Applying the IS LM Curve Flashcards
Dr Tumisang
Loate-Ntsoko
1
Slides for External material
• How to derive the aggregate demand curve
from the
The intersection of the IS curve
and the LM curve
Y
=C Y
M
P =L r Y
Y
=C Y
curve
shifts right
fall in investment partially
offsets
1
r
1 − MPC
r
smaller for T
than for an equal G…
1
T
2
…so the effects on r
and Y
are smaller for T
Monetary policy:
An increase in M
1
M > 0 shifts the LM curve
•Monetary policymakers may adjustM
in response to changes in
1
hold M
2
hold r
3
hold Y
r
Y
IS
shocks:
•
For example, suppose
•
This reduction in the demand for investment goods causes a contractionary
•
The fall in investment reduces planned expenditure and shifts the IS curve
•
This fall in equilibrium income in part validates the firms’ initial pessimism.
Shocks in the IS-LM
model
LM
shocks:
Analyse
shocks with the IS-LM model
2
consumers using cash in transactions more frequently
a.
use the IS-LM diagram to determine the effects
b.
figure out what happens to
r
and Y
I
rises because r
u
rises because Y is lower
In fact, the Fed (SARB)
targets the federal funds rate (repo rate)—
the interest rate banks charge one another on overnight
loans.
These central banks change the money supply and shifts the
LM
curve
to achieve their target.
• Even
though
1)
They are easier to measure than the money supply.
2)
The Fed might believe that
We will extend our theory of short-run
fluctuations to include
- IS-LM
and aggregate demand
So far, we’ve been using the IS-LMmodel to analyze the short
run,
However, a change in P
would shift LM and therefore affect Y.
IS-LM
and aggregate demand
Previously, we derived the AD curve
from the quantity theory of
That analysis showed that for a given
money supply, a higher price
IS-LM
and aggregate demand
the price level rises—that is, why the aggregate demand curve
is
To explain why the aggregate demand (AD)
curve
1
For any given money supply M, a higher price level P reduces
2
A lower supply of real money balances shifts the LM curve
3
The aggregate demand curve plots this negative relationship
Intuition for slope of AD
curve:
P
(M/P)
The AD curve shows
the set of
What causes the aggregate demand curve
to shift?
• Because the AD curve
summarizes the results from the
given price level) cause the aggregate demand curve
to shift.
model for any given price level; it thus shifts the
AD curve to
• An increase in government
purchases or a decrease in taxes
also shifts the aggregate demand curve
to the right.
Monetary policy and the AD
curve
The Fed or SARB can increase
r
aggregate demand:
r
M LM shifts right
r
Y at each value of P
P
Fiscal policy and the AD
curve
Expansionary fiscal policy (G
r
and/or T) increases aggregate
r
demand:
r
IS shifts right
P
Y at each value of P
P
Summary of moving
and shifting the AD curve
fiscal policy but also shocks to the goods market (the IS curve)
and
A change in income in the IS–LM model for a given
price level
The SR and LR effects of an IS
shock
A negative IS shock
r
causing Y
to fall.
equilibrium,
Y
The SR and LR effects of an IS
shock
Over time, P gradually
falls,
equilibrium with
Y
1
Draw the IS-LM and AD-AS
2
Suppose the SARB increases M.
3
Show what happens in the transition
4
How do the new long-run equilibrium
r
falls, Y
New long-run
equilibrium
Money
is neutral
billions of 1958 dollars
200
Asserts that the Depression was largely
due to an exogenous fall in
THE SPENDING HYPOTHESIS: Reasons for the IS
shift
THE MONEY HYPOTHESIS: A shock to the LM
curve
Asserts that the Depression was largely
due to huge fall in the
•Pfell even more, so M/P
actually rose slightly
leftward LM
shift would cause.
P
(M/P)
A channel through
which falling prices expand income is called the
Arthur
Pigou, a prominent classical economist in the 1930s, pointed
shift in the IS curve,
also leading to higher income.
1
The first, called the debt-deflation theory, describes the effects
2
The second explains the effects of expected
The destabilizing effects of unexpected
deflation:
aggregate spending falls, the IS
curve shifts left, and Y
The destabilizing effects of unexpected
deflation:
•
Unanticipated changes in the price level redistribute wealth
•
If a debtor owes a creditor $1,000, then the real amount of this
•
A fall in the price level raises the real amount of this debt—the
•
Therefore, an unexpected deflation enriches creditors and
The destabilizing effects of unexpected
deflation:
The destabilizing effects of unexpected
deflation:
I
because I
If i is the nominal interest rate and �� ��
is expected inflation, then
Expected inflation enters as a variable in the IS curve.
Thus, changes
2009:
Real GDP fell, unemployment rate approached 10%
interest rate (%)
6
Percent change in house prices
10%
(from 4 quarters earlier)
8%
Number of bank failures
120
% change from 4 quarters earlier
8
IS-LM
model
•endogenous:r,
Y
•IScurve:
goods market equilibrium
•LMcurve:
money market equilibrium
and shifts AD
curve
•ISor LM
shocks shift the AD
