Effect of Changes tile Variables
With the aid of Hicks-Hansen analysis, we can explain more satisfactorily the effect of changes in certain important economic variables such as desire to save, the supply of munch, investment, liquidity preferences on the rate of interest. This is illustrated
in Fig. 34.8. Changes ill to- Supply . Now suppose that the supply of money has been increased by the action of the Central Bank. Given the liquidity preference schedule, with the increase in the supply of money, more money will be held for speculative motive at each level of income and the rate of interest will come down. We see in the above Fig. that the LM curve has shifted to the right. When the LM curve has so shifted rightward, in the new equilibrium position, the rate of interest will be rower and the level of income higher than before. Point E is the intersection of LM and IS curves. When the supply of money has increased L 1 shifts to the dotted position LM ‘ and with If schedule remaining the same, the new equilibrium will be at point G corresponding to which the rate of inter t is lower and the level of income greater than at E. On the other hand, if the Central Bank has reduced the money supply, less money will be available for speculative motive at each level of income. A a result, the LM curve will shift to the left of E; and the IS curve remaining unchanged, in the new equilibrium position, the rate of interest will be higher and the level of income lower than before. Chang’s in the Desire to Save Consume. Let us now consider the effect of changes in the desire to save or propensity 10 consume. Suppose people’s desire to save decreases, i.e., the propensity to consume goes up. As a result, the level of national income will go up at e ch rate of interest. The result will be that the IS curve will shift to the right. This is shown by IS curve shifting rightward to the doted position IS ‘. With LM curve remaining unchanged, the new equilibrium position will be established at H corresponding to which the rate of interest as well as the level of income will be greater than at E. We find that decrease in the desire to save ha\ led to the increase in both rate of interest and the level of income. If. Oil the other hand. the desire to save increases i.e.• the propensity to consume decreases, the level of national income will fall for each rate of interest. As a result, the IS curve will shift to the left. With this shift and the LM curve remaining unchanged, the new equilibrium position win be reached at some point 10 the left of E corresponding to which both the rate of interest and the level of national income will be lower than at E. Changes in Investment and Government Expenditure. When investment and Government expenditure changes, the position of iS curve will be shifted. For instance. if private investment increases or government expenditure goes up, the national income will rise. This will shift the IS schedule to the right, and, given the LM curve, the rate of interest as well as the level of income will rise. On the other hand, if the private investment expenditure decreases or the government expenditure is reduced, the level of national income will go down. As a result. the IS curve will shift to the left, and, given the LM curve, the rate of interest will fall. Changes in Liquidity Preference. The position of LM curve will also shift as a result of changes in the liquidity preference. If, for instance, the liquidity preference of the people rises, the LM curve will shift to the left, because the higher liquidity preference, supply of money remaining the same, will raise the rate of interest corresponding to each level of national income. When the LM curve has shifted leftward, given the IS curve, the new equilibrium rate of interest will be higher and the level of national income lower. On the other hand, if the people’s liquidity preference decreases, the LM curve will shift to the right because, given the supply of money a downward shift in the liquidity preference curve means that. corresponding to each level of income. there will be a lower rate of interest. When the LM curve has shifted right wards, given the IS curve. the new equilibrium level of the rate of interest will be lower and the equilibrium level of the national income higher. Thus, we see that changes in factors like propensity to consume (or desire to save) investment or government expenditure, the supply of money and the liquidity preference will bring about shifts in IS or LM curves. As a result, the rate of interest as wen as the level of national income will change. Hicks-Hansen integration of the classical and the Keynesian theories of interest shows clearly that the government is in a position to influence the level of economic activities or the level of national income by monetary and fiscal measures. We find, therefore, that Hicks-Hansen Theory of interest explained above has integrated the theory of money with the theory of income indoctrination. In this way, the modern theory of interest has succeeded in synthesising the monetary and fiscal’ policies. Hence, both monetary and fiscal policies can plays useful role in regulating the rate of economic activity in the country.
Effect of Changes tile Variables