EC489.01
Special Topics in Economics:
Macroeconomics
Lecture 4

Applying the IS-LM Model
•
IS Curve representing the equilibrium in the
market for goods and services
–
Keynesian cross and Investment function
•
LM Curve representing the equilibrium in the
market for real money balances
–
The theory of liquidity preference and quantity-
equation interpretation
•
IS-LM model determine r & Y in the SR (fixed
prices)

Plan for Today
•
Potential causes of fluctuations in national
income:
–
Change in exogenous vars (G, T and M)
–
Shocks to goods market or to money market
–
Impact on endogenous vars: r and Y
•
Discuss how IS-LM model fits into AS-AD model
–
Slope and position of AD curve
–
Relaxing fixed price assumption showing the negative
relationship btw P and Y
•
Have a look into economic downturns
•
Aggregate supply and SR tradeoff btw inflation
and unemployment

Fiscal Policy, IS Curve and the Short
Run Equilibrium
•
Fiscal policy influences IS Curve through Keynesian
Cross
•
uni0394Guni2191 uni003Duni003E Planned Expenditure shig332s (Keynesian
Cross) uni003Duni003E IS Curve shifts uni0394G/(1-MPC) (multiplier
effect)
•
uni0394Guni2191 uni003Duni003E Euni2191 uni003Duni003E Yuni2191 uni003Duni003E runi2191 uni003Duni003E I↓ uni003Duni003E Y ↓
•
Goods marketuni003Duni003EMoney marketuni003Duni003EGoods market
•
Crowding out of investment due to higher r
•
Same story for tax decrease expect shift in IS curve
is uni0394T*MPC/(1-MPC)

•
An increase in Money Supply shifts LM curve
downward for any given level of income,
lowering the interest rate
•
Muni2191uni003Duni003Er↓uni003Duni003EIuni2191uni003Duni003EYuni2191
Monetary Policy, LM Curve and the
Short Run Equilibrium
•
Monetary expansion leads to higher spending:
Monetary transmission mechanism
•
(Close economy assumption-ignoring the
exchange rate)

Interaction between Monetary and
Fiscal Policy
•
Coordination of policymakers
•
An example: Tax increase
–
How does CB react?
•
Constant money supply: lower interest partially
offsetting the tax hike
•
Constant interest rate: deepens recession due to
keeping interest rate high
•
Constant income: Recession avoided, but allocation of
resources changed (higher investment, lower
consumption)