Government advisors

Submitted To Prof. Ramji Narayanan

on 3rd April, 2010

As a term paper in

MACRO ECONOMIC POLICY & ANALYSIS

By

Anupam Arora Srishti Batra

Anand Behl Vivek Verma
Ayush Gupta Rancee Sood
Sheenam Sachdeva Prateek Negi
Gaurav Choudhary Arpan Majumdar
 Contents
 ACKNOWLEDGEMENT
 PREFACE
 OBJECTIVE OF THE PROJECT
 ASSUMPTIONS
 METHODOLOGY USED
 IS-LM FRAMEWORK
 AD-AS FRAMEWORK
 CONTROLLING THE PRICE LEVEL
 REDUCING UNEMPLOYMENT
 PROMOTING GROWTH
 REDUCING FISCAL DEFICIT
 PROMOTING HEALTHY BANKING PRACTICE
 CONCLUSION
Acknowledgement
We wish to extend our sincere gratitude to Dr. Ramji Narayanan who helped us
to understand the intricacies and ideas by providing ingenuous insights, valuable
inputs, suggestions, and constructive criticism throughout the pursuit of the
project.
It has been a learning experience to understand the analytical tools and to look at
their applicability in the various scenarios. We are thankful that he painstakingly
guided us during our endeavour and it is due to his cooperation and suggestions
that we are able to present this project.

Submitted to Dr. Ramji Narayanan

Department of Financial Studies, Delhi University South Campus
 PREFACE
This project aims to analyze and critically examine the steps that the Indian
Government and Reserve bank can take to stimulate economic growth keeping
price level, unemployment level and fiscal deficit in control.
In our analysis, we use the IS‐LM and the AD‐AS supply framework. The IS curve
gives the combination of interest rate at which the goods and services market is
in equilibrium. The LM curve gives the level of interest rate at which the money
and the bonds market is in equilibrium. The intersection of both the curves gives
the macroeconomic equilibrium in the economy.

i LM

I0
i’’

e’

IS

O y* y

The fiscal and monetary policy undertaken by the government and the Reserve
bank shift the IS and the LM curves out of the old equilibrium into the new
equilibrium. We attempt to reach the new equilibrium such that the new
equilibrium corresponds to our goal of increased income and
employment, reduced budget deficit and reduced price level. We are mindful of
the fact that there is always a trade‐off between macroeconomic variables. But
we attempt to present an optimum policy solution to reach the desired
objectives.
OBJECTIVES
The objective of this project is to advice the Government to take fiscal and
monetary measure in order to:
 Control Price Level
 Stimulate Growth
 Promote High Level of Employment
 Reduce Fiscal Deficit
 Promote Healthy Banking Practice Through Monetary Policy
ASSUMPTIONS IN THE ANALYSIS

The following assumptions have been made for working out Analysis.
1) The economy is assumed to be a closed economy i.e. our analysis
comprises of the following economic agents: domestic firms, domestic
households, the domestic government and financial institutions.
2) It is in the realm of the short‐run model that we find the greatest role for
government policy and hence we consider the impact of our policy
measures in the short‐run.
3) The economy has achieved full employment.
4) Firms passively produce whatever is demanded.
5) There is no expected inflation; hence nominal rate of interest is equal to
the real rate of interest.
6) Capital and Technology are given and cannot be changed.
7) Labour market is imperfectly competitive; there is the influence of trade
unions
8) Output is a function of employment Y = f (n) and employment in turn is a
function of real wages n = g (ω – p).
9) Investments are assumed to be an inverse function of rate of interest ‘I’.
I = I (r) Investments as a function of real assets have been ignored.
10) There are 2 types of assets: Money and Bonds; the investor has the
choice to invest in either of the two.
11) Consumption expenditure is assumed to be a function of personal
disposable income and consumption as a function of real assets has been
ignored.
12) Savings is assumed to be a function of personable disposable income and
not of real assets.
13) The present level IS & LM curves are ‘IS’ & ‘LM’. Correspondingly, the
aggregate demand and aggregate supply curves are ‘AD’ and ‘AS’. The
current general price level is P0.
METHODOLOGY USED
In order to achieve the aforesaid objectives, a judicious mix of the following tools
has been used:

FISCAL POLICY
According to Arther Simithies fiscal policy is a policy under which government
uses its expenditure and revenue programme to produce desirable effects and
avoid undesirable effects on the national income, production and employment.
Fiscal policy is used by governments to influence the level of aggregate demand in
the economy, in an effort to achieve economic objectives of price stability, full
employment and economic growth. Keynesian economics suggests that adjusting
government spending and tax rates, are the best ways to stimulate aggregate
demand. This can be used in times of low economic activity as an essential tool in
providing the framework for strong economic growth and working toward full
employment.
Government can make use of various instruments of fiscal policy:‐
 Public Expenditure
 Taxes
 Public Debt
Changes in the above instruments can have an impact on the following variables
in the economy:
 Aggregate demand and the level of economic activity
 The pattern of resource allocation
 The distribution of income
Types of Fiscal Policy

The government can have the following policies -

Expansionary (or loose) Fiscal Policy.

This involves -

Increasing the government spending.

Lower taxes which will increase consumers spending because they have
more disposable income.
This will worsen the govt budget deficit

Deflationary (or tight) Fiscal Policy

This involves -

Decreasing the government spending.

Increasing the taxes as higher taxes will reduce consumer spending. This
will lead to an improvement in the government budget deficit.

MONETARY POLICY
Monetary Policy regulates the supply of money and the cost and availability of
credit in the economy. It is the process by which the government, central bank, or
monetary authority manages the nominal supply of money. Monetary policy rests
on the relationship between the rates of interest in an economy, that is the price
at which money can be borrowed, and the total supply of money. Monetary
policy uses a variety of tools to control one or both of these, to influence
outcomes like
economic growth, investments, price level, and unemployment.
The central bank is responsible for formulating and implementing Monetary
Policy. It can make use of various monetary policy instruments:‐

A. Quantitative measures:
 Open Market operations: Here, the central bank enters into sale and
purchase of government securities and treasury bills. So it can inject
money into economy by buying back the securities and vice versa.
 Bank rate policy: Popularly known as repo rate and reverse repo rate, it is
the rate at which the central bank lends and accepts short term advances
from other banks in the economy. This results into the flow of bank credit
and thus affects the money supply.
 Cash Reserve ratio (CRR)/ Statutory Liquidity Requirement (SLR): This is the
percentage of total deposits that the banks have to keep with central
bank. And this instrument can change the money supply overnight .

B. Qualitative measures:
  Credit rationing: Imposing limits and charging higher/lower rates of
interests in selective sectors.
 Moral Persuasion

Monetary policy is referred to as either being an expansionary policy, or a

contractionary policy, where an expansionary policy increases the total supply of
money in the economy, and a contractionary policy decreases the total money
supply. Expansionary policy is traditionally used to increase employment in the
economy by lowering interest rates, while contractionary policy involves
raising interest rates in order to combat price level rise.
Various measures can be taken towards the attainment of the objectives stated
above. The measures may be fiscal or monetary meaning efforts can be made
towards changing the government spending or tax as a part of fiscal measure or
supply of money can be regulated as desired (Monetary measure). A fiscal or
monetary method can be taken to achieve goals like to encourage consumer
spending government may reduce taxes or it may increase the supply of
money. But both, fiscal & monetary measures are usually taken in tandem to
obtain the best possible results in the quickest possible time.
IS-LM FRAMEWWORK
IS CURVE
Aggregate demand in a closed economy can be written as the sum of
Consumption expenditure (C), Investment expenditure (I) and Government
Expenditure (G). Therefore, the national income will be, Y = C+I+G
When taxes are deducted from income we get disposable income (Yd). Y‐T = Yd
Some part of this disposable income is consumed by the households and the
firms. The remaining part constitutes the savings portion in the economy,
Yd – C = S
Assuming that the consumption, investment, and tax functions are linear:
C=co + cy(y – t),
here co is autonomous consumption and cy is marginal propensity to consume
current disposable income: 0 < cy <1;
t = tyY,………………….................... (Tax function)
here 0 < ty < 1.
If we substitute the tax function into the consumption function and rearrange the
terms, the consumption function is:
c = co + cy (1‐ty) Y……….….. (Consumption function)
The investment function is
I = A – ar………..…………. (Investment function)
here ‘a’ measures sensitivity of investment to changes in interest rates.
In goods market equilibrium, y = yD = co + cy (1 – ty) Y+ A – ar + g
Solving for y gives:
Y= (co + A + g)/ (sy + cyty) (‐) [a/ (sy + cyty)]*r…………………………. (IS Curve)
The IS curve is downward sloping because a low interest rate generates high
investment which will be associated with high output. Also we see from the
above equation the negative relationship between the Income and Interest rate.
A change in the component or autonomous spending, i.e. an increase in
autonomous consumption, investment or government spending shift the IS curve
with no change in slope. An increase shifts it towards right and vice versa for
decrease. The extent of shift is (Multiplier)*change in autonomous variable. For
e.g.: For government spending: dY= k dG , where k is the multiplier.
LM CURVE
LM curve deals with asset markets as stocks at a point in time. As per Keynes, in
the short run price level and nominal wages are fixed and national income adjusts
to clear the commodity market. Also, the monetary influences determine the rate
of interest. Keynes visualized that people hold cash balances for transactions
purposes because of their immediate liquidity needs and because of the non‐
synchronization of payments and receipts.
People demand money for speculative purposes as well. If interest rates are high
and its expected to fall in near future (bond prices are expected to rise), it would
be rational for an investor to buy more bonds and reduce the demand for money.
Analogously, when interest rates are low and people expect the rates to rise and
bond prices to fall and will therefore tend to sell the bonds to make capital gains.
In this process they will increase their demand for money. Therefore the demand
for money for speculative purposes depends negatively on the interest rate.
Therefore, the aggregate demand for money can be written as L(r,y).
Equilibrium in the money market is given by:
L (r.y) = M/P (4)
here M is the nominal stock of money supply and P is the aggregate price level.
M/P therefore is the real value of cash balances.
Assuming that the demand for money function is linear and writing it in real
terms:
Ms/P = l ‐ lie + [1/vT]*y
Solving for i gives,
i = (l – Ms/P)/li + [1/vTli]*y………………….. (LM Curve)

1. A rise in the transaction velocity of circulation makes the LM curve flatter .

2. A rise in interest sensitivity of the demand for money makes the LM curve
flatter.
3. A rise in money supply shifts the LM curve rightwards with no change in slope.
The size of the shift is dy = v. dM/P.
4. A rise in the price level shifts the LM curve leftwards with no change in the
slope of the curve. The size of the shift is dy = v. M/sp here ‘v’ is the transaction
velocity of money.
AS-AD FRAMEWORK

AGGREGATE DEMAND SCHEDULE

At all the points on the aggregate Demand Curve the goods and money market
are in equilibrium. We start at point E0 where the IS and LM curve intersect. Now
at this point holding the nominal money supply constant, we decrease the price
level. This increases the supply of real balances. As a result people have too much
money. This pushes up the bond prices and lowers the interest rate. This moves
the economy into a new equilibrium at E1 with a higher output. Mapping the
equilibrium points of E0 and E1 into the output –price schedule, we see that with
lower price, the output is greater. Hence we have achieved a downward sloping
Demand Curve

AGGREGATE SUPPLY SCHEDULE

The AD curve, by itself, cannot determine Price level and Y, to complete the
system we introduce an aggregate supply schedule. The derivation of the AS
schedule, which shows combinations of Price and Y consistent with production
conditions in the labor market, has two key elements :
(i) an aggregate production function relates total output produced to labor
input, and
(ii) labor market supply and demand conditions relating labor supply and
demand to the real wages.
The short run aggregate supply curve is upward sloping. In the medium run we
assume the supply curve to be perfectly inelastic or vertical at the full
employment level of output.

WAGE SETTING
Under Imperfect Competition, there is an upward‐sloping wage setting (WS) curve
that is the counterpart of the labour supply curve in the competitive model.
Because of labour market imperfections, the wage setting curve lies above the
labour supply curve. Conditions in the labour market are the key determinant of
the ‘wage setting real wage’. In terms of money wages, the wage setting equation
is: W = P. b(E) ………………………………………………Wage Equation
here P is the Price level, E is the level of employment and b is a rising function of
employment.
When wages are set by unions, employers, or through bargaining, it is the
nominal (i.e. money) wage that is fixed. However, workers will evaluate wage
offers in terms of the real wage that they are expected to deliver – i.e. it is the
money wage relative to the expected consumer price level that affects the
standard of living and hence the worker’s utility.
Assuming that the actual and expected price level is equal, the wage equation can
be written in terms of real wages to define the upward‐sloping wage‐setting curve
in the labour market
Wws = b(E) ………………………………..Wage‐Setting real wage
here Wws = W/P

The excess of the real wage on the WS curve above that on the labour supply
curve at any level of employment is the mark‐up per worker(in real terms)
associated with labour market imperfections. Two common interpretations of this
mark‐up, both relying on imperfect competition, are Wage setting by unions and
Efficiency wage setting by firms.

PRICE SETTING
Under perfect competition, the real wage implied by competitive pricing by firms
is the marginal product of labour (or labour demand) curve. Firms take the
market price, P, and set it equal to their marginal cost.
P = MC
= W/MPL
= W/P = MPL
By contrast, under imperfect competition, firms set a price to maximise profits.
The mark‐up on marginal cost will depend on the elasticity of demand: as the
elasticity of demand rises, the mark‐up falls until comes a special case of perfect
competition where the elasticity of demand is infinite.
 CONTROLLING THE PRICE LEVEL
Introduction
It is imperative for an economy to keep the price levels under control. However, this
entails a cost in the form of loss of output and employment. Thus, the government must
attain a trade off between the conflicting objectives.

Objective
The objective of the following section is to advise the Government of India to reduce the
price level in the economy maintaining the same output level and employment.

Strategy
Case 1:
Reduce government expenditure as well as the nominal money supply in the economy
in equal proportion to control prices.

Explanation
The IS curve is the locus of combinations of the interest rate and output level at which
there is equilibrium in the goods market, while LM curve is the locus of combinations of
interest rate and income which keep the money market is in equilibrium.

The short run equilibrium level of output and interest rate is determined by the
intersection of IS and LM curve.

IS curve can be written as-

y d =c 0 +c y ( 1−t y ) y+ A−ar + g 1

Where ‘g’ is government spending

c 0 is autonomous consumption

( 1−t y ) y is the disposable income

c y is the marginal propensity to consume
 ais the interest rate sensitivity of investment

1 y Ms
The equation of LM curve initially is: i=
l1 v[
× +l−
P ]
Where ‘ Ms’ represents the money supply in the market at a given price level of ‘P’.

Every point of the Aggregate Demand curve (AD) is a point of intersection of IS and
LM. In the medium run (before reducing money supply and government expenditure)
when the market is in equilibrium the real wages prevalent in the market is given by w 0.
This we get by intersection of WS (wage setting) and PS (price setting curve), as shown
in the figure.

Rearranging the above given IS curve by using the fact that in goods market equilibrium
y d =y we get the IS curve as:-

1
y= ⌊ c + ( A−ar ) + g1 ⌋
1−c y (1−t y ) 0

1
Where represent the multiplier.
1−c y (1−t y )

Any change in government expenditure ‘g’ (reduction in our case) will cause the IS
curve to shift leftwards by the change in autonomous spending times the multiplier.
Similarly on reducing the money supply in the market the LM curve will shift upwards to
the extent of ¿

Shifting of IS and LM curves will cause the Aggregate demand curve to shift downwards
to AD ' from AD. Due to shift in aggregate demand curve we will see that level of output
will also decreased from y 0 to y 1. Due to the decrease in level of demand, the firms will
require lesser labour to provide the output required. Thus, the level of employment will
fall from E0 to E1.

Now in the first period due to decrease in output two main events will take place-
 a) Output decreases, so requirement of labour in the firms decreases. Supply of
labour remaining the same, unions will become less powerful and labour will
accept to work at lower nominal wages. Price level remaining the same, the real
wages would fall below w 0 . This effect is shown by ∝ in the WS-PS graph where
w 1 represents the real wages at which labour are ready to work (below the
equilibrium level of real wage ofw 0), which ultimately causes the prices to fall.
b) Now due to less labour working in the firms marginal product of labour i.e. MP L
will increase, which causes marginal cost, MC to fall. The fall in the cost of
production would be translated into a proportionate fall in the price of product. To
compensate for that real wages must rise (this effect will be shown by β in the
figure).

So in both cases we have seen that price must fall. Real wages will remain at PS line.
We will see that now the short run aggregate supply curve (SAS) will cut the new
aggregate demand curve at ‘A’. Here prices have fallen to P1 from initial equilibrium
price level of P0. Corresponding to this price level, labour will be ready to work at lower
wage rate which are less thatw 2, but real wages will follow the PS curve only.

When prices fall, the real balances in the economy rise causing the LM curve to shift to
the right. This leads to a fall in the interest rates. Projects which were not viable earlier
become favourable now and hence the level of investment rises. This causes the
Aggregate demand to rise.

In the next period, the labour will enter into wage contracts asking for lower nominal
wages. Firms on finding that the cost of production has decreased will further reduce
prices. Thus the same output is supplied at lower prices causing the SAS curve to shift
downwards. This new short run aggregate supply curve will cuts the AD ' curve at ‘B’,
now at point B we will see that prices will again fall to P2 and real wages on the PS
curve will reduce further. At point ‘B’ we will again see that more output can be
produced, we will again get a new short run aggregate supply curve as SAS2. This curve
will cut the AD ' curve at ‘C’. Now this process will keeps on occurring in short run till the
real wages get back tow 0. As we know that any changes in money market is reflected
quickly while goods and service market reflects late for any changes, we will see that for
every intersection point of SAS curves and AD ' our LM curve will shift to right wards as
LM ' , LM ' ' , LM ' ' ' till it reaches LM f .
 i LM’ LM

LM’’ LM’’’

LMf

i0 e1 e0

i1

if
IS’ IS

P AS SAS

SAS1
SAS2
SASf

P0

P2
P2 A
P3 B
Pf

P AD

AD’

y1 y0 y

w2 WS

w0

w1

PS

O E1 E0 E
CASE 2
We will try to reduce the price level by reducing government expenditure as well as the
nominal money supply in the economy. We will reduce the money supply more than the
government expenditure i.e. in unequal proportion.

As we know that short run equilibrium level of output and interest rate is determined by
the intersection of IS and LM curve.

d
IS curve can be written as- y =c 0 +c y ( 1−t y ) y+ A−ar + g 1

Where ‘g’ is government spending

1 y Ms
The equation of LM curve initially is: i=
l1 [
× +l−
v P ]
Where ‘ Ms’ represents the money supply in the market at a given price level of ‘P’.

Intersection of IS and LM curve gives us the Aggregate demand curve (see figure)
denoted by AD.

In the medium run (before reducing money supply and government expenditure) when
the market is in equilibrium the real wages prevalent in the market is given by w 0. This
we get by intersection of WS (wage setting) and PS (price setting curve), as shown in
the figure.

Rearranging the above given IS curve by using the fact that in goods market equilibrium
y d =y we get the IS curve as:-

1
y= ⌊ c + ( A−ar ) + g1 ⌋
1−c y (1−t y ) 0

1
Where represent the multiplier effect.
1−c y (1−t y )

Any change in government expenditure ‘g’ (reduction in our case) will cause the IS
curve to shift leftwards by the change in autonomous spending times the multiplier.
Similarly on reducing the money supply in the market the LM curve will shift upwards to
the extent of ¿
Now in our case reduction in money supply is more than the reduction in government
expenditure and hence shift in LM curve is higher than the shift in IS curve. Due to
higher shift in LM curve than the IS curve we will get the new equilibrium point at e 1.

Shifting of IS and LM curves will cause the Aggregate demand curve to shift downwards
to AD ' from AD. Due to shift in aggregate demand curve we will see that level of output
will also decreased from y 0 to y 1. Decrease in level of output will cause the level of
employment to fall from E0 to E1.

Now in the first period due to decrease in output two main events will take place-

a) Output decreases, so requirement of labour in the firms decreases. Now due to

no change in labour supply labour will accept to work at lower nominal wages.

This effect is shown by in the WS-PS graph where w 1 represents the real
wages at which labour are ready to work (below the equilibrium level of real
wage ofw 0), which ultimately causes the prices to fall.
b) Now due to less labour working in the firms marginal product of labour i.e. MP L
will increase, which causes marginal cost MC to fall. Due to which cost of
production and price of product will also falls and to compensate for that real
wages must rise (this effect will be shown by β in the figure).

So in both cases we have seen that price must fall. Real wages will remain at PS line.
We will see that now the short run aggregate supply curve (SAS) will cut the new
aggregate demand curve at ‘A’. Here prices have fallen to P1 from initial equilibrium
price level of P0. Corresponding to this price level labour will be ready to work at lower
wage rate which are less thatw 2, but real wages will follow the PS curve only.

Now we will see that at price level of P1 we can still produce more to reach the
equilibrium level of output of y 0 i.e. we can supply more and hence we will get a new
SAS curve as SAS1. This new short run aggregate supply curve will cuts the AD ' curve
at ‘B’, now at point B we will see that prices will again fall to P2 and real wages on the
PS curve will further reduces. At point ‘B’ we will again see that more output can be
produced, we will again get a new short run aggregate supply curve as SAS2. This curve
will cut the AD ' curve at ‘C’.

Now this process will keeps on occurring in short run till the real wages get back to w 0.
As we know that any changes in money market is reflected quickly while goods and
service market reflects late for any changes, we will see that for every intersection point
of SAS curves and AD ' our LM curve will shift to right wards as LM ' , LM ' ' , LM ' ' ' till it
reaches LM f .
 LM’ LM’’ LM

i LM’’’

LMF

i1 e1
e0
i0

i3

IS

IS’

0 y1 y0 y

P AS SAS SAS1

SAS2

SASf

P0

P1
P2 A B
Pf
Pf

P
AD

AD’

0 y1 y0 y

WS

w2

w0 β

w1

PS

0 E1 E0 E
CASE 3
We will now attempt to reduce the government expenditure more than the nominal
money supply i.e. in unequal proportionate to control prices.

As we know that short run equilibrium level of output and interest rate is determined by
the intersection of IS and LM curve.

d
IS curve can be written as- y =c 0 +c y ( 1−t y ) y+ A−ar + g 1

Where ‘g’ is government spending

1 y Ms
The equation of LM curve initially is: i=
l1 [
× +l−
v P ]
Where ‘ Ms’ represents the money supply in the market at a given price level of ‘P’.

Intersection of IS and LM curve gives us the Aggregate demand curve (see figure)
denoted by AD.

In the medium run (before reducing money supply and government expenditure) when
the market is in equilibrium the real wages prevalent in the market is given by w 0. This
we get by intersection of WS (wage setting) and PS (price setting curve), as shown in
the figure.

Rearranging the above given IS curve by using the fact that in goods market equilibrium
y d =y we get the IS curve as:-

1
y= ⌊ c + ( A−ar ) + g1 ⌋
1−c y (1−t y ) 0

1
Where represent the multiplier effect.
1−c y (1−t y )

Any change in government expenditure ‘g’ (reduction in our case) will cause the IS
curve to shift leftwards by the change in autonomous spending times the multiplier.
Similarly on reducing the money supply in the market the LM curve will shift upwards to
the extent of ¿
Now in our case reduction in government spending is more than the reduction in money
supply and hence shift in IS curve is much higher than the shift in LM curve. Due to
higher shift in IS curve than the LM curve we will get the new equilibrium point at e 1.

Shifting of IS and LM curves will cause the Aggregate demand curve to shift downwards
to AD ' from AD. Due to shift in aggregate demand curve we will see that level of output
will also decreased from y 0 to y 1. Decrease in level of output will cause the level of
employment to fall from E0 to E1.

Now in the first period due to decrease in output two main events will take place-

c) Output decreases, so requirement of labour in the firms decreases. Now due to

no change in labour supply labour will accept to work at lower nominal wages.

This effect is shown by in the WS-PS graph where w 1 represents the real
wages at which labour are ready to work (below the equilibrium level of real
wage ofw 0), which ultimately causes the prices to fall.
d) Now due to less labour working in the firms marginal product of labour i.e. MP L
will increase, which causes marginal cost MC to fall. Due to which cost of
production and price of product will also falls and to compensate for that real
wages must rise (this effect will be shown by β in the figure).

So in both cases we have seen that price must fall. Real wages will remain at PS line.
We will see that now the short run aggregate supply curve (SAS) will cut the new
aggregate demand curve at ‘A’. Here prices have fallen to P1 from initial equilibrium
price level of P0. Corresponding to this price level labour will be ready to work at lower
wage rate which are less thatw 2, but real wages will follow the PS curve only.

Now we will see that at price level of P1 we can still produce more to reach the
equilibrium level of output of y 0 i.e. we can supply more and hence we will get a new
SAS curve as SAS1. This new short run aggregate supply curve will cuts the AD ' curve
at ‘B’, now at point B we will see that prices will again fall to P2 and real wages on the
PS curve will further reduces. At point ‘B’ we will again see that more output can be
produced, we will again get a new short run aggregate supply curve as SAS2. This curve
will cut the AD ' curve at ‘C’.

Now this process will keeps on occurring in short run till the real wages get back to w 0.
As we know that any changes in money market is reflected quickly while goods and
service market reflects late for any changes, we will see that for every intersection point
of SAS curves and AD ' our LM curve will shift to right wards as LM ' , LM ' ' , LM ' ' ' till it
reaches LM f .
i LM’ LM

LM’’ LM’’’

LMF

i0 e0

i1 e1

i2

IS’ IS

0 y

P AS SAS SAS1

SAS2

SASF

P0

P2
A
P2
P3 B
Pf

P
AD

AD’

0 y1 y0 y

w1 WS

w0 β

w2

PS

0 E1 E0 E
Conclusion
Case1:

Both government expenditure and nominal money supply have been decreased
in the economy.
Prices have fallen from P0 to Pf while the level of output and employment have
remained at y 0 and E0 .
Real wages have also remained at w 0.
Real money supply in the economy has ultimately increased due to fall in the
price level. This in-turn has caused nomin al interest rate to fall and fall in
government spending is covered up by rise in investments.

Case2:

Both government expenditure and nominal money supply have been decreased
in the economy.
Prices have fallen from P0 to Pf while the level of output and employment have
remained at y 0 and E0 .
Real wages have also remained at w 0.
Real money supply in the economy has ultimately increased due to fall in the
price level. This in-turn has caused nominal interest rate to fall to i f and fall in
government spending is covered up by rise in investments.

Case 3:

Both government expenditure and nominal money supply have been decreased
in the economy.
Prices have fallen from P0 to Pf while the level of output and employment have
remained at y 0 and E0 .
Real wages have also remained at w 0.
Real money supply in the economy has ultimately increased due to fall in the
price level. This in-turn has caused nominal interest rate to fall to if and fall in
government spending is covered up by rise in investments.
 REDUCING UNEMPLOYMENT
Definition
The unemployment rate is the % of people in the labour force without a job
but registered as being willing and available for work. The natural rate of unemployment
is defined as the equilibrium rate of unemployment i.e. the rate of unemployment
where real wages have found their free market level and where the aggregate supply of
labour is in balance with the aggregate demand for labour. At the natural rate, all those
wanting to work at the prevailing real wage rate have found employment and thus there
is assumed to be no involuntary unemployment. There remains some voluntary
unemployment as some people remain out of a job searching for work offering higher
real wages or better conditions.

Objective
The objective of the following section is to advise the Government of India to increase
employment level in the economy. However, there is a trade-off between reducing the level of
unemployment and reducing the price level. Thus, providing employment opportunities entails a
cost.

Possible strategies
The government could use the fiscal policy, the monetary policy or an interplay of both to
promote employment.

Strategy Adopted
Case 1:
We will try to achieve the objective by increasing government expenditure and nominal money
supply in the economy. We propose to increase nominal money supply as much as increase in
the government expenditure i.e. in equal proportion.
Explanation
In the short run equilibrium level of output and interest rate is determined by the intersection of
IS and LM curve.

IS curve can be written as-

y d =c 0 +c y ( 1−t y ) y+ A−ar + g 1

Where:

g is government spending

C is the marginal propensity to consume

T represents government taxes

Co is that part of consumption financed from wealth and future stream of income

a is the interest sensitivity of investment

r is the real rate of interest

The equation of original LM curve is:

1 y Ms
i=
l1 [
× +l−
v P ]

Where ‘ Ms’ represents the money supply in the market at a given price level of ‘P’.

Intersection of IS and LM curve gives us the Aggregate demand curve (see figure) denoted by
AD.

Initially in the medium run when the market is in equilibrium the real wages prevalent in the
market is given byw 0. This we get by intersection of WS (wage setting) and PS (price setting
curve), as shown in the figure.
Rearranging the above given IS curve by using the fact that in goods market equilibrium y d =y
we get the IS curve as:-

1
y= ⌊ c + ( A−ar ) + g1 ⌋
1−c y (1−t y ) 0

1
Where represent the multiplier effect.
1−c y (1−t y )

Any change in government expenditure ‘g’ (increase in our case) will cause the IS curve to shift
rightwards by the change in autonomous spending times the multiplier.

Shift in IS curve = ___∆g___

1-c(1-t)

Similarly on increasing the money supply in the market the LM curve will shift rightwards to the
extent of ¿

Shifting of IS and LM curves will cause the Aggregate demand curve to shift upwards from AD
to AD '. Due to shift in aggregate demand curve we will see that level of output increases from
y 0 to y 2. This will cause the level of employment to rise from E0 to E2.

To meet the excess demand the firms require more labour which is equal to OE’. OE’ labour
won’t be forthcoming unless real wages ↑ from w◦ to w1

Initially, w = W◦ / Po

Since the power of the unions increase, they demand higher nominal wages, leading to higher
real wage.
 Thus, w1 = W1 / P◦

Hence the cost of labour increases which results in firms increasing the price accordingly. This
is denoted by ‘α’

Further, in the medium run, capital is fixed. So ↑in labour results in ↓ in MPL. Fall in marginal
product causes the marginal cost MC to rise. Thus, the cost of production and this is translated
into a rise in prices. The real wages thus fall.

This ↑ in price by the firms still further. This is denoted by ‘β’

P = MC

MC = w◦ / MPL

As MPL ↓, MC ↑, hence P ↑

Therefore w2 = W◦ / P2

Thus in both cases price must increase. Real wage will remain at the price setting curve
because the percentage increase in the nominal wages is equal to the increase in price level.
Hence real wages would remain at w◦

Here, employment has increased, but the economy pays a price in the form of higher prices.

Now, in the money market, the rise in the price levels causes the real balances to fall and thus
the LM curve would shift to the left, intersecting at a lesser level of output. We will see that now
the short run aggregate supply curve (SAS) will cut the new aggregate demand curve at ‘A’.
Here prices have risen to P1 from initial equilibrium price level of P0. Corresponding to this price

level labour will be ready to work at lower wage rate which are less that w 2, but real wages will
follow the PS curve only.

Now we will see that at price level of P1 we still have excess supply till the original equilibrium

level of output of y 0 i.e. supply has to be reduced and hence we will get a leftward shift of SAS
curve. This new short run aggregate supply curve will cut the new aggregate demand curve,

AD ', at a point corresponding to higher price level.

Now this process will keep on occurring in short run till price level is P 2 and real wages get back
tow 0.

Any changes in money market is reflected quickly while goods and service market reflects late
for any changes, we will see that for every intersection point of SAS curves and AD ', our LM

curve will shift left wards till it reaches LM ' ' ' .
i LM’’’ LM
LM’’
’ LM’
I2

I1
I0
e

e’ IS’

IS

O y◦ y1 Y2 Fig(1) y

P SAS1

AS SAS
P2

P1
α+β
P0

AD’

AD

O y◦ y1 Y2 Fig(2) y

W WS

W1

W0 α+β

W2

PS

O E0 E1 E2 Fig(3) E
Case 2:
Alternately, we can try to achieve objective by increasing government expenditure and nominal
money supply in the economy wherein the increase in government expenditure is more
than the increase in the nominal money supply.

In the short run equilibrium level of output and interest rate is determined by the intersection of
IS and LM curve.

d
IS curve can be written as- y =c 0 +c y ( 1−t y ) y+ A−ar + g 1

Where ‘g’ is government spending

1 y Ms
The equation of LM curve initially is: i=
l1 [
× +l−
v P ]
Where ‘ Ms’ represents the money supply in the market at a given price level of ‘P’.

Intersection of IS and LM curve gives us the Aggregate demand curve (see figure) denoted by
AD.

Initially in the medium run when the market is in equilibrium the real wages prevalent in the
market is given byw 0. This we get by intersection of WS (wage setting) and PS (price setting
curve), as shown in the figure.

Rearranging the above given IS curve by using the fact that in goods market equilibrium y d =y
we get the IS curve as:-

1
y= ⌊ c + ( A−ar ) + g1 ⌋
1−c y (1−t y ) 0

1
Where represent the multiplier effect.
1−c y (1−t y )

Any change in government expenditure ‘g’ (increase in our case) will cause the IS curve to shift
rightwards by the change in autonomous spending times the multiplier.

Similarly on increasing the money supply in the market the LM curve will shift rightwards to the
extent of ¿
In this case increase in government spending is more than the increase in money supply and
hence shift in IS curve is much higher than the shift in LM curve and a new equilibrium point is
established at pointe 1.

Shifting of IS and LM curves will cause the Aggregate demand curve to shift upwards from AD
to AD '. Due to shift in aggregate demand curve we will see that level of output increases from
y 0 to y 2. This will cause the level of employment to rise from E0 to E2.

Now in the first period due to increase in output two main events will take place-

Again and explain the cause of the price change.

Real wages will remain at PS line. We will see that now the short run aggregate supply curve
(SAS) will cut the new aggregate demand curve at ‘A’. Here prices have risen to P1 from initial

equilibrium price level of P0. Corresponding to this price level labour will be ready to work at
higher nominal wage rate, but real wages will follow the PS curve only.

Now we will see that at price level of P1 we still have excess supply till the original equilibrium

level of output of y 0 i.e. supply has to be reduced and hence we will get a leftward shift of SAS
curve. This new short run aggregate supply curve will cut the new aggregate demand curve,

AD ', at a point corresponding to higher price level.

Now this process will keep on occurring in short run till price level is P 2 and real wages get back
tow 0.

Any changes in money market is reflected quickly while goods and service market reflects late
for any changes, we will see that for every intersection point of SAS curves and AD ', our LM

curve will shift left wards till it reaches LM ' ' ' .
 LM’’’
LM’’ LM
i
LM’
I3

I2
I1
I0
e

IS’
e’

IS

O y◦ y1 Y2 Fig(1) y

SAS1
P
AS SAS

P2
P1 α+β
P0

AD’

AD

O y◦ y1 Y2 Fig(2) y

WS
W

W1

W0 α+β

W2

PS

O E0 E1 E2 Fig(3) E
Case
3:

Another scenario is where the government increases the nominal money supply more than it
increases in the government expenditure i.e. in unequal proportionate. In this case, again, an
increase in employment would only be temporary or in the short period. (refer to diagram on
next page).
 i LM’’’ LM LM’’

e LM’
I3
I2
I0
i’’ I1

e’ IS’

IS

O y◦ y1 Y2 Fig(1) y

P SAS1
AS SAS

P2
P1 α+β i’’

P0

AD’

AD

O y◦ y1 Y2 Fig(2) y
W
WS

W1

W0 α+β

W2

PS

O E0 E1 E2 Fig(3) E
If the government wishes to implement only an expansionary fiscal policy to attain higher
employment levels, it would fail. The economy would settle at a less than full employment level
of output. Government expenditure would not work to its full potentials under variable prices.
The variable price dampens the effect of the fiscal policy. Similarly, a monetary policy would be
less effective with flexible prices.

Conclusion
Increase in government expenditure is equal to fall in real money supply in the
economy.
Prices have risen from P0 to P2 while the level of output and employment have

remained at y 0 and E0 .
Real wages have also remained at w 0.
Employment in economy did increase but only in the transitionary period
 PROMOTING GROWTH

Definition
Economic growth is the term used to indicate increase in per capita GDP or other measures of
aggregate income. It refers to permanent increase in goods and services in the economy. By
permanent increase we mean an increase in output in not just one period but a continuous
increase in output over more than one period. This increase in real GDP means there is an
increase in the value of national output / national expenditure.

Benefits
The Benefits of economic growth include:

Higher Incomes This enables consumers to enjoy more goods and services
Lower unemployment With higher output firms tend to employ more workers creating
more employment.
Lower Government borrowing Economic growth creates higher tax revenues and
there is less need to spend money on benefits such as unemployment benefit.
Improved public services With increased tax revenues the government can spend
more on the NHS and education etc.

Possible strategies
Potential growth can increase due to the following reasons:
Increased Capital e.g. investment in new factories or investment in infrastructure
such as roads and telephones.
Increase in Labour productivity, through better education and training
Technological improvements to improve the productivity of Capital and labour e.g.
Microcomputers and the internet have both contributed to increased economic
growth

Strategy Adopted
We suggest increasing capital investment to promote growth in the economy.
Now, investment can be expressed as a function as:

I(A,r)= A-ar
 Where A = encompasses business outlook and technology etc

a = interest sensitivity to investment

r = rate of interest

such that,

 IαA
 I α 1/r

Therefore to increase investment we need to reduce the rate of interest.

When rate of interest decreases, the cost of borrowing decreases. Projects which were unviable
earlier become favorable and hence investment increases.

Even if the firms choose to use its own funds in investment, the interest rate represents the
opportunity cost of investing those funds rather than lending out that money for interest.

In order to decrease rate of interest to stimulate investment, the strategies we are adopting are-

Increase in money supply by the central bank that causes LM curve to shift
downwards and rightwards.
Decrease in government spending which causes IS curve to shift leftwards and
downwards.

Explanation
In the short run equilibrium level of output and interest rate is determined by the intersection of
IS and LM curve.
d
IS curve can be written as- y =c 0 +c y ( 1−t y ) y+ A−ar + g 1

Where ‘g’ is government spending

 1 y Ms
The equation of LM curve initially is: i=
l1 [
× +l−
v P ]
here ‘ Ms’ represents the money supply in the market at a given price level of ‘P’.

Intersection of IS and LM curve gives us the Aggregate demand curve (see figure) denoted by
AD.

Initially in the medium run when the market is in equilibrium the real wages prevalent in the
market is given byw 0. This we get by intersection of WS (wage setting) and PS (price setting
curve), as shown in the figure.

Rearranging the above given IS curve by using the fact that in goods market equilibrium y d =y
we get the IS curve as:-

1
y= ⌊ c + ( A−ar ) + g1 ⌋
1−c y (1−t y ) 0

1
Where represent the multiplier effect.
1−c y (1−t y )

SHIFTS-

1 M
Shift in LM curve =
l1
×d
P ( )
This shift in the LM curve would be caused by a change in money supply.

∆g
Shift in IS curve =
1−c ( 1−t 1 )

This shift in the IS curve is caused by a change in government spending.

CASE 1
When increase in money supply > decrease in government spending

i.e magnitude of rightward shift in LM curve > leftward shift in IS curve

IS LM FRAMEWORK
Initially economy is at equilibrium at E.

Due to ↑ in money supply and ↓ in government spending, we would move to E’ which would be
the new equilibrium level. This is the point of intersection of LM’ and IS’.

E’ corresponds to

Lower rate of interest, i3

Higher level of output/ income, y1

AS-AD FRAMEWORK
At the existing price level P0, there is an increase in Y resulting in the shift of AD curve to the
right. The new aggregate demand curve is AD’.

Due to ↑ in the aggregate demand the price level increases to P 1. This ↑ in price level is
because of 2 reasons:

To meet the excess demand the firms require more labour which is equal to OE 1. OE1
labour won’t be forthcoming unless real wages ↑ from w0 to w1
Thus initially w = w◦ / P0

To ↑ real wage rate at the existing price level P 0, the labour asks for a higher nominal wage
i.e W1

Thus w1 = W1 / P0

Hence the cost of labour increases which results in firms increasing the price accordingly. This
is denoted by ‘α’
 In short to medium run, capital is fixed. So ↑in labour results in ↓ in MPL.
This results in ↑ in price by the firms still further. This is denoted by ‘β’

P = MC

MC = w◦ / MPL

As MPL ↓, MC ↑, hence P ↑

Therefore w2 = W0 / P2

Thus in both cases price must increase. Real wage will remain at the price setting curve
because the percentage increase in the nominal wages as well as the price level is the same
resulting in the real wage to be w0

Now, in the money market, the rise in the price levels causes the real balances to fall and thus
the LM curve would shift to the left, intersecting at a lesser level of output. We will see that now
the short run aggregate supply curve (SAS) will cut the new aggregate demand curve at ‘A’.
Here prices have risen to P1 from initial equilibrium price level of P0. Corresponding to this price

level labour will be ready to work at lower wage rate which are less that w 2, but real wages will
follow the PS curve only.

Now we will see that at price level of P1 we will produce less to reach the equilibrium level of

output of y 0 i.e. we can supply less and hence we will get a new SAS curve as SAS1. This new

short run aggregate supply curve will cuts the AD ' curve at a point corresponding to new price
level P1.

Now this process will keeps on occurring in short run till the real wages get back to w 0 and price
level rises to P2.

Any changes in money market is reflected quickly while goods and service market reflects late
for any changes, we will see that for every intersection point of SAS curves and AD ', our LM

curve will shift to leftwards till it reaches LM ' ' ' .

i LM LM’’’ LM” LM’

e
I0
I1
I2
I3
e’

IS’ IS

y◦ y2 y1 Fig(1) y
0

P SAS1
AS SAS

P2 α+β
P1
P0

AD’

AD

0 y◦ y2 Y1 Fig(2) y
W

WS

W1

W0 α+β

W2

PS

0 E◦ E2 E1 Fig(3) E
CASE 2
When increase in money supply = decrease in government spending

i.e magnitude of rightward shift in LM curve = leftward shift in IS curve

LM-IS FRAMEWORK
Initially economy was at equilibrium at E. Due to an increase in money supply and decrease in
government spending by an equal amount, the economy would move to a new equilibrium point
E’.

The new equilibrium point is the point of intersection of LM’ and IS’.

E’ corresponds to

A lower rate of interest, i’

The same level of output / income, y

AS-AD FRAMEWORK
At the existing price level P0, there is no shift in the AD curve

In the second panel, the intersection of SAS and AD gives the equilibrium level of output.

Since there is no change in the aggregate demand, the equilibrium level of employment
remains the same i.e OE

Thus the real wage rate remains the same at w0

 i LM

LM’

i0 e

i’ e’
IS’ IS

y₀ y Fig(1)
P

AS

SAS

P₀

AD

y₀ y Fig(2)
W

WS

w₀
PS

E₀ E Fig(3)
Case
3:
When decrease in government spending > increase in money supply
i.e magnitude of leftward shift in IS curve > rightward shift in LM curve

IS LM FRAMEWORK
Initially economy is at equilibrium at E.

Due to ↑ in money supply and ↓ in government spending, we would move to E’ which would be
the new equilibrium level. This is the point of intersection of LM’ and IS’.

E’ corresponds to

Lower rate of interest, i1

Lower level of output/ income, y0

AS-AD FRAMEWORK
At the existing price level P0, there is a decrease in Y resulting in the shift of AD curve to the
left. The new aggregate demand curve is AD’.

Due to in the aggregate demand the price level decreases to P1. This in price level is
because of 2 reasons:

To meet the deficit demand the firms require less labour which is equal to OE 0. OE0
labour would be willing to accept low wages w2
Thus initially w = w◦ / P0

To real wage rate at the existing price level P0, the labour asks for a lower nominal wage i.e
W2

Thus w2 = W2 / P0

Hence the cost of labour falls which results in firms reducing the price accordingly. This
is denoted by ‘α’
 In short to medium run, capital is fixed. So in labour results in in MPL.
This results in in price by the firms still further. This is denoted by ‘β’

P = MC

MC = w◦ / MPL

As MPL , MC , hence P

Therefore w2 = W0 / P2

Thus in both cases price must fall. Real wage will remain at the price setting curve because the
percentage decrease in the nominal wages as well as the price level is the same resulting in the
real wage to be w0

Now, in the money market, the fall in the price levels causes the real balances to rise and thus
the LM curve would shift to the right, intersecting at a higher level of output. We will see that
now the short run aggregate supply curve (SAS) will cut the new aggregate demand curve at a
point corresponding to reduced price level P1. Corresponding to this price level labour will be
ready to work only at higher wage rate but real wages will follow the PS curve only.

Now we will see that at price level of P1 we will produce more to reach the equilibrium level of

output of y 0 i.e. we can supply more and hence we will get a new SAS curve as SAS1.

Now this process will keeps on occurring in short run till the real wages get back to w 0 and price
level falls to P2.

Any changes in money market is reflected quickly while goods and service market reflects late
for any changes, we will see that for every intersection point of SAS curves and AD ', our LM

curve will shift rightwards till it reaches LM ' ' ' .

i LM LM’’’ LM” LM’

e
I0
I1
I2
I3
e’

IS’ IS

y◦ y2 y1 Fig(1) y
0

P SAS1
AS SAS

P2 α+β
P1
P0

AD’

AD

0 y◦ y2 Y1 Fig(2) y
W

WS

W1

W0 α+β

W2

PS

0 E◦ E2 E1 Fig(3) E
CONCLUSION

CASE 1
There is a decrease in the rate of interest which stimulates investment and hence
promotes growth
In the short to medium run there is an increase in level of output, income and hence
employment.

CASE 2
There is a decrease in the rate of interest promoting growth.
In the short to medium run there is an increase in output, hence income.
Correspondingly the level of employment remains the same.

CASE 3
Fall in government expenditure is equal to increase in real money supply in the
economy.
Prices have fallen from P0 to P2 while the level of output and employment have

remained at y 0 and E0 .
Real wages have also remained at w 0.
Real money supply in the economy has ultimately increased due to fall in the price
level. This in-turn has caused nominal interest rate to fall to i3 and fall in government
spending is covered up by rise in investments.
 REDUCING FISCAL DEFICIT
Definition
Fiscal deficit is an economic phenomenon, where the Government's total expenditure
surpasses its revenue. It is the difference between the government's total receipts
(excluding borrowing) and total expenditure.

Reasons for an increased fiscal deficit

The fiscal deficit increases mainly due to following reasons:
1. Actual tax collection < target tax collections
2. Government spending > government receipts
In 2008-09 governments around the world incurred huge fiscal deficits due to stimulus
packages undertaken in order to counter slowdown in economy. To spur economic
activity, they had initiated various measures like massive spending programme and
slashed taxes, levies and duties. The slash in duties resulted in a decrease in the
revenue generation for the country and thereby increasing the fiscal deficit.

Objective
The objective of the following section is to advise the Government of India about how to
reign in fiscal deficit.

Strategy to reign in Fiscal deficit

Fiscal deficit arises when a government's total expenditures exceed the revenue that it
generates; taxes form a major portion of government’s revenue.

FD = G – T -------------------- (1)

FD: Fiscal Deficit

G: Government Expenditure

T: Taxes collected by the government

From equation 1 it can be ascertained that fiscal deficit can be reduced by decreasing
the amount of government spending (G) and increasing the amount of tax collected (T).
The amount of tax collected can be increased by increasing the applicable tax rate. The
short run equilibrium level of output and interest rate is determined by the intersection of
IS and LM curve. (Refer to figure No 1 & 2).

C0 + A+ g 1 1−C ( 1−t 1 )
The equation of IS curve initially is: i=
a
−y[ a ] (IS )
1

1 y M1
The equation of LM curve initially is: i=
l1 [
× +l−
v P1 ] (LM1)

To determine the equilibrium level of output and interest rate the aforementioned
equations of IS1 and LM1 are solved. The two unknown variables in these equations are
i and y.

After solving the equilibrium level of output (y1) obtained is:

C0+ A + g 1 l M1
− +
a l 1 P1∗l1
y 1=
1 1−C ( 1−t 1 )
l1∗v
+
a[ ]
And equilibrium level of interest rate (i1) obtained is

M1

i1=
1
l1 [ (
l1 ( C 0+ A + g 1 )−a l−
P1
a+l 1∗v [ 1−C ( 1−t 1 ) ]
)+l− ]
M 1 The government spending is now reduced to
P1

g2 (Refer to figure No 3) and the applicable tax rate is increased to t 2 (Refer to figure No
4). The aforementioned changes would ramify into the IS curve (IS 1) shifting left and
inverting inwards. The IS curve will invert inwards because of the increase in tax rate to
t2. It will cause the value of the multiplier to decrease thereby increasing the absolute
value of the slope (i.e. the slope will become steeper).

∆g
The extent of leftward shift of the IS curve is given by
1−c (1−t 1)
The equation of the IS curve after the aforementioned changes is:

C0 + A+ g 2 1−C ( 1−t 2 )
i=
a
−y [a ] (IS2)

1−C ( 1−t 2 )
Slope of IS2: [ a ] the slope of IS2 is steeper because of higher tax rate t 2.

At this juncture the nominal money supply in the economy is increased to M 2; this level
of nominal money supply will cause the LM curve to shift rightwards or downwards to
the extent so that the level of output where LM 2 and IS2 intersect is the same as
equilibrium level of output which prevailed in the first place (y 1). Increasing the nominal
money supply to M2 will cause the equilibrium level of rate of interest to fall to i 2 (Refer to
figure No 5). This fall in interest rate will stimulate private investments; increase in
investments will be exactly equal to fall in government expenditure, thus ensuring there
is no change in aggregate demand, price level and employment level even in the short
run. (Refer to figure No 6, 7& 8).

Reason for increasing the money supply If the money supply is not increased, the LM
curve will shift rightwards to a lesser extent in the short term which will cause a
decrease in the level of employment and price. In order to obviate such a scenario in
which there is a decrease in the level of employment in the intermediate term, the
nominal supply of money has been increased.

−1 M
The LM curve will shift downwards to the extent of l 1 × d P ( )
1 y M2
The equation of LM curve after the shift is i=
l1 [
× +l−
v P1 ] (LM2)

To determine the new equilibrium level of output equations IS 2 and LM2 are solved
simultaneously.

After solving the equilibrium level of output (y2) obtained is:

 C0+ A + g 2 l M2
− +
a l 1 P 1∗l 1
y 2=
1 1−C ( 1−t 2 )
l1∗v
+[ a ]
i

LM11

i1

IS1

y1 y
Fig (1)

SAS

P1

AD

y1 y
Fig (2)
P i

LM1

SAS
LM2
i1
P1 AD
i2 IS1

IS2

y1 y
y Fig (6)

SAS

P1
AD

y1 y Fig (7)

WS

α
w1
β
AD

E1 E Fig (8)
i

LM1

IS1

IS2

y
Fig (3)

LM1

IS1

IS2

y
Fig (4)

LM1

LM2
i1

IS1
i2

IS2

y1 y
The new equilibrium level of output should be equal to y 1.

y2=y1

On solving the value of M2 is determined as

M 2=
[ y 1 × {a+l 1× v ( 1−c (1−t 2)) }−l 1 v {C + A+ g 2 }+l ×a × v ]
0

a×v

And equilibrium level of interest rate (i2) obtained is

M2

i2=
1
l1 [ (
l1 ( C 0+ A + g 2 )−a l−
P1
a+l 1∗v [ 1−C ( 1−t 2 ) ]
)
+l−
M2
P1 ]
Conclusion
1. Fiscal deficit has been reduced as there has been a reduction in Government
spending(G) and an increase in tax collected by the government through an
increase in applicable tax rate(t1 to t2).
2. The level of output and the price level has not been affected in both short and
medium term
3. Interest rates have decreased from i 1 to i2. The magnitude of the decrease in
interest rates is i1-i2. The reduction in interest rates will stimulate investment as
the level of investment in the economy is inversely related to the level of real
interest rates in the economy.
4. The level of employment will be unaffected in the short and medium term.
Promotion of Healthy Banking Practice through
Monetary Policy Measures

To initiate a change in LM curve, central bank has to change the amount of

nominal money supply (i.e. liquidity of money) in the economy. This can be
achieved through open market operations or by changing statutory reserve ratios.

In open market operations the central bank enters into sale and purchase of
government securities and treasury bills. By selling the bonds, money liquidity in
the economy is reduced as the central bank keeps the proceeds with itself. Also,
bonds prices fall and yield (nominal interest rates) rises. If bonds are bought by
central bank, they would be using their money reserves to pay for the proceeds
and hence enhance money liquidity in the economy. Also, bond prices rise due to
increase in their demand and yield (nominal interest rates) falls.
These transactions are done with mostly financial institutions and other banks in
the country.

Another way to change nominal money supply is to change statutory reserve

ratios. These ratios are Cash Reserve Ratio and Statutory Liquidity Ratio. Banks
have to keep a certain portion of their total deposits with the central bank in the
form of cash and government bonds. An increase in the ratio requirement by
central bank raises the amount of cash and bonds that banks have to keep with
central bank and thereby reduce nominal money supply in the economy. It also
raises the demand for bonds, raising their prices and reducing nominal interest
rates. A decrease in reserve requirements would result in injection of money
liquidity in economy, fall in bond demand and its prices and a rise in yield
(nominal interest rates).

Both measures mentioned above have an impact on the deposit and lending
interest rates of the banks. A reduction in liquidity increases their cost of funds
and thus they increase both deposit and lending rates being offered to the public.
But an increase in liquidity brings down the cost of bank’s funds and in turn
reduces the deposit and lending rates offered to the public in the economy.

Hence, central bank can use monetary policy measures to ensure healthy banking
practices are being followed in the economy.
 Strategy’s Result Summary
Strategy Benefitted Objectives Tick the Best ones
Increase Money Supply >  Stimulate Growth
Decrease Government  Promote High Level
Expenditure of Employment
 Reduce Fiscal Deficit
Increase Money Supply <  Stimulate Growth
Decrease Government  Reduce Fiscal Deficit
Expenditure  Control Price Level
Increase Money Supply =  Stimulate Growth
Decrease Government  Reduce Fiscal Deficit
Expenditure

Strategy Benefitted Objectives Tick the Best ones

Decrease Money Supply >  Stimulate Growth
Decrease Government  Reduce Fiscal Deficit
Expenditure  Control Price Level
Decrease Money Supply <  Stimulate Growth
Decrease Government  Reduce Fiscal Deficit
Expenditure  Control Price Level
Decrease Money Supply =  Stimulate Growth
Decrease Government  Reduce Fiscal Deficit
Expenditure  Control Price Level

Strategy Benefitted Objectives Tick the Best ones

Increase Money Supply >  Promote High Level
Increase Government of Employment
Expenditure
Increase Money Supply <  Promote High Level
Increase Government of Employment
Expenditure
Increase Money Supply =  Promote High Level
Increase Government of Employment
Expenditure
Further, it can be seen that the objectives are conflicting in nature. Attaining one
objective requires compromising the other. The government would choose a
point on its indifference curve which maximizes its satisfaction. Thus, choosing
the best strategy is very subjective and depends on the governments taste and
preferences.