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EC21A-Lecture_6_2009 - Intermediate Macroeconomics I...

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Unformatted text preview: Intermediate Macroeconomics I Macroeconomics EC21A (Econ 2002) Explaining Fluctuations Explaining with the IS-LM with Questions you should be able to answer Why is the IS curve insufficient by itself. What is the LM curve? What theory is used to derive the LM curve? Explain the Money Demand function. Explain the Money Supply function. Derive the LM curve. Explain the reason for slope of the LM curve. How does monetary policy affect the LM curve? Explain equilibrium in the IS-LM model. Explaining Fluctuations with IS-LM Model Recall: Intersection of IS and LM curve determines the level of national income. Shifts in IS or LM curve changes the SR equilibrium in economy and national income fluctuates. In this section, we examine how changes in policy and shocks to the economy can cause these curves to shift. Fiscal Policy in the IS-LM Model Fiscal Government can pursue a contractionary or Government an expansionary fiscal policy. an An expansionary policy (increased G) will An cause: cause: the IS curve to shift to the right (upwards) the an increase in both income and interest rate. Expansionary Fiscal Policy R 1. IS curve shifts 1. IS right by 1 MLR LM ×∆ G causing Y to rise. R2 2. R1 2. Increased Y raises 2. Md, causing R to causing rise. rise. 3. Higher R reduces I and 3. NX, so the final increase in Y is smaller than 1 ×∆ G MLR 1. IS1 Y1 Y2 Y3 3. IS2 Y Fiscal Policy in the IS-LM Model Fiscal The crowding-out effect The crowding-out effect Reduction in private investment and net exports Reduction resulting from an increase in government spending. resulting When income increases the interest rate will When increase. An increased interest rate causes firms to invest An less and net exports to fall. less Fiscal Policy in the IS-LM Model Fiscal The crowding-out effect The crowding-out effect Reduction in private investment and net exports Reduction resulting from an increase in government spending. spending. ↑ G →↑ AE →↑ Y →↑ MD →↑ R → ↓ ( I , NX ) →↓ AE →↓ Y Monetary Policy in the IS-LM Model Monetary The monetary authority can pursue a The contractionary or an expansionary policy. contractionary An expansionary policy (increased M) will cause: (increased the LM curve to shift to the right (downwards) the a decrease in interest rate and an increase income. Expansionary Monetary Policy 1. Increase in M shifts 1. the LM curve to LM the right. the R LM1 LM2 R1 2. The interest rate 2. The falls. 3. This causes I and This NX to rise and hence Y increases. hence R2 IS Y1 Y2 Y Monetary Policy in the IS-LM Model Monetary An expansionary monetary policy results in a decrease in interest rate and an increase in income. increase ↑ MS →↓ R →↑ ( I , NX ) →↑ AE →↑ Y Monetary Policy Response to an Expansionary Fiscal Policy Expansionary Suppose government decides to increase G. Suppose Possible responses by monetary authority: 1. Hold M constant 2. Hold R constant 3. Hold Y constant In each case, the effect of the ∆ G In is different: Response 1: Hold M constant Response R If government raises G, the IS curve shifts right. IS If BOJ holds M constant, If LM1 R2 R1 IS2 the LM curve does not LM shift. shift. IS1 Y1 Y2 Results: Y increases R increases increases Y Response 2: Hold R constant R LM1 If government raises G, If the IS curve shifts right. IS LM2 R2 R1 To keep R constant, To BOJ increases M to shift LM curve right. to Results: Y increases R is constant is No crowding out No because R is constant because IS2 IS1 Y1 Y2 Y3 Y Response 3: Hold Y constant Response If government raises G, If the IS curve shifts IS right. right. To keep Y constant, To BOJ reduces M to shift LM curve left. LM Results: R increases Y is constant is LM2 LM1 R R3 R2 R1 IS2 IS1 Y1 Y2 Y Effectiveness of Fiscal and Monetary Policy Monetary By effectiveness we mean how much does income change By in response to a policy change. in An effective fiscal policy means: A relatively small increase in G results in a large increase in Y relatively OR OR A relatively small decrease in G results in a large decrease in Y relatively An effective monetary policy means: A relatively small increase in M results in a large increase in Y relatively OR OR A relatively small decrease in M results in a large decrease in Y relatively Effectiveness of Fiscal Policy Effectiveness Recall that the path of an expansionary fiscal policy is: ↑ G →↑ AE →↑ Y →↑ MD →↑ R →↓ ( I , NX ) →↓ AE →↓ Y If the multiplier is high Y will increase substantially when G If increases. increases. If R increases significantly when Y increases (steeper MD and LM curve) then Y would fall back significantly. Therefore, the flatter the LM curve the more effective fiscal policy would be. flatter The less responsive investment and net exports are to changes The in the interest rate (steeper IS) the less Y will fall when interest rate increase. Therefore, the steeper the IS curve the more effective fiscal policy will be. effective Effectiveness of Fiscal Policy Effectiveness ↑G → ↑Y, ↑R Y, Assume now a flatter LM curve resulting from a flatter MD curve resulting Same results as above R LMS LMF R2 R3 R1 IS2 ↑G → ↑Y, ↑R Except that ↑Y is now more, ↑R is now less IS1 Y1 Y2 Y3 Y Effectiveness of Monetary Policy Effectiveness Recall that the path of an expansionary monetary policy is: ↑ MS →↓ R →↑ ( I , NX ) →↑ AE →↑ Y ↓ R →↑ ( I , NX ) determines the slope of the IS curve. IS The more responsive I and NX is to changes in the interest rate the flatter the IS curve. Therefore, monetary policy is IS monetary more effective when the IS curve is flatter. more The steeper the LM curve (steeper MD curve) the more The steeper effective monetary policy will be. This is so because the effective expansion in money supply will lead to a greater decrease in interest rate. Quick Quiz Quick If the demand for money is independent of If the interest rate, is the LM curve vertical or horizontal? horizontal? Does an increase in the money supply have Does strong or weak effects when the LM curve is steep than normal? steep When it is flatter than normal? Shocks in the IS-LM model Changes in fiscal and monetary policy shifts the IS and LM curve respectively. Other disturbances which are exogenous to the model can be grouped into two categories: shocks to the IS and shocks to the LM curve. Shocks in the IS -LM model IS IS shocks: exogenous changes in the aggregate exogenous expenditure. This would affect the equilibrium in the goods & services market . Examples: Stock market boom or crash ⇒ change in households’ wealth ⇒ ∆ Ca ⇒∆ C Change in business or consumer Change confidence or expectations ⇒ ∆ Ia ⇒ ∆ I and/or ⇒ ∆ Ca ⇒ ∆ C Shocks in the IS -LM model IS LM shocks: exogenous changes in the exogenous demand for money. This would affect the equilibrium in the money market . Examples: Examples: Households lose confidence in financial Households institutions. institutions. ⇒ rightward shift of the MD curve. rightward households demand more money at all households interest rate ⇒ LM curve shifts left. shifts Please Attempt Your Problem Sets Problem ...
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