Liquidity Preference-Money Supply (LM) and Investment- Saving’s model (IS) are two important macroeconomic approaches of the Keynesian model (Jhinghan, 2017). Now, the mentioned statement that “Some economists claim that the government should always use monetary policy to stabilize (or target) the real interest rate in the short-run if they also wish to keep the resulting impact on (changes to) consumption to a minimum”is absolutely true. This can be briefly explained with the help of the Investment- Savings and Liquidity Preference-Money Supply model. This structure shows the connection between the real rate of interest and the yield level in the economy where merchandise market and currency advertise is in balance at the same time. LM bend shows the variances in the currency market and IS bend shows the changes in the products showcase (Nattrass and Varma, 2014). Along these lines, utilizing expansionary fiscal approach will prompt a diminishing in the financing cost and it will likewise affect the genuine loan cost legitimately. Along these lines, the administration should utilize the expansionary fiscal approach to settle the financing cost. In the event that inflation rate is high, at that point the administration diminishes the supply of money that increment interest that abatement aggregate demand in the economy. When total interest diminishes then it decline yield and rate of inflation.
At the point when government decline the supply of money then its LM bend moves upward/left expanding financing costs decreases the utilization (consumption) which is better answer for balance out economy. This can be explained with the help of a diagram as well:
In the above given diagram AD is the aggregate demand whereas AS is the aggregate supply curve which intersect at equilibrium point e. Price and output are taken simultaneously on the Y and X axis respectively But when the curve AD shifts showing an increase in aggregate demand then the price rises to P’ from P whereby the level of quantity produced (Output) is increasing from Y to Y’ thus showing expansion in the economy by increase in the output.
A business cycle change emerges because of a deficiency in the administration spending plan (government budget). To diminish the effect the effect of this business cycle vacillation on yield (output) and the joblessness, government should utilize the expansionary monetary approach which prompts an increment in the administration spending straightforwardly (Vanita, 2010). Increment in government spending will straightforwardly affect the person's utilization and the level of consumption and the degree of self-governing interest in the economy or simply on the autonomous investment. Consequently, given articulation is - The government should always use monetary policy to combat the effect of business cycle fluctuations coming from changes in autonomous government spending on goods & services if it wishes to keep movements in unemployment to a minimum is absolutely not true. This can also be depicted with the help of a diagram:
In the above diagram Interest rates and Output are taken on the Y and X axis respectively. The IS curve intersects the LM curve at point e initially which is the equilibrium point with l as the interest rate and Y as the output. But when there is change in the rate of interest that is it rises from l to l’ then the IS curve shifts from IS to IS’ and then the equilibrium point shifts from e to e’ where it intersects the LM curve. With this the level of output increases as well from Y to Y’.
Aggregate supply and aggregate demand approach shows the connection between value level and the yield level in the economy where products showcase, currency market, and work advertise is in balance all the while (Benassy, 2014). On the off chance that administration needs to build the self-governing spending however would prefer not to affect the cost level a lot of then the legislature should utilize expansionary financial arrangement (fiscal policy) since it will affect the rate of interest just as will prompt an increment in the yield and output level (Vroey, 2016). Along these lines, autonomous investment will be expanded as it doesn't rely upon the rate of interest. Thus with the above explanation it is quite clear that the given statement- The government should never use fiscal policy to combat business cycle fluctuations coming from changes in autonomous investment if it also wishes to keep longer term movements in the price level to a minimum is absolutely false. This can also be understood with the help of a diagram using aggregate supply and aggregate demand.
In the above diagram, Output and Price are taken on X-axis and Y-axis respectively. The AD curve represents the aggregate demand curve and AS depicts the Aggregate supply curve. Both the AD and AS curve intersects at point e that represents the equilibrium point. Point P represents the equilibrium price and Y as the equilibrium level of output produced by the economy. When the price increases from P to P’ then there occurs a shift in the aggregate demand (AD) curve to the right of the original demand curve and the new aggregate demand curve becomes AD’. As an outcome of this there is a shift in the level of equilibrium. The new equilibrium is now at point e’ that is formed as a result of the convergence of the aggregate supply curve (AS) and the new aggregate demand curve. Due to this, the output also increases in the economy from Y to Y'.
References for Macroeconomic Theory and Policy
Benassy, J. P. (2014). Macroeconomics: An introduction to the walsarisan approach. Paris: Academic Press.
Jhinghan, M. L. (2017). Macro economic Theory. New Delhi: Vrinda Publications
Nattrass, N. & Varma, G. V. (2014). Macroeconomic simplified. New Delhi: Sage Publications
Vanita, A. (2010). Macroeconomic theory and policy. New Delhi: Pearson.
Vroey, M. D. (2016). A history of macroeconomics from keynes to lucas and beyond. New York: Cambridge University Press.
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