The IS and MP Curves, and Aggregate Demand Curve

In this chapter, we have discussed the IS curve by using households’ consumption function, business sector investments, government spending, and foreign sector goods and services market. We have also developed the MP curve from the money market by employing the demand for money and supply of money. We have explained why the LM curve which assumed constant prices, even when a nation is employing an expansionary fiscal policy, is inconsistent and unrealistic. We have derived multipliers for both fiscal and monetary policies by using algebra and geometry. We have derived IS and LM curves; and employed them to illustrate that an expansionary fiscal policy caused by increase in government spending, raises interest rate and real output without affecting prices, which is inconsistent with real world observation. Consequently, the LM curve is dropped from the analysis, and the MPC and IS curves are used to derive the AD curve, which is used together with the AS curve to study effects of monetary and fiscal policies on market dynamics. We have also depicted schematically, that both Keynesian liquidity or monetary policy principles (or Taylor’s rule) or Exchange rate principle can employ either interest rate or exchange rate as operating targeting instruments to stabilize inflation. Furthermore, we have empirically tested to confirm that the exchange rate, as an optimal operating policy instrument, is more effective in developing countries than the central bank’s standard choice of inter-bank or policy or federal fund rates.