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Chapter 21
Monetary andFiscal Policy in
the ISLM Model
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Factors that Shift the ISCurve
• A change in autonomous factors that isunrelated to the interest rate
– Changes in autonomous consumer expenditure
– Changes in planned investment spendingunrelated to the interest rate
– Changes in government spending
– Changes in taxes– Changes in net exports unrelated to the
interest rate
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FIGURE 1 Shift in the IS Curve
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Factors that Shift the LMCurve
• Changes in the money supply
• Autonomous changes in money demand
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FIGURE 2 Shift in the LM Curve from anIncrease in the Money Supply
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FIGURE Shift in the LM CurveWhen Money Demand Increases
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Response to a Chan!e inMonetary Policy
• An increase in the money supply creates anexcess supply of money
• The interest rate declines
• Investment spending and net exports rise
• Aggregate demand rises
• Aggregate output rises
• The excess supply of money is eliminated• Aggregate output is positively related to the
money supply
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FIGURE " esponse of Aggregate !utput andthe Interest ate to an Increase in the MoneySupply
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Response to a Chan!e inFiscal Policy
• An increase in government spending raisesaggregate demand directly" a decrease intaxes ma#es more income availa$le for
spending
• The increase in aggregate demand causeaggregate output to rise
• A higher level of aggregate output increasesthe demand for money
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Response to a Chan!e inFiscal Policy #cont$d%
• The excess demand for money pushes theinterest rate higher
• The rise in the interest rate eliminates theexcess demand for money
• Aggregate output and the interest rate arepositively related to government spending
and negatively related to taxes
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FIGURE & esponse of Aggregate !utput andthe Interest ate to an %xpansionary &iscal 'olicy
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Monetary versus Fiscal Policy
• Complete cro(ding out
– %xpansionary fiscal policy does not lead to a risein output
– Increased government spending increases theinterest rate and )cro(ds out* investmentspending and net exports
• The less interest+sensitive money demand is,
the more effective monetary policy isrelative to fiscal policy
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Su''ary (a)le 1 %ffects from &actorsThat Shift the IS and LM Curves
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FIGURE * %ffectiveness of Monetary and &iscal'olicy When Money Demand Is -naffected $y theInterest ate
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(ar!etin! Ms versus InterestRates
• If the IS curve is more unsta$le .uncertain/than the 0M curve, a Ms target is prefera$le
• If the 0M curve is more unsta$le than the IScurve, an interest+rate target is preferred
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FIGURE + Money Supply and Interest+ateTargets When the IS Curve Is -nsta$le and theLM Curve Is Sta$le
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FIGURE , Money Supply and Interest+ateTargets When the LM Curve Is -nsta$le and the IS Curve Is Sta$le
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ISLM Model in the Lon! Run
• 1atural rate level of output .Y n/
– ate of output at (hich the price level has no tendencyto change
• -sing real values, so (hen the price level changes,the IS curve does not change
• The 0M curve is affected $y the price level
– As the price level rises, the 2uantity of money in real
terms falls, and the 0M curve shifts to the left until itreaches Y n .long+run monetary neutrality/
• 1either monetary or fiscal policy affects output inthe long run
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FIGURE - ISLM Model in the 0ongun
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FIGURE 1. Deriving the AggregateDemand Curve
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/erivin! the 0!!re!ate/e'and Curve
• Aggregate demand curve3 relationship$et(een the price level and 2uantity ofaggregate output for (hich the goods
mar#et and mar#et for money are ine2uili$rium
• As the price level increases, output falls4
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FIGURE 11 Shift in the Aggregate DemandCurve Caused $y a Shift in the IS Curve
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FIGURE 12 Shift in the Aggregate DemandCurve Caused $y a Shift in the LM Curve