B.Com.

(H) Semester-II Introductory Macroeconomics

GENERIC ELECTIVE
Introductory Macroeconomics
Unit III & IV
(Lesson 11-15)

SCHOOL OF OPEN LEARNING

University of Delhi

Department of Economics
Editor : Dr. Janmejoy Khuntia
 Graduate Course
Generic Elective

Introductory Macroeconomics

CONTENTS

Unit III
Lesson 11 : Inflation

Unit IV
Lesson 12 : Classical Macroeconomics: Equilibrium Output and Employment
Lesson 13 : Keynesian Macroeconomics: Equilibrium Determination and Multiplier
Lesson 14 : IS-LM Determination
Lesson15 : Fiscal and Monetary Multiplier

Editor :
Dr. Janmejoy Khuntia

SCHOOL OF OPEN LEARNING

University of Delhi
5, Cavalry Lane, Delhi-110007
 LESSON 11

INFLATION

11.1 INTRODUCTION

A situation that affects all the economies of the world is the changes in the price level
which can be either increase or decrease in prices. The former one where there is
persistent and considerable increase in the prices is known as inflation. It affects the
standard of living of the people of an economy as it reduces there real income or the
purchasing power. Some percentage of inflation is bound to exist in an economy that is
expanding or growing. Its opposite is known as Deflation which means a reduction in the
price level in an economy. One should not be confused between deflation and
Disinflation as the latter one means there is inflation in the economy but its rate has
reduced. Various economists have tried to analyse the relation between inflation and
interest rates and one equation which is of utmost importance is given by Fisher that
would be taken up in the chapter. Another feature that is common in all the economies of
the world is the problem of unemployment. It refers to a situation where people who are
able and willing to work are unable to find a job at the prevailing wage rates. Again,
some percentage of unemployment is bound to be present in all the economies because of
people changing jobs and other reasons. But still if unemployment is huge and chronic it
is devastating for any economy. So, the various types and causes of unemployment too
would be taken up in this chapter.

11.2 INFLATION AND INTEREST RATES- FISHER EQUATION

Fisher effect is a theory propounded by economist Irvin Fisher that explains the relation
between inflation and interest rates - both real and nominal. Nominal interest rate is the
rate that prevails in the market whereas real interest rate shows change in the purchasing
power. Fisher provided that expected real interest rate can be calculated by deducting the
expected rate of inflation from the expected nominal rate of interest. For example, if the
nominal interest rate on a savings account is 6% and the expected rate of inflation is 3%,
then the money in the savings account is really growing at 3%. The smaller the real
interest rate the longer it will take for savings deposits to grow substantially when
observed from a purchasing power perspective. It can be presented in the following
equation:
re = i –  e
Where re = Expected Real interest rate
i = Nominal rate of interest and
e = Expected rate of inflation

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This equation holds in the short run as the changes in nominal rate of interest takes place
because of changes in real interest rate and expected inflation. In the long run however if
the real interest rate is assumed to be constant and expected inflation is equal to actual
inflation because the economy is operating at full employment level of output the above
equation changes as:
r* = i – 
Where r* = given real interest rate
i = Nominal rate of interest and
 = Actual rate of inflation
Thus, in the long run the changes in inflation are shown in the nominal rate of interest. It
is called Fisher's Effect. The Fisher effect is more than just an equation: It shows how the
money supply affects nominal interest rate and inflation rate.

11.3 INFLATION AND TYPES OF INFLATION

Inflation refers to persistent and considerable increase in the prices in an economy such
that the real income of the people of that economy reduces. However if there is an
increase in price which is either not significant or not continuous then it cannot be termed
as inflation. Inflation can be of various degrees depending upon its intensity like.
1. Creeping, Mild or Low Inflation: It is the mildest form of inflation where rate of
increase in prices is very low that is not more than 3% per annum then it is called
creeping inflation.
2. Chronic or Secular Inflation: When creeping inflation continues for a long
period of time it takes the form of chronic inflation. It is named chronic because if
an inflation rate continues to grow for a longer period without any downturn, then
it possibly leads to Hyperinflation.
3. Walking or Trotting Inflation: When the rate of increase in prices is more than
3% per annum but less than 10% per annum it is termed as walking inflation. It
should be corrected in time as otherwise it may lead to serious consequences.
4. Moderate Inflation: Prof. Samuelson clubbed together concept of Creeping and
Walking inflation into Moderate Inflation. It happens when prices rise by less than
10% per annum (single digit inflation rate). According to him, it is a stable
inflation and not a serious economic problem.
5. Running Inflation: When prices rise at a fast rate that is more than 10% per
annum it is termed as running inflation as rate of increase in prices is in double
digits which is not good for the economy.
6. Galloping or Jumping Inflation: According to Prof. Samuelson, if prices rise by
dual or triple digit inflation rates like 30% or 400% or 999% yearly, then the

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 situation can be termed as Galloping Inflation. When prices rise by more than
20%, but less than 1000% per annum (i.e. between 20% to 1000% per annum),
Galloping Inflation occurs. Jumping Inflation is it’s another name.
7. Hyperinflation: When rate of increase in prices takes an alarming situation it is
termed as hyperinflation and it is beyond the corrective action of any government.
When prices rise above 1000% per annum (quadruple or four-digit inflation rate),
it is termed as Hyperinflation. During a worst-case scenario of hyperinflation, the
value of the national currency (money) of an affected country reduces almost to
zero. Paper money becomes worthless, and people start trading either in gold and
silver or sometimes even use the old barter system of commerce. Two worst
examples of hyperinflation recorded in the world history are of those experienced
by Hungary in the year 1946 and Zimbabwe during 2004-2009 under Robert
Mugabe's regime.
Inflation which is a general and persistent rise in the prices over a considerable period
of time can be divided into perfectly anticipated inflation and imperfectly anticipated
inflation. The types of inflation based on the expectation or predictability:
Anticipated Inflation: If the rate of inflation corresponds to what the majority of
people are either expecting or predicting, then is called Anticipated Inflation.
Expected Inflation is it's another name.
Unanticipated Inflation: If the rate of inflation corresponds to what the majority of
people are neither anticipating nor predicting, then is called Unanticipated Inflation.
Unexpected Inflation is it's another name.
11.4 SOCIAL COST OF INFLATION

11.4.1 Costs of Perfectly Anticipated Inflation

1. Shoe leather Cost: A high anticipated inflation means a higher nominal rate of
interest as shown by the above Fisher equation which means people hold less
money with them as the opportunity cost of holding money is quite high thus
making frequent visits to the banks. This inconvenience of reducing money
holding is called the shoe-leather cost of inflation. This cost of wearing out of
one's shoes while making frequent trips to banks because of reduced money
holding is called the shoe leather cost of inflation.
2. Menu costs: When inflation is high then it increases the cost of production of the
firms which forces the firms to change their prices often which is costly as it
involves printing of new catalogues, packaging that has prices printed on them.
This increased cost of frequent printing of menus is known as menu cost that
arises because of high anticipated inflation.
3. Microeconomic Inefficiencies: As the firms' menu changes frequently because of
changes in the prices the variability in relative prices is quite high and it bring

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 difficulty in market allocations as it is based on relative prices thus bringing
inefficiency in the resource allocations.
4. Tax Issues: Inflation affects the tax liability of individuals and companies that are
not taken care of in the tax rules. As inflation changes the nominal income there is
change in the tax liability irrespective of the fact whether real income has changed
or not. Thus it again brings inefficiency if it is not taken care of in the tax rules.
5. Inconvenience: Money is common measure of value, it is the yardstick to
measure economic transactions but when the worth of the yardstick itself is
changing it brings distortions in measuring the economic worth or value of
different transactions
6. Reduced Purchasing Power: If nominal income changes at the same rate as that
of the inflation then there is no change in the real income as shown by Fisher
equation in the long run, however if inflation and nominal income do not keep
pace then there might be a reduction in the purchasing power.
7. Fiscal Drag: With rising income because of inflation more people fall in the
higher tax brackets, thus the amount of tax per person increases and they are
dragged into tax payments because of higher inflation.
If inflation is unanticipated (e.g. people expect a lower inflation rate) then the costs will
be more serious than if the inflation rate was expected. It is unanticipated inflation that
can negatively impact on a firm's costs.
11.4.2 Costs of Unanticipated Inflation
Unanticipated inflation has effects that are far worse then the inflation which was
correctly anticipated in advance. Unanticipated inflation arbitrarily redistributes income
and wealth among individuals. This brings losses to one and gains to other and it is
something which was not expected in advance, it can be understood with a simple loan
example where the interest rates were fixed in advance which was based on an anticipated
inflation rate. The ex post real return that the debtor pays to the creditor differs from what
both parties anticipated. Now here if inflation is higher than what was anticipated the
debtor is at a gain as he pays a lesser sum in terms of real balances as interest rate was
fixed based on a lower anticipated inflation rate and creditor loses as he gets less. The
opposite would be true if the actual inflation is les than the anticipated inflation. Thus it
brings wealth distribution distortions.
Unanticipated Cost / unexpected cost of Inflation
1) Arbitrary Redistributions of wealth
Unanticipated changes in Prices (or change in Price level) redistribute wealth
among debtors & creditors. At the time of inflation, a debtor gets benefits due to fall in
real value of debts creditor bear loss. When inflation is very difficult to predict, it will
create risk for both debtors’ creditors.

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2) Unanticipated Inflation is uncertain and volatile in nature – inflation is volatile in
nature because in same countries inflation is low in average & in others such as Germany
in late 20th century.
Inflation is high in average such as in Latin America. The relationship between the level
of inflation (high or low) and volatility of inflation is another cost of inflation.
If a country makes monetary policy at the time of high Inflation, it will have to bear not
only the cost of anticipated Inflation but also the cost of unanticipated inflation like
arbitrary distribution of wealth.
Unanticipated Inflation hurts individuals on fixed Pension
Pension received by the worker or employees after retirement (or even earlier) by firms or
any other govt. institutions. Pension is deferred earnings because in young age worker
provide labour services to the firm but does not get fully paid until old age. In case of
creditor, the worker is hurt when inflation is higher than anticipated. In case of debtor, the
firm is hurt when inflation is lower than anticipated.

11.5 HYPERINFLATION

Hyper inflation begins when government finance large budget deficits by Printing money.
It may end when fiscal reforms eliminate the need for seigniorage.
Hyperinflation is generally defined when inflation or price level exceeds 50% per month.
During 1920s hyperinflation occurred in Austria, Hungary, Germany & Poland.
It occurs due to following reasons: -
i) High spending (expenditure) of Govt.
ii) Inadequate collection of Tax & Non-tax Receipts
iii) Limited ability to borrow
iv) Printing more paper currency or massive increase in the quantity of money.
Example of Hyper Inflation

Hyper Inflation in Zimbabwe Venezuela recently

During in 2000 occur due to large Govt. One kg. tomato price was 50 lakhs in
budget deficits leads to large supply of Venezuela Mono Product economy
money and fall in value of money. (petroleum / based export)

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11.6 SEIGNIORAGE

Govt. can finance its expenditures by following ways:-

1. through taxation
2. “Borrowing from the Public or selling govt. bonds.
3. By Printing money or more currency
The revenue raised by printing more currency is called “seigniorage”. This term comes
from ‘seigneur’ the French word for feudal lord. Historically a feudal lord had the
exclusive right to issue money but at Present this right (note or currency issuing
authority) belongs to RBI in India.
Inflation Tax when govt. Prints money to finance its expenditures then Money Supply
increases which increase money inflation. Printing money to raise revenue is just like
inflation Tax. Inflation is like a tax on holding money which reduces real balances of the
individual.

11.7 INFLATION IS BAD BUT DEFLATION IS WORST

Inflation is bad but deflation is a situation when Price rises continuously or persistently. It
reduces the value of money purchasing power of the consumers. On the other land
deflation is a situation when Prices falls continuously. It increases the value of money &
Purchasing Power but at the time of deflation, Producers profits will start to fall. They
will have no incentive to produce goods & services so that output will fall, employment
will fall & income will also fall. Deflation reduces the growth of the economy but
inflation encourages all economic activities like production, employment, income etc.
that’s why inflation is much better than deflation because inflation continues the path of
economic growth & development which is hampered by deflation. But hyper inflation is
bad for the economy.

QUESTIONS FOR REVIEW

1. Define Inflation & what are its various types?

2. Explain the Social Cost of Inflation?
3. Is Inflation good or bad? Give reason for your Answer.
4. What is Hyperinflation & what are the causes of it?

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 LESSON 12
CLASSICAL MACROECONOMICS: EQUILIBRIUM OUTPUT AND
EMPLOYMENT

12.1 INTRODUCTION - THE STARTING POINT

The term Macroeconomics originated in the 1930s. That decade witnessed
substantial progress in the study of aggregative economic questions. After a long period
in which Microeconomic questions dominated the field of economics, the forces that
determine income, employment and prices had been receiving greater attention since the
turn of the century. The products of this research were theories of the “business cycles”
and accompanying policy prescriptions for stabilizing economic activity. The book
containing this theory was “The General Theory of Employment, Interest and Money” by
“JOHN MAYNARD KEYNES” in 1936, and the process of change in economic thinking
that resulted from this work has been called the “Keynesian Revolution”. But revolution
against what? What was the old orthodoxy? Keynes termed it “CLASSICAL
ECONOMICS”, as it was before Keynes General Theory.
The pre Keynesian era (period before 1936) refers to the period of economic
thoughts of classical; Keynes used the term classical to refer to virtually all economists
who had written on macroeconomic questions before 1936. More conventional modern
terminology distinguishes between two periods in the development of economic theory
before 1930.
The term ‘Classical’ has been used in economic literature to refer to different
group of economists dominated by the work of Adam Smith (Wealth of Nations, 1776),
David Ricardo (Principles of political economy, 1st ed., 1817), and John Stuart Mill
(Principles of Political Economy, 1st ed., 1848). The second, termed the Neo-Classical
period, had as its most prominent English representatives Alfred Marshall (Principles of
Economics, 8th ed., 1920) and A.C Pigou (The Theory of Unemployment, 1933). The
theoretical advances distinguishing the classical and neo-classical periods were related
primarily to microeconomic theory. Keynes felt that the macroeconomic theory of the
two periods was homogeneous enough to be dealt with as a whole. The classical had not
produced any unified macroeconomic theory though some macroeconomic thoughts
could be traced into their writings. Their macroeconomic thoughts were in the form of
certain Postulates.
12.2 THE CLASSICAL REVOLUTION
Classical economics emerged as a revolution against an earlier orthodoxy. Classical
economists attached a body of economic doctrines known as ‘Mercantilism’. According
to the Mercantilist’s belief, the wealth and power of a nation were determined by its stock

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of precious metals. They believed in the need for state action to direct the development of
the capitalist system. Adherence to this view, under state action countries attempted to
secure an excess of exports over imports in order to earn gold and silver through foreign
trade.
12.2.1 The Classical View
The classical economists, in contrast to the mercantilists, emphasized the importance of
real factors as opposed to monetary factors in determining the “Wealth of Nations” (i.e.
variables such as output and employment). Money does not play any significant role in
determining real variables output and employment. Money played a role only in
facilitating transactions as a means of exchange. The classical economists held the view
that an economy should based on "Laissez faire principles". In other words, they stressed
the optimizing tendencies of the free market in the absence of state-control. According to
them, the harmony of an individual and national interest can be had only when the market
was free from government rules and regulations. Thus, two features of the classical
analysis, then, arose as part of the attack on mercantilism:
1. Money has no intrinsic value- Money was held only for the sake of the goods that it
could purchase. It was treated only as a medium of exchange.
2. Classical economist stressed the self-adjusting tendencies of the economy- In
other words, they believed in the efficacy of the free market mechanism.
12.2.2 Importance of the Classical Theory
The theory of employment and income determination which today constitutes the core of
modern macroeconomics was first developed by John Maynard Keynes in the ‘General
Theory of Employment, Interest and Money’ in 1936. But, to understand that, a pre-
requisite is the knowledge of the classical system that Keynes attacked.
Classical theory plays a more positive role in the later development of
macroeconomics. The classical model also provides the starting point for later challenges
that have been mounted against the Keynesian theory by monetarists, new classical
economists, and real business cycle theorists.

12.3 CLASSICAL THEORY OF INCOME, OUTPUT AND EMPLOYMENT

The equilibrium levels of output and employment are determined in the classical system
with:
(1) economy's production system from which demand curve for labour is derived.
(2) the supply curve of labour.
According to classical theory, equilibrium of labour market determines the level
of employment and equilibrium level of employment in turn, determines National output.

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The classical model presented below displays the determination of the real output and
employment required to produce equilibrium level of national output.
12.3.1 Assumptions
The classical economists held the view that:
1. A capitalist economy due to its built-in system operates at full-employment
i.e. absence of involuntary unemployment.
2. Absence of Government control and monopolies restrictive trade policies.
3. Money is used only as a medium of exchange.
4. “Say’s law” is regarded as the core of classical theory which states – “supply
creates its own demand”.
5. The entire system works automatically and free play of demand and supply,
forces the economy in equilibrium whenever there is a deviation from the
equilibrium.
6. There is neither over production nor under-production. In other words, all the
resources are utilized to their fullest possible extent.

12.3.2 Production
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.
The Factors of Production
These are the inputs used to produce goods and services. The two most important factors
of production are capital and labour.
(a) Capital is the set of tools that workers use e.g. accountant's calculator,
businessman's computer used in office etc. We use symbol 'K' to denote the amount
of capital.
(b) Labour is working the time people spend. It is calculated in terms of number of
working hours. We use the symbol 'L' to denote the amount of labour. It is assumed
that both factors of production are fully utilized in the Production Function
A central relationship in the classical model is the aggregate production function.
The available technology determines how much output is produced from given amounts
of capital and labour. Therefore,
The production function can be expressed as:
The production function, which is based on the technology of an individual firm, is a
relationship between the level of output and the level of factor inputs
Y = f(K, L) ....... Aggregate Production Function

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where,
Y = real output
K = constant stock of capital
L = the quantity of the homogeneous labour input
This equation states that output is a function of the fixed amount of capital and the
amount of labour. For the short run, the stock of capital is assumed to be fixed, as
indicated by the bar over the symbol for capital. The state of technology and the
production are also assumed to be constant over the period considered. For this short
period, output varies solely with change in labour input (L) drawn from the fixed
population.

12.1 (a)

12.1 (b)

Production Function and MP of Labour Curves

In the short run, the production function shows a technological relationship between the
level of the quantity of the homogeneous labour input (L). 12.1 (a) we plot the output that
will be produced by the efficient utilization of each level of labour input. In fig. 12.1 (a)
(i) At low levels of labour input (before L1), the production function is a straight line,
i.e. having constant slope. This portion of the curve exhibits constant returns to
increases in labour input.

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(ii) To the right of L. (between L1 and L2), as we add more of input, total output
increases but the size of the increments to output declines as more labour is
employed. In other words, beyond L1 till L2, output increases but at a decreasing
rate.
(iii) Beyond L2, the additional units of labour employed produce no increment to
output.
Marginal product of labour
In fig. 12.1 (b), we plot the increment to output per increment to the labour input termed
the marginal product of labour
The marginal product of labour (MPL) is the extra amount of output the firm gets from
one extra unit of labour, holding capital amount fixed.
Using the Production function the MPL can be written as :
MPL = f (K, L+I) – f(K, L)
Y
MPL =
L
Where,
F (K, L+I) = output produced by using K units of capital and L+I units of labour
F (K, L) = output produced by using K units of capital and I units of labour.
The marginal product of labour is the difference between the amount of output produced
by using L+I units of labour and that produced by using L units of labour. In fig. 12.1 (b)
(i) As units of labour increases below L1 the curve is flat, representing the
constant marginal product of labour.
(ii) Beyond L1 till L2, as we add more labour, the marginal product of labour is
positive but decreases and the curve hits the X-axis at L2.
(iii) Beyond L2 extra unit of labour cannot contribute additional output.
Thus, the marginal product of labour is measured by the slope of the production function
and is a downward sloping curve when plotted against employment (12.1 (b), as slope of
the production function (MPL) is positive but decreases as we move along the curve.

12.4 EMPLOYMENT
Classical economists assumed that the market works well. Firms and individuals
workers optimize. They all have perfect information about relevant prices. There are no
barriers to the adjustment of money wages; the market clears.

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 In the classical model, firms are considered to be perfect competitors who choose
their output level so as to maximize profits. As in the short run, output is varied solely by
changing the labour input, so they have to make a decision about quantity of the labour
input which can maximize firm's profits. Classical economists assumed that the quantity
of labour employed would be determined by the forces of demand and supply in the
labour market.
12.4.1 Labour Demand
On the demand side of labour market, purchasers of labour services are firms that
produce commodities. To see how the aggregate demand of labour is determined, we
begin by considering the demand for labour on the part of an individual firm.
The perfectly competitive firm will increase its output until the marginal cost of
producing a unit of output is equal to the marginal revenue received from its sale. i.e.
MC = MR
In other words, in making its decision whether to hire additional labour, a profit
maximizing competitive firm will compare extra revenue from the increased production
that results from added labour to extra cost of hiring that additional unit of labour.
For the perfectly competitive firm, marginal revenue is equal to product price
MR = P
And, the marginal cost of each additional unit of output is the marginal labour
cost, being labour is the only variable factor input, therefore,
Marginal cost = Marginal labour cost
Marginal labour cost equals the money wage divided by the number of unit of
output produced by the additional unit of labour. Thus, marginal cost (MC) of the firm is
equal to the money wage (W) divided by the marginal product of labour for that firm
(MPL).
MC = W/ MPL
The condition for short run profit maximization is:
MR = MC
P = W/MPL
Alternatively,
MPL = W/P ................................. Profit maximizing condition
Where, W/P is the real wage –the payment to labour measured in units of output i.e. in
real terms, rather than in rupees.

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For example, suppose the price P of a bag is Rs. 2 per unit, and a worker earns a wage W
of Rs. O per hour. The real wage W/P is:
W/P = 6/2 =3 bags per hour
In this example, the firm keeps hiring workers as long as each additional worker
would produce at least 3 bags per hour. When the MPL falls below 3 bags per hour,
hiring additional workers is no longer profitable.
Hence, the condition for profit maximisation shows, to maximize profits the firm
will on hiring labour till the marginal product of labour equals the real wages paid by the
firm.
From this profit maximizing condition, the demand for labour schedule for the
firm plotted against the real wages, is the marginal product of labour schedule as shown
in figure.

Fig 12.2 Labour Demand Curve for a Firm

Fig. 12.2 shows how the marginal product of labour depends on the amount of labour
employed (holding the firm's capital stock constant). That is, this figure graphs the MPL
schedule. Because the MPL diminishes as the amount of labour 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, MPL schedule is the firm's labour demand schedule.
As shown in fig. 12.2
The condition for profit maximization is met at the point ‘e’ where the real wage
(W/P) is equated with the marginal product of labour (MPL).
W/P = MP
Therefore, the firm maximizes its profits by employing OL* (500) units of labour
is the real wage is 3.

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 If it employs less than OL* i.e. say OL1 (400) units of labour, the marginal
product of labour (4) exceeds the real wage of 3 i.e.
MPL > W/P
4>3
And, the firm can increase its profits by hiring additional labour.
Alternatively, at a higher labour input than OL * i.e. say OL2 (600) units of labour, the
marginal product of labour (2) falls short of the real wage of 3 i.e.
MPL < W/P
2<3
The payment to labour will exceed the real product of the marginal worker and
marginal cost will exceed product price. Therefore, the firm will reduce the number of
labour inputs employed to increase profits. Thus, the profit maximizing quantity of labour
demanded by a firm at each level of the real wages is given by quantity of labour input
that equates the real wage and marginal product of labour. Hence,
The Marginal product curve (MPL) is the firm's demand curve for labour
This implies that as MPL is downward sloping, so labour demand depends inversely on
the level of real wages, the higher the real wages, lesser is the number of labour input.
The aggregate demand curve for labour is the horizontal summation of the individual
firm's demand curves. For each real wage this curve will give the sum of quantities of
labour input demanded by the firms in the economy.
The Aggregate Demand Function is written as :
Id = f(W/P) ................ Aggregate Labour Demand function
12.4.2 Labour Supply
The next step in determining employment, and hence output in the classical system is the
determination of labour supply. Labour services are supplied by individual workers in the
economy. Classical economists assumed that each individual attempts to maximize their
utility or satisfaction in his life. The level of utility depends positively on “real income"
(which gives command over goods and services), and “leisure” (leisure hours are also a
necessary commodity as they provides satisfaction to the individual).
There is a trade-off between the two goals, income and leisure. Out of 24 hours in
a day, he has to divide his time into working hours and leisure hours. However, income
can be increased only by working and work reduces the available leisure time. So, there is
an inverse relationship between hours worked and leisure hours. The individual, therefore
faces a choice between income and leisure.

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 Labour supply curve is derived from the income-leisure trade-off how individual
allocates one 24 hour period between leisure hours and hour worked. Fig. 12.3(a)
illustrates the choice facing the individual.
(i) On the horizontal axis, we measure total number of hours (maximum of
24) which are available to an individual over a given period of time. These
hours can be either used for work or for leisure. We measure leisure hours
from left to right and work hours per day from right to left.

Fig. 12.3 (a) The Income-leisure Trade-off

Fig. 12.3 (b) Individual Labour Supply Decision

(ii) The vertical axis shows the real income which is equal to the real wages
(W/P) multiplied by the number of hours an individual works.
(iii) The curved lines in the graph, IC1. IC2 IC3 are the indifference curves.
Each indifference curve shows the different combinations of income and
leisure that give the same level of satisfaction to the individual so, he is
indifferent to these combinations on same IC. The higher the indifference
curve and to the right, the more is the level of satisfaction associated with

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 it. For example, all points on IC; represent greater satisfaction than any
point on IC2. An individual tries 10 achieve the highest possible
indifference curve in order to maximize his satisfaction.
The slope of the indifference curve is called Marginal rate of Substitution as it
measures the substitution ratio between the two goods. Here, the slope of the indifference
curve represents the rate at which the individual is willing to trade-off leisure for income,
that is, the increase in income the person would have to receive to be just as well off after
giving up a unit of leisure.
The indifference curve becomes steeper as we move from right to left on the same
curve. For example -for the fifteen hour of work, one would require greater compensation
to maintain same level of satisfaction than the fifth hour of work.
(iv) The straight lines originating from point Z on the horizontal axis
represents individual's budget line. The slope of the budget line is the real
wage, as the individual can trade-off leisure for income at a rate equal to
the hourly real wage (W/P). The higher is the real wage, the steeper is the
budget line, reflecting the fact that at a higher real wage an individual who
increases hours of work by one unit (i.e. moves one unit to the left along
the horizontal axis) will receive a larger increment to income (will move
farther up the vertical axis along the budget line) than would have been
received at the lower real wage. Three budget lines, corresponding to real
wages rules of 2.0, 3.0 and 4.0 are shown in Fig 12.3(a)
For any given real wage rate, in order to maximize utility, the individual will
choose the point where the indifference curve is tangent to the budget line corresponding
to that particular wage rate. At this point, the slope of the indifference curve is equal to
the slope of the budget line. In other words, this implies that the rate at which the
individual is willing to trade-off leisure for income (the slope of the indifference curve) is
equal to rate at which he is able to trade-off the slope of the budget line).
• At a real wage of 2.0, the individual worker attains equilibrium at point A1
working for AZ hours(6 hours of labour services), earning an income of AA1 (a
real income of 12) and spending OA hours on leisure(18 hours of leisure).
• When the real wage rises to 3.0 , the workers reaches equilibrium at point B1
working for BZ hours (8 hours of work ) earning an income of BB1 (a real income
of 24) and spending OB hours on leisure (16 hours of leisure).
• Similarly, at real wage of 4.0, points like C1 can be derived.
We now can say, more labour services are supplied at the higher real wage rates.
Using this fact, we can arrive at the supply curve for labour as shown in fig. 12.3(b).
In fig. 12.3 (b), on the horizontal axis measuring number of hours worked from
left to right and real wage rate on the vertical axis. By plotting the points A, B AND C

16
from fig. 12.3 (a) giving the amount of labour (in terms of working hours) the individual
worker will supply at real wage rate, we obtain the upward-sloping labour supply curve
by joining these points.
12.4.3 The Aggregate Labour Supply Curve is obtained by a horizontal summation of
all the individual labour supply curves and gives the total labour supplied al each level of
the real wage. It can be written as:
L = (W/P) ...............Aggregate Labour Supply function
The classical labour supply theory depicts two features:
(i) the wage variable is the real wage rate that is, the aggregate supply of labour is a
function of real wage.
(ii) the supply curve of labour is positively sloped that is more labour is assumed to
be supplied at higher real wage rates. This is because of the two effects that
take place : income effect and substitution effect.
(a) Income effect: when the real wage increases, the worker earns higher
income, and at higher levels of real income, leisure may become more
desirable. This enables him to indulge in more leisure activities which is
only possible if he works less.
(b) Substitution effect: when the real wages increases, the cost of leisure
hours rise in terms of the income which is given up. So, leisure becomes
expensive. Hence, the worker would choose leisure at this high price of
labour.
Here, in the derivation of labour supply curve, the substitution effect is
greater than the income effect, so the supply curve of labour is positively sloped.
Beyond a certain level of wage rate, the income effect outweighs the substitution
effect. This will the labour supply curve to bend backwards towards the vertical axis and
takes a negative slope.
In our analysis, however it is assumed that every time real wage rises, substitution
effect outweighs the income effect and hence the aggregate supply curve of labour has a
positive slope, throughout.

12.5 EQUILIBRIUM OUTPUT AND EMPLOYMENT

So far the following relationships have been derived :
Y = I'(K/L) - Aggregate Production Function
LD = I'(W/P) - Aggregate Labour Demand Function
LS = I'(W/P) - Aggregate Labour Supply Function

17
These relationships, together with the equilibrium condition for the labour market,
determine output, employment and the real wage in the classical system.

Classical Output and Employment

Fig. 12.4 (a) shows the determination of the equilibrium levels of employment (L1) and
the real wages (W/P1) at the point of intersection between the aggregate labour demand
and labour supply curves. From the equilibrium level of employment, the equilibrium
level of output (Y) given by the production function can be determined as shown in fig
12.4(b).
12.5.1 Determinants of Output and Employment
We can classify the variables into two as:
(i) Endogenous Variables: They are determined within or by the model, such as
output, employment and the real wage are designated as the endogenous variables
in the classical model.
(ii) Exogeneous Variables: They are determined outside the model.
In the classical model, it is the exogeneous variables which when changed, causes
changes in output and employment. The factors that determines the output and
employment are those that influence the positions of the labour demand and labour
supply curves.
The Demand curve for labour depends on the Production function, as it is the
slope of the production function:

18
 (i) When the production function shills that is, the productivity of labour
changes because of Technological changes, then the demand curve for
labour shifts.
(ii) The production function also shifts as the capital sock changes over time
which leads to change in the position of labour demand curve.
The Supply curve of labour depends on:
(i) The size of the labour force. An increase in population will shill the labour
supply curve to the right.
(ii) Individual tastes and preferences: Individuals express their labour-leisure
trade-off by indifference curves. With changes in individual's preference
functions the labour supply curve also shifts.
A common feature of all the factors that determine output in the classical model is
that they are the variables that affect the supply side of the market for output - the amount
that firms choose to produce. So, we can conclude:
In the Classical model, the levels of output and employment are determined solely
by factors operating at supply side of the market.
12.5.2 Supply Determined Nature of Output and Employment
The supply determined nature of output and employment is a crucial feature of the
classical system. fig. 12.5(a) shows the aggregate labour supply and aggregate labour
demand curves as functions of the real wage, (W/P).
Fig. 12.5(b) plots the labour supply and labour demand curves as functions of the
money wage rate, (W)

19
 In fig.12.5(b): for plotting the labour demand curve against the money wage, we
use the fact that the labour demand is nothing but equivalent to Marginal product of
labour which is a function of real wages, that is ;
LD = MPL = W/P
The quantity of labour that will be demanded at any given money wage, depends
on the price level. The firm will choose the level of employment at which
W = MPLP
A rise in the price level (P1, 2P1 , 3P1) will shifts the labour demand curve to the
right (from MPL, P1 to MPL, 2P1 to MPL, 3P1) plotted against the money wage. In other
words, for a given money wage, more labour is demanded at higher price levels because
that money wage corresponds to a lower real wage rate and the demand for labour varies
inversely with real wage rate.
Similarly, in fig. 12.5(l): for plotting the labour supply curve against the money
wage, we draw a positively sloped curve such as LS (P1) which gives the amount of
labour supplied for each value of the money wage, given that the price level is P1. The
curve is upward sloping because at the given price level a higher money wage is a higher
real wage. For a given money wage each price level will mean a different real wage and
hence, a different amount of labour supplied. A rise in the price level (P1, 2P1, 3P1) shifts
the labour supply curve upward to the left (from LS P1 to LS 2 P1 LS 3P1). In other words,
for a given money wage, less labour is supplied at higher price levels because that money
wage corresponds to lower real wage rule, and the supply of labour varies directly with
the real wage rate.
As both, the labour demand and labour supply depends only on the real wage, so
an equi-proportional increase (or decrease) in both the money wage and the price level,
leave the real wage unchanged at (W1/P1) which corresponds to the unchanged quantity
of labour demanded and quantity of labour supplied at level L1.

12.6 AGGREGATE SUPPLY CURVE IN THE CLASSICAL MODEL

The aggregate supply curve in the macroeconomics is same as microeconomic
concept of the firm’s supply curve, in fig 12.6 the classical aggregate supply curve has
been constructed by using the analysis of fig 12.5(b)
(i) At a price level of P1 and money wage W1, employment is L1 and the
resultant output is Y1 (point e1 in fig 12.5(b)).
(ii) when the price level rises (from P1 to 2P1), keeping money wage constant,
the real wage rate (W/P) will fall. As a result, the labour demand curve,
when plotted against the money wage rated in fig 12.5(b)) will shift to the
right, that is, firms demand more labour at lower real wage rate. (point e2),

20
 and the labour supply curve, when plotted against the money wage rate (in
fig 12.5(b)) will shift to the left, that is, supply of labour decreases (point
e3). As a result of this, there will be an excess demand of labour (i.e.
shortage of labour) equal to L2L3 units of labour.
(iii) Now, the firm would try to expand both employment and output. This
results in money wages to rise in order to expand employment and money
wages will continue to rise, as long as there is an excess demand of labour.
Equilibrium will be attained only when money wages have risen to a level
where demand for labour is equal to supply of labour (that is, the entire
excess demand is wiped out). This position is attained at point e4 where
the new money wage rate is 2W, which has increased proportionately with
the price level i.e.,
Increase in money wage = increase in price
As it can be seen in fig 12.5(b), at this point of e4, the initial real wage rate is
restored (2W/2P = W/P)
and employment is restored at its original level of L1 consequently output supplied
is equal to Y1 (same output supplied at P1)
(iv) Similarly, at still higher price level of 3P1, the money wage rises to 3W1,
but output remain unchanged at Y1. This relationship between price level
and output supplied is shown in fig. 12.6:

Fig 12.6 Classical Aggregate Supply Curve

21
 The aggregate supply curve is vertical, showing that if the higher price levels are
accompanied with proportionate higher levels of the money wage rate in the labour
market, the employment and the output will remain the same (at L1 and Y1, respectively)
irrespective of the price level. This shows that:
In the Classical model, the vertical supply curve illustrates that the level of
output is determined completely from supply side.

12.7 FACTORS THAT DO NOT AFFECT OUTPUT

As output and employment are supply determined, the level of aggregate demand
will have no affect on output. Factors such as the quantity of money, level of government
spending and the level of demand for investment goods by the business sector are all
demand-side factors that have no role in determining the equilibrium level of output and
employment in the classical model.
12.8 KEY POINTS
1. The period before Keynes General Theory was considered as classical.
2. According to classical economists, real factors determines the level of output and
employment.
3. The classical economists believed in the efficacy of free market mechanism.
4. As per the classical thought, the equilibrium level of income can be only at full
employment level.
5. The factors of production and the production technology- determines the
economy's output of goods and services.
6. A perfectly competitive firm will demand labour such that it maximizes its profits.
It will go on hiring labour till the MPL is equal to the real wage. Hence, the MPL
curve is the firm's demand curve for labour.
7. The supply of labour by an individual worker depends upon his choice between
'work' and “leisure.
8. Both aggregate labour demand and aggregate labour supply are functions of real
wage.
9. The aggregate labour demand curve is a downward sloping curve.
10. The aggregate labour supply curve is an upward sloping positively sloped curve
due to greater substitution effect than income effect.
11. Intersection of labour demand and labour supply forces determines equilibrium in
labour market which in turn together with the production function determines the
equilibrium level of output.

22
12. Equilibrium level of output and employment is restored in the economy if the rise
in the price level is accompanied by proportionate rise in the money wage rate.
That results in vertical aggregate supply curve.
13. The vertical aggregate supply curve in the classical model illustrates the supply
determined nature of output.
14. The demand side factors will not play any role in determining the equilibrium
level of output and employment in the classical model.
Reference
Froyen, Richard T. Macroeconomics Theories and Policies, 3rd edition. Macmillan
Publishing Co. 1990.
Questions For Review
1. In what respect was the classical attack on mercantilism important in shaping
classical economist's views on macroeconomic questions?
2. What are the main assumptions in the classical theory?
3. “The Supply creates its own Demand”. Explain how this law applies to classical
theory?
4. What determines the amount of output an economy produces?
5. Explain the concept of an aggregate production function. How would the
production function be affected by an increase in the marginal productivity of
labour for a given output level? How would the shift in the production function
affect the level of output and employment in the classical model?
6. What factors affect the output and employment in the classical model?
7. Explain the classical theories of labour demand and labour supply. Why is the
labour demand schedule downward sloping whereas the labour supply schedule is
upward sloping?
8. What factors are the major determinants of output and employment in the classical
system? What role does aggregate demand play in the determination of output and
employment?
9. How is the output level determined in the classical model? What will happen to
the output if employment falls because of fall in preference of labour at all wages?
10. The classical aggregate supply curve of the firm is vertical. Why?
11. Explain the supply determined nature of output and employment.
12. What all factors do not affect the level of output and employment?

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 LESSON 13

KEYNESIAN MACROECONOMICS : EQUILIBRIUM

DETERMINATION AND MULTIPLIER

13.1 INTRODUCTION

Economics has two diverse fields - Micro and Macro. While Micro is concerned with
analysis of a particular unit, macro economics is concerned with the aggregate or the
total. In macro economics, the economies can be classified as Open and closed economy,
a closed economy is one where there is no interaction with the external economies having
no export and import. An open economy on the other hand is one where the economies
are interlinked because of export and import of goods and services. Further there can be
two sector, three sector or four sector economies. In two sector there are Households and
Firms. In three sector along with the above two there is also Government. Four sector
comprises of external sector too along with export and import in addition to above three
sectors.
Household: A sector that makes the expenditure for own consumption. The entire
expenditure by this sector can be clubbed under the consumption function which is
explained as follows:
C = C + c Y (Linear Consumption function)
Where C = Autonomous Consumption that is the level of consumption which is fixed
irrespective of the level of income. It is there even at zero level of income. This is the
consumption that households derive out of past savings. It thus determines the intercept
of consumption function.
c = Slope of consumption function which shows change in consumption because of
c
change in income. It is shown by MPC (marginal propensity to consume) = . In a
y
linear consumption function MPC is constant that is the slope is same everywhere on the
consumption curve. In non linear consumption function however the marginal propensity
to consume decreases with increase in income. For simplicity we assume that the
consumption function is linear with constant MPC.
Y = Real Income or total output of the economy.
Linear consumption function can be plotted as:

24
 Figure 13.1: Linear Consumption Curve
Here consumption function is a straight line starting from an intercept shown by C
showing the level of consumption which is there even at zero level of income which
is being supported by past savings. The slope is given by MPC (Marginal Propensity
to consume).
Firm: This is the second component of macroeconomics. It shows all expenditure
done by the private enterprises that spend so that goods or services can be
manufactured and sold further. For simplicity it is assumed that it is constant or fixed.
This assumption would be relaxed in the next chapter when we discuss the concept of
IS-LM curves. It is shown by
I = i that is autonomous investment or fixed investment

Figure 13.2 Investment Curve

25
Investment by private enterprises is fixed irrespective of the level of income or rate of
interest in the economy. This assumption would however be relaxed later in the IS-
LM model.
Government: This is the third component in macroeconomics. Government has
mainly three functions - imposition of tax, granting of subsidy, and government
expenditure also called government purchases.
External Sector: The last component of open economy that includes export and import
of goods and services.
13.2 EQUILIBRIUM IN TWO SECTOR AND THREE SECTOR ECONOMY
Equilibrium is a state of rest where there is no tendency to change. An economy is
said to be in equilibrium when the total output (real disposable income) is equal to the
total or aggregate demand as shown by:
Y = AD where AD= C + I (in 2 sector economy) and C +I+ G (in 3 sector economy).
If Y =ft AD there is disequilibrium and it leads to unplanned inventory which is
calculated as:
IU = Y-AD
If Y > AD, there is accumulation of inventory as total output being produced is more
than the total demand in the economy leading to increase in the unplanned stock and
IU > 0 whereas
If Y < AD, there is depletion of inventory as total output being produced in the
economy is less than the total demand and hence the excess demand is met out of the
stock that reduces the existing stock and IU < 0.
Equilibrium in Two Sector Economy
A two-sector economy is one where there is presence of households and private firms
and there is neither government nor the external sector. It can also be called a closed
economy as there is no interaction with the outside world in the form of exports and
imports. A two-sector economy would be in equilibrium when the total output is
equal to aggregate demand by the households and firms as shown below:
Y=AD, Y=C+ I, Y=C+cY+ i, Y=A+cY
Where A = C + I its autonomous spending
Y -cY = A, Y(l-c) = A, Y = A/(1-c). Thus, the equilibrium condition is
Y = At (1-c)
Equilibrium is thus dependent on autonomous spending and marginal propensity to
consume. If any or both of them changes, there is change in the equilibrium level of
output.
Equilibrium can also be attained using an alternative approach as shown below:

26
Y = C + S (As households can either consume the income or save it). Thus, total
income is spent on either the consumption or saving.
S=Y-C,S=Y-(C+cY),S =-C+(l- c) Y,
In equilibrium Y = AD (C +I). So, from above two equations we get
C+S = C+l, S=I.
Here savings are the leakages from the economy and investment is the injection in the
economy. Thus, according to this approach equilibrium is where leakages and
injections are equal.
Both the above equilibriums can be presented in the following figure:

Figure 13.3 Equilibrium in 2 sector economy

Equilibrium in two sector economy can be achieved by using two approaches that is
Y = AD approach also called Keynesian cross or Savings and Investment approach
which is derived from the above approach only. In the figure above there is a 45
degree guideline that shows that any point on this guideline is the equilibrium as the

27
values on X axis and Y axis are equidistant on the guideline. Thus, equilibrium would
always be on this line. Then there is consumption function that is shown by C which
is the linear consumption function with slope 'c' and AD is the aggregate demand
curve that is parallel to C. The point where guideline and consumption function
intersect is the break even point where savings are zero and Y = C. It is shown by
point B at Y 1 level of income. Equilibrium is where guideline and AD intersect
which is at point E in the Keynesian cross and E* in the panel below and equilibrium
level of output is Y 2.
Equilibrium in Three Sector Economy
A three-sector economy is one where there is presence of government in addition to
the households and firms. Households spend on consumption, Firms spend on
Investment and Government performs three functions - Government expenditure
called government purchases which is assumed to be autonomous, collect taxes (it can
be fixed or proportionate tax) and provides transfer payments which is also assumed
to be constant. The equilibrium thus can be attained in two ways:
When there are Fixed Taxes
Equilibrium condition is
Y=AD,
Now here aggregate demand comprises of consumption which is dependent on
disposable income and not only income as was in two sector income as income and
disposable income are different because of presence of taxes and transfer payments in
case of three sector economy whereas in two sector economy the disposable income
and income were one and the same.
Y = C +I+ G, Y = C + cYd + i + G, Y = C + c(Y -TA+ TR)+ i + G
Where TA and TR are assumed to be constant in addition to Investment and
government
Y =A+ cY, Y = A /1-c (Equilibrium Condition)

28
 Figure 13.4 Equilibrium in 3 sector using Fixed Taxes
When there are proportionate taxes
Y = AD, Y = C +I+ G, Y = C + cYd + i + G, Y = C + c(Y - tY +TR)+ i + G
Where TR is assumed to be constant in addition to Investment and government
purchases and tax rate is fixed as a proportion of Y.
Y =A+ c (1-t)Y, Y = A /1-c(l-t) (Equilibrium Condition)

Figure 13.5 Equilibrium in 3 sector using Proportionate Taxes

29
 Both the cases above consider Yd as compared to Y used in two sector economy. Yd
is the disposable income that is the income available in the income after deduction of
taxes and addition of transfer payments. In fixed tax the slope of aggregate demand
function is given by MPC (c) which is same as that of two sector economy as impact
of taxes and transfer payments is considered in autonomous spending. On the other
hand, slope of aggregate demand function with proportionate taxes is c (1-t). Thus,
aggregate demand curve becomes flatter as slope of AD reduces. The difference
between the two equilibrium outputs would be shown under automatic stabilizers.

13.3 CONCEPT OF MULTIPLIER

The change in equilibrium level of output because of change in autonomous spending

by 1 rupee is known as multiplier. As shown above the equilibrium output in a two-
sector economy is given by the following equation
__
Y = A / (1- c) where A = Autonomous spending that includes fixed consumption
by the households and autonomous investment by private firms.
c = Marginal Propensity to consume (MPC).
From the above equation the value of multiplier can be obtained as:
__ __
Y =  A/1 − C, Y = 1/1 − Cx  A

Thus, the change in equilibrium level of output is more than the change in
autonomous spending because of presence of multiplier shown by the 1 / (1- c).
Example 1- Let Autonomous spending increases by Re 1 and MPC is 0.8 then value
of multiplier would be: 1 / (1- 0.8) = 5 times that is change in equilibrium level of
output is more than change in autonomous spending.
The value of multiplier depends on the value of 'c' and as 'c' varies from 0 to 1 so the
value of multiplier also varies from 1 to infinity as shown below:
Example 2- Calculate value of multiplier in the following cases: a) MPC = 0b) MPC
= 1, c) MPC = 0.2 d) MPC = 0.8
__
Solution: a) l / (1-0) = 1 times so no multiplier effect. Y =  A
b) l / (1-1) = Infinity
__
c) l / (1-0.2) = 1.25 times Y   A
__
d) l / (1-0.8) = 5 times, Y   A

30
Thus, it shows that multiplier has a direct relation with MPC, the greater is MPC the
higher is the value of multiplier.
Graphical derivation of Multiplier

Figure 13.6 Multiplier in Two Sector Economy

The figure above shows original Aggregate demand curve with an intercept equal to
autonomous spending and slope equal to MPC. Equilibrium is where the AD
intersects the guideline shown by Y1 level of output. If there is an increase in
autonomous spending by M, the aggregate demand curve shifts parallel up by the
same amount as slope is still the same (c). The new equilibrium is at Y2 level of
output. The increase in output from Y1 to Y2 is the change in equilibrium level of
output shown by the horizontal and vertical arrows whereas the distance between the
__
two aggregate demand curves is M. Thus, graphically also it shows that Y   A
because of multiplier.
To show the impact of MPC on multiplier we can take the following two cases that
show that as MPC increases multiplier also increases:

31
 Figure 13.7 (a): Multiplier and Marginal Propensity to Consume

Figure 13.7(b) Multiplier and Marginal Propensity to Consume

Figure in panel (a) shows aggregate demand curve corresponding to a MPC of 'c'
which is less than MPC (c') exhibited by panel (b). Thus, the slope of aggregate
demand curve of panel (a) is less than that of panel (b). The intercept in both the cases
is shown by autonomous spending an increase with initial equilibrium at Y1 level of
output in panel (a) and Y1' in panel (b). With an increase in autonomous spending by

32
Min both the cases the equilibrium is at Y 2 in panel (a) and Y2' in panel (b). the
change in output is greater in case of higher MPC shoeing that there is a direct
relation between MPC and multiplier which is because of the fact that aggregate
demand curve is steeper in the second case as compared to the first one.
Multiplier in case of Three Sector Economy

Figure 13.8 Multiplier in Three Sector Economy

The figure above shows original Aggregate demand curve in case of three sector
economy with proportionate tax with an intercept equal to autonomous spending and
slope equal to c(l-t). Equilibrium is where the AD intersects the guideline shown by
Y1 level of output. If there is an increase in autonomous spending by Ā, the
aggregate demand curve shifts parallel up by the same amount as slope is still the
same c(l- t). The new equilibrium is at Y2 level of output. The increase in output from
Y1 to Y2 is the change in equilibrium level of output shown by the horizontal and
vertical arrows whereas the distance between the two aggregate demand curves is Ā
Thus graphically also it shows that Y > Ā because of multiplier.
The above discussion thus shows that the economy moves to a new level of
equilibrium output when there is change in the autonomous spending, the quantum of
change depends on the marginal propensity to consume and also on the taxation
system being applicable in the economy (fixed or proportionate tax). However ever
economy tries not to deviate too much from the initial equilibrium and there are
certain forces imbibed in the economy itself that prevents a drastic change which are
known as the automatic stabilizers. It is being taken up in the next heading-

33
13.4 CONCEPT OF AUTOMATIC STABILIZER

Automatic stabilizers offset fluctuations in economic activity without direct intervention

by policymakers. When incomes are high, tax liabilities rise and eligibility for
government benefits falls, without any change in the tax code or other legislation.
Conversely, when incomes slip, tax liabilities drop and more families become eligible for
government transfer programs, such as food stamps and unemployment insurance that
help buttress their income.
Two examples of Automatic stabilizers are-
Proportionate Tax - The presence of proportionate tax reduces the multiplier effect
thereby bringing a lesser diversion in the equilibrium income as compared to fixed tax.
This is because in case of proportionate taxes whatever is the change in income because
of change in the autonomous spending a part of it goes to the government in form of
taxation and hence disposable income is less as compared to fixed taxes. This can be
illustrated using the following example and figure-
Example 3- If MPC is 0.8 and tax rate is 0.5 in case of proportionate tax. The effect of
automatic stabilizer can be shown as:
Slope of AD in case of fixed Tax = c = 0.8
Slope of AD in case of Proportionate Tax = c (1- t) = 0.8 (1-0.5) = 0.4
Thus, AD is flatter in case of proportionate tax as compared to fixed tax and change m
equilibrium using above data can be shown as-

Figure 13.9(a): Change in Equilibrium Output in case of Proportionate Tax

34
 Figure 13.9(b): Change in Equilibrium Output in case of Fixed Tax
Thus, in case of Fixed Tax the change in equilibrium level of output is greater as
multiplier effect is more as can be shown mathematically too
Multiplier Effect in case of Fixed Tax: 1/1-c = 1/1- 0.8 = 5 times
Multiplier Effect in case of Proportionate Tax: 1/1- c (1-t) = 1/1- 0.8(1- 0.5) =1.67 times
Thus it is visible that multiplier effect weakens in case of proportionate tax because of
reduction in disposable income as with every increase in income a part of it goes towards
payment of taxes and hence less is available with the households for consumption as
compared to fixed tax where tax is fixed irrespective of the level of income and hence
disposable income is greater that provides greater change in the output.
Unemployment Benefits - The change in equilibrium output reduces if government
provides unemployment benefits to the households thus acting as a stabilizing agent.
Impact of Fiscal Policy on the Equilibrium Level of Output
Fiscal policy refers to change in the government policy with respect to change in
government expenditure or taxation policy. There are two types of Fiscal policy -
Expansionary fiscal policy where there is either increase in Government purchases or
decrease in taxes and contractionary fiscal policy where the government reduces the
government purchases or increases the tax. The former brings and upward shift in the
aggregate demand curve causing a change in the equilibrium level of output as shown
below:

35
 Figure 13.10 Effect of Fiscal policy on Equilibrium
The figure above shows that original equilibrium is at Y 1 level of output where AD is
intersecting the guideline. With an increase in government purchases there is an increase
in autonomous spending as government purchases is a part of autonomous spending. This
shifts the AD curve parallel up and new equilibrium is at Y 2. The change in equilibrium
level of output from Y1 to Y2 is because of fiscal policy. This change is more than change
in government purchases because of presence of government multiplier.

13.5 SUMMARY

Microeconomics and macro economics are two parts that are studied in Economics.
While microeconomics deals with an individual unit - its equilibrium determination,
pricing decisions and policies. Macro economics is wider in sense as it covers all the
components of an economy. The equilibrium condition in both the economics is broadly
the same that is where demand and supply are equal and there is neither excess demand
nor excess supply. In macro we just change the demand to aggregate demand and supply
to total output or total income. Macro Economics can be a two sector economy
comprising of only households that spend on consumption expenditure and private firms
that go for investment expenditure, a three sector economy having Government in
addition to the above two sectors that spends on purchases, collect taxes and provides
subsidies and a four sector economy that is also called open economy as it includes the
external sector too in addition to above three, it makes expenditure on imports and earns
though exports. Equilibrium condition is where total output produced in an economy is
exactly equal to the total demand by the different sectors and in case the two are not equal
there are changes in the unplanned inventory and automatic forces that bring the economy
back to equilibrium. Further once equilibrium is attained it may change over a period of
time if any component of autonomous spending changes but the change in equilibrium

36
level of output is more than the change in autonomous spending and this is because of the
presence of multiplier which is dependent on marginal propensity to consume and/or
proportionate taxes. This change in the equilibrium level of output should not be very
large as that can be destabilizing for the economy so there are some automatic stabilizers
in the economy that prevents the economy from moving too far off from the initial
equilibrium. There are two main stabilizers that is proportionate tax and unemployment
benefits that help in reducing the gap between original and new equilibrium level of
output.

13.6 SELF ASSESSMENT QUESTIONS

Check your progress
Exercise 1: True and False
(a) Macro Economics is narrower as compared to Microeconomics
(b) Both micro and macro economics attain equilibrium when demand and supply are
equal.
(c) A two sector Economy is also called open economy.
(d) Taxes in a three-sector economy are always assumed to be autonomous.
(e) Multiplier shows the change in equilibrium level of output because of change in
autonomous spending.
(f) Equilibrium level of output depends on the slope of Aggregate demand curve
Ans. a(F), b(T), c(F), d(F), e(T), f(T)
Exercise 2: Fill in the Blanks
(1) A three sector economy has three components namely _________ .
(2) If MPC is 1 then value of multiplier is _________ .
(3) The two automatic stabilizers are _________ .and _________ .
(4) An open economy is one where there is _______ in addition to households, firms
and government purchases.
Ans 1. Households, Firms and Government 2. Infinity 3. Proportional Tax and
Unemployment Benefits 4. External Sector.
Questions for review
1. Explain the equilibrium in case of two sector Economy.
2. Why the change in equilibrium level of output is greater than change in
autonomous spending.
3. How is equilibrium attained in case of three sector economy with proportionate
tax.
4. Explain the concept of automatic stabilizers by giving suitable example.

37
 5. Explain how fixed taxes bring more change in equilibrium as compared to
proportionate tax.
6. Explain the concept of multiplier in a two-sector economy.
7. What is the effect of expansionary fiscal policy on the equilibrium level of
output?
8. What is the role of government in a three-sector economy?
Suggested Readings
Mankiw, N. Gregory, Macro Economics, Macmillan Worth Publishers New York,
Hampshire U.K.
Dornbusch, Rudiger and Stanley, Fischer, Macro Economics Theory, McGraw-Hill
Barro Robert J., Macroeconomics Theory and Applications, MIT Press.

38
 LESSON 14

IS-LM DETERMINATION

14.1 INTRODUCTION

The previous chapter discussed about how equilibrium is obtained in a two sector and
three sector economy and what IS the change in output because of change in the
autonomous spending. This chapter would discuss about how the goods market and
money market are in equilibrium and how both achieve the simultaneous equilibrium. For
explaining the equilibrium in Goods market is curve would be derived where I stand for
investment and S stands for saving. Equilibrium in Money market would be explained
through LM curve (L stands for demand of real money and M stands for supply of real
money). IS-LM analysis was introduced by Prof. Hicks in 1937 to explain the short run
phenomenon. It would further explain the relationship between price level and
equilibrium level of output through the aggregate demand curve and changes in the
aggregate demand curve because of fiscal or monetary policy multiplier. The fiscal policy
explains the change in the government expenditure or taxation policy to bring a change in
the equilibrium level of output whereas monetary policy shows change in the money
supply to bring a change in the level of income. There are certain assumptions on which
the whole IS-LM model is based like constant price level, firms willing to supply any
amount of quantity at the given price and the short run aggregate supply curve is flat.

14.2 DERIVATION OF IS CURVE

IS and LM curve analysis is applicable in the short run where the price level is assumed
to be constant.
IS curve shows different combinations of real interest rates and equilibrium level of
output where goods market is in equilibrium. Derivation of IS curve can be established
through the following two steps -
Derivation of Investment Function: Investment is the total expenditure done by the
private firms. It is an important component of aggregate demand function. Earlier
investment was assumed to be autonomous but now it would be explained as follows-
__
I = I + ar
__
Where I = Autonomous investment which is not related to rate of interest
a = Sensitivity of Investment to real rate of interest
r = Real rate of interest

39
There is inverse relation between rate of interest and level of investment as if rate of
interest increases there is decrease in investment because it is expensive for the firms to
borrow and invest whereas a lower interest rate increases the amount of borrowing and
investment by the firms. But how sensitive is the investment to rate of interest depends on
'a' which shows the sensitivity of investment to interest.
Investment function can be shown graphically as:

14.1 (1) Less Sensitive 14.1 (b) More Sensitive

Figure 1: Investment Function
Panel (a) shows a steeper investment curve which shows a lesser value of 'a' that is
investment is not that sensitive to rate of interest showing that when rate of interest
reduces investment expands but by a smaller quantum whereas in panel (b) the curve is
flatter because of greater 'a' and higher sensitivity of investment to rate of interest
showing that reduction in rate of interest increases the investment by a greater amount.
After getting the investment function the equilibrium in goods market can be attained as
follows-
Equilibrium is when the economy which is a three-sector economy and in the short run
has its output and aggregate demand in equilibrium
__
Y=AD, Y=C+I+G, Y=C+cYd+ I - ar+G,
__
Y = C + c(Y - tY + TR) + I - ar + G,
Y =A+ (1- t) Y - ar, Y = A-ar/1- c (1- t) (Equilibrium condition)
Thus, here the equilibrium is the same as in case of three sector economy with
proportionate tax with an addition of 'ar'. The IS can be derived graphically as-

40
 Figure 14.2 IS Curve
IS curve is derived from the Keynesian cross in figure above in the upper part. When
interest rate is r1 the investment is I1 where the corresponding aggregate demand curve is
AD and equilibrium level of output is Y1. If rate of interest reduces investment increases
and there is a parallel upward shift in the AD curve with a new equilibrium level of
output Y2. Thus, there is an inverse relation between real rate of interest and equilibrium
level of output as shown in the figure above. It is because when rate of interest reduces,
investment increases and it being a part of AD the aggregate demand increases. In the
equilibrium Y should be equal to AD and when AD increases Y also has to increase to
retain the equilibrium, thus bringing an inverse relation between rate of interest and
equilibrium level of output. Now moving to derivation of slope and position of IS curve.
Modifying above equation, we get-
Y = A- ar/1- c (1- t), r = A/a - Y/mga where mg = 1/1- c (1- t), (mg-govt. multiplier)
Thus, slope of the IS curve is -1/ mga and position of IS curve depends on autonomous
spending that is A. The negative sign in the slope shows that IS curve is downward
sloping. The slope in turn depends on government multiplier 'mg' which in turn depends
on MPC (c) and sensitivity of investment to rate of interest 'a'. The slope of IS can be
shown as follows-

41
Let us elaborate taking two different MPC C1 = 0.2 and C2 = 0.8. Assuming proportionate
tax to be 0.5 we calculate government multiplier. In the first case mg1 would be 1/1-
0.2(1-0.5) = 1.11 and in the second case it is mg2 = 1/1- 0.8(1-0.5) = 1.67. Thus, it shows
that higher the MPC higher is the government multiplier and lower would be the slope
and flatter would be the IS. It can be shown graphically as-

Figure 14.3 Slope of IS Curve

Above figure shows how different Marginal Propensity to Consume have different impact
on the slope of the IS curve the slope of aggregate demand curve in a two sector economy
is given by MPC only but in three sector economy with proportionate tax the slope
changes to MPC(l-tax rate). Taking this further we would show how there can be
different slope of IS because of different government multiplier which in turn depends on
MPC. Initially the aggregate demand curve is AD having an intercept of A-ar1 and as
MPC is 0.2 which is lesser than MPC of 0.8 so this AD is flatter. It gives equilibrium of
Y1. Now if interest rate reduces the AD curve shifts parallel up and provides a new
equilibrium at Y2 level of income. Joining the two combinations we get the IS curve

42
corresponding to c1 level of marginal propensity to consume. Now similarly if we draw
IS curve corresponding to a higher level of MPC (0.8) we get a flatter IS' curve whose
slope is lesser than the previous IS because of the government multiplier being large and
hence slope being less.
Similarly the component that affects the intercept or position of the IS curve is given by
autonomous spending (A) In case of three sector economy Autonomous spending
comprises of autonomous consumption, autonomous investment by private firms, fixed
government purchases and a part of fixed transfer payments. If any of these components
of 'A' changes, there is a shift in the IS curve as can be shown below-

Figure 14.4 Position of IS Curve

The above panel shows Keynesian cross that shows equilibrium using a 450degree
guideline and derivation of equilibrium. Initially at 'r' rate of interest and 'A' autonomous
spending equilibrium output is Y1. This shows one combination of IS curve where IS
passes through 'r' and 'Y1'. Now if autonomous spending increases to A' there is a parallel
upward shift in the AD curve as slope is still the same. The new equilibrium is at Y2 level
of output. Thus, there is a parallel shift in the IS curve to the right showing the change in
the position or the intercept of the IS. The figure above shows that it is the change in the

43
autonomous spending that affects the intercept/position of the IS curve. Thus fiscal policy
by government would bring a shift in the IS if there is change in autonomous government
purchases and if tax rate changes then there would be change in the slope of IS as change
in proportionate tax rate would change the slope of aggregate demand curve in the
Keynesian cross thereby changing the equilibrium level of output.

14.3 DERIVATION OF LM CURVE

LM curve shows different combinations of real interest rates and equilibrium level of
output where money market is in equilibrium. Derivation of LM curve can be established
through the following two steps-
Derivation of Money Demand: Demand for money is demand for transactionary purposes
that is demand for real balances. It is the money that people hold and does not provide
any return. Demand for money can be shown using the following equation:
L=kY-hr
Where L = demand for real money, Y = national income, r = real interest rate, k =
sensitivity of demand to real income and h = sensitivity of money demand to real interest
rate of interest. Demand for money can be plotted as-

Figure 14.5 Demand of Money

If there is a change in the real rate of interest, then there is a movement up or down on the
demand curve whereas with a change in the income the curve shifts to right or left.
Equilibrium in Money Market: Money market is in equilibrium when money demand is
equal to money supply. It can be shown as:
kY-hr=M/P

44
Where M = Nominal money supply which is fixed by the central bank and P = Price level
in the economy. For derivation of LM we assume that central bank keeps the nominal
money supply fixed and P the price level is also fixed as IS-LM is a short run
phenomenon where price level is constant. LM thus can be derived as:

Figure 14.6 Derivation of LM Curve

LM curve shows equilibrium in the money market and hence it shows the combinations
of different real interest rates and income. Initially the demand curve is shown by kY1-hn
where money demand and supply are equal, and rate of interest is n and corresponding
equilibrium output is Y1. If rate of interest reduces to r2 then money supply being fixed
there is excess demand of money that leads to disequilibrium and restore the equilibrium
level of output has to be reduced which shifts the demand curve of money to left as
income reduces and new equilibrium is at reduced rate of interest and reduced level of
income. Both the combinations are shown in the right-hand side diagram. Joining the two
combinations we get the upward sloping LM curve which shows direct relation between
rate of interest and equilibrium level of output.
Now to derive the slope and position of LM, the above equilibrium equation can be
modified as:
r = 1/h (kY-M/P)
Slope of LM is thus k/h that is dependent on sensitivity of demand to real income and rate
of interest and position is dependent on the money supply. The changes in slope and
position can be interpreted as:
Slope of LM curve:
1) If 'k' is more the slope is more and LM is steeper

45
2) If 'k' is less the slope is less and LM is flatter
3) If 'h' is more the slope is less and LM is flatter
4) If 'h' is less the slope is more and LM is steeper
Position of LM curve:
The position of LM curve depends on the nominal money supply keeping price level
constant. This is because if money supply changes there is a change in the equilibrium
and shift in the LM. It can be explained with the diagram below:

Figure 14.7 Position of LM Curve

Initially the equilibrium is at n rate of interest corresponding to a demand curve of money
and real money supply (M as nominal supply and P the price level). The corresponding
LM curve is shown in the right panel. Now if central bank increases the nominal money
supply to M1 the new equilibrium rate of interest reduces to r2 at the same level of
equilibrium output. Thus, the LM curve shifts parallel to right to LM1. The shift in LM is
thus because of change in the money supply. If money supply increases LM shifts parallel
to right and if money supply reduces then LM shifts parallel to left.

14.4 SIMULTANEOUS EQUILIBRIUM

Simultaneous equilibrium is where both the goods market and money market are in
equilibrium. Any point on the IS curve shows that Goods market is in equilibrium and
any point on LM represents equilibrium in money market. The simultaneous equilibrium
is shown in figure below:

46
 Figure 14.8 Simultaneous Equilibrium

14.5 IMPACT OF FISCAL POLICY ON THE SIMULTANEOUS EQUILIBRIUM

Fiscal policy means change in government expenditure and/or taxes to bring changes in
the equilibrium level of output. If government follows an expansionary fiscal policy and
increases the government expenditure, then the autonomous spending would increase and
it would bring an upward parallel shift in the AD curve that would increase the
equilibrium level of output at the same rate of interest. Thus new goods market
equilibrium would be at same rate of interest and higher level of output that would bring a
rightward shift in the IS and hence increased level of output and at that point money
market would be in disequilibrium so to bring it to equilibrium rate of interest would
finally increase because of decrease in price level because of increase in income. It can be
shown below-

47
 Figure 14.9 Impact of Fiscal Policy on Equilibrium
Similarly, an expansionary monetary policy would increase the money supply and shift
LM curve to right that too would increase the equilibrium level of output and reduce real
rate of interest. Thereby bringing a new simultaneous equilibrium.

14.6 NUMERICAL ON IS- LM

Question 1. Find out IS and LM equation in the following three sector economy
C = 100 + 0.8 Yd
I= 1000-Si
G=80
T=0.25 Y
L = 0.8Y-0.2i
M=200
P=2
Solution: Equilibrium in goods market is when Y = AD

48
Y=C+I+G
Y = 100 + 0.8 (Y-0.25Y) + 1000-Si + 80, 1180 + 0.8*0.75Y-5i, 1180 + 0.6Y-5i 0.4Y =
1180 -Si, Y = 2950 -12.5i IS equation
Equilibrium in Money Market is where Money demand = Money supply
0.8Y-0.2i = 200/2, 0.8Y = 100 + 0.2i, Y = 125-0.25i LMequation
Question 2 C = 100 + 0.9 Yd, I= 600 -30r, G = 300, T = 1/3Y, Md= 0.4Y -50r M= 1040,
P=2
Full Employment level of equilibrium is 2500.
a) Derive IS and LM equations and compute equilibrium.
b) Explain change in slope and position of IS and LM if MPC changes to 0.6.
Solution: a) Equation of IS curve is Y = AD
Y = 100 + 0.9(Y-1/3Y) + 600 -30r + 300, Y = 1000 + 0.6Y -30r, 0.4 Y = 1000-30r
Y =2500-75r
Equation of LM curve is Md = Ms
0.4Y -50r = 1040/2, Y = 1300 + 125r
Solving above IS and LM curve we get the following
2500 -75r = 1300 + 125r, Y = 2050, r = 6%
b) Impact of MPC is only on the slope of IS curve as it is a part of slope of IS curve
Old Slope= 1/mga = l/[1/1-0.9(1-1/3)].30 = 0.0133
New Slope= 1/mga = l/[1/1-0.6(1-1/3)].30 = 0.02
Thus, the slope of IS has increased when MPC changes to 0.6
Question 3 (Practice question) C = 100 + 0.8Y d, I= 150 -6i, G = 100, T = 0.25Y
Md= 0.2Y -2i, Ms= 300, P = 2
Calculate equilibrium level of output and rate of interest. Also, if government spending
are raised from 100 to 150 find the shift in the IS curve.

14.7 SUMMARY

The previous chapter talked about how equilibrium is attained in case of two sector and
three sector economy using the concept of Keynesian cross. This chapter talked about
attainment of equilibrium in Goods market and Money market using the concept of IS
and LM curves. Where IS curve gave different combinations of real rate of interest and

49
equilibrium output where goods market is in equilibrium, the LM curve provided
different combinations of the same where money market achieves its equilibrium. Both IS
and LM curves are based on certain assumptions through which they get their downward
or upward sloping slopes and once these assumptions are relaxed there is a change in the
slope and/or position of the two curves. For an economy to be in total equilibrium both
goods and money market should be in equilibrium such that simultaneous equilibrium is
when IS and LM intersects. There can be changes in this simultaneous equilibrium once
achieved by a change in the fiscal or monetary policy as simultaneous equilibrium is
based on IS and LM and if either of them changes there is anew equilibrium. A change in
the fiscal policy brings a new IS curve and a change in the monetary policy changes the
LM curve thus changing the final equilibrium of the economy. While doing IS-LM we
assumed that price level is constant as it is a short run phenomenon, but price level
usually changes in the long run. Further IS-LM analysis will be used to derive relation
between Price level and equilibrium level of output known as aggregate demand curve
and it would be taken up in the next chapter. As discussed in the chapter that an increase
the government purchases brings a parallel shift in the IS curve, government increases the
purchases to bring an increase in the equilibrium level of output but while doing so
government does not take into consideration the simultaneous increase in the real rate of
interest which in tum reduces the private investment leading to crowding out and it would
be studied in detail in the next chapter.

14.8 SELF ASSESSMENT QUESTIONS

Check your progress

Exercise 1: True and False
(a) IS curve shows equilibrium in money market.
(b) LM curve shows different combinations of rate of interest and equilibrium level of
output where money market is in equilibrium.
(c) A two-sector economy does not differentiate between Gross income and
Disposable income.
(d) Fiscal policy refers to change in government expenditure or change in taxes.
(e) Multiplier shows the change in equilibrium level of output because of change in
autonomous spending.
(f) Aggregate demand curve shows relation between price level and equilibrium level
of output.
(g) Proportionate Tax is zero when income is zero.

50
(h) If the expenditure of the government is more than the revenue of the government
it is called surplus budget.
Ans. a (F), b(T), c(T), d(T), e(T), f(T), g(T), h(F)
Exercise 2: Fill in the Blanks
(a) Government has three roles to perform in an economy _________ .
(b) If MPC is O then value of multiplier is _________.
(c) The slope of lS curve depends on _______ and _______ .
(d) Slope of LM is _______ related to 'k' that is sensitivity of demand of money to
real income.
(e) Fiscal Policy means changes in ______ . or ______ .
(f) The shift in the IS curve because of change in government spending can be
measured by __ .
(g) Monetary policy includes changes in _______ . in the short run.
(h) The relation between Price level and equilibrium level of output is shown by
________ .
Ans a. Government Purchases, Tax collection and Transfer Payment b. Unity c.
Government Multiplier and Sensitivity of Investment to rate of interest. d. Directly. e.
Government Purchases or taxes. f. Government Multiplier. g. Money Supply h.
Aggregate Demand Curve
Questions for Review
1. Explain the equilibrium in case of three sector Economy.
2. Explain the derivation of IS curve and how is its slope and position derived
3. How is equilibrium attained in case of three sector economy with proportionate
tax?
4. Explain the concept of shift in IS and LM curves.
5. Explain how the Aggregate demand curve is derived
6. What is the reason for inverse relation between real rate of interest and
equilibrium level of output in case of IS curve?
7. What is the effect of increase in nominal money supply on the LM curve in the
money market?
8. What is the role of price level in case of money market equilibrium?

51
Suggested Readings
Mankiw, N. Gregory, Macro Economics, Macmillan Worth Publishers New York,
Hampshire U.K.
Dornbusch, Rudiger and Stanley, Fischer, Macro Economics Theory, McGraw-Hill
Barro Robert J., Macroeconomics Theory and Applications, MIT Press

52
 LESSON-15
FISCAL AND MONETARY MULTIPLIES
15.1 INTRODUCTION
The previous chapter talked about equilibrium in macro economy that comprises of two
sector, three sector economy with presence of fixed and proportionate tax. It also showed
how change in the autonomous spending brings a change in the equilibrium level of
output. The present chapter goes ahead and talks about the derivation of aggregate
demand curve that is basically a long run phenomenon as it shows relation between price
level and equilibrium level of output. The shift in the aggregate demand curve can be
because of shift in either the IS or the LM curve and the change in the equilibrium level
of output and this is shown by the fiscal and monetary policy multipliers respectively
which would be studied in this chapter. Another important topic of discussion is the
crowding out effect that shows how because of increase in the government spending the
rate of interest increases and leads to decrease in the private investment that reduces the
desired effect expected by government. This too would be shown using concept of
multiplier in the present chapter.

15.2 DERIVATION OF AGGREGATE DEMAND CURVE

The concept of IS- LM curve as given by Hicks was based on Short run whereby prices
were assumed to be constant. But here in aggregate demand curve the relation is shown
between price level and equilibrium level of output as it's a long run phenomenon. The
AD curve is derived from simultaneous equilibrium that is IS- LM curve intersections. It
is being shown in figure below:

Figure 15.1 Derivation of AD curve

53
Upper panel shows simultaneous equilibrium derived from IS-LM curve. As every LM is
corresponding to a price level. So, the initial price level is P where equilibrium output is
Y1 and equilibrium rate of interest is n. This gives a combination for the AD curve drawn
in the panel below. Now if price level reduces to P1 then real money supply increases
assuming nominal money supply to be constant which shifts the LM curve parallel to
right providing a new equilibrium at r2 and Y2 level of income. This provides second
combination for the AD curve which shows that at reduced price level equilibrium level
of national income increases showing inverse relation between price level and
equilibrium level of output and thereby providing a downward sloping AD curve.

15.3 MONETARY AND FISCAL MULTIPLIER

In previous two chapters we discussed about the concept of multiplier that shows change
in the equilibrium level of output because of change in autonomous spending. This can be
applied in case of two sector, three sector economies. The multiplier in three sector
economy with proportionate tax shows what is the desired change in the equilibrium level
of output if government increases its purchases assuming that it has no impact on the
interest rates. However, it shows a shift in the IS curve and hence at the new equilibrium
only goods market is in equilibrium. But this is not the equilibrium of the economy as
money market is in disequilibrium. So, in this entire process there is increase in the
interest rates that crowds out the private investment and hence actual change in te
equilibrium is less than the desired change. While desired change is shown by the
government multiplier, the actual change is shown by fiscal multiplier. It can be
presented diagrammatically as:

Figure 15.2 Fiscal Multiplier and its impact on the AD curve

54
Panel above shows that initially the Goods equilibrium is shown by IS curve and money
market equilibrium is shown by LM curve which is corresponding to a particular price
level that is P* where simultaneous equilibrium level of output is Y1 and real rate of
interest is r1. The panel below shows that corresponding to Price level P* and Y1 level of
output there is an aggregate demand curve AD. Now if government increases its
purchases and expects that the output would increase to Y2 at the same rate of interest but
here the goods market is in equilibrium as this is a point on the IS curve but money
market is not in equilibrium as the point is not on the LM curve. The new simultaneous
equilibrium where both money market and goods market are in equilibrium is at r2 rate of
interest and Y3 level of output which is less than what is expected by the government.
This change from Y1 to Y3 is the fiscal multiplier. It is shown by a parallel rightward shift
in the aggregate demand curve showing that at the same price level because of increase in
government purchases the equilibrium level of output also increases though not in the
same quantum as was expected. The opposite would hold if there is decrease in the
government purchases as aggregate demand curve would shift parallel to left.
Similarly, we can show the concept of money multiplier which shows the change in
equilibrium level of output when there is increase in the nominal money supply keeping
the price level constant. When there is increase in the nominal money supply the LM
curve shifts to the right as with increase in money supply there is a reduction in the rate of
interest that increases the money demand to bring the money market to equilibrium again.
It can be shown using the following diagram

Figure 15.3 Monetary Multiplier and its impact on the AD curve

55
The two panels above show how an increase in the nominal money supply shifts the LM
curve to the right in the above panel that brings a reduction in the real rate of interest and
increase in the equilibrium level of output. This increase in the equilibrium level of
output is shown by the monetary policy multiplier which shows how much is the change
in the equilibrium level of output if nominal money supply changes keeping constant the
price level and other factors impacting the simultaneous equilibrium. An increase in
nominal money supply brings a rightward parallel shift in the aggregate demand curve as
shown by the panel below. The reverse would happen with reduction in the price level.
The concept of Fiscal and Monetary policy multiplier can also be shown mathematically
as follows-
Goods Market is in equilibrium when total output produced is equal to the aggregate
demand of the economy
IS equilibrium Equation is:
Y=C+cYd+I- ar+G,
Y = C + c(Y - tY + TR) + I - ar + G,
Y =A+ (1-t) Y - ar, Y = A-ar/1- c (1-t), Y = mg (A - ar) (1)
LM equilibrium Equation is:
r = 1/h [ KY - M/P] (2)
Substituting value of interest rate in equation (1) we get
Y = mg [A- a/h (KY - M/P)], Y = mg [ A- aKY/h + Ma/Ph]
Y = mgA - mgaKY /h + mgMa/Ph, Y = mgAhP/Ph - mgaKYP/Ph + mgMa/Ph
YPh = mgAhP - mgaKYP + mgMa
YPh + mgaKYP = mgAhP + mgMa, Y (Ph + mgaKP) = mgAhP + mgMa
Y = mgAhP/ (Ph+ mgaKP) + mgMa/(Ph + mgaKP)
Y = mgAh/ (h + mgaK) + mgaM/P(h + mgaK)
Substituting  = hmg/h+Kamg we get,

Y =  A + [a/h] [M/P]
Here Fiscal multiplier shows change in equilibrium level of output because of change in
autonomous spending that includes government expenditure and other components but
we assume that the major component here is government purchases and thus fiscal
multiplier shows the impact of changed government expenditure on equilibrium level of
output. Thus 'a' shows how much is the change or shift in the equilibrium when there is a

56
change in government purchases. Similarly change in the equilibrium level of output
because of change in the money supply is shown by Monetary policy Multiplier that
shows by how much there is change in the equilibrium level of output if nominal money
supply changes keeping the price level constant. Graphically it is shown by a shift in the
LM curve as the slope has not changed and only the position is being changed because of
the change in the nominal money supply. Thus, the two multipliers that shows the impact
of two government policies namely fiscal and monetary policy are the monetary and
fiscal multiplier.

15.4 CROWDING OUT

Gross Domestic Product or national income shows how much production is taking place
in any economy. If the government expects that the production is less than what it should
be then it goes for expansionary fiscal policy where it increases the government
purchases assuming that there would not be any change in the other variables (also the
interest rate) and the output would increase by government multiplier multiplied by
change in the government expenditure. However this is not true as with an increase in the
government purchases the aggregate demand in an economy increases and money supply
being constant the real rate of interest increases because of which the private investment
is bound to decrease as there is inverse relation between rate of interest and private
investment. Thus, the change in output is less than what is expected by the government.
However, whether there can be increase in output or not depends on whether the
economy is operating at full employment that is output is already at potential output and
no further increase in output is possible. Another case can be when the current output is
less than the full employment level and with government policy it is possible to bring an
increase in the actual output. The last case can be when government does not want any
crowding out or decrease in private investment and there by increases the government
expenditure by printing of currency and increasing the money supply simultaneously. All
the three cases are shown using the following diagrams:

Figure 15.4 (a) Crowding Out - Full Employment

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Here IS curve is the original goods market curve and LM is the original Money market
curve where the simultaneous equilibrium is at the intersection of the two. Now if it is
already at the full employment Y* then with an increase in the government spending the
IS curve shifts to the right but because of the full employment output there is a
corresponding increase in the rate of interest that shifts the LM curve to the left. Thus,
there is hundred percent crowding out of private investment as there is no actual change
in the output.

Figure 15.4 (b) Crowding Out - Less than Full Employment

In case output is less than the full employment then an increase in the government
spending brings a simultaneous rightward parallel shift in the IS curve. Though
government intended that output would increase from Y1 to Y2 but in this process the real
rate of interest increased and the actual change in output is from Y1 to Y3. The reduction
in private investment from Y2 to Y3 because of increase in the real rate of interest is
known as partial crowding out.

Figure 15.4 (c) Crowding Out - Monetary Accommodation of Fiscal Expansion

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The third case also known as monetizing fiscal deficits means printing of currency by the
government to finance its increased government expenditure. Thus, there is rightward
shift in the IS as well as LM curve and no corresponding increase in the real rate of
interest thus the intended change in output and the actual change in output are equal with
no crowding out.
WHY CROWDING OUT IS SO IMPORTANT
Crowding out Effect is so important because it tells us that both the policies monetary
& fiscal are necessary to stabilize the economy.
If IS curve & LM curve both shifts rightward simultaneous by the same ratio then
inte4rest rate will remain same, only national Income will increase multiplier time. In this
situation, there will be no crowding out effect. Thus, both monetary policy and fiscal
policy will be effective. Thus, both play role in regulating the level of economic activity
in the country.

15.5 SUMMARY

The previous chapter discussed about how goods market and money market are
simultaneously in equilibrium which is shown using the concept of Aggregate Demand
curve which shows inverse relation between price level and equilibrium level of output.
The chapter further discussed how changes in fiscal and monetary policy have an impact
the real rate of interest in the economy and hence the simultaneous equilibrium. There are
three situations of crowding out with it ranging from zero percent crowding out to full
crowding out depending on the level of output where the economy is operating that is at
full employment, less than full employment. There is also an extreme situation where
government finances its spending by printing of currency known as monetary
accommodation of fiscal expansion.

15.6 SELF ASSESSMENT QUESTIONS

Check your progress

Exercise 1: True and False
(a) AD curve is a short run phenomenon.
(b) Crowding Out happens because of Monetary Policy.
(c) A two-sector economy does not differentiate between Gross income and Disposable
income.
(d) Fiscal policy refers to change in government expenditure or change in taxes.
(e) Monetizing Fiscal deficit is another name of Monetary Accommodation of Fiscal
Expansion

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(f) Aggregate demand curve shows relation between price level and equilibrium level
of output.
(g) There is no crowding out when output is at full employment level.
(h) Fiscal multiplier shows change in simultaneous equilibrium because of change in
government expenditure.
Ans. a (F), b(F), c(T), d(T), e(T), f(T), g(F), h(T)
Exercise 2: Fill in the Blanks
(a) IS-LM is a________ run phenomenon.
(b) Aggregate Demand shows relation between _________ and _______ .
(c) AD shows ________equilibrium.
(d) Crowding out shows _______ in private investment.
(e) Monetary Policy means changes in ________.
(f) Monetary Accommodation of Fiscal Expansion means _______ of currency to
________ Government expenditure.
Ans a. Short b. Price Level and Equilibrium Level of Output c. Simultaneous.
d. Decrease. e. Nominal Money Supply. f Printing of currency, finance.
Questions for Review
1. Explain the derivation of simultaneous equilibrium.
2. What is Crowding Out.
3. Explain derivation of Aggregate Demand Curve.
4. How do monetary and Fiscal multipliers have an impact on the simultaneous
equilibrium.
5. What happens when there is full employment in the economy and government
increases its purchases.
6. Derive monetary and Fiscal multiplier mathematically.
7. What happens when government increases its money supply to fund its additional
expenditure.
Suggested Readings
Mankiw, N. Gregory, Macro Economics, Macmillan Worth Publishers New York,
Hampshire U.K..
Dornbusch, Rudiger and Stanley, Fischer, Macro Economics Theory, McGraw-Hill
Barro Robert J ., Macroeconomics Theory and Applications, MIT Press

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