H_-_Business_Cycle_Theory_2

H_-_Business_Cycle_Theory_2 - Business Cycle Theory 2...

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Unformatted text preview: Business Cycle Theory 2 Winter 2011 UCLA Professor Mark Wright The IS- LM / AD-AS Model Winter 2011 UCLA Professor Mark Wright In this section, you will learn how to use the IS-LM model to analyze the effects of shocks, fiscal policy, and monetary policy Bush tax rebate 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 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 Feds 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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H_-_Business_Cycle_Theory_2 - Business Cycle Theory 2...

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