# ch11 - In this chapter, you will learn how to use the IS-LM...

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slide 0 CHAPTER 11 Aggregate Demand II 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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slide 1 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 r LM 1
slide 2 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 r LM 1

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slide 3 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 1 2 2 1. 2. This raises money demand, causing the interest rate to rise… 2. 3. …which reduces investment, so the final increase in Y 3.
slide 4 CHAPTER 11 Aggregate Demand II IS 1 1. A tax cut Y r LM 1 2 2 Consumers save (1- MPC ) of the tax cut, so the initial boost in spending is smaller for Δ T than for an equal Δ G and the IS curve shifts by 1. 2. 2. …so the effects on r and Y are smaller for Δ T than for an equal Δ G . 2.

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slide 5 CHAPTER 11 Aggregate Demand II 2. …causing the interest rate to fall IS Monetary policy: An increase in M 1. Δ M > 0 shifts the LM curve down (or to the right) Y r LM 1 1 2 2 3. …which increases investment, causing output & income to rise.
slide 6 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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slide 7 CHAPTER 11 Aggregate Demand II The Fed’s response to Δ 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 Δ G are different:
slide 8 CHAPTER 11 Aggregate Demand II If Congress raises G , the IS curve shifts right. IS 1 Response 1: Hold M constant Y r LM 1 2 2 If Fed holds M constant, then LM curve doesn’t shift. Results:

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slide 9 CHAPTER 11 Aggregate Demand II If Congress raises G , the IS curve shifts right. IS 1 Response 2: Hold r constant Y LM 1 2 2 To keep r constant, Fed increases M to shift LM curve right. 3 Results: