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Unformatted text preview: 1 CHAPTER 11 Aggregate Demand II Lecture NoteChapter 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 ISLM model, the basis of the aggregate demand curve. In this chapter, you will learn: In this chapter, you will learn: how to use the ISLM model to analyze the effects of shocks, fiscal policy, and monetary policy. how to derive the aggregate demand curve from the ISLM 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 ISLM 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.
 Spring '10
 AngelaTrimarchi
 Economics

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