econ305_11_Nov04

# econ305_11_Nov04 - Context aggregate demand and supply...

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slide 1 Context aggregate demand and supply. IS-LM model, the basis of the aggregate demand curve.

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slide 2 now… how to use the IS-LM model to analyze the effects of shocks, fiscal policy, and monetary policy how to derive the aggregate demand curve from the IS-LM model several theories about what caused the Great Depression
slide 3 The intersection determines the unique combination of Y and r that satisfies equilibrium in both markets. The LM curve represents money market equilibrium. Equilibrium in the  IS   - LM     model The IS curve represents equilibrium in the goods market. ( ) ( ) Y C Y T I r G = - + + ( , ) M P L r Y = IS Y r LM r 1 Y 1

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slide 4 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 C Y T I r G = - + + ( , ) M P L r Y = IS Y r LM r 1 Y 1
slide 5 causing output & income to rise. IS 1 An increase in government purchases 1. IS curve shifts right Y r LM r 1 Y 1 1 by 1 MPC G - IS 2 Y 2 r 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 1 MPC G - 3.

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slide 6 IS 1 1. A tax cut Y r LM r 1 Y 1 IS 2 Y 2 r 2 Consumers save (1 - MPC ) of the tax cut, so the initial boost in spending is smaller for T than for an equal G and the IS curve shifts by MPC 1 MPC T - - 1. 2. 2. …so the effects on r and Y are smaller for T than for an equal G . 2.
slide 7 2. …causing the interest rate to fall IS Monetary policy:  An increase in  M 1. M > 0 shifts the LM curve down (or to the right) Y r LM 1 r 1 Y 1 Y 2 r 2 LM 2 3. …which increases investment, causing output & income to rise.

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slide 8 Interaction between  Model: Monetary & fiscal policy variables ( M , G, and T ) are exogenous. Real world: Monetary policymakers may adjust M in response to changes in fiscal policy, or vice versa. Such interaction may alter the impact of the original policy change.
slide 9 The Fed’s response to   G   > 0 Suppose Congress increases G . Possible Fed responses: 1. hold M constant 2. hold r constant 3. hold Y constant In each case, the effects of the G are different:

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slide 10 If Congress raises G , the IS curve shifts right. IS 1 Response 1:   Hold  M   constant Y r LM 1 r 1 Y 1 If Fed holds M constant, then LM curve doesn’t shift. Results: 2 1 Y Y Y = - 2 1 r r r = -
slide 11 If Congress raises G , the IS curve shifts right. IS

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econ305_11_Nov04 - Context aggregate demand and supply...

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