Download ISLM Framework 2-Macroeconomics-Lecture Notes and more Study notes Macroeconomics in PDF only on Docsity!
Lesson 28 IS-LM FRAMEWORK (CONTINUED)
THE BIG PICTURE
EQUILIBRIUM IN THE IS-LM MODEL
The IS curve represents equilibrium in the goods market.
The LM curve represents money market equilibrium
The intersection determines the unique combination of Y and r that satisfies equilibrium in both markets.
POLICY ANALYSIS WITH THE IS-LM MODEL Policymakers can affect macroeconomic variables with fiscal policy: G and/or T and monetary policy: M. We can use the IS-LM model to analyze the effects of these policies.
AN INCREASE IN GOVERNMENT PURCHASES
Keynesian Cross
Theory of Liquidity Preference
IS Curve
LM curve
IS-LM Model
Aggregate. Demand Curve
Aggregate. Supply Curve
Model of aggregate demand and aggregate supply
Explanation of short-run fluctuations
IS Y
r LM
r 1
Y 1
IS (^1) Y
r LM
r 1
Y 1
IS (^2)
Y 2
r 2
Y C (Y T ) I ( r ) G
M P L ( r ,Y )
docsity.com
- IS curve shifts right by G, causing output & income to rise.
- This raises money demand, causing the interest rate to rise.
- Which reduces investment, so the final increase in Y is smaller than G.
A TAX CUT
Because consumers save (1MPC) of the tax cut, the initial boost in spending is smaller for T than for an equal G … and the IS curve shifts by
- T
- So the effects on r and Y are smaller for a T than for an equal G.
MONETARY POLICY: AN INCREASE IN M
1. M > 0 shifts the LM curve down (or to the right). 2. Causing the interest rate to fall. 3. This increases investment, causing output & income to rise.
INTERACTION BETWEEN MONETARY & FISCAL POLICY
Model: monetary & fiscal policy variables ( M , G and T) are exogenous. Real world: Monetary policymakers may adjust M in response to changes in fiscal policy, or vice versa. Such interaction may alter the impact of the original policy change.
CENTRAL BANK’S RESPONSE TO G > 0
Suppose Government increases G. Possible central bank responses are:
1. Hold M constant 2. Hold r constant
IS (^1)
Y
r LM
r 1
Y 1
IS (^2)
Y 2
r 2
IS Y
r LM 1
r 1
Y 1 Y 2
r 2
LM 2
1 (1-MPC)
1 (1-MPC)
1 (1-MPC)
docsity.com
SHOCKS IN THE IS-LM MODEL
IS SHOCKS: exogenous changes in the demand for goods & services. Examples: Stock market boom or crash, change in households’ wealth, C Change in business or consumer confidence or expectations I and/or C LM SHOCKS : exogenous changes in the demand for money. Examples: A wave of credit card fraud increases demand for money More ATMs or the Internet reduce money demand
Exercise Questions: Use the IS-LM model to analyze the effects of: A boom in the stock market makes consumers wealthier. After a wave of credit card fraud, consumers use cash more frequently in transactions. For each shock, Use the IS-LM diagram to show the effects of the shock on Y and r. Determine what happens to C, I, and the unemployment rate.
WHAT IS THE CENTRAL BANK’S POLICY INSTRUMENT?
What the newspaper says: “The central bank lowered interest rates by one-half point today”. What actually happened: The central bank conducted expansionary monetary policy to shift the LM curve to the right until the interest rate fell 0.5 points. The central bank targets the discount rate: it announces a target value, and uses monetary policy to shift the LM curve as needed to attain its target rate. Why does the central bank target interest rates instead of the money supply? a) They are easier to measure than the money supply b) The central bank might believe that LM shocks are more prevalent than IS shocks. If so, then targeting the interest rate stabilizes income better than targeting the money supply.
docsity.com
