IS-LM model

 

IS-LM model

Part I (IS) good market equilibrium

Part II (LM) money market equilibrium

Part III simultaneous equilibrium model & previous year questions

 

Intro

IS-LM model also called a Hisk- Hansen model

IS-LM model developed by JR Hisk in 1937 and extended by Alvin Hanson.

IS	LM
Product/goods market	Money market
Equality of investment (I) and saving(S)	Equality of money (L) and money supply (M)

 

Keynesian views:

It has been asserted that in the Keynesian model whereas, The changes in rate of interest in the money market affect investment and therefore the level of income and output in the good market,

In others word, in Keynes simple model the level of national income IS shown to be determined by the good market equilibrium.

The rate of interest, according to Keynes, is determined by money market equilibrium by the demand for and supply of money.

In this simple analysis of equilibrium in the goods market Keynes considers investment to be determined by the rate of interest along with the marginal efficiency of capital and IS shown to be independent of the level of national income.

Hicks, Hansen, Learner and Johnson have put forward a complete and integrated model.

Based on the Keynesian framework where in the variables such as investment, national income, rate of interest, demand for and supply of money are interrelated and mutually interdependent and can be represented by the two curves called the IS and LM curves.

Theirs extended Keynesian model IS therefore known as IS-LM curve model.

In this model they have shown how the level of national income and rate of interest are jointly determined by the simultaneous equilibrium I n the two interdependent goods and money market.

Part I

Good Market Equilibrium (IS)

The goods market IS in equilibrium when aggregate demand IS equal to income. The aggregate demand is determined by consumption demand and investment demand.

Like Keynes ROI is an important determinant of investments.

When the rate of interest falls the level of investment increase and vice versa.

Thus, changes in the rate of interest affect aggregate demand or aggregate expenditure by causing changes in the investment demand.

Thus, IS curve relating different equilibrium levels of national income with various rate of interest.

The lower the rate of interest, the higher will be the equilibrium level of national income.

Thus, the IS curve is the locus of those combination of rate of interest and the level of national income at which goods market is in equilibrium.

The relationship between rate of interest and planned investment is depicted by the invest demand curve II

At rate of interest Or₀ the planned investment, aggregate demand curve IS c+I₀ which, as will be seen in panel (b) equals aggregate output OY, level of income.

The rate of interest Or₂, level of income equals to OY₀ has been plotted.

Now of the rate of interest falls to Or2 the planned investment by business man increaser form Oi₀ to Oi₁

The aggregate demand curves shifts upwards to the new position C+11 in panel (b).

General equilibrium is occurred in where both goods market and money market are interacted with each other's.

IS represent investment and saving

LM represent money demand and money supply

IS-good market equilibrium

LM- money market equilibrium

 

 

IS curve

It shows investment saving relationship.

The independent variables is interest rate and dependent variables is level of national income… that’s why

Interest rate - y axis

Level of income - x axis

 

Slope of IS curve

IS curve IS negatively slopped

The slope of IS dependent on-

1.     Sensitiveness (elasticity)

2.     Size of Multiplier

IS curve shift right

IS curve shift  left

 

 

Shift in IS curve

Why IS curve shift right	Why IS curve shift left
Reduction in saving	Increase in saving
Increase in consumption	Decrease in consumption
Autonomous increase in investment	Autonomous decrease in investment
Auto investment IS independent of income and ROI.

 

 

Part II

LM Approach- Money Market Equilibrium

The LM curve can be derived from the Keynesian theory from its analysis of money market equilibrium.

According to Keynes, demand for money to hold depends upon transactions motive, precaution motive and speculative motive.

It is the money held for transaction motive which is a function of income.

The demand for money also depends on the rate of interest which is the cost of holding money.

The LM curves tells what the various rate of interest will be at different level of income.

As income increases, money demand curve shifts outward and therefore the rate of interest which equates supply of money, with demand for money rises.

In diagram we measure income on the x-axis and plot the income level corresponding to the various interest rate determined at those income level through money market equilibrium by the equality of demand for and the supply of money in (a).

There are two factor on which the slope of the LM curve depends.

First, the responsiveness of demand for money (i.e. liquidity preference) to the changes in income.

As the income increases, say from Y₀ to Y₁ the demand curve for money shifts from Md₀ to Md₁ that is,

With an increase in income demand for money would increase for being held for transactions motive, M_d or

L₁=f(Y).

 

In the new eqm, position with the given stock of money supply, money held under the transaction motive will increase where as the money held for speculative motive will decline.

The second factor which determines the slope of the LM curve is the elasticity or responsiveness of demand for money (i.e. liquidity preference for speculative motive) to the changes in rate of interest.

The  lower the elasticity f liquidity preference for speculative motive with respect to the changes in the rate of interest, the steeper will be the LM curve.

On the other hand, if the elasticity of liquidity preference (money demand-function) to the changes in the rate of interest is high, the LM curve will be flatter or less steep.

 

Shift in LM curve

LM curve shift right

LM curve shift left

 

 

Why LM curve shift right	Why LM curve shift left
Increase in money supply.	Decrease in money supply.
Decrease in demand for money.	Increase in demand for money.

 

Effects of changes in supply of money on the rate of interest and income level.

With the increase in the supply of money, more money will be available for speculative motive at a given level of income which will cause the interest rate to fall. As a result, the LM curve will shift to the right.

With this rightward shift in the LM curve, in the new equilibrium position rate of interest will be lower and the level of income greater then before.

Where with a given supply of money, LM and IS curves intersect at point E.

With the increase in the supply of money, L curve shifts to the right to the position LM and with IS schedule remaining unchanged.

Changes in the desire to save or propensity to consume:

When the people's desire to save falls, that is, when propensity to consume rises, the aggregate demand curve will shift upward and, therefore, level of income will rise at each rate of interest.

As a result, the IS curve will shift outward to the right.

Suppose with a certain given fall n the desire to save (or increase in the propensity to consume), the IS curve shifts rightward to the dotted position IS'. With LM curve remaining unchanged,

The new equilibrium position will be established at H corresponding to which rate of interest as well as level of income will be greater then at E.

On the other  hands, if the desire to save rises, that is, if the propensity to consume falls, aggregate demand curve will shift downward which will cause the level of national income to falls for each rate of interest and as a result the is curve will shift to the left.

With this, and LM curve remaining unchanged,

The new equm position will be reached to the left of E, say at point L corresponding to which both rate of interest and level of national income will be smaller the at E.

 

Part III

Simultaneous changes in IS-LM curve

If investment and money supply increases simultaneously then IS-LM curve shift right.

New equm will be set on new IS-LM curve, but ROI remain same.

 

 

Effectiveness of monetary policy and fiscal policy

I. Effectiveness of monetary policy in LM curve.

a.      Monetary policy is perfectly ineffective when LM curve is horizontal.

b.     MP less effective LM flat.

c.      MP more effective LM steeper.

d.     MP perfectly effective LM vertical.

 

II. effectiveness of monetary policy in is curve

a.      MP is perfectly effective when IS curve is horizontal.

b.     MP is more effective IS curve flat

c.      MP less effective IS curve steep.

d.     MP perfectly ineffective IS vertical.

 

III. effectiveness of fiscal policy in LM curve

a.      Fiscal policy is perfectly effective when LM curve is horizontal.

b.     FP more effective LM flatter.

c.      FP less effective LM steep

d.     FP perfectly ineffective LM vertical.

IV. effectiveness of fiscal policy in IS curve

a.      Fiscal policy is perfectly ineffective when IS curve is horizontal.

b.     FP less effective - IS flat

c.      FP more effective- IS steep

d.     FP perfectly effective- IS vertical.

 

राष्ट्रिय आय लेखांकन

 राष्ट्रिय आय लेखांकनको अवधारणा र विधिहरु एक आपसमा फरक छन । 

राष्ट्रिय आय लेखांकनको अवधारणा (Concepts of National Income Accounting)

राष्ट्रिय आय गणना गर्ने तरिका तथा आयमा समावेश गरिने उत्पादनहरुको आधारमा समग्र राष्ट्रिय आयलाई निम्न अनुसार बर्गिकरण गरि अध्ययन गर्ने गरिएको छ ।

१. कुल ग्राहस्थ उत्पादन (GDP)

कुनै पनि मुलुकको भौगोलिक सिमा भित्र निश्चित समयावधि भित्र उत्पादन भएका अन्तिम बस्तु तथा सेवाको बजार मुल्यलाई कुल ग्राहस्थ उत्पादन (GDP) भनिन्छ ।

कुल ग्राहस्थ उत्पादन बजार मुल्यमा मापन गरिन्छ ।

यसमा अन्तिम बस्तु तथा सेवाहरुको उत्पादन मात्र समावेश गरिएको हुन्छ । कच्चा पदार्थ उत्पादन यसमा समावेश गरिएको हुँदैन ।

यसमा मुलुकको भौगोलिक  सिमाना भित्र भएको उत्पादन मात्र समावेश भएको हुन्छ । उत्त सीमा भित्र कस्ले उत्पादन गर्यो भन्नेसंग प्रत्यक्ष सरोकार राख्दैन ।

उत्वादन हुने तर बजारमा खरिद विक्रि नहुने बस्तु तथा सेवाहरुको उत्पादन कुल ग्राहस्थ उत्पादनमा सजिलैसंग समावेश गर्न सकिँदैन ।

तर्सथ,  GDP लाई निम्न अनुसार उल्लेख गर्न सकिन्छ ।

where, Pi= Prce pf ist domestically  produced final product

xi quality of ith domestically produced final product

GDP लाई खर्च विधिवाट निम्न तरिकाले उल्लेख गर्न सकिन्छ । 

 GDP= C+I+G+(X-M)

Where, c= consumption expenditure

I= investment expenditure

G= Government expenditure

X= export

M=import

२. कुल राष्ट्रिय उत्पादन GNP

कुनै निश्चित समयावधिमा स्वदेशी उत्पादनका साधनले देश भित्र वा बाहिर जहाँ जुनसुकै भएता पनि उत्पादन गरेको अन्तिम बस्तु तथा सेवाको मौद्रिक मुल्यलाई न्ल्ए भनिन्छ । यस अन्र्तगत स्वदेशी उच्पादनका साधनले विदेशवाट प्राप्त आयलाई जोडिन्छ भने विदेशी उत्पादनका साधनलाई तिरेको रकम न्म्ए बाट घटाइन्छ ।

GNP = GDP + earning of domestic factor from abroad-payment to foreign factor of product

GNP=GDP+ net factor income from abroad (NFIA)

कुनै पनि मुलुकको स्वमित्वमा भएका उत्पादनका साधनहरुले निश्चित समयावधिमा उत्पादन गरेका अन्तिम बस्तु तथा सेवाको बजार मुल्यलाई कुल राष्ट्रिय उत्पादन भनिन्छ ।

३. खुद राष्ट्यि उत्पादन (GNE)

उत्पादन प्रक्रियामा पुँजीगत ह्रास हुने हुन्छ जस्ले गर्दा खुद उत्पादन (GNE) निकाल्न न्ल्ए वाट सो अवधीमा पुँजीगत बस्तुमा भएको कुल मुल्य ह्रासलाई घटाउनु पर्दछ, तर्सथ न्ल्ए बाट मुल्यह्रास घटाएपछि ल्ल्ए प्राप्त हुन्छ । 

NNP= GNP- Depreciation

४. राष्ट्रिय आय (National Income)

कुनै निश्चित समयावधिमा स्वदेशी उत्पादनका साधनले प्राप्त गरेको कुल आम्दानीलाई राष्ट्रिय आय भनिन्छ ।

अर्थात यदि कुनै बर्षको राष्ट्रिय आयलाई त्यस बर्षको प्रचलित बजार मुल्यमा ब्यक्त गरिन्छ भने त्यस्तो राष्ट्रिय आयलाई प्रचलित बजार मुल्यको राष्ट्रिय आय भनिन्छ ।

यस अन्र्तगत उत्पादनका साधनलाई श्रम, पँुजी, भुमी र संगठनमा विभाजन गरि गणना अबधि भित्र यी उत्पादनका साधनहरुले प्राप्त गरेको कुल आय नै राष्ट्रिय आय हो  तर्सथ राष्ट्रिय आयलाई निम्न अनुसार उल्लेख गर्न सकिन्छ ।

NI= wage+capital+rent+profit

५. ब्यक्तिगत आय (PI)

कुनै पनि देशमा सम्पुर्ण ब्यक्ति एवं परिवारले एक आर्थिक बर्ष भित्रमा गर्ने कुल आयको योगलाई ब्यक्तिगत आय भनिन्छ । 

राष्ट्रिय आयवाट संस्थागत बचत घटाएर ब्यक्ति वा परिवारले प्राप्त गर्ने Transfer Payment जोड्दा Personal Income प्राप्त हुन्छ ।

Pi=NI=corporate income tax - undistributed corporate profit-social security custodian+transfer payment

६. ब्यय योग्य आम्दानी (DI)

कुनै पनि ब्यक्ति वा संस्थाले परिवारले प्राप्त गर्ने सम्पुर्ण आय खर्च गर्न  सकिने हुँदैन । ब्यक्ति वा परिवारको त्यस्तो आय जस्ले आय जुन उसले खर्च गर्न सक्छ त्यसलाई नै DI भनिन्छ ।

DI=PI - Direct Tax

७. प्रति ब्यक्ति आय (Per Capita Income)

तोकिएको बर्षको राष्ट्यि आम्दानीलाई सोहि बर्षको कुल जनसंख्याले भाग गर्दा प्राप्त हुने औषत आयलाई एऋक्ष् भनिन्छ । 

PCI=National Income of the Year/Total Population  of the Year

Macro Prudential Policy and Its Tools

 

Macro prudential policy and its tools

The macroprudential regulatory changes in terms of risk weight, provisioning requirements and Loan-to-Value ratio (LTV) occurred with respect to some specific sectors of the credits class viz., housing loans, commercial real estate, capital market and other retails in emerging markets. The tightening of prudential norms made the credit to targeted sectors costlier, thereby operating the flow of credit to these sectors. There is evidence that moderation in credit flow to these sectors was also in part due to banks becoming cautious in lending to these sectors on the signaling effect of the Central Bank’s perception of build-up of sectoral risks. Now the question arises as to how to test the impact of macroprudential policies on the loan supply in these specific sectors and to identify whether the changes in the loan is due to the monetary policy shock or macroprudential shock and further, whether it is demand driven or supply driven. ‘macroprudential’ approach to safeguard the financial system as a whole. Accordingly, the IMF initiated the framework for Financial Soundness Indicators comprising aggregated micro prudential indicators, financial market indicators and macroeconomic indicators. In the aftermath of the recent global crisis, the new Basel III framework has embraced macroprudential approach with emphasis on systemic risk and stability. However, the benefits of introducing macroprudential policy tend to be sizeable when financial shocks, which affect the supply of loans, are important drivers of economic dynamics.

The macroprudential norms enabled banks to withstand some of the adverse impacts when macroeconomic conditions changed especially when the global financial crisis hit. First, the countercyclical prudential requirement relating to investment fluctuations reserve enabled banks to absorb some of the adverse impact when interest rates began moving in the opposite direction in late 2004. When capital charge for market risk was introduced, banks did not face any difficulty in meeting the same.

Second, banks’ capital to risk-weighted assets ratio increased every year from 2007 to 2011. The

improved capital to risk weighted assets ratio was due to improved profitability as well as also to the decline in the gross non-performing assets ratio. This enabled banks to plough back increased profits. The increase in risk weights for lending to certain sectors and increased provisioning requirements against standard assets also enabled banks to improve their capital adequacy ratio.

Macroprudential policy measures fall into the following three broad categories (Table 4): (i) Credit controls including caps on ratios of LTV and of debt-to-income (DTI) and on foreign currency lending as well as ceilings on credit or credit growth; (ii) liquidity regulations that place limits on net open currency positions or currency mismatches and on maturity mismatches while establishing reserve requirements; and, (iii) capital requirements including countercyclical capital requirements, time-varying and dynamic provisioning, and restrictions on profit distribution. Macroprudential tools such as minimum capital ratios and LTV ratios have been used for some time. Reserve requirements could provide liquidity cushions while dynamic provisioning could help build capital buffers during upturns.

Conceptual Basis of Macroprudential Policy Instruments

Instrument	Conceptual Basis
Caps on the loan-to-value ratio (LTV)	The LTV imposes a down payment constraints on household capacity to borrow. In theory, the constraint limits the procyclicality of collateralized lending since housing prices and household capacity to borrow based on the collateralized value of the house interact in a procyclical manner. Set at an appropriate level, the LTV address systematic risk whether or not it is frequently adjusted, however, the adjustment of the LTV makes it a more potent countercyclical policy instrument.
Caps on the debts to income ratio (DTI)	The DTI represents prudential regulation aimed at ensuring banks asset quality when used alone. When used in conjunction with the LTV, however, the DTI can help further dampen the cyclicality of collateralized lending by adding another constraint on household capacity to borrow. As with the LTV, adjustments in the DTI can be made in a countercyclical manner to address the time dimension of systematic risk.
Caps on foreign currency lending	Loans in foreign currency expose the unhedged borrower to foreign exchange risk with, in turn, subject the lender to credit risks. The risks can become systemic if the common exposure is large. Caps (or higher risk weights, deposit requirements, etc.) on foreign currency lending may be used to address this foreign exchange induced systemic risk.
Ceiling on credit/credit growth	A ceiling may be imposed on either total bank lending or credit to a specific sector. The ceiling on aggregate credit or credit growth may be used to dampen the credit/assets price cycle--in the time dimension of systemic risk. The ceiling on credit to a specific sector, such real estate, may be used to contain a specific type of asset price inflation or limit common exposure to a specific risk—the cross-sectional dimension of systemic risk.
Reserve requirement	The monetary policy tools may be used to address systemic risk in two senses. First, the reserve requirement has a direct impact on credit growth, so it may be used to dampen the credit/assets price cycle—the time dimeson of systemic risk. Second, the required reserves provide a liquidity cushion that may be used to alleviate a systemic liquidity crunch when the situation warrants.
Countercyclical reserve requirement	The requirement can take the form of a ratio or risk weights raised during an upturn as a restraint on credit expansion and reduced during a downtown to provide a cushion so that banks do not reduce assets to meet the capital requirement. A permanent capital buffer, which is built up during an upturn and deleted during a downturn, serve the same purpose. Both can address the cyclicality in the risk weights under Basel ii based on external rating that are procyclical.
Provisioning	Traditional provisioning is calibrated historical bank-specific losses, but it can also be used to dampen the cyclicality in the financial system. The provisioning requirement can be raised during an upturn to build a buffer and limit credit expansion and lowered during a downturn to support bank lending. It may be adjusted either according to a fixed formula or at the discretion of the policy maker to affect bank lending behavior in a countercyclical manner.
Restriction on profit distribution	These prudential regulation requirements are intended to ensure the capital adequacy of banks. Since undistributed profits are added to bank capital, the restrictions tend to have a countercyclical effect on bank lending of used in a downturn. The capital conservation buffer of Basel III has a similar role.
Limits on net open positions/currency mismatch	These prudential regulation tools may be used to address systematic risk since the choice of asset/liability maturity creates an externality—fire sale of assets. In a crisis, the inability of a financial institution to meet its short-term obligations due to maturity mismatches may force it to liquidated assets thus imposing a fire sale cost on the rest of the financial system. The funding shortages of a few institution could also result in a systemic liquidity crisis due to the contagion effects.