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The IS-LM model

The LM curve shifts downward and lowers the interest rate which raises income. Why? Because when the Fed increases the supply of money, people have more money than they want to hold at the prevailing interest rate. As a result, they start depositing this extra money in banks or use it to buy bonds. The interest rate r then falls until people are willing to hold all the extra money that the Fed has created; this brings the money market to a new equilibrium. The lower interest rate, in turn has ramifications for the goods market. A lower interest rate stimulates planned investment, which increases planned expenditure, production, | ® A PowerPoint Tutorial to Accompany macroeconomics, 5th ed. N. Gregory Mankiw CHAPTER ELEVEN Aggregate Demand II Mannig J. Simidian Chapter Eleven 1 Now that we’ve assembled the IS-LM model of aggregate demand, let’s apply it to three issues: 1) Causes of fluctuations in national income 2) How IS-LM fits into the model of aggregate supply and aggregate demand 3) The Great Depression Chapter Eleven 2 1 The intersection of the IS curve and the LM curve determines the level of national income. When one of these curves shifts, the short-run equilibrium of the economy changes, and M -L national income fluctuates. Let’s examine how S I changes in policy and shocks to the economy can cause these curves to shift. Chapter Eleven 3 Chapter Eleven 4 2 Consider an increase in government purchases. +∆G This will raise the level of income by ∆G/(1- MPC) r IS IS´ LM B A Y The IS curve shifts to the right by ∆G/(1- MPC) which raises income and the interest rate. Chapter Eleven 5 Chapter Eleven 6 3 +∆M Consider an increase in the money supply. r IS LM LM′ A B Y The LM curve shifts downward and lowers the interest rate which raises income. Why? Because when the Fed increases the supply of money, people have more money than they want to hold at the prevailing interest rate. As a result, they start depositing this extra money in banks or use it to buy bonds. The interest rate r then falls until people are willing to hold all the extra money that the Fed has created; this brings the money market to a new equilibrium. The lower interest rate, in turn has ramifications for the goods market. A lower interest rate stimulates planned investment, which increases planned expenditure, production, and income Y. Chapter Eleven 7 The IS-LM model shows that monetary policy influences income by changing the interest rate. This conclusion sheds light on our analysis of monetary policy in Chapter 9. In that chapter we showed that in the short run, when prices are sticky, an expansion in the money .