Aggregate Demand 2: Applying the IS-LM Model
Context
Equilibrium point of liquidity market curve and Investment Savings market gives us a unique interest rate and output level.
● IS = equilibrium of the goods market
● LM = Money market
Increase in government purchases Increase in Money Supply
● Increase G which increase Y
● Shift IS to the right
● Raises money demand, increasing the interest rate
● Increased r reduces investment, the final increase in Y is smaller than when there was no interest change (moves from r1, IS2 to LM = IS2)
● Increase in M, will increase the ratio of M/P
● LM curves shifts to the right to point Y1 along the LM2 curve
● Interest rate will fall
● Increasing investment causing output and income to rise - to new equilibrium
Interaction between Monetary Policy and Fiscal Policy
Suppose ∆G> 0
Suppose ∆G > 0
● Treasury increase G
● In response, the RBA will:
○ Hold M constant
○ Hold r constant
○ Hold Y constant Holding M constant
∆Y = Y2 - Y1
∆r = r2 - r1
Increase in G will increase IS by shifting to the right
Holding r constant
Holding r constant, the RBA increase M (money supply)
● Shifting LM to the right, increasing output (Y) but leaving r constant
Holding Y constant
The RBA reduces M to shift LM curve to left
∆Y = 0
∆r = r3 - r1
Shocks to the IS-LM model
Exogenous changes in demand for goods and services
● Example: Stock market boom or crash
○ Change in household' wealth
○ ∆C
● Change in business or consumer confidence our expectations
○ ∆I and ∆C
Example: Housing Market Crash Example: Increase in Money Demand
● Wealth effect, consumers feel poorer
○ Causing C to fall
● I rises because r is lower
● Y decreases, causing Ue to increase, OKUNs Law
● C falls from lower income
● I falls from higher r
● Ue rises from lower Y
IS-LM & Aggregate Demand
Increase in P will decrease LM (M/P)
● Shift the LM curve to the left
● Increase r
● Decrease I
● Decrease Y
Monetary Policy and the AD Curve
● Increase in M will increase M/P
● Decrease r
● Increase I
● Increase Y at each value of P
Fiscal Policy and the AD Curve
● Increase in G or Decrease in T
● Increase C
● IS Shifts right
● Increase in Y at each value of P
SR and LR effects of IS Shock
● Negative IS Shock shifts IS to the left, causing Y to decrease
● Short run , real output is lower than planned output
● P will gradually fall in the long run
● Until it reaches long run equilibrium
Effects of Falling prices Expected Deflation
● Decrease in P will increase M/P
○ LM will shift right
○ Y will increase
● Pigou Effect
○ Decrease in P, increase in M/P will:
○ Increase consumer wealth
○ Increase C
○ IS shifts right
○ Increase in Y
● Decrease Eπ
○ r will increase for each unit of i
○ I will decrease because I = I(r)
○ Planned Expenditure and Aggregate Demand will decrease
○ Income and output will decrease
Unexpected Deflation: Debt Deflation Theory
● Transfers purchasing power for borrowers to lenders
● Borrowers spend less, borrowers spend more
● If borrowers propensity to spend is higher than the lenders
○ AD will fall
○ IS Shifts left
○ Y falls Inverse:
