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Fiscal policy in the IS-LM model
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In this presentation we deal with the impact of fiscal policy in the IS-LM model. Before
you start this section you must be familiar with the following concepts and relationships:
What is fiscal policy? (1)
Expansionary and contractionary fiscal policy (2)
The goods market and the IS curve (3 + 3a)
Shifts of the IS curve (4 + 4a)
Movement along an IS curve (5 + 5a)
The financial market and the LM curve (6 + 6a)
Movement along an LM curve (7 + 7a)
Simultaneous equilibrium in the goods and financial markets (8 + 8a)
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Let’s first deal with expansionary fiscal policy (1) which is used to stimulate economic
activity (2) by increasing the demand for goods (3)by increasing government spending
(4) and/or by decreasing taxes (5). For instance, when announcing the 2006/2007 budget
the Minister of Finance indicated that “ South Africa’s economic outlook supports a more
expansive fiscal stance …” which would be achieved through increased government
spending and reduced income taxes.
(There is no 6)
Let’s take the case of lower income taxation and see how it impacts on output and the
interest rate as reflected in the IS-LM model which takes account of a goods market (7),
shown as the IS curve (8), and a financial market (9), shown as the LM curve (10). You
first decision is which market is impacted first – is it on the goods market or the financial
market (11). Fiscal policy impacts the goods market (12) first while monetary policy the
financial market first (13).
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Using a chain of events this initial impact of a decrease in taxation on the goods market
can be described as follows:
On the goods market (1) lower taxation increases households’ disposable income (2).
Households react by increasing their consumption spending (3), thus increasing the
demand for goods (4), since the demand for goods is equal to C + I + G. Firms in turn
react to this increase in demand by increasing their production and therefore income
increases (5).
Higher output and income (6) again leads to higher consumption spending (7) and
therefore higher demand for goods (8) and output and income (9). This is the multiplier
effect in operation. Higher output and income (10) also stimulates investment spending
(11) since firms’ sales increases due to the higher demand for goods.
The level of output is on an expansionary path. This is reflected by the IS-LM model in
that the IS curve shifts to the right (12) and output and income initially increase from Y1
to Y3 (13).
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This decrease in income taxation which caused a higher output also impacts the financial
market (14) since increased output and income (2) increases the demand for money (3)
which induces a higher interest rate (4) since the supply of money is fixed.
The increase in the interest rate in the financial market in return affects the goods market
(5). With rising interest rates (6) investment spending falls (7) on the goods market since
investment spending is negatively or inversely related to the interest rate. The decline in
investment leads to a decline in the demand for goods (8) and consequently the level of
output and income declines (9).
This is shown on the IS-LM model as a movement along the IS curve from point b to
point c (10). A new equilibrium position where the goods and financial markets are in
equilibrium is achieved at point c (11) with an equilibrium income Y2 (12) and an
equilibrium interest rate i2 (13).
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What is the end result of this decrease in income taxation?
Comparing point a (1) with point c (2) you can see that both the level of output (3) and
the interest rate (4) are higher than before the decrease in income taxation.
The interest rate is higher in keeping with a higher output that increases the demand for
money (5). Output is higher due to a higher demand for goods (6). The demand function
C + I + G (7) shows a clear increase in consumption spending (8) which is due to lower
income taxation (9) and the multiplier effect (10). Investment spending first increases
(11) but then decreases (12). The increase in investment spending is due to the increase
in output (13) and the decline due to a rising interest rate (14). Which effect dominates is
uncertain and the change in investment spending is indeterminate. If the interest for some
reason did not increase we would have reached a point such as point b (15) where the
level of output is Y3 (16). To simplify things we assume that these two effects cancel
each other and investment spending is unchanged (17).
Consumption spending is definitely higher (18), though, which increases the demand for
goods and the level of output. Note that government spending is unchanged (19).
As reflected by the IS-LM model an expansionary fiscal policy, therefore, increases the
interest rate (20) and the level of output (21) in the IS-LM model for a closed economy.
Next we consider the impact of a contractionary fiscal policy.
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A contractionary fiscal policy (1) can be the result of either a decrease in government
spending (2) and/or an increase in taxation (3) to lower the demand for goods (4) and the
levels of output and income (5) . Both actions will reduce the budget deficit. We
consider only the case of a decrease in government spending (6).
Using a chain of events this impact on the goods market can be described as follows:
The initial effect is on the goods market where a decrease in government spending (7)
reduces the demand for goods (8) since the demand for goods is equal to C + I + G. The
lower demand for goods lower output and income (9) since the level of output and
income depends on the demand for goods.
Lower output and income (10) decreases households’ consumption spending (11) since it
correlates positively with output and income. The decrease in consumption spending
causes a decline in the demand for goods (12), and output and income falls (13). The
multiplier effect is in reverse.
Lower output and income (14) means lower sales and consequently the level of
investment spending (15) decline since investment spending is a positive function of the
level of output.
This is reflected by the IS-LM model as a leftward shift (16) of the IS curve and the level
of output and income initially declines from Y3 to Y1 (17).
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Reduced output also affects the financial market (1). On the financial market the decline
in the level of output (2) decreases the demand for money (3) since there is a lower level
of transactions. This decrease in the demand for money leads to a decline in the interest
rate (4) on the financial market.
The lower interest rate (6) on the financial market impacts on the goods market (5) by
causing higher investment spending (7) that stimulates the demand for goods (8), which
leads to higher output and income levels (9).
This is reflected by the IS-LM model as a movement along the IS curve (10) from point b
to point c. A new equilibrium position where both the goods and the financial markets
are in equilibrium is formed at point c (11) with an equilibrium income Y2 (12) and an
equilibrium interest rate i1 (13).
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Let’s see what the end result is of a decrease in government spending.
Comparing point a (1), which is the initial equilibrium point before the decrease in
government spending, with point c (2) , which is the equilibrium point after the decrease
in government spending we can see that the level of output is lower, it decrease from Y3
to Y2 (3) and the interest rate is lower, it decreases from i2 to i1 (4).
The interest rate fell in response to lower output and income levels (5). Looking at the
demand for goods (6) government spending is lower (7) by assumption. Investment
spending first decreases (8) because output is lower (9) and then increases (10) because
the interest rate is lower (11). Assuming that these two forces cancel one another, the
decrease in investment spending matches the increase and investment spending is
unchanged (12). Consumption spending is lower (13) because output and income is
lower (14). With lower government and consumption spending the level of demand is
lower (15) and so is output and income .
The IS-LM model shows that reduced government spending lowers output and income
(16) and lowers the interest rate (17).