Lecture 19: The IS/LM Model (continued). Based Primarily on Mankiw Chapters 11. Review And Learning Objectives. In this lecture we will present the complete IS/LM model.
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We begin by examining how changes in fiscal policy (taxes and spending) alter the economy’s short-run equilibrium.
An increase in government spending is represented in the next slide.
The equilibrium of the economy moves from point A to point B. Income rises from Y1 to Y2 and the real interest rate rises from r1 to r2.
When the government increases its spending, total income Y begins to rise (from the Keynesian cross model). As Y rises, the economy’s demand for money rises and so, assuming that the supply of real balances is fixed, the interest rate r begins to rise. As r rises, I falls thus partially offsetting the effects of the increased government spending.
We now examine the effects of monetary policy. This is represented in the next slide.
Consider an increase in the money supply. An increase in M leads to an increase in M/P since we are assuming that P is fixed. The LM curve shifts downward and the economy moves from point A to point B. The increase in the money supply lowers the interest rate and raises the level of income.
This is because the increase in M/P lowers r and this causes I to increase since I is inversely related to r. This, in turn, increases planned expenditure, production and income Y.
This process is called the “monetary transmission mechanism”.
Shocks to the IS curve are exogenous changes in the demand for goods and services.
Keynes called self-fulfilling shocks to planned investment spending “animal spirits”. IS shocks may also arise from shocks to consumption demand.
Shocks to the LM curve arise from exogenous changes in the demand for money. For example, restrictions on credit card availability affect the amount of money people wish to hold. This would be an LM shock.
We can use IS/LM to provide another derivation of the AD curve.
Remember, in earlier lectures we derived this from the quantity theory of money.
The new derivation is explained in the next slide.
The effects of fiscal and monetary expansion on the economy are shown in slide 15.
This is why we say that IS/LM is a theory of aggregate demand determination. By this, we mean that the position of the AD curve is determined by the position of the economy’s IS curve and its LM curve.
How does the economy make the transition from the short-run to the long-run?
In the Keynesian model of the economy, prices are stuck at P1. The short-run equilibrium of the economy is represented by point K. Output is below the natural rate, Y* (represented by the vertical LRAS curve). Over time, prices fall and so the LM curve shifts to the right. The economy moves down the AD curve from point K to point C.
In the long-run, after prices have adjusted, the economy returns to its natural rate of output.
We deal with this point mathematically in slide 18.
Friedman and Schwartz argue that contraction in the money supply caused the LM curve to shift to the left.
Considerable empirical controversy over this claim. Evidence does not seem to support the hypothesis. The nominal money supply fell, but so did prices and thus real balances were unaffected. The LM curve should have remained constant.
Prices fell from 1929 to 1933 by 25%.
Controversy about the causes of the Great Depression continues today.