Ch_11 - AggregateDemandII University of Waterloo Department...

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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
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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.
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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.
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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
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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
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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.
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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.
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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.
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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.
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10 CHAPTER 11 Aggregate Demand II 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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11 CHAPTER 11 Aggregate Demand II If Congress raises G , the IS curve shifts right.
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