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

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

3. 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

4. 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

5. 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

6. 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

7. 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

8. Monetary Policy EffectivenessIS
LM1 IS
LM1
LM2
LM2 ? Y Y
Investment not responsive to interest rate changes
Investment is responsive to interest rate changes

9. Fiscal Policy EffectivenessLM
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

10. 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