MACROECONOMICSMACROECONOMICS

Chapter 11Chapter 11

Aggregate Demand II: Aggregate Demand II: Applying the IS-LM ModelApplying the IS-LM Model

22

Shifts in IS CurveShifts in IS Curve

Any exogenous change in the Planned Any exogenous change in the Planned Expenditures will shift the IS curve.Expenditures will shift the IS curve.Fiscal PolicyFiscal Policy

Change in GChange in GChange in TChange in T

Other multiplier effectsOther multiplier effectsChange in autonomous consumptionChange in autonomous consumptionChange in autonomous investmentChange in autonomous investmentChange in autonomous NX (Foreign preferences)Change in autonomous NX (Foreign preferences)

33

Increase in Government Purchases

ΔG

Y

PE1

PE2

Income increase causes demand for real balances to increase and as a result interest rates to increase.

44

Decrease in Taxes

-ΔT(MPC)

Try your hand with an increase in uncertainty, increase in optimism, and increase in economic nationalism in our trading partners.

55

Shifts in LMShifts in LM

Any impact on money supply or money Any impact on money supply or money demand other than income will shift the demand other than income will shift the LM curve. Changes in r are tracked along LM curve. Changes in r are tracked along the money demand curve already.the money demand curve already.Money supply increase will shift LM right.Money supply increase will shift LM right.Money demand increase will shift LM left.Money demand increase will shift LM left.

66

Increase in the Money Supply

77

Policies Can Enhance or Policies Can Enhance or Cancel Each OtherCancel Each Other

Monetary policy can add to the stimulus of Monetary policy can add to the stimulus of the fiscal policy or can eliminate the the fiscal policy or can eliminate the stimulus.stimulus.

One reason to make the Central Banks One reason to make the Central Banks independent is to keep them from independent is to keep them from supporting the fiscal policies all the time.supporting the fiscal policies all the time.

88

Tax IncreaseIn this case, the Fed is just watching at the sidelines.

99

Tax IncreaseIn this case, the Fed is enhancing the fiscal policy because it doesn’t let the interest rate fall.

As a result, the recession is much more severe.

Do the same for tax decrease.

1010

Tax IncreaseIn this case the Fed is countering the effect of fiscal policy.

How are resources allocated as a result of these policies?

Draw the example of Germany after unification when G increased very Much and the Central Bank kept income constant.

1111

There are 1279 variables in the DRI Model. 301 variables are exogenous, 661 variables are identities, and 317 are endogenous.

http://tonto.eia.doe.gov/FTPROOT/modeldoc/m061.pdf

Show the DRI multipliers in terms of IS-LM diagrams.

1212

Deriving the AD CurveDeriving the AD Curve

Remember money demand/money supply diagram has Real Money Balances measured on the horizontal axis.

If the price level rises while money supply is kept constant, real money balances will decrease forcing interest rate to rise.

This is a left shift of LM.

The new equilibrium Y takes place at the higher P.

1313

You would see the impact on Y better if you put these diagrams on top of each other.

1414

Both expansionary policies increase Y. What is the difference between them in terms of interest rates? What does it mean for allocation of resources?

1515

Long Run AdjustmentLong Run Adjustment

Remember to put IS-LM and AD-AS diagrams one under the other to trace the Y.

1616

Huge increase in unemployment rate, of course, means a huge decrease in Y. Among the components of GDP, investment dropped precipitously. Government spending did not compensate for the expenditure drops, at all.

1717

What Happened During the Great Depression?

Real money balances were relatively constant. Nominal interest rates dropped but deflation meant real interest rates were high.

1818

Expected DeflationWhen expected deflation increases the real interest rate above the nominal interest rate (i=r+πe), investments dry up. This will shift the IS curve to the left by ΔI[1/(1-MPC)].