Page 166 - DECO201_MACRO_ECONOMICS_ENGLISH

Unit 9: General Equilibrium of an Economy: IS-LM Analysis

Expansionary fiscal policy implies use of fiscal instruments to bring about an increase in national Notes
income. Figure 9.13 shows the effects of expansionary fiscal policy. The increase in government
expenditure shifts the IS-curve to the right. As a result, there is increase in income and interest
rate.
If the economy is initially in equilibrium at point E , expansionary fiscal policy (say, increase in
1
government expenditure) will result in movement to point E , if the interest rate remained
3
constant. At E the goods market is in equilibrium with planned spending equal to output. But
3
the money market is no longer in equilibrium. Income has increased, and therefore the quantity
of money demanded is higher. Because there is an excess demand for real balances, the interest
rate rises. Firms planned investment spending decline at higher interest rate, and thus aggregate
demand falls off.

Figure 9.13

The complete adjustment, taking into account the expansionary effect of higher government

spending the dampening effect of the higher interest rate on private spending is given by E , a
2
point at which both goods and money markets are simultaneously in equilibrium. Only at point
E is planned spending equal to the given real money stock. The reason that income rises only to
2
Y rather than to Y , is that the rise in interest rate from i to i reduces the level of investment
2 3 1 2
spending. Thus, the increase in government spending crowds out investment spending. Crowding
out occurs when expansionary policy causes interest rates to rise, thereby reducing private
spending, particularly investment. The extent of crowding out depends on the slopes of IS and
LM schedules and the extent of shift in the IS-curve. One can easily demonstrate the following
propositions:

1. Income increases more and interest rates increase less, the flatter is LM schedule.
2. Income increase less interest rates increase less, the flatter the IS schedule.
3. Income and interest rate increase more the larger the horizontal shift of the IS schedule.

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