Page 192 - DECO402_Macro Economics

Unit–21: Effect of Fiscal Policies Under Different Cases in IS-LM Framework

21.3 Monetary Policy and Shift in the AD Curve Notes

The reduction in interest rate from Or to Or shifts LM Curve to LM (Part A of figure 21.1). From the
1
2
shift of LM Curve on definite IS Curve, AD Curve is shifted left from AD to AD while price level OP
1
remains constant (Part B). Similarly, the rise in interest rate shifts LM Curve to LM , which further
2
shifts the AD Curve from AD to AD . Therefore, the AD curve is shifted on the change in interest rate
2
and is helpful to bring the stability.

Did You Know? The shift occurs in AD Curve from the change in Fiscal policy of Government
also.

21.4 Fiscal Policy and Shift in the AD Curve

The shift occurs in AD Curve from the change
in Fiscal Policy of government (Government
policy related to tax, expenditure and loan).
Expansionary Fiscal policy (To reduce the tax rate
and increase the social expenditure) shifts the IS
Curve towards right side which further shifts the
AD Curve (By the increase in actual GDP) towards
right on the circulated price level. Similarly, in
Contractionary Fiscal policy (High tax rate and low
social expenditure), the IS Curve is shifted backward
which further shifts the AD Curve towards left.
Figure 21.1 explains these situations. In the part B
of figure 21.1, initial equilibrium is shown by the
point E where IS = LM. From the Expansionary
Fiscal policy of government, the IS Curve becomes
IS on being shifted. New equilibrium actual GDP
1
level is OY . While AD becomes AD on being
1
1
shifted on the circulated price level and constant
money supply. Undoubtedly, interest rate becomes
Or on increment, which is against the government
1
adopted Expansionary Fiscal policy. In such
situation, Monetary Authority can permit to rise in
money supply after which the LM Curve becomes
LM on being shifted and the interest rate, on
1
returning, stays on it’s initial level Or. The mean of
shift of LM Curve is the becoming of AD Curve into
AD on shift. According to initial interest rate Or, the
2
IS-LM equilibrium is established on E and the level
2
of AD is shown by E which is similar to circulated
1
price level OP. The actual GDP becomes OY after
2
increasing. So if Monetary Authority increases the Figure 21.1
money supply for keeping the interest rate on it’s
initial level (Before the increment in government expenditure what he do in the form of full attempt
of his expansionary fiscal policy). Then there will higher AD and actual GDP be found in the economy

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