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Thus monetary policy under a fixed exchange rate

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Unformatted text preview: hey expect a recession. According to the theory of liquidity preference, when money demand rises, the interest rate necessary to equilibrate the money market is higher. Hence, an increase in money demand shift the LM curve upward, which causes the recession that individuals had feared. In chapter 9 we used the quantity theory of money to derive the aggregate demand curve, the relationship between the price level and the level of national income. We now use the IS- LM model to show why national income falls as the price level rises – that is, why the AD curve is downward sloping. We examine what happens in the IS- LM model when the price level changes. For any given money supply M, a higher price level P reduces the supply of real money balance M/P. This shifts the LM curve upward, which raises r and lowers Y. The price level rises from P1 to P2, and income falls from Y1 to Y2. Therefore, AD slopes downward. The AD curve shows the set of equilibrium points that arise in the IS- LM model as we vary the price level and see what happens to income. Because the AD curve is merely a summary of results from the IS- LM model, events that shift IS or LM (for a given price level) cause the aggregate demand curve to shift. An increase in the money supply raises income for a given price level, thus it shifts AD right, as does an increase in government purchases or a decrease in taxes. Conversely, a decrease in the money supply, a decrease in government purchases, or an increase in taxes lowers income in the IS- LM model and shifts the aggregate demand curve to the left. Factors shifting the aggregate demand curve include not only monetary and fiscal policy but also shocks to the goods market (the IS curve) and shocks to the money market (the LM curve). A change in income in the IS- LM model resulting from a change in the price level represents a movement along the aggregate demand curve. A change in income in the IS- LM model for a fixed price level represents a shift in the position of the aggregate demand curve. We can adjust the IS- LM model to apply to the long run by inserting the LRAS curve at the natural level of output Y¯,. This is the level of output that emerges when the market-...
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