This document discusses how the IS-LM model can be used to analyze fluctuations in aggregate demand and how fiscal and monetary policy can shift the IS and LM curves. It explains that an increase in government spending or a decrease in taxes shifts the IS curve to the right by stimulating private expenditure. An increase in the money supply shifts the LM curve downward by lowering interest rates and stimulating investment. The interaction between fiscal and monetary policy and their effects on income, interest rates, and aggregate demand are also analyzed.

1. AGGREGATE DEMAND II

2. • We now turn our attention to applying the IS-
LM model to analyze two issues:
• First we examine the potential causes of
fluctuations in NI.
• Second we discuss how IS-LM model fits into
the model of AD and AS.
•

3. How FP shifts the IS curve and changes
in SR equilibrium.
• An increase in G shifts the IS curve to the right.
• The economy’s planned expenditure rises.
• The increase in PE stimulates production of G & S
which causes Y to rise.
• Because economy’s demand for money depends
on income, the rise in total income increases the
quantity of money demanded at every interest
rate.
• The supply of money has not changed, so higher
money demand causes equilibrium rate to rise.

4. How changes in taxes shift the IS
curve?
• A decrease in taxes encourages consumers to
spend more and therefore increases PE.
• IS curve shifts to the right.
• The tax cut raises both income and interest
rate.

5. How MP shifts the LM curve and
changes in SR equilibrium
• An increase in money supply increases the
amount of money in people’s hand
• That is people have more money than they
want to hold at the prevailing interest rate.
• They start depositing this extra money in
banks or they use it to buy bonds.
• The interest rate then falls until people are
willing to hold all the money that the central
bank has created

6. • This brings the money market to a new equilibrium.
• The lower interest in turn, stimulates PI which
increases PE production and income.
• Thus IS-LM model shows that MP influences income by
changing interest rate.
• We see here how a monetary expansion induces
greater spending on G & S ---a process called monetary
transmission mechanism.
• The IS-LM model shows that an increase in M/S lowers
interest rate, which stimulates investment and thereby
the demand for G and S.

7. The Interaction between MP and FP
• We can analyse the situation in three ways:
• First we assume that CB holds M/S constant
• Second we assume that CB holds I/R constant
• Third, we assume that CB hold income
constant.

8. • In the first case, the tax increase shifts the IS
curve to the left.
• Income falls because higher taxes reduce
consumer spending and i/r falls because lower
income reduces the demand for money.
• The fall in income indicates that the tax hike
causes a recession

9. • In the second case, when the tax increase
shifts the IS curve to the left the CB must
decrease the M/S to keep i/r at its original
level,
• The fall in m/s shifts lm curve upward
• The i/r does not fall but income falls by a
larger amount than if the CB held the M/S
constant.

10. • Whereas in the first case lower i/r stimulated
investment and partly offset the contractionary
effect of tax hike, in the second case, the CB
deepens the recession by keeping i/r high.
• In the third case CB wants to prevent the tax
increase from lowering income.
• It must therefore raise the money supply and
shift the LM curve downward enough to offset a
shift in IS curve.

11. • In this case tax increase does not cause a
recession but it does cause a large fall in i/r.
• Although the level of income is not changed, the
combination of a tax increase and a monetary
expansion changes the allocation of economy’s
resources.
• The higher taxes depresses consumption while
lower interest rate stimulates investment.
• Income is not affected because two effects
exactly balance.