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Review of the Previous Lecture

Review of the Previous Lecture. Policy Analysis in IS-LM Model Interaction between Monetary and Fiscal Policy Shocks in IS-LM Model Central Bank’s Policy Instrument. Topics under Discussion. IS-LM and Aggregate Demand IS-LM and AD in Short-run and Long-run Shocks to IS Curve

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Review of the Previous Lecture

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  1. Review of the Previous Lecture • Policy Analysis in IS-LM Model • Interaction between Monetary and Fiscal Policy • Shocks in IS-LM Model • Central Bank’s Policy Instrument

  2. Topics under Discussion • IS-LM and Aggregate Demand • IS-LM and AD in Short-run and Long-run • Shocks to IS Curve • Shocks to LM Curve

  3. IS-LM and Aggregate Demand • So far, we’ve been using the IS-LMmodel to analyze the short run, when the price level is assumed fixed. • However, a change in P would shift the LMcurve and therefore affect Y. • The aggregate demand curve captures this relationship between P and Y

  4. r P LM(P2) LM(P1) r2 r1 IS Y Y P2 P1 Deriving the AD curve Intuition for slope of ADcurve: P  (M/P)  LMshifts left  r  I  Y Y1 Y2 AD Y2 Y1

  5. P r LM(M1/P1) LM(M2/P1) r1 r2 IS Y Y Y2 Y1 P1 AD2 AD1 Y1 Y2 Monetary policy and the AD curve The central bank can increase aggregate demand: M  LMshifts right  r  I  Y at each value of P

  6. r P LM r2 r1 IS2 IS1 Y Y Y2 Y1 P1 AD2 AD1 Y1 Y2 Fiscal policy and the AD curve Expansionary fiscal policy (G and/or T ) increases agg. demand: T  C  IS shifts right  Y at each value of P

  7. > Y Y < Y Y = Y Y IS-LM and AD-AS in the short run & long run Recall :The force that moves the economy from the short run to the long run is the gradual adjustment of prices. In the short-run equilibrium, if then over time, the price level will rise fall remain constant

  8. r P LM(P1) IS1 IS2 Y Y Y < Y Y SRAS1 P1 AD1 AD2 Y The SR and LR effects of an IS shock A negative ISshock shifts ISand ADleft, causing Y to fall. LRAS In the new short-run equilibrium, LRAS

  9. r P LM(P2) IS2 Y Y Y SRAS2 P2 AD2 Y The SR and LR effects of an IS shock LRAS LM(P1) Over time, P gradually falls, which causes • SRAS to move down • M/P to increase, which causes LMto move down IS1 LRAS SRAS1 P1 AD1

  10. r P LM(P2) IS2 Y Y = Y Y Y SRAS2 P2 AD2 Y The SR and LR effects of an IS shock LRAS LM(P1) This process continues until economy reaches a long-run equilibrium with IS1 LRAS SRAS1 P1 AD1

  11. Short run Impacts Now it’s time to determine the effects on the variables in the economy. Y +, because Y moved P 0, because prices are sticky in the SR. +, because a +Y leads to a rise in r as IS slides along the LM curve. r +, because a + Y increases the level of consumption (C=C(Y-T)). C I – , since r increased, the level of investment decreased.

  12. Long Run Impacts 0, because rising P shifts LM to left, returning Y to Y* as required by long-run LRAS. Y +, in order to eliminate the excess demand at P0. P r +, reflecting the leftward shift in LM due to + P 0, since both Y and T are back to their initial levels (C=C(Y-T)) C I – – , since r has risen even more due to the + P.

  13. r P IS1 Y Y Y SRAS1 P1 AD2 AD1 Y Analyze SR & LR effects of M LRAS LM(M1/P1) • We Have IS-LM and AD-AS diagrams as shown here. • Suppose central bank increases M. LM(M2/P1) LRAS

  14. r P IS1 IS2 Y Y Y AD1 AD2 Y Analyze SR & LR effects of M LRAS LM(M1/P1) • The Graph Shows the Short run effects of the change in M and what happens in the transition from the short run to the long run. LM(M2/P1) LRAS SRAS2 P1 SRAS1

  15. r P IS2 IS1 Y Y Y SRAS1 SRAS2 P2 P1 AD1 AD2 Y Analyze SR & LR effects of M LRAS LM(M1/P1) • The new long-run equilibrium values of the endogenous variables as compared to their initial values LM(M2/P1) LRAS

  16. Short Run Impacts Now it’s time to determine the effects on the variables in the economy. Y +, because Y moved 0, because prices are sticky in the SR. P r –, because a +DY leads to a decrease in r as LM slides along the IS curve. C +, because a +DY increases the level of consumption (C=C(Y-T)). + , since r increased, the level of investment decreased. I

  17. Long Run Impacts Y 0, because rising P shifts LM to left, returning Y to Y* as required by LRAS. P +, in order to eliminate the excess demand at P0. r 0, reflecting the leftward shift in LM due to +DP, restoring r to its original level. C 0, since both Y and T are back to their initial levels (C=C(Y-T)). I 0, since Y or r has not changed. Notice that the only LR impact of an increase in the money supply was an increase in the price level.

  18. Summary • IS-LM and Aggregate Demand • IS-LM and AD in Short-run and Long-run • Shocks to IS Curve • Shocks to LM Curve

  19. Upcoming Topics • The Mundell-Fleming Model • IS-LM curve for Small Open Economy • Floating vs Fixed Exchange Rate • Fiscal Policies • Monetary Policies • Trade Policies

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