Chapter 11: Aggregate Demand II

 

This chapter uses the IS-LM model to explain fluctuations in income and interest rates based upon exogenous influences in the economy.

 

The Impact of Fiscal Policy

 

1.  Changes in fiscal policy can cause a shift in the IS curve.

 

          a.  Autonomous changes in government spending or taxes (independent of income) cause the IS curve to shift. 

          b.  More spending or lower taxes shifts the IS curve to the right, addding to national income at every interest rate. 

          c.  Less spending or higher taxes shifts the IS curve to the left, reducing income at every interest rate.

 

2.  The impact on income of a shift in the IS curve depends upon  the slope of the LM curve.

 

          a.  A flat LM curve (Keynesian money demand) results in a significant influence on income financed out of idle balances (increased money velocity).

          b.  A steep LM curve (classical money demand) results in an insignificant inflence on income unless there is an increase in the money supply (crowding out effect).

 

The Impact of Monetary Policy

 

1.  Changes in the money supply shift the LM curve.

 

          a.  More money shifts the LM curve to the right increasing income at every interest rate.

          b.  Less money shifts the LM curve to the left reducing income at every interest rate.

 

2.  The impact of changes in the money supply depends (in part) upon the slope of the IS curve.

 

          a.  A steep IS curve (interest inelastic investment function) results in little effect on income of a change in the money supply.

          b.  A flatter IS curve (interest elastic investment function) results in a larger effect on income of a change in the money supply.

 

The Interaction Between Monetary and Fiscal Policy

 

1.  Suppose taxes are increased and the Fed desires to hold interest rates constant.  What is the Fed’s response?

          a.  Higher taxes shift the IS curve to the left and lower desired spending and income.  For a given LM curve real interest rates would fall to increase the demand for speculative money balances by the amount to offset the decrease in demand for transactions balances.

          b.  To keep interest rates unchanged the Fed would have to lower the money supply, shifting the LM curve to the left until the supply of money fell by the amount of the reduction in the demand for transactions balances.

 

2.  Two other responses by the Fed to higher taxes are as follows:

          a.  No response which results in lower interest rates and income.

          b.  More money which results in even lower interest rates necessary to keep income constant.  Under this circumstance the LM curve shifts outward by the amount that the IS curve shifts inward.  Less consumer demand from higher taxes is offset by more investment demand at lower interest rates.

 

What is the impact of more government spending?

          a.  A shift in the IS curve to the right increasing equilibrium income and interest rates for an upward sloping LM curve.

          b.  If interest rates are held constant the money supply is expanded to finance the spending and the LM curve shifts to the right.

          c.  Fiscal multipliers (in fourth quarte following change) according the the DRI model are given in Table 10-1 for and increase in spending or lower taxes, with and without an accomodating change in the money supply.

 

Shocks in the Goods Market and/or the Money Market cause shifts in the IS and/or LM curves that also shift the Keynesian aggregate demand schedule.

         

 

The IS-LM Model in the Short Run and the Long Run

 

1.  Short run equilibrium occurs at a level of income where the IS-LM curves intersect.  This is consistent with a particular “sticky” price level.  However, if the level of output is not at the natural rate of output, in the long-run the price level will change until a price level and output level are at the natural rate of unemployment.

 

2.  The questions asked by policy makers are (a) will the price level adjust and (b) how long will it take for it to adjust?

 

The Great Depression

 

1.  What caused the Great Depression?  IS shift to the left, LM shift to the left, or both?

2.  The Spending Hypothesis says that consumers and investors stopped spending in response to overspeculation and overbuilding of the 20s, stock market crash in 1929, bank lending policies, and federal government policies to balance the budget.  (Both Y and r fell)

3.  The money hypothesis (Friedman and Swartz) holds that the LM curve shifted to the left because of the reduction in real money balances.

 

4.  The effects of falling prices due to less money resulted in shifts in the IS curve.

          a.  Pigou effect lowered wealth

          b.  Debt-deflation increased burden on debtors who had a higher propensity to spend than creditors.

          c.  Deflation resulted in lower price expectations that shifts IS curve downward by adversely affecting investment spending.

 

Expected Deflation Model

         

          a.  Demand for money depends upon nominal interest rates rather than real interest rates.

          b.  Demand for investment depends upon real interest rates which is the nominal rate less expected inflation (Fisher effect).

          c.  In an IS-LM model with nominal interest rates the IS curve shifts to the left with expected deflation since this raises real interest rates and lowers desred investment.