MONETARY AND FISCAL POLICY IN THE STATIC MODEL On the demand side of economy, the equilibrium conditions for

the product market, IS: y = c (y t(y)) + i(r) + g And for the money market, LM: ( ) ( )

Are shown in the r,y space of Figure 9-1 (a) as IS and LM. The investment and saving functions and level of government purchases fix the position of the IS curve. The demand for money function and the level of real balances m= /P fix the position of the LM curve. Varying the price level shifts the LM curve in Figure 9-1(a), tracing out the demand curve DD in Figure 9-2. Shown in Figure 9-1(b). This gives equilibrium employment N as a function of the price level. Employment is translated into output y by the production function, y = y(N; ) In this model, changes in P shift both the demand and supply curves in Figure 9-1 (b), changing equilibrium amployment N. This, in turn, changes equilibrium output on the supply side through the production function, tracing out the supply curve SS of the Figure 9-2. Thus, the IS and LM equations give us a demand ralationship between P and y, and the labor market equation and the production function give us a supply relationship between the same two variables. On the most aggregate level we have two equations in the to unknowns, P and y, shown in Figure 9-2. The solution to those two equations the intersection of the demand and supply curves of Figure 9-2 is equilibrium P , y , which we can trace back to W , N in Figure 9-1(b) and r , y in Figure 9-1(a). The Effects of a Fiscal Policy Stimulus

A permanent tax cut would have much the same effect as the g increase, assuming that consumers react by spending a large fraction of the increase in disposable income. The tax cut would shift the IS curve and demand curve out, raising the price level and the interest rate. Employment and output would rise, and the tax cut would yield the same y increase as the alternative dg increase if tax rates were reduced by an amount that gives a policy induced consumer expenditure increase cy dt, equal to dg. The difference between a tax cut and a g increase, as usual, is in the composition of final output. The tax cut favor increase consumer spending, while the g increase favors increased outpt of public goods.

The Effects of a Money Supply Increase The effects of a money supply increase are shown in Figure 9-3 and Figure 9-4. Figures 9-3(b) and 9-4 are exactly the same as Figures 9-1(b) and 9-2; the only difference between the analyses of a g increase and an increase lies in the origin of the demand shift in Figure 9-3(a).

MONETARY AND FISCAL POLICY IN THE CLASSICAL CASE The effects of fiscal policy in the classical model can be seen in Figures 95 and 9-6. The fiscal stimulus is translated entirely into a higher interest rate and price level. On the product side, the higher interest rate reduces investment just enough to counterbalance exactly the higher goverment spending. In the money market, with the money supply fixed and the price level rising, the supply of real balance shrinks. Thus, in the LM equation, = P[l(r) + k(y)], the rise in P must be matched by an equiproportional fall in the term within square brackets. Since y is fixed by the vertical aggregate supply curve of Figure 9-6, r must rise enough to equilibriate the money market.

These changes are shown in Figure 9-7. The increase in the money stock shifth up the demand curve in Figure 9-7(c). This pulls the price level up proportionately, with P rising as much as P in Figure 9-7(d). The result is no change in y or N in Figures 9-7(a) and (b).

FISCAL AND MONETARY MULTIPLIERS IN THE STATIC MODEL First, the fiscal and monetary policy multipliers apply to situations in which changes in policy variables shift the demand curve, and price and income adjust along the supply curve, for example, from P , y to P1 , y2 in Figure 9-8. The second point is that, as we suggested in the first section, the difference between the effects ot the three aggregate demand policy instruments is in where the initial policy induced expenditure stimulus appears. Once the excess demand is created, for example, y2 y in Figures 9-2 and 93, the adjustment of the model through the price mechanism is the same case.

The Multiplier for Changes in Government Purchases For the g multipliers expression,

( )

The multiplier of equation only in the final term in the denominator, which reduces the multipliers size y moves to y2 instead of y1 in Figure 9-8. The term dP/dy gives the price increase (shifting LM) between equilibria with a dg increase; multiplying that by M/(P2. l) gives the efferct of this LM shift on r, for example, r3 - r2 in Figure 9-1(a); multiplying again by i gives the endogenous effect on investment of including the supply side and price changes in the model.

The Multiplier for Changes in Tax Rates dy = The Multiplier for Changes in the Money Supply dr =

INCOMES POLICY IN THE STATIC MODEL Aggregate Supply Shift The effect of an incomes policy change, shifting the aggregate supply curve, is shown in figure 9-9 and 9-10. There P is reduced from P to P1 directly by incomes policy. This would shift the labor supply curve down at any initial price level P in Figure 9-9(a), increasing equilibrium employment at the initial values of P from N to N1. This in turn increases equilibrium output supplied from y to y1 in Figure 9-9(b). The increase in equilibrium output supplied at the initial price level P is shown as an outward shift in the aggregate supply curve in Figure 9-10. The objective of incomes policy is generally stated as shifting the supply curve down, but with the positively sloped SS we can interpret the shift as down in terms of P, given y or out in terms of y, given P.

INCOMES POLICY AND EXCESS DEMAND The coupling of incoes policy with expansionary demand policy is illustrated in Figure 9-11. An expansionary monetary or fiscal policy move, as discussed earlier in this chapter, would shift the demand curve out to D1 D1. This

would increase equilibrium output in the general Keynesian model to y1, but would also pull the price level up to P1. To eliminate the price increase, incomes policy could attempt to shift the supply curve out to S1 S1, taking the economy to the new equilibrium P , y2. The incomes policy in this case would increase the change in equilibrium output while holding the price constant. Clearly, if y1 was the target for income, a smaller dose of both policies could take the supplydemand intersection to P , y1. In the classical case, incomes policy would have effects somewhat different from those in the short run model. In Figure 9-12 we show an excess demand gap eliminated by the shift in the vertical classical supply curve. At the initial price level P , aggregate demand shifts to D1 D1. As we saw earlier, in the classical case this would result in the price level rising to P1 with no change in output. To obtain a change in output, the vertical supply curve must shift; incomes policy is one way to do this. In Figure 9-12, incomes policy moves equilibrium output, while demand policy controls the price level. Thus, in the classical case, movements in aggregate demand move the price level, and incomes policy offers one way to move equilibrium output.