chapter 11: aggregate demand ii: applying the is lm model* · pdf filemacroeconomics chapter...
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MACROECONOMICS
Chapter 11: Aggregate Demand II:Applying the IS -LM Model*
Chapter 11: Aggregate Demand II: Applying the IS–LM Model 0/56
Seventh Edition
N. Gregory Mankiw
* Slides based on Ron Cronovich's slides, adjusted for course in Study Abroad Program at the Wang Yanan Institute for Studies in Economics at Xiamen University.
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Learning Objectives
This chapter introduces you to understanding:
explaining fluctuations with the IS–LM model
using IS–LM as a theory of aggregate demand
Chapter 11: Aggregate Demand II: Applying the IS–LM Model 1/56
using IS–LM as a theory of aggregate demand
the great depression
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11.1) Explaining Fluctuations: IS –LM� Equilibrium in the IS -LM Model
The IS curve represents equilibrium in the goods market.
( ) ( )Y C Y T I r G= − + +
r
LM
r
Chapter 11: Aggregate Demand II: Applying the IS–LM Model 2/56
The intersection determines the unique combination of Y and rthat satisfies equilibrium in both markets.
The LM curve represents money market equilibrium.
( , )M P L r Y= IS
Y
r1
Y1
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11.1) Explaining Fluctuations: IS –LM� Policy Analysis with the IS -LM Model
We can use the IS-LMmodel to analyze the
( ) ( )Y C Y T I r G= − + +
( , )M P L r Y=
r
LM
Chapter 11: Aggregate Demand II: Applying the IS–LM Model 3/56
model to analyze the effects of
• fiscal policy: G and/or T
• monetary policy: M
IS
Y
r1
Y1
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11.1) Explaining Fluctuations: IS –LM� An Increase in Government Purchases
causing output & income to rise.
1. IS curve shifts right r
LM
r1
1by
1 MPCG∆
−r2
2.
Chapter 11: Aggregate Demand II: Applying the IS–LM Model 4/56
income to rise.
IS1
Y
r1
Y1
IS2
Y2
1.2. This raises money
demand, causing the interest rate to rise…
3. …which reduces investment, so the final increase in Y
1is smaller than
1 MPCG∆
−
3.
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11.1) Explaining Fluctuations: IS –LM� A Tax Cut
r
LM
r
r2
Consumers save (1−MPC) of the tax cut, so the initial boost in spending is smaller for ∆∆∆∆T than for an equal ∆∆∆∆G… 2.
Chapter 11: Aggregate Demand II: Applying the IS–LM Model 5/56
IS1
1.
Y
r1
Y1
IS2
Y2
equal ∆∆∆∆G…
and the IS curve shifts by
MPC1 MPC
T− ∆−
1.
2.
2.…so the effects on rand Y are smaller for ∆∆∆∆Tthan for an equal ∆∆∆∆G.
2.
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11.1) Explaining Fluctuations: IS –LM� Monetary Policy: An Increase in M
2. …causing the
1. ∆∆∆∆M > 0 shifts the LM curve down(or to the right)
rLM1
r1
LM2
Chapter 11: Aggregate Demand II: Applying the IS–LM Model 6/56
2. …causing the interest rate to fall
IS
YY1
Y2
r2
3. …which increases investment, causing output & income to rise.
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11.1) Explaining Fluctuations: IS –LM� Interaction between Monetary & Fiscal Policy
• Model: Monetary & fiscal policy variables (M, G, and T ) are exogenous.
• Real world: Monetary policymakers may adjust M
Chapter 11: Aggregate Demand II: Applying the IS–LM Model 7/56
Monetary policymakers may adjust Min response to changes in fiscal policy, or vice versa.
• Such interaction may alter the impact of the original policy change.
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11.1) Explaining Fluctuations: IS –LM� The Fed’s Response to ∆G > 0
• Suppose Congress increases G.
• Possible Fed responses:
1. wants to hold M constant
2. wants to hold r constant
Chapter 11: Aggregate Demand II: Applying the IS–LM Model 8/56
2. wants to hold r constant
3. wants to hold Y constant
• In each case, the effects of the ∆∆∆∆Gare different:
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11.1) Explaining Fluctuations: IS –LM� Response 1: Hold M Constant
If Congress raises G, the IS curve shifts right.
r
LM1
r
r2If Fed holds M
Chapter 11: Aggregate Demand II: Applying the IS–LM Model 9/56
IS1
Y
r1
Y1
IS2
Y2
constant, then LMcurve doesn’t shift.
Results:
2 1Y Y Y∆ = −
2 1r r r∆ = −
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11.1) Explaining Fluctuations: IS –LM� Response 2: Hold r Constant
If Congress raises G, the IS curve shifts right.
r
LM1
r
r2To keep r constant,
LM2
Chapter 11: Aggregate Demand II: Applying the IS–LM Model 10/56
IS1
Y
r1
Y1
IS2
Y2
Fed increases Mto shift LM curve right.
3 1Y Y Y∆ = −
0r∆ =
Y3
Results:
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11.1) Explaining Fluctuations: IS –LM� Response 3: Hold Y Constant
r
LM1
r
r2To keep Y constant,
LM2
r3
If Congress raises G, the IS curve shifts right.
Chapter 11: Aggregate Demand II: Applying the IS–LM Model 11/56
IS1
Y
r1
IS2
Y2
To keep Y constant, Fed reduces Mto shift LM curve left.
0Y∆ =3 1
r r r∆ = −
Results:Y1
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11.1) Explaining Fluctuations: IS –LM�Estimates of Fiscal Policy Multipliers
from the DRI Macroeconometric model
Assumption about monetary policy
Estimated value of ∆∆∆∆Y / ∆∆∆∆G
Estimated value of ∆∆∆∆Y / ∆∆∆∆T
Chapter 11: Aggregate Demand II: Applying the IS–LM Model 12/56
monetary policy ∆∆∆∆Y / ∆∆∆∆G
Fed holds nominal interest rate constant
Fed holds money supply constant
1.93
0.60
∆∆∆∆Y / ∆∆∆∆T
−−−−1.19
−−−−0.26
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11.1) Explaining Fluctuations: IS –LM�Shocks in the IS-LM Model
IS shocks : exogenous changes in the demand for goods & services.
Examples:
– stock market boom or crash
Chapter 11: Aggregate Demand II: Applying the IS–LM Model 13/56
– stock market boom or crash⇒ change in households’ wealth⇒ ∆∆∆∆C
– change in business or consumer confidence or expectations ⇒ ∆∆∆∆I and/or ∆∆∆∆C
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11.1) Explaining Fluctuations: IS –LM�Shocks in the IS-LM Model (cont.)
LM shocks : exogenous changes in the demand for money.
Examples:
– a wave of credit card fraud increases demand
Chapter 11: Aggregate Demand II: Applying the IS–LM Model 14/56
– a wave of credit card fraud increases demand for money.
– more ATMs or the Internet reduce money demand.
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11.1) Explaining Fluctuations: IS –LM� 该你们了: Analyze Shocks with the IS-LM Model
Use the IS-LM model to analyze the effects of1. a boom in the stock market that makes
consumers wealthier.2. after a wave of credit card fraud, consumers
using cash more frequently in transactions.
Chapter 11: Aggregate Demand II: Applying the IS–LM Model 15/56
using cash more frequently in transactions.
For each shock, a. use the IS-LM diagram to show the effects of the
shock on Y and r.b. determine what happens to C, I, and the
unemployment rate.
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11.1) Explaining Fluctuations: IS –LM� CASE STUDY: The U.S. Recession of 2001
• During 2001,
– 2.1 million people lost their jobs, as unemployment rose from 3.9% to 5.8%.
– GDP growth slowed to 0.8%
Chapter 11: Aggregate Demand II: Applying the IS–LM Model 16/56
– GDP growth slowed to 0.8% (compared to 3.9% average annual growth during 1994-2000).
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11.1) Explaining Fluctuations: IS –LM� CASE STUDY: The U.S. Recession of 2001
• Causes: 1) Stock market decline ⇒ ↓C
1200
1500
Inde
x (1
942
= 1
00) Standard & Poor’s 500
Chapter 11: Aggregate Demand II: Applying the IS–LM Model 17/56
300
600
900
1200
1995 1996 1997 1998 1999 2000 2001 2002 2003
Inde
x (1
942
= 1
00)
500
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11.1) Explaining Fluctuations: IS –LM� CASE STUDY: The U.S. Recession of 2001
• Causes: 2) 9/11
– increased uncertainty
– fall in consumer & business confidence
– result: lower spending, IS curve shifted left
Chapter 11: Aggregate Demand II: Applying the IS–LM Model 18/56
– result: lower spending, IS curve shifted left
• Causes: 3) Corporate accounting scandals
– Enron, WorldCom, etc.
– reduced stock prices, discouraged investment
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11.1) Explaining Fluctuations: IS –LM� CASE STUDY: The U.S. Recession of 2001
• Fiscal policy response: shifted IS curve right
– tax cuts in 2001 and 2003
– spending increases
• airline industry bailout
Chapter 11: Aggregate Demand II: Applying the IS–LM Model 19/56
• airline industry bailout• NYC reconstruction • Afghanistan war
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11.1) Explaining Fluctuations: IS –LM� CASE STUDY: The U.S. Recession of 2001
• Monetary policy response: shifted LM curve right
Three-month T-Bill Rate
Three-month T-Bill Rate
4
5
6
7
Chapter 11: Aggregate Demand II: Applying the IS–LM Model 20/56
0
1
2
3
4
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Learning Objectives
This chapter introduces you to understanding:
explaining fluctuations with the IS–LM model
using IS–LM as a theory of aggregate demand
Chapter 11: Aggregate Demand II: Applying the IS–LM Model 21/56
using IS–LM as a theory of aggregate demand
the great depression
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11.2) IS-LM as Theory of Agg. Demand� IS-LM and Aggregate Demand
• So far, we’ve been using the IS-LM model to analyze the short run, when the price level is assumed fixed.
• However, a change in P would
Chapter 11: Aggregate Demand II: Applying the IS–LM Model 22/56
• However, a change in P would shift LM and therefore affect Y.
• The aggregate demand curve(introduced in Chap. 9) captures this relationship between P and Y.
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11.2) IS-LM as Theory of Agg. Demand� Deriving the AD Curve
r
IS
LM(P1)
LM(P2)
r2
r1
Intuition for slope of AD curve:
↑P ⇒ ↓(M/P )
Chapter 11: Aggregate Demand II: Applying the IS–LM Model 23/56
Y1Y2Y
Y
P
IS
AD
P1
P2
Y2 Y1
⇒ LM shifts left
⇒ ↑r
⇒ ↓I
⇒ ↓Y
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IS
LM(M2/P1)
LM(M1/P1)
r1
r2
The Fed can increase aggregate demand:
↑M ⇒ LM shifts right
r
⇒ ↓
11.2) IS-LM as Theory of Agg. Demand� Monetary Policy and the AD Curve
Chapter 11: Aggregate Demand II: Applying the IS–LM Model 24/56
Y
P
IS
AD1
P1
Y1
Y1
Y2
Y2
AD2
Y⇒ ↓r
⇒ ↑I
⇒ ↑Y for a givenvalue of P
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r2
r1
r
IS1
LMExpansionary fiscal policy (↑G and/or ↓T ) increases agg. demand:
↓T ⇒ ↑C
IS2
11.2) IS-LM as Theory of Agg. Demand� Fiscal Policy and the AD Curve
Chapter 11: Aggregate Demand II: Applying the IS–LM Model 25/56
Y2
Y2
Y1
Y1
Y
Y
P
IS1
AD1
P1
↓T ⇒ ↑C
⇒ IS shifts right
⇒ ↑Y for a givenvalue of P
AD2
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11.2) IS-LM as Theory of Agg. Demand� IS-LM and AD-AS in the Short Run & Long Run
Recall from Chapter 9: The force that moves the economy from the short run to the long run is the gradual adjustment of prices.
In the short-run then over time, the
Chapter 11: Aggregate Demand II: Applying the IS–LM Model 26/56
Y Y>Y Y<
Y Y=
rise
fall
remain constant
In the short-run equilibrium, if
then over time, the price level will
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11.2) IS-LM as Theory of Agg. Demand� The SR and LR Effects of an IS Shock
A negative IS shock shifts IS and AD left, A negative IS shock shifts IS and AD left,
r LRAS
IS1
LM(P1)
IS2
Chapter 11: Aggregate Demand II: Applying the IS–LM Model 27/56
shifts IS and AD left, causing Y to fall.shifts IS and AD left, causing Y to fall.
Y
Y
P LRAS
Y
Y
SRAS1P1
AD2
AD1
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r LRAS
IS1
LM(P1)
IS2In the new short-In the new short-
11.2) IS-LM as Theory of Agg. Demand� The SR and LR effects of an IS shock
Chapter 11: Aggregate Demand II: Applying the IS–LM Model 28/56
Y
Y
P LRAS
Y
Y
SRAS1P1
AD2
AD1
run equilibrium, run equilibrium, Y Y<
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r LRAS
IS1
LM(P1)
IS2
In the new short-run equilibrium, In the new short-run equilibrium, Y Y<
Over time, P gradually Over time, P gradually
11.2) IS-LM as Theory of Agg. Demand� The SR and LR Effects of an IS Shock
Chapter 11: Aggregate Demand II: Applying the IS–LM Model 29/56
Y
Y
P LRAS
Y
Y
SRAS1P1
AD2
AD1
Over time, P gradually falls, which causes
• SRAS to move down.
• M/P to increase, which causes LMto move down.
Over time, P gradually falls, which causes
• SRAS to move down.
• M/P to increase, which causes LMto move down.
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r LRAS
IS1
LM(P1)
IS2
LM(P2)
Over time, P gradually falls, which causes
• SRAS to move down.
Over time, P gradually falls, which causes
• SRAS to move down.
11.2) IS-LM as Theory of Agg. Demand� The SR and LR Effects of an IS Shock
Chapter 11: Aggregate Demand II: Applying the IS–LM Model 30/56
AD2
Y
Y
P LRAS
Y
Y
SRAS1P1
AD1
SRAS2P2
• SRAS to move down.
• M/P to increase, which causes LMto move down.
• SRAS to move down.
• M/P to increase, which causes LMto move down.
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LM(P2)
r LRAS
IS1
LM(P1)
IS2
This process continues until economy reaches This process continues until economy reaches
11.2) IS-LM as Theory of Agg. Demand� The SR and LR Effects of an IS Shock
Chapter 11: Aggregate Demand II: Applying the IS–LM Model 31/56
AD2
SRAS2P2
Y
Y
P LRAS
Y
Y
SRAS1P1
AD1
until economy reaches a long-run equilibrium with
until economy reaches a long-run equilibrium with Y Y=
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a. Draw the IS-LM and AD-ASdiagrams as shown here.
b. Suppose Fed increases M.Show the short-run effects on your graphs.
r LRAS
IS
LM(M1/P1)
11.2) IS-LM as Theory of Agg. Demand� 该你们了: Analyze SR & LR Effects of ∆M
Chapter 11: Aggregate Demand II: Applying the IS–LM Model 32/56
c. Show what happens in the transition from the short run to the long run.
d. How do the new long-run equilibrium values of r, P and Y compare to their initial values?
Y
Y
P LRAS
Y
Y
SRAS1P1
AD1
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Learning Objectives
This chapter introduces you to understanding:
explaining fluctuations with the IS–LM model
using IS–LM as a theory of aggregate demand
Chapter 11: Aggregate Demand II: Applying the IS–LM Model 33/56
using IS–LM as a theory of aggregate demand
the great depression
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11.3) The Great Depression� Figure
Unemployment (right scale)
200
220
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Real GNP(left scale)
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1929 1931 1933 1935 1937 1939
billi
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5
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11.3) The Great Depression� Spending Hypothesis: Shocks to the IS Curve
• asserts that the Depression was largely due to an exogenous fall in the demand for goods & services – a leftward shift of the IS curve.
• evidence: output and interest rates both fell, which is what a
Chapter 11: Aggregate Demand II: Applying the IS–LM Model 35/56
output and interest rates both fell, which is what a leftward IS shift would cause.
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11.3) The Great Depression� Spending Hypothesis: Reasons for the IS Shift
• Stock market crash ⇒ exogenous ↓C
– Oct-Dec 1929: S&P 500 fell 17%
– Oct 1929-Dec 1933: S&P 500 fell 71%
• Drop in investment
Chapter 11: Aggregate Demand II: Applying the IS–LM Model 36/56
• Drop in investment
– “correction” after overbuilding in the 1920s
– widespread bank failures made it harder to obtain financing for investment
• Contractionary fiscal policy
– Politicians raised tax rates and cut spending to combat increasing deficits.
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11.3) The Great Depression� Money Hypothesis: A Shock to the LM Curve
• asserts that the Depression was largely due to huge fall in the money supply.
• evidence: M1 fell 25% during 1929-33.
Chapter 11: Aggregate Demand II: Applying the IS–LM Model 37/56
• But, two problems with this hypothesis:
– P fell even more, so M/P actually rose slightly during 1929-31.
– nominal interest rates fell, which is the opposite of what a leftward LM shift would cause.
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11.3) The Great Depression� Money Hypothesis: The Effects of Falling Prices
• asserts that the severity of the Depression was due to a huge deflation:P fell 25% during 1929-33.
• This deflation was probably caused by the fall in M, so perhaps money played an important role after all.
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so perhaps money played an important role after all.
• In what ways does a deflation affect the economy?
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11.3) The Great Depression� Money Hypothesis: The Effects of Falling Prices
The stabilizing effects of deflation:
• ↓P ⇒ ↑(M/P ) ⇒ LM shifts right ⇒ ↑Y
• Pigou effect :
↓P ⇒ ↑(M/P )
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↓P ⇒ ↑(M/P )
⇒ consumers’ wealth ↑
⇒ ↑C
⇒ IS shifts right
⇒ ↑Y
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11.3) The Great Depression� Money Hypothesis: The Effects of Falling Prices
The destabilizing effects of expected deflation:
↓π e
⇒ r ↑ (Fisher equation r=i-π e)
Chapter 11: Aggregate Demand II: Applying the IS–LM Model 40/56
⇒ I ↓ because I = I (r )
⇒ planned expenditure & agg. demand ↓↓↓↓
⇒ income & output ↓↓↓↓
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11.3) The Great Depression� Money Hypothesis: The Effects of Falling Prices
• The destabilizing effects of unexpected deflation:debt-deflation theory
↓P (if unexpected)
⇒ transfers purchasing power from borrowers to
Chapter 11: Aggregate Demand II: Applying the IS–LM Model 41/56
⇒ transfers purchasing power from borrowers to lenders
⇒ borrowers spend more, lenders spend less
⇒ if borrowers’ propensity to spend is larger than lenders’, then aggregate spending falls, the IScurve shifts left, and Y falls
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11.3) The Great Depression� Why Another Depression is Unlikely
• Policymakers (or their advisors) now know much more about macroeconomics:
– Central banks know better than to let M fall so much, especially during a contraction.
Chapter 11: Aggregate Demand II: Applying the IS–LM Model 42/56
– Fiscal policymakers know better than to raise taxes or cut spending during a contraction.
• Federal deposit insurance makes widespread bank failures very unlikely.
• Automatic stabilizers make fiscal policy expansionary during an economic downturn.
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• 2009: Real GDP fell, u-rate approached 10%
• Important factors in the crisis:
– early 2000s Federal Reserve interest rate policy
– sub-prime mortgage crisis
11.4) The 2008-09 Financial Crisis
Chapter 11: Aggregate Demand II: Applying the IS–LM Model 43/56
– sub-prime mortgage crisis
– bursting of house price bubble, rising foreclosure rates
– falling stock prices
– failing financial institutions
– declining consumer confidence, drop in spending on consumer durables and investment goods
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11.4) The 2008-09 Financial Crisis� Interest Rates and House Prices
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11.4) The 2008-09 Financial Crisis� House Price Index and Rate of Foreclosures
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New
fore
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ures
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ages
Nevada
Georgia
ColoradoArizona
California
Florida Illinois
Michigan Ohio
11.4) The 2008-09 Financial Crisis� House Price Change and Foreclosures Q3.06-Q1.09
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Cumulative change in house price index
Colorado
Texas
AlaskaWyoming
Arizona
S. Dakota
Rhode Island
N. Dakota
Oregon
New Jersey
Hawaii
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11.4) The 2008-09 Financial Crisis� U.S. Bank Failures 2000 - 2009
Chapter 11: Aggregate Demand II: Applying the IS–LM Model 47/56
* as of July 24, 2009.
*
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11.4) The 2008-09 Financial Crisis� Major U.S. Stocks, YOY-% Change
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11.4) The 2008-09 Financial Crisis� Consumer Sentiment and Growth in Durables and Investment Spending
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11.4) The 2008-09 Financial Crisis� Real GDP Growth And Unemployment
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Chapter SummaryChapter Summary
1. IS-LM model
– a theory of aggregate demand
– exogenous: M, G, T,P exogenous in short run, Y in long run
Chapter 11: Aggregate Demand II: Applying the IS–LM Model 51/56
P exogenous in short run, Y in long run
– endogenous: r,Y endogenous in short run, P in long run
– IS curve: goods market equilibrium
– LM curve: money market equilibrium
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Chapter SummaryChapter Summary2. AD curve
– shows relation between P and the IS-LM model’s equilibrium Y.
– negative slope because
Chapter 11: Aggregate Demand II: Applying the IS–LM Model 52/56
– negative slope because ↑P ⇒ ↓(M/P ) ⇒ ↑r ⇒ ↓I ⇒ ↓Y
– expansionary fiscal policy shifts IS curve right, raises income, and shifts AD curve right.
– expansionary monetary policy shifts LM curve right, raises income, and shifts AD curve right.
– IS or LM shocks shift the AD curve.