The government policy makers have to decide to increase the money supply or increase government spending to control the interest rate and aggregate output of the economy. Fiscal policy affects the aggregate demand and distribution of wealth through controlling the taxes and government spending. But when fiscal policy at controlling the level of aggregate output and when it is less effective than monetary policy is the question to answer. The ISLM model developed by Sir John Hicks based on the analysis of John Maynard Keynes’s “General Theory of Employment, Interest, and money” helps policymakers predict the aggregate output and interest rate.
Keynesian Economic Model and ISLM Model for Fiscal Policy Derivation
In the short run changes in tax structure can alter the magnitude of the pattern of demand for goods and services. It affects the allocation of resources and the capacity of the production and influences the returns to the factors of the production. Mishkin (2015) mentioned Understanding the monetary and fiscal policy theory of Keynes and ISLM model will help to look deeper. Keynes was basically interested in understanding the movements of aggregate output because he wanted to explain the reasons for the great depression. According to Keynes, the total quantity of demand of an economy is the sum of four components. These are (1) consumer expenditure (2) Planned investment spending ( (3) Government spending (4) Net export. According to Keynes price level is fixed and in the equilibrium state, the aggregate demand is equal to the aggregate supply. In great depression for the volatility of consumer spending the level of aggregate demand was weak. Government spending has a direct relationship with the aggregate output. Taxes have an indirect relationship with output as it reduces the capacity of purchasing the product.
ISLM model
The model of Keynes was incomplete for lack of the role of monetary policy. The ISLM model incorporates the role of interest rate and monetary policy. ISLM model is a little complex model but it explains the economic phenomenon in a better way. It explains how monetary policy affects the aggregate output level and interacts with the fiscal policy. ISLM model holds the basic notions of Keynes fixed price level where the nominal and real quantities are same. IS curve and LM curve two separate curves explain the demand side and supply side of the output. The relationship between the interest rate and aggregate output is called the IS curve. Only demand can’t determine equilibrium price without supply curve. So LM curve describes the combination of aggregate output and interest rate for which the money demand and supply is in equilibrium level (Adam and Billi 2007).
The relationship between the interest rate and planned investment spending is inverted. The providers of capital goods such as machines and raw materials expect to earn more when the level of interest rate is low. Higher interest rate causes the higher cost of production for the borrowed fund. So when the interest rate is lower the firms are more likely to undertake the investment. The same thing happens to net export. Higher interest rate attracts the borrowers to buy local currency bond and raise the exchange rate which reduces the demand and forces the rate down.
Figure 1: Keynesian Cross and IS curve (Mishkin 2015)
IS curve actually traces the points at which the total quantity of goods produced equal to the total quantity of goods demanded. It shows the equilibrium points. For a given interest rate, IS curve shows the equilibrium point. In the above figure, it shows that excess output pushes the curve down and sets a new equilibrium point.
Just like the IS curve LM curve is derived from the equilibrium point. The difference is ‘IS’ curve is derived from the goods market and LM curve is derived from the market for money. LM Curve incorporates the Keynes’s liquidity preference theory. Adam and Billi (2007) state the demand for money is positively related to income or output. People want to hold money for the transaction and accumulating wealth. Higher interest rate creates higher opportunity cost of holding money. So demand for money is positively related with income and negatively related to the interest rate. The level of interest is determined in the market for money. LM curve assumes the money supply fixed for simplicity.
Figure 2: LM curve (Mishkin 2015)
Thus LM curve traces the points that satisfy the equilibrium condition that the quantity of money demanded equals the quantity of money supplied. It tells us what the interest rate must be to be in the equilibrium in the market.
Figure 3: ISLM model (Mishkin 2015)
ISLM Model and Fiscal Policy
If the IS curve and LM curve is put in the same diagram it produces the ISLM curve which enables us to determine the level of interest and the level of output. It shows the point at which the market for goods and services are in equilibrium with the market for money. At point i*Y* both are in equilibrium. Any other points such as A, the market for goods is in equilibrium. But the people have demand for money is less than the supply. It causes a person to buy investment goods which forces it down to point E. on the other hand at point B the market for money is in equilibrium but for excess aggregate output, the producers hold excess inventory so cutting the production leads to lower output and forces to point E.
Both monetary policy and fiscal policy affect the ISLM curve and the aggregate level of the output of the economy. Increasing the money supply shifts a rightward shift in LM curve which pushes the interest rate down. But monetary tools can’t be applied in many cases. Such as when the unemployment rate is 10% money supply will not improve the aggregate level of output. Increase in government spending will increase the aggregate demand directly. But the increased demand for aggregate output will create increased demand for money which will push the interest rate upward (Leith 2005). Reduction in taxes will make more income available to people and increase the demand for output. So output and interest rate is positively related to government spending and negatively related to taxes.
Figure 4: Shift in IS curve (Mishkin 2015)
It must be understood that when the fiscal policy would be more effective. If the demand for money is unaffected by the changes in the interest rate the quantity of money demanded equals the quantity of money supplied. The LM curve will be vertical as the unchanged condition of demand for money irrespective of interest rate. A shift in IS curve will raise the interest rate but the aggregate level of output will be at the same level.
Figure 5: Shift in LM curve for money supply (Mishkin 2015)
Leith (2005) remarked If the economy suffers from high unemployment expansionary fiscal policy will not affect the aggregate level of output. Earlier it is said that fiscal policy always increases aggregate demand but when the economy has fixed or vertical LM curve it will only shift the IS curve outward and increase the interest rate. it crowds out the investment spending and net exports. But for money supply, the LM curve will shift rightward and increase the output and lower the interest rate. So when there is less interest sensitive money demands it is more effective to take monetary policy.
Contemporary Practices of Fiscal Policy
According to Mishkin (2015), Fiscal policy interacts with government expenditure and tax structure. When the government cuts taxes it increases consumer's disposable income but government's fiscal deficit also increases. The tax cut benefits consumers in a different way. Government debt depends on its budget deficit. If people have more money in their hand they will tend to purchase government bond. Thus it will raise the price of a bond and put the interest rate down. But a large deficit of government will raise the interest rate if the money demanded by the government is higher than the supply.
Tax cut raises the future expected taxes. Today's tax cut will affect the consumer spending, investment from the capital providers will raise the income of people and the capital provider so future tax raise can be implemented. When the economy is not in full employment tax cut can increase the aggregate level of output in short run. When the economy is in full employment the tax cut will not sufficiently increase the personal savings to offset the deficit in public savings, interest will rise and investment spending will decline. If the capital inflows from the abroad offset the deficit in national savings, then investment spending may not fall. The future capital stock level and output will remain same.
Seidman (2015) stated it is apparent that there are conflicts in using the fiscal policy when the economy is operating below the potential in short run and the long-term use of fiscal policy to form capital and national savings. But it’s clear that near full employment fiscal policy changes can depress the private investment unless there is no capital inflow and increased supply of labor. Many researchers have criticized the use of fiscal policy as the stabilizing tool for an economy. But many have found the relevance of fiscal policy in stabilizing the economy. Empirical research suggests that temporary and permanent tax changes affect the consumption spending.
Tax changes might be more compelling than the theoretical estimation when the use is ‘government purchase’. Short-run tax policy on the hand of technical experts can alleviate some effects. Tax changes can be used as inter-temporal substitutions such as a cut in sales tax, investment credit tax; on the other hand, increasing the nonproductive products will give a rise in consumer and investment spending as a counter cycle stabilization tool (Leith 2005).
The advocates of fiscal policy suggest that the policymakers should rely on the monetary tool as primary policy. Fiscal policy can be a supplement for unusual circumstances such as when the nominal interest rate is zero. Fiscal policy works as stimulus when the economy is in long and deep recession. Fiscal policy interacts with the economic budget of a country. The policymakers should resolve the conflict between the long-term goal and short-term objectives while formulating the fiscal policy.
According to Seidman (2015), the impact of debt-to-ratio should be evaluated in the context of how the debt arises. Public debt accumulated during the period of economic slack has a lower cost than the cost of debt when the cost occurs in full employed economy. As there is the long-term effect of debt and deficit of federal government it is a matter of moral concern that it is unethical to improve the living standard at the cost of economic welfare of future generations. There is two-phase of deficits, current deficit, and accumulated deficit. The current deficit is controlled by the policymakers. There is a negative feedback loop with the two deficit account. Foreign purchase of investment instrument will increase the interest rate flow to foreign countries.
Considering all the diverse opinion it can be inferred that monetary policy should be used as the primary stabilization policy. Fiscal policy can be used as macroeconomic stabilization instrument when the economy is in a severe downturn and the interest rate is very low. A clear tension exists between the long-term goal and short-term objectives. Long-term fiscal expansion can crowd out the private investment. But semi-automatic rule-based fiscal stabilizer can address the problem. The volume of deficits in future and composition of federal expenditures has reduced the latitude to make the short-run adjustments in a budget. To prevent the crowding out of private investment government may limit the ability to accommodate future deficits. Policymakers have to take discreet decision to resolve the conflict between fiscal policy and the interest rate, aggregate of the economy.
References
Adam, K. and Billi, R. (2007). Monetary conservatism and fiscal policy. Kansas City, MO: Federal Reserve Bank of Kansas City, Economic Research Department.
Leith, C. (2005). Fiscal Stabilization Policy and Fiscal Institutions. Oxford Review of Economic Policy, 21(4), pp.584-597.
Mishkin, F. (2015). The economics of money, banking, and financial markets. 8th ed. New York: Pearson Addison Wesley, pp.300-450.
Seidman, L. (2015). Automatic Fiscal Policies to Combat Recessions. London: Routledge.
