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Unformatted text preview: Business Cycle Theory 2 Winter 2011 UCLA Professor Mark Wright The IS LM / ADAS Model Winter 2011 UCLA Professor Mark Wright In this section, you will learn… how to use the ISLM model to analyze the effects of shocks, fiscal policy, and monetary policy – Bush tax rebate how to derive the aggregate demand curve from the ISLM 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 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 M P C 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 M P C G 3. IS 1 1. The Bush Tax rebate 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 M P C T 1. 2. 2. …so the effects on r and Y are smaller for T than for an equal G . 2. 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. 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. 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: If Congress raises G , the IS curve shifts right....
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 Winter '08
 Serra
 Fiscal Policy, ISLM Model, Monetary Policy, lm curve, Fed, LM

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