Economics test.

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ISLMASADPolicyInterventions.pptx
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Policy Interventions

ISLM-ASAD Full Model

Remember key equations

IS: Y = C + I + G + NX

LM: MS/P = L (r, Y)

AD: Combine IS + LM

LRAS: Yn = A x F (K, L, N, H)

SRAS: Y = Yn + z (P – Pe)

C = C0 + m (Y – T)

I = I0 – j x r

Monetary Policy

Stimulus / Boost GDP

Increase money supply

Example: Buy bonds

r

P

Y

Y

LM

IS

r*

P*=Pe*

Y*=Yn*

SRAS

LRAS

AD

Y*

r

P

Y

Y

LM

IS

r*

P*=Pe*

Y*=Yn*=Y-L

SRAS

LRAS

AD

Y*=Y-L

LM2

AD2

Ps

Ys

Ys

LMs

rs

P

r

P

Y

Y

LM

IS

r*=r-L

P*=Pe*

Y*=Yn*=Y-L

SRAS

LRAS

AD

Y*=Y-L

LM2

AD2

Ps

Ys

Ys

LMs

rs

SRAS-L

P

P-L=Pe-L

LM-L

Fiscal Policy

Stimulus / Boost GDP

Increase government spending OR

Cut taxes

Goal: Raise GDP, lower unemployment

r

P

Y

Y

LM

IS

r*

P*=Pe*

Y*=Yn*

SRAS

LRAS

AD

Y*

r

P

Y

Y

LM

IS

r*

P*=Pe*

Y*=Yn*

SRAS

LRAS

AD

IS2

AD2

rs

Ps

Ys

LMS

Y*

Ys

r

P

Y

Y

LM

IS

r*

P*=Pe*

Y*=Yn*=YL

SRAS

LRAS

AD

IS2

AD2

rs

Ps

Ys

SRASL

LMS

LML

Y*=YL

rL

PL =Pe-L

Ys

r

P

Y

Y

LM

IS

r*

P*=Pe*

Y*=Yn*=YL

SRAS

LRAS

AD

IS2

AD2

rs

Ps

Ys

SRASL

LMS

LML

Y*=YL

rL

PL =Pe-L

Ys

r

P

Y

Y

LM

IS

r*=r-L

P*=Pe*

Y*=Yn*=Y-L

SRAS

LRAS

AD

Y*=Y-L

LM2

AD2

Ps

Ys

Ys

LMs

rs

SRAS-L

P

P-L=Pe-L

LM-L

Monetary Policy

Fight inflation

Lower money supply

Example: Sell bonds

r

P

Y

Y

LM

IS

r*

P*=Pe*

Y*=Yn*

SRAS

LRAS

AD

Y*

r

P

Y

Y

LM

IS

r*

P*=Pe*

Y*=Yn*

SRAS

LRAS

AD

LM2

AD2

rs

Ps

Ys

LMS

Y*

Ys

r

P

Y

Y

LM = LML

IS

r* = rL

P*=Pe*

Y*=Yn*=YL

SRAS

LRAS

AD

LM2

AD2

rs

Ps

Ys

SRASL

LMS

Y*=YL

PL =Pe-L

Ys

Federal Reserve Dual Mandate

Stabilize prices

Maximize employment

Policy tools:

Buy/sell bonds

Raise/lower discount rate

Etc.

NOT: Change gov’t spending or taxes

Problem: Stock market crash

Wealth falls, so C0 drops

First: Show what happens in the short run with no intervention

What is our policy recommendation?

- BUY BONDS

Then, show the short run and long run outcome of the initial problem COMBINED with our intervention

r

P

Y

Y

LM

IS

r*

P*=Pe*

Y*=Yn*

SRAS

LRAS

AD

Y*

r

P

Y

Y

LM

IS

r*

P*=Pe*

Y*=Yn*

SRAS

LRAS

AD

IS2

AD2

rs

Ps

Ys

LMS

Y*

Ys

r

P

Y

Y

LM

IS

r*

P*=Pe*=Ps=PL

Y*=Yn*=Ys =YL

SRAS

LRAS

AD = ADReact

IS2

AD2

rs

Y*

Ys

LMReact

Problem: We run out of oil

Fall in our supply of natural resources.

Show the short-run problem

Make a policy recommendation (For the Fed)

Show the short run and long run outcome of your recommendation

Federal Reserve Dual Mandate

Stabilize prices

Maximize employment

Policy tools:

Buy/sell bonds

Raise/lower discount rate

Etc.

NOT: Change gov’t spending or taxes

r

P

Y

Y

LM

IS

r*

P*=Pe*

Y*=Yn*

SRAS

LRAS

AD

Y*

r

P

Y

Y

LM

IS

r*

P*=Pe*

Y*=Yn*

SRAS

LRAS

AD

Y*

LRAS2

SRAS2

Ps

rs

Ys

LMS

Ys

YL=YnL

Option 1: Do Nothing

r

P

Y

Y

LM

IS

r*

P*=Pe*

Y*=Yn*

SRAS

LRAS

AD

Y*

LRAS2

SRAS2

Ps

rs

Ys

LMS

Ys

SRASL

LML

rL

PL =Pe-L

YL=YnL

YL

Option 1: Do Nothing

Short run: Inflation, recession, high unemployment

Long run:

Even worse inflation, even worse recession, even worse unemployment

You’re fired.

Option 2: Stimulus

Buy bonds

Bring GDP back to initial level

r

P

Y

Y

LM = LMs

IS

r* = rs

P*=Pe*

Y*=Yn*

SRAS

LRAS

AD

Y*

LRAS2

SRAS2

Ps

Ys

LMReact

Ys

AD2

r

P

Y

Y

LM = LMs

IS

r* = rs

P*=Pe*

Y*=Yn*

SRAS

LRAS

AD

Y*

LRAS2

SRAS2

Ps

Ys

LMReact

Ys

YL=YnL

AD2

SRASL

PL =Pe-L

rL

LML

Option 2: Stimulus

Short run: No recession! But massive Inflation

Long run:

Crushing inflation, even worse recession, even worse unemployment

You’re fired. But you might have kept your job for a year or two first.

Option 2: Contraction

Sell bonds

Stabilize prices

r

P

Y

Y

LM = LMs

IS

r*

Y*=Yn*

SRAS

LRAS

AD

Y*

LRAS2

SRAS2

Ys

LMReact

Ys

YL=YnL

AD2

rs = rL

P*=Pe*=Ps=PL

Option 2: Contraction

Short run: Deep recession right away, but inflation controlled

Long run:

Stable prices, no further changes

Outcome: You’re probably fired, but you did your job

General rule

Stabilize prices first.

We solve this in reverse (start at the end and work backwards):

Move AD so it crosses LRAS at the current price level

To do that, move LM so it crosses IS at the same Y as your target for AD

Then find short run and long run outcomes