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Aggregate Demand II: Applying the IS-LM Model 12CHAPTER 1CHAPTER 12 Aggregate Demand II Context § Chapter 10 introduced the model of aggregate demand and supply. § Chapter 11 developed the IS-LM model, the basis of the aggregate demand curve. IN THIS CHAPTER, YOU WILL LEARN: § how to use the IS-LM model to analyze the effects of shocks, fiscal policy, and monetary policy § how to derive the aggregate demand curve from the IS-LM model § several theories about what caused the Great Depression 2 3CHAPTER 12 Aggregate Demand II The intersection determines the unique combination of Y and r that satisfies equilibrium in both markets. The LM curve represents money market equilibrium. Equilibrium in the IS-LM model The IS curve represents equilibrium in the goods market. Y C Y T I r G= - + +( ) ( ) ( , )M P L r Y= IS Y r LM r1 Y1 4CHAPTER 12 Aggregate Demand II Policy analysis with the IS-LM model We can use the IS-LM model to analyze the effects of • fiscal policy: G and/or T • monetary policy: M Y C Y T I r G= - + +( ) ( ) ( , )M P L r Y= IS Y r LM r1 Y1 5CHAPTER 12 Aggregate Demand II causing output & income to rise. IS1 An increase in government purchases 1. IS curve shifts right Y r LM r1 Y1 GD - 1by 1 MPC IS2 Y2 r2 1. 2. This raises money demand, causing the interest rate to rise… 2. 3. …which reduces investment, so the final increase in Y GD - 1is smaller than 1 MPC 3. 6CHAPTER 12 Aggregate Demand II IS1 1. A tax cut Y r LM r1 Y1 IS2 Y2 r2 Consumers save (1−MPC) of the tax cut, so the initial boost in spending is smaller for ΔT than for an equal ΔG… and the IS curve shifts by T- D -1 MPC MPC 1. 2. 2. …so the effects on r and Y are smaller for ΔT than for an equal ΔG. 2. 7CHAPTER 12 Aggregate Demand II 2. …causing the interest rate to fall IS Monetary policy: An increase in M 1. ΔM > 0 shifts the LM curve down (or to the right) Y r LM1 r1 Y1 Y2 r2 LM2 3. …which increases investment, causing output & income to rise. 8CHAPTER 12 Aggregate Demand II 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 interactions may alter the impact of the original policy change. 9CHAPTER 12 Aggregate Demand II The Fed’s response to ΔG > 0 § Suppose Congress increases G. § Possible Fed responses: 1. hold M constant 2. hold r constant 3. hold Y constant § In each case, the effects of the ΔG are different… 10CHAPTER 12 Aggregate Demand II If Congress raises G, the IS curve shifts right. IS1 Response 1: Hold M constant Y r LM1 r1 Y1 IS2 Y2 r2 If Fed holds M constant, then LM curve doesn’t shift. Results: 2 1Y Y YD = - 2 1r r rD = - 11CHAPTER 12 Aggregate Demand II If Congress raises G, the IS curve shifts right. IS1 Response 2: Hold r constant Y r LM1 r1 Y1 IS2 Y2 r2 To keep r constant, Fed increases M to shift LM curve right. 3 1Y Y YD = - 0rD = LM2 Y3 Results: 12CHAPTER 12 Aggregate Demand II IS1 Response 3: Hold Y constant Y r LM1 r1 IS2 Y2 r2 To keep Y constant, Fed reduces M to shift LM curve left. 0YD = 3 1r r rD = - LM2 Results: Y1 r3 If Congress raises G, the IS curve shifts right. 13CHAPTER 12 Aggregate Demand II Shocks in the IS-LM model IS shocks: exogenous changes in the demand for goods & services. Examples: § stock market boom or crash g change in households’ wealth g ΔC § change in business or consumer confidence or expectations g ΔI and/or ΔC 14CHAPTER 12 Aggregate Demand II Shocks in the IS-LM model 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. NOW YOU TRY Analyze shocks with the IS-LM model Use the IS-LM model to analyze the effects of 1. a housing market crash that reduces consumers’ wealth 2. consumers using cash in transactions more frequently in response to an increase in identity theft For each shock, a. use the IS-LM diagram to determine the effects on Y and r. b. figure out what happens to C, I, and the unemployment rate.