1. The Economy in the Short-Run
Aggregate Demand II
The Economy in the Short-Run
Source: "Macroeconomics", Mankiw, 4th Edition: Chapter 11, Fifth Edition: Chapter 11

2. Introduction In the last chapter we derived the IS and LM curves
IS curve: represents the equilibrium in the market for goods and services
LM Curve: represents the equilibrium in the market for real money balances
IS and LM curves together determine the interest rate and the national income in the short run, when the price level is fixed
Source: "Macroeconomics", Mankiw, 4th Edition: Chapter 11, Fifth Edition: Chapter 11

3. Introduction
Here, we examine potential causes of fluctuations in national income
Use IS-LM model to see:
How changes in government purchase and taxes (i.e. fiscal policy) influence the interest rate and national income. Note: Government purchases and taxes are the exogenous variables and interest rate and national income are the endogenous variables
Source: "Macroeconomics", Mankiw, 4th Edition: Chapter 11, Fifth Edition: Chapter 11

4. Introduction Use IS-LM model to see:
How changes in money supply (i.e. monetary policy) influence the interest rate and national income. Note: money supply is the exogenous variable. Interest rate and national income are the endogenous variables.
How shocks to the goods market (IS Curve) and the money market (LM Curve) affect the interest rate and national income.
Source: "Macroeconomics", Mankiw, 4th Edition: Chapter 11, Fifth Edition: Chapter 11

5. Introduction Use IS-LM model to see:
The slope and position of the aggregate demand curve
To determine the slope of the AD curve, we must relax the assumption that the price level is fixed
Source: "Macroeconomics", Mankiw, 4th Edition: Chapter 11, Fifth Edition: Chapter 11

6. Summary of what we will cover in this chapter
Explaining fluctuations with the IS-LM model:
How fiscal policy shifts the IS curve
How monetary policy shifts the LM curve
The interaction of fiscal and monetary policy
How shocks affect the IS and LM curves
IS-LM as a theory of aggregate demand
Source: "Macroeconomics", Mankiw, 4th Edition: Chapter 11, Fifth Edition: Chapter 11

7. IS-LM Model: How Fiscal Policy shifts the IS Curve
Fiscal policy: change in government purchases, change in taxes
Changes in fiscal policy ( G and T) affect expenditure in the economy and thereby shift the IS curve
Note: (Expenditure) E = C(Y-T) + I + G
Source: "Macroeconomics", Mankiw, 4th Edition: Chapter 11, Fifth Edition: Chapter 11

8. IS-LM Model: How Fiscal Policy shifts the IS Curve
An increase in Government purchases:
An increase in government purchases by ∆G
Government purchases multiplier = 1/1-MPC
This change in government purchases raises the level of income by ∆G/1-MPC
Therefore, the IS Curve shifts to the right by this amount
Equilibrium of the economy moves from A to B
Increase in Government purchases raises both income and the interest rate (See graph on next slide)
Source: "Macroeconomics", Mankiw, 4th Edition: Chapter 11, Fifth Edition: Chapter 11

9. Source: "Macroeconomics", Mankiw, 4th Edition: Chapter 11, Fifth Edition: Chapter 11

10. IS-LM Model: How Fiscal Policy shifts the IS Curve
A decrease in taxes:
A decrease in taxes by ∆T
A tax cut encourages consumers to spend more
It increases expenditure
Tax multiplier = -MPC/1-MPC
This change in tax raises the level of income by ∆T x MPC/1-MPC
Therefore, the IS curve shifts to the right by this amount
Equilibrium in the economy moves from point a to point b (see graph on next slide)
Source: "Macroeconomics", Mankiw, 4th Edition: Chapter 11, Fifth Edition: Chapter 11

11. Source: "Macroeconomics", Mankiw, 4th Edition: Chapter 11, Fifth Edition: Chapter 11