The LM and IS Curve

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CHAPTER 24
1.The LM curve represents combinations of interest rates and income levels that result in equilibrium in the money market (money supply  money demand), for given M/P. The IS curve represents combinations of interest rates and income levels that result in equilibrium in the goods market (investment  saving), for given T and G. 2.Equilibrium must be at the ISLM intersection; only at that point does investment equal saving and the money supply equal money demand. At a point on the IS curve and to the left of the LM curve, the money supply exceeds the demand for money. In trying to buy more bonds the interest rate is driven down, which encourages investment, increases income levels, and returns the economy to overall equilibrium. 3.When you draw these graphs, the key is to know which graph to shift. Fiscal policy implies shifts in the IS curve and monetary policy implies shifts in the LM curve. In the case of monetary policy, draw two downward sloping IS curves, one flat and one steep. Then draw an upward sloping LM curve through the point where they intersect one another. Shift the LM curve to the right in a parallel fashion and note that the flat IS curve gives a higher level of output at the new equilibrium. In the case of fiscal policy, draw a new graph with two upward sloping LM curves, one flat and one steep. Then draw a downward sloping IS curve through the point where they intersect one another. Shift the IS curve to the right in a parallel fashion and note that the flat LM curve gives a higher level of output at the new equilibrium. Se class notes. 4.The crowding-out effect occurs when an increase in government spending is financed by selling government bonds. This raises the market interest rates and thus reduces private investment and consumer borrowing. Crowding out is evident in the ISLM world when the LM curve has a positive slope or is vertical, reducing the government spending multiplier relative to that of the simple...
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