IS-LM model also known as the Investment Saving-Liquidity Preference Money supply model is a macroeconomic tool that shows the interrelationship between interest rates and the actual output, in the money market as well as the goods and services market. The point at which the IS and LM curves intersect is known as the general equilibrium. This is an extremely fundamental tool and has been used by different economists in a bid to explain the various macroeconomic concepts that define how activities flow in the goods and services market and monetary market. As a critical tool among monetarists and Keynesians the IS-LM model is used for short run studies of an economy when prices are fixed and no element of inflation (Mankiw, 2010). The two schools of thought have been keen on the different views that they have brought forth in arguments concerning the fiscal and monetary policies. Each of the two has developed a school of thought, which is a definition of the unique believe of the people who follow their arguments.
Monetarists are defined by the element of monetarism, which is a term that was first used by Brunner in 1968. The term may be explained in two main ways where the first one relates to the view of quantity of money as the main source of economic activities and the disruptions that come with money such as inflation. This term is also built on a belief that money supply is the most outstanding monetary policy. Secondly the term refers to a pool of economists who are adherent to these thoughts and were led by Milton Friedman, as well as the economics school of Chicago (Mankiw, 2010).
The 1968 paradigm has close connection to neoclassical economics, which believe that free flow of credit as well as interest rates, and the laissez faire attitude is the most outstanding way to follow. This is because minimal intervention of the public, and a competitive economic system will lead to extremely high results than the ones resulting from Keynesians. Following monetarists’’ consideration of monetary policy as more effective , government control over money supply is paramount. On the other hand, since monetarists had confidence on the significance of the quantity of money, the equation of exchange became popular again (Hahnel, 2002).
Monetarists look at fiscal policy as inferior compared to the monetary policy. There point of argument is mainly based on the low interest elasticity of money demand. Following this, when put into application the IS-LM model, monetarists believe the IS curve more elastic than the one that Keynesians use. On the other hand, the LM curve as defined by the Keynesians is more inelastic. This is the main cause for a crowding out effect over private investment when a monetarist IS-LM model for public investment is developed by fiscal policy and this leads to reduced effectiveness of public spending (Lipsey andChrystal, 2011). Nevertheless, even if monetary policy is extremely reliable, its effects may take a good deal of time before it is noted in the economy, and it may be extremely difficult to implement the policy.
Crowding effect is an economic element that mainly occurs when there is increased government borrowing. This is a form of expansionary fiscal policy aiming at reducing investment spending. The government makes excessive borrowing that plays critical role in reducing private investment. In a case where increased government spending or reduction in tax revenues causes a deficit that is financed by reduced private investment. At a point where the economy is at full employment, then the government immediately raises its budget deficit (Mankiw, 2010). This leads to competition with the private sector for minimal funds that is out for investment, leading to an increase in interest rates, as well as reduced private investment.
Monetarists have also succeeded in raising their views through the Phillips curve. They have been extremely keen to criticize the money illusion that has been implied through the Phillips curve through exclusive analysis of the relationship that exists between inflation and unemployment. The monetarists believe that in a situation where there is, an unanticipated high inflation and the consequent decrease in levels of unemployment, the trade-off indicated in the Phillips curve will have to be applicable (Mankiw, 2010). However, this must not be the case when monetary policies are anticipated, having an implication that the trade-off between inflation and unemployment is not applicable in the long run.
The Phillips curve was drawn as an indication of the relationship that exists between the rate of change money wage rates per year, as well as the rate of unemployment. The tool is practical representation of the effects of inflation to level of unemployment. This is practical representation of the monetarists point of argument. As the level of inflation rises as a result of uncompetitive fiscal policies the level of unemployment rises. This may be attributed to the existence of low levels of private investments. The government raises the rate of interest to a point that most people cannot afford money that may be required for private investments. The public investments that have been installed in an economy would not be enough to sustain the individuals within the given economy (Hahnel, 2002).
Also, the IS-LM model has been used by Keynesian economists. Keynesian economics emphasizes on the view that in the short run, especially in times of recessions, the output of an economy is mainly influenced by the aggregate demand. According to Keynesians, aggregate demand is not necessarily equal to the economy’s productive capacity. Instead, it results from a host of factors and at some point causes individuals to behave erratically, causing extensive influence to production, employment, as well as inflation. John Keynes is the mastermind of the Keynesian school of thought. He developed exclusively unique arguments which have stood to prove the different claims made on fiscal and monetary policies (Lipsey andChrystal, 2011).
Keynes’ theory suggests that there could be effective government policy for use in managing the economy. Instead of viewing unbalanced government budgets as erroneous, Keynes pushed for what has been known as countercyclical fiscal policies. These may be defined as policies that has operated against the wave of the business cycle, which is a deficit spending when an economy of a nation suffers from recession, or when economic recovery was delayed for a long time and the levels of unemployment were persistently high. In addition, the oppression would be because of the suppression of inflation in high economic times by raising taxes or cutting back on government outlays. Keynes is famous following the outstanding argument that he made when he said that a government should solve its problems in the short run instead of waiting for the influence of market forces to solve the problem in the long run, since “in the long run, we are all dead” (Mankiw, 2010).
This argument by Keynes was contrary to the classical and neoclassical economic argument on fiscal policy. Fiscal stimulus or deficit spending could trigger production. However, stimulation by these schools could not create any platform that would outrun the side-effects of crowd out in private investment. Initially, it would lead to increases demand of labor and increase wages, which would negatively influence profitability. Secondly, a government deficit raises the government bonds stock, reducing their market price, as well as encouraging high interest rates, making it extremely expensive for business to finance fixed investment. Therefore, efforts to inspire the economy would be extremely competitive.
The Keynesian response has been that fiscal policy is mainly appropriate when unemployment is extensively high, and is above the non-accelerating inflation rate of unemployment (NAIRU). In such a case, crowding out is minimal. Further, private investment can be “crowded in”. this means that fiscal stimulus raises the market for business output, raising cash flow and profitability spurring business alertness. According to Keynes, the accelerator effect means that the government and business could complement rather than substitute in such a situation. Secondly, as the stimulus takes place, gross domestic product rises, raising the amount of saving, helping to finance the increase in fixed investment. Finally, the government outlays must not be wasteful all times since government investment in public goods that will not be provided individuals who are out chasing profit will encourage the growth of the private sector (Mankiw, 2010). This means that extensive expenditure by the government on certain things such as basic research, education, public health, as well as infrastructure could be helpful in the long-term advancement of potential output.
A Keynesian economist might indicate that classical as well as neoclassical theory does not extend ample explanation on why firms operating as special interests to influence the government policy are assumed to bring in negative results. On the other hand, the same firms operating under the same motivations outside the government should bring forth positive results. Libertarians discourage that because both parties consent, free trade raises net happiness, while government inflicts its will by force reducing happiness (Gordon, 2012). Thus, firms that participate in government’s manipulation do ne t harm, while firms that respond to the free market cause net good.
According to Keynes’ theory there exists exclusive slack in the labor market before the justification of fiscal expansion. This assumption has been questioned by conservative and neoliberal economists unless labor unions or the government intervene in the free market causing a persistent supply side or classical unemployment. However, their role is to increase flexibility of the labor-market such as cutting wages, deregulating business, as well as busting unions (Gordon, 2012).
Deficit spending may not be defined as Keynesianism. Keynesianism defines counter-cyclical policies as vital in smoothening out fluctuations in the business cycle. An instance of a counter-cyclical policy is raising taxes to minimize pressure in the economy, as well as prevent inflation when there is excessive growth in demand, and getting involved in deficit spending on labor-intensive infrastructure projects to encourage employment, as well as stabilize wages during poor economic times (Lavoie & Seccareccia, 2005).
After exclusive analysis of fiscal and monetary policies it would be extremely confusing to define which is the most outstanding between them. Each of them is unique on the economic principles that they represent. However, upon critical review of practicality of the two theories, fiscal policy would be the most significant or influential policy.
Fiscal policy stands for extensive principles, which may be defined as the merits for the policy to an economy. This policy dictates use of government revenue and government spending to influence the economy. The policy is mainly driven by advancements in the level of taxation, as well as government spending in different sectors. Taxation is a source of revenue for the government and it is useful in defining the development of a region. This is because the money collected as revenue is used for development of various areas in the country (Eggert & Goerke, 2003).
Government will always use fiscal policy to extend pressure on the level of aggregate demand in an economy. This is mainly aimed at achieving full employment, price stability, as well as economic growth. According to Keynesians increase in government spending and decrease in tax rates are the most unique ways t encourage aggregate demand, as well as reducing spending and increasing taxes after the start of economic booms (Lipsey andChrystal, 2011).
Fiscal policy is also useful as it centers its argument crowding out effect. This is a situation where the government borrowing causes high interest rates that may negatively influence spending. When there is budget deficit, the government will have to acquire funds from public borrowing through release of government bonds or overseas borrowing (Eggert & Goerke, 2003).
When government borrowing rises interest rates it extends foreign capital from foreign investors. This is because bonds issued from a country through execution of expansionary fiscal policy would attract extensively high source of capital for the government. The amount of money that the government gains from selling bonds is useful for extending development to the public. This keeps productivity in the country in line since all parties in the country benefit from government spending in form of infrastructure development (Eggert & Goerke, 2003).
Keynesians, and monetarists are extremely significant figures in the field of economics. These are different schools of thought where different principles have been used to define their belief on how useful the IS-LM economic model could be to the society. Monetarists have exclusive belief on monetary policy while they got minimal concern with fiscal policy. In the use of the IS-LM model, monetarists believe the IS curve to be extremely elastic while LM remains more inelastic. This has been the main cause of the crowing out effect, which has mainly affected private investments leading to poor performance of the economy. They have used extensive analysis through Phillips curve, which is an extremely useful tool in definition of the significance of fiscal policy. There exist exclusive differences between fiscal policy and monetary policy. Fiscal policy is mainly concerned with the use of government revenue, which is usually in form of taxation to extend development in the country. Citizens have to secure extensive benefits from the revenue they pay to the government through taxation. This will be observable through existence of development in the country. On the other hand, monetary policy is concerned with the fiscal policies of the government through the central bank. This policy controls the money supply in an economy. It is through this policy that certain element such as unemployment has become extensively critical elements for analysis of the status of an economy. This is based on the exclusive analysis that has been brought forth concerning interest rates.
Eggert, W., & Goerke, L. (2003). Fiscal policy, economic integration and unemployment. Munich: CES.
Gordon, 2012. Chapters 3 and 4: The Keynesian Cross Model and the IS Curve,Strong and Weak Effects in the IS-LM Model
Hahnel, R., 2002. Chapter 7. The ABCs of political economy a modern approach(pp. 161-174). London: Pluto Press.
Lavoie, M., & Seccareccia, M., 2005.Central banking in the modern world: alternative perspectives. Cheltenham, UK: Edward Elgar.
Lipsey andChrystal 2011. Chapter 21: The Role of Money in the Macroeconomics–Appendix.
Mankiw 2010. Chapters 10 and 11: ADI: Building the IS-LM Model, ADII: Applying the IS-LM Model