it involves IS-LM Curves, their derivations in brief and monetary and fiscal policies with good and precise explanation.

1. UNIT -3

11. Properties of the IS Curve
• Downward sloping,
i  C, I  Y*
• Shift variables consist of the shift
variables of the EP curve, except
for the nominal interest rate (i).

12. Shifting the IS Curve
• Increases in autonomous
expenditure which shift the EP
curve upward, simultaneously shift
the IS curve rightward.
• Decreases in autonomous
expenditure which shift the EP
curve downward, simultaneously
shift the IS curve leftward.

14. The LM Curve
• Depicts equilibrium in the money
market (L = M).
• A plot of the equilibrium interest rate
for various levels of output or income
versus the interest rate, within the
money market for a given level of the
nominal money supply.

15. Properties of the LM Curve
• Upward sloping,
Y  L  i*
• Shift variables consist of the shift
variables of the money demand
and supply curves (except for Y).

18. Shifting the LM Curve
• Increases in the real money supply
(MS or P) shift the LM curve
rightward.
• Decreases in the real money
supply (MS or P) shift the LM
curve leftward.

19. Steepness or
Flatness of the LM Curve
• The steepness or flatness of the
LM curve describes the elasticity
or responsiveness of money
demand (L) to the nominal interest
rate.
-- Steep LM curve: inelastic.
-- Flat LM curve: elastic.

23. `

25. Policy Analysis with
the IS-LM Model
• A Closer Look at Policy
– Fiscal Policy and Crowding Out
– Monetary Policy and the Liquidity Trap
• Real World Monetary and Fiscal Policy
• Problems of Using IS-LM in the Real World
– Interpretation Problems
– Implementation Problems

26. Policy in the IS-LM Model
• Fiscal Policy
– Expansionary fiscal policy shifts the IS curve
to the right
– Contractionary fiscal policy shifts the IS curve
to the left
• Monetary Policy
– Expansionary monetary policy shifts the LM
curve to the right
– Contractionary monetary policy shifts the LM
curve to the left

27. Fiscal Crowding Out1. The multiplier is 2 and
government spending increases by
$500, so the IS increases by $1000.
$6600
IS0
LM
Aggregate Output
IS1
$1000
4%
$6000
5%
$7000
2. The increase in income
increases money demand
which increases interest
rates from 4% to 5%.
3. The increase in the interest
rate causes a decrease in
investment so that the increase
in income is only $600, less that
the full multiplier effect.

28. Fiscal Policy and Crowding Out
• When government expenditures increase,
output and income begin to increase.
• The increase in income increases the demand for
money.
• The increase in money demand increases the
interest rate.
• Higher interest rates cause a decrease in
investment, offsetting some of the expansionary
effect of the increase in government spending.

29. Full Crowding Out1. The multiplier is 2 and
government spending increases by
$500, so the IS increases by $1000. 2. If the demand for money
is totally insensitive to the
interest rate, the interest rate
increases from 4% to 9%.
3. The increase in the interest
rate causes a decrease in
investment that completely offsets
the increase in government spending.
IS0
LM
Aggregate Output
IS1
$1000
4%
$6000
9%
$7000

30. Ineffective Fiscal Policy
• When complete crowding out occurs, fiscal
policy is ineffective, changing only interest
rates, not output.
• Crowding out is greater if:
– Money demand is very sensitive to income
changes
– Money demand is not very sensitive to
interest rate changes

31. Monetary Policy and Liquidity Traps
In a liquidity trap, increases
in the money supply do not
decrease interest rates, so
investment and output do
not increase.
The increases in money
supply which decreases
interest rates and
increases investment and
output.
Y1
IS
LM0
Aggregate Output
Y0
r0
r1
LM1
IS
LM0
Aggregate Output
Y0
r0
LM1

32. Liquidity Trap
The liquidity trap is the situation in which prevailing
interest rates are low and savings rates are high, making
monetary policy ineffective. In a liquidity trap,
consumers choose to avoid bonds and keep their funds
in savings, because of the prevailing belief that interest
rates will soon rise. Because bonds have an inverse
relationship to interest rates, many consumers do not
want to hold an asset with a price that is expected to
decline.

33. Ineffective Monetary Policy
• Investment is not sensitive to the interest
rate
– If investment does not respond to interest
rate changes (the IS curve is steep), monetary
policy in ineffective in changing output.
• Liquidity trap
– If increases in the money supply fail to lower
interest rates, monetary policy is ineffective in
increasing output.

34. Policy Effectiveness
• An effective policy is one that
obtains a large output response for
a given change .
• Policy effectiveness depends upon
the steepness or flatness of the IS
and LM curves.