Syllabus T. Y. B. A. Paper : IV advanced economic theory with effect from academic year 2010-11 in idol

LM
1
E
1
i
2
i
LM
0
i
LM
E
E
InterestRate
1
IS
2
IS
Y
Income / Output
0
1
Y
Y

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FIGURE 8.12: MONETARY ACCOMMODATION OF POLICY MIX 
In the above diagram, increased government spending shift 
the IS curve from IS
1
to IS
2
. This is followed by a sufficient increase 
in money supply so as to prevent the rate of interest from rising. 
The monetary expansion shift the LM curve from LM
1
to LM
2
is 
such a way that the full potential expansion of income given by 
Keynesian Fiscal Multiplier is achieved without an increase in 
interest rate. 
Check your Progress: 
1. Define Open Market Operation. 
2. Explain Crowding Out Effect. 
3. What is Monetary Accommodation? 
4. Explain Transmission Mechanism. 
1
E
2
E
1
LM
2
LM
InterestRate
1
Y
2
Y
0
1
IS
2
IS
Income / Output

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8.4 SUMMARY 
 
1. The IS-LM model developed in this unit is the basic model of 
aggregate demand which integrates both the goods market 
and assets market. 
2. The IS curve shows combinations of interest rates and income 
levels which keeps the goods market in equilibrium. 
Decreases in the interest rate raise aggregate demand by 
raising investment expenditure. Thus at lower interest rate, the 
level of income at which the goods market is in equilibrium is 
higher 
– the IS curve sloped downward. 
3. The demand for money is a demand for real balances. The 
demand for real balances increases with income and 
decreases with the interest rate, the cost of holding money 
rather than other assets. With an exogenously fixed supply of 
real balances, the LM curve representing money market 
equilibrium is upward sloping. 
4. The interest rate and the level of income are jointly determined 
by the simultaneous equilibrium of the goods and money 
markets. This occurs at the point of intersection of the IS and 
LM curves. 
5. Monetary policy affects the economy initially by changing the 
interest rate, and then by affecting aggregate demand. An 
increase in the money supply reduces the interest rate and 
increases investment expenditure and aggregate demand thus 
increasing equilibrium output. 
6. A fiscal expansion leads to increase in the interest rate which 
crowd out private sector investment. The extent of crowding 
out is an important issue in assessing the usefulness and 
desirability of fiscal policy as a tool of stabilization. 
7. The question of the monetary-fiscal policy mix arises because 
expansionary monetary policy reduces the interest rate while 
expansionary fiscal policy increases the interest rate. As a 
result, expansionary fiscal policy increases output while 
reducing the level of investment; expansionary monetary 
policy increases output and the level of investment.