Chapter 8. The IS - LM Model

When taxes increase, disposable income will fall, and this will cause consumption to fall. The decline in consumption will reduce aggregate expenditure and shift the IS curve to the left. The reduction in aggregate expenditure will reduce equilibrium output.

When the Federal Reserve pursues expansionary monetary policy they are increasing the money supply. The increase in the money supply will reduce the interest rate and the LM curve will shift to the right. The lower interest rate will increase aggregate expenditure and this will increase equilibrium output.

When consumers feel wealthier then they increase consumption and reduce saving. The increase in consumption will increase aggregate expenditure and equilibrium output. This will cause the IS curve to shift to the right. The increase in equilibrium output will increase the demand for money and this will increase the interest rate.

If consumers expect inflation to increase they will reduce their money demand. This reduction in money demand causes the money demand curve to shift to the left. Since the quantity of money demanded is now less than the quantity supplied, people will attempt to increase bond holdings. This will increase the price of bonds and reduce the interest rate. The LM curve will shift to the right. The lower interest rates will lead to more investment spending and equilibrium output will rise.