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Department
Economics for Management Studies
Course Code
MGEB06H3
Professor
Jack Parkinson

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Chapter 11: Aggregate Demand II: Applying the IS-LM Model Notes
11.1 Explaining Fluctuations with the IS-LM Model
x the intersection of the IS curve and the LM cure determines the level of national income
x when one of these curves shifts, the SR equilibrium of the economy changes, and national income fluctuates
How Monetary Policy Shifts the LM Curve and Changes the Short-Run Equilibrium
x monetary transmission mechanism Æ the process by which changes in the money supply influence the amount that households
and firms wish to spend on goods and services
x the IS-LM model shows an important part of that mechanism: an increase in the money supply lowers the interest rate, which
stimulates investment and thereby expands the demand for goods and services
Shocks in the IS-LM Model
x shocks to the IS curve are exogenous changes in the demand for goods and services
x some economists, including Keynes, have emphasized that such changes in demand can arise from investors’ animal spirits
exogenous and perhaps self-fulfilling waves of optimism and pessimism
x shocks to the IS curve may also arise from changes in the demand for consumer goods
x shocks to the LM curve arise from exogenous changes in the demand for money
11.2 IS-LM as a Theory of Aggregate Demand
From the IS-LM Model to the Aggregate Demand Curve
x a change in income in the IS-LM model resulting from a change in the price level represents a movement along the AD curve
x a change in income in the IS-LM model for a fixed price level represents a shift in the position of the AD curve
11.3 The Great Depression
The Money Hypothesis Again: The Effects of Falling Prices
x Pigou effect Æ increase in C that results when a fall in price level raises real money balances and, thereby, consumers wealth
x debt-deflation theory Æ a theory according to which an unexpected fall in the price level redistributes real wealth from debtors
to creditors and, therefore, reduces total spending in the economy
Summary
1. The IS-LM model is a general theory of the aggregate demand for goods and services. The exogenous variables in the model are
fiscal policy, monetary policy, and the price level. The model explains two endogenous variables: the interest rate and the level
of national income.
2. The IS curve represents the negative relationship between the interest rate and the level of income that arises from equilibrium in
the market for goods and services. The LM curve represents the positive relationship between the interest rate and the level of
income that arises from equilibrium in the market for real money balances. Equilibrium in the IS-LM model—the intersection of
the IS and LM curves—represents simultaneous equilibrium in the market for goods and services and in the market for real
money balances.
3. The aggregate demand curve summarizes the results from the IS-LM model by showing equilibrium income at any given price
level. The aggregate demand curve slopes downward because a lower price level increases real money balances, lowers the
interest rate, stimulates investment spending, and thereby raises equilibrium income.
4. Expansionary fiscal policy—an increase in government purchases or a decrease in taxes—shifts the IS curve to the right. This
shift in the IS curve increases the interest rate and income. The increase in income represents a rightward shift in the aggregate
demand curve. Similarly, contractionary fiscal policy shifts the IS curve to the left, lowers the interest rate and income, and shifts
the aggregate demand curve to the left.
5. Expansionary monetary policy shifts the LM curve downward. This shift in the LM cure lowers the interest rate and raises
income. The increase in income represents a rightward shift of the aggregate demand curve. Similarly, contractionary monetary
policy shifts the LM curve upward, raises the interest rate, lowers income, and shifts the aggregate demand curve to the left.
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Description
Chapter 11: Aggregate Demand II: Applying the IS-LM Model Notes 11.1 Explaining Fluctuations with the IS-LM Model N the intersection of the IS curve and the LM cure determines the level of national income N when one of these curves shifts, the SR equilibrium of the economy changes, and national income fluctuates How Monetary Policy Shifts the LM Curve and Changes the Short-Run Equilibrium N monetary transmission mechanism the process by which changes in the money supply influence the amount that households and firms wish to spend on goods and services N the IS-LM model shows an important part of that mechanism: an increase in the money supply lowers the interest rate, which stimulates investment and thereby expands the demand for goods and services Shocks in the IS-LM Model N shocks to the IS curve are exogenous changes in the demand for goods and services N some economists, including Keynes, have emphasized that such changes in demand can arise from investors animal spirits exogenous and perhaps self-fulfilling waves of optimism and pessimism N shocks to the IS curve may also arise from changes in the demand for consumer goods N shocks to the LM curve arise from exogenous changes in the demand for money 11.2 IS-LM as a Theory of Aggregate Demand From the IS-LM Model to the Aggregate Demand Curve N a change in income in the IS-LM model resulting from a change in the price level represents a movement along the AD curve N a change in income in the IS-LM model for a fixed price level represents a shift in the position of the AD curve 11.3 The Great Depression The Money Hypothesis Again: The Effects of Falling Prices N Pigou effect increase in C that results when a fall in price level raises real money balances and, thereby, consumers wealth N debt-deflation theory a theory according to which an unexpected fall in the price level redistributes real wealth from debtors to creditors and, therefore, reduces total spending in the economy Summary 1. The IS-LM model is a gene
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