Professional Documents
Culture Documents
Unit 2
Unit 2
Unit 2
slide 1
The IS-LM model
slide 2
The IS-LM model
slide 3
IS curve
slide 4
Why the IS curve is negatively
sloped
A fall in the interest rate motivates firms to
increase investment spending, which drives up
total planned spending (E ).
To restore equilibrium in the goods market,
output (a.k.a. actual expenditure, Y )
must increase.
slide 5
Points off IS curve
slide 7
Fiscal Policy and the IS curve
slide 8
Shifting the IS curve following
increase in G or decrease in T
At any value of r,
G Y
…so the IS curve
shifts to the right.
r Y1 Y2
r1
Y
IS1 IS2
Y
Y1 Y2
slide 9
Fiscal policy and the IS curve:
continued
Fiscal expansion increase in G or decrease in
T increase in Aggregate demand outward
shift of IS
Fiscal contraction decrease in G or increase in
T decrease in aggregate demand inward
shift of IS
slide 10
Class assignment
How will the following policies affect the IS curve?
a. A COVID income tax on rich people.
slide 11
The LM curve
slide 12
The LM curve
LM curve is upward The LM curve
rising r
LM
r2
r1
Y1 Y2 Y
slide 13
Why the LM curve is upward sloping
slide 14
Points off the LM
slide 15
Points off the LM continued
slide 16
CHAPTER
N. GREGORY MANKIW
PowerPoint® Slides by Ron Cronovich
© 2007 Worth Publishers, all rights reserved
Fiscal Policy and the IS curve
slide 18
Shifting the IS curve: G
r
r1
Y
IS1 IS2
Y1 Y2 Y
slide 19
Steps involved in expansionary
fiscal policy
G increases
Aggregate Expenditure (or aggregate
demand) increases
IS shifts outward to IS’
Y increases to Y’
At Y’ the economy is below the LM curve
So, there is disequilibrium in money market
The rate of interest increases to restore
money market equilibrium
Increase in interest rate leads to decrease in
private investment
The output decreases to Y**.
So, a part of increase in Y due to fiscal
expansion is crowded out. This is called
crowding out effect.
slide 20
Shifting the IS curve: T<0 or tax cut
At any value of r,
Decrease in T=>
increase in
E=>increase in Y
Y
IS1 IS2
Y1 Y2 Y
slide 21
Steps involves in Tax cut
T decreases
Aggregate demand increases
IS shifts outward to IS’
Y increases to Y’
But economy is below LM
Excess demand for money
Rate of interest increases
private investment decreases
and finally Y decreases to Y**.
Difference between Y’ and Y**
is called crowding out effect.
slide 22
Shifting the IS curve: T>0
At any value of r,
Increase in T=>
Decrease in
E=>decrease in Y
slide 23
Steps involves in increase in
taxes
T increases
Aggregate demand decreases
IS shifts inward to IS’
Y decreases to Y**
slide 24
Crowding out effect: Definition
slide 25
Class assignment
How will the following policies affect the IS or LM curves
and equilibrium values of Y and r?
a. A COVID income tax on rich people
b. Instead of 100 days job guarantee scheme, government
decided to offer a 200 days job guarantee scheme.
c. The government decided to buy more arms and
ammunition
d. Government decides to lower income tax rate on low
income group
slide 26
Class assignment
slide 27
Monetary policy and LM curve
slide 28
Monetary policy
29 slide 29
Monetary policy: continued
slide 30
Class Assignment
slide 31
IS-LM model and aggregate
demand curve continued
As price increases, real money balance falls
causing inward shift in LM at constant money
supply.
As price decreases, real money balance rises ,
causing outward shift in LM at constant money
supply
slide 32
IS-LM model and aggregate
demand curve continued
Given IS curve is
unchanged, Y decreases
as price increases.
So, there is and inverse
relation between
aggregate income (Y)
and price level (P)
So, there is inverse
relationship between
price and output.
slide 33
IS-LM model and aggregate
demand curve continued
So, given flexible price, the Aggregate demand
curve is downward sloping .
The long run equilibrium occurs at the point of
intersection between Aggregate demand and
aggregate supply curve.
Any fiscal or monetary expansion leads to
outward shift in Aggregate demand curve.
Any fiscal or monetary contraction leads to inward
shift in aggregate demand curve.
slide 34
• There are three reasons for this negative
relationship.
• As the price level falls, real wealth rises,
interest rates fall, and the exchange rate
depreciates.
• These effects stimulate spending on
consumption, investment, and net exports.
• Increased spending on any or all of these
components of output means a larger
quantity of goods and services demanded.
slide 35 3
Aggregate-Demand
Curve
• The AD curve might shift because of:
– Changes in consumption
– Changes in investment
– Changes in government purchases
– Changes in net exports
slide 3636
Shifts to the AD
Curve
-Increase in consumer spending
• Aggregate demand curve shifts to the right
-Decrease in consumer spending
• Aggregate demand curve shifts to the left
-Increase in investment
• Aggregate demand curve shifts to the right
-Decrease in investment
• Aggregate demand curve shifts to the left
slide 3737
Shifts to the AD
Curve
– Increase in government purchases
• Aggregate demand curve shifts to the right
– Decrease in government purchases
• Aggregate demand curve shifts to the left.
– Increase in net exports
• Aggregate demand curve shifts to the right
– Decrease in net exports
• Aggregate demand curve shifts to the left
slide 3838
Class Assignment
slide 39
Aggregate Supply
Curve
• AS: the total quantity of goods and services that
firms produce and sell at a given price level
– Importantly, its shape depends on the time horizon
• Long run aggregate-supply curve, LRAS
• Price level doesn’t affect long-run determinants of GDP:
– It is the supplies of labour, capital, natural resources
and technology that matter
– So the classical dichotomy/monetary neutrality
holds
– Real variables (GDP) do not depend on nominal ones
(prices)
• Short run
slide 4040
Shifts in the LRAS
curve
• The LRAS curve might shift because of:
– Any change in the natural rate of output
– Changes in labour
• immigration, births…
• changes in frictional and structural unemp. due to
government policy (minimum wage etc.)
– Changes in capital
• Increases in K increase productivity
– Changes in natural resources
– Changes in technological knowledge
slide 4141
Figure 9
The Short-Run Aggregate-Supply
Curve
Price Short-run
aggregate
Level 1. A decrease in
supply
the price level . . .
P1
Quantity of Output
Y2 Y1
In the short run, a fall in the price level from P1 to P2 reduces the quantity of output
supplied from Y1 to Y2. This positive relationship could be due to sticky wages, sticky
prices, or misperceptions. Over time, wages, prices, and perceptions adjust, so this
positive relationship is only temporary.
slide 4242
The short run or “surprise” AS
curve
• When the price level rises above the level
expected, output rises above its natural
rate
• When the price level falls below the level
expected, output falls below its natural
rate
slide 4343
Shifts to the SRAS
curve
• The short-run AS curve might shift because of:
– Changes in labour, capital, natural resources, or
technological knowledge
• i.e. all those factors that explained movements in the
LRAS curve (since they shift SRAS and LRAS), but also
– Increase in expected price level leads to leftward
shift of AS
– Decrease in expected price level leads to rightward
shift of AS
slide 4444
How will the following events affect the long run
and short run AS curve?
a) Labor migration causing increase in labor force.
b) improvement in technology leading to better
production efficiency.
c) Increase in expected price level.
d) Decrease in labor supply during COVID
pandemic.
slide 45 4
Exhibit
7The Long-Run Equilibrium
Price Long-run
aggregate
Level Short-run
supply
aggregate
supply
Equilibrium A
price
Aggregate
demand
Natural rate Quantity of Output
of output
slide 47
Aggregate demand- aggregate
supply analysis
Following any fiscal or
monetary contraction
AD curve shifts
inward, keeping AS
curve unaffected.
As a result, both
aggregate price level
and output decrease
in the economy.
slide 48