2022MMB1387 Economics Report

HS201 REPORT
ECONOMICS
10/05/2024
PAIDI SATWIKA
2022MMB1387
STATEMENT OF THE PROBLEM:
Let us suppose there is an economic crisis driven by demand deficiency. In that case, the
government intervenes through an expansionary fiscal policy since it assumes a higher mpc.
However, the policymakers don't want to hamper the investment and money demand, wherein the
latter's sensitivity to the interest rate is high. So, what should monetary policymakers do in order to
tackle this concern?
INTRODUCTION:
In the given scenario, When the economy is struggling and people aren’t spending much, the
government can step in to help by increasing spending and lowering taxes (Expansionary Fiscal
Policy). However, policymakers are concerned about the potential negative impact on investment
and money demand due to the high sensitivity of the latter to changes in interest rates.
To manage this, policymakers coordinate between fiscal policy (government spending taxes) and
monetary policy (interest rates set by the central bank). During economic crises, governments use
fiscal policy to boost the economy. However, if interest rates change too much because of this, it can
impact investment and savings. To keep things balanced, policymakers might adjust interest rates
using monetary policy, this helps ensure that rates stay at levels that encourage business and people
to spend and invest.
THE PROBLEM OF DEMAND DEFICIENCY:

A demand deficiency crisis, the economy lacks sufficient demand to maintain employment and
stable prices. To address this, fiscal policy becomes crucial tool for policymakers. By increasing
government spending /cutting taxes to boost aggregate demand and stimulate economic activity.
However, there’s concern that fiscal policy could impact interest rates and money-holding
behaviour, potentially offsetting its benefits if rates rise /money demand falls.
INTERACTION AND UNDERSTANDING WITHIN THE IS-LM FRAMEWORK:

The IS-LM framework illustrates fiscal and monetary policies interact in an economy. The IS curve
reflects investment and savings in the goods market, while the LM curve represents money demand
and money supply equilibrium. Their intersection indicates the economy’s equilibrium output level
and interest rate guiding policymakers on policy impacts.
IS CURVE: Investment spending function I=I’-bi where b>0. i=rate of interest, b= the responsiveness
of investment spending to the interest rate. I’= autonomous investment spending.
Equations of IS curve:
where αG = 1/(1-c(1-t) is called the multiplier.
LM -curve:
The demand for money is defines as: L=kY-hi; k and h reflect the sensitivity of the demand for real
balances to the level of Y and i. Real money supply = M’/P’. M’ = nominal quantity of money
supplied. P’ is price level. For money market equilibrium, supply must be equal to demand
M’/p’= kY-hi.
Solving i =1/h(kY-M’/P’). The real money supply held constant along LM curve. If real money balance
increases, the money supply curve shifts to right.
FISCAL POLICY: Fiscal policy involves changes in
government spending and taxation to influence
economy. During economic breakdown,
policymakers often use expansionary fiscal policy.
This causes right shift of IS curve, boosting
aggregate demand (AD) by directly increasing
demand for goods and services. As a result,
income and output levels rise. In terms of money
market higher income increases demand for
money. Although interest rates constant, but
overall, both income and interest rates rise, with
income having a bigger impact on the economy.
Expansionary Fiscal Policy and the IS Curve:

When the government increases spending (expansionary fiscal policy), the IS curve shifts right,
showing higher aggregate demand due to increased government expenditures. This boosts output
and income (real GDP) in the economy. The effect on interest rates depends on how much
investment changes to interest rate shifts.
Accommodative Monetary Policy and the LM Curve:

The LM curve shows the balance between interest rates and real GDP in the money market. With
expansionary fiscal policy increasing aggregate demand may be upward pressure on interest rates
because of higher demand for money. To support investment and money demand and preserve the
benefits of fiscal policy, Central bank can use accommodative monetary policy measures.
Accommodative Monetary Policy Tools:
Central banks use tools like buying government securities (open market operations), reducing
reserve requirement for banks, lowering the discount rate. These actions inject money into financial
system, making borrowing cheaper and encouraging more lending and investment, which helps
stimulate the economy.
Interaction between Fiscal and Monetary Policy:

Fiscal and monetary policies need to work
together during demand deficiency crisis. In
this situation, expansionary fiscal policy boosts
overall demand, while accommodating
monetary policy helps manage interest rates
and money demand.
Initially at Point A, the economy operates at
certain level of real GDP (Y1) and interest rate
(r1). To tackle insufficient aggregate demand,
policymakers implement expansionary fiscal
policy (IS curve shifts right from IS1 to IS2).
Without monetary support, this could lead to
higher interest rates (r2) at Point B, limitimg
impact of fiscal policy due to crowding-out
effect, on private investment.
To counteract rising interest rates accommodating monetary policy increases money supply (LM
curve shifts from LM1 to LM2), setting new equilibrium at Point C, where the interest rate (r*) is
lower compared to Point B, and real GDP (Y*) is higher than at Point A. Accommodating monetary
policy offsets rising interest rates from fiscal policy. By increasing the money supply, ensuring ample
liquidity to meet demand lower interest rates(r*).
Lower interest rates are crucial for boosting investment and consumption. With borrowing costs,
leading to economic expansion (from Y1 to Y*). Lower interest rate makes borrowing cheaper for
households, further boosting demand.
By coordinating fiscal and monetary policies, we mitigate the crowding-out effect. Lower interest
rates ensures that private investment isn’t crowded out by government borrowing. Leading to more
substantial increase in real GDP (Y*) compared to the scenarios without money support.
CONCLUSION:
In conclusion, combining expansionary fiscal policy with accommodating monetary policy in the IS-
LM framework effectively address a demand deficiency crisis. This coordinated approach stimulates
economic activity, boosts aggregate demand, promote investment and mitigates issues like
crowding out. The analysis underscores the importance of policy coordination and the
complementary nature of fiscal and monetary measures in stabilizing the economy and promoting
sustainable growth.

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HS201 REPORT

THE PROBLEM OF DEMAND DEFICIENCY:

INTERACTION AND UNDERSTANDING WITHIN THE IS-LM FRAMEWORK:

Expansionary Fiscal Policy and the IS Curve:

Accommodative Monetary Policy and the LM Curve:

Interaction between Fiscal and Monetary Policy:

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