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by Valentino Piana (1998-2001)



1. Introduction to our graph representation
2. The rules
3. The scheme
4. Reading the scheme: two examples
4.1. Export-led growth
4.2. Fiscal cuts
5. The advantages of this representation
Appendix 1. Justification for signs in relationships

Appendix 2. Introduction for absolute beginners


If you have never heard of IS-LM model click here.

Freely modifiable MS Word version of the graph.

Data for all the variables in IS-LM model





4.2. Fiscal cuts
GDP is the sum of public expenditure, consumption, investment and net exports; thus any fall in any of these variables will have a negative impact on it.
Accordingly, a cut in public expenditure, however decided and other things equal, has a direct impact on GDP, reducing it, with a movement in the same direction (sign "+" in our graph).
The fall in income (GDP) may be due to a decrease in production of goods and services previously bought by the public sector and/or due to a direct reduction in the number of civil servants.
At any rate, a fiscal cut reduces income of households. This, in turn, reduces their consumption, because they have less to spend.
The reduction in consumption has the further effect of reducing income, triggering a vicious circle, so strong in the '30s of the last century that it was "discovered" and conceptualised by authors of that age (Kahn and Keynes). Since then, this vicious (or virtuous - if it works the other way round!) circle is known as the Keynesian multiplier.
The on-going fall in income reduces employment as well, since less labour is required for productive aims.
Household savings will go in the same direction as income, so that they will fall.

Even more importantly from the point of view of the decision-makers, they should know that the tax revenue will shrink, since the tax base (income, value added...) goes in this direction.
If for example the public expenditure cut was justified by the necessity of reducing the public deficit (tax revenue less public expenditure), it is clear that the parallel fall in tax revenue makes this objective much farther.
All the changes we saw after a cut in public expenditure are usually considered as negative. But in the economy, at each negative side often correspond a positive element somewhere else.

In fact, the fall in income reduces the real interest rate, through a reduction of money demand for transactions.
The fall in real interest rate should increase investment, braking or even inverting the income reduction.
By the same token, the reduction in the real interest rate implies a fall in the nominal exchange rate, to the extent the latter is free to float and move.

The devaluation in both nominal and real exchange rate will improve the international price competitiveness of the economy, fostering exports and depressing imports.

Imports can play an extremely important role in inverting the business cycle.

They immediately fall as soon as income goes down. They further fall due to devaluation. This is conducive to a boost of domestic production which outperform general income dynamics, exactly because of substitution of imports (and new positive dynamics of exports).

If investment and net export dynamics are sufficiently strong, the initial fall in income will be reverted, the Keynesian multiplier will begin to work in the growth direction and the public expenditure cut will be fully compensated (in a macroeconomic perspective).

To a similar scenario can contribute also a fall in the absolute price level: to the extent the on-going reduction in employment and the symmetric increase in unemployment will reduce the absolute level of wages, the firms may decide to reduce prices.
This would increase the real money supply and further reduce the real interest rate, as well as improve the international price competitiveness with a fall in real exchange rate.
In this complex dynamics, it is pretty clear who are the losers: the households saw reduced their income, shrinked employment, and lower wages. In particular, families relying on public expenditure would be in the front line.

Another relatively clear thing is the possibly marginal role of the central bank. In all we saw, we could simply imagine that the nominal money supply was unchanged, with no work for the central banker.
Only if he decides so, the central bank can influence the cycle. If the public expenditure cut is immediately connected with an increase of the money supply, the consequent fall in the interest rate will anticipate the positive effects on investment and net export we previously saw as linked to a GDP painful fall.

In this way, the cut is immediately compensated and the Keynesian multiplier needn't to be activated in the depressive direction, as well as there will be no negative impact on the total level of employment. Since the tax base will be nearly unchanged, the State deficit will neatly improve.
If by contrast the central bank decides to reduce the money supply, the increase in the interest rate will be sudden and extremely strong.
[See previous graph] Investment and net export will shrink and the GDP, receiving depressive pressure from every side, will severely contract.

Mass unemployment will be the dominant feature of the system. Deflation is the consequence, but the fall of price is hardly capable to invert the trend.
Notwithstanding the initial expenditure cut, the state deficit will worsen because of the induced chain of events.

The recovery isn't guaranteed until a policy change is imposed.

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