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Context

- In Chapter 11, we will use the IS-LM model to
- see how policies and shocks affect income and the interest rate in the short run when prices are fixed
- derive the aggregate demand curve
- explore various explanations for the Great Depression

r

r1

IS

Y1

Y

Policy analysis with the IS-LM ModelPolicymakers 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.

Interaction between monetary & fiscal policy

- Model: monetary & fiscal policy variables (M, G and T ) are exogenous
- Real world: Monetary policymakers may adjust Min response to changes in fiscal policy, or vice versa.
- Such interaction may alter the impact of the original policy change.

The Fed’s response to G > 0

- Suppose Congress 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 Gare different:

r

r2

r1

IS2

IS1

Y1

Y2

Y

Response 1: hold M constantIf Congress raises G, the IScurve shifts right

If Central Bank holds M constant, then LM curve doesn’t shift.

Results:

r

LM2

IS2

IS1

Y3

Y1

Y2

Y

Response 2: hold r constantIf Congress raises G, the IScurve shifts right

To keep r constant, CB increases M to shift LMcurve right.

r2

r1

Results:

LM1

r

r3

r1

IS2

IS1

Y1

Y2

Y

Response 3: hold Y constantIf Congress raises G, the IScurve shifts right

To keep Y constant, CB reduces M to shift LMcurve left.

r2

Results:

What is the Fed’s policy instrument?

What the newspaper says:“the Fed lowered interest rates by one-half point today”

What actually happened:The Fed conducted expansionary monetary policy to shift the LM curve to the right until the interest rate fell 0.5 points.

The Fed targets the Federal Funds rate: it announces a target value, and uses monetary policy to shift the LM curve as needed to attain its target rate.

What is the Fed’s policy instrument?

Why does the Fed target interest rates instead of the money supply?

1) They are easier to measure than the money supply

2) The Fed might believe that LMshocks are more prevalent than ISshocks. 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-LMmodel to analyze the short run, when the price level is assumed fixed.
- However, a change in P would shift the LMcurve and therefore affect Y.
- The aggregate demand curve(introduced in chap. 9 ) captures this relationship between P and Y

P

LM(P2)

LM(P1)

r2

r1

IS

Y

Y

P2

P1

Deriving the AD curveIntuition for slope of ADcurve:

P (M/P)

LMshifts left

r

I

Y

Y1

Y2

AD

Y2

Y1

r

LM(M1/P1)

LM(M2/P1)

r1

r2

IS

Y

Y

Y2

Y1

P1

AD2

AD1

Y1

Y2

Monetary policy and the AD curveThe Fed can increase aggregate demand:

M LMshifts right

r

I

Y at each value of P

P

LM

r2

r1

IS2

IS1

Y

Y

Y2

Y1

P1

AD2

AD1

Y1

Y2

Fiscal policy and the AD curveExpansionary fiscal policy (G and/or T ) increases agg. demand:

T C

IS shifts right

Y at each value of P

r

P

LM(P1)

IS1

IS2

Y

Y

LRAS

SRAS1

P1

AD1

AD2

The SR and LR effects of an IS shockA negative ISshock shifts ISand ADleft, causing Y to fall.

r

P

LM(P1)

IS2

Y

Y

SRAS1

P1

AD2

The SR and LR effects of an IS shockIn the new short-run equilibrium,

IS1

LRAS

AD1

r

P

LM(P1)

IS2

Y

Y

SRAS1

P1

AD2

The SR and LR effects of an IS shockIn the new short-run equilibrium,

IS1

Over time, P gradually falls, which causes

- SRAS to move down
- M/P to increase, which causes LMto move down

LRAS

AD1

r

P

LM(P2)

IS2

Y

Y

SRAS2

P2

AD2

The SR and LR effects of an IS shockLM(P1)

IS1

Over time, P gradually falls, which causes

- SRAS to move down
- M/P to increase, which causes LMto move down

LRAS

SRAS1

P1

AD1

P

r

LM(P2)

IS2

Y

Y

SRAS2

P2

AD2

The SR and LR effects of an IS shockLM(P1)

This process continues until economy reaches a long-run equilibrium with

IS1

LRAS

SRAS1

P1

AD1

r

P

IS

Y

Y

LRAS

SRAS1

P1

AD1

EXERCISE: Analyze SR & LR effects of M- Draw the IS-LM and AD-AS diagrams as shown here.
- Suppose Fed increases M. Show the short-run effects on your graphs.
- Show what happens in the transition from the short run to the long run.
- How do the new long-run equilibrium values of the endogenous variables compare to their initial values?

LM(M1/P1)

The Spending Hypothesis: Shocks to the IS Curve

- asserts that the Depression was largely due to an exogenous fall in the demand for goods & services -- a leftward shift of the IScurve
- evidence: output and interest rates both fell, which is what a leftward ISshift would cause

The Spending Hypothesis: Reasons for the IS shift

- Stock market crash exogenous C
- Oct-Dec 1929: S&P 500 fell 17%
- Oct 1929-Dec 1933: S&P 500 fell 71%
- Drop in investment
- “correction” after overbuilding in the 1920s
- widespread bank failures made it harder to obtain financing for investment
- Contractionary fiscal policy
- in the face of falling tax revenues and increasing deficits, politicians raised tax rates and cut spending

The Money Hypothesis: A Shock to the LM Curve

- asserts that the Depression was largely due to huge fall in the money supply
- evidence: M1 fell 25% during 1929-33.

But, two problems with this hypothesis:

- P fell even more, so M/Pactually rose slightly during 1929-31.
- nominal interest rates fell, which is the opposite of what would result from a leftward LMshift.

Why another Depression is unlikely

- Policymakers (or their advisors) now know much more about macroeconomics:
- The Fed knows better than to let M fall so much, especially during a contraction.
- Fiscal policymakers know better than to raise taxes or cut spending during a contraction.
- Federal deposit insurance makes widespread bank failures very unlikely.
- Automatic stabilizers make fiscal policy expansionary during an economic downturn.

Simple algebra of IS-LM model

Solving for Y as a function of r, and exogenous parameters G and T yields

The algebra of the LM curve

The Aggregate Demand Equation

For homework #2, please derive this equation

Effectiveness of monetary and fiscal policy

- Which policy variables are more powerful instruments to influence aggregate demand depends on the parameters of the IS and LM curves
- If d is small then z is big. IS is almost vertical, and monetary policy has small impact on income Y
- If f is small then z is small. The LM curve is almost vertical, and fiscal policy has small impact on Y

Chapter summary

1. IS-LMmodel

- a theory of aggregate demand
- exogenous: M, G, T,P exogenous in short run, Y in long run
- endogenous: r,Y endogenous in short run, P in long run
- IScurve: goods market equilibrium
- LM curve: money market equilibrium

Chapter summary

2. AD curve

- shows relation between Pand the IS-LMmodel’s equilibrium Y.
- negative slope because P (M/P ) r I Y
- expansionary fiscal policy shifts IScurve right, raises income, and shifts ADcurve right
- expansionary monetary policy shifts LMcurve right, raises income, and shifts ADcurve right
- ISor LMshocks shift the ADcurve

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