1. LECTURE OUTLINE
• Policy analysis with the IS-LM model
– Monetary policy
– Fiscal policy
– Interaction between monetary and fiscal
policies
– Shocks in the IS-LM model
• From the short run to the long run
– Adjustment back to General equilibrium
• Temporary adverse supply shock
• Derivation of aggregate demand curve
– Monetary policy and the AD curve
– Fiscal policy and the AD curve

2. Monetary Policy, Activity,
and the Interest Rate
•Monetary contraction, or monetary
tightening, refers to a decrease in the
money supply.
•An increase in the money supply is called
monetary expansion.
•Monetary policy does not affect the IS
curve, only the LM curve. For example, an
increase in the money supply shifts the LM
curve down.

3. Policy analysis with the IS -LM
model (Short Run)
Y
C(
Y
M P
T ) I (r ) G
r
LM
L (r ,Y )
We can use the IS-LM
model to analyze the
effects of
r1
IS
• fiscal policy: G and/or T
• monetary policy: M
Y1
A word of caution: the analysis in the following few slides is in the short
run, at a given (fixed) price level: No clearing of labor markets is required
at this stage)
Y

4. Monetary policy: An increase in M
1.
M > 0 shifts
the LM curve down
(or to the right)
2. …causing the
interest rate to fall
3. …which increases
investment, causing
output & income to
rise.
r
LM1
LM2
r1
r2
IS
Y1 Y2
Y

5. An increase in government
purchases
r
1. IS curve shifts
1
right by
G
LM
1 MPC
causing output &
income to rise.
2. This raises money
demand, causing the
interest rate to rise…
2.
3. …which reduces
investment, so the final
increase in Y
1
is smaller than
G
1 MPC
r2
r1
IS2
1.
IS1
Y1 Y2
3.
Y

6. A tax cut
Consumers save
r
(1 MPC) of the tax
cut, so the initial boost in
spending is smaller for T
r2
than for an equal G…
2.
r1
and the IS curve shifts by
1.
MPC
1 MPC
LM
1.
T
2. …so the effects on r
and Y are smaller for T
than for an equal G.
IS2
IS1
Y1 Y2
2.
Y

7. Fiscal Policy, Activity,
and the Interest Rate
Figure 5 - 9
The Effects of an
Increase in Taxes
•An increase in
taxes shifts the IS
curve to the
left, and leads to a
decrease in the
equilibrium level
of output and the
equilibrium
interest rate.

8. Interaction between
monetary & fiscal policy
• Model:
Monetary & fiscal policy variables
(M, G, and T ) are exogenous.
• Real world:
Monetary policymakers may adjust M
in response to changes in fiscal policy,
or vice versa.
• Such interaction may alter the impact of
the original policy change.

9. The Central Bank’s response to
G >0
• Suppose the government increases G.
• Possible central bank responses:
1. hold M constant
2. hold r constant
3. hold Y constant
• In each case, the effects of the G
are different:

10. Response 1: Hold M constant
If the government raises
G,
the IS curve shifts right.
r
If Central Bank holds M
constant, then LM curve
doesn’t shift.
r2
r1
LM1
IS2
IS1
Results:
Y
Y2
Y1
r
r2
r1
Y1 Y2
Y

11. Response 2: Hold r constant
If government raises G,
the IS curve shifts right.
r
To keep r
constant, central bank
increases M to shift LM
curve right.
r2
r1
LM1
IS2
IS1
Results:
Y
Y3
r
0
Y1
LM2
Y1 Y2 Y3
Y

12. Response 3: Hold Y constant
If government raises G,
the IS curve shifts right.
To keep Y constant,
central bank reduces
M to shift LM curve
left.
LM2
LM1
r
r3
r2
r1
IS2
IS1
Results:
Y
0
r
r3
Y1 Y2
r1
Y

13. Estimates of fiscal policy multipliers
from the DRI macroeconometric model
Assumption about
monetary policy
Estimated
value of
Y/ G
Estimated
value of
Y/ T
Fed holds money
supply constant
0.60
0.26
Fed holds nominal
interest rate constant
1.93
1.19

14. Shocks in the IS -LM model
IS shocks: exogenous changes in the
demand for goods & services.
Examples:
– stock market boom or crash
change in households’ wealth
C
– change in business or consumer
confidence or expectations
I and/or C

15. Shocks in the IS -LM model
LM shocks: exogenous changes in the
demand for money.
Examples:
– a wave of credit card fraud increases
demand for money.
– more ATMs or the Internet reduce money
demand.

16. Figure 9.9 Effects of a monetary
expansion: the Adjustment Towards General
Equilibrium

17. Figure 9.9 Effects of a monetary expansion: Short Run
and Long Run (cont’d)
So far we have simply taken the price level, P, as fixed.
In Fig. 9.9(b), the short-run equilibrium point, F, lies on the IS curve, implying
that the goods market is in equilibrium at that point with equal aggregate quantities of goods
supplied and demanded. Recall our assumption that firms are willing to meet any increases in
aggregate demand by producing more. In that sense, then, the aggregate quantity of goods supplied
equals the aggregate quantity of goods demanded.

18. Figure 9.9 Effects of a monetary expansion: Short Run
and Long Run (cont’d)
However, in another sense the goods market is not in equilibrium at point F. The problem is that, to meet the aggregate
demand for goods at F, firms have to produce more output than their full-employment level of output, Y.
Full-employment output, Y, is the level of output that maximizes firms' profits because that level of output corresponds to the
profit-maximizing level of employment. Therefore, in meeting the higher level of aggregate demand, firms are producing
more output than they would like. In the sense that, at point F, the production of goods by firms is not the level of
output that maximizes their profits, the goods market isn't truly in equilibrium.

19. Figure 9.9 Effects of a monetary expansion: Short Run
and Long Run (cont’d)
At point F the aggregate demand for goods exceeds firms' desired supply of output, Y, so we
can expect firms to begin raising their prices, causing the price level, P, to rise. With the
nominal money supply, M, set by the central bank, an increase in the price level, P, lowers the real
money supply, M/P, which in turn causes the LM curve to shift up and to the left. Aggregate demand
equals full-employment output only when the LM curve has returned to its initial position where it
passes through the original general equilibrium point, E. At E all three markets of the economy
again are in equilibrium, with output at its full-employment level.

20. Figure 9.8 Effects of a temporary adverse
supply shock
•The inflation rate rises temporarily, not permanently
•Summary: The real wage, employment, and output decline, while the real interest rate and price level
are higher
•There is a temporary burst of inflation as the price level moves to a higher level
•Since the real interest rate is higher and output is lower, consumption and investment must be lower

21. Aggregate Demand Curve
•The aggregate demand relation captures
the effect of the price level on output. It is
derived from the equilibrium conditions in
the goods and financial markets.

22. Deriving the AD curve
r
Intuition for slope
of AD curve:
P
LM(P2)
LM(P1)
r2
r1
(M/P )
LM shifts left
r
I
IS
P
Y2
Y1
Y
P2
P1
Y
AD
Y2
Y1
Y

23. Figure 9.10 Derivation of the
aggregate demand curve

24. Figure 9.10 Derivation of the aggregate
demand curve (cont’d)

25. Figure 9.11 The effect of an increase in
government purchases on the aggregate
demand curve

26. Figure 9.11 The effect of an increase in
government purchases on the aggregate
demand curve (cont’d)

27. Monetary policy and the AD curve
The Fed can increase
aggregate demand:
M
LM shifts right
r
LM(M1/P1)
LM(M2/P1)
r1
r2
IS
r
I
P
Y at each
Y1
Y2
Y
P1
value of P
Y1
Y2
AD2
AD1
Y

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

29. Figure 9.11 The effect of an increase in
government purchases on the aggregate
demand curve

30. Figure 9.11 The effect of an increase in
government purchases on the aggregate
demand curve (cont’d)

31. Aggregate Demand
• Let’s summarize:
 Starting from the equilibrium conditions for the
goods and financial markets, we have derived
the aggregate demand relation.
 This relation implies that the level of output is a
decreasing function of the price level. It is
represented by a downward-sloping curve,
called the aggregate demand curve.
 Changes in monetary or fiscal policy – or more
generally in any variable, other than the price
level, that shifts the IS or the LM curves – shift
the aggregate demand curve.