Fiscal Policy in The IS Curve

Fiscal Policy in the IS Curve
• The equation for the IS curve is: 𝑌 = 𝛼𝐺 (𝐴ሜ − 𝑏𝑖)
– The fiscal policy variables (G, TR, and t) are within this definition
• G and TR are parts of A
• t is a part of the multiplier
→Fiscal policy actions, changes in G, TR, and t affect the IS curve
1
𝛼𝐺 =
1 − 𝑐(1 − 𝑡)
𝐴ሜ − 𝑏𝑖 = 𝐶ሜ + 𝑐𝑇ሜ 𝑅ሜ + 𝑐(1 − 𝑡)𝑌 + (𝐼ሜ − 𝑏𝑖) + 𝐺ሜ + 𝑁ሜ 𝑋ሜ

Fiscal Policy and Crowding Out
• If government
expenditures increase,
equilibrium moves from
E to E”
• The goods market is in
equilibrium at E”, but
the money market is not:
– Because Y has
increased, the demand
for money also
increases → interest
rate increases
– Firms’ planned
investment spending
declines and AD falls
→ move up the LM
curve to E’ Suppose G increases
At unchanged interest rates, AD increases
To meet increased demand, output must increase
At each level of the interest rate, equilibrium
income must rise by G G
Fiscal Policy and Crowding Out
• Comparing E to E’:
increased government
spending increases
income and the
interest rate
• Comparing E’ to E”:
adjustment of interest
rates and their impact
on AD dampen
expansionary effect
of increased G
– Income increases to
Y’0 instead of Y”
Consequences of Liquidity Trap on Fiscal Policy
• Liquidity trap implies horizontal LM curve (h is very-very large)
• Shift of IS curve does not lead to a change in interest rate
• Thus, there is no crowding out
• Fiscal policy has a full multiplier effect

Consequences of Vertical LM Curve on Fiscal Policy
• Fiscal expansion leads to rise in interest rate with no

multiplier effect
• Rise in government expenditure is completely offset by the

reduction in investment demand due to higher interest rate
• Thus, there is a full crowding out

Is Crowding Out Really Important
• We have assumed that prices are fixed, which
implied presence of unemployed resources in the
economy available for production at current prices
• However, if the economy is at full employment, what

would be the channel of crowding out
– Workers from one sector (investment) are shifted towards
another sector (government)
– Prices will increase, reducing the real money supply and
raising the interest rate
Is Crowding Out Really Important
• In economies below full employment (having
unemployed resources), LM curve will be upward
sloping but not vertical
• Thus, fiscal expansion will raise both interest rate

and output with partial crowding out
Can Crowding Out be Avoided
• If there are unemployed resources and government raise
G, the interest rate tends to rise
• The monetary authority can increase money supply.
• Thus both IS and LM curve shift rightward, without rise in

interest rate and fall in investment
• This is termed as the monetary accommodation of fiscal

expansion
– Monetizing fiscal deficit: Central bank prints notes to fund the
government borrowings (buy new government bonds)
The Composition of Output and the Policy Mix
• Monetary policy operates by stimulating interest-responsive components of
AD (investment)
• Fiscal policy operates through G and t → impact depends upon what goods the
government buys and what taxes and transfers it changes
• Impact of fiscal and monetary policy on output and interest rate
• Government guarantees for private loans (corporates, small scale industries, household –
mortgage loans/education loans) can shift the IS curve
• These are interesting tools as the expansion through fiscal policy is carried out without
outright/immediate rise in the fiscal deficit
• Credit agencies are some how fine with such expansions, as they do not enter in their excel
sheets !!
• Companies rather than bureaucrats to decide where to spend and invest
The Composition of Output
and the Policy Mix
• Policy problem of reaching
full employment output, Y*,
for an economy that is
initially at point E, with
unemployment
Choices:
1. Fiscal policy expansion,
moving to point E1, with
higher income and higher
interest rates
2. Monetary policy
expansion, resulting in full
employment with lower
interest rates at point E2
3. A mix of fiscal expansion
and accommodating
monetary policy resulting
in an intermediate position
The Composition of Output
and the Policy Mix
• Policies all increase output,
but significantly different
impact on sectors of the
economy → problem of
political economy
• Who should be the primary
beneficiary of expansion?
– An expansion through a
decline in interest rates and
increased investment
spending?
– An expansion through a tax
cut and increased personal
consumption?
– An expansion in the form of
an increase in the size of the
government?
Debate between Democrats and Republicans
(Large vs Small Govt)
• In a recession, democrats will call for larger government
(G), while republicans will call for tax-cut
• In a boom, democrats will call for higher taxes, while

republicans will call for cut in G
• Both achieve same purpose in the IS-LM framework, but

are drastically different in their long-run implications
• A construction lobby will call for investment subsidy and a

lower interest rate

Fiscal Policy in The IS Curve

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Fiscal Policy in the IS Curve

• The equation for the IS curve is: 𝑌 = 𝛼𝐺 (𝐴ሜ − 𝑏𝑖)

𝐴ሜ − 𝑏𝑖 = 𝐶ሜ + 𝑐𝑇ሜ 𝑅ሜ + 𝑐(1 − 𝑡)𝑌 + (𝐼ሜ − 𝑏𝑖) + 𝐺ሜ + 𝑁ሜ 𝑋ሜ

• Liquidity trap implies horizontal LM curve (h is very-very large)

• Shift of IS curve does not lead to a change in interest rate

• Thus, there is no crowding out

• Fiscal policy has a full multiplier effect

• Fiscal expansion leads to rise in interest rate with no

• Rise in government expenditure is completely offset by the

• Thus, there is a full crowding out

• However, if the economy is at full employment, what

• Thus, fiscal expansion will raise both interest rate

• The monetary authority can increase money supply.

• Thus both IS and LM curve shift rightward, without rise in

• This is termed as the monetary accommodation of fiscal

• In a boom, democrats will call for higher taxes, while

• Both achieve same purpose in the IS-LM framework, but

• A construction lobby will call for investment subsidy and a

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