ECMB06 Chapter 11

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University of Toronto Scarborough
Economics for Management Studies
Jack Parkinson

Part IV Business Cycle Theory The Economy in the Short Run Chapter 11Aggregate Demand II Applying the ISLM Model ReviewIS curve represents the equilibrium in the market for goods and services and the LM curve represents the equilibrium in the market for real money balances The IS and LM curves together determine the interest rate and the national income in the SR when P level is fixedThe ISLM model provides a theory to explain the slope and position of the aggregate demand curve In this chapter we examineHow changes in the exogenous variables G T and MS influence the endogenous variables interest rate and national income for a given P level using the ISLM modelHow various shocks to the goods markets the IS curve and the money market the LM curve affect the interest rate and the national income in the SR Also in this chapter we relax the assumption that the price level is fixed and we show that the ISLM model implies a negative relationship between P level and national income The model can also tell us what events shift the aggregate demand curve and in what direction111 Explaining Fluctuations with the ISLM ModelThe intersection of the IS curve and the LM curve determines the level of national incomeWhen one of these curves shifts the SR equilibrium of the economy changes and national income fluctuatesHow Fiscal Policy Shifts the IS Curve and Changes the SR EquilibriumReview Changes in fiscal policy influence planned expenditure and thereby shift the IS curveChanges in Government Purchases and Tax Consider an increase of G in government purchases and decrease in TThe G multiplier in the Keynesian cross tells us that this change in fiscal policy raises the level of income at any given interest rate by G1MPC When the government increase its purchases ofThus IS curve shifts to the right by G1MPCgoods and services the economys PE risesTheThus the increase in G raises both income and the interest rate increase in PE stimulates the production of LM Interest Rate r goods and services which causes total income Y to rise BNow because the money demand depends on r2income the rise in Y increases the quantity of money demanded at every interest rate A r 1 dNote that MS is unchanged thus higher Mcauses the equilibrium r to riseG1MPC IS2 IS 1Income Output Y Y Y 12
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