MACRO CHAPTER 12

APPLYING THE IS-LM MODEL

Equilibrium in the IS-LM model
 IS curve represents eq. in the goods market
o Y = C(Y-T’) + I(r) + G’
 LM curve represents money market eq.
o M’ / P’ = L(r,Y)
 the intersection determines the unique combination of Y and r that satisfies eq. in both
markets
 we can use the IS-LM model to analyze the effects of
o fiscal policy: G and/ or T
o monetary policy: M

A tax cut or an increase in G shifts IS to the right  increase in Y and interest rate.
An increase in MS  shifts LM down  raises income, but lowers interest rate.
Interaction between monetary and fiscal policy:
 in the model, the variables (M, G and T) are exogenous
 in the real world, monetary policymakers may adjust M in response to changes in
fiscal policy or vice versa
 Congress increases T (T > 0)
o the Fed
1. hold MS constant
2. adjust MS to hold r constant
3. adjust MS to hold Y constant
Response 1:
 tax increase shifts the IS curve left, but leaves the LM unchanged

Response 2:
 tax increase shifts the IS curve left, and the LM shifts left with it
Response 3:
 tax increase shifts the IS curve left, but the LM shifts to the right

Shocks in the IS-LM model

 IS shocks: exogeous changes in the demand for G&S
o stock market boom or crash (C)
o change in business or consumer confidence or expectations (I and/ or C)
 LM shocks: exogenous changes in the demand for money
o wave of credit card fraud  increase in MD
o more ATMs and the Internet  decrease in MD (technological change)
The Fed’s Policy Instrument
 the Fed targets the federal funds rate – the interest rate banks charge one another on
overnight loans
 the Fed changes MS and shifts the LM curve to achieve its interest rate target
 other short-term rates move with federal funds rate
IS-LM and AD
 the AD curve captures the relationship between P and Y
 a higher P shifts LM upward  lowers Y
 monetary policy shifting the AD curve
o increase in M  shifts LM right  lowers r  increases I  increases Y at
each value of P
 fiscal policy shifting the AD curve
o increase in G or a decrease in T  IS shifts right  increases Y at each value
of P
IS-LM (short run) and AD-AS (long run)
 in the short run prices are fixed:
o Y > Y’ P will rise
o Y < Y’  P will fall
o Y = Y’ P will remain constant
 Y’ = natural level of output

SR and LR effects of an IS shock

 negative IS shock shifts IS and AD left  Y decreases
 new short run eq.: Y < Y’
 P will fall over time  SRAS moves down M/P increases  LM moves down
 this goes on until economy reaches an eq. with Y=Y’

The Spending Hypothesis

 the Great Deppression was mainly due to an exogenous fall in the demand for G&S 
a leftward shift of the IS curve
 stock market crash reduced consumption
 drop in investment
 contractionary fiscal policy
The Money Hypothesis
 the Great Deppression was mainly due to the huge fall in the money supply
 this hypothesis is less credible than the other
Why another Deppression is unlikely
 policymakers know much more about macroeconomics
 federal deposit insurance makes widespread bank failures very unlikely
 automatic stabilizers  fiscal policy expansionary during economic downturn