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Goods andFinancial Markets:The IS-LM Model
Note: The ZZ line is flatter than the 45° line only if increases in consumption and investment do not exceed the corresponding increase in output.
Equilibrium in the Goods Market
The demand for goods is an increasing function of output. Equilibrium requires that the demand for goods be equal to output.
An increase in the interest rate decreases the demand for goods at any level of output.
The Effects of an Increase inthe Interest Rate on Output
Equilibrium in the goods market implies that an increase in the interest rate leads to a decrease in output. The IS curve is downward sloping.
The Derivation of the IS Curve
An increase in taxes shifts the IS curve to the left.
Shifts of the IS Curve
M = nominal money stock$YL(i) = demand for money$Y = nominal incomei = nominal interest rate
An increase in income leads, at a given interest rate, to an increase in the demand for money. Given the money supply, this leads to an increase in the equilibrium interest rate.
The Effects of an Increase in Income on the Interest Rate
Equilibrium in financial markets implies that an increase in income leads to an increase in the interest rate. The LM curve is upward-sloping.
The Derivation of the LM Curve
An increase in money leads the LM curve to shift down.
Shifts of the LM Curve
Equilibrium in the goods market implies that an increase in the interest rate leads to a decrease in output.
Equilibrium in financial markets implies that an increase in output leads to an increase in the interest rate.
When the IS curve intersects the LM curve, both goods and financial markets are in equilibrium.
The IS-LM Model
An increase in taxes shifts the IS curve to the left, and leads to a decrease in the equilibrium level of output and the equilibrium interest rate.
The Effects of an Increase in Taxes
Monetary expansion leads to higher output and a lower interest rate.
The Effects of a Monetary Expansion
The appropriate combination of deficit reduction and monetary expansion can achieve a reduction in the deficit without adverse effects on output.
Deficit Reduction and Monetary Expansion
The Monetary-Fiscal Policy Mix of Post-Unification Germany
The Empirical Effects of an Increasein the Federal Funds Rate
The two dotted lines and the tinted space between them gives us a confidence band, a band within which the true value of the effect lies with 60% probability.
In the short run, an increase in the federal funds rate leads to a decrease in output and to an increase in unemployment, but has little effect on the price level.