MEC-102

MACROECONOMIC
ANALYSIS

School of Social Sciences

Indira Gandhi National Open University
Maidan Garhi, New Delhi-110068
EXPERT COMMITTEE
Prof. Romar Correa (retd.) Prof. Errol D’Souza Prof. M Ramachandran
University of Mubai Indian Institute of Ahmedabad Pondicherry University
Prof. Ashima Goyal Prof. Subrata Guha Prof. Mita K Mehra
Indira Gandhi Institute of CESP, Jawaharlal Nehru University CITD, Jawaharlal Nehru University
Development Research, Mumbai New Delhi New Delhi
Prof. Gopinath Pradhan (retd.) Prof. Narayan Prasad Prof. B S Prakash
Indira Gandhi National Open Indira Gandhi National Open Indira Gandhi National Open
University, New Delhi University, New Delhi University, New Delhi
Prof. Kaustuva Barik Saugato Sen
Indira Gandhi National Open Indira Gandhi National Open
University, New Delhi University, New Delhi

COURSE PREPARATION TEAM

Block/ Unit Title Unit Writer
Block 1 Traditional Approaches to Macroeconomics
Unit 1 The Classical Approach Dr. Jagannath Mallick, Independent Researcher, New Delhi
Unit 2 The Keynesian Model Prof. Ananya Ghosh Dastidar, University of Delhi
Unit 3 Neoclassical Synthesis Prof. Kaustuva Barik, IGNOU
Unit 4 Open Economy Macroecon. - I Prof. Ananya Ghosh Dastidar, Department of Business and Finance,
Unit 5 Open Economy Macroecon. - II University of Delhi
Block 2 Expectations and Macroeconomics
Unit 6 Inflation and Unemployment Prof. Kaustuva Barik, IGNOU
Unit 7 Rational Expectations Dr. Manjula Singh, St. Stephens College, University of Delhi
Block 3 Intertemporal Decision-Making
Unit 8 Consumption and Asset Prices
Prof. Mausumi Das, Delhi School of Economics, Delhi
Unit 9 Ramsey-Cass-Koopmans Model
Unit 10 Overlapping Generations Model
Block 4 Theories of the Business Cycles
Unit 11 Traditional Models of Business Dr. Archi Bhatia, Associate Professor, Ramjas College, University of
Cycles Delhi
Unit 12 Real Business Cycles Dr. Jagannath Mallick, Independent Researcher, Delhi and Prof.
Kaustuva Barik, IGNOU
Block 5 Labour Markets
Unit 13 Nominal and Real Rigidities
Prof. Avadhhot Nadkarni (retd.), University of Mumbai
Unit 14 Search Theory and
Unemployment
Block 6 Issues in Monetary Policy
Unit 15 Central Banks and the Supply of Dr. Jagannath Mallick, Independent Researcher, Delhi
Money
Unit 16 Conduct of Monetary Policy Prof. Kaustuva Barik and Ms. Apica Sharma, IGNOU
Unit 17 Theory of Monetary Policy Dr. Vineet Kohli, Tata Institute of Social Sciences, Mumbai
Block 7 Fiscal Policy and Macroeconomics
Unit 18 Fiscal Policy Dr. Archi Bhatia, Associate Professor, Ramjas College, University of
Delhi
Unit 19 Fiscal Sustainability

Course Coordinator: Prof. Kaustuva Barik

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 CONTENTS
BLOCK 1 TRADITIONAL APPROACHES TO Page
MACROECONOMICS
Unit 1 The Classical Approach 7
Unit 2 The Keynesian Model 27
Unit 3 Neoclassical Synthesis 54
Unit 4 Open Economy Macroeconomics - I 70
Unit 5 Open Economy Macroeconomics - II 81
BLOCK 2 EXPECTATIONS AND MACROECONOMICS
Unit 6 Inflation and Unemployment 94
Unit 7 Rational Expectations 105
BLOCK 3 INTERTEMPORAL DECISION-MAKING
Unit 8 Consumption and Asset Prices 124
Unit 9 Ramsey-Cass-Koopmans Model 137
Unit 10 Overlapping Generations Model 153
BLOCK 4 THEORIES OF BUSINESS CYCLES
Unit 11 Traditional Models of Business Cycles 164
Unit 12 Real Business Cycles 184
BLOCK 5 LABOUR MARKETS
Unit 13 Nominal and Real Rigidities 199
Unit 14 Search Theory and Unemployment 221
BLOCK 6 ISSUES IN MONETARY POLICY
Unit 15 Central Banks and the Supply of Money 235
Unit 16 Conduct of Monetary Policy 249
Unit 17 Theory of Monetary Policy 262
BLOCK 7 FISCAL POLICY AND MACROECONOMICS
Unit 18 Fiscal Policy 278
Unit 19 Fiscal Sustainability 292
Glossary 305
COURSE INTRODUCTION
Macroeconomics analyses and establishes functional relationships among economy level
aggregates. Aggregative analysis has assumed such a great significance in recent times that a
prior understanding of macroeconomic theoretical structure is considered essential for proper
comprehension of various issues and policies. Macroeconomics now is not only a scientific
method of analysis but also a body of empirical economic knowledge.
After going through this course a student is expected to
 have an intuitive understanding of the theoretical developments in macroeconomics;
 contrast among various schools of macroeconomic thought;
 analyse real world issues with the help of macroeconomic theories; and
 apply macroeconomic theory to empirical data.
The course comprises seven blocks.
Block 1, entitled Traditional Approaches to Macroeconomics, is somewhat introductory in
nature. After explaining some basic concepts that are used frequently in macroeconomics and
form building blocks of the subject, it presents the classical and Keynesian views on
determination of output and employment in an economy. Subsequently, it presents a synthesis
of the classical and Keynesian ideas through the tools of IS-LM curves. The block also deals
with issues pertaining to open economy macroeconomics.
Block 2, entitled Expectations and Macroeconomics, deals with issues such as inflation and
unemployment. It traces the evolution of Phillips Curve – how it originated as a relationship
between real and monetary variables; how it occupied a prime place as an analytical tool in
Keynesian economics; and how it became irrelevant in the new-classical economics. In the
course of discussion, this block deals with two important concepts, viz., adaptive expectations
and rational expectations.
Block 3, entitled Intertemporal Decision-making, analyses the behavior of economic agents
such as households and firms in an inter-temporal framework. It discusses the Ramsey-Cass-
Koopmans model and overlapping-generations model. It also looks into issues such as the
choice between work and leisure on the part of households.
Block 4, entitled Theories of Business Cycles, is devoted to the analysis of economic
fluctuations in an economy, particularly the business cycles. It begins with traditional theories
of business cycles and later moves on to real business cycles models with inter-temporal
substitution and the propagation mechanism.
Block 5, entitled Labour Markets, discusses issues related to unemployment in the
economy. Apart from presenting nominal and real rigidities, the block throws lights on search
theories and unemployment.
The subject matter of Block 6 is Issues in Monetary Policy. It deals with issues such as
money supply, conduct of monetary policy, and theory of monetary policy. In recent years
inflation targeting, policy rules, and dynamic consistency have been important concerns of
policy makers.
Block 7, entitled Fiscal Policy and Macroeconomics, looks into the implications fiscal
policy in an economy. Debt sustainability and Ricardian equivalence are two important issues
discussed in this Block.
UNIT 1 THE CLASSICAL APPROACH
Structure
1.0 Objectives
1.1 Introduction
1.2 Various Schools of Macroeconomic Thought
1.3 Basic Features of Classical Theory
1.4 Determination of Output and Employment
1.5 Quantity Theory of Money
1.6 Say’s Law of Market
1.7 Classical Dichotomy
1.7.1 AD-AS Equilibrium

1.7.2 Neutrality of Money

1.7.3 Saving-Investment Equilibrium

1.8 Long Run vs. Short Run

1.9 Let Us Sum Up
1.10 Answers/ Hints to Check Your Progress Exercises
1.11Some Useful Books/ Further Readings

1.1 OBJECTIVES
After going through the unit, you should be in a position to
 bring out the salient features of classical economics;
 analyse the classical approach to the determination output and employment;
 explain the quantity theory of money and its implication on price
determination;
 explain the classical dichotomy in the economy and the neutrality of money
in a classical system; and
 describe the behavior of prices in the long-run and short-run.

1.1 INTRODUCTION
Being a student of economics, you must be aware that macroeconomic theory has
evolved over time in response to the dynamic macroeconomic environment.
Initially, during the nineteenth and early twentieth century, there was a consensus
among economists and economic historians that an economy could run smoothly
without much fluctuation in income, output and employment. The perception


Dr. Jagannath Mallick, Independent Researcher, New Delhi writer
Traditional Approaches was that there should be minimum state intervention in economic variables such
to Macroeconomics
as wages, prices and interest rates. The market forces (supply and demand) would
take care of economic equilibrium in an economy. Such an assumption, however,
is unrealistic – all governments have in place certain economic policies (such as
monetary policy and fiscal policy) and they carry out amendments to these
policies from time to time!
Economic theory refers to a set of ideas and principles which are used to explain,
analyse and predict certain ‘phenomenon’ or observable events. As you know,
macroeconomic theory deals with macroeconomic phenomena, which are
aggregative in nature. The need for a special branch of macroeconomics arises
because what holds for the individual units may not hold good for the economy
as a whole. For example, suppose a firm employs labour for production of output
(say, cement). It can hire as many workers it requires at the ongoing wage rate.
Thus, increase in demand for labour by a single firm does not have any impact on
the wage rate. However, if all the firms in a country increase their demand for
labour (say due to economic boom and optimism in the country), there will be
shortage of labour and increase in wage rate. Further, the number of workers
available for work in the country is limited; thus demand for labour beyond this
limit will increase wage rate only, not the supply of labour.
Let us look into the global energy crisis of 2022. This took the form of global
shortages and increased the prices of oil, gas and electricity throughout the world.
The crisis was caused by a variety of social and economic factors: labour
shortages, political disputes, climate concerns, and the war between Russia and
Ukraine. The world economy responds to such crises in certain ways. During the
global energy crisis of 2022, for example, the oil-exporting countries witnessed
an increased inflow of income while petroleum-importing countries experienced
a rise in the cost of production. There was severe inflation in most countries. In
order to control inflation, policy makers resorted to increase in interest rates and
reduction in money supply.
Countries design their monetary and fiscal policies for the welfare of people by
controlling inflation and boosting economic growth. Macroeconomic theory
guides economists and policymakers to explain the situation and design
appropriate policy measures. Among economists, however, there is no agreement
on how equilibrium levels of output, prices and employment are determined.
Historically economic data are the same, but economists differ on the reasons and
solution for economic problems. In microeconomics there is more or less some
consensus. In macroeconomics, as you will see, there are sharp and often
altogether different explanations and policy recommendations for the same
phenomenon.
Macroeconomics has been subjected to debates, particularly since the 1930s. The
reasons behind such differences among economists are the basic assumptions and
the models they take. Two major schools of thought – Classical and Keynesian –
have interpreted economic events differently. Accordingly, they have accorded
8
different explanations for the same economic issue. In this unit, we focus on the The Classical
classical theories while Keynesian theories will be discussed in Unit 2. Approach

1.2 VARIOUS SCHOOLS OF MACROECONOMIC

THOUGHT
A school of macroeconomic thought refers to a group of macroeconomic thinkers
who share similar views on the behaviour of macroeconomic variables in an
economy. As pointed out above, economists do not always share a similar
approach in dealing with macroeconomic problems. For example, Keynesian
theory came into existence as a response to the Great Depression. Further
economic events during the 1970s led to the revival of the classical views in the
form the New Classical Economics. As a response to New Classical economics, a
new school of thought – New Keynesian Economics – was born by introducing
micro-foundations and rational expectations in Keynesian economics. In later
Units of this we will discuss about both these schools of thought.
Classical economics refers to a school of thought prevalent during the eighteenth
and early nineteenth century. They believed that the levels of economic variables
in an economy were determined through market forces. It implies that wages,
prices and interest rates are flexible in an economy. However, the occurrence of
the Great Depression (1929-1933), which witnessed massive decline in income,
output, employment and price level, a stock market crash, and banking panic
falsified such assumptions. This led to the search for new explanations periodic
fluctuations in output and employment in an economy. John Maynard Keynes, a
British economist, opposed the classical ideas and advocated that prices and
wages are not flexible; rather they are sticky. He coined the term “classical” to
reflect the ideas presented by economists prior to him. Prominent among classical
economists are Adam Smith, David Ricardo, Thomas Malthus, Anne Robert
Jacques Turgot, John Stuart Mill, Jean-Baptiste Say, and Eugen Böhm von
Bawerk.
As opposed to the classical economists, Keynes advocated that the government
should actively intervene in the market to counter recessionary conditions. From
Keynes’s beliefs evolved a new school of macroeconomic thought that is called
the Keynesian school. According to Keynesian economists, actual output could
be lower than potential output of an economy and the gap can be closed through
fiscal and monetary policy interventions.
There are two major schools of thought: classical and Keynesian. Classical
theory emerged in the 18th and 19th centuries. It attempted to explain and analyse
the remarkable increase in wealth. Classical theory relies on the assumption of
fully flexible prices and wages, which results in an automatic adjustment in the
market, ensuring no deficiency of aggregate demand. The economy operates at its
full capacity or full employment level. These classical ideas failed to explain and
understand the great depression of the 1930s. The depression had affected all the
major advanced countries, wherein about one fourth of the labour force had
become unemployed. Against this backdrop, John Maynard Keynes came up with
his ideas, called Keynesian theory. He attempted to explain the event and
advocated that such huge unemployment was because of inadequate aggregate
9
Traditional Approaches demand, which in turn was the result of a deficiency in investment demand. He
to Macroeconomics criticized the assumption of a laissez-faire economy in the classical theory and
advocated policy intervention to increase demand and employment.
Later, attempts were made to integrate ideas from both the schools, which led to
the “neoclassical synthesis”. The IS-LM model that we discuss in Unit 3 is an
outcome of the neoclassical synthesis. During the 1950s, economists such as
Harrod, Domar and Kaldor extended the Keynesian ideas from short-run to long-
run. They argued that there would be an increase in production capacity in the
long run because of large investments. This in turn would boost economic
growth. The focus of these economists, called the Post-Keynesians, was to
understand, explain and analyse economic growth. In order to overcome certain
limitations of the post-Keynesian growth models, Robert M. Solow came up with
the neoclassical growth model. You will go through these growth models in the
course, ‘Economics of Growth and Development’.
Keynesian school of thought dominated economic theory and policy after the
World War II until the 1970s. During the 1970s most of the advanced economies
witnessed stagnation and inflation, a situation called “stagflation”. Keynesian
theories did not have appropriate policy response to stagflation, which led to the
exploration of fresh explanations of economic behavior. Robert E. Lucas, an
American economist, revived the classical ideas and countered the prevailing
Keynesian thought. The ideas of classical and Keynesian schools differ from
each other on various issues, including: i) the role played by demand and supply
in determination of equilibrium output, employment and prices; ii) the
assumption of flexibility of price level and wage rate in the economy; iii) the
dichotomy of real and monetary sectors of the economy, and (iv) neutrality of
money.
After the 1970s, however, there was revival of classical economics in the form of
new-classical theory. In response to that, new-Keynesian models came up. New
Classical economics retained the basic characteristics of classical economics but
introduced two new concepts: rational expectations and micro-foundations. We
will cover these aspects in later units of this course.
Along with these mainstream schools of thought, there is heterodox schools of
thought or heterodox economics. It includes Marxist, Austrian, institutional,
feminist and social economics among many others. In fact, there is a need for
promoting pluralism in economics these days and researchers are venturing into
many new areas. The mainstream or conventional economics, as mentioned,
earlier have been Classical and Keynesian. The legacy of these two schools of
thought have continued in different forms. Two prominent schools of thought in
recent years have been New-Classical economics and New-Keynesian
economics. There are certain common features of these two schools of thought:
(i) general equilibrium models, (ii) micro-foundations in behaviour of economic
agents, and (iii) rational expectations. Two major differences between both the
schools of thought are: (i) the assumption regarding market structure – the new-
classical school assumes that there is perfect competition in the market while the
new-Keynesian school assumes market imperfection. (ii) the assumption of
flexibility in wages and prices – the new-classical school assumes flexibility in
10
wages and prices while the new-Keynesin school assumes rigidities in wages and The Classical
prices. Approach

1.3 BASIC FEATURES OF CLASSICAL THEORY

Classical economics evolved against the perception of ‘mercantilism’. The
mercantilists believed that the wealth of nations depended on the stock of bullion
(or, gold and silver) and adopted policies that promoted exports and discouraged
imports through subsidies and tariffs. Classical economists discarded such ideas
and believed that ‘wealth of nations’ depended on real factors. For them, money
is merely a medium of exchange. Important features of classical theory are as
follows:
(i) Microeconomic Issues: Classical economists dealt mostly with
microeconomic issues pertaining to behavior of economic agents such as
firms and households. In classical view, a firm maximizes its profits subject
to a resource constraint. Similarly, households try to maximize their utilities
or economic gains given their budget constraints. Classical economists
believed in the optimising tendencies of the market mechanism. According
to classical economists, variables such as price level, wage rate and output
level should be determined by market forces (supply and demand).
(ii) Laissez Faire: Classical economists believed in the philosophy of ‘laissez
faire’, which is a French term meaning ‘leave alone’ or ‘let you do’.
According to this view, there should be minimal intervention from the
government in business affairs. In fact, Adam Smith suggested that
government should confine itself to three main duties, viz., (i) national
defense, (ii) administration of justice (law and order), and (iii) establishing
and maintaining certain public works (infrastructure, education, etc.).
(iii) Invisible Hand: Adam Smith introduced the concept of the ‘invisible
hand’. According to him, the economy will function well if everyone
pursues his/ her own interest. According to him, “It is not from the
benevolence of the butcher, the brewer, or the baker that we expect our
dinner, but from their regard to their own interest”. Individuals pursuing
self-interest seem to be led by an ‘invisible hand’ to maximise the general
welfare of everyone in the economy. It is not the generosity of a producer in
selling a commodity; it is his/her self interest. Similarly, the consumers are
not doing a favour to the producer; they are pursuing their own interest in
buying the commodity. The philosophy of the invisible hand confined
classical economists to the analysis of the behavior of economic agents;
they failed to see any conflict between interest of economic agents and that
of the economy as a whole.
(iv) Continuous Market Clearing: Classical economists assumed that prices
and wage rates are flexible. As you know from microeconomics,
equilibrium price is determined at the level where supply and demand are
equal. Given the supply and demand curves, if demand is more compared to
supply, price will increase. Similarly, if supply is more compared to
demand, price will decrease. This principle applies not only to
commodities, but also to wage rate. If supply of labour is more than its
11
Traditional Approaches demand, there will be a decline in wage rate till supply of labour equates its
to Macroeconomics demand. An implication of the above is that there is no unemployment in
the economy – wage rate will decline till all workers are employed. There is
no disequilibrium in the market.
(v) Perfect Competition: Classical economists assumed that there is perfect
competition in the market so that markets function smoothly. As there is
full employment (due to flexibility in wage rate), production is always at
the full employment level. An implication of the above is that there is no
scope for ups and downs in the level of output. Going by this logic, the
classical economists ruled out the possibility of ‘business cycle’.
(vi) Say’s Law of Market: Classical economists believed that production or
supply is the key to economic prosperity. Thus, they emphasized more on
the supply side of the economy. This approach is summarized very well in
the Say’s law, named after the prominent classical economist J B Say.
According to J B Say, ‘supply creates its own demand’. Whenever some
production takes place, there is a stream of income in the hands of people,
which generates demand.
A person should have produced something to sell (say, for example, labour)
and thereby earned certain income. Thus, in the classical viewpoint, there is
no scope of deficiency of demand in the economy. Therefore, primary
concern before an economy is production or supply, not demand.
(vii) Neutrality of Money: According to classical economists, economic growth
of an economy is due to increase in the factors of production and
technological progress. Money is just a medium of exchange; and it
facilitates transactions among economic agents. Thus, increase in money
supply does not affect the level of output – it only leads to increase in prices
(see quantity theory of money discussed below). They believed that there is
dichotomy between monetary variables such as money supply and prices,
and real variables such as output and employment. Thus, classical
economists stressed the role of real factors in deciding the real variables
such as output and employment. As mentioned earlier, classical economists
believed in free market systems without government intervention.
Determination of output, employment and interest rate in the classical
system is given below.
We discuss some of the major issues in the next section.
Check Your Progress 1
1) Write down the important features of classical theory.
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12
 2) What are the main features of new-classical economics? The Classical
Approach
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1.4 DETERMINATION OF OUTPUT AND

EMPLOYMENT
The classical theory is based on the following assumptions:
a) firms and workers are optimisers,
b) they have perfect knowledge, and
c) they operate in competitive (perfect) markets.
An implication of the above is that wages and prices are fully flexible. Under
perfect competition, the demand for labour for the profit maximising firms is
P = W/MPN … (1.1)
where, P is the product price,
W is nominal wages, and
MPN is the marginal product of labour.
As there is perfect competition, P is equal to Marginal Revenue (MR) which is
received from t h e sale of one unit of output. Here, W/MPN represents the
marginal cost of production, that is, the cost of production of an additional unit of
output.
Equation (1.1) can be rewritten as
MPN = W/P … (1.2)
(We denote nominal wage by W and real wage by its lower case, i.e., w)
Equation (1.2) indicates that the marginal product of labour is equal to the real
wage (W/P). Hence, the labour demand curve in terms of real wage is nothing but
the Marginal Product of Labour. The labour demand curve is downward sloping.
MPN d = f (W / P) … (1.3)
The of supply of labour varies positively with the real wage. It assumes that
individual labour maximises its utility.
This can be written as
N s = g (W / P) … (1.4)
where N s indicates the supply of labour. We explain below in Fig. 1.1 the
equilibrium in the labour market. Note that the labour market is in equilibrium at
full employment of labour. At the equilibrium point, the supply of labour is
equal to demand for labour. In the upper panel, we provide labour supply and
labour demand as functions of real wage . In the lower panel, we provide
labour supply and labour demand as functions of nominal wage. As price level
13
Traditional Approaches increases from 𝑃1 to 𝑃2 and then to 𝑃3, real wage can be maintained at the same
to Macroeconomics level if nominal wage increases to 2W and 3W respectively. The shifts in the
supply curve of labour and demand curve of labour are shown in panel (b) of Fig.
1.1. Notice that there is no change in labour supply, as full employment is
ensured (since there is no change in real wage). If there is an increase in output
prices, but no increase in nominal wage rate, there will be a decline in real wage.
This will lead to a decrease in labour supply.
𝑊
𝑊 𝑁 =𝑔
𝑃
𝑃

Real Wage

3𝑊 2𝑊 𝑊
= =
3𝑃 2𝑃 𝑃

𝑊
𝑀𝑃𝑁 = 𝑁 = 𝑓
𝑃

N1 N

Ns(P3)

Ns(P2)
3𝑊 Ns(P1)
Normal Wage

2𝑊

MPN(P1) MPN(2P1) MPN(3P1)

N0 N1 N2 Labour

Employment

Fig.1.1: Supply of and Demand for Labour

14
Let us assume that there are only two factors of production, i.e., labour and The Classical
capital. Output is determined by the production function Y=F(K,N) as given in Approach

Fig. 1.2, panel (b). Equilibrium in the labour market (see panel (a) of Fig. 1.2)
determines the full employment labour supply and real wage rate. Based on that
full employment out is given in panel (b) of Fig. 1.2. As you can see, the
economy operates with full employment output (Y0) and full employment labour
supply (N0).
Labor Market Equilibrium

𝑊
𝑃 𝑁
Real Wage

𝑊 A
𝑃

𝑀𝑃𝑁 = 𝑁

N
Employment N0

Output Determination

𝑌 = 𝐹(𝐾, 𝑁)
A
𝑌
Output

N
Employment N0

Fig. 1.2: Equilibrium Output and Employment

15
Traditional Approaches Since there is full employment in the economy all the time, with a given
to Macroeconomics
production function and capital, the Aggregate Supply (AS) is inelastic at full
employment level of output. In Fig 1.3 we have shown the AS curve as a vertical
straight line. Note that the AS curve will shift if there is a change in the level of
technology (production function) or the level of capital.

P AS

3P1

Aggregate Price Level

2P1

Output Y1 Y

Fig. 1.3: Aggregate Supply Curve

1.5 QUANTITY THEORY OF MONEY

To understand the effects of changes in the stock of money, we need to study the
money market equilibrium. Money is a stock variable. Its stock means its
quantity at a point of time. Money is an asset demanded by the public for its
holding. Money is supplied by the government and the banking system. The
interaction of the demand for money and the supply of money create a money
market. In this unit, we assume that the monetary authority autonomously
determines the supply of money in an economy. Hence, the aggregate demand for
money refers to the demand for money by the public. Thus, demand for money
means the sum of all the money demanded by individual members of the public,
whether households or firms.
There are various theories of demand for money, such as (i) the classical theory
of demand for money, or the Quantity Theory of Money (QTM); (ii) the
Keynesian theory of demand for money; and (iii) Friedman’s restatement of
Classical QTM. In this Unit, we will discuss the classical theory of demand for
money. It is popularly known as the QTM, which is basically a theory of the
price level. Recall that money has four functions; (i) a medium of exchange, (ii) a
standard of deferred payment, (iii) a store of value, and (iv) a unit of account.
According to classical economists, money is demanded for its function as a
medium of exchange. There are several versions of the popular classical QTM.
Below we present the transaction version, which is known as the Fisher’s
equation of exchange:
16
M.V = P.T … (1.5) The Classical
Approach
where,
T is number of transactions of average size, and proxy for income level
M is quantity o f money supply,
V is velocity of circulation of money, and
P i s the average price level.
Classical economists rely heavily on the QTM to establish the theory of demand
for money. The QTM says that there is a proportional relationship between the
amount of money held by the public and the price level. As per the classical
assumption of full employment, the output level is given. Hence, T in equation
(1.5) is fixed as a proxy for national income. Further, V is defined as the number
of times a rupee moves from one hand to another during a given period. This
means that it relies on the public’s payment behaviour, which is constant in the
long run.
The right-hand side of equation (1.5), PT represents the total amount of money
required to facilitate transactions, i.e., the purchase or sale of total output in the
economy. The left-hand side of equation (1.5) In the same equation, the left-side
term MV is the product of the number of rupees in circulation and the number of
times each is used for public payments. Hence, MV represents the total amount
of money available for transactions during the given period. Equilibrium is
achieved in the system at the point where money demanded (PT) equals money
supply (MV).
The equation (1.5) can be rewritten as below,
𝑃= 𝑀 … (1.6)

As mentioned earlier, the terms V and T are constants in equation (1.6). Thus, the
equation indicates that money supply directly affects price level. For instance, if
M is increased by four times, price level P will rise by four times. Therefore,
classical QTM is known as a theory of price level.
The other approach of classical QTM describes the relationship between the
demand for money and ‘nominal output’ by taking directly real output instead of
number of transactions. In equation form, it can be expressed as
MV = PY … (1.7)
where,
M is the money supply
V is the velocity of money that is the number of times the money changes
hand.
P is the output price, and
Y is the real output level.
17
Traditional Approaches The total stock of money in the economy, measured by money supply times the
to Macroeconomics
velocity of circulation (MV), equals the nominal value of transactions or the
nominal value of income or output in the economy (PY). The identity given at
(1.7) is converted into the QTM under the assumption that Y and V are stable or
constant in the short run. With Y and V being constant, the assumption that price
level is passive means that P depends on changes in M rather than M depends on
changes in P. These assumptions indicate that any short-run decrease (or
increase) in M must lead to a proportional decrease (or increase) in P. Relaxation
or invalidity of any one of these assumptions would not hold the proportionality
relationship of P with M.
According to classical theory, under perfect competition with full employment in
the economy, the output level is fixed (𝑌⃑ ). The velocity of circulation is
predetermined (𝑉⃑) and money supply is exogenously given. From equation (1.6),
Price level (P) is proportional to the money supply (M).
𝑃 = (𝑉⃑⁄𝑌⃑) × 𝑀 … (1.8)

P AS

AD0

𝑌 Y

Fig. 1.4: Equilibrium Output and Prices

Thus, the labour market and production function determine the output level while
money supply determines the price level in the classical scheme. The quantity
theory of the money also gives the aggregate demand curve (see Fig. 1.4).
Although the classical theory is accepted by most economists, Keynesian
economists and Monetarists have criticized it. They believe that the classical
theory fails in the short run when the prices are sticky. Also, it has been
established that the velocity of money does not remain constant over
time. Nevertheless, the classical theory can be used to understand and control
inflation in the economy.

18
 The Classical
1.6 SAY’S LAW OF MARKET Approach
The Say’s law of market has been a basic pillar of classical economic theory.
According to this law, every supply generates its own demand. An implication of
the above is that if a commodity is produced, it will create sufficient income for
the owners of factors such as land, labor and capital to purchase the produced
commodity. After all, the price of the commodity is divided into its components
such as rent, wages and profits. Hence, this income will be sufficient to realize
the price of the commodity.
According to the Say’s law, enough income will always exist to purchase the
entire produced output, so that there will not be any surplus left under the laissez-
faire orientation. Using this logic, it can be concluded that there should not be
any major depression. If it occurs, it must be caused by some interference with
the free flow of commodities and money. The Say’s Law thus supported the
laissez-faire orientation of classical economics. The law is heavily dependent on
the assumption of perfect flexibility in prices. Under this assumption, whatever
quantity is produced can be sold in the market. In the short run, supply (or
demand) may exceed demand (or supply). Such discrepancy is adjusted
automatically, and instantaneously, through a decline (or rise) in prices. Such
instantaneous adjustment exists for all commodities and factor inputs. Says’ law
is also regarded as a natural consequence of perfect competition.
The proponents of the Say’s law believe that the law is valid both in a barter
economy as well as a money economy. The law states that income received from
the production of output is always spent on aggregate demand, i.e., consumption
and investment. In other words, the law suggests that money is never hoarded and
that the money or expenditure stream (MV) remains neutral. There is no doubt
that the law is valid under a barter economy where production was primarily for
consumption, i.e., whatever is produced is exchanged for goods and services. But
one may doubt its validity in the present era, when production is based on future
expectations and anticipations of demand; there is bound to be some
overproduction. It is often said that the Say’s law is valid if a substantial portion
of production is used for consumption and the rest, if saved, is invested.
Check Your Progress 2
1) Describe how output and employment are determined in the classical
model.
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19
Traditional Approaches 2) What are the implications of the quantity theory of money?
to Macroeconomics
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3) What is the relevance of the Say’s law?

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1.4. CLASSICAL DICHOTOMY

From the quantity theory of money (QTM) we find the relationship between
money supply and price level. We discuss below the effect of changes in money
supply on other macroeconomic variables.
1.4.1 AD-AS Equilibrium
In an economy the real variables are real GDP, real capital stock and
employment. These variables measure certain physical quantity. For instance,
real GDP is defined as the quantity of goods and services produced in a specific
period, such as a year, quarter or month. Similarly, real capital stock is defined as
the quantity of machines and structures available at a specific time. The nominal
variables are expressed in terms of monetary value, for example, the price level
and the wage of a person in rupees.
Classical theory of output and employment suggests that the changes in the
quantity of money affects nominal variables such as prices, nominal wages and
nominal income. Changes in quantity of money, however, does not affect real
variables. Classical economists provide an argument that real supply-side factors
such as population, technology, capital stock, state of technology, marginal
physical product of labour, and households’ preferences regarding work and
leisure determine real output and employment. The assumption of flexibility in
prices leads to the self-adjustment of markets. Flexibility of prices and wages
suggests that the changes in money supply affects the price level and nominal
values such as money wages and nominal interest rates while real variables
remain unaffected. Such independence of real economic variables from changes
in money supply and nominal variables is known as ‘classical dichotomy’.

20
 The Classical
Approach

Fig. 1.5: Classical Model of Output Determination

1.4.2 Neutrality of Money
An implication of classical dichotomy is that ‘money is neutral’. We have
illustrated ‘neutrality of money’ graphically in Fig. 1.5. There are four panels in
Fig. 1.5. Suppose money supply in an economy is equal to M0 at a specific time.
The corresponding aggregate demand curve is AD0 as seen in panel (d) of Fig.
1.5. Its interaction with the aggregate supply curve AS decides the price level P0.
Corresponding to the price level P0, the labour market determines the equilibrium
money wage rate W0. Hence, the real wage rate is equal to W0 / P0 and
equilibrium level of employment is NF as seen in Panel (a) of Fig. 1.5. Given the
production function (see Panel (b)), with the equilibrium level of employment
NF the aggregate output is YF. Let us assume that the monetary authority of the
country expands its money supply from M0 to M1 which results in an upward
shift in the aggregate demand curve to AD1 as seen in Panel (d) of Fig. 1.5. As a
result, the price level increases from P0 to P1. This causes the real wage to fall
from (W0/P0) to (W0/P1) as seen in Panel (a) of Fig. 1.5. At the real wage
decreases to (W0/P1), the demand for labour increases. Thus, labour demand

21
Traditional Approaches exceeds labour supply. According to classical theory, this causes the nominal
to Macroeconomics wage rate to increase to W1 (in equal proportion to the increase in price level)
such that the original level of real wage is maintained (that is, W1/P1 = W0/P0).
Thus, there is no change in the equilibrium level of employment NF. (See panel
(a) of Fig. 1.5). At the earlier wage rate and employment level, the real output is
not affected, as seen in panel (b) of Fig. 1.5. To conclude, when there is an
expansion of money supply, the nominal wage rate and price level increase
without affecting the levels of real wage, employment and output. Such
independence of real economic variables from changes in money supply is called
neutrality of money.
There is a crucial limitation to the neutrality of money. It is a basic result derived
from the full-employment equilibrium that is based on the full flexibility of
prices. If increase in money supply (resulting in higher prices) had no real effects,
then inflation would not have been a serious concern in an economy. Inflation,
however, is a serious problem as has many adverse effects such as decrease in
quality of life of people, decrease in economic growth, etc. Thus, measures are
taken to control inflation and maintain price stability in an economy.
1.4.3 Saving-Investment Equilibrium
You should note that classical theory emphasized on the function of money that it
is a medium of exchange. According to the classical school money is demanded
for transaction purposes only. Hence, supply of and demand for money in the
classical theory do not determine the equilibrium rate of interest. An increase in
the quantity of money does not affect the real rate of interest. Thus, there is no
change in the level of saving and investment (see, Fig. 1.6). This shows that
when money supply rise, it does not disturb the capital market equilibrium (or
saving-investment equality) and the level of full-employment equilibrium
remains unchanged.
Y
𝐼
S
I
𝑆
Real Interest Rate

S
𝐼
𝑆 I

X
O Saving and Investment

Fig. 1.6: Capital Market Equilibrium

22
An increase in money supply will lead to an increase in prices. Due to the higher The Classical
Approach
prices, nominal investment expenditure will increase. However, according to
classical theory, such increase will be proportional to the increase in prices.
Therefore, investment expenditure in real terms will not change. This is
explained diagrammatically in Fig. 1.6. We measure real interest rate on the y-
axis and nominal value of saving-invest on the x-axis. The increase in money
supply causes the supply curve of nominal saving to shift downward to the right
from SS to 𝑆 ′ 𝑆 ′. Simultaneously, the investment demand curve will shift upward
from II to 𝐼 ′ 𝐼 ′ by the same amount. It implies that the interaction of 𝑆 ′ 𝑆 ′ and 𝐼 ′ 𝐼′
determines the interest rate without affecting real saving and real investment at
the higher price level too.

1.5 LONG RUN VS. SHORT RUN

In general, supply and demand fluctuate for various reasons, which affects the
level of output. There is considerable difference between short-run and long-run
fluctuations in output. Most economists believe that the behavior of processes is
different between the short run and the long run. In the long run, prices are
flexible, which may be affected by changes in supply or demand. In the short run,
most of the prices are "sticky’’ at the pre-determined level. As the behaviour of
prices in the short run is different from that in the long run, the effects of
economic events and policies vary over different time horizons. Classical theory
is considered to be applicable in the long run. In the short run, we may need a
different analytical framework. In Unit 2 we discuss the Keynesian model, which
is more applicable in the short run.

Let us explain the price behavior in both the short-run and long-run in Fig. 1.7.
Aggregate supply is the total amount of goods and services that firms sell in an
economy. Aggregate demand is the total quantity of goods and services that are
purchased. In a standard AS-AD model, output (Y) is presented on the X-axis
and price (P) is on the Y-axis. The long run aggregate supply curve (𝐴𝑆 ),
which denotes the potential output (full employment output) of the economy is
given by a vertical line at 𝑌 ∗ . The short-run supply curve is upward sloping
(𝐴𝑆 ). The interaction of supply and demand determines the equilibrium level of
output (𝑌 ). In the short run, an outward shift in the supply curve (from 𝐴𝑆 to
𝐴𝑆 ) results in rising output (from 𝑌 to 𝑌 ) and falling prices (from 𝑃 to 𝑃 ). An
outward shift in the AD curve (from 𝐴𝐷 to 𝐴𝐷 ) also results in rising output
(from 𝑌 to 𝑌 ) but rising prices (from 𝑃 to 𝑃 ).

23
Traditional Approaches
to Macroeconomics

ASLR
P

AS0

AS1

P1

AD1

AD0

𝑌∗ Y
Y0 Y1 Y2

Fig. 1.7: Determination of Prices in the Long-Run and Short-Run

Let us look into certain other situations. Short-run fluctuations in nominal

variables usually result in a change in the output level, as macroeconomic
variables not fully flexible. An increase in money supply, for example, will shift
the AD curve to the right (i.e., aggregate demand will increase). This will
increase prices and income. In contrast, a decrease in money supply will result in
a shift in the AD curve to the left, which will decrease both prices and income.
According to the classical theory an increase in money supply leads to increased
prices without affecting the real output. This may be applicable in the long run,
not in the short run.
Check Your Progress 3
1) What is meant by classical dichotomy?
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24
 2) Why is money considered to be neutral? What are its implications? The Classical
Approach
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3) Is classical theory applicable in the short run?

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1.6 LET US SUM UP

In this unit, we discussed different schools of macroeconomic thought that have
evolved over time to respond to certain events in the world economy. Relying on
the assumption of full flexibility of wages and prices, classical theory concludes
that the economy always tends to equilibrium at the full employment level of
output. Also, the capital market always ensures that there is enough demand in
the market. The classical quantity theory of money determines the level of prices
and wage rates without affecting the real economic variables. Classical theory
advocates that policy intervention cannot influence output levels in an economy
as it is self-adjusting. In the classical framework money considered to be neutral
in the sense that it does not affect real variables.

1.7 ANSWERS/HINTS TO CHECK YOUR PROGRESS

EXERCISES
Check Your Progress 1
1) In Section 1.3 we have given the important features of classical theory. Go
through it and answer.
2) New-classical economics considers a general equilibrium framework,
microfoundations and rational expectations.
Check Your Progress 2
1) Go through Sub-Section 1.4.1. Refer to Fig. 1.5 and describe the process.
2) The quantity theory of money (MV = PY) establishes the relationship
between money supply, velocity of money, price level and output. When the
velocity of money and the output level remain constant, an increase in
money supply will lead to increase in prices.

25
Traditional Approaches 3) According to the Say’s law, supply creates its own demand. It rules out the
to Macroeconomics
possibility of unemployment in an economy.
Check Your Progress 3
1) It refers to the classical proposition nominal variables do not influence real
variables in an economy. It arises from the classical assumptions of perfect
competition and full flexibility in prices and wages.
2) Classical economists emphasized that money is demanded as a medium of
exchange. An increase in money supply leads to proportionate increase in
prices and wages; real variables such as output and employment remain
unchanged.
3) Prices and wages may not be fully flexible. Rigidities in prices and wages
may not lead to instantaneous adjustment in output and employment. Thus,
classical theory may not be applicable in the short run.

26
UNIT 2 THE KEYNESIAN MODEL
Structure
2.0 Objectives
2.1 Introduction
2.2 Components of Aggregate Demand
2.2.1 Consumption Function
2.2.2 Investment Function
2.3 Determination of Output in the Keynesian Model
2.3.1 Determination of Equilibrium Output
2.3.2 Investment Multiplier
2.3.3 Government Expenditure and Tax Multipliers
2.3.4 Open Economy Multiplier
2.4 An Alternative View of Equilibrium
2.4.1 Saving Function
2.4.2 Determination of Equilibrium Output
2.4.3 Paradox of Thrift
2.5 Liquidity Preference
2.5.1 Components of Demand for Money
2.5.2 Liquidity Trap
2.6 Role of Government in the Economy
2.7 Let Us Sum Up
2.8 Answer/Hints to Check Your Progress Exercises

20.0 OBJECTIVES
After going through this Unit you should be in a position to
 appreciate the assumptions underlying the Keynesian model;
 explain the concepts of consumption function and saving function;
 identify the factors affecting investment demand;
 show that equilibrium output in the Keynesian model is determined by the
level of aggregate demand;
 explain the various types multipliers in the Keynesian system;
 explain the paradox of thrift;
 explain the concepts of liquidity preference and liquidity trap; and
 discuss the Keynesian view on the role of the government in the economy .


Prof. Ananya Ghosh Dastidar
Traditional Approaches
to Macroeconomics
2.1 INTRODUCTION
In this Unit we will learn about the Keynesian model that was first developed by
the British economist John Maynard Keynes in his famous book ‘The General
Theory of Employment, Interest and Money’, published in 1936. This model
differs in several respects from the classical approach to macroeconomics that
you studied in the previous Unit. The Keynesian model allows for the existence
of unemployment as well as rigidity in wages and prices. It recognizes that lack
of effective demand may prevent the attainment of full employment of resources.
Also, it emphasizes the need for government intervention – as the market
mechanism would not be able to restore full employment equilibrium due to
rigidities in wage rate and prices.

2.2 COMPONENTS OF AGGREGATE DEMAND

We observe that Keynesian economics gained importance against the backdrop
of the Great Depression of the 1930s, when developed economies like the USA
and Great Britain faced a deep and prolonged recession, with rising
unemployment, falling revenues and profits of firms and rise in unutilized
capacity. In this situation the market mechanism failed to restore equilibrium and
the Keynesian policy of raising aggregate demand via increase in public
expenditure played a crucial role in addressing the problem.
Aggregate demand is the planned expenditure on goods and services by all the
economic agents, such as households, firms and government. There are three
main components of aggregate demand in a closed economy: (i) planned
consumption expenditure (C) of households, (ii) planned investment expenditure
(I) of firms, and (iii) expenditure incurred by the government on goods and
services (G). Throughout our discussion in this Unit, each of C, I and G are
assumed to be in real terms (i.e., no change in prices).
2.2.1 Consumption Function
Keynes proposed the idea of a Consumption function which gives the relation
between planned consumption expenditure of households (C) and aggregate
income (Y). It can be represented by the following linear equation:
𝐶 = 𝑎 + 𝑏𝑌 … (2.1a)
In the presence of the government, a part of income would be paid in taxes (T).
In that case the consumption function would be represented as a function of
disposable incomes (𝑌 = 𝑌 − 𝑇), that is,
𝐶 = 𝑎 + 𝑏(𝑌 − 𝑇) = 𝑎 + 𝑏𝑌 … (2.1b)
For the discussion below, for simplicity, we assume that there is no government,
so that T = 0 and Y = 𝑌 .
The slope of the consumption function ‘𝑏’ is assumed to be a positive fraction
(i.e., 0 < 𝑏 < 1). It means that the consumption function can be represented as an

28
upward sloping straight line as in Fig. 2.1. It indicates that planned consumption The Keynesian Model
expenditure increases with an increase in the level of aggregate income.

𝐶 = 𝑎 + 𝑏𝑌
C
𝐶 = 𝑎 + 𝑏𝑌

a1
𝑏

a0
0 Y

Fig. 2.1: Consumption Function

Note that ‘b’ is defined as the marginal propensity to consume (MPC) and it
represents the change in consumption induced by a unit change in income. The
MPC is assumed to be less than one. If there is an increment in income by Y, the
induced increase in consumption C is a fraction of Y (i.e., C =bY and
C/Y = b < 1). It means that the entire increment in income is not spent on
consumption, a fraction (1 − 𝑏) is saved. It means total saving out of the
incremental income is (1 − 𝑏)Y.
Let us consider the case where the consumption function is given by C = 20 +
0.25Y. If aggregate income increases by Rs.100 (i.e., Y=100), then Rs. 25 (C
= 0.25×100) is the additional consumption and Rs.75 [(1 – 0.25) ×100] is
additional saving of households out of the incremental income. Similarly, if
income declines by Rs.100, then consumption would decline by Rs. 25 only,
while saving would decline by Rs. 75.
The intercept of the consumption function ‘a’ represents autonomous
consumption, with 𝑎 > 0. From equation (2.1a), you can see that when 𝑌 = 0,
we have 𝐶 = 𝑎. It implies that consumption occurs even when income is zero.
This consumption is financed by drawing down past saving or by ‘dis-saving’.
An increase in ‘a’ represents increase in planned consumption of households at
each level of income; this can happen, for instance, when consumer confidence
increases (i.e., households’ expectations about the future turn buoyant). You can
see in Fig. 2.1 that an increase in the intercept (from a0 to a1) results in a parallel,
upward shift of the consumption function, from C 0 to C1.
Aggregate consumption has two components: (i) an autonomous component ‘a’
that does not depend on income, and (ii) an ‘induced’ component ‘bY’ that
depends on aggregate income levels. An increase (decrease) in Y induces an
increase (decrease) in planned consumption expenditure by households.
The ratio of aggregate consumption expenditure to aggregate income is
defined as the average propensity to consume (APC). From equation (2.1a) you
29
Traditional Approaches can see that APC = 𝐶 ⁄𝑌 = 𝑎⁄𝑌 + 𝑏. Note that APC will decline as Y increases,
to Macroeconomics
while MPC remains constant.
2.2.2 Investment Function
The investment function (I) represents planned investment expenditure
undertaken by firms on machinery, factories and other such items that add to
productive capacity of the economy. In the simplest version of the Keynesian
model investment is assumed to be ‘autonomous’, i.e., independent of the level of
aggregate income (Y). In this case the investment function is represented by the
equation as below.
𝐼 = 𝐼̅ … (2.2a)
In equation (2.2a) a ‘bar’ over the variable investment (𝐼)̅ variable indicates a
fixed amount. However, we can easily relax this assumption and allow
investment to be a function of aggregate output. In this case the investment
function is:
I=c+dY … (2.2b)
where c > 0 and d > 0; ‘c’ is the autonomous part of investment, d is the marginal
propensity to invest (MPI) and ‘d Y’ represents investment that is induced by
aggregate income.
Fig. 2a below depicts an autonomous investment function, while Fig. 2.2b depicts
an induced investment function which has a component that is induced by
income.

I
I
I = c + dY

I̅

Y c
Y

Fig. 2.2a: Autonomous Investment Fig. 2.2b: Induced Investment

Note that the term investment refers to planned expenditure by firms on new
production equipment (e.g., machinery, building, etc.) that add to productive
capacity. It does not refer to buying of corporate bonds or shares in a company or
opening a fixed deposit account in a bank.
An important variable that affects firms’ decision to invest is the rate of interest.
As the rate of interest increases, the cost of borrowing goes up, resulting in a
reduction in the firms’ planned investment expenditure. The inverse relation
between investment and interest rate can be further explained as follows:

30
Say, the current interest rate is i and an investment project that costs Rs. A, is The Keynesian Model
expected to last for T periods. In each period it yields a return of Rt, where t =
1,2,…, T. In this case, the present value of the stream of returns from the project
P is calculated as:
P= + + + ⋯+ … (2.2c)
( ) ( ) ( ) ( )

If profit is the only motive of investment, this project will be taken up only if
(𝑃 − 𝐴) ≥ 0.
For example, if you are willing to lend Rs.100 at 10 per cent rate of interest for a
period of 1 year, then at the end of the year you will receive Rs.110. So, at the
current interest rate of 10 per cent, the present discounted value of Rs.110 is Rs.
100 [where, 100 = 110 / (1+0.1)].
Now, for the economy as a whole, for any given rate of interest, i0, the
corresponding level of investment I0 by firms would consist of all the projects for
which 𝑃 ≥ 𝐴. Now, if the interest rate increases to i1 (Rt and A remaining
unchanged), P would decrease. Consequently, some projects for which 𝑃 ≥ 𝐴,
would now be unprofitable. At a higher interest rate, therefore, all the projects for
which P < A would not be taken up, so there would be a fall in the associated
level of investment I1. Thus, when i0 > i1 we have I0 < I1.
If we include interest rate as an explanatory variable in the investment function,
we have
𝐼 = 𝑐 + 𝑑𝑌 − 𝑒 𝑖 … (2.2d)
where c > 0, d > 0 and e > 0. Here, e captures the interest responsiveness of
planned investment expenditure.
Check Your Progress 1
1) Discuss the main features of the Keynesian consumption function.
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2) Through a diagram, explain how (i) a decrease in autonomous consumption,
and (ii) an increase in the MPC, would affect the consumption function.
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31
Traditional Approaches 3) Distinguish between autonomous investment and induced investment.
to Macroeconomics
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4) State the reasons for the inverse relationship between interest rate and
investment level.
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2.3 DETERMINATION OF OUTPUT IN THE

KEYNESIAN MODEL
The Keynesian model is based on certain assumptions. First, there are
unemployed resources in the economy. In other words, there is underutilized
productive capacity (e.g., factories operating below capacity, unused machines,
labour without employment, etc.). It follows from this that output in such an
economy is demand determined, i.e., existing production capacity can be used to
step up production in case there is an increase in aggregate demand for output.
Second, money wages and prices are not flexible (i.e., there are price rigidity and
wage rigidity). Since there is unemployment and workers are willing to work at
the going wage rate, an increase in the supply of output is possible at the given
price level. Third, output is assumed to be a homogenous commodity used both
for consumption and investment.
We will present the simplest Keynesian model applicable to a three-sector
economy consisting of households, firms and the government. The economy is
closed (i.e., no external trade). Later on we relax this assumption and allow for
external trade.
In the three-sector economy, aggregate demand comprises (i) planned
consumption by households (C), (ii) planned investment by firms (I), and (iii)
expenditure on goods and services by the government (G). Initially we assume
that investment is fully autonomous, an assumption that is relaxed later. The
government is assumed to raise taxes and here we consider the cases of both
lump sum taxes as well as proportional taxes. Later we will also consider the
implications that arise when the government makes transfer payments to
households (e.g., pensions, unemployment dole, etc.).

32
Therefore, in our simple Keynesian model The Keynesian Model

Aggregate Demand (AD) = C + I + G

By substituting the values of C, I and G, we obtain
𝐴𝐷 = 𝑎 + 𝑏(𝑌 − 𝑇) + 𝐼 ̅ + 𝐺 … (2.3)
Here T is a lump sum tax levied by the government; the investment function is
given by (2.2a).
2.3.1 Determination of Equilibrium Output
The equilibrium condition in the Keynesian model is that aggregate demand for
output is equal to aggregate supply (Y) or, the total output produced in the
economy. Note that at equilibrium, the plans of households and firms (regarding
expenditure on consumption and investment) are also fulfilled. In case plans are
not fulfilled there would be changes in aggregate demand (as households and
firms would adjust their plans) and hence output produced would change as well,
so that the situation would not be one of equilibrium.
The equilibrium condition in the economy is achieved when
Aggregate Supply = Aggregate Demand
From equation (2.3) we know that
𝑌 = 𝑎 + 𝑏(𝑌 − 𝑇) + 𝐼 ̅ + 𝐺
Solving this for Y, equilibrium output (Ye) can be obtained as:
𝑌 = 𝑎 + 𝑏𝑌 − 𝑏𝑇 + 𝐼 ̅ + 𝐺
Or,
𝑌 − 𝑏𝑌 = 𝑎 − 𝑏𝑇 + 𝐼 ̅ + 𝐺
Thus,
𝑌 = (𝑎 − 𝑏𝑇 + 𝐼 ̅ + 𝐺)/(1 − 𝑏) … (2.4)
From (2.4) it should be clear to you that equilibrium output would be higher at
higher levels of (i) autonomous investment, (ii) government expenditure, and (ii)
the MPC. Recall that 0 < MPC < 1, so that the term (1– b) in the denominator is
always positive.
We will now carry out graphical analysis to further understand the process of
attainment of equilibrium in the simple Keynesian model. First we will consider
the case of a two-sector economy with only households and firms and no
government. Later we will consider a three-sector economy which has the
government sector as well.
Two-Sector Economy without Government
In a two-sector economy, there are only households and firms. Therefore,
aggregate demand has only two components, C and I. Thus, 𝐴𝐷 = 𝐶 + 𝐼.̅ Setting
G = T = 0 in equation (2.4) above, we see that equilibrium output would be
33
Traditional Approaches ̅
𝑌 = (𝑎 + 𝐼)/(1 − 𝑏) … (2.5)
to Macroeconomics
We depict equilibrium level of output in Fig. 2.3. Along the horizontal axis we
measure output or income (recall that income is generated in the process of
production of output, so we use the terms income and output interchangeably).
Along the vertical axis we measure aggregate demand and its components (C and
I).
Note that OL is a line which makes an angle of 450 with the horizontal axis, so
that a perpendicular from this line such as AY1, forms an isosceles triangle
AOY1, with OAY1 = AOY1 = 450, and as per the property of isosceles
triangles, the two sides O Y1 and A Y1 are equal. Using this construct we are able
to compare vertical distances (demand) with the horizontal distances (output or
income). Note that at A, where the consumption function cuts OL, consumption
expenditure AY1 is exactly equal to income OY1, so that saving is zero.

AD, C
L
and I H

AD = C + I̅
E
J
G
C=a+bY

A
I̅

450
o Y
Y1 Ye Y2

Fig. 2.3: Equilibrium Output in a Two-Sector Economy

In Fig. 2.3 we derive the aggregate demand curve (AD) by adding the investment
(𝐼 )̅ and consumption (C) functions. Since investment is autonomous the line AD
is parallel to the consumption function, i.e., slope of AD is the same as the slope
of the consumption function. Equilibrium output is attained at E, at the
intersection of AD with OL where aggregate demand EYe is equal to aggregate
output OYe. Note that the equilibrium is unique, as there is only one level of
income OYe at which aggregate demand is equal to aggregate supply. In this case
firms will be able to sell exactly as much as they had planned and hence there
will be no unplanned changes in their stock of inventories.
For all income levels less than OYe, i.e., to the left of E, there is excess demand
for output. For example, when aggregate income is OY1 (=AY1), the
corresponding level of aggregate demand GY1 is greater than the supply of
output AY1 (=OY1). In this case since demand is more than the output produced
by firms, they will have to run down their stock of inventories. So in the next
34
period, firms will increase production and output would move toward OY e. This The Keynesian Model
process of increase in output (and hence income) will continue till OY e is
reached, where the amount produced (OYe) being exactly equal to the amount
demanded (EYe), there is no unplanned changes in the stock of inventories and
hence no further change in production levels.
Similarly, to the right of E (i.e., at all income levels greater than OYe), there will
be excess supply of output. When income is OY2, the corresponding level of
aggregate demand JY2 is less than the supply HY2 (= OY2). In this case, firms
will be unable to sell the entire amount produced (HY2 > JY2) and hence their
stock of inventories will increase (i.e., there will be unplanned inventory
accumulation by firms). This would induce firms to reduce production in the next
period. This process will continue till the equilibrium output EY e (=OYe) is
reached, where demand and supply are equal and there are no more unanticipated
changes in firms’ stock of inventories.
From this discussion we see that output market equilibrium in the Keynesian
model is stable. Any situation of disequilibrium tends to be self-correcting,
inducing a movement back towards the equilibrium level of output.
Three-Sector Economy with Government
In equation (2.4) we derived equilibrium output in a three sector model, with
households, firms and a government sector. Diagrammatically this can be shown
in Fig. 2.4. As earlier, the OL line makes an angle of 450 with the horizontal axis
along which we measure income (or output). Aggregate demand is measured
along the vertical axis. Now, this has three components, C, I and G, where
investment and government expenditure are autonomous.

AD,C, I, G
L
AD = C + I̅ + G
A

450
Y
o
Ye

Fig. 2.4: Equilibrium Output in a Three-sector Economy

Equilibrium in the three-sector model occurs at the intersection of the AD curve
and the OL line, where demand AYe is equal to aggregate supply OYe. You
should see that equilibrium income level OYe is unique and that this equilibrium
is stable. At all income levels higher than OYe there is excess supply, so that
firms decrease production, inducing a change in output towards OYe. On the
other hand, at all income levels lower than OYe, there is excess demand, inducing
firms to increase production.
35
Traditional Approaches Note that the position of the AD curve is determined by the size of the
to Macroeconomics
autonomous components of aggregate demand (viz., I, G and autonomous
consumption a). The higher the levels of these components, the higher would be
the AD line and the higher would be the equilibrium output level (Ye), implying
that output is demand-determined in the Keynesian model.
2.3.2 Investment Multiplier
We will now examine the comparative static properties of the Keynesian model
and explain the concept of the multiplier.
Autonomous Investment
Consider once again the two-sector model with only firms and households, such
̅
that equilibrium income is 𝑌 = (𝑎 + 𝐼 )/(1 − 𝑏). If, ceteris paribus, there is a
change in the level of autonomous investment (I), the associated change in
∆
income would be given by ∆𝑌 = (1/(1 − 𝑏) × ∆𝐼. Thus, = (1/(1 − 𝑏). Here,
∆
we consider change in one component of autonomous demand at a time. This
means when I > 0, we shall assume that a = 0 and so on. The term ( ) is
greater than one, since our assumption is that (0 < b <1). An implication of the
above is that when investment increases by I, the associated increase in income
is greater than I, as it is a multiple of I. How is this possible? To see this,
consider the several rounds of increments in expenditure that are triggered by a
onetime increase in autonomous expenditure.
If we increase I by I, income will increase by I in the first round, which will
induce a second round increase in consumption by bI (since consumption is a
function of income). Since output is demand-determined, this increase in
consumption demand raises output and hence income increases further by bI.
This induces a third round increase in consumption by [b(bI) = b2I] which
triggers further increases in income (b2I). In the fourth round, consumption
demand increases by [b(b2I) = b3I]. The process continues with increase in
consumption raising output, income and yet another round of consumption. Note
that since MPC < 1 (i.e., b < 1), each subsequent round of increase in
consumption is weaker than the previous one, so that the entire process dies
down gradually.
Therefore, the total increase in income due to a onetime increase in autonomous
investment is:
Y = (I + bI + b2I + b3I + …..) = I ( 1 + b2 + b3 + b4 + …..)
…(2.6) Since 0 < b < 1, the expression in parentheses on the right hand
side of (2.6) can be expressed as the sum of a convergent infinite geometric
progression series, i.e., 1 + b2 + b3 + b4 + ….. = 1/(1 − 𝑏). Therefore, Y = [1 /
(1 – b)] I, which shows that income increases by a multiple of the initial
increase in autonomous investment and the multiplier is ( ). This is shown
diagrammatically in Fig. 2.5.

36
 The Keynesian Model

AD, C, I L

AD1 = C + I̅1
D

E AD0 = C + I0̅

∆I A
F

450
O Y
Y0 Y1

Fig. 2.5: Investment Multiplier

The initial equilibrium in Fig. 2.5 occurs at A where AD0 (= C +I0) intersects
OL. With an increase in autonomous investment toI1 (i.e., I = I1 – I0), the AD
curve shifts upward to AD1 (= C +I1) and the new equilibrium occurs at D
where AD1 intersects OL. Note that while investment increased by I (= DE), the
change in income Y (=DF) that it brings about is greater, i.e., Y > I (where,
Y = Y0Y1= AF = DF and DF > DE = I), indicating the operation of a multiplier
effect.
Induced Investment
Suppose the investment function is given by equation (2.2b) above, i.e., I = c +
dY. In this case, investment demand has an induced component that is affected by
changes in income. The equilibrium income would be derived as follows:
Y = AD = a + bY + c + dY, so that:
Ye = (a + c) / [1 – (b+d)] … (2.7)
ceteris paribus, if there is a change in autonomous investment in this case (i.e.,
I =c; a = 0), the multiplier would be given by: 1 / [1 – (b+d)]. This would
follow since Y = {1 / [1 – (b+d)]}c. Note that in this case we assumed that (b
+ d) < 1 (i.e., the sum of MPC and MPI is less than one).
2.3.3 Government Expenditure and Tax Multipliers
We now consider the case of a three-sector economy. For simplicity we assume
that investment demand is autonomous and the government incurs a constant
amount of expenditure G which is autonomous. The government also collects
taxes T. We will consider two cases: (i) the government collects a lump sum tax
T, and (ii) the government sets a proportional tax rate t, so that its tax revenue T
= tY. The government’s budget deficit (B) is defined as B = G – T – TR, where
TR refers to transfer payments made by the government. In what follows we will
assume, for simplicity that TR = 0.

37
Traditional Approaches Lump Sum Taxes
to Macroeconomics
When the government imposes a lump sum tax T, the equilibrium income would
be given by (2.4) above: Ye = (a – bT +I + G) / (1–b). In this case, the multiplier
for any change in autonomous expenditure (either investment or government
expenditure) would be given by: 1 / (1 – b). Thus, Y/G = 1 / (1 – b) or Y/I
= 1 / (1 – b). If there is an increase in the amount of tax collected, then income
would fall. In such a case the tax multiplier would be given by: –b / (1 – b). Thus,
Y/T = – b / (1 – b). Recall that taxes are a leakage from the income stream, so
increase in taxes leads to a decrease in disposable income. Consequently, there is
a decrease in consumption demand, leading to a decline in output (as output is
demand-determined, lower demand results in lowering of output). You should
note that there is a two-way relationship: consumption is influenced by the level
of income (evident from the consumption function) and income is influenced by
consumption demand.
Balanced Budget Multiplier
Suppose the government increases its spending (i.e., G > 0) and cut taxes by
exactly the same amount (T < 0). It implies that the government budget remains
unchanged. If B indicates budget balance, then B = G – T = 0.
Alternatively we can write G = T. You may think that such action would have
no impact on equilibrium income as the injection of additional demand (G) is
exactly offset by a leakage from the demand stream (G = T). However, we can
show that the multiplier in this case is equal to one, i.e. income increases by the
amount of increase in government expenditure. From equation (2.4) we know
that Ye = (a – bT +I + G) / (1–b), so that Y = (– bT + G) / (1– b). Since G
= T, this can be written as Y = (1 –b) G / (1– b), or Y / G = 1.
Proportional Taxes
Now suppose the government levies a proportional tax on income at tax rate t,
where 0 < t < 1. Since AD = a + b (Y – tY) +I + G, the equilibrium condition is
given by
Y = a + b (1 – t)Y + +I + G … (2.7)
By re-arranging terms, we obtain the equilibrium level of output as
Ye = (a +I + G) / {1 – b (1 – t)} … (2.8)
Equation (2.8) implies that the autonomous expenditure multiplier (for a change
in investment or government expenditure) is now lower compared to the cases
without the proportional tax. Without proportional taxes the multiplier is given
by 1/(1 – b). Now, in the presence of proportional taxes, it is given by Y / G =
Y / I = 1 /{1 – b (1 – t)). The reduction in the value of the multiplier arises
because, out of the increase in income in each round, a fraction t has to be paid in
taxes.
You can see from equation (2.8) that any increase in the tax rate would lower
equilibrium income, whereas any decrease in tax rate would have the opposite
38
effect. Therefore, you should see the logic behind tax cuts offered by The Keynesian Model
governments to revive economic activity. However, remember that our
assumption is that there is excess production capacity, which is the main reason
why the increase in consumption demand spurred by a cut in taxes would lead to
an increase in output. Else, it will lead to price rise instead of increase in output.
2.3.4 Open Economy Multiplier
In an open economy there is an additional source of demand for domestic output,
viz., exports (X). Exports are autonomous as they depend on foreign incomes
(i.e., incomes of foreign residents who buy domestic products) rather than
domestic income. Therefore, an increase in exports will have multiplier effect on
income, via various rounds of induced increases in consumption. Firms and
households purchase goods and services from foreign countries in an open
economy. Such imports (M) are a leakage from the domestic expenditure and
income streams. We assume that demand for imports depend on domestic income
level. The import demand function is given by M = h + mY, where h is the
autonomous component of import demand. Here, m is the marginal propensity to
import (MPM) and m > 0. Note that both exports and imports are influenced by
exchange rate changes also (we will take up such issues later in the course on
International Economics). In the present Unit we consider any change in exports
and imports due to exchange rate fluctuation is treated as an autonomous change.
In an open economy, exports are an injection while imports are a leakage from
the stream of aggregate demand for domestic goods. Thus, aggregate demand is
given by: AD = C +I + G + X – M = a + b Y +I + G + X – h – m Y. Therefore,
the equilibrium condition is given by
Y = a + b Y + I + G + X – h – m Y … (2.9)
The equilibrium level of output or income is given by
Ye = (a – h +I + G + X) / (1 – b + m) … (2.10)
In (2.10), the autonomous components are I, G and X. Any change in these
autonomous components will have a multiplier effect. The autonomous
expenditure multiplier for investment, government expenditure or exports is
given by: Y / G = Y / I = Y / X = 1 / (1 – b + m). Clearly, the open
economy multiplier is smaller compared to the one for the closed economy (1/(1
– b). The reason is that a proportion m out of the increment in income is now
spent on imports and domestic demand is lower to that extent as compared to a
closed economy.
In general, from our discussion on multipliers you should note the following
points: (i) the multiplier would be larger, the larger is the MPC (b) and MPI (d),
the lower the tax rate (t) and the smaller the m; (ii) the multiplier is applicable
both in case of a rise as well as a fall in autonomous incomes, meaning that
income would fall by a multiple in case of a given cut in any autonomous
component of demand; and (iii) the operation of the multiplier is driven by the

39
Traditional Approaches assumption that the economy has ample excess capacity and unemployed
to Macroeconomics
resources, so that output can be demand-determined.
2.3.5 Limitations of the Keynesian Model
In the beginning of this section we mentioned that the Keynesian model is more
relevant for an economy facing recessionary conditions, having excess
production capacity in place. In economies having supply constraints (i.e., where
there are supply bottlenecks), an increase in demand is likely to result in a rise in
prices rather than in output. Second, Keynesian model would not apply to
economies that are operating near full employment, where increase in output
would require increase in factor and goods prices. Third, Keynesian model is
generally used for macroeconomic analysis pertaining to the ‘short run’.
Normally, once wage contracts are written they last for some time; also, prices
printed on sales catalogues are expected to be valid for some time. So the
assumption of wage and price rigidity is quite reasonable for the short run.
Check Your Progress 2
1. State the assumptions on which the Keynesian model is based.
........................................................................................................................
........................................................................................................................
........................................................................................................................
........................................................................................................................

2. You are given the following information for a closed economy: C = 10 +

0.75 Y and I = 20.
a) Find the aggregate demand function and calculate equilibrium
income for this economy.
b) Suppose autonomous investment increases to 25. How would
equilibrium income change?
c) What is the value of the multiplier?
d) How would the value of the multiplier in (b) change if we introducethe
government sector which imposes (i) only a lump sum tax, and (ii) only
a proportional tax where t = 0.1?
e) How would the value of the multiplier in (b) change if the economy
is open and MPM = 0.3?
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40
3. By using appropriate diagram of the Keynesian model, explain how The Keynesian Model
situations of disequilibrium (excess demand or excess supply) are self-
correcting.
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2.4 AN ALTERNATIVE VIEW OF EQUILIBRIUM

The Keynesian model can alternatively be described through the saving-
investment relationship. When saving is equal to planned investment, the
economy is operating at the equilibrium level of output.

2.4.1 Saving Function

The saving function is a mirror image of the consumption function that gives the
relationship between planned saving (S) and income (Y) in the economy. In the
two-sector model, with only households and firms, aggregate income is either
consumed or saved. Thus,

Y=C+S … (2.11)

The decision to consume more is essentially the same as the decision to save less.

The saving function may be derived as follows:

S = Y – (a + b Y) = – a + (1– b) Y … (2.12).

Note that the intercept of the saving function is negative, indicating that ‘dis-
saving’ (running down past saving) occur at relatively low levels of income. The
slope of the saving function is (1–b), which is known as the marginal propensity
to save (MPS). Note that MPS = (1–MPC), so that higher the MPC, lower is the
MPS. In economic analysis it is often assumed that richer households have higher
MPS compared poor households.

In Fig. 2.6 we derive the saving function diagrammatically. The top panel
represents the consumption function C, while the lower panel represents the
saving function.

41
Traditional Approaches
to Macroeconomics

C L
E
C = a + bY
D
A
F

450
O Y
Y1 Y2 Y3

H S = – a + (1– b)Y Y

Y1
Y
Y2 Y3
-a
Y1

Fig. 2.6: Saving Function

At income level Y2, where C intersects OL (the 450 line), planned consumption
DY2 is equal to income OY2 (= DY2) and planned saving is zero. At this level of
income, the saving function intersects the x-axis. For all income levels less than
OY2 planned consumption exceeds income so that saving is negative. For
example, in the top panel, at income level OY1, planned consumption AY1 is
greater than income BY1 (= OY1) and the difference is reflected in negative
saving Y1G in the lower panel. For income levels such as OY3, which is higher
than OY2, planned saving is positive (HY3, in the lower panel).
2.4.2 Determination of Equilibrium Output
In a two-sector economy with only households and firms, equilibrium in the
output market occurs at the level of income (or output) at which planned saving
is equal to planned investment. This can be shown as follows: Suppose
investment is autonomous and the investment function is given by I =I as in
(2.2a). Recall that Y = C +I at equilibrium. We know that income is either
consumed or saved, i.e., Y = C + S. Thus, we can put these together to write
C + S = Y = C +I, or, S =I … (2.13)
In a closed economy without government, at equilibrium, planned saving must be
equal to planned investment. Abstaining from current consumption (i.e., saving)

42
involves producing fewer consumer goods and freeing resources for the The Keynesian Model
production of investment goods. This can also be represented diagrammatically
as in Fig. 2.7, where equilibrium income Ye is attained at the intersection of the
saving function and the investment function.

S,I S = –a + (1–b) Y

I̅

0 Y
Ye

Fig. 2.7: Saving-Investment Equality

In a three-sector economy, the output market equilibrium condition is Y = C +I
+ G. Income has three uses: consumption, saving and payment of taxes. Thus, Y
= C + S + T. Putting these together, we can write the output market equilibrium
condition as:
C + S + T = Y = C +I + G, or, S + T =I + G … (2.14)
This can also be written as S + (T – G ) =I , which shows that at equilibrium in a
closed economy, planned investment must be equal to total saving that include
planned saving by households and public saving (T – G). We can also re-write
(2.14) as, (S –I )= (G – T). An implication of the above is: when planned
investment is less than planned saving (S –I > 0), the government is running a
budget deficit (G – T > 0). The financing of the budget deficit is by borrowing
from households.
2.4.3 Paradox of Thrift
An important result regarding the role of saving in the Keynesian model is
referred to as the ‘saving paradox’ or the ‘paradox of thrift’. You know that
saving on the part of a household is considered as a virtue. Higher saving
increases the assets and wealth of a household in the long run. For the economy
as a whole, however, an increase in saving may not be good; it may be a vice.
When households plan to save more, aggregate saving either remain the same or
may even decrease. Let us explain it through a diagram (see Fig. 2.8).
In Fig. 2.8, equilibrium in the economy is at point A, where S = I. Output
produced is Y0. Suppose there is an increase in the autonomous component of
households’ planned saving, i.e., at each level of income planned saving is
higher. This involves an upward shift of the saving function from S 0 to S1. Note
that S1 is parallel to S0 since there is no change in MPS. Now, the equilibrium
output level increases to
43
Traditional Approaches
to Macroeconomics

S1 = –a1 + (1–b)Y
S,I B

D S0 = –a0 + (1–b)Y
I̅
A

0
Y1 Y0 Y
–a1

Fig. 2.8: Paradox of Thrift

Since there is no change in planned investment, there is disequilibrium in the
economy now. Planned investment (DY1) is the same as before (DY1 = AY0).
Since people now wish to save more (saving function has shifted to S 1), income
must be lower, so that saving is the same as before. The paradox is, despite an
increase in thriftiness, there is no change in aggregate saving.

The desire to save more reduces planned consumption, thereby lowering

aggregate demand and hence output (and income). At lower income levels,
saving is correspondingly lower – instead of BY0, aggregate saving fall to DY1,
since income has fallen to OY1.
If the investment function has an induced component and is given by I = c + d Y,
as in (2.2b), then an increase in planned saving can actually lead to lower level of
saving at equilibrium, as shown in Fig. 2.9 below.

S1
S0
S, I I0 = c0 + dY
B
A

c0

0 Y
Y1 Y0

Fig. 2.9: Paradox of Thrift (Induced Investment)

In Fig. 2.9 the saving function shifts from S0 to S1. In this case, the reduction in
consumption demand (due to rise in planned saving), leads to lower output which
44
further leads to a decrease in induced s, thereby lowering income further. At the The Keynesian Model

lower level of equilibrium income (OY1 < OY0), planned saving is

correspondingly lower (BY1 < AY0), with the desire to save more leading to
lower aggregate saving at equilibrium.

This result provides an important insight into the role of saving in the short run.
In an economy that faces no supply constraints and has excess production
capacity, an increase in the desire to save essentially lowers output by lowering
aggregate demand. Therefore, at a lower equilibrium income level aggregate
saving is the same or may even be lower than before. Note that such decline in
output due to higher saving could be a short run phenomenon. In the long run,
higher saving allows for higher investment and hence for creation of additional
productive capacity. You will learn more about the role of saving in the long run
while studying economic growth.
Check Your Progress 3
1. (a) In a two-sector economy (with only households and firms) derive the
output market equilibrium condition in terms of planned saving and
planned investment.
(b) In a three-sector economy (with households, firms and government), what
would be the relation between saving and investment at equilibrium if the
government runs a budget surplus?
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.......................................................................................................................
.......................................................................................................................

2. What is meant by the ‘paradox of thrift’? Use appropriate diagram to

explain the cases of (i) investment demand is autonomous; and (ii)
investment demand has an induced component.
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45
Traditional Approaches 3. In a two-sector economy (with only households and firms), the
to Macroeconomics
consumption function is given by C = 10 + 0.75 Y and I = 20.
(i) Derive the saving function.
(ii) Derive equilibrium output in terms of the equality of planned saving
and investment.
(iii) Suppose there is an increase in the desire to save while planned
investment remains unchanged. The new saving function is given by
S = – 8 + 0.25 Y. Find out the new equilibrium income level.
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2.5 LIQUIDITY PREFERENCE

To complete our understanding of the Keynesian model we have to discuss the
concept of ‘liquidity preference’ or the demand for money in this system. An
important contribution of Keynes was to point out the interest sensitivity of the
demand for money. Note that demand for money refers to the demand for ‘real
balances’, i.e., nominal money demand deflated by the general price level. Since
prices are constant in the Keynesian system, any change in money demand is
essentially a change in the demand for real balances.
2.5.1 Components of Demand for Money
There are three main reasons people wish to hold money. The main components
of the demand for money are (i) transactions demand, (ii) precautionary demand,
and (iii) speculative demand. Let us discuss each of the above.
Transaction Demand: People hold cash since it is a medium of exchange and is
useful for making transactions. This gives rise to transactions demand for money.
You would have noticed that people with higher income tend to hold more
money for transactions compared to the poor. So it is assumed that the amount of
liquid cash people wish to hold for transactions is directly proportional to their
incomes.
Precautionary Demand: People wish to hold money as it would be useful in
contingencies such as medical emergency, accident, etc. It is reasonable to
assume that precautionary demand for money is also an increasing function of
income.
Speculative Demand: According to Keynes, people also hold money for
speculation in the asset market, which gives rise to speculative demand for
money. To understand why speculative demand for money is sensitive to the rate
of interest, consider an economy where there are only two types of financial
46
assets – money and bonds. Money is useful for transactions, but it yields no The Keynesian Model
returns, while bonds offer interest income and possibility of making capital gains
when bond prices rise. There is an inverse relation between the price of bonds
and rate of interest. Now consider the effect of change in interest rate on
speculative demand for money. When interest rate is high, people will mostly
expect it to fall and expect bond prices to rise. Therefore, they would reduce
money holdings and buy bonds in the expectation of making a capital gain. So, at
high rates of interest, demand for money would be low. Conversely, at low rates
of interest, people expect interest rates to rise (i.e., fall in bond prices). Capital
loss would induce people to sell bonds and increase the demand for money.
Therefore, speculative demand for money is inversely related to the rate of
interest.
In general, the higher the market rate of interest, the higher is the opportunity
cost (interest income forgone) of holding money. So when interest rates rise,
people would reduce money demand and try to hold interest-bearing assets
instead which explains the inverse relation between interest rates and the demand
for money. This is another way of understanding the inverse relation between
money demand and interest rates, without assuming the presence of speculative
demand.
From our discussion above, you should see that the money demand function can
be expressed as follows:
L = q Y – t.i … (2.15)
where q > 0, t > 0; L is the demand for real balances, Y is aggregate income and i
is the rate of interest. Diagrammatically the money demand function can be
shown as a downward sloping line in Fig. 2.10, where interest rate is presented
along the vertical axis and money demand is along the horizontal axis.
i

i0

i1
L(Y0) = -qY0 -ti dY

M M
p p L, M p

Fig. 2.10: Demand for Money

47
Traditional Approaches Note that the money demand function L(Y0) represents demand for money at the
to Macroeconomics
income levelY0. Movement along L(Y0) demonstrates the interest sensitivity of
the money demand function. As interest rate falls from i0 to i1, there is an increase
in the demand for money due to speculative demand for money, as discussed
above. For all income levels, demand for money greater than Y0 would be higher
at each interest rate (since transactions and precautionary demands for money
increase with income), and the money demand curve would shift to the right. For
incomes lower than Y0, money demand would be lower at each interest rate and
the money demand curve would shift to the left.
Money supply is determined by the central bank of the country (you will learn
more about it in subsequent Units) and is given by the vertical line M s/ P, where
Ms is nominal money supply, P is the price level and Ms/ P is the real money
supply. Equilibrium in the money market occurs at the intersection of money
supply and money demand. Note that with the downward sloping money demand
function, an increase in money supply (from (Ms/P)0 to(Ms/P)1) brings about a
reduction in the rate of interest (from i0 to i1).
2.5.2 Liquidity Trap
A special situation can arise if interest rates become unusually low and hit the
lowest possible level, so that the demand for money becomes infinitely elastic
and the economy faces a ‘liquidity trap’. This can happen when interest rates
have fallen so low (and bond prices have risen so high) that everyone expects
interest rates to rise (and bond prices to fall). Therefore no one wants to hold
bonds, in fear of making a capital loss and everyone wants to hold money. In this
situation, the money demand curve becomes horizontal as presented in Fig. 2.11
and t in equation (2.16) tends to infinity.

L
i*
L, M p
M M
p p

Fig. 2.11: Liquidity Trap

48
When interest rates hit a floor such as i*, any injection of extra liquidity in the The Keynesian Model
system is absorbed, as people willingly hold money (liquidity) rather than bonds
at an unchanged rate of interest, i*. Therefore once the economy is in a liquidity
trap monetary policy cannot lower the rate of interest beyond i * and hence it
cannot affect real variables like s. An increase in money supply (from (M s/P)0
to(Ms/P)1) has no impact on the interest rate which remains unchanged at i *. Once
you learn about monetary and fiscal policies, you will see that conventional
monetary policy becomes ineffective when the economy is in a liquidity trap
whereas fiscal policy is very effective in this case.
The concept of liquidity trap became important in policy circles during the global
financial crisis of 2007-08, when in advanced economies like USA and Japan
interest rates hit a floor and became zero (USA) or almost zero (Japan). In this
case conventional monetary policy could not be used to reduce the rate of interest
on government bonds any further and policy experiments involving the use of
unconventional monetary policy measures had to be explored. Fiscal policy
measures were also employed, but increase in public debt levels raised concerns
regarding debt sustainability. In the next section we will explore the role of fiscal
policy in the Keynesian model and touch on some of these policy issues.

2.6 ROLE OF GOVERNMENT

The classical economists, as we saw in Unit 1, advocated minimal government
intervention in determination of prices and wage rate. According to them the
activity of the government should be limited to law and order, justice and
defence. They assumed that prices and wage rate are flexible, and there is perfect
competition in the markets. Consequently, there is no unemployment in the
economy.
The Keynesian economics is in sharp contrast to the classical economics.
Keynesian model implies that the government has an important role to play in the
economy. The government should play an active role to bring in equilibrium in
the market. Keynes highlighted that rigidities in prices and wage rate prevent
smooth functioning of market mechanism in the real world. He also highlighted
the critical role of effective demand in determining the level of output and
employment in a macroeconomic context. The classical economists had focused
almost exclusively on the supply side (i.e., on production of output). In contrast,
Keynesian analysis showed that aggregate demand (i.e., planned spending by
economic agents) plays a key role in determining the level of output and
employment in the short run.
Keynes pointed out that when lack of effective demand is the underlying cause of
an economic recession. When there is high unemployment, there is tendency for
wage rate to decline. This will worsen the situation by reducing purchasing
power and hence effective demand. Therefore, government should intervene by
49
Traditional Approaches increasing public expenditure; it should go for a deficit budget. Fiscal and
to Macroeconomics
monetary policies can be used to inject additional demand in the economy, so as
to enhance spending (aggregate demand). That would lead to increases in output,
income and employment in the economy, and the economy would emerge out of
the recession.
The success of Keynesian policies during the Great Depression (1929-33) made a
strong case for an activist role of the government. In particular, Keynesian
economists advocated the use of discretionary fiscal policies, as Keynes had
pointed out the limitations of monetary policy. If the economy was in a liquidity
trap, conventional monetary policy would be completely ineffective, while fiscal
policy would still remain effective.
During the global financial crisis of 2007-08, most countries used the Keynesian
prescription of expansionary fiscal policy (increases in government spending) to
boost economic activity, although it resulted in widening budget deficits and high
levels of public debt. High interest burden on public debt contributes to further
widening of budget deficits, raising concerns about sustainability of the deficits.
Further, high interest rate may lead to ‘crowing out’ of private investment.
You must be aware that during 2020 and 2021, the world economy suffered a
severe economic crisis due to Covid-19. There was acute shortage in aggregate
demand due to decrease in economic activity. The response of the governments
to this crisis situation brought to the fore the importance of the policies advocated
by Keynes.
Check Your Progress 4
1. Discuss some of the factors that influence the demand for money.
.......................................................................................................................
.......................................................................................................................
.......................................................................................................................
.......................................................................................................................
.......................................................................................................................

2. What is speculative demand for money? How does it affect the slope of
the money demand function?
.......................................................................................................................
.......................................................................................................................
.......................................................................................................................
.......................................................................................................................
.......................................................................................................................

50
 3. What is meant by ‘liquidity trap’? What are its implications? The Keynesian Model
.......................................................................................................................
.......................................................................................................................
.......................................................................................................................
.......................................................................................................................
.......................................................................................................................
4. Discuss the role of the government in an economy that is facing a
prolonged recession.
.......................................................................................................................
.......................................................................................................................
.......................................................................................................................
.......................................................................................................................
.......................................................................................................................

5. Give any three reasons why policy makers tend to be concerned about
mounting budget deficits.
.......................................................................................................................
.......................................................................................................................
.......................................................................................................................
.......................................................................................................................
.......................................................................................................................

2.7 LET US SUM UP

Keynesian model is appropriate for an economy facing recessionary conditions
with unemployed resources and lack of effective demand. Keynes assumes that
markets are imperfect with wage and price rigidity. Within this framework,
output is demand-determined. An increase in any autonomous component of
aggregate demand has a multiplier effect, leading to several rounds of increment
in output. Our discussion on the consumption and investment functions
highlighted the factors that influence these two important components of
aggregate demand.
Equilibrium in the Keynesian model can be viewed in terms of the equality
between planned saving and planned investment. We learnt about the paradox of
thrift, which shows that an increase in the propensity to save results in a situation
where aggregate saving may remain unchanged or decline. Since output is
demand-determined in this model, an increase in planned saving leads to lower
aggregate demand and hence lower output, explaining why we observe the
paradox of thrift.
The demand for money (liquidity preference) increases with increase in income
and decreases with increase in interest rate. The inverse relationship between
51
Traditional Approaches money demand and the rate of interest could be explained by the Keynesian
to Macroeconomics
concept of speculative demand for money. We also learnt about the liquidity trap
– at unusually low rate of interest the demand for money becomes infinitely
elastic and traditional monetary policy became ineffective.

2.8 ANSWERS/HINTS TO CHECK YOUR PROGRESS

EXERCISES
Check Your Progress 1

1) Consumption function is a linear function given by 𝐶 = 𝑎 + 𝑏𝑌. The APC

declines with increase in Y while the MPC remains constant.

2) i) A decrease in autonomous consumption will lead to a parallel downward

shift in the consumption function.

(ii) An increase in MPC will increase the slope of the consumption function.

3) Autonomous investment remains constant irrespective of the level of income

or interest. Induced invest depends on income or rate or interest or both. See
Sub-Section 2.2.2 for details.

4) As interest rate decreases the cost of borrowing decreases. Thus, some of the
projects which were unviable earlier become profitable. Therefore, more
investment takes place with decrease in interest rate.

Check Your Progress 2

1) Keynesian model is based on the assumption that resources are under-

utlised, prices and wage rate are rigid, and output is a homogenous
commodity.

2) a) Aggregate demand function is: 𝑌 = 30 + 0.75𝑌. Equilibrium income is

120.

b) Equilibrium output will increase to 140.

c) 4

d) In the case of lump sum tax, the multiplier will be the same as
autonomous expenditure multiplier given in (b). In the case of proportional
tax at the rate of 0.1, the multiplier will be reduce to = 3.08
. × .

e) The open economy multiplier is given by 1 / (1 – b + m). Therefore, the

multiplier will be 1.8.

3) Go through Sub-Section 2.3.1 and answer.

Check Your Progress 3

1) (a) Go through Sub-Section 2.4.2; explain Fig. 2.7.

52
 ̅
(b) Saving will be lower than investment, since (S + T) = (𝐼+G). The Keynesian Model

2) Refer to Fig. 2.8 and Fig. 2.9 for the answer.

3) (i) 𝑆 = −10 + 0.25𝑌; (ii) 120; (iii) 112

Check Your Progress 4

1) You should discuss about transaction demand, precautionary demand

and speculative demand for money.

2) Refer to Sub-Section 2.5.1 and answer.

3) It refers to the insensitiveness of the demand for money to rate of

interest, when the rate of interest is very low. Conventional instruments
of monetary policy become ineffective in liquidity trap.

4) Government should increase public expenditure so that there is no

decrease in effective demand.

5) High fiscal deficit increases government debt burden, increases interest

rate amd may lead to crowding out of private expenditure.

53
UNIT 3 THE NEOCLASSICAL SYNTHESIS
Structure
3.0 Objectives
3.1 Introduction
3.2 Equilibrium in the Real Sector
3.2.1 Derivation of the IS Curve
3.2.2 Shift in the IS Curve
3.3 Equilibrium in the Monetary Sector
3.3.1 Derivation of the LM Curve
3.3.2 Shift in the LM Curve
3.4 Simultaneous Equilibrium of Real and Monetary Sectors
3.4.1 Shocks in the IS-LM Model
3.4.2 Adjustment Process in the Economy
3.4.3 Impact of Supply Shocks
3.5 AD-AS Model
3.5.1 Derivation of the AD Curve
3.5.2 Aggregate Supply Curve

3.6 Let Us Sum Up

3.7 Answers/Hints to Check Your Progress Exercises

3.0 OBJECTIVES
After going through this unit, you should be in a position to
 explain the equilibrium in the real sector and the monetary sector in an
economy;
 explain the underlying ideas behind the IS curve;
 explain the underlying ideas behind the LM curve;
 explain how the IS and LM curves interact;
 identify factors that influence the position and slope of the IS and the LM
curves;
 derive aggregate demand (AD) curve from the IS-LM model; and
 find out the factors that influence the AD curve.
3.1 INTRODUCTION
In Unit 2 we discussed how the equilibrium level of output is determined in the
Keynesian model. Recall that Keynes came up with his analysis in the aftermath
of the Great Depression. He considered an economy with underutilization of
resources (i.e., presence of idle capacity) with an objective of correcting the


Prof. Kaustuva Barik, Indira Gandhi National Open University, New Delhi
economy immediately. Thus, he focused on the short-run. He reasoned that an The Neoclassical
Synthesis
increase in aggregate expenditure (which represents aggregate demand) leads to an
increase in output; it does not lead to rise in prices till full employment is reached.
In view of above, price level is kept fixed in the simple Keynesian model. An
implication of fixed prices is that nominal values and real values are the same.
In this Unit we deal with a closed economy; there is no external trade. We begin
with the derivation of IS and LM curves. Subsequently, we derive the AD curve
from the equilibrium points of the IS-LM model.

3.2 EQUILIBRIUM IN THE REAL SECTOR

The aggregate expenditure (or, aggregate demand) of an economy is given by
Y=C+I+G
where Y is output (or, aggregate supply), C is consumption expenditure, I is
investment expenditure, and G is government expenditure.
The consumption function is given by
𝐶 = 𝑎 + 𝑏(𝑌 − 𝑇) = 𝑎 + 𝑏𝑌 … (3.1)
where 𝑌 is disposable income (i.e., Y – T). Here T is a lump sum tax levied by the
government. The investment function is given by
𝐼 = 𝑐 + 𝑑𝑌 − 𝑒 𝑖 … (3.2)
where 𝑖 is the rate of interest (there is no difference between nominal rate of
interest and real rate of interest as price is kept fixed). Let us assume that
government expenditure (G) is constant, and exogenously given. Thus,
𝑌 = 𝑎 + 𝑏(𝑌 − 𝑇) + (𝑐 + 𝑑𝑌 − 𝑒 𝑖) + 𝐺̅ … (3.3)
On re-arrangement of terms in equation (3.3), we obtain
𝑌 − 𝑏𝑌 − 𝑑𝑌 = 𝑎 − 𝑏𝑇 + 𝑐 − 𝑒𝑖 + 𝐺̅
̅
Or, 𝑌 = − 𝑖 … (3.4)
( ) ( )

The IS equation, in its general form, is given by

𝑌 = 𝛼 (𝐴̅ − 𝑒𝑖) … (3.4a)
where 𝛼 = and 𝐴̅ = 𝑎 + 𝑐 + 𝐺̅ − 𝑏𝑇 .
( )

In equation (3.4) we find an inverse relationship between Y and 𝑖. It implies that,

as 𝑖 increases, there is a decrease in Y. In order to find out the slope of equation
(3.4) you have to express it in terms 𝑖 and find out the slope . You can find out
( )
the slope of the IS curve as − . Depending upon the value of the parameters,
the IS curve would be flatter or steeper.
3.2.1 Derivation of the IS Curve
In Fig. 3.1 we explain the relationship between Y and 𝑖 through a diagram. In Panel
(a) of Fig. 3.1 we take aggregate expenditure (AE) on the y-axis and output (Y) on 55
Traditional Approaches the x-axis. Let us assume that the economy is operating with AE0 while the rate of
to Macroeconomics
interest is 𝑖 . The intersection of AE0 with the 45 line at point ‘a’ is of utmost
importance to us. Note that the 45 line in Fig. 3.1(a) indicates equality between
aggregate demand (AE) and aggregate supply (Y), such that it corresponds to
equilibrium in the economy. We plot this point ‘a’ in panel (b) of Fig. 3.1. In panel
(b) we take interest rate (𝑖) on the y-axis and output (Y) on the x-axis.
Panel (a)

AD
AE1
b AE0

Y0 Y1 Y

Panel (b)
i

i0 a
i1 b

IS
O Y0 Y1 Y
Fig. 3.1: Derivation of the IS Curve
Suppose, there is a decrease in the rate of interest from 𝑖 to 𝑖 . As a result of this,
the level of investment in the economy increases and the new aggregate
expenditure level rises to AE1. The aggregate expenditure curve (AE1) intersects
the 45 line at point-b. Due to the increase in the aggregate expenditure, there is
an increase in the equilibrium level of output from Y0 to Y1. We plot point-b in
Fig. 3.1(b) corresponding to output level Y1 and intertest rate 𝑖 . When we combine
points ‘a’ and ‘b’ we obtain a downward-sloping curve, called the IS curve. A point
on the IS curve denotes equilibrium in the real sector (also called the goods sector)
of the economy and there is equality between investment (I) and saving (S). Note
56 that the real sector of the economy is at equilibrium on each and every point of the
IS curve. An implication of the above is that any point outside the IS curve shows The Neoclassical
Synthesis
disequilibrium in the real sector. In Fig. 3.2 we consider two such points ‘c’ and
‘d’ which are not on the IS curve, and find out their implications.

Fig. 3.2: Disequilibrium in the Real Sector

At point ‘c’ in Fig. 3.2, interest rate is 𝑖 while output is 𝑌 . Notice that at 𝑌 level
of output, the equilibrium rate of interest should be 𝑖 . Thus, the actual rate interest
is higher than what it should. As a result, the aggregate demand will decrease
(largely due to decrease in investment) and the rate of interest will decline. It
implies that at point-c, there is excess supply of goods in the market. We can
generalize that any point which is above and to the right of the IS curve, indicates
excess supply of goods.
Let us look at point ‘d’ which is below and to the left of the IS curve. At point ‘d’
in Fig. 3.2, income is at Y0 but the rate of interest is at 𝑖 . Since the rate of interest
is lower than the equilibrium rate of interest, the demand for investment will
increase. Consequently, the rate of interest will rise upward. Thus, at point ‘d’ there
is excess demand for goods. We can generalize that at any point below and to the
left of the IS curve, there is excess demand for goods.
3.2.2 Shift in the IS Curve
The IS curve depicts the relationship between income and interest rate. Therefore,
any change in other parameters or variables will result in a shift in the IS curve.
The position and the slope of the IS curve depends upon the value of the parameters
in equation (3.4). If the IS curve is flatter, the economy is more sensitive to interest
rate – a small decrease in interest rate will lead to a large increase in income. On
the other hand, a steeper IS curve implies insensitivity to interest rate change.
There are two exogenous variables in equation (3.4), viz., G and T. In equation
(3.4) we assumed that government expenditure and taxes are fixed. Thus, changes
in taxes and government expenditure will also result in shifts in the IS curve. Let
us look into equation (3.4). An increase in the value of 𝐺̅ will result in an increase
in the intercept; thus, there will be an upward parallel shift in the IS curve. An
increase in 𝑇 , on the other hand, will decrease the intercept and shift the IS curve
downward to the left.

57
Traditional Approaches A change in the value of a parameter leads to a shift in the IS curve. An increase
to Macroeconomics
in autonomous consumption (the coefficient ‘a’ in equation (3.4)) or autonomous
investment (the coefficient ‘c’ in equation (3.4)) will lead to a parallel shift of the
IS curve upward to the right. A change in the marginal propensity to consume,
however, will affect the slope of the IS curve.
Check Your Progress 1
1) What will be the nature of change in the IS curve if there is a decrease in the
propensity to consume?
………………………………………………………………………………
………………………………………………………………………………
………………………………………………………………………………
………………………………………………………………………………
2) What is the implication of the following on the position of the IS curve?
(i) Decrease in autonomous government expenditure
(ii) Decrease in tax rate
………………………………………………………………………………
………………………………………………………………………………
………………………………………………………………………………
………………………………………………………………………………

3.3 EQUILIBRIUM IN THE MONETARY SECTOR

The derivation of LM curve utilises the Keynesian view that speculative demand
and transaction demand for money are separate. The speculative demand for
money depends on the rate of interest while the transaction demand and the
precautionary demand for money depend on the level of income. Thus, total
demand for money (M) depends on both income (Y) and rate of interest (i). The
demand for money in real terms ( ) is given by

𝐿 = 𝑘𝑌 − ℎ𝑖 … (3.5)
where k > 0, h > 0; L is the demand for real balances (liquidity), Y is aggregate
income and 𝑖 is the rate of interest. You should remember three issues about the
monetary sector: (i) A person would like to deposit his money in bank and earn
interest on it. The alternative is to hold on to the cash, where no interest income is
earned. Thus, the opportunity cost of holding money is the interest foregone. If
there is an increase in the rate of interest, the interest foregone increases.
Conversely, if the rate of interest decreases, the interest income foregone
decreases. Therefore, the demand for money is a downward-sloping curve, if we
measure rate of interest on the y-axis and quantity of money on the x-axis. You
may be familiar with the concept of liquidity trap; a situation where the rate of
interest is very low, and people prefer to keep all their money in the form of liquid
cash as the interest income foregone is negligible. (ii) The demand for real balances
is described for a given level of income. We consider the money demand function
58
while keeping the level of income fixed (say, 𝐿(𝑌 )). If there is an increase in the The Neoclassical
Synthesis
level of income, there is an increase in the level of transactions and wealth in the
economy, which in turn increases the demand for money. Thus, there will be a
parallel shift in the money demand function. (iii) The supply of money is
determined by the central bank and it is constant. Thus, the supply of money is a
vertical straight line. If the supply of money is increased by the central bank, the
vertical straight line will shift to the right. When we deal with the short-run, we
assume that money supply does not change.
3.3.1 Derivation of the LM Curve

The supply of money in real terms is given by . Equilibrium in the money market
is achieved when 𝐿 = 𝑀 = 𝑀 . Thus, equilibrium in the money market is given by

= 𝑘𝑌 − ℎ𝑖 … (3.6)

We can re-arrange terms in the above equation and obtain

𝑌=− + 𝑖 … (3.6a)

There is a positive relationship between 𝑌 and 𝑖 in the LM curve. In order to find

out the slope of equation (3.6) you have to express the equation in terms 𝑖 and find
out the slope . You can find out the slope of the LM curve as . Depending upon
the value of the parameters, the LM curve would be flatter or steeper.

Fig. 3.3: Derivation of the LM Curve

In Fig. 3.3, Panel (a) we depict the equilibrium in the money market (or, in the
monetary sector). We take demand for real balances ( ) on the x-axis and the rate
of interest on the y-axis. Let the money demand in the economy be given as (𝑌 )
when the aggregate income is 𝑌 . In panel (a) of Fig. 3.3, this equilibrium is
represented by point ‘a’. The equilibrium rate of interest and income are 𝑖 and 𝑌
w respectively.
Let there be an increase in the level of income from 𝑌 to 𝑌 . Such an increase in
income will lead to a parallel upward shift in the money demand function. We 59
Traditional Approaches
to Macroeconomics
depict this money demand function as a dotted line (𝑌 ) in Panel (a) of Fig. 3.3.
With money supply remaining constant, an increase in aggregate demand will lead
to a rise in the interest rate. The economy is now at equilibrium with output level
𝑌 and interest rate 𝑖 . The intersection between the money supply function and the
money demand function is denoted by point ‘b’ in Fig. 3.3, panel (a).
In panel (b) of Fig. 3.3 we plot the LM curve by taking combinations of interest
rate and aggregate income where the money market is in equilibrium. We have two
such points, ‘a’ and ‘b’ in panel (a) of Fig. 3.3. You should note that the LM curve
is the combination of all the points where the money market is in equilibrium. The
LM curve is upward-sloping as you can see from the figure. An implication of the
LM curve is that as income increases people want to hold more money, thus driving
up the interest rate. If the speculative demand for money is perfectly elastic to
interest rate (liquidity trap situation) the LM curve will be horizontal. On the other
hand, if speculative demand is perfectly inelastic to interest rate, the LM curve will
be vertical.
To the left side of the LM curve there is excess supply of money (for example,
point ‘c’ in Fig. 3.3 panel (b)). Excess supply in the money market implies that the
demand for money is less than its supply. It means that people want to reduce the
amount of liquid cash they possess. This induces people to buy bonds so that bond
prices rise and rate of interest declines. A decline in the rate of interest restores
equilibrium in the economy. To the right side of the LM curve, there is excess
demand for money (for example, point ‘d’ in Fig. 3.3 panel (b)). Excess demand
for money causes people to sell bonds (so that they can keep higher amount of
liquid cash). This leads to a fall in bond prices and rise in the rate of interest. This
way equilibrium in the monetary sector is restored.
3.3.2 Shift in the LM Curve
The position and the slope of the LM curve depend upon certain factors, including
money supply. An increase in money supply shifts the LM curve to the right. As a
result, at every level of output, the equilibrium rate of interest is lower than before.
Thus, increase in money supply shifts the LM curve to the right. Conversely, a
decrease in money supply will shift the LM curve to the left so that equilibrium
rate of interest is higher at every level of output.

3.4 SIMULTANEOUS EQUILIBRIUM OF REAL

AND MONETARY SECTORS
Now let us combine IS and LM curves as shown in Fig. 3.4. Such integration of
IS-LM gives a unique combination of 𝑖 and 𝑌, which represents equilibrium in
both real market and money market. In Fig. 3.4 we superimpose 𝐼𝑆 and 𝐿𝑀 in
the same diagram. We measure income (Y) on the x-axis income (Y) and rate of
interest on the y-axis. The equilibrium rate of interest and the equilibrium output
level are given by 𝑖 and 𝑌 respectively.

60
 The Neoclassical
Synthesis

Fig. 3.4: Simultaneous Equilibrium

3.4.1 Shocks in the IS-LM Model
Previously we have discussed about the factors that lead to a shift in the IS curve
and the LM curve. Often the economy experiences exogenous demand shocks and
supply shocks. Let us analyse the impact of such shocks in terms of the IS-LM
model. Suppose there is a boom in the stock market, which changes the wealth of
households. Such a situation will increase the level of consumption in the
economy. Consequently, there will be an increase in aggregate expenditure and the
IS curve will shift to the right from 𝐼𝑆 to 𝐼𝑆 (see Fig. 3.4). As a result, there is an
increase in output from 𝑌 to 𝑌 . A negative shock such as a decrease in business
confidence of firms will shift the IS curve to the left. Such a left-ward shift in the
IS curve will decrease output as well as interest rate.
Let us consider another example. Suppose there is a series of online financial fraud
cases in the country. This will send a negative signal to people – this will
discourage people to keep their income in the formal system; there will be a decline
in online transactions and the demand for money will increase. As a result, the LM
curve will shift to the right from 𝐿𝑀 to 𝐿𝑀 (see Fig. 3.4). Consequently, there
will be an increase in output from 𝑌 to 𝑌 , and decrease in interest rate from 𝑖 to
𝑖 .
You should note that the nature and extent of change in output and interest rate
will depend upon the slope of the IS and LM curves. If the LM curve is flatter,
monetary policy is quite effective. A small decrease in interest rate by the central
bank will increase output by a large amount. If the LM curve is steeper, monetary
policy will not be effective. In order to increase output by a small amount we will
need a large decrease in the interest rate.
3.4.2 Adjustment Process in the Economy
A question arises at this point: What happens to the economy if it is operating at a
point which is not at the intersection of the IS and LM curves? Does it
automatically converge to the equilibrium point? Let us try to answer this question.
61
Traditional Approaches If the economy is not operating at the unique point where the IS and LM curves
to Macroeconomics
intersect, there is disequilibrium in the economy. In that case an adjustment process
starts and the economy moves to an equilibrium point. The following two issues
are important in this context:
a) If there is an excess demand for money (to the right of the LM curve), the
interest rate will increase. The interest rate will fall in case we observe
excess supply in the money market. Fall in interest rate will lead to increase
in investment. Increase in investment will affect the IS curve.
b) Excess demand for goods (to the left of the IS curve) leads to an increase
in output. Increase in output will lead to increased demand for money.
Increase in demand for money will lead to rise in interest rate and outward
shift in the LM curve.
We observe from the above that both real sector and monetary sector are inter-
related. A real shock to the economy will have effects on the monetary sector and
vice versa.

Fig. 3.5: Convergence to Equilibrium Point

In Fig. 3.5 we plot the IS and LM curves. The economy is in equilibrium at point
E, with 𝑖 to 𝑌 as equilibrium interest rate and output respectively. Suppose, due
to certain shock to the economy, the equilibrium is disturbed. We have indicated
the points F, G, H and K where the economy is not in equilibrium.
Let us consider point G. As mentioned earlier, at point G, there is excess demand
for money and excess supply of goods. The arrows given at point G specify the
direction in which adjustment takes place. Due to excess demand for money, there
will be a rise in the rate of interest. This is because people will sell bonds so as to
hold more of liquid cash, as a result of which the bond prices will decline and rate
of interest will increase. Upward pointing arrow in Fig. 3.5 represents rising
interest rate. At point G, there is excess supply of goods also. This will lead to
involuntary accumulation of goods; inventories will increase. As a result, firms
will cut down production and the level of output will decline. The leftward pointing
arrow represents the declining output. Finally, the economy will move towards
62 equilibrium point E.
Points F, H and K in Fig. 3.5 also are disequilibrium points. You can analyse the The Neoclassical
Synthesis
supply and demand conditions at these points and find out the directions in which
adjustment will take place. For example, at point ‘H’ there is excess supply of
money (since it is to the left of the LM curve) and excess demand for goods (since
it is to the left of the IS curve). Excess supply of money will lead to a decrease in
interest rate. Excess demand for goods will lead to an increase in output level.
Consequently, the economy will move towards the equilibrium point E.
Suppose the economy is at point F (see Fig. 3.5) – here the monetary sector is in
equilibrium, but the real sector is in disequilibrium. There is an excess supply of
goods in the economy. This will lead to an increase in inventory accumulation. As
a result, firms will decrease their production levels. Decrease in output will lead to
a decrease in the demand for money and consequent decrease in the rate of interest.
Finally, the economy will reach the equilibrium point E where both the IS and LM
curves intersect.

Fig. 3.6: Adjustment Process in the Economy

Note that when one of the two markets is observing disequilibrium, the economy
reaches back to equilibrium after the adjustment process. In Fig. 3.6 we have
indicated the direction of change by arrow marks.
3.4.3 Impact of Supply Shocks
In the IS-LM model it is not necessary that the equilibrium occurs at the level of
potential output of the economy (or, full employment output). Equilibrium could
be at any level of output in the economy. An objective of policy makers has always
been that the economy should operate at potential output level with unemployment
at its natural level. In the long run does the economy maintain equilibrium at the
full employment output level?
In the long run prices do not remain constant. If actual output is above the potential
out, there will be price rise. The aggregate expenditure of the economy (such as
consumption, investment and government expenditure) describes the demand for
goods and services, which refer to physical quantities of goods and services. A
change in the price level may not affect these quantities. Thus, the IS curve is
relatively stable – it may not shift. The LM curve, on the other hand, is based on
the supply of and demand for real balances. Thus, a change in price level will shift
the LM curve.
63
Traditional Approaches The full employment output is given by the production capacity of the economy.
to Macroeconomics
It is derived from the production function (see Unit 1). Suppose the full
employment output (potential output) of the economy is given by 𝑌 ∗ . We depict it
by a vertical straight line in Fig. 3.7. The IS0 curve and LM0 curve intersect at E
which corresponds to the full employment output.

Fig. 3.7: Adjustment to Adverse Supply Shocks

Suppose the economy gets an adverse supply shock (for example, decline in
agricultural productivity due to drought), as a result of which there is a decrease in
the potential output of the economy from 𝑌 ∗ to 𝑌 ∗∗ . As pointed out above, the IS
curve is relatively stable in such situations and the economy adjusts through a shift
in the LM curve. Due to the adverse supply shock, there is a rise in prices and
consequent leftward shift in the LM curve. Thus, there is a rise in the rate of interest
and the new equilibrium is at F.
Check Your Progress 2
1) Explain how the LM curve is derived.
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2) Suppose the LM curve is vertical. What are its implications?
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3) In the IS-LM model, explain how adjustment to supply shocks takes place.
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64
3.5 AD-AS MODEL The Neoclassical
Synthesis

In the IS-LM model we assumed that price level is constant. Let us relax that
assumption and look into the impact of prices on equilibrium output in the
economy. First, we derive the aggregate demand (AD) curve. Subsequently, we
juxtapose the AD curve with the aggregate supply (AS) curve and find out the
equilibrium level of output.
3.5.1 Derivation of the AD Curve

A change in the price level changes the real money supply ( ) in the economy.
This will result in a shift in the LM curve if money supply (M) is assumed to be
constant. Thus, there will be a change in the equilibrium rate of interest and output.
If we assume that the price level keeps changing over time, we will obtain a series
of equilibrium levels of output corresponding to different price levels. If we plot
such combinations of prices and output, we obtain the aggregate demand (AD)
curve.
The derivation of the AD curve from IS-LM curves is shown in Fig. 3.8. In panel
(a) of Fig. 3.8 we juxtapose 𝐼𝑆 and 𝐿𝑀 curves intersecting at point E with an
equilibrium income level of 𝑌 and interest rate 𝑖 . The 𝐿𝑀 curve is based on real
money stock of 𝑀 /𝑃 . Thus, we describe the combination 𝑃 and 𝑌 as point ‘a’
on the AD curve in panel (b) of Fig.3.8.

Fig. 3.8: Derivation of AD Curve

Now, let us assume that price level declines to 𝑃 . If there is no change in money
stock, supply of real balances increases to 𝑀 /𝑃 . Note that the increase in real
balances is due to decrease in prices, not due to an increase nominal money stock.
The LM curve shifts to the right. In panel (a) of Fig. 3.8 we depict the new LM
curve as 𝐿𝑀 . With 𝐼𝑆 and 𝐿𝑀 , the new equilibrium point is ‘b’; the rate of
interest falls to 𝑖 and income rises to 𝑌 . The combination of 𝑃 and 𝑌 becomes
point ‘b’ in Panel (b) of Fig. 3.7. By joining all such points as ‘a’ and ‘b’, we obtain
the AD curve.
65
Traditional Approaches The AD curve is downward-sloping, which indicates an inverse relationship
to Macroeconomics
between prices and output. A decline in price level increases the real money
supply, which creates disequilibrium in the money market. Increase in the supply
of real balances lead to a decrease in interest rate. A decrease in the rate of interest
restores equilibrium in the money market. A decrease in the rate of interest leads
to an increase in the level of investment. An increase in the level of investment
leads to an increase in aggregate expenditure, thereby increasing the level of
output.
The AD curve is flatter, if a given change in price leads to a larger change in output.
On the other hand, the AD curve is steeper if a given change in price leads to a
smaller increase in output. The AD curve shifts upward to the right as a result of
expansionary fiscal policy (e.g., increase in government expenditure, reduction in
tax rate). A contractionary fiscal policy, on the other hand, shifts the AD curve
downward to the left. Similarly, an expansionary monetary policy (e.g., reduction
in interest rate, increase in money supply through open market operations, reserve
requirements, etc.) will shift the AD curve to the right while a contractionary
monetary policy will shift the AD curve to the left.
You should note that any factor that leads to a shift in the IS curve or the LM curve
to the right will shift the AD curve to the right side. Similarly, any factor that shifts
the IS curve or LM curve to the left will shift the AD curve to the left. Thus, an
increase in any component of autonomous spending such as an increase in
government spending leads to a rightward shift of the AD curve. Also, an increase
in the nominal money supply will shift the AD curve upwards.
3.5.2 Aggregate Supply (AS) Curve
From microeconomics we know that the AS curve is upward-sloping – when price
of a product increases, firms produce more of the product. In the case of the whole
economy, production capacity is limited. Resources available to the economy are
not unlimited. The behaviour of the AS curve is different in the long run compared
to the short run. Short run, as you know, is a time period in which wages and certain
other economic variables do not respond to changes in economic environment. In
the long run is a time period in which wages and prices are flexible.
Classical theory discussed in Unit 1 assumed that the AS curve is vertical at the
full employment level. Thus, output is perfectly inelastic to changes in prices.
Keynes went to the other extreme and assumed that the AS curve is horizontal. An
implication of the horizontal AS curve is that firms can increase production to any
level without affecting prices. Both the versions (vertical and horizontal) of the AS
curve seems unrealistic. As you will learn in later units, the new-classical
economists suggest that the AS curve is upward-sloping in the short run. Lucas’ in
his ‘aggregate supply hypothesis’ advocate that economic agents respond to price
and wage incentives, which influences their trade-off between leisure and work.
As a result, when actual wage is higher than equilibrium wage rate, households
supply more labour. Conversely, when actual wage rate is lower than equilibrium
wage rate, household will decrease their supply of labour. As a result of this, the
66
short run aggregate supply (SRAS) curve would be upward-sloping. The long run The Neoclassical
Synthesis
aggregate supply curve (LRAS), however, will be vertical. Any change in the
production capacity of the economy will shift the LRAS curve.
In Fig. 3.9 we depict the AD curve and an upward-sloping AS curve. The
equilibrium in the economy is described by point E corresponding to output 𝑌 and
prices 𝑃 . Suppose there is a favourbale demand shock to the economy so that the
AD curve shifts to 𝐴𝐷 . As a result, there are increases in both output and prices.
The new equilibrium described by point F corresponds to output 𝑌 and prices 𝑃 .
The increase in output however will be temporary and output will be back at the
LRAS level in the long run.

Fig. 3.9: Impact of Demand Shock

Check Your Progress 3

1) Explain how the AD curve is derived?
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2) Point out the factors that influence the position and slope of the AD curve.
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67
Traditional Approaches
to Macroeconomics
3.6 LET US SUM UP
In this Unit we described the IS-LM model, which signify the equilibrium in the
real sector and the monetary sector of the economy. We derived the IS curve – on
each and every point of the IS curve the real sector is in equilibrium. On the left
side of the IS curve there is excess demand for goods while on the right side there
is excess supply. The LM curve is the combination of all such points where the
monetary sector of the economy is in equilibrium. On the right side of the LM
curve, there is excess demand for money while on the left side there is excess
supply of money. If the economy is operating at a point away from the IS and LM
curves, it has a tendency to move towards the equilibrium point.
We derived the AD curve on the basis of IS-LM model. The AD curve traces the
combinations of equilibrium output and prices. The equilibrium output and prices
in the economy derived from the AS-AD model is also discussed.

3.7 ANSWERS/HINTS TO CHECK YOUR

PROGRESS EXERCISES
Check Your Progress 1
1) It will affect both the intercept and slope of the IS curve. Look into equation
(3.4). Decrease in the marginal propensity to consume (coefficient ‘b’) will
lead to a decrease in the value of the intercept term. Look into the last term
of the equation. It will increase the value of . Thus, the IS curve will
( )
be steeper.
2) (i) Decrease in autonomous government expenditure will lead to a parallel
downward shift in the IS curve to the left.
(ii) Decrease in lumpsum tax will lead to a parallel upward shift in the IS
curve. But the question is about decrease in tax rate, which depends on
income (Y). Thus, it will affect the slope of the IS curve. The IS curve will
become flatter (why? You can take a tax function 𝑇 = 𝑡 + 𝑡 𝑌, substitute it
in place of T in equation (3.4) and find out).
Check Your Progress 2
1) The LM curve is derived from the equality between the demand for and supply
of real balances. See Section 3.3, particularly Fig. 3.3.
2) When the LM curve is vertical, demand for money is insensitive to interest
rate. This is a case of liquidity trap situation.
3) Go through Sub-Section 3.4.3 and answer.
Check Your Progress 3
1) The AD curve is derived from the IS-LM model. Go through Sub-Section
3.5.1 and explain Fig. 3.8.

68
2) Since the AD curve is derived from the IS-LM model, it depends on the factors The Neoclassical
Synthesis
that influence the IS and LM curves. Explain the impact of these factors on
the AD curve.

69
UNIT 4 OPEN ECONOMY
MACROECONOMICS -I
Structure
4.0 Objectives
4.1 Introduction
4.2 National Income Identity in an Open Economy
4.3 Balance of Payments and Exchange Rate
4.3.1 Balance of Payments
4.3.2 Exchange Rate
4.4 Let Us Sum Up
4.5 Answer/Hints to Check Your Progress Exercises
4.0 OBJECTIVES
After going through this Unit you should be in a position to
 explain the national income identities in an open economy;
 assess the relation between aggregate expenditure and income in an open
economy;
 explain the relation between private savings-investment gap, fiscal deficit and
current account deficit;
 explain the concept of Balance of Payments (BOP);
 explain current and Capital accounts of BOP;
 explain the concepts of nominal and real exchange rates; and
 explain fixed and flexible exchange rate regimes.

4.1 INTRODUCTION
In this Unit we will examine the national income identities, with a view to
identifying certain fundamental differences between open and closed economies.
Thereafter we examine certain basic concepts relating to Balance of Payments
(BOP) and exchange rates. The BOP accounts record the transactions of an
economy with the ‘rest of the world’ and provide important insights into the
pattern of international trade and capital flows. The exchange rate is also an
important variable in an open economy with important implications for
international trade and competitiveness.

4.1 NATIONAL INCOME IDENTITY IN AN OPEN

ECONOMY
In an open economy domestic agents have manifold economic interactions with
foreigners; e.g., goods are sold to, as well as purchased from foreigners. The sale
of goods and services to foreigners are exports (X) of the country and purchases
from foreigners constitute imports (M). In an open economy, aggregate
expenditure on final goods by domestic agents (households, firms and


Prof. Ananya Ghosh Dastidar, Department of Finance and Economics, University of Delhi
government) given by [C + I + G], includes expenditure on domestic as well as Open Economy
Macroeconomics-I
imported goods. Aggregate spending on domestic goods by domestic agents is
given by [C + I + G – M]. To this we add expenditure on domestic goods by
foreigners or exports, to obtain total final expenditure on domestically produced
goods, i.e., [C + I + G + X –M].
From the equivalence between the expenditure, income and product approaches
to measurement of aggregate output, we can say that aggregate final expenditure
is equal to aggregate output produced in the economy or GDP (Y).
So the national income identity for an open economy can be written as:
Y=C+I+G+X–M
or, Y = C + I + G + NX (where NX = X – M) (4.1)
Note that (X – M) is also referred to as net exports (NX) or balance of trade.
When exports exceed imports, NX is positive and there is a trade surplus; when
imports exceed exports, NX is negative and there is a trade deficit.
In an open economy we draw a distinction between GDP and GNP (Gross
National Product). While GDP refers to aggregate incomes earned (by domestic
residents and foreigners) within the geographical boundaries of the country, GNP
is defined as the aggregate income of citizens of the country, irrespective of
whether they are located within the country or abroad. E.g., the salary of a
German consultant located in New Delhi would be a part of German GNP and
India’s GDP; the salary of an Indian worker in Singapore would be a part of
Singapore’s GDP and India’s GNP.
So we define net factor income from abroad (NFIA) as follows:
NFIA = Income earned abroad by domestic factors of production minus income
earned by foreign factors of production in the domestic economy.
To obtain GNP, NFIA is added to GDP (denoted often as Y in macroeconomics):
i.e., GNP = Y + NFIA (4.2)
Note that NFIA can be positive or negative and the difference between GDP and
GNP can often bequite large.For example, GDP may exceed GNP (NFIA < 0) in
countries where mostproduction units are owned by foreign multinationals (so
that a large share of the incomes generated within the economy, accrue to
foreigners) or which have a sizeable migrant population employed abroad.
Using the national income identity we can show in an open economy aggregate
expenditure (C+I+G) can exceedaggregate income (GNP) and that this imbalance
is reflected in a current account deficit.
We can also write (4.2) as:
GNP = C+I+G+NX +NFIA
or, GNP = C+I+G+ CA, (where CA = NX + NFIA)
or, GNP – (C+I+G) = CA (4.3)
71
Traditional Approches Note that CA represents the ‘current account balance’ of a country, which may be
to Macroeconomics
positive (current account surplus) or negative (current account deficit).
The identity (4.3) indicates that aggregate domestic absorption (C+I+G) exceeds
aggregate income (GNP) in a country that has a current account deficit (CA < 0).
Such a country is a net debtor (or, borrower) as it has to borrow to bridge the gap
between income and expenditure whereas aggregate income exceeds expenditure
in a country running a current account surplus (CA > 0) and it is a net lender.
A current account deficit may be financed by borrowing from the rest of the
world or by sale of foreign assets held by domestic agents. We will have more to
say on this in the next section on balance of payments.
The national income identity can be further used to understand whether the real
sector imbalance reflected in a current account deficit, stems mainly from the
private sector, or the government sector, or both.
From the income side, we know that aggregate income is either consumed (C), or
saved (S) or paid out in taxes (T), so that,
C + S + T = GNP (4.4)
Combining (4.3) and (4.4), we can write,
C + S + T = GNP = C+I+G+CA
or, C + S + T = C+I+G+CA,
or, S + T = I+G+CA
or, (S – I) + (T – G) = CA (4.5)
From identity (4.5) it is clear that a current account deficit (CA <0) reflects either
an excess of private investments over private savings (i.e., (S – I) < 0 ) or, a
budget deficit (i.e., (T–G) < 0) or, both. Also, if (S – I) > 0 but, (T–G) < 0 and
absolute value of (T–G) is larger than that of (S – I), there would be a current
account deficit. The identity (4.5) represents the ‘twin deficits’, where an external
deficit (CA < 0) is reflected as a deficit in the private sector (i.e., (S – I) < 0), or
in the government sector (i.e., (T–G) < 0), or in both.
The national income identities clearly indicate that an imbalance in the current
account reflects an imbalance in the real economy.That is, whenever a country
runs a current account deficit, there is an excess of aggregate expenditure over
income; this may occur because, private savings are too low, or there is aprivate
investment boom, or, the government is running a budget deficit or some
combination of these factors. Conversely, aggregate income exceeds expenditure
in a country that runs a current account surplus and either its private savings
would exceed investments (i.e. (S – I) > 0) or, public savings would be positive
(i.e., (T – G) > 0) or, both.
The main difference between closed and open economies should be evident from
the above discussion. In a closed economy, by definition, there are no
transactions with the ‘rest of the world’and CA is zero. Thus aggregate
72
expenditure cannot exceed aggregate income. It means, an excess of private Open Economy
Macroeconomics-I
investments over savings (S – I < 0) needs to be compensated by public savings
(T–G > 0). However, open economies can borrow from the rest of the world.
Thus it can sustain excess of expenditure over income and excess of investments
(I) over private (S) and public savings (T – G). International trade and capital
flows allow countries running current account deficits to draw on the savings of
other countries running current account surpluses.

Check Your Progress 1

1) Use the national income identity for an open economy and show that in a
country running a trade deficit (i.e., NX < 0): (a) aggregate expenditure
must be greater than GDP, and (b) national savings (i.e., sum of private
savings and public savings) must be less than investments.
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2) Use the national income identity to bring out at least two fundamental
differences between open and closed economies.
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4.3 BALANCE OF PAYMENTS AND EXCHANGE

RATE
The Balance of Payments (BOP) of a country is a record of all its transactions
with foreigners during a given period (typically one year). The transactions
include those involving purchase and sale of goods, services, physical and
financial assets, as well as transfer payments.
4.3.1 Balance of Payments
The BOP account has two main components, viz., the current account and the
capital account.
Current Account: The current account of BOP records receipts from and
payments to foreigners due to international trade in goods and services (including
factor services). In the current account transactions involving inflows of foreign

73
Traditional Approches exchange (e.g. exports) are a credit and those involving outflows of foreign
to Macroeconomics
exchange (e.g., imports) are a debit entry. The current account comprises two
main components: the balance of trade and the balance on invisibles.
Transactions involving trade in services, factor incomes and transfers are also
referred to as ‘invisibles’ in the current account. These are further explained
below.
The balance of trade or merchandise trade balance is the difference between
exports and imports of goods by a country and it may be positive, negative or
zero. A negative balance of trade or a trade deficit indicates that the country’s
imports of goods exceed exports; a positive trade balance indicates the country
has a trade surplus, with exports of goods exceeding imports.
Trade in services (e.g., India’s software exports) is a part of invisibles in the
current account. The balance of trade in services captures the difference between
a country’s service exports and imports and it may also be positive or negative,
depending on whether the country is a net exporter or net importer of services.
Factor incomes include net investment incomefrom abroad which measures
investment earnings from abroad earned by Indians minus foreigners’ earnings
from their Indian assets. Indian residents may receive investment income, such as
dividends and interest, on the foreign assets they hold while foreign residents
receive investment income on the Indian assets they possess. The former is a
credit (inflow of foreign exchange) while the latter is a debit entry (outflow of
foreign exchange) in the current account.
Unilateral Transfers, that are overseas payments made without any quid pro quo,
are also recorded in the current account. These include assistance by foreign
governments during war or natural calamity (foreign aid), workers’ remittances
(e.g., money sent by overseas Indians to their families in India), personal gifts,
donations etc. The net unilateral transfers are transfers received by Indians from
abroad minus similar transfers sent to foreigners from India. For many
developing countries workers’ remittances are an important source of foreign
exchange earnings.
The current account balance is the sum of (i) the balance on merchandise trade
and (ii) the balance on invisibles (which comprises balance on services trade, net
investment income and net transfers). When total foreign exchange receipts on
account of all the transactions recorded in the current account are greater than
total payments, the country has a current account surplus. In case the foreign
exchange payments exceed the receipts, the country has a current account deficit.
Note that even if a country has a trade deficit it could have a current account
surplus, if it has a positive and very high net invisibles balance. This can be seen
in many countries that are net recipients of large unilateral transfers and
remittances. For example, remittances received from Indian workers employed
abroad are an important source of foreign exchange earnings for India. India is
the largest recipient of remittances in absolute figure ($87 billion in 2021) while

74
in terms of percentage of GDP Lebanon is the largest recipient that contributed Open Economy
Macroeconomics-I
54 per cent of GDP in 2021.
Capital Account: The capital account of the BOP includes transactions involving
cross-border purchase and sale of real and financial assets. The asset in question
could be physical assets like land, factories, houses or financial assets like stocks
and bonds. In the capital account each transaction is recorded twice, once as a
credit and once as a debit entry, thereby capturing the two aspects of each
transaction. E.g., purchase of a foreign financial asset such as foreign government
bond or shares of a foreign firm by a domestic resident involves an asset import
and a capital outflow (payment made by the domestic resident for the foreign
asset).
Broadly two types of capital flows are recorded in the capital account – debt
creating and non-debt creating flows. For example, when domestic agents borrow
from foreign financial institutions, the country experiences a debt creating capital
inflow, as this loan has to be repaid at a future date. However, foreign firms
investing in the domestic country (e.g., foreign direct investment or FDI), involve
a non-debt creating capital inflow, as this does not create any commitment for
repayment for the recipient nation. Capital flows can also be classified on the
basis of the duration involved. For example, foreign institutional investors (FIIs)
purchasing shares of domestic firms, involves a short term capital inflow (also
known as foreign portfolio investment or FPI). The FIIs may sell the equity and
withdraw their funds at a short notice. Such withdrawal of foreign funds would
involve a capital outflow. Typically, investment by foreign firms in country’s
production sector (e.g., Greenfield FDI) involves longer term capital inflows that
are not likely to be withdrawn at short notice unlike investment in the financial
sector (e.g., FPI).
When capital inflows exceed capital outflows, the country has a capital account
surplus. In the opposite case, when outflows exceed inflows it has a capital
account deficit.
In the current account, in general, transactions involving the inflow of foreign
exchange are recorded as a credit entry, with the corresponding debit entry
appearing in the capital account. Therefore a surplus (or deficit) in current
account is mirrored in a corresponding deficit (or surplus) in the capital account.
If a country has a current account deficit, this must be financed either by selling
assets or by borrowing, so there must be a corresponding surplus in the capital
account. So a current account deficit is financed by net capital inflows, either on
account of the private sector or the government sector or both.
Overall BOP Balance: Every transaction is recorded twice in the BOP account,
once as a debit and once as credit, as per the principles of double entry
bookkeeping. Therefore in an accounting sense the BOP is always balanced.
However, in practice, this is not observed, primarily because of problems related
to data collection. There are time lags involved in the international transactions;
e.g., data on exports is collected from customs, at the time goods are shipped,
75
Traditional Approches whereas payments for the same may be received six months later and hence may
to Macroeconomics
not be recorded in BOP of that year. Therefore, in order to balance the BOP
account an entry for errors and omissions is included.
Even though the BOP always balances, we can talk about an overall BOP surplus
or deficit. Overall BOP balance is obtained by adding the current and capital
account balances. A country has a BOP surplus in the following cases: (i) there is
current account surplus as well as capital account surplus; (ii) there is a current
account deficit but a capital account surplus that is larger in magnitude; (iii) there
is a current account surplus and a relatively smaller capital account deficit. There
would be a BOP deficit, either when there is a deficit on both current and capital
accounts or when there is a relatively large deficit in either one of the current or
capital accounts.
In the case of a BOP surplus there is an increase in the foreign exchange reserves
of the country. In the case of a deficit, the stock of foreign exchange reserves is
depleted. Let us discuss this issue in details.
Change in Foreign Exchange Reserves
Apart from transactions made by private and government agents, the capital
account of the BOP also includes official reserve transactions that involve
change in the stock of foreign exchange reserves held by the central bank. When
there is a BOP surplus, the country experiences a net inflow of foreign exchange,
leading to a correspondingincrease in foreign exchange reserves. In the case of a
BOP deficit, there is net outflow of foreign exchange and a corresponding
reduction in foreign exchange reserves. Thus,
BOP Balance = Current Account + Capital Account (including errors and
omissions) + Official Reserve Transactions = 0
In case a country has a current account deficit (of say, – $15,000), but a capital
account surplus that is smaller in magnitude (say, $12,000), then it has a BOP
deficit (of –$3000) that leads to a decrease in foreign exchange reserves (by
$3000).
Note that a BOP surplus is recorded with a positive sign in the BOP, while the
corresponding increase in reserves has a negative sign, so that the two add up to
zero. Therefore in BOP accounts an increase in foreign exchange reserves
appears with a negative sign whereas a decrease in reserves has a positive sign.
4.3.2 Exchange Rate
The exchange rate is an important concept in an open economysuch as India, that
has transactions involving foreign goods, services and assets, whose prices are
denominated in terms of foreign currencies. Throughout the following discussion
we assume that the domestic country is India and the foreign country is the USA.
Demand for foreign exchange arises whenever domestic agents purchase foreign
goods, services or assets (i.e., imports and capital outflows); whereas, sale of
domestic goods, services and assets to foreigners (i.e., exports and capital
76
inflows) constitutes the primary source of supply of foreign exchange. The Open Economy
Macroeconomics-I
market value of the exchange rate is determined by demand and supply in the
foreign exchange market. However, often the official exchange rate may differ
from its market value as you will see from our discussion on alternate exchange
rate regimes. First we shall learn about various exchange rate concepts.
Nominal Exchange Rates
The nominal exchange rate ‘e’ can be defined as the number of units of domestic
currency (Rupee) required forpurchasing one unit of foreign currency (dollar).
For example, if Rs. 80 is required to buy one dollar, then the exchange rate e =
Rs. 80 per dollar. Similarly, the exchange rate of the Indian rupee can also be
defined in terms of other currencies, e.g., yen, euro, pound, etc.
When the exchange rate ‘e’ rises (say, from Rs. 80 to Rs.82 per dollar), there is
an increase in the price of dollars in terms of rupees and there is nominal
depreciation of the rupee vis-à-vis dollar (and nominal appreciation of the dollar
vis-à-vis rupee). When ‘e’ falls (e.g., from Rs. 80 to Rs. 78 per dollar), the dollar
becomes cheaper in terms of rupees and there is a nominal appreciation of the
rupee (and nominal depreciation of the dollar vis-à-vis rupee).
Real Exchange Rate
While nominal exchange rates measure the rate of exchange between domestic
and foreign currencies, the real exchange rate captures the rate at which domestic
goods are exchanged for foreign goods. It isthe price of foreign goods in terms of
domestic goods and is computed using the nominal exchange rate and prices of a
comparable basket of domestic and foreign goods as bellow:
r = (e pf) / pd (4.6)
where‘e’ is the nominal exchange rate (rupees per dollar), pd denotes the
domestic price level (in rupees) and pfdenotes the foreign price level (in dollars).
‘e pf’ is the price in rupees of a foreign basket of goods and ‘pd’ is the price (in
Rupees) of a comparable domestic basket.
The real exchange rate between rupee and dollar reflects the price of goods
produced in the USA relative to those produced in India. A rise in r means
American goods become relatively more expensive vis a vis Indian goods and
there is real depreciation of the rupee; whereas a reduction in r makes Indian
goods relatively more expensive and there isreal appreciation of the rupee. The
real exchange rate is often used as an index of a country’s international price
competitiveness. In case a country faces real appreciation of its currency,
domestic goods become more expensive and this can lead to a reduction in
demand for exports. In contrast, a real depreciation of the currency can boost
export demand.
When domestic and foreign prices remain unchanged (that is, is constant), a
nominal depreciation (‘e’ rises) of the domestic currency causes a corresponding
real depreciation (‘r’ rises). In this case the nominal and real exchange rates
77
Traditional Approches move in the same direction. However, prices may change simultaneously with
to Macroeconomics
exchange rates; e.g., an appreciation in nominal exchange rates (‘e’ falls), along
with a large fall in domestic prices (𝑝 falls) may lead to a real depreciation (r
rises). So, ‘e’ and ‘r’ may also move in opposite directions.
Exchange Rate Regimes
The exchange rate regime of a country determines how its exchange rate is
determined.
Under a flexible (or floating) exchange rate regime, the value of ‘e’ is
determined by the demand and supply of foreign exchange, without any
government intervention. In this case the currency is on a clean float or pure
float. That means the exchange rate is fully flexible and adjusts continuously to
equate market demand and supply of foreign exchange, so there is no role for
intervention by the central bank and hence no need of foreign exchange reserves.
In this case BOP balance is attained via exchange rate fluctuations. That is, in
case there is a BOP surplus (supply of foreign currency exceeds demand), the
exchange rate appreciates (e falls, so that given prices, r falls, so foreign goods
are relatively cheaper), X falls, M rises and NX falls (the current account deficit
widens and BOP surplus is reduced), till BOP equilibrium is restored. Floating
exchange rates lead to considerable volatility in exchange rates that may be
unfavorable for exporters and importers and may have adverse impacts on
domestic production, investment and employment. As such, ‘pure floats’ are
rarely observed in practice.
In most countries central banks maintain a stock of foreign exchange reserves
and intervene and try to maintain the value of exchange rate within a certain
band. Such exchange rate arrangements, widely prevalent across countries, are
called a ‘managed float’ or dirty float. Intervention refers to the central bank
buying or selling foreign exchange in an attempt to influence the exchange rate.
In a managed float, the currency is allowed to float within a certain ‘target zone’
and the central bank stands ready to intervene (e.g., buy or sell dollars against
rupees) whenever the exchange rate appears to breach the limits of this band.

At the other extreme we have the system of fixed exchange rate, wherein the
exchange rate is not freely floating, but is fixed by the government. An
important function of central banks in a fixed exchange rate system is to
intervene in foreign exchange markets to keep the price of foreign exchange
fixed at the pre-announced level. For this, central banks have to maintain
adequate stock of foreign exchange reserves.

Under a fixed exchange rate system, the fixed parity announced by the central
bank may be revised at times; in this case a decrease in ‘e’ due to official
intervention is called revaluation while an increase in ‘e’ by official intervention
is called devaluation. In a world with few restrictions on international
transactions in goods and assets, maintaining a fixed exchange rate poses an
78
immense challenge for a country’s government. We will discuss a few aspects of Open Economy
Macroeconomics-I
policy dilemmas under a fixed exchange rate regime in the next section.

Check Your Progress 2

1) State whether the following statements are ‘True’ or ‘False’, giving reasons
for your answer in each case:

(a) A country can have a current account surplus, even when it has a negative
trade balance (or merchandise trade deficit).

(b) When Indian firms invest in foreign firms (‘outward FDI’), there would
be a corresponding capital inflow in the current account of India’s BOP.

(c) A country can have an overall BOP deficit even when it has a current
account surplus.

(d) When a country has a current account deficit (of say –$20,000) and a
capital account surplus (of say $8000), its foreign exchange reserves
would increase.
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...........................................................................................................................
...........................................................................................................................
...........................................................................................................................
2) Suppose that domestic currency depreciates by 2 percent and simultaneously
domestic prices rise by 5 percent, while foreign prices remain unchanged.
(i) What would be the impact on (a) real exchange rate; and (b) net
exports?
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...........................................................................................................................
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(ii) How would your answer in (b) above wouldchange if domestic prices
remained constant following the nominal currency depreciation?
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3) Suppose a country experiences a sudden surge in capital inflows (e.g., FPI
inflows) that create an excess supply of foreign exchange (say dollars). How
would this affect the following?
79
Traditional Approches (a) the exchange rate and net exports under a flexible exchange rate regime
to Macroeconomics
...........................................................................................................................
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(b) the exchange rate and foreign exchange reserves under a fixed exchange rate
regime ?

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4.4 LET US SUM UP

In this unit, we learnt that how openness to international trade and capital flows
affects policy and macroeconomic outcomes within an economy. Our discussion
on national income identities highlighted important differences between closed
and open economies. For example, we saw that open economies can run current
account deficits and borrow from the rest of the world to cover an excess of
aggregate expenditure over income. Exchange rates are an important
macroeconomic variable in open economies and from our analysis of BOP we
got a flavor of the various factors, related to international trade in goods, services
and assets that affect the demand and supply of foreign exchange and have an
impact on nominal and real exchange rates. In this context we also learnt about
alternate exchange rate regimes, viz., fixed and flexible exchange rate regimes.

4.5 ANSWERS/HINTS TO CHECK YOUR PROGRESS

EXERCISES
Check Your Progress 1
1) Refer to Section 4.2 and answer.
2) Refer to Section 4.2 and answer
Check Your Progress 2
1) a) True
b) False
c) True
d) False
2) Refer to Sub-section 4.3.2 and answer.
3) Refer to Sub-section 4.3.2 and answer.
80
UNIT 5 OPEN ECONOMY
MACROECONOMICS -II
Structure
5.0 Objectives
5.1 Introduction
5.2 The Open Economy IS-LM Framework
5.2.1 The IS Curve
5.2.2 The LM Curve
5.2.3 Equilibrium in Open Economy IS-LM Model
5.3 Monetary and Fiscal Policies under Flexible Exchange Rate
5.3.1 Fiscal Policy under Flexible Exchange Rate
5.3.2 Monetary Policy under Flexible Exchange Rates
5.4 Monetary and Fiscal Policies under Fixed Exchange Rate
5.4.1 Fiscal Policy under Fixed Exchange Rates
5.4.2 Monetary Policy under Fixed Exchange Rates
5.5 Let Us Sum Up
5.6 Answer/Hints to Check Your Progress Exercises

5.0 OBJECTIVES
After going through this Unit you should be in a position to
 analyse short run macroeconomic equilibrium using the open economy IS-
LM model; and
 discuss the limits to monetary and fiscal policies under fixed vis-à-vis flexible
exchange rate regimes.

5.1 INTRODUCTION
In this Unit we will introduce the open economy IS-LM framework and use it to
understand the complications involved in framing monetary and fiscal policy
under alternate exchange rate regimes. In particular we consider two different
exchange rate regimes, viz., fixed and flexible rate systems and explore the
implications for conduct of monetary and fiscal policies under the assumption of
unrestricted international capital mobility.
Apart from the above, we use the open economy IS-LM framework with perfect
capital mobility to study the conduct of monetary and fiscal policy under
alternate exchange rate regimes. First we examine the conduct of policy making
under flexible exchange rates, followed by the case of a fixed exchange rate
regime. This is known as the ‘Mundell-Fleming model’, named after economists
Robert Mundell and Marcus Fleming, who developed this framework and
analysed policymaking in open economies in the early 1960s.


Prof. Ananya Ghosh Dastidar, Department of Finance and Economics, University of Delhi
Traditional Approches
to Macroeconomics
5.2 THE OPEN ECONOMY IS-LM FRAMEWORK
After our discussion above on certain basic concepts and accounting tools
pertaining to open economies (see Unit 4), we will now examine output market
equilibrium in the short run Keynesian framework using the open economy IS-
LM model.
As in case of the closed economy IS-LM model, here also we assume that prices
are given and there is ‘excess capacity’, so that output is demand determined.
5.2.1 The IS Curve
You are familiar with the IS curve in a closed economy (see Unit 3). In an open
economy, aggregate demand (AD) is given by:
AD = C + I + G + X – M = C + I + G + NX, (5.1)
where, C = C (Yd), is aggregate consumption expenditure which is a function of
disposable income, Yd= Y – T ;
I [= I (i)] is private investments, an inverse function of the rate of interest i;
G represents exogenous government expenditure;
X [= X (Yf, r)] is exports, the demand for domestic goods by foreigners, which is
a function of foreign GDP (Yf) and the real exchange rate r;
M [= M (Y, r)[ is imports, the demand for foreign goods by domestic agents,
which is a function of domestic GDP (Y) and the real exchange rate r;
NX [= (X – M) = NX (Yf, Y, r)] stands for the net exports that depend on the
factors underlying demand for imports and exports, i.e., Y f, Y and r.
Clearly imports are a leakage from the domestic economy as it is the expenditure
ofdomestic agents on output that is produced in a different economy (hence part
of their GDP) while exports are an addition to the total expenditure on domestic
goods. Exports depend on Yf, ceteris paribus, the higher is Yf, higher would be
export demand. Similarly, the higher is Y, higher would be the demand for
imports. Both exports and imports depend on the real exchange rate which
represents the relative price of foreign vis-à-vis domestic goods as discussed in
equation (6). With an increase in r (a real depreciation), foreign goods become
relatively more expensive. Thus, there is a decline in imports, while exports
increase as domestic goods become relatively cheaper. So a rise in r would lead
to a rise in X and a fall in M and net exports would be higher. Note that
economists Alfred Marshall and Abba Lerner gave certain conditions under
which a real devaluation or depreciation leads to an improvement in the trade
balance (increase in NX), known as the Marshall- Lerner condition. According to
the Marshall-Lerner condition, depreciation will lead to an improvement in the
balance of trade of a country only if the sum of the price-elasticities of exports
and imports of the country is greater than one. Throughout our discussion we
assume that the Marshall-Lerner condition is satisfied.

82
Note that one of the assumptions in the IS-LM framework is that of given prices. Open Economy
Macroeconomics-II
Therefore, with given foreign (pf) and domestic prices (pd), a nominal
depreciation or appreciation (rise or fall in e) brings about a real depreciation or
appreciation (rise or fall in r).

As in the closed economy case, the IS curve, represents goods market

equilibrium, so that along the IS curve we have aggregate demand equal to
aggregate output or GDP (Y):

i.e., Y = AD

or, Y = C (Yd) + I (i) + G + NX (Yf, Y, r) (5.2)

However, compared to the closed economy case, now there are two new
determinants of aggregate demand, viz., foreign GDP and the real exchange rate.
These two factors affect net exports and hence demand and output in an open
economy. If Yf increases (decreases) or r increases (decreases), NX would also
increase (decrease) and the IS curve would shift to the right (left).

Another aspect of open economies reflected in (5.2) is that any change in

aggregate demand (e.g., due to an increase in G), would affect Y and hence M
and therefore lead to a change in NX. For instance, ceteris paribus an increase in
government spending would lead to an increase in Y and M and thus reduce NX
(i.e. reduce the size of the trade surplus or widen an existing trade deficit).
However, if foreign GDP Yf increases, ceteris paribus, exports would increase
(as these are imports of the foreign country), also leading to an increase in Y, but
in this case the trade balance would improve, i.e., NX would rise (assuming that
rise in X due to increase in Yf, would be more than the rise in M induced by rise
in Y).

5.2.2 The LM Curve

So far as the LM curve is concerned, openness of an economy does not

fundamentally change the inverse relation between money demand and the rate of
interest (see Unit 3). If the demand for money is higher, the lower is the rate of
interest, as in the case of a closed economy. Thus the LM curve, representing
money market equilibrium (equality between demand for money and supply of
money) is upward sloping. However, in an open economy, asset transactions with
the rest of the world would give rise to capital flows (recorded in the capital
account of the BOP). This also affects the rate of interest and money supply in an
open economy. We discuss further on this issue below.

Let us assume that there is perfect capital mobility, i.e., there are no restrictions
on international capital inflows and outflows and cross-border capital movements
involve zero transaction costs. This is a simplifying assumption that captures the
83
Traditional Approches reality of large-scale international capital mobility observed in the era of
to Macroeconomics
globalization, with advances in technology greatly reducing the cost of moving
capital across international borders.

The assumption of perfect capital mobility has certain implications for the
determination of interest rates in an open economy. It means that the domestic
and foreign bonds are perfect substitutes, so that therate of intereston domestic
bonds (i)has to be in line withthe rate of interest on foreign bonds (if), i.e., i = if
must hold. Here we assume that the foreign interest rate is given and not
influenced by domestic economic policy.

If if is higher than i (i.e., if > i), foreign bondswould be preferred by investors

owing to relatively higher returns on them. In this case, the domestic economy
would experience capital outflows, as agents sell domestic bonds and buy dollars
to purchase foreign bonds. The outflows continue until i rises (as price of
domestic bonds fall) and equality is restored between i and if. When i = if,
economic agents (such as households and firms) are indifferent between domestic
bonds and foreign bonds.

Another point you should note regarding the money market in open economies
relating to the supply of money and the role of foreign exchange reserves. Note
that the stock of foreign exchange reserves is an asset of the central bank. When
the central bank buys foreign currency, adding to its assets, it issues domestic
currency so there is matching rise in its liability. As such, any change in foreign
exchange reserves affects the monetary base or high powered money (liabilities
of the central bank) and hence money supply in the economy, via the money
multiplier.

Therefore, when a country experiences capital inflows and has a BOP surplus,
this increasesforeign exchange reserves and leads to an increase in money supply.
Similarly, a capital outflow can result in a BOP deficit and a fall in money supply
via a reduction in the stock of foreign exchange reserves.

In this context you should note that the central bank often uses a policy of
sterilization to offset the impact of a change in foreign exchange reserves on the
money supply. This can be done by using open market operations. In particular,
central banks often use foreign exchange reserves for intervention in the foreign
exchange market. Suppose the RBI intervenes to buy dollars (in order to absorb
an excess supply of dollars) against rupees. This would add to its foreign
exchange reserves and hence increase money supply. However, the RBI can carry
out a sterilized intervention, by simultaneously selling bonds, in an open market
operation, to reduce money supply. Thereby the RBI can either fully or partially

84
offset the impact of the increase in foreign exchange reserves on the money Open Economy
Macroeconomics-II
supply.

5.2.3 Equilibrium in Open Economy IS-LM Model

As in case of a closed economy, macroeconomic equilibrium occurs at the

intersection of the IS and LM curves as shown in Fig. 5.1.

LM M p

E
i0 = if BP

IS

Y
Y0
Fig. 5.1: “Macroeconomic Equilibrium in Open Economy IS-LM Model

Note that at the equilibrium E,the rate of interest, i0 = if, owing to the assumption
of perfect capital mobility. The point E represents macroeconomic equilibrium in
the sense that there is both internal balance (goods and money market
equilibrium) and external balance (BOP equilibrium).
The horizontal line BP that passes through the equilibrium rate of interest
represents BOP equilibrium, in the sense that it represents interest rate – income
combinations for which the current account surplus (deficit) is exactly offset by a
capital account deficit (surplus). Note that here NX represents the current account
balance.
With perfect capital mobility, the BP curve is horizontal, as the slightest
deviation of i from if, would create BOP disequilibrium and trigger either infinite
capital inflows or outflows. If i> if, there will be a surge in capital inflows and a
BOP surplus, since inflows would be higher than required for BOP balance, at
any given level of income. Whereas, or any i < if, there will be unlimited capital
outflows and a BOP deficit. That is, for any Y (say Y0), there is BOP surplus at
all points above BP and a BOP deficit at all points below BP.
With imperfect capital mobility the BP curve would be upward sloping. As Y
increases, M would rise, NX would fall and the current account deficit would
widen. To maintain BOP balance therefore, i would have to increase to attract
capital inflows and create a matching capital account surplus. With imperfect

85
Traditional Approches capital mobility, which occurs when there are restrictions on cross-border capital
to Macroeconomics
flows or when domestic and foreign bonds are imperfect substitutes, there can be
a difference between iand if. However, here we will only consider the case of
perfect capital mobility.

5.3 MONETARY AND FISCAL POLICIES UNDER

FLEXIBLE EXCHANGE RATE
When a country has a flexible exchange rate regime, its exchange rate is
determined by demand and supply in the foreign exchange market. We consider
the case of a pure float, where there is no official intervention in currency
markets and hence no role of foreign exchange reserves, with BOP equilibrium
achieved via exchange rate fluctuations.
5.3.1 Fiscal Policy under Flexible Exchange Rates
Consider the open economy IS-LM model with perfect capital mobility and
suppose the government follows expansionary fiscal policy in this set up as in
Fig. 5.2.

LM M p
i E1

i1
i2 E0
BP
i0 = if
IS2 IS1

IS0

Y
Y0 Y1

Fig. 5.2: Expansionary Fiscal Policy under Flexible Exchange Rates

Initially the economy is at E1 (see Fig. 5.2), where goods and money markets are
in equilibrium and there is BOP equilibrium as well, with i 0= if. With fiscal
expansion (or fall in tax rate t), there is an increase in G. The IS curve shifts from
IS0 to IS1 and the interest rises from i0 to i1 as the economy moves to the new
equilibrium E1. However, with if remaining the same, the rise in domestic interest
rate makes domestic bonds relatively more attractive and there is a surge in
capital inflows, that leads to a BOP surplus (excess supply of foreign exchange),
causing a currency appreciation (e falls). With given prices (implying prices
remaining constant), a nominal appreciation leads to a real appreciation (r falls),
reducing X, raising M and worsening the trade balance (NX falls). As a result
aggregate demand falls and the IS curve shifts to the left. It shifts back all the
way to IS0, where once again i = i0 = if and output is back to Y0.Note that at any
other IS curve, e.g., IS2, the domestic interest rate is still above if (i2> if), so e, r

86
and NX would fall and IS would shift further to the left. Therefore, we see that Open Economy
Macroeconomics-II
with flexible exchange rates, fiscal expansion is ineffective. It fails to raise output
(the increase in output from Y0 to Y1 is only temporary), the trade balance
worsens because of appreciation in the exchange rate (NX is lower) and the fiscal
position deteriorates (G has increased or tax rate t has fallen).
5.3.2 Monetary Policy under Flexible Exchange Rates
We now examine the impact of expansionary monetary policy under a flexible
exchange rate regime.

i LM
M
p

M
LM p

E0
i0 = if BP
E
i2
E IS3
i1 E

IS0 IS2

Y
Y0 Y1 Y3
[Fig. 5.3: Expansionary Monetary Policy under Flexible Exchange Rates]

In Fig. 5.3 an increase in nominal money supply (from M0 to M1) shifts the LM
curve outward from LM0 to LM1 and the economy moves from E0 to E1, as
domestic interest rate falls from i0 to i1.At i1 there is internal balance (output and
money markets are in equilibrium) but there is external imbalance (BOP
disequilibrium) that triggers capital flows. Since i 1< if, this triggers a capital
outflow, leading to a BOP deficit (excess demand for dollars) and causing a
depreciation of the nominal (e rises) and real exchange rates (r rises). As a result
domestic goods become relatively cheaper, X rises, M falls and NX increases,
and with higher external demand, the IS curve shifts to the right. This process
continues till the IS curve shifts all the way to IS3 and the economy is at E3,
where once again i = if and both internal and external balance are restored. At any
other point (e.g., E2 on IS2, i2< if, so e and r would rise, NX would fall, moving
the IS curve further to the right).
This shows, that in complete contrast to fiscal policy, monetary expansion is an
extremely effective policy tool in an open economy with flexible exchange rates

87
Traditional Approches and perfect capital mobility. It brings about currency depreciation that improves
to Macroeconomics
the trade balance, so that output increases from Y0 all the way to Y3.
Check Your Progress 1
1. What is the effect of monetary expansion on output and interest rates in an
open economy with perfect capital mobility under flexible exchange rate?
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2. Comment on the effectiveness of monetary policy in open economies in light

of your answer to Question 1 above.
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3. What is the effect of fiscal contraction (cut in tax rate) on output and interest
rates in an open economy with perfect capital mobility under flexible
exchange rates?
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5.4 MONETARY AND FISCAL POLICIES UNDER

FIXED EXCHANGE RATE
With fixed exchange rates, exchange rate fluctuations are ruled out and the
central bank plays a very important role as it holds foreign exchange reserves and
intervenesin foreign exchange markets to maintain the fixed parity.
5.4.1 Fiscal Policy under Fixed Exchange Rates

88
We first consider the impact of expansionary fiscal policy under a fixed exchange Open Economy
Macroeconomics-II
rate system, where e = e* is the official parity (Fig. 5.4).

M
i LM p

M
LM p

i1
E0 E1

i0 = if BP

IS1

IS0
Y
Y0 Y1
Fig. 5.4: Expansionary Fiscal Policy under Fixed Exchange Rates

Suppose there is fiscal expansion, either through an increase in government

expenditure or via a cut in taxes. The IS curve shifts out from IS 0 to IS1 and the
interest rate rises to i1 (see Fig. 5.4). With higher domestic interest rates (i1> if),
there is a surge in capital inflows as there is BOP surplus and an excess supply of
dollars (foreign exchange). This creates pressure for currency appreciation, but
the central bank is committed to maintaining a fixed rate. Therefore it intervenes
and buys dollars in order to mop up the excess supply. As a result foreign
exchange reserves increase, leading to an increase in money supply, which shifts
the LM curve outward. This process continues as long as i> if and it stops only
when LM shiftsto LM1, where money supply has increased to M1 (M1> M0) and
the economy reaches E1 where i =if, output has increased to Y1 and there is no
crowding out.

Therefore, fiscal policy is extremely effective under a system of fixed exchange

rates, as change in foreign exchange reserves brings about monetary expansion to
accommodate the fiscal expansion. This is in complete contrast to the case of
flexible exchange rates under which fiscal policy was quite ineffective.

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Traditional Approches 5.4.2 Monetary Policy under Fixed Exchange Rates
to Macroeconomics
Now we consider the case of a monetary expansion under a system of fixed
exchange rates (Fig. 5.5).

M
LM p
i
M
LM p

E0

i0 = if BP

i1 E1

IS0

Y
Y0

Fig. 5.5: Expansionary Monetary Policy under Fixed Exchange Rates

Suppose the central bank engages in an open market purchase of bonds in a bid to
increase domestic money supply. This shifts the LM curve from LM0 to
LM1(since money supply increases from M0 to M1) and the economy moves to
E1, where the interest rate i1< if (see Fig. 5.5). Due to lower domestic rates of
interest, investors would move to foreign bonds, triggering capital outflows and
giving rise to a BOP deficit and excess demand for dollars. This creates pressure
for currency depreciation, but the central bank is committed to maintain a fixed
parity. Therefore it intervenes to sell dollars against rupees, leading to a fall in
foreign exchange reserves and contraction in money supply. As money supply
falls, the LM curve shifts to the left of LM1 and this process continues as long as
i< if. Ultimately the economy is back to E0, with money supply falling back to its
initial level (M0), so that i = if and output is back to its initial level Y0.
Clearly with fixed exchange rates and perfect capital mobility, money supply
becomes ineffective as a policy tool as monetary expansion has no effect on
output in the short run.

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In fact the above discussion indicatesthat money supply becomes endogenous Open Economy
Macroeconomics-II
with fixed exchange rates and perfect capital mobility, in the sense that it
passively adjusts to changes in the foreign exchange reserves as the central bank
intervenes in foreign currency markets to defend the fixed parity. That is, since
the central bank wants to hold the exchange rate constant, it has to intervene to
keep the exchange rate from depreciating or appreciating, so foreign exchange
reserves and hence money supply adjusts accordingly.
Our discussion also highlights the fact that it is impossible to simultaneously
have the following three features in a single policy regime, viz.: (a) perfect
capital mobility; (b) independent monetary policy; and (c) fixed exchange rates.
This is also known as the ‘policy trilemma’. In the presence of perfect capital
mobilityand fixed exchange rates, money supply becomes endogenous and the
Central Bank’s attempt to pursue an independent monetary policy isnot
effectiveasthe Central Bank is committed to maintaining a fixed parity. Whereas,
in the case of flexible exchange rates, perfect capital mobility and independent
monetary policy do indeed go together, as we saw that monetary policy is very
effective in this case. Countries may adopt fixed exchange rates and yet retain
monetary policy independence only with restrictions on international capital
flows, i.e., in the absence of perfect capital mobility. In this case, interest rate
differentials between countries would persist owing to restrictions on capital
mobility.
Check Your Progress 2
1. What is the effect of fiscal contraction (cut in tax rate) on output and interest
rates in an open economy with perfect capital mobility under fixed
exchange rate?
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..............................................................................................................................

2. Comment on the effectiveness of fiscal policy in open economies in light of

your answer toquestion 1 above.
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Traditional Approches 3. (a) What is the effect of monetary contraction (sale of bonds by central bank)
to Macroeconomics
on output and interest rate in an open economy with perfect capital
mobility under (i) fixed exchange rates, and (ii) flexible exchange rates?
..............................................................................................................................
..............................................................................................................................
..............................................................................................................................
..............................................................................................................................
..............................................................................................................................

(b) Explain the concept of ‘endogeneity’ of money supply.

..............................................................................................................................
..............................................................................................................................
..............................................................................................................................
..............................................................................................................................
..............................................................................................................................

(c) Comment on the effectiveness of monetary policy in open economies in

light of your answer in part (a) above.
..............................................................................................................................
..............................................................................................................................
..............................................................................................................................
..............................................................................................................................
..............................................................................................................................

4. Use the open economy IS-LM model to explain the concept of ‘policy
trilemma’.
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5.5 LET US SUM UP

In this Unit we discussed the open economy IS-LM model wherein we saw that
international trade affects aggregate demand in an economy, while capital flows
play an important role in shaping policy outcomes through their impact on
interest rates, exchange rates and money supply. In particular we saw that with
fixed exchange rates and perfect capital mobility, money supply becomes
endogenous, i.e., countries cannot conduct independent monetary policy. Fiscal
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policy is an effective policy tool when the exchange rate is fixed; however, with Open Economy
Macroeconomics-II
flexible exchange rates and perfect capital mobility, fiscal expansion becomes
ineffective as it has no effect on output and leads to a worsening of the trade
balance. Finally, the effectiveness of monetary policy under flexible exchange
rates demonstrates that countries can have at most any two of the three policy
choices of having independent monetary policy, fixed exchange rates and perfect
capital mobility.

5.6 ANSWER/HINTS TO CHECK YOUR PROGRESS

EXERCISES
Check Your Progress 1
1) Refer to Sub-section 5.3.1 and Fig. 5.3.
2) Refer to Sub-section 5.3.1.
3) Refer to Sub-sections 5.2.2 and 5.2.3 and Fig. 5.1
Check Your Progress 2
1) Refer to Sub-section 5.4.1 and Fig. 5.4.
2) Refer to Sub-section 5.4.1 and Fig. 5.4.
3) a) Refer to Sub-section 5.3.2 and 5.4.2, and Fig. 5.3 and Fig. 5.5.
b) Refer to Sub-section 5.4.2, and Fig. 5.5.
c) Refer to Sub-sections 5.3.2 and 5.4.2, and Fig. 5.3 and Fig. 5.5.
4) Refer to Sub-section 5.4.2.

93