ABSTRACT
These are the fiscal policy multipliers. An increase in exogenous exports or government expenditure or a reduction in taxes shifts the IS curve outwards without disturbing the LM schedule. It can be checked from equation (3.6) that in all these three cases r also rises. This is shown in Figure 3.5. Clearly the magnitude of these multipliers depends upon the sizes of the coefficients Ly, Ir and the like. In particular we realise that as (the absolute value of) Lr rises these multipliers drop. In extreme
cases the LM is nearly vertical, Lr is very large and the multipliers are nearly zero. This is the so-called ‘classical case’. In another extreme case Lr is very small and the LM schedule is nearly horizontal. In this case the multiplier is large (the so-called liquidity trap case). Classroom expositions of IS-LM analysis often depict a schedule as in Figure 3.6. This shows a LM schedule with three distinct ranges. At low rates of interest everyone expects the interest rate to rise so that the LM schedule is horizontal (the liquidity trap case). At moderate rates of interest the LM schedule is upward sloping. At very high rates of interest the LM curve becomes vertical. Any increase in exogenous expenditure simply raises the rate of interest and ‘crowds out’ private investment with no effect on equilibrium output. This last situation has often been used by some economists to argue against expansionary fiscal policy.
