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Macroeconomics
ECO 403
VU
LESSON
28
AGGREGATE
DEMAND AND AGGREGATE SUPPLY
(Continued...)
The
Big Picture
Keynesian
IS
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
Y
The
LM curve
represents money market
equilibrium
M
P = L
(r ,Y
)
LM
r
r1
IS
Y
Y1
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
r
LM
r2
2.
r1
1.
IS2
IS1
Y
Y1
Y2
3.
1
ΔG, causing
output & income to
rise.
(1-MPC)
1.
IS curve
shifts right by
1
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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Macroeconomics
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A
tax cut
r
LM
r2
2.
r1
1.
IS2
IS1
Y
Y1
Y2
2.
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
1
ΔT
1.
(1-MPC)
2.
...so the effects on r and Y
are smaller for a ΔT than
for an equal ΔG.
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Macroeconomics
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Monetary
Policy: an increase in M
r
LM1
LM2
r1
r2
IS
Y
Y2
Y1
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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Macroeconomics
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r
LM1
r2
r1
IS2
IS1
Y
Y1
Y2
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
r
LM1
LM2
r2
r1
IS2
IS1
Y
Y1
Y2
Y3
to
shift LM
curve
right.
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Macroeconomics
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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.
r
LM2
LM1
r3
r2
r1
IS2
IS1
Y
Y1
Y2
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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Macroeconomics
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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?
1)
They
are easier to measure than
the money supply
2)
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)
r
LM
(P1)
r2
r1
IS
Y1
Y
Y2
P
P2
P1
AD
Y
Y2
Y1
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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Macroeconomics
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LM
(M1/P1)
r
LM
(M2/P1)
r1
r2
IS
Y2
Y
Y1
P
P1
AD2
AD1
Y
Y1
Y2
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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r
LM
r2
r1
IS2
IS1
Y
Y2
Y1
P
P1
AD2
AD1
Y
Y2
Y1
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