# 302-11 - C H A P T E R Aggregate Demand II Applying the IS...

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Unformatted text preview: C H A P T E R Aggregate Demand II: Applying the IS - LM Model University of Wisconsin Charles Engel 11 CHAPTER 11.01 slide 2 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 CHAPTER 11.01 slide 3 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 CHAPTER 11.01 slide 4 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. CHAPTER 11.01 slide 5 IS 1 1. A tax cut Y r LM r 1 Y 1 IS 2 Y 2 r 2 The IS curve shifts by 2. 2. … r rises so the final increase in Y is smaller than the direct effect of a tax cut. 2. MPC 1 MPC T- ∆- 1. CHAPTER 11.01 slide 6 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. CHAPTER 11.01 slide 7 The Housing Boom - Krainer Housing investment is one of the most interest sensitive components of overall investment. Between May, 2000 and June, 2003, the Fed lowered the “Fed funds rate” 13 times from 6.5% to 1.0%. Krainer: housing investment depends not only on interest rates, but also on the level of GDP. What does our model say happens to housing investment when the money supply increases? CHAPTER 11.01 slide 8 When is a Rate Hike Not Tighter Policy? -- Altig Between June, 2003 and June, 2006, the Fed raised the Fed funds rate 17 times from 1.0% to 5.25%. Does this necessarily indicate tighter policy by the Fed? That is, is the LM curve necessarily shifting to the left? CHAPTER 11.01 slide 9 Interaction between monetary & fiscal policy 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. CHAPTER 11.01 slide 10 The Fed’s response to ∆ G > 0 Suppose Congress increases G ....
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## This note was uploaded on 07/28/2010 for the course ECON 302 taught by Professor Gold during the Spring '07 term at University of Wisconsin.

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302-11 - C H A P T E R Aggregate Demand II Applying the IS...

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