Chapter 12 – Aggregate Demand II

Chapter 12 – Aggregate Demand II - Chapter 12 Aggregate...

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Chapter 12 – Aggregate Demand II: Applying the IS-LM Model 12.1 How Fiscal Policy Shifts the IS Curve and Changes the SR Equilibrium Change in Government Purchases - An increase of government purchases raises both income and the interest rates - The government increases its purchases of goods and service, the economy’s planned expenditure rises - The economy’s demand for money depends on income, the rise in total income increases the quantity of money demanded at every interest rate - When the interest rate rises, firms cut back on their investment plans. This fall in investment partially offsets the expansionary effect of the increase in government purchases. Thus, the increases in income in response to a fiscal expansion is smaller in the IS-LM model than it is in the Keynesian Cross (where investment is fixed) Changes in Taxes - The tax cut raises both income and the interest rate How Monetary Policy Shifts the LM Curve and Changes the Short Run Equilibrium - An increase in M leads to a increases in real money balances M/P because the price level P is fixed in the short run - An increase in the real money balances leads to a lower interest rate - The increase in money supply lowers the interest rate and raises the level of income - A lower interest rate stimulates planned investment, which increases planned expenditure, production, and income Y - The IS-LM model shows that monetary policy influences income by changing the interest rate - Monetary expansion induces greater spending on goods and services – a process called the monetary transmission mechanism - An increase in the money supply lowers the interest rate, which stimulates investment and thereby expands the demand for goods and services Policy Analysis with Macroeconometric Models - A macroeconometric model is a model that describes the economy quantitatively instead of just qualitatively - If nominal interest rate held constant – Gov Multiplier 1.93, Tax Multiplier -1.19 - Money supply held constant – Gov Multiplier 0.60, Tax Multiplier -0.26 Shocks in the IS-LM Model - Animal spirits – exogenous and perhaps self fulfilling waves of optimism and pessimism - Increases in consumer confidence (shift in consumption function) increases planned expenditure and shifts the IS curve to the right, and this raises income - Hence, increase in money demand shifts the LM curve upward, which tends to raise the interest rate and depress income U.S. Recession
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