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Applying the IS-LM Model
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Chapter 2
Eleven
The intersection of the IS curve and the LM
curve determines the level of national income,
and the interest rate for a given price level. If the
IS or LM curve shifts, the short-run equilibrium
LM
Chapter 3
Eleven
r
LM
IS
Chapter y 4
Eleven
+G Consider an increase in government purchases.
This will raise the level of income by G/(1- MPC)
r IS IS´ LM
B
A
The IS curve shifts to the right by G/(1- MPC) which raises income
and the interest rate.
Chapter 5
Eleven
-T Consider a decrease in taxes of T.
This will raise the level of income by
T × MPC/(1- MPC)
r IS IS´ LM
B
A
Chapter y 7
Eleven
+M Consider an increase in the money supply.
r IS LM
LM
A
B
Y
The LM curve shifts downward and lowers the interest rate which raises
income. Why? Because when the Fed increases the supply of money, people
have more money than they want to hold at the prevailing interest rate. As a
result, they start depositing this extra money in banks or use it to buy bonds.
The interest rate r then falls until people are willing to hold all the extra
money that the Fed has created; this brings the money market to a new
equilibrium. The lower interest rate, in turn, has ramifications for the goods
market. A lower interest rate stimulates planned investment, which increases
planned expenditure, production, and income Y.
Chapter 8
Eleven
The IS-LM model shows that monetary policy influences income by
changing the interest rate. This conclusion sheds light on our analysis
of monetary policy in Chapter 9. In that chapter we showed that in
the short run, when prices are sticky, an expansion in the money
supply raises income. But we didn’t discuss how a monetary
expansion induces greater spending on goods and services—a process
called the monetary transmission mechanism.
The IS-LM model shows that an increase in the money supply lowers
the interest rate, which stimulates investment and thereby expands the
demand for goods and services.
Chapter 9
Eleven
The IS-LM model shows how monetary and fiscal policy influence
the equilibrium level of income. The predictions of the model,
however, are qualitative, not quantitative. The IS-LM model that
shows that increases in government purchases raise GDP and that
increases in taxes lower GDP. But, when economists analyze specific
policy proposals, they must know the direction and size of the effect.
Macroeconometric models describe the economy quantitatively,
rather than just qualitatively.
Chapter 10
Eleven
Chapter 11
Eleven
You probably noticed from the IS and LM diagrams that r and Y were on
the two axes. Now we’re going to bring a third variable, the price level
(P) into the analysis. We can accomplish this by linking both two-
dimensional graphs.
r IS LM(P2) To derive AD, start at point A in the top
LM(P1) graph. Now increase the price level from P1
B to P2.
An increase in P lowers the value of real money
A balances, and Y, shifting LM leftward to point B.
Notice that r increased. Since r increased, we know
P Y that investment will decrease, as it just got more
costly to take on various investment projects. This
P2 B sets off a multiplier process since -I causes a –Y.
P1 A The - Y triggers -C as we move up the IS curve.
AD The +P triggers a sequence of events that end
Chapter
Y with a -Y, the inverse relationship that defines
12
Eleven the downward slope of AD.
+G Y = C (Y-T) + I(r) + G
Suppose there is a +G.
Now it’s time to determine the effects on the variables in the economy.
For the variables Y, P, and r, you can read the effects right off the diagrams.
LM(P2)
r IS IS´ LM(P0)
Y +, because Y moved from Y* to Y´ C
P 0, because prices are sticky in the SR. A B
r +, because a +Y leads to a rise in r
as IS slides along the LM curve.
C +, because a +Y increases the level of
LRAS Y
consumption (C=C(Y-T)). P
I – , since r increased, the level of
P2 C
investment decreased. B
P0 SRAS
A
AD´
AD
Chapter Y* Y´ Y 14
Eleven
For the variables Y, P, and r, you can read the effects right off the diagrams.
For the variables Y, P, and r, you can read the effects right off the diagrams.
Y 0, because rising P shifts LM to left, returning
r IS LM (P0)
Y to Y* as required by LRAS.
P +, in order to eliminate the excess demand at P . LM
r 0, reflecting the leftward shift in LM due
0
A= C
to +P, restoring r to its original level. B
C 0, since both Y and T are back to their initial
levels (C=C(Y-T)).
I 0, since Y or r has not changed. LRAS Y
P
P2 C
Notice that the only LR impact of an P0 B SRAS
increase in the money supply was an A AD´
increase in the price level. AD
Chapter
Y* Y´ Y 18
Eleven
Chapter 19
Eleven
IS' LM(P2) 1) +C causes the IS curve to shift
r IS LM(P0) right to IS‘.
C
Y = C (Y-T) + I(r) + G
2) This leads to a rightward shift in AD
to AD’.
Short Run:
Move from A to B.
LRAS Y Long Run:
P
Market clears at P0 to P2
P2 C
from B to C.
3) +P causes LM(P0) to shift leftward
P0 LRAS to LM(P2) due to the lowering of the
real value of the money supply.
AD AD' M/ P = L (r, Y)
Y
M
-L
Chapter 20
IS
Eleven
IS' LM(P2)
r IS LM(P0)
C
Short Long
Run: Run:
Y + 0
Y
P 0 +
P LRAS r + ++
P2 C C + +
I - --
P0
SRAS
AD AD'
Chapter
Eleven
Y 21
The spending hypothesis suggests that perhaps the cause of the
decline may have been a contractionary shift of the IS curve.
Chapter 24
Eleven
In the IS-LM model, falling prices raise income. For any given
supply of money M, a lower price level implies higher real
money balances, M/P. An increase in real money balances causes
an expansionary shift in the LM curve, which leads to higher
income.
Chapter 25
Eleven
There are two theories to explain how falling prices could depress
income rather than raise it.
Y
An expected deflation (a negative value of e) raises the real interest
rate for any given nominal interest rate, and this depresses investment
spending. The reduction in investment shifts the IS curve downward.
The level of income and the nominal interest rate (i) fall, but the real
interest rate (r) rises.
Chapter 27
Eleven
Monetary
Monetarytransmission
transmissionmechanism
mechanism
Pigou
PigouEffect
Effect
Debt-deflation
Debt-deflationtheory
theory
Chapter 28
Eleven