BA112: Intermediate

Macroeconomics I
Unit 1: Dornbusch and Fischer,
Macroeconomics, 6th Edition, Chap - 4
and Chap - 5 (5.1 to 5.3)
And
Unit 2: Dornbusch and Fischer,
Macroeconomics, 6th Edition, Chap – 7
(read this chapter from PPT only)
 Chapter – 4
Money, Interest and Income
▪ In the previous chapter (Chap-3 discussed in Intro Macro) ,
we noticed that money/monetary policy had no role in
income determination. But, in practice, monetary policy
does play a central role in the income determination
because monetary policy changes the interest rate, thereby
it changes the AD and hence the economy’s income (Y).
▪ In this chapter, we will therefore consider the simultaneous
interaction between goods market and money market and
will see how the simultaneous interaction between the two
markets will determine equilibrium level of income and
equilibrium interest rate in the economy.
▪ We will basically be introducing IS-LM model in this
chapter, which is a core of short-run macroeconomics.
Where IS represents goods market equilibrium whereas LM
represents money market equilibrium.
▪ IS-LM model was introduced by John Hicks in 1937 after
Keynes published his book “General theory of
Employment, Interest and Money” in 1936 - a book in
which Keynes presented all his ideas.
▪ John Hicks developed the IS-LM model in order to
formalize the Keynesian theory in equations to explain the
interrelationships between the theory of effective demand
and the theory of liquidity preference given by Keynes.
▪ The IS-LM model was later popularized by Economist
‘Alvin Hansen’ (1949); Hence, the model is also called
“Hicks-Hansen model”.
▪ The IS-LM model believes in Keynesian ideas for the
short-run but for the long run, it largely believes in
Classical ideas. That is why the model is also called “Neo
Classical-Keynesian Synthesis”.
 Assumptions of IS-LM Model
1) The model explains short-run dynamics of the economy
and assumes prices as constant.
2) Economy is working below the full employment level of
output.
3) Interest rate is determined in the money market and output
is determined in the goods market. Therefore,
a) Goods market takes interest rate as given and see how
changes in interest rate (i) affect the output (Y) in goods
market to derive the IS curve –which represents goods
market equilibrium.
b) Similarly, money market takes output as given and see
how changes in output (Y) will affect the interest rate (i) in
money market to derive the LM curve – which represents
money market equilibrium.
 Assumptions of IS-LM Model
4) We assume that both borrowing and lending interest rates
are equal and denoted by ‘i’. (At eqm, they are equal)
5) Since prices are assumed to constant in this model, there
is no difference between nominal interest rate and real
interest rate. (Note: remember formula for real interest rate =
nominal interest rate – inflation)
 Goods Market and the IS Curve
▪ IS Curve, also called Investment/Saving Curve, is the
locus of different combinations of interest rate (i) and
output (Y) along with goods market is in equilibrium.

Derivation of IS Curve
▪ So far we assumed investment spending to be only
autonomous i.e. I = 𝐼ഥ. But, in practice, investment also
inversely depends on interest rate (i). So, investment function
can be written as:
I = 𝑰ഥ - bi (1)

where 𝐼ഥ : autonomous investment spending

b>0, which denotes responsiveness of investment
spending (I) to the interest rate (i)
 Derivation of IS Curve
▪ Eqn (1) implies that if interest rate increases, investment
spending will fall whereas if interest rate decreases,
investment spending will rise.
▪ Eqn (1) also implies that if b is higher, then investment will
be highly responsive to interest rate and if b is lower, then
investment will less responsive to interest rate.
▪ Graphical representation of Investment function:
i
ത𝑰 The position of investment
𝒃 function depends on 𝐼ഥ i.e.
when 𝐼ഥ will change,
investment curve will shift.
I = 𝐼ഥ - bi or
𝐼ҧ I
i= - Slope of the investment
𝒃 𝒃
function i.e. di/dI = -1/b
I
 Derivation of IS Curve
▪ We know IS curve represents goods market equilibrium
i.e. Y = AD
▪ AD Equation?
AD = C + I + G + NX
= Cഥ + cYD + Iҧ -bi + G
ഥ + (ഥ
X - IM - mY)
= 𝐶ഥ + 𝑐 (Y - T + 𝑇𝑅) + Iҧ - bi + G
ഥ + (ഥ
X - IM - mY)
= 𝐶ഥ + 𝑐 (Y - 𝑇ത - tY + 𝑇𝑅) + Iҧ - bi + G
ഥ + (ഥ
X - IM -mY)
= (𝐶ഥ + Iҧ + G
ഥ + c 𝑇𝑅 - c 𝑇ത + ഥ
X - IM) + cY- ctY- mY- bi
AD = (𝐶ഥ + Iҧ + G
ഥ + c 𝑇𝑅 - c 𝑇ത + ഥ
X - IM) + (c – ct – m)Y - bi
[Assuming (𝐶ഥ + Iҧ + G
ഥ + c 𝑇𝑅 - c 𝑇ത + ഥ
X - IM) = 𝐴ҧ : Autonomous
component of aggregate demand]
AD ഥ + (c – ct – m)Y – bi
=𝑨 (2)
 Derivation of IS Curve
▪ Eqn (2) is the final equation of Aggregate Demand in the four
sector economy of IS-LM model, where 𝐴ҧ = (𝐶ഥ + Iҧ + G
ഥ + c 𝑇𝑅
- c 𝑇ത + ഥ
X - IM)
▪ Mathematical derivation of IS curve: For IS curve, we need
goods market equilibrium i.e. Y = AD. So, equating Y with AD
derived in Eqn (2), we get
Intuition for –ve relation:
Y = 𝐴ҧ + (c – ct – m)Y – bi When interest rate (i) rises,
𝟏 investment spending falls,
Y= (𝐴ҧ - bi) hence AD falls and as a result
𝟏−𝒄+𝒄𝒕+𝒎
output (Y) falls.

Y = 𝜶𝑮ഥ (𝐴ҧ - bi) Or IS Equation: showing

negative relation between
𝐴ҧ 𝑌 i and Y, meaning a
(3)
i = -
𝒃 𝜶𝑮ഥ 𝒃 downward sloping curve.
 Derivation of IS Curve
Graphical representation of IS Curve:
i
Points to Note:
1. At every point on IS curve,
goods market is in equilibrium
1
2. Slope of IS: di/dY = -
𝜶𝑮
ഥ𝒃

3. When slope of IS changes, IS

𝐴ҧ 𝑌 curve will rotate (become steeper
IS: i = -
𝒃 ഥ 𝒃 or flatter).
𝜶𝑮
4. IS curve is drawn for a given
Y value of 𝐴ҧ ; also 𝐴ҧ is a part of
intercept of IS curve. So when 𝐴ҧ
5. Change in ‘b’ will cause changes, IS curve will shift.
both shift and rotation of IS And the magnitude of shift is
curve as it changes both the given by ΔY = 𝜶𝑮ഥ Δ𝐴ҧ [note
intercept value as well as the magnitude of shift is always
slope value. measured horizontally]
 Graphical Derivation of IS Curve
AD, AS Y=AS

ഥ + (c–ct–m)Y- b𝒊𝟐
𝑨𝑫𝟐 =𝑨
e2
ഥ + (c–ct–m)Y- b𝒊𝟏
𝑨𝑫𝟏 =𝑨
We note in the top diagram that when
ഥ𝑨 - b𝒊𝟐 e1 interest rate is 𝑖1, equilibrium output
ഥ𝑨 - b𝒊𝟏 in goods market is Y1 - this gives us
first point of the IS curve (e1).
And as interest rate falls to 𝑖2,
𝐘𝟏 𝐘𝟐 Y equilibrium output in goods market
increases to Y2 - this gives us second
point of the IS curve (e2).
𝒊 Adjoining the two points helps us
derive the IS curve as represented
ESG in the bottom diagram.
𝒊𝟏 e1 B
Any point on the right of IS curve (e.g
A
𝒊𝟐 e2 point B) represents excess supply of
EDG goods (ESG) and any point on the left
IS of IS curve (e.g point A) represents
𝐘𝟏 𝐘𝟐 Y excess demand of goods (EDG).
 Money Market and the LM Curve
▪ LM Curve, also called liquidity/money market
equilibrium Curve, is the locus of different combinations of
interest rate and output along with money market is in
equilibrium.
Derivation of LM Curve
▪ LM curve derivation requires money market equilibrium. So we
need to know what is demand for money and what is supply
for money?
▪ People care about purchasing power of money; so demand for
money is a theory of real demand not nominal demand.
Therefore, when we talk of demand for money, we actually
talking about real demand for money or demand for real
money balances or real money demand. We denote it by ‘L’.
▪ We know demand for money increases with the increase in…..
 Derivation of LM Curve
income (Y) and decreases with increase in interest rate (i).
Hence, function of real demand for money/demand for real
money balances/real money demand (L) can be written as:
L = kY – hi, where k, h > 0
where k, h denotes responsiveness of demand for real money
balances to the level of income and interest rate respectively.
Graphical representation of real money demand function:
Real money demand curve is drawn for a
i Slope of real money given level of income (Y). It shows that for
demand curve a given level of income, there will be
= di/dL = -1/h inverse relationship between interest rate
(i) and quantity of real money balances
demanded (L).

L = kY – hi As it is drawn for a given level of income,

the change in level of income will cause
L shift in the real money demand curve.
 Derivation of LM Curve
▪ Real supply of money or supply of real money balances
or real money supply = =

▪ Nominal money supply is exogenously given in the economy

as it is determined by the central bank ഥ and price
Ms = M
is assumed to be constant P=ഥ P.
▪ Hence, real money supply in the economy is given by:

=
▪ For LM curve derivation, we need money market equilibrium
which occurs at a point where real money demand/demand
for real money balances is equal to real money supply/supply
𝐌𝐬
of real money balances i.e. L = ………..
𝐏
 Derivation of LM Curve
ഥ
M
kY-hi = ഥ
P

1 Mഥ
Y = ( ഥ + hi) Or LM Equation: showing
𝑘 P
positive relation between (4)
1 ഥ
M i and Y, meaning a
i = (kY- ഥ )
ℎ P upward sloping Curve
LM curve shows positive relationship between interest rate and
output. Intuition: When income increases, demand for real
money balances increases. Since supply of real money
balances is fixed (as it is exogenously given), the demand for
real money balances would need to fall to attain equilibrium in
the money market which will happen only when interest rate
increases. Hence, there is a positive relationship between
income (Y) and interest rate (i) in LM curve.
 Derivation of LM Curve
Graphical Representation of LM Curve:
i Points to Note:
1 ഥ
M
LM : i = (kY- ) 1. At every point on LM curve,
ℎ ഥ
P money market is in equilibrium.
𝑘
2. Slope of LM: di/dY =
𝒉
3. When slope of LM changes,
LM curve will rotate (become
steeper or flatter).
Y 4. LM curve is drawn for a given
ഥ
M ഥ
M
ഥ
M value of So when
. changes,
When ഥ increases, then for every ഥ
P ഥ
P
P LM curve will shift.
output level, interest rate should be
lower. So LM will shift to the right And And the magnitude of shift is
ഥ
M 1 Mഥ
When ഥ falls, then for every output given by ΔY = Δ( ഥ ) [note
P 𝒌 P
level, interest rate should be higher. magnitude of shift is always
So LM will shift to the left. measured horizontally]
 Derivation of LM Curve
Some more points to note with respect to LM curve and
Money Market Eqm:
1) People divide/keep their wealth into money (cash holdings)
and assets (bonds) i.e. with given wealth, people hold both
money and bonds in their portfolio. This means if money market
is in equilibrium, bond/asset market will also be in equilibrium.
Similarly, if money market is in disequilibrium, bond/asset
market will also be in disequilibrium.
2) So, the derivation of LM curve can be done either through
money market equilibrium or through bond market equilibrium;
however, we generally focus on the former.
3) Also note that when price of bond falls, yield on bonds
increases (as bonds can be bought at lower price). This
increase in yield on bonds in bond market means increase in
interest rates in money market.
 Graphical Derivation of LM Curve
Money Market LM Curve
i i
LM
e2 A ESM e2
i2 i2

L2 = kY2 - hi
e1 e1
i1 i1 B
EDM
L1 = kY1 - hi

ഥ 𝐏
𝑴/ ഥ L Y1 Y2 Y
We note in the left diagram that when output is 𝑌1 ,
equilibrium interest rate in money market is i1 - this Any point above the LM
gives us first point of the LM curve (e1). curve (e.g point A) represents
And as output rises to 𝑌2 , equilibrium interest in excess supply of money
money market increases to i2 - this gives us second (ESM) and any point below
point of the LM curve (e2). the LM curve (e.g point B)
represents excess demand of
Adjoining the two points helps us derive the LM
money (EDM).
curve as represented in the right diagram.
Equilibrium in IS-LM model:
Simultaneous Equilibrium in Goods and
Money Market
▪ Equilibrium in IS-LM model occurs at a point where IS curve
and LM curve intersect each other.
▪ The interest rate corresponding to the intersection is known
as equilibrium interest rate (i*) and output corresponding to
intersection is known equilibrium level of output (Y*) in the IS-
LM model.
i LM
i* : Equilibrium interest rate in the
e IS-LM model
i*
Y* : Equilibrium level of
output/income in the IS-LM model
IS
Y* Y
Equilibrium in IS-LM model: Solving
Mathematically
▪ To derive the mathematical value of equilibrium output and
equilibrium interest rate in IS-LM model, we solve IS curve
equation [Eqn (3)] and LM curve equation [Eqn (4)] together.
▪ Substituting Eqn (4) in Eqn (3) and solving for Y, we get
equilibrium level of income in IS-LM model as:

ℎ𝛼𝐺
ഥ 𝑏𝛼𝐺
ഥ ഥ
M
Y* = ഥ +
A Or
ℎ + 𝑘𝑏𝛼𝐺
ഥ ℎ + 𝑘𝑏𝛼𝐺 ഥ
ഥ P

ഥ
𝒃 𝐌 ℎ𝛼𝐺
ഥ
Y* = 𝜸 ഥ + 𝜸
𝐀 , where 𝛾= (5)
ഥ
𝒉 𝐏 ℎ + 𝑘𝑏𝛼𝐺
ഥ

Eqn (5) implies that equilibrium level of output in IS-LM model

depends on two exogeneous variables; i) autonomous spending
ഥ), and ii) the real money stock (M/
(A ഥ ഥP). It also depends ………
Equilibrium in IS-LM model: Solving
Mathematically
……….on k, b, h and 𝛼𝐺ҧ - all of which are assumed to be
constant at a given point in time.
▪ Substituting Eqn (5) in LM curve Eqn (4), we get equilibrium
level of interest rate in IS-LM model as:

𝑘𝛼𝐺
ഥ 1 ഥ
M
i* = ഥ -
A Or
ℎ + 𝑘𝑏𝛼𝐺
ഥ ℎ + 𝑘𝑏𝛼𝐺 ഥ
ഥ P

𝒌 𝟏 ഥ
𝐌 ℎ𝛼𝐺
ഥ
i* = 𝜸 ഥ - 𝜸
𝐀 , where 𝛾 = (6)
𝒉 ℎ𝛼𝐺 ഥ
ഥ 𝐏 ℎ + 𝑘𝑏𝛼𝐺
ഥ

Eqn (6) implies that equilibrium interest rate depends on two

exogeneous variables; i) autonomous spending (A ഥ), and ii) the
ഥ ഥ
real money stock (M/ P). It also depends k, b, h and 𝛼𝐺ҧ - all of
which are assumed to be constant at a given point in time.
Impact of increase in Autonomous
investment (𝑰ത) on Eqm in IS-LM model.
▪ The increase in ത𝑰 causes 𝑨ഥ to increase. As a result, IS curve
shifts to the right, causing equilibrium output and equilibrium
interest rate to increase (as represented in the figure below).
i LM1
Increase in ത𝑰 causes IS curve
e2 to shift right from IS1 to IS2,
i2 shifting the Eqm from e1 to
e2. As a result, in the IS-LM
e1
i1 model, equilibrium output
𝜶𝑮ഥ Δ𝐈 ҧ
increases from Y1 to Y2 and
IS2 equilibrium interest rate
IS1 increases from i1 to i2.

Y1 Y2 Y

▪ However, the point to note is that the increase in Eqm output

ҧ The….
is less than the magnitude of shift in IS curve (𝜶𝑮ഥ ΔI).
Impact of increase in Autonomous
ത on Eqm in IS-LM model.
investment (𝑰)
….reason for this is as follows:
when ത𝑰 increases, initially Y increases by 𝜶𝑮ഥ ΔI.ҧ But this
increase in Y also increases the demand for money and as
result, interest rate in the money market increases. This
increase in interest rate causes private investment to fall,
thereby leads to contraction in AD and Y. As a result, the
eventual increase in Eqm output is less or increase in Eqm
output is less than the magnitude of shift in IS curve.
In other words, there is a dampening effect of increased
interest rate on private investment and as a result of this
dampening effect, increase in Eqm output is less than the
magnitude of shift in IS curve (or we can say ‘full multiplier
effect is not realized’).
 Chapter – 5 (5.1 to 5.3)
Monetary and Fiscal Policy
Effect of monetary policy on Eqm in IS-
LM model
ഥ
Q. Suppose Central Bank increases the money supply (𝐌).
How will it affect the Eqm in IS-LM model?
Answer:
ഥ increases the
Increase in 𝐌
i ഥ
M
LM1 real money supply (ഥ) and
P
LM2 thereby shifts the LM curve to
the right, causing Eqm to shift
e1
from e1 to e2. As a result, Eqm
i1
interest rate falls from i1 to i2
and equilibrium output
i2 e2
increases from Y1 to Y2.
e’ IS1 Magnitude of shift in LM curve
1 1
Y1 Y2 Y = ഥ
Δ𝐌
𝒌 ഥ
P
 Effect of monetary policy on Eqm in
IS-LM model
▪ We know from the previous figure that the increase in money
ഥ eventually causes Eqm to shifts from e1 to e2. But
supply (𝐌)
the question is:
Q. What is the transmission mechanism of movement towards
the new equilibrium (e2) or what is the adjustment process
happening in the background?
Answer: Transmission mechanism towards new Eqm (e2)
happens in two stages:
a) In the first stage (adjustments in only money market take
place): when money supply increases, it creates disequilibrium
in money market. To remove this disequilibrium, real money
demand must increase which requires interest rate to fall.
Therefore, in the first stage, economy moves from e1 to e’.
Effect of monetary policy on Eqm in IS-
LM model
b) In the second stage (where the adjustments in both money
market and goods market take place): The fall in interest rate in
the first stage leads to increase in investment spending in the
second stage. So AD starts rising and hence Y starts rising. As
Y is rising, money demand will increase and there will again be
disequilibrium in money market, which would require interest
rate to rise to re-establish the Eqm. Therefore, in this stage,
economy will move diagonally upward and thereby it will
eventually reach to e2.
Note: Adjustments in money market happen immediately
whereas adjustments in goods market happen gradually (or
happen after the adjustments in money market).
Q. Prove that steeper the LM curve, greater will be
the change in Eqm Y and Eqm ‘i' in case of monetary
policy change.
Answer: Say, there is monetary/monetary policy expansion
ഥ
i.e. increase in money supply/nominal money supply ( 𝐌).
LM1S LM2S
i We can note that
LM1F when LM curve is
LM2F steep, the
increase in Eqm Y
e1
i1 and the decrease
eF in Eqm ‘i’ is
iF
es greater in case of
iS monetary
expansion
IS1 (assuming ‘k’ is
constant)
Y1 YF YS Y
Q. Prove that smaller is ‘h’, greater will be the
increase in Eqm Y and decrease in Eqm ‘i' in case of
monetary policy expansion.
Answer: The diagram at the previous slide proves the same,
where steeper LM means ‘small h’ and flatter LM means
‘large h’. Now think about the reasoning of this result.

Effect of fiscal policy on Eqm in IS-LM

model
▪ Expansionary fiscal policy: increase in Gഥ or increase in TR or
decrease in T or any combination of the three.
▪ Contractionary fiscal policy: decrease in Gഥ or decrease in TR
or increase in T or any combination of the three.
………………..
 Effect of Fiscal Policy on Eqm in IS-
LM model
▪ Consider expansionary fiscal policy, say increase in Gഥ. Lets
see how it affects the Eqm in IS-LM model.
i Increase in 𝑮 ഥ causes IS
LM1 curve to shift right from IS1
to IS2, shifting the Eqm from
e1 to e2. As a result, in the
i2 e2 IS-LM model, equilibrium
output increases from Y1 to
e1 Y2 and equilibrium interest
i1 e’ rate increases from i1 to i2.
ഥ
𝜶𝑮ഥ Δ𝑮
This much of Economy’s
IS2 income has been crowded
out due to fall in private
IS1 investment as a result of
Y1 Y2 Y’ Y increase in interest rate in
this case.
Effect of Fiscal Policy on Eqm in IS-LM
model
▪ However, the point to note is that the increase in Eqm output
ഥ). The
is less than the magnitude of shift in IS curve (𝜶𝑮ഥ ΔG
reason for this is as follows:
When 𝐆 ഥ increases, initially Y increases by 𝜶𝑮ഥ ΔG
ഥ. But this
increase in Y also increases the demand for money and as
result, interest rate in the money market increases. This increase
in interest rate causes private investment to fall, thereby leads to
contraction in AD and Y. As a result, the eventual increase in
Eqm output is less or increase in Eqm output is less than the
magnitude of shift in IS curve.
▪ In other words, there is a dampening effect of increased
interest rate on private investment and as a result of this
dampening effect, increase in Eqm output is less than …….
Effect of Fiscal Policy on Eqm in IS-LM
model
….. the magnitude of shift in IS curve (or we can say ‘full
multiplier effect is not realized’).
▪ This fall in private investment due to increase in interest rate
ഥ, in
as a result of expansionary fiscal policy or increase in 𝐆
macroeconomics, is called crowding out effect or crowding
out of private investment. Here increase in government
spending crowds out the private investment spending.
▪ Similarly, we can show the crowding out effect when there is
increase in TR or decrease in ഥ
T.
▪ Note: Crowding out effect is applicable only in case of
expansionary fiscal policy. Q. What happens in case of
contractionary fiscal policy? Crowding in effect?
Fiscal Policy and Crowding out effect in
IS-LM model
Q. What factors determine how much crowding out take place in
case of expansionary fiscal policy?
Answer: There are three statements in this regard:
(a) Income increases more (less crowding out), and interest
rates increase less, the flatter the LM curve
(b) Income increases less (more crowding out), and interest
rates increase less, the flatter the IS curve
(c) Income and interest rates increase more (less crowding out)
the larger the multiplier (𝜶𝑮ഥ ), and thus the larger the horizontal
shift of the IS curve.
We will discuss the cases mentioned above one by one in the
next three slides.
Fiscal Policy and Crowding out effect in
IS-LM model
(a) Income increases more, and interest rates increase less, the
flatter the LM curve in case of expansionary fiscal policy.
LMs
Y
es
LMF
iS We can note that when
iF LM curve is flat, the
e1 eF
increase in output is
i1 more (less crowding
out) and increase in
interest rate is less in
case of expansionary
IS2
fiscal policy.
IS1
Y1 Ys YF Y
Fiscal Policy and Crowding out effect in
IS-LM model
(b) Income increases less, and interest rates increase less, the
flatter the IS curve in case of expansionary fiscal policy.
i IS1S IS2S
We can note that
LM1
when IS curve is
eS flat, the increase
iS in output is less
(more crowding
eF
iF out) as well as
i1 increase in
e1 interest rate is
IS2F
less in case of
IS1F
expansionary
fiscal policy.
(Assuming 𝜶𝑮ഥ is
Y1 YF YS constant).
Y
Fiscal Policy and Crowding out effect in
IS-LM model We can note from the second figure that when
𝜶𝑮ഥ is large, income and interest rate increase
Comparing the two more (less crowding out) in case of
figures below expansionary fiscal policy.
(c) Income and interest rates increase more (less crowding out)
the larger the multiplier (𝜶𝑮ഥ ), and thus the larger the horizontal
shift of the IS curve (in case of expansionary fiscal policy).
i i LM1
LM1

i2 e2
i2 e2
e1 e1 IS2large 𝜶
i1 i1
IS2small 𝜶
IS1small 𝜶 IS1large 𝜶

Y1 Y2 Y Y1 Y2 Y
Fiscal Policy and Crowding out effect in
IS-LM model-Points to Note:
1) Intuition for crowding out: crowding out occurs because
when government follows expansionary fiscal policy (and
thereby creates budget deficit for itself), it would need to
borrow from the market to finance its budget deficit. This action
reduces the funds available for private investment in the
market, making it costly (through increase in interest rate) and
thereby causes private investment to fall.
2) Suppose a) there is monetary policy expansion along with
fiscal policy expansion in the same magnitude Or b) there is
monetary accommodation of fiscal expansion i.e. monetization
of budget deficit i.e. printing of money to finance increased
government expenditure/budget deficit.
In case a) and case b), both IS and LM curve will shift to ……..
Fiscal Policy and Crowding out effect in
IS-LM model-Points to Note:
……..the right in the same magnitude. As a result, equilibrium
interest rate will not change and the equilibrium output will
increase exactly by the magnitude of shift in IS curve - meaning
there will be no crowding out i.e. full multiplier effect will be
realized. (Try it at home).
3) In this model, we have assumed that economy is working
below the full employment i.e. there is unemployment in the
economy and prices are constant in the short run.
But suppose, instead, economy is working at full employment
(YF) and prices are allowed to change in short run (as happens
in case of classical economy). What will happen in this case
when there is fiscal policy expansion?
Answer: Under the assumption that economy is working at full
employment (YF) and prices are allowed to change even ……..
Fiscal Policy and Crowding out effect in
IS-LM model-Points to Note:
……in the short run, the fiscal policy expansion will have no
effect on equilibrium output i.e. there will be full crowing out
which means no multiplier effect will be realised.
In this case due to expansionary fiscal
i LM2 policy, AD increases and IS curve shifts
right. Since economy is already at full
LM1 employment, output cannot increase;
e2 hence there will be excess demand in the
i2 economy. As prices are allowed to change,
Excess due to excess demand, price level will
Demand
start rising. This will reduce the real money
i1 e1 stock in the economy, causing LM curve to
shift left. As a result, the new equilibrium
will establish at point ‘e2’. It is clear that
IS2
Eqm Y has not changed even despite
IS1 expansionary fiscal policy, meaning full
crowding out (i.e. no multiplier effect).
YF Y
 Fiscal Policy Multiplier
▪ Fiscal Policy Multiplier: It shows the multiple by which
equilibrium level of income in the IS-LM model will change
when a fiscal policy variable, say government expenditure ( ഥ
G),
changes by one unit, holding real money supply constant.

=
=𝜸

[We get it after partial

derivative of Eqn (5)
with respect to govt
expenditure (Gഥ)] Change in output implied by fiscal policy multiplier
 Monetary Policy Multiplier
▪ Monetary Policy Multiplier: It shows the multiple by which
equilibrium level of income in the IS-LM model changes when
real money supply (𝑴/ ഥ 𝐏ഥ) changes by one unit, keeping fiscal
policy/government expenditure unchanged.

=
𝑏
=
ℎ
𝜸

[We get it after partial

derivative of Eqn (5)
w. r. to real money
supply (𝑴/ഥ 𝐏 ഥ)] Change in output implied by monetary policy multiplier
 Extreme Cases in IS-LM model: A)
Liquidity Trap
A) Liquidity Trap: It is situation in which the public is
prepared, at a given interest rate, to hold whatever amount of
money is supplied. This concept was given by Keynes. The
liquidity trap generally occurs at a very low interest rate.
▪ In this case, real money demand (L) curve will be horizontal,
meaning real money demand is perfectly elastic with respect
to interest rate (refer slide no. 14). We know slope of L is
given by (-1/h). Since L is horizontal, that means h = ∞.
▪ As h = ∞, slope of LM = (k/h) = 0. This means LM curve will
also be horizontal in this case. As change in monetary
policy/money supply will not change the given interest rate in
the money market in this case, LM curve will also not shift
because of change in monetary policy/money supply.
▪ In this case, Monetary policy will be ineffective i.e. ……….
 Extreme Cases in IS-LM model: A)
Liquidity Trap
………monetary policy changes will have no effect on
economy’s income. It will also not have any affect on
economy’s interest rate. Proving that monetary policy will be
ineffective in case of liquidity trap:
i As we know when economy is in
liquidity trap, changes in money
supply/monetary policy changes will not
shift the LM curve. Since LM curve is
e1 not shifting due to change in money
i1 LM1
supply, Eqm Y will also not change.
This proves that monetary changes has
no effect on Eqm Y in case of liquidity
IS1 trap which means monetary policy will
be ineffective in this case.
Y1 Y
We can also note that it has no effect
on economy’s interest rate as well.
 Extreme Cases in IS-LM model: A)
Liquidity Trap
▪ However, in this case, Fiscal policy will be fully effective
as it will have maximum impact on the output.
Proving that fiscal policy will be
i fully effective in case of liquidity
trap: Assume there is fiscal policy
expansion, say increase in ഥ G. In this
case, IS curve will shift to the right
e1 e2 and as a result Eqm will shift from e1
i1 LM1 to e2. Here, we can note that Eqm
output has increased exactly by the
magnitude of shift in IS curve. This
IS2 implies full multiplier effect is realized
IS1
i.e. there is no crowding out. Thus,
Y1 Y2 Y we can say that fiscal policy is fully
effective in case of liquidity trap.
 Extreme Cases in IS-LM model: B)
Classical Case
B) Classical Case: Classical economists say that money is
demanded only for transaction purpose and demand for money
is a function of Y only.
▪ This means, according to classical economists, demand for
money is entirely unresponsive to interest rate, which means
we will have h = 0 in the real money demand function (L).
▪ As a result, LM curve will be vertical in this case as the
slope of LM is now infinity.
▪ In fact, with h = 0 in LM equation, we get quantity theory of
money (QTM) – which is a classical theory.
▪ In the classical case i.e. when LM is vertical, Monetary
policy will be fully effective as it will have maximum
impact on the output. ……………
 Extreme Cases in IS-LM model: B)
Classical Case
Proving that Monetary policy will be fully effective in
Classical case i.e. when LM is vertical:
Assume there is monetary policy
expansion, say increase in M. ഥ In
i LM1 LM2
this case, LM curve will shift to the
right and as a result Eqm will shift
from e1 to e2, causing Eqm
interest rate to fall from i1 to i2 and
e1 Eqm output to increase from Y1 to
i1
Y2. Here, we can note that Eqm
e2 output has increased exactly by
i2
the magnitude of shift in LM curve.
IS1 Thus, we can say that monetary
policy is fully effective in the
Y1 Y2 Y classical case.
 Extreme Cases in IS-LM model: B)
Classical Case
▪ However, in this case, Fiscal policy will be ineffective as it
will have no effect on Eqm output.
Assume there is fiscal policy
expansion, say increase in ഥ G. In
i LM1
this case, IS curve will shift to the
right and as a result Eqm will shift
from e1 to e2, causing Eqm
i2 e2 interest rate to increase from i1 to
i2. However, we can note that
Eqm output has not changed
e1 despite the shift in IS curve due to
i1
IS2 expansionary fiscal policy. This
implies no multiplier is realized i.e.
IS1 there is full crowding out. Thus, we
can say that fiscal policy is
Y1 Y ineffective in classical case.
 Extreme Cases in IS-LM model: C) IS
curve is Vertical
C) IS curve is Vertical : This is a hypothetical case. In this
case, Fiscal policy will be fully effective whereas Monetary
policy will be ineffective.
Proving that Fiscal policy is fully effective when IS
Curve is vertical:
Assume there is fiscal policy
i IS1 IS2 expansion, say increase in G ഥ. In this
LM1
case, IS curve will shift to the right and
as a result Eqm will shift from e1 to e2.
i2 e2 Here, we can note that Eqm output
has increased exactly by the
i1
magnitude of shift in IS curve. This
e1 implies full multiplier effect is realized
i.e. there is no crowding out. Thus, we
can say that fiscal policy is fully
Y1 Y2 effective when IS is vertical.
Y
 Extreme Cases in IS-LM model: C) IS
Curve is Vertical
Proving that Monetary policy is ineffective when IS
Curve is vertical:
Assume there is monetary policy
expansion, say increase in M. ഥ In
i IS1 this case, LM curve will shift to
LM1 the right and as a result Eqm will
shift from e1 to e2, causing Eqm
interest rate to fall from i1 to i2.
i1 LM2
e1 However, we can note that Eqm
output has not changed despite
i2 the shift in LM curve due to
e2
expansionary monetary policy.
Thus, we can say that monetary
policy is ineffective when IS
curve is Vertical.
Y1 Y
 Extreme Cases in IS-LM model: D) IS
Curve is horizontal
D) IS Curve is Horizontal: This is also a hypothetical
case. In this case, Fiscal policy will be ineffective whereas
Monetary policy will be fully effective.
(i) Proving that Fiscal policy is ineffective when IS Curve is
horizontal: (Homework) Hint: IS curve horizontal means at a
given interest rate, there is infinite supply of goods and hence
change in fiscal policy will not shift it.
(ii) Proving that Monetary policy is fully effective when IS Curve
is horizontal: (Homework)

Also Do Section 5.3: ‘The Composition of Output

and the Policy Mix’ on Your Own (Homework)
Question1: Suppose an economy is working below the full
employment level of output in IS-LM framework. Tell how the
economy can achieve full employment level of output (YF)?
i
LM1

There can be three possible

policies to achieve full
e1
employment level of output
i1
(YF). However, different
policy will have different
IS1 impact on interest rate.

Y1 YF Y

Question2: Cases where we have full crowing out in case of

expansionary fiscal policy? (three cases)
Question3: Cases where we have no crowing out in case of
expansionary fiscal policy? (three cases)
 Numerical
Example 1: Chap - 4 (Q.1):
 Numerical
Example 1: Chap - 4 (Q.1):
(a) IS equation requires goods market Eqm i.e.
Y = AD
Y = C + I + G (three sector economy)
= 0.8(1-t)Y + 900-50i + 800
= 0.8(1-0.25)Y + 1700 - 50i
= (0.8*0.75)Y + 1700 - 50i
Y = 0.6Y + 1700 - 50i
0.4Y = 1700 - 50i
IS curve: Y = 4250 - 125i (1a)
(b) Provide definition of IS curve
 Numerical
Example 1: Chap - 4 (Q.1):
(c) LM equation requires money market Eqm i.e.
ഥ 𝐏
Real money demand (L) = Real money supply (𝑴/ ഥ)
0.25Y - 62.5i = 500
0.25Y = 500 + 62.5i
LM Curve: Y = 2000 + 250i (1b)
(d) Provide definition of LM curve
(e) To determine Eqm income and Eqm interest rate, we solve
the IS curve equation i.e. Eqn (1a) and LM curve equation i.e.
Eqn (1b) together i.e.
4250 - 125i = 2000 + 250i
Solving above equality, we get Eqm interest rate: i* = 6
 Numerical
Example 1: Chap - 4 (Q.1):
To get Eqm output (Y*), substitute Eqm interest rate (i*) in
either IS curve or LM curve, we get
Eqm output: Y* = (2000 + 250*6) = 3500
Graphical Representation
of Eqm in IS-LM model: (f) At the intersection, both
i goods market and money
LM: Y=2000+250i
market are in Eqm
simultaneously. This is a
e1 Eqm situation because
6 there is no incentive to
deviate from here at a
given point in time; both
IS:Y=4250-125i
the markets are in
3500 Y equilibrium simultaneously.
 Numerical
Example 2 : Consider an economy with: C = 50+0.9YD,
Autonomous tax (𝑇)ത = 100, 𝐺ҧ = 10, I = 150 - 5i, L = 0.2Y-10i, 𝑀
ഥ=
200, 𝑋ത = 20, Import (IM) = 10+0.1Y, and 𝑃ത = 2.
(a) Derive IS and LM equations and find out the equilibrium level
of income and equilibrium level of interest rate.
(b) Suppose 𝐺ҧ increases by 50. Given this, find out the new
equilibrium income and new equilibrium interest rate.
(c) Calculate government expenditure multiplier (𝛼𝐺 ) and the fiscal
policy multiplier. Tell whether two are different. If yes, then why?
(d) Is there crowding out of private investment? If yes, then find
out the magnitude of income that has been crowded out.
(e) To realize the full multiplier effect in part (b), how much should
be the change in money supply/nominal money supply by central
bank?
 Numerical
Example 2 :
(a) IS Equation: Goods market Eqm i.e.
Y = AD
Y = C + I + G + NX (four sector economy)
= 50 + 0.9YD+ 150 - 5i + 10 + (20 - 10 - 0.1Y)
= 220 + 0.9(Y-100) - 5i - 0.1Y
= 220 + 0.9Y - 90 - 5i - 0.1Y
Y = 130 + 0.8Y - 5i
IS Equation: Y = 650 - 25i (2a)

LM Equation: Money market Equilibrium i.e.

ഥ 𝐏
Real money demand (L) = Real money supply ( 𝑴/ ഥ)
0.2Y-10i = (200/2)
 Numerical
Example 2 :
0.2Y - 10i = 100
0.2Y = 100 + 10i
LM equation: Y = 500 + 50i (2b)

For Eqm in IS-LM model, we solve Eqn (2a) and Eqn (2b)
together, we get
650 - 25i = 500 + 50i
Eqm Interest rate: i 1* = 2

For Eqm output, substitute Eqm interest rate in (2a) or (2b), we

get
Eqm output: Y1* = 500 + (50*2) = 600
 Numerical
Example 2 :
ഥ = 60, New IS Equation: Goods market Eqm i.e.
(b) New 𝑮
Y = AD
Y = C + I + G + NX (four sector economy)
= 50 + 0.9YD+ 150 - 5i + 60 + (20 - 10 - 0.1Y)
= 270 + 0.9(Y-100) - 5i - 0.1Y
= 270 + 0.9Y - 90 - 5i - 0.1Y
Y = 180 + 0.8Y - 5i
New IS Equation: Y = 900 - 25i (2c)
For new Eqm in IS-LM model, we equate new IS equation (2c)
with initial LM equation (2b), we get
900 - 25i = 500 + 50i
New Eqm interest rate: i 2* = 5.33
 Numerical
Example 2 :
Substituting new Eqm interest rate in New IS equation (2c) or
initial LM equation (2b), we get
New Eqm output: Y2* = 500 + (50*5.33) = 766.67
(c) Government expenditure multiplier (𝜶𝑮ഥ )
𝟏 𝟏 𝟏
= = = =5
𝟏−𝒄+𝒄𝒕+𝒎 𝟏−𝟎.𝟗+𝟎.𝟏 𝟎.𝟐

Δ𝒀 𝒉𝜶𝑮
ഥ (𝟏𝟎∗𝟓)
Fiscal policy multiplier (𝜸) = ഥ
= = = 3.33
Δ𝑮 𝒉 + 𝒌𝒃𝜶𝑮
ഥ 𝟏𝟎 +(𝟎.𝟐∗𝟓∗𝟓)

[ Fiscal policy multiplier is lower than government expenditure multiplier

because fiscal policy multiplier gives us the change in income in IS-LM
model after accounting for crowding out/crowding in effects Or it gives us
the net/precise change in the Eqm income in IS-LM model when there is
ഥ )]
change in a fiscal policy variable (say, 𝑮
 Numerical
Example 2 :
(d) Yes, there is a crowding out of private investment because
equilibrium interest rate has increased after the increase in
government expenditure - an expansionary fiscal policy.
ഥ) = (5*50) = 250
Magnitude of shift in IS curve = (𝜶𝑮ഥ *Δ𝐆

i IS2
LM1
IS1
e2
5.33
e1
2
Crowded out income = Shift
in IS Curve – increase in
Eqm income in IS-LM model
= 250 – 166.67 = 83.33
600 766.67 Y
 Numerical
Example 2 :
(e) To realize the full multiplier effect, money supply/nominal
money supply should be changed in such a way that LM curve
shifts right exactly in the same magnitude of rightward shift in IS
curve i.e. rightward shift in LM curve = right ward shift in IS curve
1 ഥ
M
Δ( ഥ ) = 𝜶𝑮ഥ *Δ𝐆ഥ
𝒌 P
1 1
Δ Mഥ = 5*50
𝒌 Pഥ
ഥ = 250*k*ഥ
ΔM P
ഥ = 250*0.2*2 = 100
ΔM
[ This means central bank should increase the nominal money supply
ഥ]
by 100 in this case to realize the full multiplier effect of increase in G

Solve back questions of Ch-4 (Homework)

 Chapter-7
Aggregate Demand and Aggregate
Supply: An Introduction
(read this chapter from PPT only)
▪ The biggest shortcoming of IS-LM model is that it completely
ignores the supply side factors in the determination of output.
It focuses mainly on demand side factors such as A ഥ, M
ഥ etc.
for the determination of output.
▪ Also, in the IS-LM model, we assume that prices are constant
in short run. But in reality, prices are not completely constant
in the short run rather they move/change slowly.
▪ In this chapter, I will provide introduction to the theory of
aggregate demand and aggregate supply curve which will not
only overcome the above mentioned shortcomings of IS-LM
model but also discuss the theory of output determination
from the perspective of long run.
Aggregate Demand (AD) Curve
▪ Aggregate Demand (AD) Curve is derived on the basis of
IS-LM model studied earlier.
Aggregate Demand (AD) Curve
▪ In particular, Aggregate demand (AD) curve is the locus of
different combination of the price level and level of output
at which both goods market and the money/asset
market are in equilibrium simultaneously (or at which IS-
LM model is in Equilibrium).
(Note: the AD curve studied earlier in Chapter-3 was in
someway an incomplete AD curve because it took prices as
constant; also it ignored the role of money market (thereby the
role of interest rate) in the determination of AD and Y. The AD
curve which we discuss in this chapter is a general case and the
most relevant one for the economy)
▪ Since AD curve shows the relationship between price level
and Eqm output from IS-LM model, the equation for Eqm
output in IS-LM model i.e. Eqn (5) will actually denote the
equation of AD curve. Hence, the equation of AD curve…...
Aggregate Demand (AD) Curve
…….is given by:
ഥ
𝒃𝐌 ℎ𝛼 𝐺
ഥ
ഥ + 𝜸
Y=𝜸𝐀 , where 𝛾 =
𝒉 𝐏 ℎ + 𝑘𝑏𝛼𝐺
ഥ
Or (7)
ഥ
𝐌 ℎ𝛼𝐺
ഥ b
P=𝛃 ഥ
, where 𝛾 = and β = γ
𝐘 − 𝛄𝐀 ℎ + 𝑘𝑏𝛼𝐺
ഥ h
(Note: Now prices are allowed to vary. That is why there is not
bar on P in the above equation)
▪ We can note from Eqn (7) that there is negative relationship
between price level and output, this implies AD curve will be
a downward sloping curve.
▪ The logic for downward sloping AD curve: When price level
falls, real money supply increases causing interest rate in
the economy to fall. This fall in interest rate leads to………
Aggregate Demand (AD) Curve
………increase in investment spending, hence increase in AD
and output (Y). In this way, we get negative relationship
between price level and the output in AD curve.
▪ We can also note from Eqn (7) that AD curve is drawn for a
ഥ and A
given value of M ഥ, meaning change in M
ഥ and A
ഥ will shift
the AD curve.
The increase in M ഥ (which reduces interest
ഥ rate) and the increase in A ഥ, will cause
P 𝐌
AD: P = 𝛃 ഥ aggregate demand in the economy to rise
𝐘 − 𝛄𝐀
at all levels of prices and thereby they will
lead to rightward shift in AD curve.

The decrease in M ഥ (which increases

interest rate) and the decrease in A ഥ, will
cause aggregate demand in the economy
AD to fall at all levels of prices and thereby
they will lead to leftward shift in AD curve.
Y
 Graphical Derivation of AD Curve
. i ഥ
We note in the top diagram that
𝐌
LM2 ( ) when price level is P1 ,
𝐏𝟐
e2 ഥ
𝐌 corresponding LM is LM1 and
i2 LM1 ( )
e1 𝐏𝟏 equilibrium output in IS-LM
i1 model is Y1 - this gives us first
IS1 point of the AD curve (e1).

And as price level increases to

P2 , LM curve shifts left to LM2 (as
Y2 Y1 Y real money stock has fallen) and
P equilibrium output in IS-LM
model falls to Y2 - this gives us
e2
second point of the AD curve
P2 (e2).
e1
P1 Adjoining the two points helps
AD us derive the AD curve as
represented in the bottom
Y2 Y1 Y diagram .
 Aggregate Supply (AS) Curve
▪ Aggregate Supply (AS) Curve: It shows the quantity of
output firms are willing to supply for each given price level.
▪ And the amount of output firms are willing to supply depends
on the price they receive for their goods and the cost of
factors of production. Thus, aggregate supply curve reflects
conditions in the factor markets as well as goods markets.
▪ There are three cases of AS curves: (two special cases
and one general case)

Special Case I: Special Case II: General Case:

Classical Case. Keynesian Case. Intermediate Case.
In this case, AS In this case, AS In this case, AS
curve will be curve will be curve will be
vertical. horizontal. upward sloping.
 Aggregate Supply (AS) Curve
▪ In this chapter, we will discuss only the special cases and
derive results for the economy in these cases. The general
case will be discussed in the next reading. Note: it is the
general case which is more applicable in real world.

AS Curve: Classical Case

▪ As we know, as per classical economists, economy always
works at full employment. This means, in this case, AS curve
will be vertical at full employment level of output (YF),
meaning firms will supply YF whatever the price level is.
P AS
As per classical economists,
this is always true no matter
whether there is short run or
long run.

YF Y
 Equilibrium in AS-AD model
▪ Equilibrium in AS-AD model occurs at a point where AS
curve intersect the AD curve or the two curves intersect
each other.
Equilibrium in AS-AD model: Classical
Case
▪ Equilibrium in Classical case will occur at a point where
vertical AS curve intersects the AD curve.
P
AS

P1 e1

AD1

YF Y
 Equilibrium in AS-AD model: Classical
Case: Fiscal Policy Change
Q. How do fiscal policy changes affect the Eqm in AS-AD model
under classical case? Say there is expansionary fiscal policy
ഥ.
i.e. increase in 𝐆 As the economy is already working at
P AS
full employment level of output (YF), the
fiscal expansion which causes AD curve
to shift right, will have no effect on
P2 e2 economy’s output; it only increases the
price level in the economy to deal
P1 e1 with the excess demand created
AD2
through expansionary fiscal policy.
AD1 Therefore, we can say that fiscal policy
YF Y is ineffective in classical case.

In other words, we can say that there is full crowding out effect. Private
investment here has fallen exactly by the amount of increase in G. Hence,
eventually we find no change in AD and Y. This is what we noticed at the
slide number 40 and 48 through IS-LM model.
 Equilibrium in AS-AD model: Classical
Case: Monetary Policy Change
Q. How does monetary policy affect the Eqm in AS-AD model
under classical case? Say there is expansionary monetary
ഥ
policy i.e. increase in 𝐌. As the economy is already working at full
P employment level of output (YF), the
AS
monetary expansion which causes AD
curve to shift right, will have no effect on
P2 e2 economy’s output; it only increases the
price level in the economy to deal with
P1 e1 the excess demand created through
AD2
expansionary monetary policy.
AD1 Therefore, we can say that monetary
policy is also ineffective in classical case.
YF Y

However, the point to note is that the increase in nominal money supply
in the Classical case raises the price level exactly in the same
proportion, leaving real output (Y), real interest rate and real money
balances (or supply) unchanged.
 Equilibrium in AS-AD model: Classical
Case: Monetary Policy Change
▪ Real output remains unchanged due to monetary policy
change because the economy is already working at full
employment (as represented in previous figure).
▪ As output cannot change (as it is on full employment level),
real money supply has to be constant in case of
expansionary monetary policy which requires price to
increase exactly in the same proportion as increase in money
supply [refer Eqn (7)].
▪ As price level increases exactly in the same proportion of
increase in money supply, leaving real money stock
unchanged, Eqm interest rate in the IS-LM model will also
not change [refer Eqn (6)].
▪ This implies that under classical conditions, change in
money supply does not affect real variables such as…….
 Equilibrium in AS-AD model: Classical
Case: Monetary Policy Change
……….real output (Y), employment, real interest rate, real
money supply. It affects only the price level i.e. only the
nominal variables, where price level changes exactly in the
same proportion of change in nominal money supply (or simply
money supply).
▪ In this sense, we can conclude that under classical case,
money is neutral i.e. change in money supply/monetary
policy changes affects only the nominal variables (through
change in price level) but not the real variables.
▪ These implications about the effects of monetary policy on
output are consistent with the quantity theory of money
(QTM), which is a Classical theory.
QTM: MV=PY, where V is constant known as
velocity of money and Y is constant at YF)
 Equilibrium in AS-AD model: Classical
Case: Monetary Policy Change
▪ According to QTM, there is direct and equi-proportionate
relationship between price level and the money supply. In
this sense, change in money supply will change only the
nominal variables (through change in price level) but it will
have no effect on real variables such as real output, real
money supply etc. Hence, money can be called neutral.
▪ According to classical economists, implications of QTM is
true both in short run as well as long run i.e. Money is neutral
both in short run as well long run.
▪ Note: If we indeed believe that money is neutral, then there
would be an easy way to reduce the inflation rate in the
economy. All we need to do is to reduce the rate at which
money stock/supply is growing.
 AS Curve: Keynesian Case
▪ In Keynesian case, aggregate supply curve is horizontal,
indicating that firms will supply whatever amount of goods is
demanded at the existing price level.
▪ Reason for having horizontal AS curve: According to
Keynesians, economy operates with unemployment. This
means firms can hire as much labor as they want at the
current wage. So, their average cost of production is not
likely to change with change in their output levels. Hence,
they are willing to supply as many output as demanded at the
existing price level. P This Keynesian
aggregate supply
curve mainly applies
P1 AS in very short run
period where prices
can be assumed
completely constant.
Y
Equilibrium in AS-AD model
▪ Equilibrium in AS-AD model occurs at a point where AS
curve intersect the AD curve or the two curves intersect
each other.
Equilibrium in AS-AD model: Keynesian
Case
▪ Equilibrium in Keynesian case will occur at a point where
horizontal AS curve intersects the AD curve.
P

e1
P1 AS

AD1

Y1 Y
 Equilibrium in AS-AD model: Keynesian
Case: Fiscal Policy Change
Q. How do fiscal policy changes affect the Eqm in AS-AD model
under Keynesian case? Say there is expansionary fiscal
ഥ.
policy i.e. increase in 𝐆
P The expansionary fiscal policy shifts the
AD curve right, causing Eqm to shift
from e1 to e2. As a result, Eqm output
increases from Y1 to Y2 but there is no
e1 e2 change in price level. Hence, we can
P1 AS
say that under Keynesian case of AS
curve, expansionary fiscal policy will
AD1 AD2 cause output to expand but there will be
Y1 Y2 Y no change in price level.

In addition, as we know from IS-LM model that lies behind the AD curve, the
fiscal expansion will raise the equilibrium interest rate. And the magnitude of
the output expansion above will be given by fiscal policy multiplier.
 Equilibrium in AS-AD model: Keynesian
Case: Monetary Policy Change
Q. How do Monetary policy changes affect the Eqm in AS-AD
model under Keynesian case? Say there is expansionary
ഥ
monetary policy i.e. increase in 𝐌.
P The expansionary monetary policy shifts
the AD curve right, causing Eqm to shift
from e1 to e2. As a result, Eqm output
increases from Y1 to Y2 but there is no
e1 e2
P1 AS change in price level. Hence, we can say
that under Keynesian case of AS curve,
expansionary monetary policy will cause
AD1 AD2 output to expand but there will be no
Y1 Y2 Y change in price level.

In addition, as we know from IS-LM model that lies behind the AD curve, the
monetary expansion will reduce the equilibrium interest rate. And the magnitude
of the output expansion above will be given by monetary policy multiplier.
 Natural Rate of Unemployment
▪ When we say there is full employment in the economy or
economy is working at the full employment level of output
(YF), it simply means, in Eqm, everyone who wants to work is
working. But that does not mean there is no unemployment
in the economy.
▪ There is always some unemployment in the economy that
arises because of labor market frictions and it exists even
when labour market is in Eqm (or even when economy is at
full employment). This unemployment is called ‘natural rate
of unemployment’.
▪ Example of labor market frictions: At any given point in time,
there are always some people moving and changing jobs,
other people are looking for the jobs for the first time, some
firms are expanding and are hiring new workers, some firms
have lost their businesses and are firing workers etc.
 Natural Rate of Unemployment
▪ This means there will always be some unemployment in the
economy because of these labor market frictions and it will
exist even when economy is operating at the full employment
or even when labor market is in Eqm. As explained earlier,
this type of unemployment is knowns as ‘natural rate of
unemployment’.
▪ So when we say that there is full employment in the economy
or economy is working at full employment level of output, we
actually mean that economy is working at natural rate of
unemployment.
▪ There are two types of natural rate of unemployment:
1) Frictional unemployment: It arises as a result of individuals
shifting between jobs or looking for new jobs.
2) Structural Unemployment: It arises as a result of the……….
 Natural Rate of Unemployment
………mismatch between skill which is demanded and the skill
which is supplied. It typically arises due to the technological
change.
▪ This means natural rate of unemployment = frictional
unemployment + structural unemployment
▪ There is one more kind of unemployment, known as Cyclical
Unemployment: When unemployment rate in the economy
is greater than natural rate of unemployment. It arise
because of business cycle/demand shock/supply shock.
▪ Note: It is the cyclical unemployment which the policymakers
should be concerned of. If the cyclical unemployment is very
high, that means lots of people are out of job and the
economy is in deep trouble.
 Modern Quantity Theory of Money:
Monetarism
▪ Monetarism is a set of economic ideas which emphasize on
the role of money and monetary policy in affecting the
economy’s output and price level. And the economists
believing in these ideas are known as Monetarists.
▪ A major thinker of this approach was Milton Friedman.
▪ The monetarists redefined the classical Quantity theory of
money (QTM) into modern quantity theory of money and
claimed that monetary policy is the most effective policy in
the short run (even stronger than fiscal policy).
▪ Two points to note with regard to Monetarism:
1) Monetarists agree with classical economists into believing
that money supply is the most important factor producing
inflation in the economy.
 Modern Quantity Theory of Money:
Monetarism
2) However, Monetarists disagree with Classical economists
when the later claim that money is neutral both in the short run
and long run.
As per monetarists, money is not neutral in the short run. This
means in the short run, the change in money supply/monetary
policy does have real effects i.e. it will change the real output.
In contrast, for the long run, monetarists agree with classical
economists and argue that money is more or less neutral in the
long run i.e. in the long run, change in money supply/monetary
policy will have no real effects on the economy; it will affect only
the price level and thereby only the nominal variables.