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Compare and contrast, the assumptions, the predictions and the policy implications of the IS/LM model with those of the New Classical model

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Introduction

There is no universal agreement among economists as to how the economy functions at a macroeconomic level. In stead there are various schools of thought. Theses schools of thought see very different roles for the government in managing various macroeconomic objectives. There are various models and theories which try to elucidate the economy/markets. There are two key markets in which both fiscal and monetary policy operate. The first is the goods market and the; the second is the money market. Each of theses markets can be analysed using the IS-LM model. The goods market, uses the Keynesian injections (investments) /withdrawals (savings) model (IS model). Fiscal policy operates directly in this market. In the case of the money market, the model is the one showing the demand for money (L) and the supply of money (M) and their effects on the rate of interest. Monetary policy operates directly in this market, either by affecting the supply of money or by operating on interest rates. The Investments and savings (IS) curve is based on Keynesian theory of withdrawals and injections. The IS curve is derived from this theory. Figure -1 examines how the IS curve is derived. Figure-1 has two parts. The top part shows the Keynesian injections and withdrawals diagram where we are assuming that savings is the only withdrawals from the circular flow of income, and investments are the only injection. Where the bottom part of the diagram shows the IS curve. This shows all the various combinations of interest rates (r) and national income (Y) ...read more.

Middle

As you can see this (REH) assumption is significantly different to that from either the Keynesian or monetarist assumptions, where it uses the means of conjecture derived from past/current information's and experience to rationally predict or forecast inflation, where the Keynesian and monetarist use a approach more derived from the aspects mentioned in their policies that are interdependent where a fall/rise in one aspect will have a consequence on the other etc i.e. For the goods market a fall in interest rates results in a rise in expenditure. The marketing clearing assumption, assumes that the goods market (prices), money Market (interest rates) and the labour market (wages) are all flexible. These flexible prices allow inflation to be controlled, ensuring that natural rates (equilibriums) are established in these markets. Equilibrium is achieved in these markets by controlling/balancing the elements, such as, prices, interest rate and wages. This policy in contrast to the LM and IS policies assume that there is flexibility in the markets, where the fiscal and monetary polices for the IS and LM models assume that that each element in there market (i.e. investments/expenditure in the money market) are interdependent upon each other where their flexibility is limited to one another i.e. investments/ expenditure is interest-sensitive, where by small changes in interest rates mean larger changes in expenditure/ investments. Fiscal policy operates directly in goods market; it is where the government alters the balance between their expenditure and taxation, altering the balance between withdrawal and injections. This allows the government to control aggregate demand. ...read more.

Conclusion

The Keynesians argue that the fiscal policy is the superior than the monetary policy where the new classicists argue the opposite, where in true fact an integration of the policies is altogether better refer to figure-5. It is also argued by Extreme Keynesian that the aggregate supply curve is horizontal up to full employment in the short-run, where a rise in aggregate demand will raise output, without effecting price until full employment is reached. However the new classicists argue against this debating that the aggregate supply curve is vertical in the long run, where output and employment will not be affected from changes in aggregate demand where the only effected element is prices. It is obverse at this point that the Keynesians and new classicists are from opposite's end of the spectrum opposing each other. * John Sloman, Economics, 4th edition, Financial Times Prentice Hall, 2000. Chapter 20.3, page 580-586, IS/LM curves, shifts. Chapter 17, page 497, Fiscal policy. Chapter 19, page 555, Monetary policy. * J. Bradford Delong, Macroeconomics, McGraw Hill. * W.Samuelson & S Marks, Economics, 4th edition, Dryden Press, 2003 Section 11.1, page 271, the new classical model. * Dave hall, Business Studies, 2000, Cpl" Section 8, Page 198, LM and IS models. * Gillian Butler and Freda McManus, Economic policies 2nd edition, Oxford University Press, 2000 * http://www.economist.com- IS-LM models, curves, shifts * http://www.Econmic policies.com- Fiscal and monetary policy * http://www.BSstudies.co.uk - Economic index * http://www.Google.com - New classical model, policies * R.T. Froyen, Macroeconomics, Theories and Polices, Prentice * John Sloman, Economics, 4th edition, Financial Times Prentice hall, 2000. * Nicky Stanton, Economics, 3rd edition, Palgrave masters series, 2000. , page 445, aggregate supply and demand. ?? ?? ?? ?? - 1 - ...read more.

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