macro-ISLM1-2

# macro-ISLM1-2 - Cooleconomics.com macro-ISLM1 Cooleconomics...

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Cooleconomics.com macro-ISLM1 © Michael Francis Williams. Authorized use is encouraged; unauthorized use is prohibited. Cooleconomics Macroeconomics A Short Run Model of a Closed Economy: the IS-LM model Equilibrium in a closed economy (no NX) in the short run: In short run equilibrium, two important conditions are met: ! Condition 1. real Aggregate demand = real GDP, or C + I + G = Y -- This is known as product market equilibrium . ! Condition 2. real Money demand = real Money Supply, or L(r,Y) = M s /P --This is known as money market equilibrium It is sometimes useful to view the short run economy using a graph, known as an IS-LM diagram . The IS-LM diagram lets us view the product market separately from the money market on one graph; this may help us to better understand the short run effects of fiscal and monetary policy on the economy. Important Assumption: Sticky Prices For now, we’ll assume that the average price level is constant when using the IS-LM model. This is a simplification, but it emphasizes an important truth; prices tend to rise or fall less in the short run than in the long run.

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macro-ISLM1.doc © 2001 Michael Francis Williams. Authorized use is encouraged; unauthorized use is prohibited. 2 And Now, the IS-LM Model (for a closed economy) Preview : The IS Curve: The IS curve depicts all combinations of the real interest rate and real GDP at which aggregate demand equals output. It depicts product market equilibrium . The IS curve depicts all (r, Y) combinations such that C + I + G = Y. LM IS GDP,NI real interest rate r 0 Y 0
macro-ISLM1.doc © 2001 Michael Francis Williams. Authorized use is encouraged; unauthorized use is prohibited. 3 The IS curve slopes downward. Why? Pick a point on the upper portion of the IS curve—say, point A depicted below. Notice that the real interest rate is at level r A , and the GDP level is at Y A . Now suppose that something happens in the economy (say, an increase in the money supply) which reduces the real interest rate to r B . What must happen to GDP in order to keep aggregate demand equal to GDP—to maintain product market equilibrium? Answer: GDP must increase, bigger than its level at Y A . Here’s why: Why The IS Curve Slopes Downward real interest rate falls from r A to r B (say, due to money supply increase) Consumption and investment rise. (It’s cheaper to borrow.) Aggregate demand rises (since C and I are important components of AD) GDP must increase from Y A to Y B to keep production equal to aggregate demand IS GDP,NI real interest rate r A Y A r B Y B A B

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macro-ISLM1.doc © 2001 Michael Francis Williams. Authorized use is encouraged; unauthorized use is prohibited. 4 Shifting the IS Curve: Events that increase or decrease aggregate demand at any real interest rate cause the IS curve to shift—leftward if aggregate demand diminishes, rightward if aggregate demand increases. Here’s a list: Events that shift the IS curve to the right: 1. A cut in household tax rates 2. An increase in household transfer payments
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## This note was uploaded on 12/06/2010 for the course ECON 3020 taught by Professor Williamson during the Spring '10 term at FSU.

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macro-ISLM1-2 - Cooleconomics.com macro-ISLM1 Cooleconomics...

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