Using islm show the impact of removal investment policy on invome
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Answer:
Let us first explain how IS-LM model shows the effect of expansionary fiscal policy of increase in Government expenditure on level of national income.
This is illustrated in Fig. 20.6. Increase in Government expenditure which is of autonomous nature raises aggregate demand for goods and services and thereby causes an outward shift in IS curve, as is shown in Fig. 20.6 where increase in Government expenditure leads to the shift in IS curve from IS1 to IS2.
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Note that the horizontal distance between the two IS curves is equal to the increase in government expenditure times the government expenditure multiplier, that is, ΔG x 1/1-MPC which shows the increase in national income equal to the horizontal distance EK that occurs in Keynes’ multiplier model. However, in IS-LM model actual increase in national income is not equal to EK caused by the working of Keynesian multiplier.
This is because with the rightward shift in IS curve rate of interest also rises which causes reduction in private investment. It will be seen from Fig. 20.6 that, with the LM curve remaining unchanged, the new IS2 curve intersects LM curve at point B. Thus, in IS-LM model with the increase in Government expenditure (ΔG), the equilibrium moves from point E to B and with this the rate of interest rises from r1 to r2 and income level from Y1 to Y2.
Income equal to CK has been wiped out because of rise in interest causing a decline in private investment. Thus CK represents crowding-out effect of increase in government expenditure Thus, IS-LM model shows that expansionary fiscal policy of increase in Government expenditure raises both the level of income and rate of interest.
Expansionary Fiscal Policy: Impact of Increase in Government Expenditure on Interest Rate and Income
It is worth noting that in the IS-LM model increase in national income by Y1 Y2 in Fig. 20.6 is less than EK which would occur in Keynes’ model. This is because Keynes in his simple multiplier model assumes that investment is fixed and autonomous, whereas IS-LM model takes into account the fall in private investment due to the rise in interest rate that takes place with the increase in Government expenditure. That is, increase in Government expenditure crowds out some private investment.
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Likewise, it can be illustrated that the reduction in Government expenditure will cause a leftward shift in the IS curve, and given the LM curve unchanged, will lead to the fall in both rate of interest and level of income. It should be noted that Government often cuts expenditure to control inflation in the economy.
Expansionary Fiscal Policy: Reduction in Taxes:
An alternative measure of expansionary fiscal policy that may be adopted is the reduction in taxes which through increase in disposable income of the people raises consumption demand of the people. As a result, cut in taxes causes a shift in the IS curve to the right as is shown in Fig. 20.7 from IS1 to IS2.
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It may however be noted that in the Keynesian multiplier model, the horizontal shift in the IS curve is determined by the value of tax multiplier times the reduction in taxes (ΔT), that is, ΔT x MPC/1-MPC and causes level of income to increase by EH.
However, in the IS-LM model, with the shift of the IS curve from IS1 to IS2 following the reduction in taxes, the economy moves from equilibrium point E to D and, as is evident from Fig. 20.7, rate of interest rises from r1 to r2 and level of income increases from Y1 to Y2. Income equal to LH has been wiped out because of crowding-out effect on private investment as a result of rise in interest rate.
Expansionary Fiscal Policy: Effect of Cut in Taxes
On the other hand, if the Government intervenes in the economy to reduce inflationary pressures, it will raise the rates of personal taxes to reduce disposable income of the people. Rise in personal taxes will lead to the decrease in aggregate demand. Decrease in aggregate demand will help in controlling inflation. This case can also be shown by IS-LM curve model.
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