The Keynesian System III: Policy Effects in the IS-LM Model Professor Steve Cunningham Graduate Macroeconomics I ECON 309

Increasing the Money Supply LM(M0) Ms0 Ms1 r LM(M1) r0 r0 r1 r1 Md IS Y0 Y1 M

Increase in Gov’t Spending IS(G1) IS(G0) LM Recall that: Y = C + I + G + NX. When G then Y. r1 r0 Y0 Y1

P AS w0 AD w/p Y (w/p) Y N Nd Y=F(N,K) N AD2 AD1 AD0 NOTES: G rises, increasing AD. Employment and output result from AD increases. Prices (P) also rise. As prices rise, the real wages fall, making labor more attractive. As more workers are employed, and unemployment falls. AS w0 AD AD2 AD1 AD0 w/p Y (w/p) Y N Nd Y=F(N,K) N

Increase in Taxes Recall that: Y = C + I + G + NX. When T then Yd, IS(T0) LM IS(T1) LM Recall that: Y = C + I + G + NX. When T then Yd, and so must C and Y. r0 r1 Y1 Y0

Investment Falls Recall that: Y = C + I + G + NX. When I then Y. r IS(I0) IS(I1) LM Recall that: Y = C + I + G + NX. When I then Y. r0 r1 Y1 Y0

P AS w0 AD w/p Y (w/p) Y N Nd Y=F(N,K) N AD0 AD1 AD2 NOTES: Rising taxes or falling investment reduces AD. Final sales and output (Y) fall. As prices fall, the real wages rise, making labor more expensive to firms. Firms require fewer workers to build products and find workers more expensive, so they lay off workers. Unemployment rises. AS w0 AD AD0 AD1 AD2 w/p Y (w/p) Y N Nd Y=F(N,K) N

Monetary Policy Effectiveness IS LM1 IS LM1 LM2 LM2 ? Y Y Investment not responsive to interest rate changes Investment is responsive to interest rate changes

Fiscal Policy Effectiveness LM IS2 IS1 r r IS1 IS2 LM Y ? Y Money demand is responsive to interest rate changes Money demand not responsive to interest rate changes

Keynesian Theory of Inflation Keynesian or Depression Region Bottleneck Region P AS P AD6 AD4 AD5 AD2 AD3 Classical Region AD1 P P=0 Y=0 Y Y Y