IS-LM Model: Understanding Macroeconomic Policy

The IS-LM Model and Macroeconomic Policy

Expansionary Monetary Policy (2007-2008)

In late 2007 and early 2008, the U.S. Federal Reserve pursued an expansionary monetary policy. As a result of this monetary policy action, the LM curve shifts down.

Increase in Government Spending

An increase in government spending will likely cause a rightward shift in the IS curve.

Simultaneous Increase in Government Spending and Taxes

If government spending and taxes increase by the same amount, the IS curve shifts rightward.

U.S. Recession of 2001 (Dot-Com Recession)

The U.S. recession of 2001, also known as the dot-com recession, was triggered by a decline in investment demand.

Investment Spending and Interest Rates

Assume that investment spending depends only on the interest rate and no longer depends on output. Given this information, a reduction in government spending will cause investment to increase.

Increase in Consumer Confidence

Suppose there is an increase in consumer confidence. The following variables must increase in response to this: consumption, output, and the interest rate.

Fiscal Contraction

Suppose there is a fiscal contraction. The following variables must decrease: consumption and output.

Simultaneous Fiscal and Monetary Expansion

Suppose there is a simultaneous fiscal expansion and monetary expansion. We know with certainty that output will increase.

Dynamic Assumption for the IS-LM Model

A reasonable dynamic assumption for the IS-LM model is that the economy is always on the IS curve, but moves only slowly to the LM curve.

Increase in Consumer Confidence and the IS Curve

An increase in consumer confidence will tend to cause a rightward shift in the IS curve.

Factors that do NOT Shift the IS Curve

The IS curve will NOT shift when there is a reduction in the interest rate.

Dynamic Effects of Reduced Government Spending

Based on our understanding of the IS-LM model that takes into account dynamics, a reduction in government spending will cause a gradual reduction in i (interest rate) and a gradual reduction in Y (output).

Real Supply of Money

The real supply of money is defined as the stock of money measured in terms of goods, not dollars.

Monetary Contraction Dynamics

Under the reasonable dynamic assumptions discussed in the text, a monetary contraction should result in an immediate rise in the interest rate, and then a fall in the interest rate over time.

Increase in Money Supply

An increase in the money supply must cause no change in output if investment is independent of the interest rate.

Increase in Reserve Deposit Ratio

An increase in the reserve deposit ratio (θ) will most likely cause an upward shift in the LM curve.

Fed Purchase of Securities

A Fed purchase of securities will most likely cause a downward shift in the LM curve.

Reduction in the Aggregate Price Level

A reduction in the aggregate price level (P) will most likely cause a downward shift in the LM curve.

Increase in the Aggregate Price Level

An increase in the aggregate price level (P) will most likely cause an upward shift in the LM curve.

Dynamic Effects of Reduced Money Supply

Based on our understanding of the IS-LM model that takes into account dynamics, a reduction in the money supply will cause an immediate increase in i (interest rate) and no initial change in Y (output).