Ch_11 - 1 CHAPTER 11 Aggregate Demand II Lecture...

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Unformatted text preview: 1 CHAPTER 11 Aggregate Demand II Lecture Note-Chapter 11 Aggregate Demand II: Applying the IS - LM Model University of Waterloo Department of Economics Spring 2010 2 CHAPTER 11 Aggregate Demand II Context Chapter 9 introduced the model of aggregate demand and supply. Chapter 10 developed the IS-LM model, the basis of the aggregate demand curve. In this chapter, you will learn: In this chapter, you will learn: 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. 4 CHAPTER 11 Aggregate Demand II 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 5 CHAPTER 11 Aggregate Demand II 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 6 CHAPTER 11 Aggregate Demand II 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. 7 CHAPTER 11 Aggregate Demand II 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. 8 CHAPTER 11 Aggregate Demand II 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. 9 CHAPTER 11 Aggregate Demand II 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. 10 CHAPTER 11 Aggregate Demand II The Fed’s response to ∆ G > 0 Suppose Congress increases G ....
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This note was uploaded on 11/25/2010 for the course ECON 202 taught by Professor Angelatrimarchi during the Spring '10 term at Waterloo.

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Ch_11 - 1 CHAPTER 11 Aggregate Demand II Lecture...

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