E2000 - Chapter 11 Notes - ECON 2000 Chapter 11 Aggregate Demand 2 Applying the IS-LM Model Notes Explaining the Fluctuations with the IS-LM model

E2000 - Chapter 11 Notes - ECON 2000 Chapter 11 Aggregate...

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ECON 2000 Chapter 11 – Aggregate Demand 2: Applying the IS-LM Model Notes Explaining the Fluctuations with the IS-LM model Intersection of IS curve and LM curve determines the level of national income. o When one curve shits, equilibrium changes and national income fluctuates. How Fiscal Policy Shifts the IS Curve and Changes the Short-Run Equilibrium o Changes in fiscal policy influence planned expenditure and thereby shift the IS curve. o Changes in Government Purchases Increase in G, level of income at any given interest rate increases by delta- G/(1-MPC) IS curve shifts to right by this amount and at new point, and both interest rate and income higher at new equilibrium point. When G rises, planned expenditure rises and this stimulates higher production and raises Y as well (Keynesian Cross). Rise in income raises interest rates (theory of liquidity preference) keeping supply of money fixed. Rise in interest rate crowds out some investment, thus increase in income in response to fiscal expansion is smaller in IS-LM model than in Keynesian cross (where investment assumed to be fixed). o In other words, new equilibrium experiences less of an increase in income in IS-LM than Keynesian cross. o Changes in Taxes Taxes affect expenditure through consumption (and have same kind of effect as G). Decrease in taxes increases planned expenditure and raises level of income by (delta-T*MPC) / (1-MPC) IS curve shifts right by this amount. Tax cur raises both income and interest rate, and this higher interest rate depresses investment, therefore, increase in income is smaller in IS-LM model than in Keynesian cross. How Monetary Policy Shifts the LM Curve and Changes the Short-Run Equilibrium o Increase in money supply increases in real money balances M/P for fixed level of P in short run for given level of income, increase in real money balances leads to lower interest rate therefore, LM curve shifts downward. Increase in money supply lowers interest rate and raises level of income (in short run) When money supply increases, people deposit it in banks until interest rate falls enough for people to hold extra money that central bank has created. Lower interest rate stimulates investment and raises planed expenditure, production and income Y. o Thus, monetary policy influences income by changing the interest rate.

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