The Lm And Is Curve

The LM and IS curve:

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 economic growth and employment levels, this include fiscal policies that include government expenditure which affect the IS curve, the other type of policy include the monetary policies which affect the LM curve.

The diagram below shows the IS and LM curve:

The LM curve joins together combinations of interest rates and national income at which the monetary sector is at equilibrium, when there is equilibrium in the money market then the amount of money demanded is equal to the quantity of money supplied. 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

The LM and IS curve

factors that lead to a shift in the IS curve will also help in reducing unemployment and these factors include government expenditure and exports.

According to Keynes, aggregate demand is equal to consumption plus investment plus government, this can be stated as Y = C + I + G for a closed economy and Y = C + I + G + (X –M) for an open economy, an increase in government expenditure therefore will increase aggregate demand. When the government increases expenditure then the level of employment will increase but the outcome will be inflationary, the diagram below shows the increase in government expenditure which in turn increases aggregate demand and the level of employment in the economy increases.

The 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.

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 increased 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.

From the above diagram it is clear that an increase in government expenditure will result to an increase in aggregate demand will result into increased income, the income level signifies the employment level in the economy and in our case it is clear that this results to higher employment level from y1 to y2.

The LM and IS curve

The LM curve on the other hand 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 diagram below depicts an increase in money supply which results into a downward shift in the LM curve:

The diagram above 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 output level shifts from Y1 to Y2 which signifies an increase in the employment level.

From the above discussion it is clear that the effect of reducing unemployment will result into inflation in the economy, this is in line with the theory by Phillips, the Phillips curve depicts the relationship between inflation and unemployment, his curve is depicted below:

The above discussion relies on the Keynes theory General Theory of Employment which he developed after the 1930n depression; he argued that there was need for government intervention into the free market to reduce unemployment and promotion of economic growth. According to the classical economist however the government should not intervene with the free market economy because this may lead to the destabilisation of the economy because the market had a self clearing mechanism.

The LM and IS curve

Deflationary measures:

Deflationary measures can be undertaken by the government to reduce the rate of inflation, this is done by reducing money supply by increasing interest rates by the monetary policy makers, and this will result into an upward shift in the LM curve as shown below:

The above diagram shows a decline in money supply and its effect on the LM curve, if wwe assume that the original LM curve is LM curve 1 then a decline in money supply will lead to a shift of the LM curve from LM curve 1 to LM curve 2, as a result of this the income or output level will shift from Y1 to Y2 which is a lower output level. This will result to lower employment levels and also lower output levels.

This effect can be explained by the reduction in investment in the economy, when there is an increase in interest rate will discourage lending by investors and individuals, this will result into reduced employment levels and also lower employment levels, as a result the deflationary measure can be viewed as one that distorts the free market.

Reducing prices in the economy is therefore not an option to keep the economy at pace and this can in turn lead to the destabilisation of the economy, the government should therefore cope with low inflation levels and not avoid inflation, when there is a deflation measure by the government this will lead to the destabilisation of the economy where there will be low output levels in the entire economy which will lead to instability in the entire economy.

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,

The LM and IS curve

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 used by governments today 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.

From the above discussion therefore 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 these policies are used with reference to the Phillips curve the economy will still experience inflation. However it is clear that the government has the ability to reduce employment through the use of its policy tools at their disposal.

The LM and IS curve

References:

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,

London