Docsity
Docsity
Prepare for your exams
Prepare for your exams

Study with the several resources on Docsity

Earn points to download
Earn points to download

Earn points by helping other students or get them with a premium plan

Guidelines and tips
Guidelines and tips
Sell on Docsity
Sell on Docsity
Docsity AI
Docsity AI
Log inSign up

Prepare for your exams

Study with the several resources on Docsity

Find documents

Prepare for your exams with the study notes shared by other students like you on Docsity

Search for your university

Find the specific documents for your university's exams

Docsity AINEW

Summarize your documents, ask them questions, convert them into quizzes and concept maps

Explore questions

Clear up your doubts by reading the answers to questions asked by your fellow students

Earn points to download

Earn points by helping other students or get them with a premium plan

Share documents
download point icon20 Points

For each uploaded document

Answer questions
download point icon5 Points

For each given answer (max 1 per day)

All the ways to get free points
Get points immediately

Choose a premium plan with all the points you need

Study Opportunities

Choose your next study program

Get in touch with the best universities in the world. Search through thousands of universities and official partners

Community

Ask the community

Ask the community for help and clear up your study doubts

Free resources

Our save-the-student-ebooks!

Download our free guides on studying techniques, anxiety management strategies, and thesis advice from Docsity tutors

The Complete Model - Lecture Notes | ECON 202, Study notes of Economics

Wellesley CollegeEconomics

Material Type: Notes; Class: Intermediate Macro Analysis; Subject: Economics; University: Wellesley College; Term: Unknown 1989;

Typology: Study notes

Pre 2010

Uploaded on 08/19/2009

koofers-user-ik2
koofers-user-ik2 🇺🇸

10 documents

1 / 4

Toggle sidebar

This page cannot be seen from the preview

Don't miss anything!

bg1
Fall Semester ’05-’06
Akila Weerapana
Lecture 18: The Complete Model
I. OVERVIEW
•In the last class, we looked at the complete model involving both IS-LM analysis and aggregate
demand analysis. We showed that the relationship between the level of potential output and
the short run equilibrium output from the IS-LM model determine whether prices increase
or decrease in the intermediate run.
•Today we will take a close look at how we can use the complete model to analyze monetary
policy decisions as well as fiscal policy decisions. Adding inflation to the IS-LM model greatly
enhances its usefulness as a tool for evaluating monetary policy decisions in particular.
•In the next class, we will return to some of the applications we examined using the IS-LM
model and take a fresh look at them using the aggregate demand/aggregate supply model.
II. FISCAL POLICY IN THE LONG RUN
Case 1: An Increase in G
•Suppose the economy was initially at potential output. If the government increases the
purchases of goods and services then the IS curve will shift out and the AD curve will shift
out as well. In the short run interest rates will rise from r0to r1, output will rise from Y∗to
Y1and prices will not change.
•From the AD curve we see that the short run equilibrium level of output will exceed potential
output. Then over time prices will increase.
•As Pincreases the LM curve will start shifting back, this process will continue until the
economy returns to the original level of potential output. In the long run interest rates are
much higher at r2. Output has returned back to potential output Y∗. Prices, however are
higher at P∗.
•Notice that the long-run multiplier effects of an increase in G is zero! Output is unchanged
in the long run.
pf3
pf4

Partial preview of the text

Download The Complete Model - Lecture Notes | ECON 202 and more Study notes Economics in PDF only on Docsity!

Fall Semester ’05-’ Akila Weerapana

Lecture 18: The Complete Model

I. OVERVIEW

  • In the last class, we looked at the complete model involving both IS-LM analysis and aggregate demand analysis. We showed that the relationship between the level of potential output and the short run equilibrium output from the IS-LM model determine whether prices increase or decrease in the intermediate run.
  • Today we will take a close look at how we can use the complete model to analyze monetary policy decisions as well as fiscal policy decisions. Adding inflation to the IS-LM model greatly enhances its usefulness as a tool for evaluating monetary policy decisions in particular.
  • In the next class, we will return to some of the applications we examined using the IS-LM model and take a fresh look at them using the aggregate demand/aggregate supply model.

II. FISCAL POLICY IN THE LONG RUN

Case 1: An Increase in G

  • Suppose the economy was initially at potential output. If the government increases the purchases of goods and services then the IS curve will shift out and the AD curve will shift out as well. In the short run interest rates will rise from r 0 to r 1 , output will rise from Y ∗^ to Y 1 and prices will not change.
  • From the AD curve we see that the short run equilibrium level of output will exceed potential output. Then over time prices will increase.
  • As P increases the LM curve will start shifting back, this process will continue until the economy returns to the original level of potential output. In the long run interest rates are much higher at r 2. Output has returned back to potential output Y ∗. Prices, however are higher at P ∗.
  • Notice that the long-run multiplier effects of an increase in G is zero! Output is unchanged in the long run.

6 @ @ @ @ @ @ @ @

@@

@ @ @ @ @ @ @ @ @

@@

r

Y

IS

LM

IS′

LM′

Y ∗

r 0

Y 1

r 1

r 2

  • (^)  

6

P

Y

AD

AD′

Y ∗

P 0 SRAS

SRAS′

LRAS

Y 1

P ∗

6

6

  • We can get intuition for why the multiplier effects are smaller by looking at what happens to the various components of the IS curve and the LM curve when G increases (you should be able to figure out what happens when G decreases). - C = C¯ + b(1 − t)Y ↔ (since Y is unchanged) - I = I¯ − βr ↓ (since r increased) - G ↑ (G increased, according to the question) - NX ↔ (NX is exogenous and unchanged) - M s^ ↔ (Exogenous and unchanged) - M d^ ↔ (↓ since r increased and ↑ since P increased. We know that they must offset because M s^ = M d^ and M s^ ↔)

Case 2: A Tax Cut

  • Let’s assume the economy starts out at Y ∗.The first task is to look at what would happen to the economy as a result of the tax cut. The tax cut will swing the IS curve out (i.e. shift it out and make it flatter) and also shift the AD curve out as well.
  • In the short run, output rises to Y 1 , interest rates rise to r 1 and prices remain unchanged.
  • Since output is above potential prices will rise over time shifting the LM curve back gradually to LM’. The long-term impact is to raise prices to P ∗, leave output unchanged at Y 1 and leave interest rates higher at r 2. [See below]
  • Again, notice that the long-run effects of a tax-cut is zero! Output is unchanged in the long run.
  • This is one of the most important ideas in macroeconomics, that monetary policy can only influence the real economy (i.e. output) in the short run (when prices are fixed or sticky) but not in the long run (when prices are flexible). -

6 @ @ @ @ @ @ @

@@

r

Y

IS

LM (^) LM′

Y ∗

r 0

Y 1

r 1





6

P

Y

AD

AD′

Y ∗

P 0 SRAS

SRAS′

LRAS

Y 1

P ∗

6

6

  • C = C¯ + b(1 − t)Y ↔ (since Y is unchanged)
  • I = I¯ − βr ↔ (since r is unchanged)
  • G ↔ (G is exogenous and unchanged)
  • NX ↔ (NX is exogenous and unchanged)
  • M s^ ↑ (Increased)
  • M d^ ↑ (Since P increased)