As government expenditure increases, the income increases. This increase in income leads to a rise in consumption expenditure. A 1 unit rise in income leads to a rise in consumption by the marginal propensity to consume. As consumption expenditure increases, this induces further increase in output in the economy. So income increases. The increase in government expenditure creates a multiplier effect. This multiplier depends on the marginal propensity to consume (MPC). Higher the MPC higher is the multiplier effect.
The money market is at equilibrium when the demand for money equals the supply of money. The demand for money has two major components, the transaction demand and the speculative demand. The transaction demand depends on the income level. As income increases, the transaction demand for money increases. The speculative demand for money depends on the rate of interest. As interest rate rises, people prefer to keep more money in the bank than in their hands. So according to the liquidity preference theory, the demand for money is negatively associated with the rate of interest. So the rate of interest can be adjusted to obtain equilibrium in the money market.
Problems and applications:
- As government expenditure increases, the output level increases in the short-run, the interest rate remaining the same. This can be shown as an upward shift in the expenditure curve.
- With an increase in the tax rate the effective demand falls. So the expenditure falls, given the rate of interest. This leads to a fall in the level of output as shown by a downward shift in the expenditure curve.
- As government expenditure (G) and tax (T) increases by one unit each, the output level will also increase by one unit.
Part 2: Question 2.
We know that the planned expenditure (PE) consists of consumption expenditure (C), investment (I) and government expenditure (G), as shown below:
PE = C (Y − T) + I + G (1)
Substituting the value of C, I, G and T in equation (1) we get,
PE = 200 + 0.75(Y − 100) + 100 + 100
= 0.75Y + 325
PE = 0.75Y + 325 (2)
b. The equilibrium level of income:
We have already obtained PE as a function of the income Y. We know that at the equilibrium the planned expenditure equals the level of income.
Y = PE
Substituting PE by Y in equation (2) we have,
Y = 0.75Y + 325
Or, Y = 1300.
c. The government expenditure increases from 100 to 125. Replacing 100 by 125 in equation (1), we get
PE = 0.75Y + 350 (3)
Now, imposing the equilibrium condition PE = Y in equation (3), we have
Y = 0.75Y + 350
Or, Y = 1400
Thus, an increase in government expenditure by 25 units has led to an increase in income by 100 units.
d. The consumption function is given by
C = 200 + 0.75(Y – T)
Here, 0.75 is the MPC. We know that the government expenditure multiplier is 1/1-MPC. So an increase in government expenditure by 1 unit will increase income Y 1/1-0.75 times or 4 times. If income level is now 1600 there has been an increase by 300 units. This can be caused by an increase in government expenditure by 75 units (75*4 = 300). So government expenditure has increased from 100 to 175.
- The demand for money is given by the equation below:
M/P = 1000 -100r
Where, r is the rate of interest.
The real money balances or the money supply is M/P = 1000/2 = 500
- At equilibrium Money supply = demand for money
500 = 1000 -100r
Or, r = 5
- Now, the money supply increases to 1200, price level remaining the same. The real money balance is now 1200/2 = 600. The equilibrium rate of interest r will be
600 = 1000 – 100r
Or , r = 4.
There has been a decrease in r by 1%.
- Now the rate of interest has to be increased from 5% to 7%. The price level remains the same. Let us find out the money supply required to achieve this rate.
M/P = 1000 -100r
Or, M/2 = 1000 -100*7
Or, M/2 = 300
Or, M = 600
Therefore, money supply has to be reduced to 600.
The aggregate demand (AD) curve shows the equilibrium income at different price levels. The AD curve is obtained from the IS-LM model. In the IS-LM model, a fall in the price level leads to a rise in the real money supply leading to a fall in the rate of interest. A lower rate of interest induces more investment leading to a rise in the equilibrium level of income. So there is a negative relationship between equilibrium income and the price level. This is represented by a downward sloping AD curve.
With an increase in the tax level the consumption expenditure falls leading to a fall in the level of output. This is shown by a leftward shift in the IS curve. The leftward shift means a fall in the rate of interest and a rise in investment.
Part 2: Question 2:
- With the new invention of a high-speed computer chip, the firms will be induced to reorganize their computer systems. This will lead to an increased flow of investment at the existing rate of interest. The higher investment will lead to higher output and income making the IS curve shift to the right. The higher income will increase the transaction demand for money. The money supply remaining the same, the higher demand for money will be accompanied by a higher interest rate to restore money market equilibrium. The increase in rate of interest will reduce investment to some extent lowering the output level than the initial increase. The new equilibrium will be at a higher rate of interest and income with higher investment and consumption expenditure.
- With a sudden wave of credit card fraud, people will prefer to make more transactions in cash. This will increase the demand for real balances. There will be excess demand fro money. To keep the money market in equilibrium, the rate of interest will rise for the same level of income. So, the LM curve will shift upwards denoting higher interest rates at the given income level. Investment falls leading to a fall in income and thereby consumption expenditure. If the central bank now increase money supply to restore the output to its previous level, the LM curve shifts downward to the previous level and the original equilibrium condition is restored. There will be no change in the equilibrium output and rate of interest.
c) With the increase popularity of the book Retire Rich, the people are induced to save more. The increase in saving leads to a fall in consumption expenditure, shifting the IS curve leftwards. The output falls. With a fall in the demand for money, the rate of interest falls. This induces more investment. If the central bank aims at keeping the output at the previous level, it will increase the money supply. The LM curve will shift rightwards further decreasing the rate of interest. The investment will rose to restore the output to the original level. The new equilibrium is characterized by the same output level but lower interest rate, higher investment and lower consumption expenditure.
Problems and applications:
a) With an increase in money supply there is excess supply of money balances in the economy. To keep the money market in equilibrium the rate of interest falls, there by inducing investment and output. This is depicted by a rightward shift in the LM curve from LM1 to LM2 leading to a fall in rate of interest from r1 to r2 and a rise in income to Y2 as shown in the adjacent figure. The rise in income is above the full employment level. So the increase in expenditure leads to increased price level. The increased price level leads to reduced supply of real balances. The price level rises until the expenditure reaches the long-term level. So the LM curve shifts leftwards to its original position as interest rate rises to restore money market equilibrium. Investment also comes back to the previous level. When the economy has reached the full employment level the increase in money supply produces no effect on income and expenditure.
- The increase in government expenditure leads to a higher output in the short-run. This is shown by a rightward shift in the IS curve from IS1 to IS2 leading to an increase in income to Y2 and rate of interest from r1 to r2, as shown in the adjacent figure. But since the increase in expenditure is more than the long-run full employment output level, the prices tend to increase leading to a leftward shift of the LM curve as real balances fall. Rate of interest increases reducing investment until the long-term level of income is restored. The output remains the same, the price level and rate of interest rises due to the increase in government spending at the full employment level.
c) With an increase in the tax rate consumption expenditure falls leading to a fall in output to Y2. This can be shown by a leftward shift in the IS curve leading to a new equilibrium point at B. But this Y2 level is below the long-run level of output. The reduced expenditure leads to fall in prices thereby increasing real balances shown by a rightward shift in the LM curve. The rate of interest rises to restore money market equilibrium. The investment expenditure falls leading to a fall in output to the previous long-run level. The new equilibrium is at point A with a higher level of rate of interest but reduced prices. The output level remains unchanged.
- Even if money demand is assumed to be dependent on disposable income rather than total expenditure, the effect of an increase in government expenditure remains the same. The increase in government expenditure leads to a rightward shift in the IS curve resulting in higher output and interest rate but keeps the LM curve unchanged.
- If money demand is made dependent on disposable income, the effect of a tax cut is significant. A tax cut increases consumption expenditure leading to a right ward shift in the IS curve. The corresponding increase in money demand due to the increase in disposable income makes the LM curve to shift leftward leading to lower output and higher rate of interest.
Question 2. In a floating exchange rate model in the Mundell-Fleming framework, a fall in the supply of real balances leads to a leftward shift in the LM* curve reducing output and increasing the exchange rate. A higher exchange rate will reduce exports and so trade balances will move adversely.
If the exchange rate is kept pegged at a particular level, the increase in the exchange rate will be checked by purchase of foreign exchange by the central bank leading to an increase in money supply thereby shifting the LM curve to the right. The equilibrium income remains the same. There is no effect on the trade balances. Thus we see that the monetary policy will be effective in an open economy only in a floating exchange rate regime.
In economic theory, the impossible trinity states that it is not possible to have an independent monetary policy along with a fixed exchange rate as well as a free capital movement.
Problems and application:
a. A reduction in consumer confidence will be reflected in a fall in the consumption expenditure leading to a leftward shift in the IS curve. This fall in consumption will raise net exports due to a fall in the exchange rate, in a floating exchange rate regime. So there is no net effect on the aggregate output level. But, in a fixed exchange rate system a fall in consumption expenditure will not reduce the exchange rate as the central bank will keep the exchange rate pegged by reducing money supply so that the LM curve shifts leftwards.
b. An increase in consumption of foreign cars will increase imports leading to a leftward shift of the NX curve thereby leading to a leftward shift of the IS curve. There will be no change in the aggregate demand in a floating exchange rate system as exchange rate will fall. In fixed exchange rate regime the LM curve will shift leftwards as money supply falls. The exchange rate remains the same but net exports and output falls.
c. Reduction in demand for money will shift LM curves to the right, leading to increase in the equilibrium aggregate output demand. Under floating exchange rate this will reduce exchange rate and increase NX. Under fixed exchange rate LM curve shifts back to its original level to keep exchange rate constant.
- When prices tend to be sticky, a change in nominal exchange rate will lead to a change in the real exchange rate as well. But in the long-run prices tend to change leading to change in the PPP. An increase in the exchange rate will make the domestic products more expensive in the world market. Exports will fall and trade balance will move adversely. Policy makers would prefer more exports as that will increase the supply of foreign exchange and reduce the supply of Canadian dollars.
- A decrease in imports will make the domestic industry to expand, so that they can achieve scale economies and become more efficient. The increase in competitiveness will lead to increase in the net exports at a given level of Y.
In a flexible exchange rate regime IS shifts leftwards and LM shifts leftwards. In a fixed exchange rate system though the IS shifts leftward the LM curve shifts to the right as money supply increases to keep the exchange rate pegged.
With a tax cut, the income will increase via the multiplier effect (MPC/1-MPC) thereby increasing the disposable income Y-T. With a constant rate of interest, the real money balances M/P has to increase leading to a fall in the exchange rate.
- Since each province runs its own fiscal policy Alberta should follow a floating exchange rate regime with the other provinces. If there is an economic turndown in one province, it will follow fiscal and monetary expansion. Then Alberta will tend to gain from the lower exchange rate in the other province.
- Both monetary and fiscal expansion policies can be used to create jobs. A tax cut policy will increase consumption expenditure and induce more output thereby increasing employment. An increase in government spending directly creates employment in the government sector, induces businesses to hire more workers or provides subsidies to the state government so that employment is not reduced. An expansionary monetary policy means a reduction in the rate of interest to induce investment and increase consumption expenditure through credit which in turn increases output and employment.
- If Alberta stops import of wine from Ontario, in the short-run net exports and output will be affected. In the long-run Alberta will tend to import wine from other sources so NX and output will come back to the original levels.