Factors Influencing Income Balance and Interest Rates
Factors Influencing Income Balance and Interest Rates
An increase in the amount of money shifts the LM curve to the right; hence, the interest rate falls and income rises.
The increase in the stock of money creates an excess supply of money, which decreases the rate of interest. As the interest rate falls, investment demand increases, leading to an increase in revenue, with a further increase in consumption demand induced by income.
A decline in the stock of money makes the LM curve move to the left, causing the equilibrium income level to decrease and the equilibrium interest rate to increase.
Another factor that shifts the LM curve is a shift in the demand function of money.
Posting of the Curve:
The fiscal policy variables are a set of factors that shift the IS curve and thus affect the equilibrium income and interest rates.
The force that drives income growth is the increase in aggregate demand in two ways: directly, with increasing government demand, and indirectly as a result of an income-induced increase in consumer spending. The increase in income due to the change in fiscal policy creates adjustments in interest rates as income increases the demand for money for transactions.
The magnitude of the curve is the increase in public spending by the autonomous expenditure multiplier from the simple Keynesian model; this horizontal displacement is equal to the amount that would have increased income in this simple model.
The difference between the model and the simple Keynesian IS-LM model is that the latter includes the money market.
An increase in tax collection displaces the curve to the left, which decreases income as the tax increase reduces disposable income and causes a decrease in consumption.
In the IS-LM multipliers of fiscal policy, the effects are reduced in relation to our results for the simple Keynesian model. The simple Keynesian model assumes that investment is constant and overestimates the impact of increased taxes.
A decrease in taxes produces opposite effects; the curve shifts to the right, and both income and interest rates increase.
In short, as in the simple Keynesian model, changes to government spending have a greater effect on changes in income taxes. Therefore, a change in the magnitude of the budget, while keeping the deficit, causes income to vary in the same direction as the change in the size of the budget.
The fiscal policy variables are not the only factors that can shift the IS curve; any change in autonomous aggregate demand production will have the same effect.
On Effectiveness of Monetary and Fiscal Policy
Effectiveness is about the size of the effect on income produced by a given change in an economic policy variable.
Effectiveness of economic policies and the slope of the IS curve: The crucial parameter that determines the slope of the curve is the elasticity of investment with respect to interest. If investment demand is highly elastic to interest, a given increase in interest rates reduces investment by a larger amount, making the IS curve relatively flat. However, as the elasticity of investment demand with respect to interest decreases, the IS curve becomes steep.
To see if fiscal policy measures are effective, we compare the effect of economic policy measures on income with the effect predicted by the simple Keynesian model. Considering the IS-LM model, we add the money market to the Keynesian system. When comparing the effect of fiscal policy in the IS-LM model with the simple Keynesian system, we find that fiscal policy variables are important determinants of income.
To evaluate the effectiveness of monetary policy, we compare the income effect of a change in the stock of money with the magnitude of the horizontal displacement of the LM curve.
In the IS-LM model, monetary policy affects income by lowering interest rates and stimulating investment demand. If the demand for investment is unaffected by changes in interest rates, monetary policy will be ineffective. Our first result shows that monetary policy is ineffective when the curve is steep, i.e., when investment is inelastic to interest. Conversely, monetary policy is most effective when the elasticity of investment to interest is greater, i.e., when the curve is flatter.
The less sensitive investment is to interest rates, the greater the effect of a particular measure of fiscal policy.
How Important is the Effect on Investment Shift? One factor that determines the importance of private investment is the slope of the curve. If investment is not very sensitive to changes in interest rates, then an increase in the interest rate produces only a slight decrease in investment, and income increases by an amount almost equal to the total horizontal displacement of the IS curve. Alternatively, if investment is highly sensitive to interest rates, increased interest rates substantially reduce investment, leading to a significant decrease in income compared to the simple Keynesian model prediction.
In the case of a vertical IS curve, investment is completely interest-sensitive. Increased public spending raises the interest rate, but this does not cause a decrease in investment.
Effectiveness of Economic Policy and the Slope of the LM Curve
Fiscal policy is most effective when the elasticity of demand for money with respect to interest is high, which causes the LM curve to be relatively flat. The reason for this result relates to the effect of the interest rate on investment produced by the change in fiscal policy. Increased government spending raises income; as income increases, the demand for money for transactions also increases. To rebalance the money market, where the stock of money has not changed, an increase in the interest rate is required.
When money demand is relatively inelastic to interest, a further increase in the rate of interest is required to rebalance the money market as incomes rise.
If money demand is completely insensitive to changes in interest rates, only one level of income can be balanced—the level that generates a demand for transactions exactly equal to the constant stock of money.
Monetary policy is most effective where the LM curve is relatively flat (the elasticity of demand for money with respect to interest is high). The effect of an increase in the stock of money on income is greater where the elasticity of demand for money with respect to interest is lower, and where the elasticity of demand for money with respect to interest is zero, resulting in a vertical LM curve.
When the elasticity of money demand with respect to interest is lower, a greater decrease in the rate of interest is required to rebalance the money market after an increase in the money stock.
In summary, the effect on the level of income from a specified increase in the stock of money is greater the lower the elasticity of money demand with respect to interest.
The effectiveness of monetary policy increases when the elasticity of money demand with respect to interest decreases. Income is affected by an effect on the rate of interest; the higher the response rate, the more effective the economic policy.