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Chapter 23 Monetary and Fiscal Policy in the ISLM Model © 2008 Pearson Education Canada 23.1 1. Factors that Shift the IS Curve • A change in autonomous factors that is unrelated to the interest rate – Changes in (autonomous) consumer expenditure unrelated to income: C – Changes in (planned) investment spending unrelated to the interest rate: I – Changes in government spending: G – Changes in taxes: T – Changes in net exports: NX © 2008 Pearson Education Canada 23.2 Summary: What shifts IS? • IS(C+I+G+X-M; T) © 2008 Pearson Education Canada 23.3 2. What Shifts LM Curve? • Changes in the money supply: M - Expansionary Monetary Policy shifts LM to the right - Contractionary Monetary Policy shifts LM to the left • Autonomous changes in money demand= Shocks/Disturbances in Monetary Markets: u -More Money Demand sends LM to the left -Less Money Demand sends LM to the right • Changes in the Price Level: P © 2008 Pearson Education Canada 23.4 *Sum: What shift LM curve? (MS/P, u) © 2008 Pearson Education Canada 23.5 Example 1) Shift in the LM Curve from an Increase in the Money Supply © 2008 Pearson Education Canada 23.6 Example 2) Shift in the LM Curve from an Increase in Money Demand © 2008 Pearson Education Canada 23.7 The above case of an increased money demand is highly relevant to the current financial crisis: • Recall that Money Market and Bond Market are closely related(substitutes) An increase in demand for cash = decrease in demand for financial assets such as bonds • The LM curve shifts to the ‘left’ • The net impact on the Money Market is equivalent to a decrease in Money Supply © 2008 Pearson Education Canada 23.8 3. Combining IS and LM shift What will happen to the equilibrium Y and the equilibrium i if LM shifts? © 2008 Pearson Education Canada 23.9 (1) Response to a Change in Monetary Policy • An increase in the money supply creates an excess supply of money -The interest rate declines -Investment spending and net exports rise - Y rises in the IS-LM. -Aggregate demand side of National Income rises © 2008 Pearson Education Canada 23.10 Response of National Income and Interest Rate to an Increase in the Money Supply © 2008 Pearson Education Canada 23.11 * Effects from Various Factors That Shift (the IS and) LM Curves © 2008 Pearson Education Canada 23.12 (3) Effectiveness of (Expansionary) Monetary Policy on Interest Rate and Y • With a normally shaped upward-sloping LM curve and a variety shapes of IS curves: • With a normally shaped IS and a speicial form of LM curve: © 2008 Pearson Education Canada 23.13 © 2008 Pearson Education Canada 23.14 Monetary Policy • The less interest-sensitive money demand is, the more effective monetary policy is relative to fiscal policy © 2008 Pearson Education Canada 23.15 4. Long-Run IS-LM 1) Flexible Price Level in LR So far, we have assumed that the Price Level is fixed- it is justifiable in the Short-run In the Long-run, the Price Level is flexible. Thus, the LM curve adjusts itself so that the equilibrium Y is equal to the full employment national income(Yf)1) © 2008 Pearson Education Canada 23.16 (2) Yn in the Long Run • Full employment nantional income is called ‘Natural rate level of output (Yn)’ – It is called ‘Full Employment National Income’ Yf as well – Rate of output at which the price level has no tendency to change – Neither monetary nor fiscal policy affects output in the long run – It is affected by Capital, Labor, and Technology. © 2008 Pearson Education Canada 23.17 (3) Which adjusts? • The IS curve is based on real values, so when the price level changes, the IS curve does not change • The LM curve is affected by the price level – As the price level rises, the quantity of money in real terms falls, and the LM curve shifts to the left until it reaches Yn (long-run monetary neutrality) © 2008 Pearson Education Canada 23.18 (4) Illustration: ISLM in the Long Run © 2008 Pearson Education Canada 23.19 • This is the end of IS-LM model. • The rest of chapter 23 serves as an introduction of Chapter 24 © 2008 Pearson Education Canada 23.20 5. Ultimately, AS-AD Model (1) AS and AD • Aggregate Supply Short-run AS Long-run AS • Aggregate Demand © 2008 Pearson Education Canada 23.21 (1) AS Curve • There are two AS curves: One is the Short-run AS curve, and the other corresponds to Yf or Yn © 2008 Pearson Education Canada 23.22 (2) AD First, focus on Deriving AD curve, And then shifting AD © 2008 Pearson Education Canada 23.23 (i) deriving the AD Curve by changing Price Level © 2008 Pearson Education Canada 23.24 (ii) Shifts of Aggregate Demand Curve For a given price level - change in C, I, G, NX,and/or T shifts IS curve and then AD curve(illustrated in b) - changes in M, u shifts LM curve and then AD curve(illustrate in a) © 2008 Pearson Education Canada 23.25 (a) Shift in the Aggregate Demand Curve from a Shift in the LM Curve © 2008 Pearson Education Canada 23.26 (b) Shift in the Aggregate Demand Curve from a Shift in the IS Curve © 2008 Pearson Education Canada 23.27 In sum, AD shifts due to Δ in C, I, G, NX, T and M, u. © 2008 Pearson Education Canada 23.28 (3) Equilibrium of AS-AD • (i) Basic © 2008 Pearson Education Canada 23.29 (ii) Changes to an increased MS • In the short-run, Y rises. • In the long-run, it depends on where the initial Y is compared to Yf. © 2008 Pearson Education Canada 23.30