Page 193 - DECO402_Macro Economics

Macroeconomic Theory

Notes with the condition that the interest rate should be left as it is and If the government has to adopt the
Contractionary fiscal policy then vice-versa.

Task Express your views about the Monetary and Fiscal Policy.

Key Points

y IS Curve: It shows the coincidence of interest rate and actual GDP which brings the equality
between saving and investment or total expenditure and total production.
y Steps to derive the IS Curve: (i) The relationship between investment and interest rate,
(ii) The relationship between investment expenditure and actual GDP.
y Investment Demand Function: The purpose with it is from the inverse relationship between
investment and interest rate.
y Slope of IS Curve: The slope of IS Curve is downward which shows the negative relationship
between interest rate and actual GDP. It is measured on taking the ratio of change in the
interest rate to change in GDP.
y Shift in the IS Curve: The IS Curve shifts from the change in any of the autonomous components
of total expenditure.
y LM Curve: It shows those different coincidences of actual GDP and interest rate which bring
the equality between demand of money and supply of money.
y Steps to derive the LM Curve: (i) The relationship among money supply, interest rate and
actual GDP, (ii) The equality between demand and supply of money.
y Slope of LM Curve: This curve bend toward upside which indicates negative impact between
GDP and rate of Interest. This is calculated by difference in rate of interest and ratio of difference
in real GDP.
y Shift in LM Curve: The shift in LM Curve happens because of the change in demand of money
or in supply of money.
y Simultaneous Equilibrium in Product and Money Market: The Simultaneous Equilibrium in
Product and Money Market occurs on that point where the IS and LM Curves cut each other. It
shows the coincidence of actual GDP and interest rate, which equals the demand and supply
of product and the demand, and supply of money.
y Derivation of AD: The IS-LM Model is helpful in derivation of AD Curve. The Real money
supply decreases after the rise in price level, which means the backward shift of LM Curve,
and accordingly the lower level of balanced actual GDP, which means the lower level of AD.
Therefore, the derivation of AD is the result of inverse relationship between price level and
actual GDP.

y Monetary Policy and AD: The LM Curve shifts towards right because of Expansionary
Monetary Policy. It is intended to forward shift of AD on the circulated price level.
y Fiscal Policy and AD: The IS Curve shifts towards right because of Expansionary Fiscal Policy.
It is intended to forward shift of AD on the circulated price level.

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