Any changes in national income will cause movements either upward or downward the LM curve to a new interest rate. we can see (from Using figure- 2) that a rise in national income from Y1 to Y2 leads to a rise in the rate of interest from r1 to r2 where higher national income rates are associated with higher rates of interest and vice-versa. Therefore higher national income will lead to greater demand for money and hence higher interest rates if equilibrium is to be maintained in the money market. This will result in the LM curve sloping upwards. Likewise there is an opposite effect if there is a fall in national income. Thus predictions can be made using this information.
The Keynesian analysis makes the following assumptions for the LM and IS curves.
Keynesian stresses that changes in money supply affect aggregate demand indirectly via changes in interest/exchange rates (transmission mechanisms are indirect, refer to figure-3 below)
Aggregate demand is affected by the changes in money supply in three stages, refer to figure-3
Stage 1; a rise in money supply (Q1 to Q2) from M to M1, leads to a fall in interest rates from r1 to r2.
Stage 2; fall in interest rates from r1 to r2 leads to a rise in expenditure/ investments from I1 to I2.
Stage 3; an increase in investments (from J1 to J2) leads to a multiplied increase in the national income (from Y1 to Y2).
This assumption is based on the money supply curve being upward sloping.
With regards to the IS-LM model, the assumption made by the Keynesians is that The Lm curve is fairly flat, since the liquidity curve (L) is also relatively flat and downward sloping which is due to speculative demand for money; Thus a rise in the money supply will lead to a fall in interest rates consequently increasing investment and finally leading to a multiplied rise income (refer to stage 1 & figure-3(a)).
However the Keynesians also assume that the IS curve is relativity steep, as the investment demand curve is inelastic (I curve is relatively steep), since changes in the rate of interest do not ‘proportionality more’ affect the demand for investments, where the demand for investment is unresponsive to changes in the rate of interest. Likewise this also the similar case for the savings curve where savings are also relatively unresponsive to changes in interest rates. This assumption is derived from figure-3(b), stage2.
On the other had The Monetarist say that, the IS curve is fairly flat, because the investment curve is fairly shallow, since investments/expenditure is interest-sensitive, where by small changes in interest rates mean larger changes in expenditure/ investments. Thus the investment demand curve is elastic, responsive to changes in the rate of interest (refer to figure-4(a), stage- 1).
The monetarists also assume that the LM curve is relativity steep; as the demand for money curve is interest inelastic, whereby changes in the demand for money is insensitive to changes in the rate of interest rates. (Refer to figure-4(b), stage2)
These assumptions raised by the monetarists and Keynesians analysis have a different approach to that of the new classical models assumptions which are; the rational expectation hypothesis and market clearing prices.
The rational expectation hypothesis (REH) is basically where ‘people’ use their reason to assess the future on the basis of past/current information where economic agents use rational expectation to predict future levels of inflation.
These predictions are based on the current information using these resources people/economic agents predict what the rate of inflation will be. But the argument for this assumption is that, predictions made by people/economic agents maybe imprecise as the information used may be inaccurate. However the argument against this is that as theses errors in prediction are random, people’s predictions of Inflation are just as likely to be right or wrong where theses economic agents do not repeatedly under or over predict inflation as they learn from their experiences.
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.
In the other hand the monetary policy operates directly in the money market, it is where the government alters the supply of money in the economy or controls interest rates.
Using the ISLM analysis and Assuming that the economy is in recession where government wishes to increase national income in attempt to encourage spending. Figure-5 illustrates the policy alternatives.
The fiscal policies attempts to increase national income have lead to some crowding occurring (as shown in figure-5 (a)). Figure-5(a) shows the effect of an increase in government expenditure and reduction in taxes. Where this shifts the IS curve to the right from IS1 to IS2, this shift increases income from Y1 to Y2 but also increases the rate of interest form r1 to r2. As this policy operates without making changes to the money supply in this case it therefore cannot prevent crowding (as it operates in the goods market).
However in other the hand, the monetary policy shows the effect of an increase in money supply from LM1 to LM2, this shifts the LM curve downwards. Hence interest rates fall to r3, encouraging a rise investment, resulting in this increase in national income from Y1 to Y3 thus minimising crowding.
This ineffectiveness of the fiscal policy is isolated to that of the LM curve being steep and the IS being shallow, where it is most effective when the IS curve is steep and LM curve is shallow where crowding is minimised. Subsequently the monetary policies attempt to increase national income is most effective when the fiscal policy is most ineffective (opposites of fiscal polices LM and IS slopes).
It is argued by either polices that one another’s is ineffective, where the true fact is that both polices are most effective when applied simultaneously, as illustrated in figure -5 (c).
Monetary anticipated/un-anticipated policies directly operates in the new classical model, where anticipated monetary policy is when monetary expansion is announced where the economic agents know the prices will rise e.g. as a result from increase consumer spending as interest rates are low, increase money supply, increased government expenditures and low taxes etc, hence wages and prices will be adjusted upwards to compensate for inflation. However if this monetary expansion is not announced this is known as the un-anticipated monetary policy, where economic agents will not know whether prices have increased or the actions taken by the government. Hence ‘fooling’ the agents/people so that the government can achieve its goal. But this is usually short lived,
“It will be difficult for the government to fool people that inflation will not happen, if employers, unions, city financiers, economic advisers, journalists all expect it to happen, it will happen in the short-run. Why should firms produce more in response to demand if costs are rising just as much ……” (Friedman Milton, ‘John Sloman, economics forth edition’.
It is clear from these assumptions that the new classical model and the LM curve both use the same policy (monetary) to some extent; however t, the new classical model tends to has more flexibility in making its predictions/assumptions and resolving inflation for example as its policy, anticipated monetary merely provided information and dose not limit the model, but this is only if there is anticipated monetary, where unanticipated monetary, may mean inaccurate predictions etc being made as current information is not known. However this flexibility is isolated to that of the new classical model, as the elements in the IS-LM models e.g. for LM model money supply, demand for money, limit there predictions, methods in resolving economic problems etc as the elements are interdependent.
The centre of the Keynesian/monetarists/new classical debate, concerns the aggregate supply curve.
Referring to figure6 (a), It is argued by Extreme Keynesians that (at least in the short run) up to full employment (y1) the aggregate supply curve (AS) is horizontal, where a rise in aggregate demand from AD1 to AD2 will raise output from Y1 to Y2, where prices will not be effected until full employment is reached.
Aggregate supply up to the full employment level is determined entirely by the level of aggregate demand in this model. Nevertheless there is no guarantee that that aggregate demand will intersect aggregate supply at full employment. This is why the Keynesians argue that governments should use appropriate fiscal and monetary policies to manage aggregate demand in order to ensure production is reached at Y1 (refer to figure -6 (a)).
On the other hand Referring to figure6 (b) the monetarist argue that the aggregate supply curve is vertical, at least in the long-run, where its also argued by new classicists that the aggregate supply curve is also vertical in the short-run. Where output and employment (Y) will not be affected in consequence to any rise in aggregate demand where i.e. from AD1 to AD2, this will only lead to an increase in price from P1 to P2.
Thus this is why it is crucial to control demand as this affects prices, whereby by controlling demand, prices will also be able to be controlled. Hence Supply-side policies will be required to shift the AS curve to right thus increasing the output and employment.
It is clear that the new classical model is significantly different to that of the IS-LM model, where the classical model takes a more ‘rational expectation’ approach where current information’s on the economy, government etc and peoples experiences are used to make these rational predictions for inflation, however in the other hand the LM-IS model uses particular elements (in the goods market, elements include interest rates, income, investments and savings) interdependently to make predicts, i.e. an increase in injections will mean an increase in income, in the case of the goods market.
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.
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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.
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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.
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Gillian Butler and Freda McManus, Economic policies 2nd edition, Oxford University Press, 2000
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http://www.economist.com- IS-LM models, curves, shifts
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Fiscal and monetary policy
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– New classical model, policies
- R.T. Froyen, Macroeconomics, Theories and Polices, Prentice
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John Sloman, Economics, 4th edition, Financial Times Prentice hall, 2000.
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Nicky Stanton, Economics, 3rd edition, Palgrave masters series, 2000. , page 445, aggregate supply and demand.
