This exercise demonstrates how government policies and shock alter output in the short run. A simulation of the IS-LM model shows the effects of changes in the variables of the model. A graph of the IS and LM curves shows the shifts that occur when there is a change in government policy or a shock to the economy.

The IS curve is derived from the national income accounts identity:

Y = C(Y - T) + I(r) + G

where

Y is output

C is consumption

I is investment

G is government spending

T is taxes

r is the interest rate

This implies that Y and r are negatively correlated: if r is high, planned investment is low, so Y is low.

The LM curve is derived from the money market equilibrium condition:

M/P = L(r, Y)

where

M is the money supply

P is the price level

L is money demand

r is the interest rate

Y is output

This implies that r and Y are positively related: at higher levels of r, Y must be higher in order for money demand to equal money supply.

In summary, the IS-LM model has two components:

A downward sloping IS curve representing pairs of Y and r for which the goods market is in equilibrium.

An upward sloping LM curve representing pairs of Y and r for which the money market is in equilibrium.

This simulation uses the IS-LM model to calculate how Y, C, I and r respond to changes in policy and shocks. It will also show how the IS and LM curves will shift.

The IS curve will shift in response to:

changes in government spending

changes in taxes

shocks to investment

shocks to consumption

The LM curve will shift in response to:

changes in the money supply

shocks to money demand