demand applying islm model

8/20/2019 Demand Applying ISLM Model

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Aggregate Demand II: Applying the IS–LM Model

Explaining Fluctuations with the IS–LM Model

Consider an increase in government purchases of ΔG. Here is the story. When the governmentincreases its purchases of goods and services, the economy’s planned expenditure rises. The increase inplanned expenditure stimulates the production of goods and services, which causes total income torise. !ow consider the money mar"et, as descri#ed #y the theory of li$uidity preference. %ecause theeconomy’s demand for money depends on income, the rise in total income increases the $uantity of money demanded at every interest rate. The supply of money has not changed, however, so highermoney demand causes the e$uili#rium interest rate r to rise.The higher interest rate arising in the money mar"et, in turn, has ramifications #ac" in the goodsmar"et. When the interest rate rises, firms cut #ac" on their investment plans. This fall in investmentpartially offsets the expansionary effect of the increase in government purchases. Thus, the increase inincome in response to a fiscal expansion is smaller in the &'()* model than it is in the +eynesian crosswhere investment is assumed to #e fixed-. The difference is explained #y the crowding out of investment due to a higher interest rate.

&n the &'()* model, changesin taxes affect the economy

much the same as changes ingovernment purchases do,except that taxes affectexpenditure throughconsumption. Consider, forinstance, a decrease in taxes of ΔT. The tax cut encouragesconsumers to spend more and,therefore, increases plannedexpenditure. Therefore, the &'curve shifts to the right #y thisamount. The e$uili#rium of theeconomy moves from point to point %. The tax cut raises

#oth income and the interestrate. /nce again, #ecause thehigher interest rate depressesinvestment, the increase inincome is smaller in the &'()*

model than it is in the +eynesian cross.

Consider an increase in the money supply. n increase in * leads to an increase in real money#alances *01, #ecause the price level 1 is fixed in the short run. The theory of li$uidity preference showsthat for any given level of income, an increase in real money #alances leads to a lower interest rate.Therefore, the )* curve shifts downward, and the e$uili#rium moves from point to point %. Theincrease in the money supply lowers the interest rate and raises the level of income.

/nce again, to tell the story, thistime, we #egin with the moneymar"et, where the monetary2policyaction occurs. When the 3ederal4eserve increases the supply of money, people have more moneythan they want to hold at theprevailing interest rate. s a result,they start depositing this extramoney in #an"s or using it to #uy#onds. The interest rate r then fallsuntil people are willing to hold allthe extra money that the 3ed hascreated5 this #rings the money

mar"et to a new e$uili#rium. Thelower interest rate, in turn, has



ramifications for the goods mar"et. lower interest rate stimulates planned investment, which increasesplanned expenditure, production, and income .

The &'()* model shows that an increase in the money supply lowers the interest rate, which stimulatesinvestment and there#y expands the demand for goods and services.

Shocs in the IS–LM Model

%ecause the &'()* model shows how national income is determined in the short run, we can use the

model to examine how various economic distur#ances affect income. We can group distur#ances intotwo categories6 shoc"s to the &' curve and shoc"s to the )* curve.'hoc"s to the &' curve are exogenous changes in the demand for goods and services. 'ome economists,

including +eynes, have emphasi7ed that such changes in demand can arise from investors’ animal spirits8exogenous and perhaps self2fulfilling waves of optimism and pessimism. 3or example, suppose that

firms #ecome pessimistic a#out the future of the economy and that this pessimism causes them to #uildfewer new factories. This reduction in the demand for investment goods causes a contractionary shift in

the investment function6 at every interest rate, firms want to invest less. The fall in investment reducesplanned expenditure and shifts the &' curve to the left, reducing income and employment. This fall in

e$uili#rium income in part validates the firms’ initial pessimism.'hoc"s to the &' curve may also arise from changes in the demand for consumer goods. 'uppose, for

instance, that the election of a popular president increases consumer confidence in the economy. Thisinduces consumers to save less for the future and consume more today. We can interpret this change as

an upward shift in the consumption function. This shift in the consumption function increases planned

expenditure and shifts the &' curve to the right, and this raises income.'hoc"s to the )* curve arise from exogenous changes in the demand for money. 3or example, supposethat new restrictions on credit2card availa#ility increase the amount of money people choose to hold.

ccording to the theory of li$uidity preference, when money demand rises, the interest rate necessary toe$uili#rate the money mar"et is higher for any given level of income and money supply-. Hence, an

increase in money demand shifts the )* curve upward, which tends to raise the interest rate anddepress income.

&n summary, several "inds of events can cause economic fluctuations #y shifting the &' curve or the )*curve.

IS–LM as a !heory o" Aggregate Demand

3or any given money supply *, a higher price level 1 reduces the supply of real money #alances *01. lower supply of real money #alances shifts the )* curve upward, which raises the e$uili#rium interest

rate and lowers the e$uili#rium level of income.

nything that changes income in the &'()* model other than a change in the price level causes a shiftin the aggregate demand curve. The factors shifting aggregate demand include not only monetary andfiscal policy #ut also shoc"s to the goods mar"et the &' curve- and shoc"s to the money mar"et the)* curve-.We can summari7e these results as follows6 change in income in the &'()* model resulting from achange in the price level represents a movement along the aggregate demand curve. change inincome in the &'()* model for a given price level represents a shift in the aggregate demand curve.



!he IS–LM Model in the Short #un and Long #un

The &'()* model isdesigned to explain theeconomy in the shortrun when the pricelevel is fixed. et, nowthat we have seen howa change in the pricelevel influences the

e$uili#rium in the &'()* model, we can alsouse the model todescri#e the economyin the long run whenthe price level ad9uststo ensure that theeconomy produces at

its natural rate.1anel a- of 3igure ::2; shows the three curves that are necessary for understanding the short2run andlong2run e$uili#ria6 the &' curve, the )* curve, and the vertical line representing the natural level of output . The )* curve is, as always, drawn for a fixed price level 1:. The short2run e$uili#rium of theeconomy is point +, where the &' curve crosses the )* curve. !otice that in this short2run e$uili#rium,the economy’s income is less than its natural level.1anel #- of 3igure ::2; shows the same situation in the diagram of aggregate supply and aggregatedemand. t the price level 1:, the $uantity of output demanded is #elow the natural level. &n other



words, at the existing price level, there is insufficient demand for goods and services to "eep theeconomy producing at its potential.

1oint + descri#es the short2run e$uili#rium, #ecause it assumes that the price level is stuc" at 1:.

<ventually, the low demand for goods and services causes prices to fall, and the economy moves #ac"toward its natural rate. When the price level reaches 1=, the economy is at point C, the long2run

e$uili#rium. The diagram of aggregate supply and aggregate demand shows that at point C, the $uantity

of goods and services demanded e$uals the natural level of output. This long2run e$uili#rium is achievedin the &'()* diagram #y a shift in the )* curve6 the fall in the price level raises real money #alancesand therefore shifts the )* curve to the right.

The +eynesian assumption represented #y point +- is that the price level is stuc". >epending onmonetary policy, fiscal policy, and the other determinants of aggregate demand, output may deviate

from its natural level. The classical assumption represented #y point C- is that the price level is fullyflexi#le. The price level ad9usts to ensure that national income is always at its natural level.

We can thin" of the economy as #eing descri#ed #y three e$uations. The first two are the &' and )*

e$uations6&'6 ? C ( T- @ &r- @ G

)*6 *01 ? )r,-The &' e$uation descri#es the e$uili#rium in the goods mar"et, and the )* e$uation descri#es the

e$uili#rium in the money mar"et. These two e$uations contain three endogenous varia#les6 , 1, and r.

To complete the system, we need a third e$uation. The +eynesian approach completes the model withthe assumption of fixed prices, so the +eynesian third e$uation is 1 ? 1:.This assumption implies that the remaining two varia#les r and must ad9ust to satisfy the remaining

two e$uations &' and )*.The classical approach completes the model with the assumption that output reaches its natural level, so

the classical third e$uation is ? .This assumption implies that the remaining two varia#les r and 1 must ad9ust to satisfy the remaining

two e$uations &' and )*. Thus, the classical approach fixes output and allows the price level to ad9ust tosatisfy the goods and money mar"et e$uili#rium conditions, whereas the +eynesian approach fixes the

price level and lets output move to satisfy the e$uili#rium conditions.Which assumption is most appropriateA The answer depends on the time hori7on. The classical

assumption #est descri#es the long run. Hence, our long2run analysis of national income in Chapter Band prices in Chapter assumes that output e$uals its natural level. The +eynesian assumption #est

descri#es the short run. Therefore, our analysis of economic fluctuations relies on the assumption of afixed price level.

demand applying islm model

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