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

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

---

M
i
I
Y
L
i
Where, M = Money Supply 
i = Interest Rate 
I = Investment 
Y = Income/Output 
L = Demand for Money 
 
 
8.3.2 Real (Fiscal) Influences: Shift in the IS Schedule: 
A fiscal policy expansion by government will affect 
equilibrium level of income in goods market. Fiscal policy 
expansion take place on amount of a fall in tax rate or increase in 
government spending on goods and services or an increase in 
transfer income. 
Consider that change in fiscal policy due to an increase in 
government spending on goods and services ( G). This lead to 
shift into the aggregate demand function and a shift in IS curve as 
shown below. 
FIGURE 8.9: FISCAL POLICY 
1
E
2
E
1
Y
2
Y
0
1
i
1
IS
2
IS
Income / Output
InterestRate
Y=k* G


Y
AD
1
A c 1 t Y bi
1
E
2
E
2
Y
1
Y
0
Income / Output
InterestRate
G

1
AD
2
AD
1
A c 1 t Y bi

---

The increase in government spending leads to a shift of 
aggregate demand curve from AD
1
to AD
2
. As a result, the 
equilibrium income increases from Y
1
to Y
2
. But the interest rate 
remains same. In lower panel of diagram, this is shown as shift of 
IS curve to the right. The horizontal distance between two IS curves 
shows the multiplier effect on the income in the goods market
(k * G). 
However, in the presence of money market and the LM 
curve, the full expansion in income as given by Keynesian multiplier 
is not realised. This is illustrated in the following diagram.