Accommodating monetary policy

It is worth noting that in the IS-LM model increase in national income by Y in Fig.

20.6 is less than EK which would occur in Keynes’ model.

As a result, cut in taxes causes a shift in the IS curve to the right as is shown in Fig. 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.

The higher cash reserve ratio implies that the banks have to keep more cash reserve with the Central Bank.

As a result, the cash reserves with the banks fall which force them to contract credit. Thus, IS-LM model can be used to show that reduction in money supply will cause a leftward shift in LM curve and will lead to the rise in interest rate and fall in the level of income.

Decrease in aggregate demand will help in controlling inflation. Through making appropriate changes in monetary policy the Government can influence the level of economic activity.

Monetary policy may also be expansionary or contractionary depending on the prevailing economic situation.

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