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falls and the government takes a larger share of national output.
Chapter 11 Aggregate Demand II 111 LM1 r LM2
The policy mix in the early 1980s did exactly the opposite. Fiscal policy was
expansionary, while monetary policy was contractionary. Such a policy mix shifts
the IS curve to the right and the LM curve to the left, as in Figure 11–21. The real
interest rate rises and investment falls.
r2 IS 1
Figure 11–21 r IS2 LM2 Y Interest rate LM1
r1 Y1 B A
IS2 IS1 9. Chapter 11 Problem Y 6
# Y 1 Answer: Income, output 6. a. a. An increase in the money supply shifts thethe LM curve to rightright in the short run.
An increase in the money supply shifts LM curve to the the in the short run. This moves
theThis moves thepoint A to from pointFigure 11–22:in Figure 11–22: the from r1 to r2, and
economy from economy point B in A to point B the interest rate falls interest rate
falls from r1 to r2, and output rises from Y to Y2. The increase in output occurs
output rises from Y to Y2. The increase in output occurs because the lower interest rate stimulates
because the lower interest rate stimulates investment, which increases output. investment, which increases output. r Figure 11–22 Y= Y Interest rate LM1
r1 A r2 B IS
Y Y2 Y Income, output Since the level theoutput of now above its long-run level, prices beginprices begin to rise. level
Since of level is output is now above its long-run level, to rise. A rising price
A rising price level lowers real balances, which raises the interest rate. As indicated in Figure 11–22, the LM curve shifts back to the left. Prices continue to rise
until the economy returns to its original position at point A. The interest rate
returns to r1, and investment returns to its original level. Thus, in the long run,
there is no impact on real variables from an increase in the money supply. (This is
what we called monetary neutrality in Chapter 4.) b. An increase in government purchases shifts the IS curve to the right, and the economy moves b. from point A to point B, as shownpurchases11–23. In the S curve to the right, andfrom Y to
An increase in government in Figure shifts the I short run, output increases the
economy moves from point A to point B, as shown in Figure 11–23. In the short
Y2, and the interest rate increases from r1 to r2.
run, output increases from Y to Y2, and the interest rate increases from r1 to r2. Figure 11–23
r Y= Y LM2
LM1 Interest rate C
r2 B r1
Y Y Y2 Income, output The increase in the interest rate reduces investment and out” part of the expansionary
The increase in the interest rate reduces investment and “crowds “crowds out” part of the
expansionary effect of the increase in government purchases. Initially, the LM
effect of the increase in government purchases. Initially, the LM curve is not affected because
curve is not affected because government spending does not enter the
government spending does not enter the LM equation. After the increase, outputLM equa- longis above its
tion. After the increase, output is above its long-run equilibrium level, so prices
run equilibrium level, so prices begin to rise. The rise in prices reduces real balances, which shifts
begin to rise. The rise in prices reduces real balances, which shifts the LM curve
the toM curve toThe left. The interest rate risesmore more than in short run. This process
L the left. the interest rate rises even even than in the the short run. This process
continues until the long-long-run level of output is reached. At the newthe new equilibri- C,
continues until the run level of output is again again reached. At equilibrium, point
interest rates haveinterest rrates have risen to r , permanently higher. Note that, like monetary
um, point C, risen to 3, and the price level is and the price level is permanently
policy, fiscal policy cannot change the long-run level policy cannot change the long-run
higher. Note that, like monetary policy, fiscal of output. Unlike monetary policy,
however,of can change the composition policy, however, it can the level the composition point C
level it output. Unlike monetary of output. For example, change of investment at
of output. is at point A.
is lower than itFor example, the level of investment at point C is lower than it is at point A.
c. c. An increase in in taxes reduces disposable income for consumers, shiftingurve toS left,
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