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A G G R E G AT E D E M A N D - I I : A P P LY I N G T H E
IS-LM MODEL
C O U R S E T E AC H E R :
D R . TA M G I D A H M E D C H OW D H U RY
A S S O C I AT E P R O F E S S O R , S B E
OBJECTIVES OF THE CHAPTER
Y C (Y T ) I (r ) G
r1
The LM curve represents money
market equilibrium.
IS
M P L (r ,Y )
Y
Y1
The intersection determines
the unique combination of Y and r
that satisfies equilibrium in both markets.
POLICY ANALYSIS WITH THE IS - LM MODEL
Y C (Y T ) I (r ) G r
LM
M P L (r ,Y )
Policymakers can affect macroeconomic
variables with r1
• fiscal policy: G and/or T
• monetary policy: M
IS
We can use the IS-LM model to analyze Y
Y1
the effects of these policies.
AN INCREASE IN GOVERNMENT PURCHASES
1. IS curve shifts right r
1 LM
by G
1 MPC
r2
causing output & income to rise.
2.
r1
2. This raises money demand, causing the
interest rate to rise… 1. IS2
IS1
Y
3. …which reduces investment, so the final increase in Y Y1 Y2
3.
1
is smaller than G
1 MPC
A TAX CUT
Because consumers save (1MPC) r
of the tax cut, the initial boost in LM
spending is smaller for T than for
an equal G…
r2
and the IS curve 2. r
shifts by 1
1. IS2
MPC
1. T IS1
1 MPC Y
Y1 Y2
2. …so the effects on r and Y are 2.
smaller for a T than for an equal
G.
MONETARY POLICY: AN INCREASE IN M
r
1. M > 0 shifts LM1
the LM curve down
LM2
(or to the right)
r1
2. …causing the interest rate to fall
r2
• Model:
monetary & fiscal policy variables
(M, G and T ) are exogenous
• Real world:
Monetary policymakers may adjust M
in response to changes in fiscal policy,
or vice versa.
• Such interaction may alter the impact of the original policy
change.
THE CENTRAL BANK’S (BB) RESPONSE TO G > 0
• Suppose ministries increase G.
• Possible BB responses:
1. hold M constant
2. hold r constant
3. hold Y constant
If ministry raises G, r
If BB holds M constant, r2
then LM curve doesn’t r1
shift. IS2
Results: IS1
Y
Y Y 2 Y1 Y1 Y 2
r r2 r1
RESPONSE 2: HOLD R CONSTANT
If Ministry raises G, r
To keep r constant, BB r2
increases M to shift LM r1
r 0
RESPONSE 3: HOLD Y CONSTANT
LM2
If Ministry raises G, r
r3
To keep Y constant, BB r2
reduces M to shift LM curve r1
left. IS2
Results: IS1
Y
Y 0 Y1 Y2
r r3 r1
EXERCISE:
ANALYZE SHOCKS WITH THE IS-LM MODEL
r LM(M1/P1)
The BB can increase aggregate
r1 LM(M2/P1)
demand:
M LM shifts right r2
IS
r
Y1 Y2 Y
I P
Y at each
P1
value of P
AD2
AD1
Y1 Y2 Y
FISCAL POLICY AND THE AD CURVE
r
Expansionary fiscal policy (G LM
and/or T ) increases agg. r2
demand: r1 IS2
T C IS1
IS shifts right Y1 Y2 Y
P
Y at each
value of P P1
AD2
AD1
Y1 Y2 Y
THE SR AND LR EFFECTS OF AN IS SHOCK
r LRAS LM(P1)
IS1
A negative IS shock shifts IS IS2
and AD left, causing Y to fall. Y
Y
P LRAS
P1 SRAS1
AD1
AD2
Y Y
THE SR AND LR EFFECTS OF AN IS SHOCK
r LRAS LM(P1)
In the new short-run
equilibrium, Y Y
IS1
IS2
Over time, Y Y
P gradually falls, which causes P LRAS
• SRAS to move down
• M/P to increase, which P1 SRAS1
causes LM
to move down AD1
AD2
Y Y
THE SR AND LR EFFECTS OF AN IS SHOCK
r LRAS LM(P1)
LM(P2)
This process continues until
economy reaches a long-run IS1
equilibrium with IS2
Y Y Y Y
P LRAS
P1 SRAS1
P2 SRAS2
AD1
AD2
Y Y
EXERCISE: ANALYZE SR & LR EFFECTS OF M
a. Draw the IS-LM and AD-AS diagrams r LRAS LM(M1/P1)
as shown here.
b. Suppose Fed increases M. Show the
short-run effects on your graphs. IS
c. Show what happens in the transition
Y Y
from the short run to the long run.
P LRAS
d. How do the new long-run equilibrium
values of the endogenous variables
P1 SRAS1
compare to their initial values?
AD1
Y Y
THE GREAT DEPRESSION
240 30
Unemployment
220 (right scale) 25
billions of 1958 dollars
180 15
160 10
Real GNP
140 5
(left scale)
120 0
1929 1931 1933 1935 1937 1939
THE SPENDING HYPOTHESIS:
SHOCKS TO THE IS CURVE
• asserts that the Depression was largely due to huge fall in the
money supply
• evidence:
M1 fell 25% during 1929-33.
But, two problems with this hypothesis:
1. P fell even more, so M/P actually rose slightly during 1929-31.
2. nominal interest rates fell, which is the opposite of what would
result from a leftward LM shift.
WHY ANOTHER DEPRESSION IS UNLIKELY
• Policymakers (or their advisors) now know
much more about macroeconomics:
The Fed knows better than to let M fall
so much, especially during a contraction.
Fiscal policymakers know better than to raise taxes or cut spending
during a contraction.
• Federal deposit insurance makes widespread bank failures very unlikely.
• Automatic stabilizers make fiscal policy expansionary during an
economic downturn.