11_chapter-4.pdf - Chapter 4 Monetary and Fiscal Policies in ISIS-LM Framework Monetary and Fiscal Policies in IS-LM Framework 64 CHAPTER-4 MONETARY AND

11_chapter-4.pdf - Chapter 4 Monetary and Fiscal Policies...

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Chapter Chapter 4 Monetary Monetary and Fiscal nd Fiscal Policies Policies Policies in n n n IS IS IS-LM LM LM Framework Framework
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Monetary and Fiscal Policies in IS-LM Framework 64 CHAPTER-4 MONETARY AND FISCAL POLICIES IN IS-LM FRAMEWORK 4.1 INTRODUCTION S ince World War II, government policymakers have tried to promote high employment without causing inflation. If the economy experiences a recession, policy makers have to follow two principle sets of tools that they can use to affect aggregate economic activity. Monetary policy, the control of interest rates or the money supply, and fiscal policy, the control of government spending and taxes. The adjustment policies which are used to achieve full employment with price stability and equilibrium in the balance of payments. The economist most responsible for shifting the emphasis from automatic adjustment mechanisms to adjustment policies was James Meade. The most important economic goals or objectives of nations are – 1) Internal balance 2) External balance 3) A reasonable rate of growth, 4) An equitable distribution of income, and 5) Adequate protection of the environment Internal balance refers to full employment or a rate of unemployment of no more than, say 4-5 percent per year and a rate of
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Monetary and Fiscal Policies in IS-LM Framework 65 inflation of no more than 2 or 3 percent per year. External balance refers to equilibrium in the balance of payments, In general, nations place priority on internal over external balance, but they are sometimes forced to switch their priority when faced with large and persistent external imbalances. To achieve these objectives, nations have the following policy instruments at their disposal: 1) Expenditure - changing or demand policies 2) Expenditure - switching policies and 3) Direct controls Expenditure – changing policies include both fiscal and monetary policies. Fiscal policy refers to changes in government expenditures, taxes, or both. Fiscal policy is expansionary if government expenditures are increased and taxes reduced. These actions lead to an expansion of domestic production and income through a multiplier process and induce a rise in imports. Contractionary fiscal policy refers to a reduction in government expenditures or an increase in taxes, both of which reduce domestic production and income and induce a fall in imports. Monetary policy involves a change in the nation’s money supply that affects domestic interest rates. Monetary policy is easy if the money supply is increased and interest rates fall. This includes an increase in the level of investment and income in the nation (through the multiplier process) and induces imports to rise. At the same time, the reduction in the interest rate induces, a short term capital outflow or reduced inflow.
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