Determinants of Income, Interest Rates, and Economic Policy Effectiveness

Factors Affecting Income Balance and Interest Rates

An increase in the money supply shifts the LM curve rightward, decreasing the interest rate and increasing income.

This increase in the money stock creates excess money supply, decreasing the interest rate. As the interest rate falls, investment demand rises, leading to increased revenue and consumption, induced by higher income. Conversely, a decline in the money stock shifts the LM curve leftward, decreasing equilibrium income and increasing the equilibrium interest rate.

Another factor shifting the LM curve is a change in money demand.

Curve Analysis

Fiscal policy variables shift the IS curve, affecting equilibrium income and interest rates. Income growth is driven by increased aggregate demand: directly through government spending and indirectly through income-induced consumer spending. This income increase adjusts interest rates upward as money demand for transactions rises.

The curve's magnitude is the increase in public spending multiplied by the autonomous expenditure multiplier from the simple Keynesian model; this horizontal shift equals the income increase in that model.

The IS-LM model differs from the simple Keynesian model by including the money market.

Increased tax collection shifts the IS curve leftward, decreasing income as higher taxes reduce disposable income and consumption. In the IS-LM model, fiscal policy multipliers are smaller than in the simple Keynesian model, which overestimates the impact of tax increases by assuming constant investment. Decreased taxes have opposite effects, shifting the IS curve rightward and increasing both income and interest rates.

In short, changes in government spending have a greater impact on income than equivalent changes in taxes. Therefore, a change in budget size, maintaining the deficit, changes income in the same direction.

Besides fiscal policy, any change in autonomous aggregate demand can shift the IS curve.

Effectiveness of Monetary and Fiscal Policy

Effectiveness refers to the size of the income change resulting from a given policy change.

Policy Effectiveness and IS Curve Slope

The IS curve's slope is determined by investment's interest elasticity. If investment is highly interest-elastic, the IS curve is relatively flat, as interest rate increases significantly reduce investment. If investment is interest-inelastic, the IS curve is steep.

To assess fiscal policy effectiveness, we compare its income effect to that predicted by the simple Keynesian model, which considers fiscal variables as primary income determinants. To evaluate monetary policy, we compare the income effect of a money stock change to the LM curve's horizontal shift.

In the IS-LM model, monetary policy affects income by lowering interest rates and stimulating investment. If investment is interest-insensitive, monetary policy is ineffective. Monetary policy is most effective when investment is highly interest-elastic (flatter IS curve) and ineffective when investment is interest-inelastic (steeper IS curve). The less interest-sensitive investment is, the greater the effect of fiscal policy.

How important is the investment shift effect? The IS curve's slope determines private investment's importance. If investment is interest-insensitive, interest rate increases only slightly decrease investment, and income increases by nearly the IS curve's total horizontal shift. If investment is highly interest-sensitive, interest rate increases substantially reduce investment, and income increases significantly less than predicted by the simple Keynesian model.

With a vertical IS curve, investment is completely interest-insensitive. Increased public spending raises the interest rate without decreasing investment.

Effectiveness of Economic Policy and the LM Curve Slope

Fiscal Policy

Fiscal policy is most effective when money demand is highly interest-elastic (relatively flat LM curve). This is because the interest rate's effect on investment is influenced by fiscal policy changes. Increased government spending raises income, increasing money demand for transactions. To rebalance the money market (with a fixed money stock), the interest rate must rise.

When money demand is interest-inelastic, a larger interest rate increase is needed to rebalance the money market as income rises. If money demand is completely interest-insensitive, only one income level can be balanced: the level generating transaction demand equal to the fixed money stock.

Monetary Policy

Monetary policy is most effective when the LM curve is relatively flat (high interest elasticity of money demand). The income effect of a money stock increase is greater when money demand's interest elasticity is lower, and when it's zero (vertical LM curve).

When money demand's interest elasticity is lower, a larger interest rate decrease is needed to rebalance the money market after a money stock increase.

In summary, the income effect of a money stock increase is greater the lower the interest elasticity of money demand. Monetary policy effectiveness increases when money demand's interest elasticity decreases. Income is affected by the interest rate; a higher response rate makes economic policy more effective.