Applying the IS-LM model (CHAPTER 11)

Applying the IS-LM model (CHAPTER 11)

1. Causes of Fluctuations in national income (Y)

   • Use IS-LM Model to study effect of SHOCKS, MONETARY POLICY, and FISCAL POLICY
     • Reminder: Fluctuations are caused by shocks, monetary and fiscal policy used to counter
   • Equilibrium in IS-LM Model
     • *IS is represents the goods market equilibrium
       • Y = [(a - cT(-) + d +G(-)) / (1/(1-c))] + [(e/1-c) x r]
     • *LM is represents money market equilibrium
       • r = [(f/g) x Y] - [(1/g) x (M(-)/P(-))]
     • Stabilization Policy Analysis with IS-LM Model
       • Fiscal Policy (G and T)
         • Expansionary Fiscal (G increase)
           • Central Banks response to Expansionary Fiscal Policy (Increase G)
             • 3 Responses:
               • 1. Hold M constant
                 • This is what happens typically, increase Y leads to INCREASE (M/P)D leads to INCREASE r, IS curve shifts
               • 2. Hold R constant
                 • INCREASE Y leads to INCREASE r, INCREASE M leads to LM curve shifts DOWN, r DECREASE; overall r CONSTANT
               • 3. Hold Y constant
                 • INCREASE Y leads to RIGHT shift of IS, Central Bank reduces M, LM curve shift up causes Y to DECREASE, overall Y constant
           • Step 1: Goods market: PE INCREASE leads to Y INCREASE, IS Curve shifts right
             • *Step 3: Goods Market: INCREASE Y leads to DECREASE I leads to DECREASE PE, leads to slight DECREASE in Y
               • *INCREASE in G CROWDS OUT I, therefore a smaller resulting INCREASEin Y
           • Step 2: Money Market: Y INCREASE leads to (M/P)D INCREASE leads to r INCREASE, LM shift ALONG the CURVE
           • *Fiscal Policy causes IS curve to shift, as a result, r and Y move in same direction
         • Government controls fiscal policy
       • Monetary Policy (M)
         • Expansionary Monetary (M Increase)
           • Step 1: Money Market: M INCREASE leads to (M/P)(-)S INCREASE leads to r DECREASE, LM curve shifts DOWN
             • Step 2: Goods Market: r DECREASE leads to INCREASE I leads to INCREASE PE leads to Y INCREASE, IS curve shift DOWN ALONG the curve
               • Step 3: Money Market: Y increase leads to (M/P)D INCREASE leads to r INCREASE
                 • *OVERALL, r DECREASES
           • *Monetary Policy causes LM curve to shift, as a result , r and Y move in OPPOSITE directions.
         • Central bank controls money supply (M)
   • Shocks in IS-LM
     • IS Shocks
       • Definition: Exogenous changes in demand for goods and services
       • Stock Market Crash/Boom
         • Change C
         • Change Household Wealth
       • Change in business / consumer confidence
         • Change in I/c
           • INCREASE consumer confidence = INCREASE C, INCREASE Y, INCREASE PE, IS curve shift RIGHT
         • Change Fiscal Polciy
     • LM Shocks
       • Defintion: Exogenous Change in demand for money
         • Technology
           • Ex) Internet, ATMS reduce money demand (holding money)
         • INCREASE M
         • Financial Market expectations of Central bank monetary policies

2. Derive the Aggregate Demand Curve from IS-LM Model

   • AD curve shows a negative relationship between price (P) and output/income (Y)
   • EX 1) INCREASE P
     • Money Market: DECREASE money demand (M(-)/P)
     • Goods Market: DECREASE I, DECREASE Y
     • AD tilts left
   • EX 2) Expansionary Fiscal (G increase)
     • IS shifts right
       • AD shifts right

3. The Great Depression

   • Theory 1: Spending Hypothesis (Shocks to IS curve)
     • Exogenous drop in demand for G+S causing leftward shift of IS curve
       • Evidence: Y and r DECREASE = leftward IS shift
     • Reasons: Stock market crash, drop in investment (b/c of bank defaulting), contractionary fiscal (increase tax, cut spending)
   • Theory 2: Money Hypothesis (LM Shock)
     • Large Deflation
       • P DECREASE caused by DECREASE in M

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