INCOME DETERMINATION

MODEL INCLUDING MONEY

AND INTEREST
 Session Outline
• Equilibrium in the Goods and Money
Markets (Simultaneous Equilibrium)
• Monetary and Fiscal Policy
• The Transmission Mechanism
• Crowding Out
 Equilibrium in the Goods and
Money Markets (Simultaneous
Equilibrium)
• Simultaneous equilibrium in the goods and
money markets is possible only at the point
where the IS and the LM curves intercept
each other.
• At any point other than E, we have
equilibrium only in the goods market, or
equilibrium only in the money market, or no
equilibrium in either market
 Interest Rate

LM

E
i0

IS

Y0

Income and Output (Y)

 Continued…..
• It is worth recalling our assumptions and
the meaning of equilibrium at point E. The
important assumption that we made here is
that price level is constant and firms are
willing and able to supply any amount of
output demanded at that price level.
Characteristics of Points that do
not lie on the IS and LM Curves
Interest
Rate

ESG
LM
ESM
I
II
E
i0 EDM
ESG
EDG
IV
ESM
EDM III
EDG
IS

Y0

Income and Output (Y)

Figure 1.9
 Characteristics of Points that do
not lie on the IS and LM Curves
• Let us discuss the characteristics of points that do not lie
on the IS and the LM curves. We have seen that points
above the IS curve indicate excess supply of goods (ESG)
and below it indicate excess demand for goods (EDG).
• Similarly, points above the LM curve indicate excess
supply of money (ESM) and below it indicate excess
demand for money (EDM).
• The intersection of the IS and LM curve, thus, leads to
four zones with different characteristics. The four zones
are shown in figure 1.9. Except for point E, all other points
are disequilibrium points.
The above table shows what happens if
the economy is at different
disequilibrium points.
Region Goods Market Money Market
Disequilibri Output Disequilibri Interest
um um Rate

I ESG Falls ESM Falls

II EDG Rises ESM Falls

III EDG Rises EDM Rises

IV ESG Falls EDM Rises

Changes in the Equilibrium Levels of
Income and the Interest Rate
• A shift in the IS curve or LM curve would shift the
equilibrium levels of income and the interest rate.
• For example, increase in autonomous investment would
shift the IS curve to the right, leading to increase in interest
rate and income. Similarly increase in autonomous
spending of government, G also leads to increase in
interest rate and income.
• On the other hand, a change in real money supply shifts
the LM curve.
• An increase in real money supply shifts the LM curve
down and to the right, leading to increase in income, but
decrease in interest rate.
 Monetary and Fiscal Policy
• We now discuss how the IS-LM model can be used in
understanding the working of monetary and fiscal policy.
• Fiscal and monetary policies are two important
macroeconomic tools the government uses to keep the
economy growing at a reasonable rate, with low inflation.
• While fiscal policy has its initial impact on the goods
market, monetary policy affects the assets market initially.
• But, because of close proximity between goods and assets
market, both monetary and fiscal policies have effects on
both the output level and the interest rates
 Monetary Policy
• Let the initial equilibrium be at point E, where the LM
schedule intercepts IS schedule. The corresponding real
money supply to the initial LM curve is . Suppose the RBI
increases the nominal money supply, say through open
market operation*, the real money supply also increases,
given the price level.
• With the increase of real money supply, the LM curve
shifts down and to the right, say to LM1 (see figure 1.10).
Consequently, the equilibrium changes to E1 with a lower
rate of interest and a higher level of income. The
equilibrium level of income increases because the
investment spending increases with the fall in interest rate
in the economy.
• If the demand for real money is extremely sensitive to
interest rate (represented by a relatively flat LM curve), a
change in the money supply will be absorbed in the assets
markets and there will be only a very small change in the
rate of interest. Consequently, the investment spending
 Impact of monetary policy
Inter
est
Rate
LM

E
i0 LM1

E1

i1

E1
IS

Y0 Y1

Income and Output

(Y) Figure 1.10
 Impact of monetary policy
• If the demand for real money is extremely sensitive to
interest rate (represented by a relatively flat LM curve), a
change in the money supply will be absorbed in the assets
markets and there will be only a very small change in the
rate of interest.
• Consequently, the investment spending would also be
small. Conversely, when the money demand is insensitive
(represented by a relatively steeper LM curve), a change in
the money supply causes a great change in the interest rate,
and thereby has a greater impact on investment demand
 adjustments during monetary
expansion
• When money supply is increased, the LM curve shifts to
the right. Consequently, the equilibrium point changes to
E1. But the economy is at the initial equilibrium point E.
At point E, the increase in money supply creates an excess
supply of money in the market which makes people to buy
more financial assets.
• As demand increases for financial assets, asset prices
increase and yields decline. The adjustment process in the
assets market is much more rapid than that in the goods
market and, therefore, we move immediately to point E1
when the money supply increases.
 Adjustment continued….
• At point E1, the demand for real balances increases as the
interest rate has declined significantly. However, at point
E1, there is excess demand for goods. This excess demand
leads to increase in output and thereby income. As output
expands, the interest rate (after immediate decline in
interest rate when money supply is increased) rises
because increase in output and income raises the demand
for money. Ultimately, the equilibrium in money market is
reached at point E1. (Note: rise in interest rate would be
less than the initial fall in interest rate. Hence, an increase
in the money supply leads to overall decline in interest
rate).
• Thus, rise in money supply leads to decline in interest
rates, which in turn leads to increase in aggregate demand
and thereby output and income.
 The Transmission Mechanism
• The mechanism by which the changes in monetary policy
affect aggregate demand is called Transmission
Mechanism. Two steps are involved in the process of
Transmission mechanism
• Step one: when there is a change in real money supply,
portfolio adjustments lead to change in the prices of assets
and interest rates. For example, if real money supply
increases, people hold more money than they want. People
reduce their money holdings by buying financial assets;
thereby leading to increase in asset prices and decline in
yields (i.e. interest rates).
• Step two: Changes in interest rates affect aggregate
demand and ultimately output and income. Thus, in our
above example, fall in interest rates lead to increase in
aggregate demand which in turn increases output and
income in the economy.
 Tabular presentation of Transmission
Mechanism
The Transmission Mechanism
Step One Step Two
Change
Change in real money Adjustments in Changes in
supply the portfolio, in aggregate
leading to a interest demand
change in asset rates lead results in
prices and to change adjustme
interest rates in nts in
aggregate output
demand and
income.
 Fiscal Policy
• While changes in monetary policy affect the LM curve,
fiscal policy changes affect the IS curve. Let us see how
changes in the government spending influence the level of
income and interest rates in the economy. When
government spending (G) increases, the aggregate demand
increases
• given the interest rates. To meet the increased demand for
goods, output must rise as shown by a shift in the IS
schedule in figure 1.11. For example, if government
spending increases by 100, the income increases by 400 at
each level of interest rate, given the multiplier as 4. Thus,
the IS curve shifts up to the right by 400.
Impact of changes in govt. spending
• When the government spending increases by 100,
the economy would move to point E11 from initial
equilibrium point E, given the interest rates remain
same at i0. The corresponding income level is Y11
which is more than Y0 by 400. At E11, the goods
market is in equilibrium, but the money market is
not. At point E11, the goods demanded equals
goods supplied, but there is excess demand for
money in the market because of lower interest rate
 Continued….
• When income increases, the quantity of money demanded
goes up. Consequently, the interest rate rises. Firms reduce
their planned investment spending at higher rate of interest
and the aggregate demand falls from the high level it
reaches immediately on increase in the government
spending. However, the economy finally reaches a new
equilibrium at point E1 where both goods and asset
markets are in equilibrium.
• Thus, an increase in government spending would lead to
an increase in the income level and increase in interest
rates.
 Policy Effects on Income and Interest Rates

Policy Equilibrium Equilibrium

Income Interest Rate
Expansionary Monetary Increase Decrease
Policy
Expansionary Fiscal Policy Increase Increase

Note that expansionary policy (fiscal or monetary) is aimed at

increasing income. Expansionary monetary policy, thus, includes
increasing money supply in the economy, while expansionary fiscal
policy involves increasing government spending and reducing taxes.
We discuss these aspects in detail in the later chapters.
 Crowding Out
• Crowding out is the phenomenon where increase
in interest rates due to increase in government
spending crowds out the private investment
spending, leading to decline in aggregate demand.
• Recall that when government spending increases,
the income increases only to Y1, although it may
have increased initially to Y11. This is so because
an increase in interest rates in the market from i0
to i1 reduces the level of private investment
spending (called crowding out), leading to drop in
aggregate demand and income.
Crowding out of private investment

Rate
Interest LM
E
1

i1

E11 LM1
E
I0

IS1

IS

Y0 Y1 Y11

Income and Output (Y)

Figure 1.12
 Crowding out effect
• crowding out of private investment that is caused
by the expansionary fiscal policy
• To prevent such crowding out, interest rates
should be prevented from rising by increasing the
money supply in the economy.
• Thus, an expansionary monetary policy can be
used to prevent crowding out caused by an
expansionary fiscal policy.
 A fiscal expansion
• A fiscal expansion shifts the IS curve to IS1 and
moves the equilibrium of the economy from E to
E1, as shown in figure 1.12. At E1, both the
income and the IS1 interest rate are also higher
than at E (i.e. i1 > i0).
• This higher interest rate would crowd out
investment spending. But an increase in money
supply shifts the LM curve to LM1 and helps the
economy to at reach E11 (where the equilibrium
income is higher, but interest rate is lower at i0)
by keeping the interest rate at its initial level, i0.