Aggregate Demand II student

# Aggregate Demand II student - Aggregate Demand II Click to...

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Topic Overview 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
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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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
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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IS 1 1. A tax cut Y   r LM r 1 Y 1 IS 2 Y 2 r 2 Consumers save MPC ) of the tax cut, so the initial boost in spending is smaller for l T than for an equal l G and the IS curve shifts by MPC 1 MPC T - - 1. 2. 2. …so the effects on r and Y are smaller for l T than for an equal l G . 2.
2. causing the interest rate to fall IS Monetary policy: An increase in M 1. l M > 0 shifts the LM curve down 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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Interaction between 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.
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 l G

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If Congress raises G , the IS curve shifts right. IS 1 Response 1: Hold M constant Y   r LM 1 r 1 Y 1 IS 2 Y 2 r 2 If Fed holds M constant, then LM curve doesn’t shift. Results: 2 1 Y Y Y = - 2 1 r r r = -
If Congress raises G , the IS curve shifts right. IS 1 Response 2: Hold r constant Y   r LM 1 r 1 Y 1 IS 2 Y 2 r 2 To keep r constant, Fed increases M to shift LM curve right. Obj109 0 r = LM 2 Y 3 Results:

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IS 1 Response 3: Hold Y constant Y   r LM 1 r 1 IS 2 Y 2 r 2 To keep Y constant, Fed reduces M to shift LM curve left. 0 Y = 3 1 r r r = - LM 2 Results: Y 1 r 3 If Congress raises G , the IS curve shifts right.
Estimates of fiscal policy multipliers from the DRI macroeconometric model Assumption about monetary policy Estimated value of Y / G Fed holds nominal interest rate constant Fed holds money supply constant 1.93 0.60 Estimated value of Y / T l 1.19 l 0.2 6

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Shocks in the IS - LM model IS shocks : exogenous changes in
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Aggregate Demand II student - Aggregate Demand II Click to...

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