7- Policy Effects in the IS-LM Model.pptx - EXEE1104...

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EXEE1104/ EIA1003MACROECONOMICS ILecture 7The Keynesian System (III):Policy Effects in the IS-LM ModelReference: Froyen (Chapter 7)1
Figure 7.1: Effects of an Increase in the Quantity of Money r0Y0rYIS0LM(M1)Interest RateIncome r1Y1LM(M0)AB·Increase in Msfrom M0to M1·LM (M0)shifts to the right to LM (M1)·Interest rate falls from r0to r1·Income rises from Y0to Y1·Equilibrium moves from Ato BShifts in the LM Schedule 2
·The horizontal shift in IS when G increases (Figure 7.2) is shown by ΔG[1/(1-b)]- change in G is G1 ·In the Keynesian simple model (without money market), income would have increased to Y’1. However, in the IS-LM model, money market is taken into account.·When G rises, rmust rise to equilibrate IS –LM.·Rise in r will cause I to fall. The fall in I will be partially offset by the increase in AD resulting from an increase in G.·Therefore, Y increases only to Y1not Y’1 .Shifts in the IS Schedule
G0
Figure 7.2: Effects of an Increase in Government Spendingr0Y0rYIS(G0)LM0Interest RateIncome r1Y1ABIS(G1)Y’1·Increase in G from G0to G1·IS (G0)shifts to the right to IS (G1)·Interest rate rises from r0to r1·Income rises from Y0to Y1·Equilibrium moves from Ato B4bG11
·The horizontal shift in IS when T increases (Figure 7.3) is shown by ΔT[-b/(1-b)]- change in T is T1 ·In the Keynesian simple model, Y would have decreased more than YHowever, in the IS-LM model, money market is taken into account.·The multiplier is smaller;·Fall in r will cause I to increase. This increase will be partially offsetting the decline in Ccaused by the increase in T;·Therefore, Y falls only to Contd.T01Y1
Figure 7.3: Effects of an Increase in Taxesr1Y1rYIS(T1)LM0Interest RateIncome r0Y0ABIS(T0)·Increase in tax from T0to T1·IS (T0)shifts to the left to IS (T1)·Interest rate falls from r0to r1·Income falls from Y0to Y1·Equilibrium moves from Ato B·As Trises, Ydfalls and Cfalls·As Y declines due to an increase in T, Md declines, bond demand rises causing r to fall6bbT1
·Factors other than G and T.·Any autonomous change in AD·Assume autonomous decline in I (Figure 7.4).·In panel (a):oI0(r) shifts leftward to I1(r)oI falls at each r·In panel (b):oIS (I0)shifts to the left to IS (I1)oInterest rate falls from r0to r1oIncome falls from Y0to Y1·Equilibrium moves from Ato BContd.
Figure 7.4: Effects of an Autonomous Decline in Investmentr1Y1rYIS(I1)LM0Interest RateIncome r0Y0BAIS(I0)II’1I1I0Interest RateI1(r)r0r1r2I0 (r)r2Investment 8bI11I
·Y declines because I at initial r has fallen from I0to I’·As Y falls, Calso falls.·As Y declines, Mddeclines, bond demand rises causing r to fall.·With a decline in r, I returns to its initial level.·At the new equilibrium, investment is I1having increased from I’1as a result of a decline in r.Contd.
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Monetary and fiscal policies have different effects on r and I.Expansionary monetary policy – r declines, I increases.Expansionary fiscal policy – r rises, I falls.One suggestion is to use a policy mix - relatively ‘tight’ fiscal policy and relatively ‘easy’ monetary policy.Contd.

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