is at В where the IS2 curve intersects the LM1
curve and the income level is OY2 and the interest rate is OR3.The increase in the money supply shifts the LM1
curve to LM2 position. As a result, the new equilibrium is established at point С where the IS2 curve crosses the
LM2 curve. It shows that with the increase in the money supply the rate of interest falls from OR3 to OR2and the
income level rises from OY2 to OY3. In the intermediate range, the increase in income by Y2Y3 is less than that in
the classical range, (Y2Y3 < Y4Y5). This is because in the classical case the entire increase in the money supply is
absorbed for transactions purposes. But in the intermediate case, the increased money supply is partly absorbed for
speculative purposes and partly for transactions purposes. That which is held for speculative purposes is not
invested by wealth holders and remains with them in the form of idle balances. This has the effect of raising the
income level by less than the increase in the money supply. Thus in the intermediate range monetary policy is less
effective than in the classical range.
Fiscal Policy
Fiscal policy is explained in Figure 11.28 in which the three range LM curve is taken along with six IS curves that
arise after increase in government expenditure in the case of the Keynesian, intermediate and classical ranges.
The Keynesian Range:
Consider first the Keynesian range when the initial equilibrium is at A where the IS1 curve intersects the LM curve.
Suppose the government expenditure is increased. This brings about new equilibrium at В where the IS2 curve cuts
the LM curve. Consequently, the income level rises from OY1 to OY2 with the interest rate unchanged at OR. The
increase in income in the Keynesian case is equal to the full multiplier times the increase in government
expenditure.

Figure 11.28: Effectiveness of Fiscal Policy: Three Range Analysis
This is because with fixed money supply at low levels of interest rate and income, there is a lot of idle money with
the wealth holders. This can be used to finance higher transactions without raising the interest rate. When the
interest rate does not rise, the level of investment remains the same as before and the increase in income is equal to
the full multiplier times the increase in government expenditure. Thus in the Keynesian range, the fiscal policy is
very effective.
The Classical or Monetarist Range:
Now in the classical range, the LM curve is perfectly inelastic and the IS5 curve intersects it at E so that the interest
rate is OR3 and the income level is OY5. When the government expenditure increases for an expansionary fiscal
policy, the IS5 curve shifts upward to IS6. As a result, the IS6 curve crosses the LM curve at F and the interest rate
rises to OR4 with income remaining unchanged at OY5. This is because the classical case relates to a fully
employed economy where the increase in government expenditure has the effect of raising the interest rate which
reduces private investment. Since the increase in government expenditure exactly equals the reduction in the
private investment, there is no effect on the level of income which remains constant at OY5. Thus fiscal policy is
not at all effective in the classical range.
The Intermediate Range:
In the intermediate range, the initial equilibrium is at С where the IS3 curve intersects the LM curve. Here OR1is
the interest rate with OY3 the level of income. With the increase in the government expenditure, the IS3 curve shifts
upward to the right from IS3 to IS4 and the new equilibrium between IS4 and LM curves is established at point D.
As a result, the increase in government expenditure raises the income level from OY3 to OY4 and the interest rate
from OR1 to OR2.The increase in both the income level and the interest rate in the intermediate range are due to
two reasons:
 First, the increase in income resulting from a rise in government expenditure occurs because additional
money balances are available for transactions purposes.
 Second, given a fixed money supply, a part of available transactions are held as idle balances by wealth
holders which raise the interest rate. As a result of the rise in the interest rate, investment falls and the
fiscal policy is not so effective as in the Keynesian range. In general, fiscal policy “will be more effective
the closer equilibrium is to the Keynesian range and less effective the closer equilibrium is to the classical
range.”

Effects of Elasticities of IS Curve on Monetary and Fiscal Policies

The elasticities of the IS curve affect monetary and fiscal policies in a slightly different way. This is explained in
terms of Figure 11.29.
Figure 11.29: Effects of Elasticities of IS Curve on Monetary and Fiscal Policies
In the Keynesian range, monetary policy is ineffective whether the IS curve is elastic (ISF) or inelastic (ISS). On the
other hand, fiscal policy is only effective when the IS curve is elastic or inelastic. The elastic curve IS F, shifts to
ISF1 and income rises from OY1 to OY2 in Figure 11.29. The same result follows in the case of the shifting of an
inelastic IS curve. In the classical range, fiscal policy is ineffective whether the IS curve is elastic (IS F2) or inelastic
(ISS2). But monetary policy is effective under both the elastic and inelastic curves. Income rises from OY3 to OY6,
as shown in Figure 11.29.
In the intermediate range, monetary policy is less effective when the ISS1 curve is inelastic because the rise in
income in this case is Y2Y3 where as in the case of the elastic curve ISF1, it is more effective, the rise in income
being Y2F5 (>Y2Y3). But fiscal policy is more effective, whether the IS curve is elastic or inelastic. The shifting of
the inelastic curve from ISS1 to ISS0 shows the increase in income from OY3 to OY4.
Conclusion
The relative effectiveness of monetary and fiscal policy depends upon the shape of the IS and LM curves and the
economy’s initial position. If the economy is in the Keynesian range, monetary policy is ineffective and fiscal
policy is highly effective. On the other hand, in the classical range, monetary policy is effective and fiscal policy is
ineffective. But in the intermediate range both monetary and fiscal policies are effective.
This case bridges the gap between the Keynesian and classical views. In this range, the elasticities of the IS and LM
curves are neither highly interest elastic nor highly interest inelastic. In fact, in the intermediate range, the
effectiveness of monetary and fiscal policies depends largely on the elasticities of the IS curve. If the IS curve is
inelastic, fiscal policy is more effective than monetary policy. On the other hand, if the IS curve is elastic, monetary
policy is more effective than fiscal policy. Thus for a complete effectiveness of both monetary and fiscal policies
the best course is to have a monetary-fiscal mix.
Monetary-Fiscal Mix
Consider a situation where an expansionary mix of monetary-fiscal policies is adopted to achieve full employment
in the economy. This is illustrated in Figure 11.30 where the economy is in the initial situation at A on the basis of
the interaction of IS1and LM1 curves.

Figure 11.30: Expansionary Mix of Monetary-Fiscal Policies
This situation depicts OR2 interest rate and OY1 income level. Now an expansionary fiscal policy is adopted in the
form of increase in government expenditure or decrease in taxes. This shifts the curve IS1 to IS2. This will have the
effect of raising the interest rate further to OR3 if an expansionary monetary policy is not adopted simultaneously.
So in order to reduce the interest rate and encourage investment for achieving full employment, the monetary
authority increases the money supply through open market purchase of securities. This tends to shift the curve LM1
to the right in the position of LM2 curve. Now fiscal policy has led to the new IS2 curve and monetary policy to the
LM2 curve. Both the curves intersect at В whereby the interest rate is lowered to OR1 and the level of income rises
to the full employment level OYF.
Let us take another situation when the economy is at the full employment level of income OY F where the IS curve
intersects the LM curve at point E in Figure 11.31. But due to some reasons, the economy’s growth rate has slowed
down. In order to overcome this, more investment is required to be made in the economy.
For this, the monetary authority increases the money supply which leads to the shifting of the curve LM to the right
to LM1.The LM1 curve intersects the IS curve at point E1 which lowers the interest rate to OR1 and raises the
income level to OY1. But the rise in national income being higher than the full employment income level, this
policy is inflationary. Therefore, the economy requires a change in the monetary-fiscal policy mix.
Figure 11.31: Mix of Monetary-Fiscal Policies at Full

Employment Level
For this, the expansionary monetary policy should be combined with a restrictive fiscal policy. Accordingly, the
government reduces its investment expenditure or/and increases taxes so that the IS curve shifts to the left to IS1.
Now the IS1, curve intersects the LM1curve at point Е2 so that the new equilibrium is established at a lower interest
rate OR2 and income OYF which is the full employment income level. This level can be maintained by the present

monetary-fiscal policy mix because the lower interest rate would keep large investment spending in the economy
and reduced government expenditure or high taxes would control inflation.
Analysis of Economic Fluctuations in an Open Economy: The Mundell–Fleming

Model and the Exchange-Rate Regime
The international flow of goods and services and the international flow of capital can affect an economy in profound
ways. It would be worthwhile to extend the analysis of aggregate demand to include international trade and finance.
The model used for the purpose is called the Mundell–Fleming model, which has been described as “the dominant
policy paradigm for studying open-economy monetary and fiscal policy.” The Mundell–Fleming model is a close
relative of the IS–LM model. Both models stress the interaction between the goods market and the money market.
Both models assume that the price level is fixed and then show what causes short-run fluctuations in aggregate
income (or, equivalently, shifts in the aggregate demand curve). The key difference is that the IS–LM model
assumes a closed economy, whereas the Mundell–Fleming model assumes an open economy.
The Mundell–Fleming model makes one important and extreme assumption: it assumes that the economy being
studied is a small open economy with perfect capital mobility. That is, the economy can borrow or lend as much as
it wants in world financial markets and, as a result, the economy’s interest rate is determined by the world interest
rate.
The Key Assumption: Small Open Economy with Perfect Capital Mobility
Let’s begin with the assumption of a small open economy with perfect capital mobility. This assumption means that
the interest rate in this economy r is determined by the world interest rate r*. Mathematically, we can write this
assumption as
 r = r *.
This world interest rate is assumed to be exogenously fixed because the economy is sufficiently small relative to
the world economy that it can borrow or lend as much as it wants in world financial markets without affecting the
world interest rate. In a small open economy, the domestic interest rate might rise by a little bit for a short time, but
as soon as it did, foreigners would see the higher interest rate and start lending to this country (by, for instance,
buying this country’s bonds). The capital inflow would drive the domestic interest rate back toward r*. Similarly, if
any event started to drive the domestic interest rate downward, capital would flow out of the country to earn a
higher return abroad, and this capital outflow would drive the domestic interest rate back up to r*. Hence, the r = r*
equation represents the assumption that the international flow of capital is rapid enough to keep the domestic
interest rate equal to the world interest rate.
The Goods Market and the IS* Curve
The Mundell–Fleming model describes the market for goods and services much as the IS–LM model does, but it
adds a new term for net exports. In particular, the goods market is represented with the following equation:
Y = C(Y – T) + I(r) + G + NX (e)
This equation states that aggregate income Y is the sum of consumption C, investment I, government purchases G,
and net exports NX. Consumption depends positively on disposable income Y − T. Investment depends negatively
on the interest rate. Net exports depend negatively on the exchange rate e. If e is the nominal exchange rate, then
the real exchange rate e equals eP/P *, where P is the domestic price level and P* is the foreign price level. The
Mundell–Fleming model, however, assumes that the price levels at home and abroad are fixed, so the real exchange
rate is proportional to the nominal exchange rate.
The goods-market equilibrium condition above has two financial variables affecting expenditure on goods and
services (the interest rate and the exchange rate), but the situation can be simplified using the assumption of perfect
capital mobility, so r = r*. We obtain
Y = C(Y − T) + I(r *) + G + NX (e)

Let’s call this the IS* equation. (The asterisk implies that the equation holds the interest rate constant at the world
interest rate r*.) We can illustrate this equation on a graph in which income is on the horizontal axis and the
exchange rate is on the vertical axis. This curve is shown in panel (c) of Figure 11.13.
The IS* curve slopes downward because a higher exchange rate reduces net exports, which in turn lowers
aggregate income. To show how this works, the other panels of Figure 10.13 combine the net-exports schedule and
the Keynesian cross to derive the IS* curve. In panel (a), an increase in the exchange rate from e1 to e2 lowers net
exports from NX (e1) to NX (e2). In panel (b), the reduction in net exports shifts the planned-expenditure schedule
downward and thus lowers income from Y1 to Y2. The IS* curve summarizes this relationship between the
exchange rate e and income Y.
The Money Market and the LM* Curve
The Mundell–Fleming model represents the money market with an equation that should be familiar from the IS–
LM model:
M/P = L(r, Y ).
This equation states that the supply of real money balances M/P equals the demand L(r, Y). The demand for real
balances depends negatively on the interest rate and positively on income Y. The money supply M is an exogenous
variable controlled by the central bank, and because the Mundell–Fleming model is designed to analyze short-run
fluctuations, the price level P is also assumed to be exogenously fixed. Once again, we add the assumption that the
domestic interest rate equals the world interest rate, so r = r*:
M/P = L(r*, Y ).
Figure 11.13: Derivation of IS* Curve

Let’s call this the LM * equation. We can represent it graphically with a vertical line, as in panel (b) of Figure
11.14. The LM * curve is vertical because the exchange rate does not enter into the LM * equation. Given the world
interest rate, the LM * equation determines aggregate income, regardless of the exchange rate. Figure 10.14 shows
how the LM * curve arises from the world interest rate and the LM curve, which relates the interest rate and income.
Putting the Pieces Together

According to the Mundell–Fleming model, a small open economy with perfect capital mobility can be described by
two equations:
Y = C(Y − T ) + I(r*) + G + NX(e) IS*,

M/P = L(r*, Y ) LM*.
The first equation describes equilibrium in the goods market; the second describes equilibrium in the money
market. The exogenous variables are fiscal policy G and T, monetary policy M, the price level P, and the world
interest rate r *. The endogenous variables are income Y and the exchange rate e.
Figure 11.14: Derivation of LM* Curve

Figure 11.15 illustrates these two relationships. The equilibrium for the economy is found where the IS* curve and
the LM * curve intersect. This intersection shows the exchange rate and the level of income at which the goods
market and the money market are both in equilibrium. With this diagram, we can use the Mundell–Fleming model
to show how aggregate income Y and the exchange rate e respond to changes in policy.
Figure 11.15: Mundell-Flemmimg Model
The Small Open Economy under Floating Exchange Rates

Under a system of floating exchange rates, the exchange rate is set by market forces and is allowed to fluctuate in
response to changing economic conditions. In this case, the exchange rate e adjusts to achieve simultaneous
equilibrium in the goods market and the money market. When something happens to change that equilibrium, the
exchange rate is allowed to move to a new equilibrium value. Let’s now consider three policies that can change the
equilibrium: fiscal policy, monetary policy, and trade policy. Our goal is to use the Mundell–Fleming model to
show the impact of policy changes and to understand the economic forces at work as the economy moves from one
position of equilibrium to another.
Fiscal Policy
Suppose that the government stimulates domestic spending by increasing government purchases or by cutting taxes.
Because such expansionary fiscal policy increases planned expenditure, it shifts the IS* curve to the right, as in
Figure 11.16. As a result, the exchange rate appreciates, while the level of income remains the same.
It may be observed that fiscal policy has very different effects in a small open economy than it does in a closed
economy. In the closed-economy IS–LM model, a fiscal expansion raises income, whereas in a small open
economy with a floating exchange rate, a fiscal expansion leaves income at the same level. Mechanically, the
difference arises because the LM * curve is vertical, while the LM curve we used to study a closed economy is
upward sloping. But this explanation is not very satisfying. What are the economic forces that lie behind the
different outcomes? To answer this question, we must think through what is happening to the international flow of
capital and the implications of these capital flows for the domestic economy.

Figure 11.16: A Fiscal Expansion Under Floating Exchange Rates
The interest rate and the exchange rate are the key variables in the story. When income rises in a closed economy,
the interest rate rises, because higher income increases the demand for money. That is not possible in a small open
economy because, as soon as the interest rate starts to rise above the world interest rate r*, capital quickly flows in
from abroad to take advantage of the higher return. As this capital inflow pushes the interest rate back to r*, it also
has another effect: because foreign investors need to buy the domestic currency to invest in the domestic economy,
the capital inflow increases the demand for the domestic currency in the market for foreign-currency exchange,
bidding up the value of the domestic currency. The appreciation of the domestic currency makes domestic goods
expensive relative to foreign goods, reducing net exports. The fall in net exports exactly offsets the effects of the
expansionary fiscal policy on income.
Why is the fall in net exports so great that it renders fiscal policy powerless to influence income? To answer this
question, consider the equation that describes the money market:
M/P = L(r, Y ).
In both closed and open economies, the quantity of real money balances supplied M/P is fixed by the central bank
(which sets M) and the assumption of sticky prices (which fixes P). The quantity demanded (determined by r and Y)
must equal this fixed supply. In a closed economy, a fiscal expansion causes the equilibrium interest rate to rise.
This increase in the interest rate (which reduces the quantity of money demanded) implies an increase in
equilibrium income (which raises the quantity of money demanded); these two effects together maintain equilibrium
in the money market. By contrast, in a small open economy, r is fixed at r*, so there is only one level of income that
can satisfy this equation, and this level of income does not change when fiscal policy changes. Thus, when the
government increases spending or cuts taxes, the appreciation of the currency and the fall in net exports must be
large enough to offset fully the expansionary effect of the policy on income.
Monetary Policy
Suppose now that the central bank increases the money supply. Because the price level is assumed to be fixed, the
increase in the money supply means an increase in real money balances. The increase in real balances shifts the
LM* curve to the right, as in Figure 11.17. Hence, an increase in the money supply raises income and lowers the
exchange rate. Although monetary policy influences income in an open economy, as it does in a closed economy,
the monetary transmission mechanism is different. Recall that in a closed economy an increase in the money supply

increases spending because it lowers the interest rate and stimulates investment. In a small open economy, this
channel of monetary transmission is not available because the interest rate is fixed by the world interest rate.
Figure 11.17: A Monetary Expansion Under Floating Exchange
So how does monetary policy influence spending? To answer this question, we once again need to think about the
international flow of capital and its implications for the domestic economy. The interest rate and the exchange rate
are again the key variables. As soon as an increase in the money supply starts putting downward pressure on the
domestic interest rate, capital flows out of the economy, as investors seek a higher return elsewhere. This capital
outflow prevents the domestic interest rate from falling below the world interest rate r*. It also has another effect:
because investing abroad requires converting domestic currency into foreign currency, the capital outflow increases
the supply of the domestic currency in the market for foreign-currency exchange, causing the domestic currency to
depreciate in value. This depreciation makes domestic goods inexpensive relative to foreign goods, stimulating net
exports and thus total income. Hence, in a small open economy, monetary policy influences income by altering the
exchange rate rather than the interest rate.
Trade Policy
Suppose that the government reduces the demand for imported goods by imposing an import quota or a tariff. What
happens to aggregate income and the exchange rate? How does the economy reach its new equilibrium? Because
net exports equal exports minus imports, a reduction in imports means an increase in net exports. That is, the net-
exports schedule shifts to the right, as in Figure 11.18. This shift in the net-exports schedule increases planned
expenditure and thus moves the IS* curve to the right. Because the LM* curve is vertical, the trade restriction raises
the exchange rate but does not affect income.

Figure 11.18: A Trade Restriction Under Floating Exchange Rates
The economic forces behind this transition are similar to the case of expansionary fiscal policy. Because net exports
are a component of GDP, the rightward shift in the net-exports schedule, other things equal, puts upward pressure
on income Y; an increase in Y, in turn, increases money demand and puts upward pressure on the interest rate r.
Foreign capital quickly responds by flowing into the domestic economy, pushing the interest rate back to the world
interest rate r* and causing the domestic currency to appreciate in value. Finally, the appreciation of the currency
makes domestic goods more expensive relative to foreign goods, which decreases net exports NX and returns
income Y to its initial level.
Often a stated goal of policies to restrict trade is to alter the trade balance NX. Yet such policies do not necessarily
have that effect. The same conclusion holds in the Mundell–Fleming model under floating exchange rates. Given
that
NX (e) = Y − C(Y − T ) − I(r *) − G.
Because a trade restriction does not affect income, consumption, investment, or government purchases, it does not
affect the trade balance. Although the shift in the net-exports schedule tends to raise NX, the increase in the
exchange rate reduces NX by the same amount. The overall effect is simply less trade. The domestic economy
imports less than it did before the trade restriction, but it exports less as well.

The Small Open Economy under Fixed Exchange Rates

We now turn to the second type of exchange-rate system: fixed exchange rates. Under a fixed exchange rate, the
central bank announces a value for the exchange rate and stands ready to buy and sell the domestic currency to keep
the exchange rate at its announced level. In the 1950s and 1960s, most of the world’s major economies, including
that of the United States, operated within the Bretton Woods system—an international monetary system under
which most governments agreed to fix exchange rates. The world abandoned this sys-tem in the early 1970s, and
most exchange rates were allowed to float. Yet fixed exchange rates are not merely of historical interest. More
recently, China fixed the value of its currency against the U.S. dollar—a policy that, as we will see, was a source of
some tension between the two countries. We now discuss how such a system works, and we examine the impact of
economic policies on an economy with a fixed exchange rate. Later in the chapter we examine the pros and cons of
fixed exchange rates.
How a Fixed-Exchange-Rate System Works
Under a system of fixed exchange rates, a central bank stands ready to buy or sell the domestic currency for foreign
currencies at a predetermined price. For example, suppose the RBI announced that it was going to fix the exchange
rate at 70 rupee per dollar. It would then stand ready to give $1 in exchange for 70 rupee or to 70 rupee in exchange
for $1. To carry out this policy, the RBI would need a reserve of rupee (which it can print) and a reserve of dollar
(which it must have purchased previously). A fixed exchange rate dedicates a country’s monetary policy to the
single goal of keeping the exchange rate at the announced level. In other words, the essence of a fixed-exchange-
rate system is the commitment of the central bank to allow the money supply to adjust to whatever level will ensure
that the equilibrium exchange rate in the market for foreign-currency exchange equals the announced exchange
rate. Moreover, as long as the central bank stands ready to buy or sell foreign currency at the fixed exchange rate,
the money supply adjusts automatically to the necessary level.
To see how fixing the exchange rate determines the money supply, consider the following example. Suppose the
RBI announces that it will fix the exchange rate at 70 rupee per dollar, but, in the current equilibrium with the
current money supply, the market exchange rate is 100 rupee per dollar. This situation is illustrated in panel (b) of
Figure 11.19.
Figure 11.19: How a Fixed Exchange Rate Governs the Money Supply
It may be observed that there is a profit opportunity: an arbitrageur could buy 200 rupee in the foreign-exchange
market for $2 and then sell the rupee to the RBI for $2.80, making a $0.8 profit. When the RBI buys these dollars
from the arbitrageur, the rupees it pays for them automatically increase the money supply. The rise in the money
supply shifts the LM* curve to the right, lowering the equilibrium exchange rate. In this way, the money supply

continues to rise until the equilibrium exchange rate falls to the announced level. Conversely, suppose that when
the RBI announces that it will fix the exchange rate at 100 rupee per dollar, the equilibrium has a market exchange
rate of 50 rupee per dollar. Panel (a) of Figure 11.19 shows this situation. In this case, an arbitrageur could make a
profit by buying 100 rupee from the RBI for $1 and then selling the rupee in the marketplace for $2. When the RBI
sells these rupees, the $1 it receives automatically reduces the money supply. The fall in the money supply shifts
the LM* curve to the left, raising the equilibrium exchange rate. The money supply continues to fall until the
equilibrium exchange rate rises to the announced level.
It is important to understand that this exchange-rate system fixes the nominal exchange rate. Whether it also fixes
the real exchange rate depends on the time horizon under consideration. If prices are flexible, as they are in the long
run, then the real exchange rate can change even while the nominal exchange rate is fixed. Therefore, in the long
run, a policy to fix the nominal exchange rate would not influence any real variable, including the real exchange
rate. A fixed nominal exchange rate would influence only the money supply and the price level. Yet in the short run
described by the Mundell–Fleming model, prices are fixed, so a fixed nominal exchange rate implies a fixed real
exchange rate as well.
Fiscal Policy
Let’s now examine how economic policies affect a small open economy with a fixed exchange rate. Suppose that
the government stimulates domestic spending by increasing government purchases or by cutting taxes. This policy
shifts the IS* curve to the right, as in Figure 11.20, putting upward pressure on the market exchange rate. But
because the central bank stands ready to trade foreign and domestic currency at the fixed exchange rate,
arbitrageurs quickly respond to the rising exchange rate by selling foreign currency to the central bank, leading to
an automatic monetary expansion. The rise in the money supply shifts the LM* curve to the right. Thus, under a
fixed exchange rate, a fiscal expansion raises aggregate income.
Figure 10.20: A Fiscal Expansion Under Fixed Exchange Rates

Figure 11.21: A Monetary Expansion Under Fixed Exchange Rates
Monetary Policy
Imagine that a central bank operating with a fixed exchange rate tries to increase the money supply—for example,
by buying bonds from the public. What would happen? The initial impact of this policy is to shift the LM* curve to
the right, lowering the exchange rate, as in Figure 11.21.
But, because the central bank is committed to trading foreign and domestic currency at a fixed exchange rate,
arbitrageurs quickly respond to the falling exchange rate by selling the domestic currency to the central bank,
causing the money supply and the LM* curve to return to their initial positions. Hence, monetary policy as usually
conducted is ineffectual under a fixed exchange rate. By agreeing to fix the exchange rate, the central bank gives up
its control over the money supply.
A country with a fixed exchange rate can, however, conduct a type of monetary policy: it can decide to change the
level at which the exchange rate is fixed. A reduction in the official value of the currency is called devaluation, and
an increase in its official value is called a revaluation. In the Mundell–Fleming model, a devaluation shifts the
LM* curve to the right; it acts like an increase in the money supply under a floating exchange rate. Devaluation thus
expands net exports and raises aggregate income. Conversely, a revaluation shifts the LM* curve to the left, reduces
net exports, and lowers aggregate income.
Trade Policy
Suppose that the government reduces imports by imposing an import quota or a tariff. This policy shifts the net-
exports schedule to the right and thus shifts the IS* curve to the right, as in Figure 11.22

Figure 11.22: A Trade Restriction Under Fixed Exchange Rates
The shift in the IS* curve tends to raise the exchange rate. To keep the exchange rate at the fixed level, the money
supply must rise, shifting the LM* curve to the right. The result of a trade restriction under a fixed exchange rate is
very different from that under a floating exchange rate. In both cases, a trade restriction shifts the net-exports
schedule to the right, but only under a fixed exchange rate does a trade restriction increase net exports NX. The
reason is that a trade restriction under a fixed exchange rate induces monetary expansion rather than an appreciation
of the currency. The monetary expansion, in turn, raises aggregate income. Recall the accounting identity
NX = S − I.
When income rises, saving also rises, and this implies an increase in net exports.
Policy in the Mundell–Fleming Model: A Summary
The Mundell–Fleming model shows that the effect of almost any economic pol-icy on a small open economy
depends on whether the exchange rate is floating or fixed. Table 10.1 summarizes our analysis of the short-run
effects of fiscal, monetary, and trade policies on income, the exchange rate, and the trade balance.

What is most striking is that all of the results are different under floating and fixed exchange rates.To be more
specific, the Mundell–Fleming model shows that the power of monetary and fiscal policy to influence aggregate
income depends on the exchange-rate regime. Under floating exchange rates, only monetary policy can affect
income. The usual expansionary impact of fiscal policy is offset by a rise in the value of the currency and a decrease
in net exports. Under fixed exchange rates, only fiscal policy can affect income. The normal potency of monetary
pol-icy is lost because the money supply is dedicated to maintaining the exchange rate at the announced level.
Interest Rate Differentials

So far, our analysis has assumed that the interest rate in a small open economy is equal to the world interest rate: r
= r*. To some extent, however, interest rates differ around the world. We now extend our analysis by considering
the causes and effects of international interest rate differentials.
Country Risk and Exchange-Rate Expectations

When we assumed earlier that the interest rate in our small open economy is determined by the world interest rate,
we were applying the law of one price. We reasoned that if the domestic interest rate were above the world interest
rate, people from abroad would lend to that country, driving the domestic interest rate down. And if the domestic
interest rate were below the world interest rate, domestic residents would lend abroad to earn a higher return,
driving the domestic interest rate up. In the end, the domestic interest rate would equal the world interest rate. Why
doesn’t this logic always apply? There are two reasons: One reason is country risk another reason interest rates
differ across countries is expected changes in the exchange rate. Thus, because of both country risk and
expectations of future exchange-rate changes, the interest rate of a small open economy can differ from interest
rates in other economies around the world. Let’s now see how this fact affects our analysis.
Differentials in the Mundell–Fleming Model

To incorporate interest rate differentials into the Mundell–Fleming model, we assume that the interest rate in our
small open economy is determined by the world interest rate plus a risk premium θ:
 = r* + θ.
The risk premium is determined by the perceived political risk of making loans in a country and the expected
change in the real exchange rate. For our purposes here, we can take the risk premium as exogenous in order to
examine how changes in the risk premium affect the economy. The model is largely the same as before. The two
equations are
For any given fiscal policy, monetary policy, price level, and risk premium, these two equations determine the level
of income and exchange rate that equilibrate the goods market and the money market. Holding constant the risk
premium, the tools of monetary, fiscal, and trade policy work we have already seen. Now suppose that political
turmoil causes the country’s risk premium θ to rise. Because r = r* + θ, the most direct effect is that the domestic
interest rate r rises. The higher interest rate, in turn, has two effects. First, the IS* curve shifts to the left, because the
higher interest rate reduces investment. Second, the LM* curve shifts to the right, as the higher interest rate reduces
the demand for money, and this allows a higher level of income for any given money supply. [Recall that Y must
satisfy the equation M/P = L(r* + θ, Y).] As Figure 11.23 shows, these two shifts cause income to rise and the
currency to depreciate. This analysis has an important implication: expectations about the exchange rate are
partially self-fulfilling.

Figure 11.23: An Increase in the Risk Premium
For example, suppose that people come to believe that the Indian rupee will not be valuable in the future. Investors
will place a larger risk premium on rupee assets: θ will rise in Mexico. This expectation will drive up Indian interest
rates and, as we have just seen, will drive down the value of the Indian currency. Thus, the expectation that a
currency will lose value in the future causes it to lose value today. One prediction of this analysis is that an increase
in country risk as measured by θ will cause the economy’s income to increase. This occurs in Figure 11.23 because
of the rightward shift in the LM* curve. Although higher interest rates depress investment, the depreciation of the
currency stimulates net exports by an even greater amount. As a result, aggregate income rises.
There are three reasons why, in practice, such a boom in income does not occur. First, the central bank might want
to avoid the large depreciation of the domestic currency and, therefore, may respond by decreasing the money
supply M. Second, the depreciation of the domestic currency may suddenly increase the price of imported goods,
causing an increase in the price level P. Third, when some event increases the country risk premium θ, residents of
the country might respond to the same event by increasing their demand for money (for any given income and
interest rate), because money is often the safest asset available. All three of these changes would tend to shift the
LM* curve toward the left, which mitigates the fall in the exchange rate but also tends to depress income.
Thus, increases in country risk are not desirable. In the short run, they typically lead to a depreciating currency and,
through the three channels just described, falling aggregate income. In addition, because a higher interest rate
reduces investment, the long-run implication is reduced capital accumulation and lower economic growth.
Should Exchange Rates be Floating or Fixed?

Having analyzed how an economy works under floating and fixed exchange rates, let’s consider which exchange-
rate regime is better.

Pros and Cons of Different Exchange-Rate Systems

The primary argument for a floating exchange rate is that it allows monetary policy to be used for other purposes.
Under fixed rates, monetary policy is com-mitted to the single goal of maintaining the exchange rate at its
announced level. Yet the exchange rate is only one of many macroeconomic variables that monetary policy can
influence. A system of floating exchange rates leaves monetary policymakers free to pursue other goals, such as
stabilizing employment or prices. Advocates of fixed exchange rates argue that exchange-rate uncertainty makes
international trade more difficult. After the world abandoned the Bretton Woods system of fixed exchange rates in
the early 1970s, both real and nominal exchange rates became (and have remained) much more volatile than
anyone had expected. Some economists attribute this volatility to irrational and destabilizing speculation by
international investors. Business executives often claim that this volatility is harmful because it increases the
uncertainty that accompanies inter-national business transactions. Despite this exchange-rate volatility, however,
the amount of world trade has continued to rise under floating exchange rates.
Advocates of fixed exchange rates sometimes argue that a commitment to a fixed exchange rate is one way to
discipline a nation’s monetary authority and prevent excessive growth in the money supply. In practice, the choice
between floating and fixed rates is not as stark as it may seem at first. Under systems of fixed exchange rates,
countries can change the value of their currency if maintaining the exchange rate conflicts too severely with other
goals. Under systems of floating exchange rates, countries often use formal or informal targets for the exchange
rate when deciding whether to expand or contract the money supply. We rarely observe exchange rates that are
completely fixed or completely floating. Instead, under both systems, stability of the exchange rate is usually one
among many objectives of the central bank
The Impossible Trinity

The analysis of exchange-rate regimes leads to a simple conclusion: you can’t have it all. To be more precise, it is
impossible for a nation to have free capital flows, a fixed exchange rate, and independent monetary policy. This
fact, often called the impossible trinity, is illustrated in Figure 11.24. A nation must choose one side of this
triangle, giving up the institutional feature at the opposite corner.
 The first option is to allow free flows of capital and to conduct an independent monetary policy, as the
United States has done in recent years. In this case, it is impossible to have a fixed exchange rate. Instead,
the exchange rate must float to equilibrate the market for foreign-currency exchange.
 The second option is to allow free flows of capital and to fix the exchange rate, as Hong Kong has done in
recent years. In this case, the nation loses the ability to run an independent monetary policy. The money
supply must adjust to keep the exchange rate at its predetermined level. In a sense, when a nation fixes its
currency to that of another nation, it is adopting that other nation’s monetary policy.
 The third option is to restrict the international flow of capital in and out of the country, as China has done
in recent years. In this case, the interest rate is no longer fixed by world interest rates but is determined by
domestic forces, much as is the case in a completely closed economy.

Figure 11.24: The Impossible Trinity: It is impossible for a nation to have

free capital flows, a fixed exchange rate, and independent monetary policy.
A nation must choose one side of this triangle, giving up the opposite corner
It is then possible to both fix the exchange rate and conduct an independent monetary policy. History has shown
that nations can, and do, choose different sides of the trinity. Every nation must ask itself the following question:
Does it want to live with exchange-rate volatility (option 1), does it want to give up the use of monetary policy for
purposes of domestic stabilization (option 2), or does it want to restrict its citizens from participating in world
financial markets (option 3)? The impossible trinity says that no nation can avoid making one of these choices.
From the Short Run to the Long Run: The Mundell–Fleming Model with a Changing Price Level
So far we have used the Mundell–Fleming model to study the small open economy in the short run when the price
level is fixed. We now consider what hap-pens when the price level changes. Doing so will show how the Mundell–
Fleming model provides a theory of the aggregate demand curve in a small open economy. It will also show how
this short-run model relates to the long-run model of the open economy. Because we now want to consider changes
in the price level, the nominal and real exchange rates in the economy will no longer be moving in tandem. Thus,
we must distinguish between these two variables. The nominal exchange rate is e and the real exchange rate is e,
which equals eP/P*, we can write the Mundell–Fleming model as
These equations should be familiar by now. The first equation describes the IS* curve; and the second describes the
LM* curve. Note that net exports depend on the real exchange rate. Figure 11.25 shows what happens when the
price level falls. As the lower price level raises the level of real money balances, the LM* curve shifts to the right,
as in panel (a). The real exchange rate falls, and the equilibrium level of income rises. The aggregate demand curve
summarizes this negative relationship between the price level and the level of income, as shown in panel (b). Thus,
just as the IS–LM model explains the aggregate demand curve in a closed economy, the Mundell–Fleming model
explains the aggregate demand curve for a small open economy. In both cases, the aggregate demand curve shows
the set of equilibria in the goods and money markets that arise as the price level varies. And in both cases, anything
that changes equilibrium income, other than a change in the price level, shifts the aggregate demand curve.

Figure 11.25:Mundell-Flemmimg as a Theory of Aggregate Demand
Policies and events that raise income for a given price level shift the aggregate demand curve to the right; policies
and events that lower income for a given price level shift the aggregate demand curve to the left. We can use this
diagram to show how the short-run model is related to the long-run model. Figure 11.26 shows the short-run and
long-run equilibria. In both panels of the figure, point K describes the short-run equilibrium, because it assumes a
fixed price level. At this equilibrium, the demand for goods and services is too low to keep the economy producing
at its natural level. Over time, low demand causes the price level to fall.
The fall in the price level raises real money balances, shifting the LM* curve to the right. The real exchange rate
depreciates, so net exports rise. Eventually, the economy reaches point C, the long-run equilibrium. The speed of
transition between the short-run and long-run equilibria depends on how quickly the price level adjusts to restore
the economy to the natural level of output.

Figure 11.26: The Short-Run and Long-Run Equilibria in a Small Open Economy
The levels of income at point K and point C are both of interest. Our central concern in this chapter has been how
policy influences point K, the short-run equilibrium. In Chapter 5 we examined the determinants of point C, the
long-run equilibrium. Whenever policymakers consider any change in policy, they need to consider both the short-
run and long-run effects of their decision.

6 ANALYSIS OF ECONOMIC
CHAPTER FLUCTUATIONS IN AN OPEN
ECONOMY: THE MUNDELL–FLEMING MODEL
The international flow of goods and services and the international flow of capital can affect an economy in
profound ways. It would be worthwhile to extend the analysis of aggregate demand to include international trade
and finance. The model used for the purpose is called the Mundell–Fleming model, which has been described as
“the dominant policy paradigm for studying open-economy monetary and fiscal policy.” The Mundell–Fleming
model is a close relative of the IS–LM model. Both models stress the interaction between the goods market and the
money market. Both models assume that the price level is fixed and then show what causes short-run fluctuations
in aggregate income (or, equivalently, shifts in the aggregate demand curve). The key difference is that the IS–LM
model assumes a closed economy, whereas the Mundell–Fleming model assumes an open economy.
The Mundell–Fleming model makes one important and extreme assumption: it assumes that the economy being
studied is a small open economy with perfect capital mobility. That is, the economy can borrow or lend as much as
it wants in world financial markets and, as a result, the economy’s interest rate is determined by the world interest
rate.
The Key Assumption: Small Open Economy with Perfect Capital Mobility
Let’s begin with the assumption of a small open economy with perfect capital mobility. This assumption means
that the interest rate in this economy r is determined by the world interest rate r*. Mathematically, we can write
this assumption as
r = r *.
This world interest rate is assumed to be exogenously fixed because the economy is sufficiently small relative to
the world economy that it can borrow or lend as much as it wants in world financial markets without affecting the
world interest rate. In a small open economy, the domestic interest rate might rise by a little bit for a short time, but
as soon as it did, foreigners would see the higher interest rate and start lending to this country (by, for instance,
buying this country’s bonds). The capital inflow would drive the domestic interest rate back toward r*. Similarly, if
any event started to drive the domestic interest rate downward, capital would flow out of the country to earn a
higher return abroad, and this capital outflow would drive the domestic interest rate back up to r*. Hence, the r =
r* equation represents the assumption that the international flow of capital is rapid enough to keep the domestic
interest rate equal to the world interest rate.
The Goods Market and the IS* Curve
The Mundell–Fleming model describes the market for goods and services much as the IS–LM model does, but it
adds a new term for net exports. In particular, the goods market is represented with the following equation:
Y = C(Y – T) + I(r) + G + NX (e)
This equation states that aggregate income Y is the sum of consumption C, investment I, government purchases G,
and net exports NX. Consumption depends positively on disposable income Y − T. Investment depends negatively
on the interest rate. Net exports depend negatively on the exchange rate e. If e is the nominal exchange rate, then
the real exchange rate e equals eP/P *, where P is the domestic price level and P* is the foreign price level. The
Mundell–Fleming model, however, assumes that the price levels at home and abroad are fixed, so the real
exchange rate is proportional to the nominal exchange rate.
The goods-market equilibrium condition above has two financial variables affecting expenditure on goods and
services (the interest rate and the exchange rate), but the situation can be simplified using the assumption of perfect
capital mobility, so r = r*. We obtain

ANALYSIS OF ECONOMIC FLUCTUATIONS IN AN OPEN
Y = C(Y − T) + I(r *) + G + NX (e)

Let’s call this the IS* equation. (The asterisk implies that the equation holds the interest rate constant at the world
interest rate r*.) We can illustrate this equation on a graph in which income is on the horizontal axis and the
exchange rate is on the vertical axis. This curve is shown in panel (c) of Figure 12.1.
The IS* curve slopes downward because a higher exchange rate reduces net exports, which in turn lowers
aggregate income. To show how this works, the other panels of Figure 12.1 combine the net-exports schedule and
the Keynesian cross to derive the IS* curve. In panel (a), an increase in the exchange rate from e1 to e2 lowers net
exports from NX (e1) to NX (e2). In panel (b), the reduction in net exports shifts the planned-expenditure schedule
downward and thus lowers income from Y1 to Y2. The IS* curve summarizes this relationship between the
exchange rate e and income Y.
Figure 12.1: Derivation of IS* Curve
The Money Market and the LM* Curve

The Mundell–Fleming model represents the money market with an equation that should be familiar from the IS–
LM model:
M/P = L(r, Y ).
This equation states that the supply of real money balances M/P equals the demand L(r, Y). The demand for real
balances depends negatively on the interest rate and positively on income Y. The money supply M is an exogenous
variable controlled by the central bank, and because the Mundell–Fleming model is designed to analyze short-run

fluctuations, the price level P is also assumed to be exogenously fixed. Once again, we add the assumption that the
domestic interest rate equals the world interest rate, so r = r*:
M/P = L(r*, Y ).
Let’s call this the LM * equation. We can represent it graphically with a vertical line, as in panel (b) of Figure
11.14. The LM * curve is vertical because the exchange rate does not enter into the LM * equation. Given the world
interest rate, the LM * equation determines aggregate income, regardless of the exchange rate. Figure 12.2 shows
how the LM * curve arises from the world interest rate and the LM curve, which relates the interest rate and
income.
Figure 12.2: Derivation of LM* Curve
Putting the Pieces Together

According to the Mundell–Fleming model, a small open economy with perfect capital mobility can be described by
two equations:
Y = C(Y − T ) + I(r*) + G + NX(e) IS*,
M/P = L(r*, Y ) LM*.
The first equation describes equilibrium in the goods market; the second describes equilibrium in the money
market. The exogenous variables are fiscal policy G and T, monetary policy M, the price level P, and the world
interest rate r *. The endogenous variables are income Y and the exchange rate e.

Figure 12.3 illustrates these two relationships. The equilibrium for the economy is found where the IS* curve and
the LM * curve intersect. This intersection shows the exchange rate and the level of income at which the goods
market and the money market are both in equilibrium. With this diagram, we can use the Mundell–Fleming model
to show how aggregate income Y and the exchange rate e respond to changes in policy.
Figure 12.3: Mundell-Fleming Model
The Small Open Economy under Floating Exchange Rates

Under a system of floating exchange rates, the exchange rate is set by market forces and is allowed to fluctuate in
response to changing economic conditions. In this case, the exchange rate e adjusts to achieve simultaneous
equilibrium in the goods market and the money market. When something happens to change that equilibrium, the
exchange rate is allowed to move to a new equilibrium value. Let’s now consider three policies that can change the
equilibrium: fiscal policy, monetary policy, and trade policy. Our goal is to use the Mundell–Fleming model to
show the impact of policy changes and to understand the economic forces at work as the economy moves from one
position of equilibrium to another.
Fiscal Policy
Suppose that the government stimulates domestic spending by increasing government purchases or by cutting
taxes. Because such expansionary fiscal policy increases planned expenditure, it shifts the IS* curve to the right, as
in Figure 12.4. As a result, the exchange rate appreciates, while the level of income remains the same.
It may be observed that fiscal policy has very different effects in a small open economy than it does in a closed
economy. In the closed-economy IS–LM model, a fiscal expansion raises income, whereas in a small open
economy with a floating exchange rate, a fiscal expansion leaves income at the same level. Mechanically, the
difference arises because the LM * curve is vertical, while the LM curve we used to study a closed economy is
upward sloping. But this explanation is not very satisfying. What are the economic forces that lie behind the
different outcomes? To answer this question, we must think through what is happening to the international flow of
capital and the implications of these capital flows for the domestic economy.

Figure 12.4: A Fiscal Expansion Under Floating Exchange Rates
The interest rate and the exchange rate are the key variables in the story. When income rises in a closed economy,
the interest rate rises, because higher income increases the demand for money. That is not possible in a small open
economy because, as soon as the interest rate starts to rise above the world interest rate r*, capital quickly flows in
from abroad to take advantage of the higher return. As this capital inflow pushes the interest rate back to r*, it also
has another effect: because foreign investors need to buy the domestic currency to invest in the domestic economy,
the capital inflow increases the demand for the domestic currency in the market for foreign-currency exchange,
bidding up the value of the domestic currency. The appreciation of the domestic currency makes domestic goods
expensive relative to foreign goods, reducing net exports. The fall in net exports exactly offsets the effects of the
expansionary fiscal policy on income.
Why is the fall in net exports so great that it renders fiscal policy powerless to influence income? To answer this
question, consider the equation that describes the money market:
M/P = L(r, Y ).
In both closed and open economies, the quantity of real money balances supplied M/P is fixed by the central bank
(which sets M) and the assumption of sticky prices (which fixes P). The quantity demanded (determined by r and
Y) must equal this fixed supply. In a closed economy, a fiscal expansion causes the equilibrium interest rate to rise.
This increase in the interest rate (which reduces the quantity of money demanded) implies an increase in
equilibrium income (which raises the quantity of money demanded); these two effects together maintain
equilibrium in the money market. By contrast, in a small open economy, r is fixed at r*, so there is only one level
of income that can satisfy this equation, and this level of income does not change when fiscal policy changes. Thus,
when the government increases spending or cuts taxes, the appreciation of the currency and the fall in net exports
must be large enough to offset fully the expansionary effect of the policy on income.
Monetary Policy
Suppose now that the central bank increases the money supply. Because the price level is assumed to be fixed, the
increase in the money supply means an increase in real money balances. The increase in real balances shifts the

LM* curve to the right, as in Figure 12.5. Hence, an increase in the money supply raises income and lowers the
exchange rate. Although monetary policy influences income in an open economy, as it does in a closed economy,
the monetary transmission mechanism is different. Recall that in a closed economy an increase in the money
supply increases spending because it lowers the interest rate and stimulates investment. In a small open economy,
this channel of monetary transmission is not available because the interest rate is fixed by the world interest rate.
Figure 12.5: A Monetary Expansion Under Floating Exchange
So how does monetary policy influence spending? To answer this question, we once again need to think about the
international flow of capital and its implications for the domestic economy. The interest rate and the exchange rate
are again the key variables. As soon as an increase in the money supply starts putting downward pressure on the
domestic interest rate, capital flows out of the economy, as investors seek a higher return elsewhere. This capital
outflow prevents the domestic interest rate from falling below the world interest rate r*. It also has another effect:
because investing abroad requires converting domestic currency into foreign currency, the capital outflow increases
the supply of the domestic currency in the market for foreign-currency exchange, causing the domestic currency to
depreciate in value. This depreciation makes domestic goods inexpensive relative to foreign goods, stimulating net
exports and thus total income. Hence, in a small open economy, monetary policy influences income by altering the
exchange rate rather than the interest rate.
Trade Policy
Suppose that the government reduces the demand for imported goods by imposing an import quota or a tariff. What
happens to aggregate income and the exchange rate? How does the economy reach its new equilibrium? Because
net exports equal exports minus imports, a reduction in imports means an increase in net exports. That is, the net-
exports schedule shifts to the right, as in Figure 12.6. This shift in the net-exports schedule increases planned
expenditure and thus moves the IS* curve to the right. Because the LM* curve is vertical, the trade restriction raises
the exchange rate but does not affect income.

Figure 12.6: A Trade Restriction Under Floating Exchange Rates
The economic forces behind this transition are similar to the case of expansionary fiscal policy. Because net
exports are a component of GDP, the rightward shift in the net-exports schedule, other things equal, puts upward
pressure on income Y; an increase in Y, in turn, increases money demand and puts upward pressure on the interest
rate r. Foreign capital quickly responds by flowing into the domestic economy, pushing the interest rate back to the
world interest rate r* and causing the domestic currency to appreciate in value. Finally, the appreciation of the
currency makes domestic goods more expensive relative to foreign goods, which decreases net exports NX and
returns income Y to its initial level.
Often a stated goal of policies to restrict trade is to alter the trade balance NX. Yet such policies do not necessarily
have that effect. The same conclusion holds in the Mundell–Fleming model under floating exchange rates. Given
that
NX (e) = Y − C(Y − T ) − I(r *) − G.
Because a trade restriction does not affect income, consumption, investment, or government purchases, it does not
affect the trade balance. Although the shift in the net-exports schedule tends to raise NX, the increase in the
exchange rate reduces NX by the same amount. The overall effect is simply less trade. The domestic economy
imports less than it did before the trade restriction, but it exports less as well.
The Small Open Economy under Fixed Exchange Rates

We now turn to the second type of exchange-rate system: fixed exchange rates. Under a fixed exchange rate, the
central bank announces a value for the exchange rate and stands ready to buy and sell the domestic currency to

keep the exchange rate at its announced level. In the 1950s and 1960s, most of the world’s major economies,
including that of the United States, operated within the Bretton Woods system—an international monetary system
under which most governments agreed to fix exchange rates. The world abandoned this sys-tem in the early 1970s,
and most exchange rates were allowed to float. Yet fixed exchange rates are not merely of historical interest. More
recently, China fixed the value of its currency against the U.S. dollar—a policy that, as we will see, was a source of
some tension between the two countries. We now discuss how such a system works, and we examine the impact of
economic policies on an economy with a fixed exchange rate. Later in the chapter we examine the pros and cons of
fixed exchange rates.
How a Fixed-Exchange-Rate System Works
Under a system of fixed exchange rates, a central bank stands ready to buy or sell the domestic currency for foreign
currencies at a predetermined price. For example, suppose the RBI announced that it was going to fix the exchange
rate at 70 rupee per dollar. It would then stand ready to give $1 in exchange for 70 rupee or to 70 rupee in
exchange for $1. To carry out this policy, the RBI would need a reserve of rupee (which it can print) and a reserve
of dollar (which it must have purchased previously). A fixed exchange rate dedicates a country’s monetary policy
to the single goal of keeping the exchange rate at the announced level. In other words, the essence of a fixed-
exchange-rate system is the commitment of the central bank to allow the money supply to adjust to whatever level
will ensure that the equilibrium exchange rate in the market for foreign-currency exchange equals the announced
exchange rate. Moreover, as long as the central bank stands ready to buy or sell foreign currency at the fixed
exchange rate, the money supply adjusts automatically to the necessary level.
To see how fixing the exchange rate determines the money supply, consider the following example. Suppose the
RBI announces that it will fix the exchange rate at 70 rupee per dollar, but, in the current equilibrium with the
current money supply, the market exchange rate is 100 rupee per dollar. This situation is illustrated in panel (b) of
Figure 12.7.
Figure 12.7: How a Fixed Exchange Rate Governs the Money Supply
It may be observed that there is a profit opportunity: an arbitrageur could buy 200 rupee in the foreign-exchange
market for $2 and then sell the rupee to the RBI for $2.80, making a $0.8 profit. When the RBI buys these dollars
from the arbitrageur, the rupees it pays for them automatically increase the money supply. The rise in the money
supply shifts the LM* curve to the right, lowering the equilibrium exchange rate. In this way, the money supply
continues to rise until the equilibrium exchange rate falls to the announced level. Conversely, suppose that when
the RBI announces that it will fix the exchange rate at 100 rupee per dollar, the equilibrium has a market exchange
rate of 50 rupee per dollar. Panel (a) of Figure 11.19 shows this situation. In this case, an arbitrageur could make a
profit by buying 100 rupee from the RBI for $1 and then selling the rupee in the marketplace for $2. When the RBI
sells these rupees, the $1 it receives automatically reduces the money supply. The fall in the money supply shifts

the LM* curve to the left, raising the equilibrium exchange rate. The money supply continues to fall until the
equilibrium exchange rate rises to the announced level.
It is important to understand that this exchange-rate system fixes the nominal exchange rate. Whether it also fixes
the real exchange rate depends on the time horizon under consideration. If prices are flexible, as they are in the
long run, then the real exchange rate can change even while the nominal exchange rate is fixed. Therefore, in the
long run, a policy to fix the nominal exchange rate would not influence any real variable, including the real
exchange rate. A fixed nominal exchange rate would influence only the money supply and the price level. Yet in
the short run described by the Mundell–Fleming model, prices are fixed, so a fixed nominal exchange rate implies
a fixed real exchange rate as well.
Fiscal Policy
Let’s now examine how economic policies affect a small open economy with a fixed exchange rate. Suppose that
the government stimulates domestic spending by increasing government purchases or by cutting taxes. This policy
shifts the IS* curve to the right, as in Figure 12.8, putting upward pressure on the market exchange rate. But
because the central bank stands ready to trade foreign and domestic currency at the fixed exchange rate,
arbitrageurs quickly respond to the rising exchange rate by selling foreign currency to the central bank, leading to
an automatic monetary expansion. The rise in the money supply shifts the LM* curve to the right. Thus, under a
fixed exchange rate, a fiscal expansion raises aggregate income.
Figure 12.8: A Fiscal Expansion Under Fixed Exchange Rates
Figure 12.9: A Monetary Expansion Under Fixed Exchange Rates

Monetary Policy
Imagine that a central bank operating with a fixed exchange rate tries to increase the money supply—for example,
by buying bonds from the public. What would happen? The initial impact of this policy is to shift the LM* curve to
the right, lowering the exchange rate, as in Figure 12.9.
But, because the central bank is committed to trading foreign and domestic currency at a fixed exchange rate,
arbitrageurs quickly respond to the falling exchange rate by selling the domestic currency to the central bank,
causing the money supply and the LM* curve to return to their initial positions. Hence, monetary policy as usually
conducted is ineffectual under a fixed exchange rate. By agreeing to fix the exchange rate, the central bank gives
up its control over the money supply.
A country with a fixed exchange rate can, however, conduct a type of monetary policy: it can decide to change the
level at which the exchange rate is fixed. A reduction in the official value of the currency is called devaluation, and
an increase in its official value is called a revaluation. In the Mundell–Fleming model, a devaluation shifts the
LM* curve to the right; it acts like an increase in the money supply under a floating exchange rate. Devaluation
thus expands net exports and raises aggregate income. Conversely, a revaluation shifts the LM* curve to the left,
reduces net exports, and lowers aggregate income.
Trade Policy
Suppose that the government reduces imports by imposing an import quota or a tariff. This policy shifts the net-
exports schedule to the right and thus shifts the IS* curve to the right, as in Figure 12.10.
Figure 12.10: A Trade Restriction Under Fixed Exchange Rates
The shift in the IS* curve tends to raise the exchange rate. To keep the exchange rate at the fixed level, the money
supply must rise, shifting the LM* curve to the right. The result of a trade restriction under a fixed exchange rate is
very different from that under a floating exchange rate. In both cases, a trade restriction shifts the net-exports
schedule to the right, but only under a fixed exchange rate does a trade restriction increase net exports NX. The
reason is that a trade restriction under a fixed exchange rate induces monetary expansion rather than an
appreciation of the currency. The monetary expansion, in turn, raises aggregate income. Recall the accounting
identity

NX=S−I.
When income rises, saving also rises, and this implies an increase in net exports.
Policy in the Mundell–Fleming Model: A Summary

The Mundell–Fleming model shows that the effect of almost any economic pol-icy on a small open economy
depends on whether the exchange rate is floating or fixed. Table 10.1 summarizes our analysis of the short-run
effects of fiscal, monetary, and trade policies on income, the exchange rate, and the trade balance.
What is most striking is that all of the results are different under floating and fixed exchange rates.To be more
specific, the Mundell–Fleming model shows that the power of monetary and fiscal policy to influence aggregate
income depends on the exchange-rate regime. Under floating exchange rates, only monetary policy can affect
income. The usual expansionary impact of fiscal policy is offset by a rise in the value of the currency and a
decrease in net exports. Under fixed exchange rates, only fiscal policy can affect income. The normal potency of
monetary pol-icy is lost because the money supply is dedicated to maintaining the exchange rate at the announced
level.
Interest Rate Differentials
So far, our analysis has assumed that the interest rate in a small open economy is equal to the world interest rate: r
= r*. To some extent, however, interest rates differ around the world. We now extend our analysis by considering
the causes and effects of international interest rate differentials.
Country Risk and Exchange-Rate Expectations
When we assumed earlier that the interest rate in our small open economy is determined by the world interest rate,
we were applying the law of one price. We reasoned that if the domestic interest rate were above the world interest
rate, people from abroad would lend to that country, driving the domestic interest rate down. And if the domestic
interest rate were below the world interest rate, domestic residents would lend abroad to earn a higher return,
driving the domestic interest rate up. In the end, the domestic interest rate would equal the world interest rate. Why
doesn’t this logic always apply? There are two reasons: One reason is country risk another reason interest rates
differ across countries is expected changes in the exchange rate. Thus, because of both country risk and
expectations of future exchange-rate changes, the interest rate of a small open economy can differ from interest
rates in other economies around the world. Let’s now see how this fact affects our analysis.
Differentials in the Mundell–Fleming Model
To incorporate interest rate differentials into the Mundell–Fleming model, we assume that the interest rate in our
small open economy is determined by the world interest rate plus a risk premium θ:
= r* + θ.

The risk premium is determined by the perceived political risk of making loans in a country and the expected
change in the real exchange rate. For our purposes here, we can take the risk premium as exogenous in order to
examine how changes in the risk premium affect the economy. The model is largely the same as before. The two
equations are
For any given fiscal policy, monetary policy, price level, and risk premium, these two equations determine the
level of income and exchange rate that equilibrate the goods market and the money market. Holding constant the
risk premium, the tools of monetary, fiscal, and trade policy work we have already seen. Now suppose that political
turmoil causes the country’s risk premium θ to rise. Because r = r* + θ, the most direct effect is that the domestic
interest rate r rises. The higher interest rate, in turn, has two effects. First, the IS* curve shifts to the left, because
the higher interest rate reduces investment. Second, the LM* curve shifts to the right, as the higher interest rate
reduces the demand for money, and this allows a higher level of income for any given money supply. [Recall that Y
must satisfy the equation M/P = L(r* + θ, Y).] As Figure 12.11 shows, these two shifts cause income to rise and the
currency to depreciate. This analysis has an important implication: expectations about the exchange rate are
partially self-fulfilling.
Figure 12.11: An Increase in the Risk Premium
For example, suppose that people come to believe that the Indian rupee will not be valuable in the future. Investors
will place a larger risk premium on rupee assets: θ will rise in Mexico. This expectation will drive up Indian
interest rates and, as we have just seen, will drive down the value of the Indian currency. Thus, the expectation that
a currency will lose value in the future causes it to lose value today. One prediction of this analysis is that an
increase in country risk as measured by θ will cause the economy’s income to increase. This occurs in Figure 12.11
because of the rightward shift in the LM* curve. Although higher interest rates depress investment, the depreciation
of the currency stimulates net exports by an even greater amount. As a result, aggregate income rises.

There are three reasons why, in practice, such a boom in income does not occur. First, the central bank might want
to avoid the large depreciation of the domestic currency and, therefore, may respond by decreasing the money
supply M. Second, the depreciation of the domestic currency may suddenly increase the price of imported goods,
causing an increase in the price level P. Third, when some event increases the country risk premium θ, residents of
the country might respond to the same event by increasing their demand for money (for any given income and
interest rate), because money is often the safest asset available. All three of these changes would tend to shift the
LM* curve toward the left, which mitigates the fall in the exchange rate but also tends to depress income.
Thus, increases in country risk are not desirable. In the short run, they typically lead to a depreciating currency and,
through the three channels just described, falling aggregate income. In addition, because a higher interest rate
reduces investment, the long-run implication is reduced capital accumulation and lower economic growth.
Should Exchange Rates be Floating or Fixed?
Having analyzed how an economy works under floating and fixed exchange rates, let’s consider which exchange-
rate regime is better.
Pros and Cons of Different Exchange-Rate Systems
The primary argument for a floating exchange rate is that it allows monetary policy to be used for other purposes.
Under fixed rates, monetary policy is com-mitted to the single goal of maintaining the exchange rate at its
announced level. Yet the exchange rate is only one of many macroeconomic variables that monetary policy can
influence. A system of floating exchange rates leaves monetary policymakers free to pursue other goals, such as
stabilizing employment or prices. Advocates of fixed exchange rates argue that exchange-rate uncertainty makes
international trade more difficult. After the world abandoned the Bretton Woods system of fixed exchange rates in
the early 1970s, both real and nominal exchange rates became (and have remained) much more volatile than
anyone had expected. Some economists attribute this volatility to irrational and destabilizing speculation by
international investors. Business executives often claim that this volatility is harmful because it increases the
uncertainty that accompanies inter-national business transactions. Despite this exchange-rate volatility, however,
the amount of world trade has continued to rise under floating exchange rates.
Advocates of fixed exchange rates sometimes argue that a commitment to a fixed exchange rate is one way to
discipline a nation’s monetary authority and prevent excessive growth in the money supply. In practice, the choice
between floating and fixed rates is not as stark as it may seem at first. Under systems of fixed exchange rates,
countries can change the value of their currency if maintaining the exchange rate conflicts too severely with other
goals. Under systems of floating exchange rates, countries often use formal or informal targets for the exchange
rate when deciding whether to expand or contract the money supply. We rarely observe exchange rates that are
completely fixed or completely floating. Instead, under both systems, stability of the exchange rate is usually one
among many objectives of the central bank The Impossible Trinity
The analysis of exchange-rate regimes leads to a simple conclusion: you can’t have it all. To be more precise, it is
impossible for a nation to have free capital flows, a fixed exchange rate, and independent monetary policy. This
fact, often called the impossible trinity, is illustrated in Figure 12.12. A nation must choose one side of this triangle,
giving up the institutional feature at the opposite corner.
 The first option is to allow free flows of capital and to conduct an independent monetary policy, as the United
States has done in recent years. In this case, it is impossible to have a fixed exchange rate. Instead, the
exchange rate must float to equilibrate the market for foreign-currency exchange.
 The second option is to allow free flows of capital and to fix the exchange rate, as Hong Kong has done in
recent years. In this case, the nation loses the ability to run an independent monetary policy. The money supply
must adjust to keep the exchange rate at its predetermined level. In a sense, when a nation fixes its currency to
that of another nation, it is adopting that other nation’s monetary policy.

 The third option is to restrict the international flow of capital in and out of the country, as China has done in
recent years. In this case, the interest rate is no longer fixed by world interest rates but is determined by
domestic forces, much as is the case in a completely closed economy.
Figure 12.12: The Impossible Trinity: It is impossible for a nation to have free capital flows, a fixed
exchange rate, and independent monetary policy. A nation must choose one side of this triangle, giving up
the opposite corner
It is then possible to both fix the exchange rate and conduct an independent monetary policy. History has shown
that nations can, and do, choose different sides of the trinity. Every nation must ask itself the following question:
Does it want to live with exchange-rate volatility (option 1), does it want to give up the use of monetary policy for
purposes of domestic stabilization (option 2), or does it want to restrict its citizens from participating in world
financial markets (option 3)? The impossible trinity says that no nation can avoid making one of these choices.
From the Short Run to the Long Run: The Mundell–Fleming Model with a Changing Price Level
So far we have used the Mundell–Fleming model to study the small open economy in the short run when the price
level is fixed. We now consider what hap-pens when the price level changes. Doing so will show how the
Mundell–Fleming model provides a theory of the aggregate demand curve in a small open economy. It will also
show how this short-run model relates to the long-run model of the open economy. Because we now want to
consider changes in the price level, the nominal and real exchange rates in the economy will no longer be moving
in tandem. Thus, we must distinguish between these two variables. The nominal exchange rate is e and the real
exchange rate is e, which equals eP/P*, we can write the Mundell–Fleming model as
These equations should be familiar by now. The first equation describes the IS* curve; and the second describes the
LM* curve. Note that net exports depend on the real exchange rate. Figure 12.13 shows what happens when the
price level falls. As the lower price level raises the level of real money balances, the LM* curve shifts to the right,
as in panel (a). The real exchange rate falls, and the equilibrium level of income rises. The aggregate demand curve
summarizes this negative relationship between the price level and the level of income, as shown in panel (b). Thus,
just as the IS–LM model explains the aggregate demand curve in a closed economy, the Mundell–Fleming model
explains the aggregate demand curve for a small open economy. In both cases, the aggregate demand curve shows
the set of equilibria in the goods and money markets that arise as the price level varies. And in both cases, anything
that changes equilibrium income, other than a change in the price level, shifts the aggregate demand curve.

Figure 12.13:Mundell-Flemmimg as a Theory of Aggregate Demand
Policies and events that raise income for a given price level shift the aggregate demand curve to the right; policies
and events that lower income for a given price level shift the aggregate demand curve to the left. We can use this
diagram to show how the short-run model is related to the long-run model. Figure 12.14 shows the short-run and
long-run equilibria. In both panels of the figure, point K describes the short-run equilibrium, because it assumes a
fixed price level. At this equilibrium, the demand for goods and services is too low to keep the economy producing
at its natural level. Over time, low demand causes the price level to fall.
The fall in the price level raises real money balances, shifting the LM* curve to the right. The real exchange rate
depreciates, so net exports rise. Eventually, the economy reaches point C, the long-run equilibrium. The speed of
transition between the short-run and long-run equilibria depends on how quickly the price level adjusts to restore
the economy to the natural level of output.

Figure 12.14: The Short-Run and Long-Run Equilibria in a Small Open Economy
The levels of income at point K and point C are both of interest. Our central concern in this chapter has been how
policy influences point K, the short-run equilibrium. In Chapter 5 we examined the determinants of point C, the
long-run equilibrium. Whenever policymakers consider any change in policy, they need to consider both the short-
run and long-run effects of their decision.

AGGREGATE SUPPLY AND THE
7 SHORT-RUN TRADE OFF BETWEEN
CHAPTER INFLATION AND UNEMPLOYMENT
The IS–LM model—together with its open-economy version in the form of the Mundell–Fleming model—shows
how changes in monetary and fiscal policy and shocks to the money and goods markets shift the aggregate demand
curve. In this chapter, we consider the aggregate supply and develop theories that explain the position and slope of
the aggregate supply curve. Earlier, we mentioned that aggregate supply behaves differently in the short run than in
the long run. In the long run, prices are flexible, and the aggregate supply curve is vertical. When the aggregate
supply curve is vertical, shifts in the aggregate demand curve affect the price level, but the output of the economy
remains at its natural level. By contrast, in the short run, prices are sticky, and the aggregate supply curve is not
vertical. In this case, shifts in aggregate demand do cause fluctuations in output. Earlier we took a simplified view
of price stickiness by drawing the short-run aggregate supply curve as a horizontal line, representing the extreme
situation in which all prices are fixed.
After examining the basic theory of the short-run aggregate supply curve, we establish a key implication, that is, a
tradeoff between two measures of economic performance—inflation and unemployment. This tradeoff, called the
Phillips curve1, tell us that to reduce the rate of inflation policymakers must temporarily raise unemployment, and
to reduce unemployment they must accept higher inflation. Milton Friedman however is of the firm view that the
tradeoff between inflation and unemployment is only temporary. The goal of this chapter is to explain why
policymakers face such a tradeoff in the short run and why they do not face it in the long run.
The Basic Theory of Aggregate Supply
To understand this theory, we consider two prominent models of aggregate supply. In both models, some market
imperfection (that is, some type of friction) causes the output of the economy to deviate from its natural level. As a
result, the short-run aggregate supply curve is upward sloping rather than vertical, and shifts in the aggregate
demand curve cause output to fluctuate. These temporary deviations of output from its natural level represent the
booms and busts of the business cycle. Each of the two models highlights a particular reason why unexpected
movements in the price level are associated with fluctuations in aggregate output.
A short-run aggregate supply equation of the form where Y is output, Ȳ is the natural level of output, P is the price
level, and EP is the expected price level. This equation states that output deviates from its natural level when the
price level deviates from the expected price level. The parameter α indicates how much output responds to
unexpected changes in the price level; 1/α is the slope of the aggregate supply curve.
The Phillips curve is named after New Zealand–born economist A. W. Phillips. In 1958 Phillips observed a
negative relationship between the unemployment rate and the rate of wage inflation in data for the United
Kingdom. The Phillips curve that economists use today differs in three ways from the relationship Phillips
examined.
 First, the modern Phillips curve substitutes price inflation for wage inflation. This difference is not crucial,
because price inflation and wage inflation are closely related. In periods when wages are rising quickly, prices
are rising quickly as well.
 Second, the modern Phillips curve includes expected inflation. This addition is due to the work of Milton
Friedman and Edmund Phelps. In developing early versions of the imperfect information model in the 1960s,
these two economists emphasized the importance of expectations for aggregate supply.

AGGREGATE SUPPLY AND THE SHORT-RUN TRADE
Third, the modern Phillips curve includes supply shocks. Credit for this addition goes to OPEC, the Organization
of Petroleum Exporting Countries. In the 1970s OPEC caused large increases in the world price of oil, which made
economists more aware of the importance of shocks to aggregate supply.
The Sticky-Price Model
The most widely accepted explanation for the upward-sloping short-run aggregate supply curve is called the
sticky-price model. This model emphasizes that firms do not instantly adjust the prices they charge in response to
changes in demand. Sometimes prices are set by long-term contracts between firms and customers. Even without
formal agreements, firms may hold prices steady to avoid annoying their regular customers with frequent price
changes. Some prices are sticky because of the way certain markets are structured: once a firm has printed and
distributed its catalog or price list, it is costly to alter prices. And sometimes sticky prices can be a reflection of
sticky wages: firms base their prices on the costs of production, and wages may depend on social norms and
notions of fairness that evolve only slowly over time.
There are various ways to formalize the idea of sticky prices to show how they can help explain an upward-sloping
aggregate supply curve. Departing from the assumption of perfectly competition where firms are price-takers rather
than price-setters, consider the pricing decision facing a downward sloping demand curve, the firm’s desired price
p depends on two macroeconomic variables:
 The overall level of prices P. A higher price level implies that the firm’s costs are higher. Hence, the higher the
overall price level, the more the firm would like to charge for its product.
 The level of aggregate income Y. A higher level of income raises the demand for the firm’s product.
Because marginal cost increases at higher levels of production, the greater the demand, the higher the firm’s
desired price.
We write the firm’s desired price as
This equation says that the desired price p depends on the overall level of prices P and on the level of aggregate
output relative to the natural level Y – Ȳ. The parameter a (which is greater than zero) measures how much the
firm’s desired price responds to the level of aggregate output.
Now assume that there are two types of firms. Some have flexible prices: they always set their prices according to
this equation. Others have sticky prices: they announce their prices in advance based on what they expect economic
conditions to be. Firms with sticky prices set prices according to
Where, E represents the expected value of a variable. For simplicity, assume that these firms expect output to be at
its natural level, so that the last term, a(EY – EȲ), is zero. Then these firms set the price
p = EP.
That is, firms with sticky prices set their prices based on what they expect other firms to charge. We can use the
pricing rules of the two groups of firms to derive the aggregate supply equation. To do this, we find the overall
price level in the economy, which is the weighted average of the prices set by the two groups. If s is the fraction of
firms with sticky prices and 1 − s is the fraction with flexible prices, then the overall price level is
The first term is the price of the sticky-price firms weighted by their fraction in the economy; the second term is
the price of the flexible-price firms weighted by their fraction. Now subtract (1 − s)P from both sides of this
equation to obtain

The two terms in this equation are explained as follows:
 When firms expect a high price level, they expect high costs. Those firms that fix prices in advance set their
prices high. These high prices cause the other firms to set high prices also. Hence, a high expected price level
EP leads to a high actual price level P.
 When output is high, the demand for goods is high. Those firms with flexible prices set their prices high,
which leads to a high price level. The effect of output on the price level depends on the proportion of firms
with flexible prices.
Hence, the overall price level depends on the expected price level and on the level of output. Algebraic
rearrangement puts this aggregate pricing equation into a more familiar form:
Where α = s/[(1 – s)a]. The sticky-price model says that the deviation of output from the natural level is positively
associated with the deviation of the price level from the expected price level.
An Alternative Theory: The Imperfect-Information Model
Another explanation for the upward slope of the short-run aggregate supply curve is called the imperfect-
information model. In this model, the short-run and long-run aggregate supply curves differ because of temporary
misperceptions about prices. The imperfect-information model assumes that each supplier in the economy produces
a single good and consumes many goods. Because the number of goods is so large, suppliers cannot observe all
prices at all times. They monitor closely the prices of what they produce but less closely the prices of all the goods
they consume. Because of imperfect information, they sometimes confuse changes in the overall level of prices
with changes in relative prices. This confusion influences decisions about how much to supply, and it leads to a
positive relationship between the price level and output in the short run.
Consider the decision facing a single supplier—a wheat farmer, for instance. Because the farmer earns income
from selling wheat and uses this income to buy goods and services, the amount of wheat he chooses to produce
depends on the price of wheat relative to the prices of other goods and services in the economy. If the relative price
of wheat is high, the farmer is motivated to work hard and produce more wheat, because the reward is great. If the
relative price of wheat is low, he prefers to enjoy more leisure and produce less wheat.
Unfortunately, when the farmer makes her production decision, he does not know the relative price of wheat. As a
wheat producer, he monitors the wheat market closely and always knows the nominal price of wheat. But he does
not know the prices of all the other goods in the economy. He must, therefore, estimate the relative price of wheat
using the nominal price of wheat and her expectation of the overall price level. Consider how the farmer responds
if all prices in the economy, including the price of wheat, increase. One possibility is that he expected this change
in prices. When he observes an increase in the price of wheat, his estimate of its relative price is unchanged. He
does not work any harder. The other possibility is that the farmer did not expect the price level to increase (or to
increase by this much). When he observes the increase in the price of wheat, he is not sure whether other prices
have risen (in which case wheat’s relative price is unchanged) or whether only the price of wheat has risen (in
which case its relative price is higher). The rational inference is that some of each has happened. In other words,
the farmer infers from the increase in the nominal price of wheat that its relative price has risen somewhat. He
works harder and produces more.
Our wheat farmer is not unique. His decisions are similar to those of his neighbors, who produce broccoli,
cauliflower, etc. When the price level rises unexpectedly, all suppliers in the economy observe increases in the

prices of the goods they produce. They all infer, rationally but mistakenly, that the relative prices of the goods they
produce have risen. They work harder and produce more.
To sum up, the imperfect-information model says that when actual prices exceed expected prices, suppliers raise
their output. The model implies an aggregate supply curve with the familiar form
Output deviates from the natural level when the price level deviates from the expected price level. The imperfect-
information story described above is the version developed originally by Nobel Prize–winning economist Robert
Lucas in the 1970s. Recent work on imperfect-information models of aggregate supply has taken a somewhat
different approach. Rather than emphasizing confusion about relative prices and the absolute price level, as Lucas
did, this new work stresses the limited ability of individuals to incorporate information about the economy into
their decisions. In this case, the friction that causes the short-run aggregate supply curve to be upward sloping is
not the limited availability of information but is, instead, the limited ability of people to absorb and process
information that is widely available. This information-processing constraint causes price-setters to respond slowly
to macroeconomic news. The resulting equation for short-run aggregate supply is similar to those from the two
models we have seen, even though the microeconomic foundations are somewhat different.
Implications
We have seen two models of aggregate supply and the market imperfection that each uses to explain why the short-
run aggregate supply curve is upward sloping. One model assumes the prices of some goods are sticky; the second
assumes information about prices is imperfect. The two models of aggregate supply differ in their assumptions and
emphases, but their implications for aggregate output are similar. Both can be summarized by the equation
This equation states that deviations of output from the natural level are related to deviations of the price level from
the expected price level. If the price level is higher than the expected price level, output exceeds its natural level. If
the price level is lower than the expected price level, output falls short of its natural level. Figure 13.1 graphs this
equation. Notice that the short-run aggregate supply curve is drawn for a given expectation EP and that a change in
EP would shift the curve.
Figure 13.1: The Short-Run Aggregate Supply Curve
Figure 13.2, putting aggregate demand and aggregate supply together how the economy responds to an unexpected
increase in aggregate demand attributable, say, to an unexpected monetary expansion.

Figure 13.2: How Shifts in Aggregate Demand Lead to Short-Run Fluctuations
In the short run, the equilibrium moves from point A to point B. The increase in aggregate demand raises the actual
price level from P1 to P2. Because people did not expect this increase in the price level, the expected price level
remains at EP2, and output rises from Y1 to Y2 , which is above the natural level Ӯ . Thus, the unexpected expansion
in aggregate demand causes the economy to boom.
In the long run, the expected price level rises to catch up with reality, causing the short-run aggregate supply curve
to shift upward. As the expected price level rises from EP2 to EP3, the equilibrium of the economy moves
from point B to point C. The actual price level rises from P2 to P3, and output falls from Y2 to Y3. In other words,
the economy returns to the natural level of output in the long run, but at a much higher price level. This analysis
shows an important principle, which holds for both models of aggregate supply: long-run monetary neutrality and
short-run monetary non-neutrality are perfectly compatible. Short-run non-neutrality is represented here by the
movement from point A to point B, and long-run monetary neutrality is represented by the movement from point A
to point C. We reconcile the short-run and long-run effects of money by emphasizing the adjustment of
expectations about the price level.
Inflation, Unemployment, and the Phillips Curve
Two goals of economic policymakers are low inflation and low unemployment, but often these goals conflict.
Suppose, for instance, that policymakers were to use monetary or fiscal policy to expand aggregate demand. This
policy would move the economy along the short-run aggregate supply curve to a point of higher output and a
higher price level. (Figure 11.2 shows this as the change from point A to point B.) Higher output means lower
unemployment, because firms employ more workers when they produce more. Given the previous year’s price
level, a higher price level means higher inflation. Thus, when policymakers move the economy up along the short-
run aggregate supply curve, they reduce the unemployment rate and raise the inflation rate. Conversely, when they
contract aggregate demand and move the economy down the short-run aggregate supply curve, unemployment
rises and inflation falls. This tradeoff between inflation and unemployment, called the Phillips curve, requires
further elaboration. As we have just seen (and will derive more formally in a moment), the Phillips curve is a
reflection of the short-run aggregate supply curve: as policymakers move the economy along the short-run
aggregate supply curve, unemployment and inflation move in opposite directions. The Phillips curve is a useful
way to express aggregate supply because inflation and unemployment are such important measures of economic
performance.

Deriving the Phillips Curve from the Aggregate Supply Curve

The Phillips curve in its modern form states that the inflation rate depends on three forces:
Expected inflation
The deviation of unemployment from the natural rate, called cyclical unemployment
Supply shocks.
These three forces are expressed in the following equation:
where β is a parameter, which measures the response of inflation to cyclical unemployment. As there is a minus
sign before the cyclical unemployment term: other things equal, higher unemployment is associated with lower
inflation.
We can derive Philips Curve equation from the equation for aggregate supply, which is:
Applying the following three steps, aggregate supply equation will yield to the Phillips curve equation:
First, add to the right-hand side of the equation a supply shock v to represent exogenous events (such as a change
in world oil prices) that alter the price level and shift the short-run aggregate supply curve:
The term on the left-hand side, P − P−1, is the difference between the current price level and last year’s price level,
which is inflation Л. The term on the right-hand side, EP − P−1, is the difference between the expected price level
and last year’s price level, which is expected inflation EЛ. Therefore, we can replace
P − P−1 with p and EP – P−1 with EЛ:
Third, to go from output to unemployment, we apply the Okun’s Law2 which gives a relationship between these
two variables. One version of Okun’s law states that the deviation of output from its natural level is inversely
related to the deviation of unemployment from its natural rate; that is, when output is higher than the natural level
of output, unemployment is lower than the natural rate of unemployment. We can write this as
2
In the 1960s, economist Arthur Okun noted a statistical fact that we now call Okun’s law:

Thus, we can derive the Phillips curve equation from the aggregate supply equation. All this algebra is meant to
show one thing: the Phillips curve equation and the short-run aggregate supply equation represent essentially
the same macroeconomic ideas. In particular, both equations show a link between real and nominal variables that
causes the classical dichotomy (the theoretical separation of real and nominal variables) to break down in the short
run. According to the short-run aggregate supply equation, output is related to unexpected movements in the price
level. According to the Phillips curve equation, unemployment is related to unexpected movements in the inflation
rate. The aggregate supply curve is more convenient when we are studying output and the price level, whereas the
Phillips curve is more convenient when we are studying unemployment and inflation. But we should not lose sight
of the fact that the Phillips curve and the aggregate supply curve are two sides of the same coin.
Adaptive Expectations and Inflation Inertia
To make the Phillips curve useful for analyzing the choices facing policymakers, we need to specify what
determines expected inflation. A simple and often applied assumption is that people form their expectations of
inflation based on recently observed inflation. This assumption is called adaptive expectations. For example,
suppose that people expect prices to rise this year at the same rate as they did last year. Then expected inflation Eπ
equals last year’s inflation π−1:
which states that inflation depends on past inflation, cyclical unemployment, and a supply shock. When the
Phillips curve is written in this form, the natural rate of unemployment is sometimes called the non-accelerating
inflation rate of unemployment, or NAIRU.

The first term in this form of the Phillips curve, π−1, implies that inflation has inertia. That is, like an object
moving through space, inflation keeps going unless something acts to stop it. In particular, if unemployment is at
the NAIRU and if there are no supply shocks, the continued rise in price level neither speeds up nor slows down.
This inertia arises because past inflation influences expectations of future inflation and because these expectations
influence the wages and prices that people set. In the model of aggregate supply and aggregate demand, inflation
inertia is interpreted as persistent upward shifts in both the aggregate supply curve and the aggregate demand
curve. First, consider aggregate supply. If prices have been rising quickly, people will expect them to continue to
rise quickly. Because the position of the short-run aggregate supply curve depends on the expected price level, the
short-run aggregate supply curve will shift upward over time. It will continue to shift upward until some event,
such as a recession or a supply shock, changes inflation and thereby changes expectations of inflation. The
aggregate demand curve must also shift upward to confirm the expectations of inflation. Most often, the continued
rise in aggregate demand is due to persistent growth in the money supply. If the Central Bank suddenly halted
money growth, aggregate demand would stabilize, and the upward shift in aggregate supply would cause a
recession. The high unemployment in the recession would reduce inflation and expected inflation, causing inflation
inertia to subside.
Two Causes of Rising and Falling Inflation
The second and third terms in the Phillips curve equation show the two forces that can change the rate of inflation.
The second term, β(u − un), shows that cyclical unemployment—the deviation of unemployment from its natural
rate—exerts upward or downward pressure on inflation. Low unemployment pulls the inflation rate up. This is
called demand-pull inflation because high aggregate demand is responsible for this type of inflation. High
unemployment pulls the inflation rate down. The parameter β measures how responsive inflation is to cyclical
unemployment. The third term v shows that inflation also rises and falls because of supply shocks. An adverse
supply shock, such as the rise in world oil prices in the 1970s, implies a positive value of v and causes inflation to
rise. This is called cost-push inflation because adverse supply shocks are typically events that push up the costs of
production. A beneficial supply shock, such as the oil glut that led to a fall in oil prices in the 1980s, makes v
negative and causes inflation to fall.
The Short-Run Tradeoff between Inflation and Unemployment
Consider the options the Phillips curve gives to a policymaker who can influence aggregate demand with monetary
or fiscal policy. At any moment, expected inflation and supply shocks are beyond the policymaker’s immediate
control. Yet, by changing aggregate demand, the policymaker can alter output, unemployment, and inflation. The
policymaker can expand aggregate demand to lower unemployment and raise inflation. Or the policymaker can
depress aggregate demand to raise unemployment and lower inflation.
Figure 12.3 plots the Phillips curve equation and shows the short-run trade-off between inflation and
unemployment. When unemployment is at its natural rate (u = un), inflation depends on expected inflation and the
supply shock (π = Eπ + v). The parameter β determines the slope of the tradeoff between inflation and
unemployment. In the short run, for a given level of expected inflation, policy makers can manipulate aggregate
demand to choose any combination of inflation and unemployment on this curve, called the short-run Phillips
curve.

Figure 11.3: The Short-Run Tradeoff Between Inflation and Unemployment
It is to be noted that the position of the short-run Phillips curve depends on the expected rate of inflation. If
expected inflation rises, the curve shifts upward, and the policymaker’s tradeoff becomes less favorable: inflation
is higher for any level of unemployment. Because people adjust their expectations of inflation over time, the trade-
off between inflation and unemployment holds only in the short run. The policymaker cannot keep inflation above
expected inflation (and thus unemployment below its natural rate) forever. Eventually, expectations adapt to
whatever inflation rate the policymaker has chosen. In the long run, the classical dichotomy holds, unemployment
returns to its natural rate, and there is no tradeoff between inflation and unemployment.
Disinflation and the Sacrifice Ratio
Imagine an economy in which unemployment is at its natural rate3 and inflation is running at 6 percent. What
would happen to unemployment and output if the central bank pursued a policy to reduce inflation from 6 to 2
percent? The Phillips curve shows that in the absence of a beneficial supply shock, lowering inflation requires a
period of high unemployment and reduced output. But by how much and for how long would unemployment need
to rise above the natural rate? Before deciding whether to reduce inflation, policymakers must know how much
output would be lost during the transition to lower inflation. This cost can then be compared with the benefits of
lower inflation. Much research has used the available data to examine the Phillips curve quantitatively. The results
of these studies are often summarized in a number called the sacrifice ratio, the percentage of a year’s real GDP
that must be forgone to reduce inflation by 1 percentage point. Although estimates of the sacrifice ratio vary
substantially, a typical estimate is about 5: for every percentage point that inflation is to fall, 5 percent of one
year’s GDP must be sacrificed. We can also express the sacrifice ratio in terms of unemployment. Okun’s law says
that a change of 1 percentage point in the unemployment rate translates into a change of 2 percentage points in
GDP. Therefore, reducing inflation by 1 percentage point requires about 2.5 percentage points of cyclical
unemployment.
We can use the sacrifice ratio to estimate by how much and for how long unemployment must rise to reduce
inflation. If reducing inflation by 1 percentage point requires a sacrifice of 5 percent of a year’s GDP, reducing
inflation by 4 percentage points requires a sacrifice of 20 percent of a year’s GDP. Equivalently, this reduction in
inflation requires a sacrifice of 10 percentage points of cyclical unemployment. This disinflation could take various
forms, each totaling the same sacrifice of 20 percent of a year’s GDP. For example, a rapid disinflation would
lower output by 10 percent for two years: this is sometimes called the cold-turkey solution to inflation. A moderate
disinflation would lower output by 5 percent for four years. An even more gradual disinflation would depress
output by 2 percent for a decade.

Rational Expectations and the Possibility of Painless Disinflation

Because the expectation of inflation influences the short-run tradeoff between inflation and unemployment, it is
crucial to understand how people form expectations. So far, we have been assuming that expected inflation
depends on recently observed inflation. This assumption of adaptive expectations is probably too simple to apply in
all circumstances. An alternative approach is to assume that people have rational expectations. That is, we might
assume that people optimally use all the available information, including information about current government
policies, to forecast the future. Because monetary and fiscal policies influence inflation, expected inflation should
also depend on the monetary and fiscal policies in effect. According to the theory of rational expectations, a change
in monetary or fiscal policy will change expectations, and an evaluation of any policy change must incorporate this
effect on expectations. If people do form their expectations rationally, then inflation may have less inertia than it
first appears.
Estimates of the natural rate of unemployment, or NAIRU, are also far from precise. One problem is supply
shocks. Shocks to oil supplies, farm harvests, or technological progress can cause inflation to rise or fall in the
short run. When we observe rising inflation, therefore, we cannot be sure whether it is evidence that the
unemployment rate is below the natural rate or evidence that the economy is experiencing an adverse supply shock.
A second problem is that the natural rate changes over time. Demographic changes (such as the aging of the baby-
boom generation), policy changes (such as minimum-wage laws), and institutional changes (such as the declining
role of unions) all influence the economy’s normal level of unemployment. Estimating the natural rate is like
hitting a moving target. Economists deal with these problems using statistical techniques that yield a best guess
about the natural rate and allow them to gauge the uncertainty associated with their estimates. This conclusion has
profound implications. Policymakers may want to keep unemployment close to its natural rate, but their ability to
do so is limited by the fact that they cannot be sure what that natural rate is.
An alternative “rational expectations’’ view denies that there is any inherent momentum to the present process of
inflation. This view maintains that firms and workers have now come to expect high rates of inflation in the future
and that they strike inflationary bargains in light of these expectations. However, it is held that people expect high
rates of inflation in the future precisely because the government’s current and prospective monetary and fiscal
policies warrant those expectations. . . . Thus inflation only seems to have a momentum of its own; it is actually the
long-term government policy of persistently running large deficits and creating money at high rates which imparts
the momentum to the inflation rate. An implication of this view is that inflation can be stopped much more quickly
than advocates of the “momentum’’ view have indicated and that their estimates of the length of time and the costs
of stopping inflation in terms of foregone output are erroneous. . . . [Stopping inflation] would require a change in
the policy regime: there must be an abrupt change in the continuing government policy, or strategy, for setting
deficits now and in the future that is sufficiently binding as to be widely believed.
How costly such a move would be in terms of foregone output and how long it would be in taking effect would
depend partly on how resolute and evident the government’s commitment was.
Thus, advocates of rational expectations argue that the short-run Phillips curve does not accurately represent the
options that policymakers have available. They believe that if policymakers are credibly committed to reducing
inflation, rational people will understand the commitment and will quickly lower their expectations of inflation.
Inflation can then come down without a rise in unemployment and fall in output. According to the theory of
rational expectations, traditional estimates of the sacrifice ratio are not useful for evaluating the impact of
alternative policies. Under a credible policy, the costs of reducing inflation may be much lower than estimates of
the sacrifice ratio suggest. In the most extreme case, one can imagine reducing the rate of inflation without causing
any recession at all. A painless disinflation has two requirements. First, the plan to reduce inflation must be
announced before the workers and firms that set wages and prices have formed their expectations. Second, the
workers and firms must believe the announcement; otherwise, they will not reduce their expectations of inflation. If
both requirements are met, the announcement will immediately shift the short-run tradeoff between inflation and
unemployment downward, permitting a lower rate of inflation without higher unemployment.

Although the rational-expectations approach remains controversial, almost all economists agree that expectations
of inflation influence the short-run tradeoff between inflation and unemployment. The credibility of a policy to
reduce inflation is therefore one determinant of how costly the policy will be. Unfortunately, it is often difficult to
predict whether the public will view the announcement of a new policy as credible. The central role of expectations
makes forecasting the results of alternative policies far more difficult.
Hysteresis and the Challenge to the Natural-Rate Hypothesis
Our discussion of the cost of disinflation and eventually about the economic fluctuations has been based on an
assumption called the natural-rate hypothesis. This hypothesis is summarized in the following statement:
“Fluctuations in aggregate demand affect output and employment only in the short run. In the long run, the
economy returns to the levels of output, employment, and unemployment described by the classical model”.
The natural-rate hypothesis allows macroeconomists to study separately short-run and long-run developments in
the economy. It is one expression of the classical dichotomy. Some economists, however, have challenged the
natural-rate hypothesis by suggesting that aggregate demand may affect output and employment even in the long
run. They have pointed out a number of mechanisms through which recessions might leave permanent scars on the
economy by altering the natural rate of unemployment. Hysteresis is the term used to describe the long-lasting
influence of history on the natural rate.
A recession can have permanent effects if it changes the people who become unemployed. For instance, workers
might lose valuable job skills when unemployed, lowering their ability to find a job even after the recession ends.
Alternatively, a long period of unemployment may change an individual’s attitude toward work and reduce his
desire to find employment. In either case, the recession permanently inhibits the process of job search and raises
the amount of frictional unemployment. Another way in which a recession can permanently affect the economy is
by changing the process that determines wages. Those who become unemployed may lose their influence on the
wage-setting process. Unemployed workers may lose their status as union members, for example. More generally,
some of the insiders in the wage-setting process become outsiders. If the smaller group of insiders cares more
about high real wages and less about high employment, then the recession may permanently push real wages
farther above the equilibrium level and raise the amount of structural unemployment.
Hysteresis remains a controversial theory. Some economists believe the theory helps explain persistently high
unemployment in Europe, because the rise in European unemployment starting in the early 1980s coincided with
disinflation but continued after inflation stabilized. Moreover, the increase in unemployment tended to be larger for
those countries that experienced the greatest reductions in inflations, such as Ireland, Italy, and Spain. Yet there is
still no consensus on whether the hysteresis phenomenon is significant or why it might be more pronounced in
some countries than in others. If it is true, however, the theory is important, because hysteresis greatly increases the
cost of recessions. Put another way, hysteresis raises the sacrifice ratio, because output is lost even after the period
of disinflation is over.
Keep in mind that not all economists endorse all the ideas discussed here. There is widespread disagreement, for
instance, about the practical importance of rational expectations and the relevance of hysteresis. Therefore, the
study of aggregate supply remains one of the most unsettled—and therefore one of the most exciting—research
areas in macroeconomics.

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RAU'S IAS

ECONOMICSby Dr. J.C. Sharma

UNIT-2 : ADVANCED MACRO ECONOMICS

UNIT – II : ADVANCED MACROECONOMICS

CHAPTER TITLE OF THE CHAPTER PAGE NO.

Chapter 1 Classical Theory: An Economy in the Long Run 1-25

Microeconomic Thinking and Macroeconomic Models

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Classical Theory: The Economy in the Long Run

What Determines the Total Production of Goods and Services?

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Figure 7.1: Circular Flow of Income in an Economy

How National Income Distributed to Factors of Distribution?

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Figure 7.2: How a Factor of Production is Compensated

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Figure 7.7: An Increase in the Demand for Investment

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Figure 7.10: Capita Market Equilibrium

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Saving and Investment in a Small Open Economy

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Figure 7.12: A Fiscal Expansion at Home in Small Open Economy

Figure 7.13: A Fiscal Expansion Abroad in a Small Open Economy

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Figure 7.14: A shift in the Investment Schedule in a small Open Economy

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The Effects of Trade Policies

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The Special Case of Purchasing-Power Parity

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Figure 7.19: Purchasing-Power Parity

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From the Short Run to the Long Run

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Figure 8.7: A Long Run Equilibrium

Figure 8.8: Reduction in Aggregate Demand

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Shocks to Aggregate Demand

Figure 8.9: An Increase in Aggregate Demand

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Figure 8.10: An Adverse Supply Shock

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Aggregate Demand (AD):

Samuelson’s Multiplier Accelerator Interaction Model