Monetary Policy: an increase in M 1.△M>0 shifts the ly curve down (or to the right) 2 2. .causing the 1 interest rate to fall 3.∴ Which increases investment, causing output income to rise CHAPTER 11 Aggregate Demand Il slide 5
CHAPTER 11 Aggregate Demand II slide 5 2. …causing the interest rate to fall IS Monetary Policy: an increase in M 1. M > 0 shifts the LM curve down (or to the right) Y r LM1 r1 Y1 Y2 r2 LM2 3. …which increases investment, causing output & income to rise
Interaction between monetary fiscal policy Model: monetary fiscal policy variables ( M, G and T)are exogenous Real world Monetary policymakers may adjust M in response to changes in fiscal policy or vice versa Such interaction may alter the impact of the original policy change CHAPTER 11 Aggregate Demand Il slide 6
CHAPTER 11 Aggregate Demand II slide 6 Interaction between monetary & fiscal policy ▪ Model: monetary & fiscal policy variables (M, G and T ) are exogenous ▪ Real world: Monetary policymakers may adjust M in response to changes in fiscal policy, or vice versa. ▪ Such interaction may alter the impact of the original policy change
The Fed's response to AG>o Suppose Congress increases G. Possible fed responses 1. hold M constant 2. hold r constant 3. hold y constant In each case, the effects of the a are different CHAPTER 11 Aggregate Demand Il slide 7
CHAPTER 11 Aggregate Demand II slide 7 The Fed’s response to G > 0 ▪ Suppose Congress increases G. ▪ Possible Fed responses: 1. hold M constant 2. hold r constant 3. hold Y constant ▪ In each case, the effects of the G are different:
Response 1: hold M constant If Congress raises G, the is curve shifts LM ight If Fed holds mi constant then lm curve doesn't shift Results △y=y-y YY2 △r=12- CHAPTER 11 Aggregate Demand Il slide 8
CHAPTER 11 Aggregate Demand II slide 8 If Congress raises G, the IS curve shifts right IS1 Response 1: hold M constant Y r LM1 r1 Y1 IS2 Y2 r2 If Fed holds M constant, then LM curve doesn’t shift. Results: = − Y Y Y 2 1 2 1 = − r r r
Response 2: hold r constant If Congress raises G the s curve shifts LMi right Lm2 To keep r constant Fed increases to shift LM curve right. Results △y=y3-Y YY2Y3 △r=0 CHAPTER 11 Aggregate Demand Il slide 9
CHAPTER 11 Aggregate Demand II slide 9 If Congress raises G, the IS curve shifts right IS1 Response 2: hold r constant Y r LM1 r1 Y1 IS2 Y2 To keep r constant, r2 Fed increases M to shift LM curve right. = − Y Y Y 3 1 = r 0 LM2 Y3 Results: