Applying the IS LM Curve Flashcards
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Dr Tumisang
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Loate-Ntsoko
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Slides for External material
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• How to derive the aggregate demand curve
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from the
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The intersection of the IS curve
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and the LM curve
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Y
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=C Y
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M
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P =L r Y
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Y
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=C Y
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curve
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shifts right
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fall in investment partially
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offsets
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r
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1 − MPC
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r
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smaller for T
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than for an equal G…
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1
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T
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2
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…so the effects on r
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and Y
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are smaller for T
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Monetary policy:
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An increase in M
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1
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M > 0 shifts the LM curve
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•Monetary policymakers may adjustM
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in response to changes in
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1
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hold M
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2
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hold r
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3
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hold Y
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r
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Y
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Q
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IS
shocks:
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•
For example, suppose
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•
This reduction in the demand for investment goods causes a contractionary
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The fall in investment reduces planned expenditure and shifts the IS curve
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This fall in equilibrium income in part validates the firms’ initial pessimism.
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Shocks in the IS-LM
model
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LM
shocks:
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Analyse
shocks with the IS-LM model
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2
consumers using cash in transactions more frequently
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a.
use the IS-LM diagram to determine the effects
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b.
figure out what happens to
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r
and Y
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I
rises because r
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u
rises because Y is lower
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In fact, the Fed (SARB)
targets the federal funds rate (repo rate)—
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the interest rate banks charge one another on overnight
loans.
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These central banks change the money supply and shifts the
LM
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curve
to achieve their target.
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• Even
though
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1)
They are easier to measure than the money supply.
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2)
The Fed might believe that
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We will extend our theory of short-run
fluctuations to include
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2. IS-LM
and aggregate demand
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So far, we’ve been using the IS-LMmodel to analyze the short
run,
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However, a change in P
would shift LM and therefore affect Y.
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IS-LM
and aggregate demand
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Previously, we derived the AD curve
from the quantity theory of
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That analysis showed that for a given
money supply, a higher price
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IS-LM
and aggregate demand
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the price level rises—that is, why the aggregate demand curve
is
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To explain why the aggregate demand (AD)
curve
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1
For any given money supply M, a higher price level P reduces
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2
A lower supply of real money balances shifts the LM curve
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3
The aggregate demand curve plots this negative relationship
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Intuition for slope of AD
curve:
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P
(M/P)
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The AD curve shows
the set of
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What causes the aggregate demand curve
to shift?
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• Because the AD curve
summarizes the results from the
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given price level) cause the aggregate demand curve
to shift.
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model for any given price level; it thus shifts the
AD curve to
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• An increase in government
purchases or a decrease in taxes
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also shifts the aggregate demand curve
to the right.
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Monetary policy and the AD
curve
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The Fed or SARB can increase
r
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aggregate demand:
r
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M LM shifts right
r
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Y at each value of P
P
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Fiscal policy and the AD
curve
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Expansionary fiscal policy (G
r
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and/or T) increases aggregate
r
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demand:
r
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IS shifts right
P
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Y at each value of P
P
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Summary of moving
and shifting the AD curve
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fiscal policy but also shocks to the goods market (the IS curve)
and
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A change in income in the IS–LM model for a given
price level
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The SR and LR effects of an IS
shock
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A negative IS shock
r
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causing Y
to fall.
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equilibrium,
Y
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The SR and LR effects of an IS
shock
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Over time, P gradually
falls,
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equilibrium with
Y
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1
Draw the IS-LM and AD-AS
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2
Suppose the SARB increases M.
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3
Show what happens in the transition
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How do the new long-run equilibrium
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r
falls, Y
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New long-run
equilibrium
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Money
is neutral
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billions of 1958 dollars
200
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Asserts that the Depression was largely
due to an exogenous fall in
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THE SPENDING HYPOTHESIS: Reasons for the IS
shift
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THE MONEY HYPOTHESIS: A shock to the LM
curve
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Asserts that the Depression was largely
due to huge fall in the
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•Pfell even more, so M/P
actually rose slightly
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leftward LM
shift would cause.
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P
(M/P)
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A channel through
which falling prices expand income is called the
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Arthur
Pigou, a prominent classical economist in the 1930s, pointed
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shift in the IS curve,
also leading to higher income.
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1
The first, called the debt-deflation theory, describes the effects
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2
The second explains the effects of expected
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The destabilizing effects of unexpected
deflation:
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aggregate spending falls, the IS
curve shifts left, and Y
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The destabilizing effects of unexpected
deflation:
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•
Unanticipated changes in the price level redistribute wealth
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•
If a debtor owes a creditor $1,000, then the real amount of this
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•
A fall in the price level raises the real amount of this debt—the
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•
Therefore, an unexpected deflation enriches creditors and
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The destabilizing effects of unexpected
deflation:
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The destabilizing effects of unexpected
deflation:
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I
because I
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If i is the nominal interest rate and �� ��
is expected inflation, then
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Expected inflation enters as a variable in the IS curve.
Thus, changes
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2009:
Real GDP fell, unemployment rate approached 10%
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interest rate (%)
6
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Percent change in house prices
10%
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(from 4 quarters earlier)
8%
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Number of bank failures
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% change from 4 quarters earlier
8
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IS-LM
model
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•endogenous:r,
Y
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•IScurve:
goods market equilibrium
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•LMcurve:
money market equilibrium
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and shifts AD
curve
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•ISor LM
shocks shift the AD
