businesscycletheory2

businesscycletheory2 - Business Cycle Theory 2 Winter 2009...

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Business Cycle Theory 2 Winter 2009 UCLA Professor Mark Wright
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The IS - LM / AD-AS Model Winter 2009 UCLA Professor Mark Wright
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In this section, you will learn… z how to use the IS-LM model to analyze the effects of shocks, fiscal policy, and monetary policy Bush tax rebate z how to derive the aggregate demand curve from the IS-LM model z several theories about what caused the Great Depression
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The intersection determines the unique combination of Y and r that satisfies equilibrium in both markets. The LM curve represents money market equilibrium. The IS curve represents equilibrium in the goods market. Equilibrium in the IS - LM model () ( ) Y CY T I r G =− + + (, ) MP LrY = IS r LM 1
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Policy analysis with the IS - LM model We can use the IS- LM model to analyze the effects of fiscal policy: G and/or T monetary policy: M () ( ) Y CY T I r G =− + + (, ) MP LrY = IS r LM 1
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causing output & income to rise. IS 1 An increase in government purchases 1. IS curve shifts right Y r LM 1 by 1MPC G Δ 2 1. 2. This raises money demand, causing the interest rate to rise… 2. 3. …which reduces investment, so the final increase in Y 1 is smaller than Δ 3.
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IS 1 1. The Bush Tax rebate Y r LM 2 Consumers save (1 MPC ) of the tax cut, so the initial boost in spending is smaller for Δ T than for an equal Δ G and the IS curve shifts by MPC 1M P C T Δ 1. 2. 2. …so the effects on r and Y are smaller for Δ T than for an equal Δ G . 2.
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2. …causing the interest rate to fall IS Monetary policy: An increase in M 1. Δ M > 0 shifts the LM curve down (or to the right) Y r LM 1 2 3. …which increases investment, causing output & income to rise.
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Interaction between monetary & fiscal policy z Model: Monetary & fiscal policy variables ( M , G, and T ) are exogenous. z Real world: Monetary policymakers may adjust M in response to changes in fiscal policy, or vice versa. z Such interaction may alter the impact of the original policy change.
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The Fed’s response to Δ G > 0 z Suppose Congress increases G . z Possible Fed responses: 1. hold M constant 2. hold r constant 3. hold Y constant z In each case, the effects of the Δ G are different:
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If Congress raises G , the IS curve shifts right. IS 1 Response 1: Hold M constant Y r LM 2 If Fed holds M constant, then LM curve doesn’t shift. Results: 21 YY Δ= rr
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If Congress raises G , the IS curve shifts right. IS 1 Response 2: Hold r constant Y r LM 2 To keep r constant, Fed increases M to shift LM curve right. 31 YY Δ= 0 3 Results:
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IS 1 Response 3: Hold Y constant Y r LM 2 To keep Y constant, Fed reduces M to shift LM curve left. 0
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This note was uploaded on 04/06/2009 for the course ECON 11 taught by Professor Cunningham during the Winter '08 term at UCLA.

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businesscycletheory2 - Business Cycle Theory 2 Winter 2009...

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