Chapter 11 - Chapter 11 Aggregate Demand II Applying the...

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Chapter 11Aggregate Demand II: Applying the IS-LM Model(Section 11.1 and 11.2)
The intersection determines the unique combination of Yand that satisfies equilibrium in both markets.The LMcurve represents money market equilibrium.Equilibrium in the IS-LMmodelThe IScurve represents equilibrium in the goods market.()( )YC YTIrG(,)M PL r YISYrLMr1Y1r
Policy analysis with the IS-LMmodelWe can use the IS-LMmodel to analyze the effects offiscal policy: Gand/or Tmonetary policy: M()( )YC YTIrG(,)M PL r YISYrLMr1Y1
causing output & income to rise.IS1An increase in government purchases1. IScurve shifts right YrLMr1Y11by 1 MPCGIS2Y2r21.2. This raises money demand, causing the interest rate to rise…2.3. …which reduces investment, so the final increase in 1is smaller than 1 MPCG3.
Y
IS11.A tax cutYrLMr1Y1IS2Y2r2Consumers save (1MPC) of the tax cut, so the initial boost in spending is smaller for Tthan for an equal Gand the IScurve shifts byMPC1 MPCT1.2.2.…so the effects on rand Yare smaller for than for an equal G2.
T
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2.…causing the interest rate to fall ISMonetary policy: An increase in M1. M> 0 shifts the LMcurve down(or to the right)YrLM1r1Y1Yr2LM23.…which increases investment, causing output & income to rise.
2
Interaction between monetary & fiscal policyModel: Monetary & fiscal policy variables (M, G,and T) are exogenous.Real world: Monetary policymakers may adjust in response to changes in fiscal policy, or vice versa.Such interaction may alter the impact of the original policy change.
M
The BOC’s response to G> 0Suppose government increases GPossible BOC responses:1.hold Mconstant2.hold rconstant3.hold YconstantIn each case, the effects of the are different:
.
G
If government raises Gthe IScurve shifts right.IS1Response 1: Hold MconstantYrLM1r1Y1IS2Y2r2If BOC holds Mconstant, then LMcurve doesn’t shift.Results:21YYY21rrr
,
If government raises Gthe IScurve shifts right.IS1Response 2: Hold rconstantYrLM
,

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