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Macroeconomics ECO 403

LESSON 28

AGGREGATE DEMAND AND AGGREGATE SUPPLY (Continued...)

The Big Picture

Keynesian

Cross

curve

Explanation of

IS-LM

model

short-run

Theory of

fluctuations

LM curve

Liquidity

Preference

Aggregate.

demand

curve

Model of aggregate

demand and

aggregate supply

Aggregate.

supply

curve

Equilibrium in the IS-LM Model

The IS curve represents equilibrium in the goods market.

Y = C ( -T ) + I (r ) + G

The LM curve represents money market equilibrium

M P = L (r ,Y )

The intersection determines the unique combination of Y and r that satisfies equilibrium in both

markets.

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Policy analysis with the IS-LM Model

Policymakers can affect macroeconomic variables with

· fiscal policy: G and/or T

· monetary policy: M

We can use the IS-LM model to analyze the effects of these policies.

An increase in government purchases

IS2

IS1

ΔG, causing output & income to rise.

(1-MPC)

1. IS curve shifts right by

2. This raises money demand, causing the interest rate to rise

(1-MPC) ΔG.

3. ...which reduces investment, so the final increase in Y is smaller than

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A tax cut

IS2

IS1

Because consumers save (1-MPC) of the tax cut, the initial boost in spending is smaller for ΔT

than for an equal ΔG... and the IS curve shifts by

ΔT

(1-MPC)

2. ...so the effects on r and Y are smaller for a ΔT than for an equal ΔG.

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Monetary Policy: an increase in M

LM1

LM2

1. ΔM > 0 shifts the LM curve down (or to the right)

2. ...causing the interest rate to fall

3. ...this increases investment, causing output & income to rise.

Interaction between monetary & fiscal policy

· 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.

Central Bank's response to ΔG > 0

· Suppose Government increases G.

· Possible central bank responses:

1. Hold M constant

2. Hold r constant

3. Hold Y constant

· In each case, the effects of the ΔG are different:

Response 1: hold M constant

If Government raises G, the IS curve shifts right. If central bank holds M constant, then LM

curve doesn't shift.

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LM1

IS2

IS1

Results:

Δr = r2 - r1

ΔY = Y 2 - Y1

Response 2A: hold r constant

If Government raises G, the IS curve shifts right. To keep r constant, central bank increases M

LM1

LM2

IS2

IS1

to shift LM curve right.

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ΔY = Y 3 - Y1

Δr = 0

Results:

Response2B: hold Y constant

If Government raises G, the IS curve shifts right. To keep Y constant, central Bank reduces M

to shift LM curve left.

LM2

LM1

IS2

IS1

ΔY = 0

Δr = r3 - r1

Results:

Shocks in the IS-LM Model

IS shocks: exogenous changes in the demand for goods & services.

Examples:

Stock market boom or crash

⇒ change in households' wealth

⇒ ΔC

Change in business or consumer

confidence or expectations

⇒ ΔI and/or ΔC

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LM shocks: exogenous changes in the demand for money.

Examples:

A wave of credit card fraud increases demand for money

More ATMs or the Internet reduce money demand

Analyzing shocks with the IS-LM model

Use the IS-LM model to analyze the effects of

A boom in the stock market makes consumers wealthier.

After a wave of credit card fraud, consumers use cash more frequently in transactions.

For each shock,

Use the IS-LM diagram to show the effects of the shock on Y and r.

Determine what happens to C, I, and the unemployment rate.

What is the central bank's policy instrument?

· What the newspaper says:

"The central bank lowered interest rates by one-half point today"

· What actually happened:

The central bank conducted expansionary monetary policy to shift the LM curve to the

right until the interest rate fell 0.5 points.

· The central bank targets the discount rate: it announces a target value, and uses

monetary policy to shift the LM curve as needed to attain its target rate.

Why does the central bank target interest rates instead of the money supply?

They are easier to measure than the money supply

The central bank might believe that LM shocks are more prevalent than IS shocks.

If so, then targeting the interest rate stabilizes income better than targeting the

money supply.

IS-LM and Aggregate Demand

· So far, we've been using the IS-LM model to analyze the short run, when the price

level is assumed fixed.

· However, a change in P would shift the LM curve and therefore affect Y.

· The aggregate demand curve captures this relationship between P and Y

Deriving the AD curve

Intuition for slope of AD curve:

↑P

⇒ ↓(M/P)

⇒ LM shifts left

⇒ ↑r

⇒ ↓I

⇒ ↓Y

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LM (P2)

LM (P1)

Monetary policy and the AD curve

The central bank can increase aggregate demand:

↑M ⇒ LM shifts right

⇒ ↓r

⇒ ↑I

⇒ ↑Y at each value of P

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LM (M1/P1)

LM (M2/P1)

AD2

AD1

Fiscal policy and the AD curve

Expansionary fiscal policy (↑G and/or ↓T) increases aggregate demand:

↓T ⇒ ↑C

⇒ IS shifts right

⇒ ↑Y at each value of P

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IS2

IS1

AD2

AD1

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