Unemployment is one of the major concerns of today’s economies, this paper analysis the LM and IS curve model in determining how unemployment in the economy can be reduced, there are two types of policies that an economy can apply to fine tune the economy to achieve required growth and employment, this include fiscal policies which include government expenditure which affect the IS curve, the other type of policy include the monetary policies which affect the LM curve.
This paper first discusses the impact of an increase in government expenditure on the level of employment in the economy, when the government increases expenditure then the level of employment will increase but the outcome will be inflationary. The next analysis is the effect of an increase in money supply by the monetary policy makers which will result into an increase in employment. Finally it discusses the application of mix policy measures which will be used to ensure that the inflationary pressure does not affect the economy and at the same time achieve higher employment levels.
From this paper it will be clear that the cost of increasing employment levels is inflation, when employment is increased then inflation will increase, this is in line with the Phillips curve which depicts the relationship between employment and inflation. However the government should not attempt to increase employment due to inflation but should attempt to achieve full employment despite the cost.
The LM and IS curve:
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When there is equilibrium in the money market then the amount of money demanded is equal to the quantity of money supplied, the LM curve joins together combinations of interest rates and national income at which the monetary sector is at equilibrium. There are factors that determine the position of the LM curve. These factors include the change in the transaction demand for money, change in speculative demand for money and changes in money supply. There are factors that affect money supply and they include changes in open market operations, change in prices and changes in the reserve ratio.
The IS curve joins together combinations of interest rates and national income at which the commodity market is at equilibrium, this is to say that the equilibrium expenditure equals output.Shifts in the IS curve are attributed to changes in government expenditure and changes in net exports.
From the above discussion the factors that cause a shift in the LM and IS curve can therefore be used by the government and monetary policy makers to improve the state of the economy, those factors that lead to a shift in the LM curve which include money supply, changes in prices and reserve ratios can be used to fine tune the economy to reduce unemployment, also those factors that lead to a shift in the IS curve will also help in reducing unemployment and these factors include government expenditure and exports.
The diagram below shows the combination of the IS and LM curve:
The Is curve is a downward sloping curve while the LM curve is an upward sloping curve, the point at which the two curves intersect gives us the equilibrium level of income or output and the equilibrium interest rate that prevails in the economy, in our case our equilibrium income level is Ye and equilibrium interest rate is given by I.
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The IS curve and unemployment:
An upward shift in the IS curve could solve the problem of unemployment, an upward shift in the IS curve can be as a result of an increase in government expenditure, the following diagram below depicts how this is possible:
From the above diagram it is clear that an increase in government expenditure that results to an increase in aggregate demand will result into increased income, the income level signifies the employment level ion the economy and in our case it is clear that this results to higher employment level from y1 to y2.
The first diagram shows an increase in government expenditure which results into an increase in aggregate demand from aggregate demand 1 to aggregate demand 2, as a result the equilibrium level shifts from y1 to y2, this in turn shifts the equilibrium level of the IS LM model, the IS curve shifts from IS curve 1 to IS curve 2. According to Keynes aggregate demand is equal to consumption plus investment plus government.
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As a result of this the economy is at a higher output level and for this reason there is higher employment level, however from our diagram this position brings about an increase in the interest rate level than it was originally was at, the interest rate level increases from I1 to I2.
Therefore employment can be created by the government through an increase in the level of government expenditure. This will however result to higher levels of interest rates as a monetary policy measure to avoid inflation caused by the government expenditure.
The LM curve and unemployment:
The LM curve can also depict a policy measure by which an economy can reduce the level of unemployment, an increase in money supply will result into a downward shift in the LM curve, as a result the economy will be at a higher output level and therefore higher employment levels, the diagram below shows a the effect of an increase in money supply on the LM curve and the employment level.
The above diagram shows the effect of increase in the level of money supply, when the monetary policy makers increase the level of money supply then the LM curve shifts from LM curve 1 to LM curve 2, as a result the outpurt level shifts from Y1 to Y2 which signifies an increase in the employment level. However the interest rates are at a lower level and this can be attributed to thye actions by the monetary policy makers in order to increase money supply.
The other effect of this is inflation, when an economy increase money supply then the negative effect of this is inflation in the economy.
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From the above discussion it is clear that the effect of reducing unemployment is inflation in the economy, this is in line with the theory by Phillips who depicted the Phillips curve which plots the relationship between inflation and unemployment, his curve is depicted below:
The Phillips curve depict that as inflation increases then the level of employment is high, but when inflation is low then the level of unemployment is high.
Mixed policy measures:
There exist an alternative to the problem of inflation, this can be achieved through mix policy measure, and this involves the mixing of both monetary policies and at the same time fiscal policies. However there is need to consider whether the economy is at its full employment level,
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when the government increases expenditure as we earlier discussed then the IS curve shifts upwards, then if we shift the LM curve as shown then we will achieve higher employment levels at the same interest rate level, for this reason there is need to use both policy measure together. Mixed policy measures are what governments today use to achieve higher growth and low employment levels without experiencing high inflation level, all economies try to achieve full employment which is the situation where all the available resources in the economy are utilised including natural; resources and labour employment.
The LM and IS curves cannot clearly show the use of mixed policy measure and also this model cannot show the policy measure that are undertaken when there is a demand shock or a boom in the economy. Other policy measures that cannot be shown by the IS LM curves include policy measures in a recession, in this case the best model to show this is the AD AS model which uses the inflation adjustment curve and aggregate demand curve to show the effects of different policy measures.
From the above discussion it is clear that the policies can be used to reduce unemployment levels in the economy, the government will increase expenditure and as a result the level of employment will increase, another option is increased money supply which will result into higher employment levels, however according to the Phillips curve the cost of increased employment is inflation and therefore every economy must be aware of the inflation ally pressure caused by increased employment in the economy.
The best option however is to use mix policy measures whereby both monetary and fiscal policies are used at the same time to deal with inflation. Through increased expenditure by the government the fiscal policy measure to deal with inflation is an increase in interest rate to avoid distortion of the free market, when there is an increase in money supply there should be increased taxation by the government and this will help stabilise the economy. However it is clear that the cost of efforts to reduce unemployment is inflation and therefore no matter how
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these policies are used with reference to the Phillips curve the economy will still experience inflation.
Mixed policy measures can only be clearly shown by the AD AS model which uses the inflation adjustment line which is a horizontal line and the aggregate curve which depict the fiscal policy measures undertaken by the economy. However it is clear in this paper that the government has the ability to reduce employment through the use of its policy tools at their disposal.
Philip Hardwick (2004) Introduction to Modern Economics, Pearson Press, New York
Stanley Fischer and D. Begg and R. Dornbusch (2005) Introduction to economics, 8th edition,
McGraw Hill publishers,
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