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UNIT UN IT 17 17

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INTEGR INTE GRA ATI TION ON OF OF GOO GOODS DS AN AND D MONEY MARKETS



Integration o Mon

Structure

17.0 Obje 17. Object ctiv ives es 17.1 17 .1 In Intr trod oduc ucti tion on 17.2 17 .2 Goo Goods ds Mark Market et Equil Equilibr ibrium ium 7.2.1 .1 Con Constit stituent uentss of Goods Goods Market Market 17.2 17.2.2 Invest 17.2.2 Investment ment-Sa -Savin vings gs Equalit Equality y 17.2.3 Inves Investmenttment-Savings Savings Equality Equality at Different Different Combinati Combinations ons of Interest Interest Rate and National National Income

17.3 17 .3 Mon Money ey Mark Market et Equi Equilib libriu rium m 17.3.1 17. 3.1 Cons Constitu tituents ents of Mone Money y Market Market 17.3.2 17. 3.2 Dema Demandnd-Supp Supply ly Equali Equality ty of Money Money

17.4 17. 4 Integ Integration ration of Goods and Money Market Marketss 17.4.1 IS and LM at Differ Different ent Combination Combinationss of Interest Interest Rate Rate and National National Income 17.4.2 Steps to Resto Restore re of Equili Equilibrium brium in Goods and Money Market Marketss

17.5 17. 5 Class Classical ical Appro Approach ach with the the Help of IS-LM IS-LM Techni Technique que 17.5.1 Policy Implications Implications of Classical Approach

17.6 17. 6 Keyne Keynesian sian Appro Approach ach with the the Help of IS-LM IS-LM Techniq Technique ue 17.6.1 Policy Implications of Keynesian Approach

17.7 Le 17. Lett Us Us Su Sum m Up Up 17.8 Ke Key y Wor Word ds 17.9 17 .9 So Some me Us Usef eful ul Bo Book okss 17.10 17.1 0 Hints/Answers to Check Your Your Progress Exercises

17.0 OBJECTIVES On going through this unit you would be able to explain: l

Goods Market equilibrium;

l

Money market equilibrium;

l

Integration of Goods and Money markets;

l

Situations of disequilibrium disequilibriu m in goods and money markets;

MasterSteps your semester to restore equilibrium; with Scribd and its policy implications; and & The Classical New approach York Times l l

Special offer for students: Only $4.99/month. Keynesian approach and its policy implications. l

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Determination of Income, Employment and interest

The integration of goods and money markets will also also enable you to between Classical and Keynesian approaches to appreciate the policy of each.

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17.2 17 .2 GO GOOD ODS S MAR MARKE KET T EQU EQUIL ILIB IBRI RIUM UM

The goods goods market equilibrium has already been introduced to you in U equilibrium in goods market or what is termed as real market is achi injections are equalized to leakages. Injections consist of autonomous government expenditure and exports , which are taken as variables. Leakages on the other hand, consist of savings, taxes a assumed to be dependent on interest rate or national income. Thus combinations of interest rate and national income we can get differe equilibrium in goods market. market. This also helps helps us to identify the situation and deficit in goods market.

17.2.1 17. 2.1 Co Cons nsti titu tuen ents ts of Go Good odss Mar Marke kett

Various constituents of goods market are investment, government and exports. We are assuming away the flow flow of foreign capital and price level as given. All these constituents termed as injections autonomous variables i.e., they are not influenced by national inco constituents of goods market market are savings, taxes and imports, which are leakages. Saving is taken as an increasing function of national inco interest rate can also influence the level of saving. Taxes are an increasing increasing function function of of national income. Sometimes savings are tak increasing function of disposable income, which is defined as natio minus direct taxes. Similarly imports are taken to be an increasin of national income though we can have elements of imports whic autonomously given.

17.2.2 17. 2.2 In Inve vest stme ment nt-S -Sav avin ings gs Equal Equalit ity y

As you already know from Unit 15, in an economy where there is no g and further if it is a closed economy, i.e., there are no exports and equilibrium in goods market is ensured where (ex-ante or, planned) becomes equal to (ex-ante or, planned) savings. savings. This equality, equality, in turn, e aggregate demand in the economy is sufficiently of the level of aggre  so that there is no unplanned increase decrease in inventories. Read Free For 30this Days Sign up toor vote on title  national income where aggregate demand is equal to aggregate supp Not useful  Useful  Cancelwhich anytime. also as equilibrium level of national income, indicates Special offer for students: Only $4.99/month. goods market.

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at various combinations of interest rate and national income is reproduced in Fig. 17.1 for ready reference, to be referred to in Section 17.4.1.



Integration o Mon

Fig.17.1

Interest Rate (%) 8 –

6 – (1)

(3)

4 –

2 –

0

10

30

50

70

90

National income (Rs. crore) In Fig. 17.1: we are recalling the IS IS curve made in part (d) of the four- part part diagram in Unit 15. The vertical axis shows shows rate of interest interest in per cent cent and the horizontal axis shows the level of national income. Each point on IS curve shows equilibrium in goods market.

In Fig. 17.1, national income is measured on X-axis in rupees crore and interest interest rate in % on Y-axis. On the IS line, at point (1) at 5% interest rate and Rs. Rs. 20 crore of national income income investment is equal to saving. saving. Similarly at point (2) where 3% is the rate of interest and Rs.40 crore national income, again investment is equal to saving. We can get many many other points on IS line at which investmentsaving equality will take place. Point Point (3) indicates indicates surplus in goods market. Similarly point (4) indicates deficit in goods market. In fact fact all points above IS line indicate surplus and those below IS line show deficit in goods market.

17.3 17. 3 your MONE MO NEY Y MA MARK RKET ET EQUI EQ UILI LIBR BRIU IUM M Master semester with Scribd Read Free Foron 30this Days Sign up to vote title & The New York Times Useful16.  Not useful Money market equilibrium equilibrium has already been introduced to you  in Unit The Cancel anytime.

equilibrium in money market is achieved where demand for money is equal to Special offer for students: Only $4.99/month. supply of money money.. Supply of money is a stock, which can be measured at a point

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increasing function of national income. However, demand for money for purposes is a decreasing function of interest rate. At a very low demand of money money for speculative purposes becomes infinite. These of money market are to be considered together to arrive at equilibrium market.

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17.3.2 17.3. 2

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Deman De mandd-Su Supp pply ly Eq Equa ualit lity y of of Mone Money y

As known to you from Unit 16 equilibrium in money market is ens demand for money is equal to supply of money money.. This equality, equality, in tu demand- supply equality of money available for speculation purposes.

Fig.17.2


6 –

(3)

(1)

4 – (1)

(4)

2 – 0

10

20

40

60

80

National Income (Rs. crore)

Fig.17.2 is nothing but L M curve designed in Unit 16. Here too we have show cent rate of interest interest on the vertical vertical and national income on the horizontal a point on the L M curve shows equilibrium in the money market.

In Fig. 17.2 national income is measured on X-axis and interest axis. On the LM line, at point (1) where the interest of rate is 5% a income is Rs.45 crore, demand for money (L) is equal to supply of Similarly at point (2) at 3% interest interest rate and Rs.40 Rs.40 crore of national  many demand for money is equal to supply of money money. .this W We etitle can get Read Free Foron 30 Days Sign up to vote on the LM line at which demand-supply equality of money willtake p  Useful  Not useful Cancel anytime. (3) indicates surplus surplus in money market. Similarly point (4) indicates defic Special offer for students: Only $4.99/month. market. Disequilibrium in money market is a situation situation where demand is not equal to supply of Disequilibrium can be of two types:


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interest rate on Y-axis and national income on X-axis in a two-dimensional diagram and plotting IS and LM curves to get the point of equilibrium. We will also have to work out the mechanism by which equilibrium in one or both the markets is restored in case of an disturbance.

17.4.1 17.4 .1



Integration o Mon

IS and LM LM at Differ Different ent Comb Combina inatio tions ns of Inte Interes restt Rate Rate and National Income

We will make use of the information contained in Figs. of 17.1 and 17.2 and put these together in Fig. 17.3. Fig.17.3


7 –

(a )

4 –

(d)

(b) (1)

2 –

0

(c)

10

20

40

60

80

National Income (Rs. crores) Fig. 17.3: Brings together the Figs. 17.1 and 17.2. The IS curve shows equilibrium in goods market and the L M curve shows that in money market. The point of intersection between between these two curves curves gives us that combination of rate of interest interest and national income at which both goods and money markets markets attain equilibrium equilibrium simultaneously.. simultaneously

The points on IS and LM curves represent equilibrium in goods market and money market respectively at various combinations of interest rate and national income. Region (a) in Fig. 17.3 indicates surplus in goods market as well as in money market. Region (b) indicates a situation of deficit in goods and Read Free For 30this Days Sign market up to vote on title surplus in money market. Region (c) is indicative indicative of deficit in goods market as  Useful  Not useful Cancel anytime. well as deficit in money market. Region (d) gives us surplus in goods market and Special offer for students: Only $4.99/month. deficit in money market. It is only at point (1) where IS and LM curves intersect that we have equilibrium in goods goods market market as well as in mo market and this


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Fig.17.4



LM (a)

7 –

(1) (d)

4 –

(2) (b)

2 –

(3) (c )

(2)

(1) 0

10

20

IS 40

60

80

National Income (Rs. crore) Fig.17.4 Explains that if the economy happens to be away from intersection of IS and L M curves, that is, at any point in the regions (a), (d)

then

what

steps would restore the equilibrium again.

In Fig. 17.4 the process of restoration of equilibrium from disequ shown. Let us take point (1) in region (a), which represents a situatio in goods as well as money markets. In order to correct surplus in goo we require contractionary fiscal policy, i.e., reducing government exp autonomous investment, or increasing taxes, or or reducing exports. This a fall in national income. The direction to the left at point (1) (1) indicate of national income. income. Similarly, Similarly, to correct surplus in money market w reduce interest rate or adopt expansionary monetary policy. policy. The directio at point point (1) (1) indicates indicates reduction of interest interest rate. As we go alon contractionary fiscal policy policy and expansionary expansionary monetary policy we region (b). (b). In point (2) is in region (b), we face the situation of defi market and surplus in money market. In order to correct this situati adopting expansionary fiscal policy and expansionary monetary finally leads us to point (3), which represents simultaneous simultaneous equilibrium in money markets. 

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Special offer for students: Only $4.99/month.as well as money markets for which we adopt contractionary monetary

expansionary fiscal policy policy.. As we continue pursuing these policies, we

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............................................ ..................... .............................................. ............................................... ............................................... ......................... .. Sheet Music

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Integration o Mon

............................................ ..................... .............................................. ............................................... ............................................... ......................... .. ............................................ ..................... .............................................. ............................................... ............................................... ......................... .. ............................................ ..................... .............................................. ............................................... ............................................... ......................... .. 2) What is the reason reason for for the LM curve to be parallel parallel to to X-axis X-axis at a very very low level level of interest rate? ............................................ ..................... .............................................. ............................................... ............................................... ......................... .. ............................................ ..................... .............................................. ............................................... ............................................... ......................... .. ............................................ ..................... .............................................. ............................................... ............................................... ......................... .. ............................................ ..................... .............................................. ............................................... ............................................... ......................... .. ............................................ ..................... .............................................. ............................................... ............................................... ......................... .. 3) Distin Distinguish guish betwee between n contraction contractionary ary monetary monetary and and fiscal fiscal policies. policies. ............................................ ..................... .............................................. ............................................... ............................................... ......................... .. ............................................ ..................... .............................................. ............................................... ............................................... ......................... .. ............................................ ..................... .............................................. ............................................... ............................................... ......................... .. ............................................ ..................... .............................................. ............................................... ............................................... ......................... .. ............................................ ..................... .............................................. ............................................... ............................................... ......................... ..

17.5 CLASSICAL APPROACH WITH THE HELP OF IS-LM TECHNIQUE Using IS-LM technique developed in Section 17.4.1 we can distinguish distinguish between classical and Keynesian approaches. The classical economists were of the view that money is demanded only for transactionary transactionary purposes. purposes. They also maintained that an economy operates always at full employment of income income and there cannot exist unemploymen unemploymentt because of shortage of aggregate demand. J.B. Say propounded, what is termed as Say’ Say’ss law of market, according to which every supply creates its own demand. In case we assume non-existence of savings, Say’s law of market implies that in order to produce more goods and services we require the services of factors of production and for rendering factor services Free Foron 30this Days they receive factor incomes. Factor incomes received by factorsRead of up production Sign to vote title are used to purchase goods and services produced by enterprises. enterpris es. Useful A factor of Not useful Cancel anytime. production is Only employed upto a point where the remuneration given to it Special offer for students: $4.99/month. becomes equal to marginal revenue product - as stated by marginal productivity


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Interest Rate (%)

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Fig. 17.5

LM

LM

8 –

7 –

4 –

(1)

(2)

IS” IS’

2 –

0

IS

10 20 40 60 80 National Income (Rs. crore)

Fig.17.5 tells us that that the portion of LM curve, which is parallel parallel to to Y-axis to classical approach. In such such situation an increase in government expenditur in the right wards shift of IS curve does not lead to any increase in the nation - only rate of interest rises. Here Here the only way to raise the national income is the supply of money. In other words, the fiscal policy is totally ineffective ineffective the monetary policy can work.

The shape of LM curve beyond point (1) when it becomes parall is referred to as classical range. The meaning of such a feature is, or government expenditure rises as shown by shift of IS curve from I will result in increase in interest rate from 5% to 7.5% keeping national income at Rs.45 Rs.45 crore. If national income is to be raised fro Rs.55 crores the only way out is to increase the money money supply which shift of LM curve from LM to LM’ given the IS’ curve.

It can be easily seen that the slope slope of IS curve matters a lot in dete effect of monetary policy. policy. If IS curve is steeper than IS’ more money to be resorted to achieve a new national income level of Rs.55 crore put the same thing by saying that monetary policy will be less effective is steep. Similarly flatter the IS curve more effective will be the mon

Master your semester17.5. with Scribd 17.5.1 1 Pol Policy icy Imp Implic licatio ations nsRead of Cla Classic alon30 Approa App roach ch Free For Days Sign up tossical vote this title  & The New York Times  Useful  Not useful

anytime. It is time to see the policy implicationsCancel of the classical approach. Fig. 17.5. In this figure we are at equilibrium. equilibrium. The level of national inco

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had been adopted, as shown by the shift of IS curve from IS’ to IS’’, IS’’, the interest rate would have increased from 5% to 7.5% keeping the level of of national income unaffected at Rs.45 crore.



Integration o Mon

Therefore, monetary monetary policy is the only policy policy which will be effective in the classical classical range. The degree of effectiveness of such a policy will depend on the slope of the IS curve. Steeper the IS curve less effective will be the monetary policy or flatter the IS curve more effective will be the monetary policy policy.. The reason why interest rate rises with adoption of expansionary fiscal policy lies in the fact that increase in investment, or government expenditure will result in an increase in national income depending on the value of multiplier. This rise in national income will result result in demand for money for for transaction purposes purposes.. Given the money money supply,, if demand for money for transaction purposes increases, the supply of supply money available for for speculation purposes falls. This leads to an increase in interest rate. We can also put the same thing by saying that as public investment or government expenditure increases, private investment falls resulting in the operation of “crowding out” effect.

17.6 KEYNESIAN APPROACH WITH THE HELP OF IS-LM TECHNIQUE Unlike the classical range where LM curve is parallel to Y-axis, we have another extreme where LM curve becomes parallel to X-axis and the demand of money is infinite. Keynesian approach is at its effective best in this range. It has been depicted with the help of Fig. 17.6.

Fig.17.6

Interest rate (%) LM

IS (1)

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(2)

IS“


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situation of liquidity trap. t rap. In this region, demand of money for purposes is infinite. It is called Keynesian range.

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In Keynesian range or liquidity trap range, equilibrium level of natio is Rs. 5 crore and 0.5% interest rate. This is shown at point (2). income is to be increased from Rs.5 crore to Rs.15 Rs.15 crore crore it will not since interest rate of .5% will remain unchanged. On the other increase in autonomous investment or government expenditur multiplier will be in a position to achieve national income of Rs.15 cro already know increase in autonomous investment investment or government ex reflected by a shift of IS curve to the right. So, in this case, IS curve to the right from IS’ to IS’’ IS’’ to increase national income from Rs.5 Rs.5 cro crore. This shift of IS curve is what is referred to as the expansionary fiscal policy. Similarly to reduce national income we contractionary fiscal policy policy..

It can be seen that the suitable policy to be adopted in Keynesian policy i.e., the policy of changing government expenditure and for tax

17.6.1 17.6. 1

Policy Pol icy Imp Implic licati ations ons of Key Keynes nesian ian App Approa roach ch

In Fig. 17.6 the initial equilibrium level is given at point (2). If the full level of national income is Rs. Rs. 15 crore, it can be achieved by increasing investment or government government expenditure or reducing tax revenue revenue which by the shift of IS curve from IS’ to IS’’ IS’’ given that LM curve is axis. It is important to see that the slope of the IS curve is of no in achieving full employment level of income. The full full employment level of income is given by the intersection of IS’ IS’’’ with LM as point (3).

Thus, in the Keynesian range where LM curve becomes parallel to X-ax policy, which can work to shift equilibrium level of income, is fiscal monetary policy, policy, if adopted, would be unsuccessful unsuccessful because it opera changes in rate of interest, which is ineffective here

Another important point to be noted is the “crowding out” effect referred to in Section 17.5.1. It will be totally non-existent in Keyn The implication of of the non-existence of “crowding out” effect is that that fu effect as a consequence of change in autonomous investment or g  Read Free For 30 Days expenditure will be felt on changing the level ofon national Sign up to vote this titleincome. It is  as saying that Keynes assumes away the money market in his analysis Not useful  Useful  Cancel anytime. Special offer for students: Only $4.99/month.trap range.


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policy is more more effective. Moreover, flatter the LM LM curve with a given IS curve, monetary policy is more effective. You should take this as an exercise and show diagrammatically the four cases mentioned above concerning the relative effectiveness of monetary and fiscal policies in the intermediate range.

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Integration o Mon

Check Your Progress 2

1)

Explain the steps involved in the working of ‘crowding out’ effect. ............................................ ..................... .............................................. ............................................... ............................................... ......................... .. ............................................ ..................... .............................................. ............................................... ............................................... ......................... .. ............................................ ..................... .............................................. ............................................... ............................................... ......................... ..

2) Which polic policy, y, moneta monetary ry or fiscal fiscal,, will you recomm recommend end if if LM curve curve becom becomes es flatter given IS curve? ............................................ ..................... .............................................. ............................................... ............................................... ......................... .. ............................................ ..................... .............................................. ............................................... ............................................... ......................... .. ............................................ ..................... .............................................. ............................................... ............................................... ......................... .. ............................................ ..................... .............................................. ............................................... ............................................... ......................... .. 3) If tax is raised raised,, argue how does it lead to less fall in Nation National al Incom Incomee if Money Market is introduced along with Goods Market? ............................................ ..................... .............................................. ............................................... ............................................... ......................... .. ............................................ ..................... .............................................. ............................................... ............................................... ......................... .. ............................................... ..................... ................................................. ............................................... .............................................. ......................

17.7 LET US SUM UP In this unit we have given you an idea about goods market equilibrium by introducing its constituents. Investment-saving equality has been discussed to get the equilibrium in goods market. Various combinations of interest rate and national income are introduced to arrive at investment-saving equality. Similarly, money market equilibrium, its constituent’s equality between supply and demand for money at various combinations of interest rate and national income are discussed.

Master your semester mwith Scribd Integration of goods and money markets arkets is discussed with the help ofup IS LM Read Free For 30this Days Sign toand vote on title curves to get York a uniqueTimes combination of interest rate and national  income & The New Usefulat which  Not useful Cancel anytime. both goods market and money market are in equilibrium. How to achieve equilibrium in both the markets if they are in disequilibrium has also been discussed.

Special offer for students: Only $4.99/month.

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Financial Assets

: These are the asset assetss consis consisting ting of debentures, bills of exchange etc.

Inter-bank

: These These are the depo deposits sits of one banks.

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Deposits

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bank

Indeterminate Exchange Rate

: It is an exc exchan hange ge rat ratee which which is not scientific basis. This occurs occurs in barter exchange.

LM

: It is a loc locus us of poi points nts at whi which ch combinations of income and interest for money or liquidity is equal to suppl available.

Curve

Liquidity Trap

: It is that por portion tion of LM curv curvee wher money supply has no influence on inte it is a situation where the demand infinity at a low interest rate.

Liquid Assets

: These These are are the asset assets, s, which which can can be co money without loss of much time an undergoing monetary loss.

Money Market

: It is a marke markett where where demand demand and and suppl suppl together determine interest rate.

17. 7.9 9 SOM OME E US USEF EFU UL BO BOOKS

Introduction n to Positi Positive ve Econo Lipsey. Richar Richard d G. 1983, An Introductio Edition), E.L.B.S. and Weidenfeld and Nicolson, London (Chapters

Economic mic Anal Analysis ysis (5th Edition Shapiro, Edward, 1984, Macro Econo Publications, New Delhi (Chapters 1 to 12).

Samuelson, Paul A. 1973, Economics (9th edition), International Stud McGraw-Hill Kogakusho Ltd Tokyo (Chapters 11-12).

Master your semester17. with Scribd  R 17.10 10 HIN HINTS/ TS/AN ANSW SWER ERS S TO T O C CHEC HECK K YOUR Read Free For 30this Days Sign up to vote on titleYOU  PROGRESS EXERCISES & The New York Times  Useful  Not useful Special offer for students: Only $4.99/month. Check Your Progress 1

Cancel anytime.

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interest rate is raised. Since rise in interest rate lowers investment and hence national income, we call it a contractionary monetary policy. policy.

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Integration o Mon

Contractionary fiscal policy policy is an intervention when government expenditure is reduced keeping tax revenue unchanged or when tax revenue is raised keeping government expenditure unchanged . This leads to lowering of national income through expenditure and tax multipliers. Check Your Progress 2

1) As public inves investment tment or gover government nment expen expenditure diture is incre increased ased nation national al income rises due to multiplier effect. A rise in national income leads to rise in demand of money for transaction purposes and results in less supply of money available for speculative purposes. This raises interest rate which, in turn, leads to fall in private investment and therefore, the national income. Hence, an initial increase in autonomous expenditure does not lead to as much increase in national income as it would have happened had there been no money market existing along with goods market. 2) Fiscal policy would be more suitable since Keynesian range with LM curve becoming flatter.

we

are

approaching

3) Tax multiplier multiplier is given given by [-c]/[1–c], [-c]/[1–c], where c is marginal propens propensity ity to consume. consume. A rise in tax leads to fall in national income depending upon upon the tax multiplier [ -c ] / [ 1 – c ]. This leads to a fall in level of demand for money for transactions purposes. Consequently Consequently,, supply of money available for speculation purposes rises which, in turn, leads to fall in interest rate and through that to a rise in national income. Thus national income finally does not fall as much as it would have if money market did not exist along with goods market.



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