Chapter 11: Aggregate Demand II Fiscal Policy Initial equilibrium: IS1 = LM1 with Y1 and r1 Let G increase and/or T decrease IS increases, resulting in Y2>Y1 Crowding-out effect: As Y increases, demand for money rises, interest rate and income fall Final equilibrium: IS2 = LM1 with Y3>Y2 and r2>r1 Fiscal Policy Interest Rate LM1 r2 r1 IS2 IS1 Y1 Y3 Y2 Income Monetary Policy Initial equilibrium: IS1 = LM1 with Y1 and r1 Let M increase at constant P LM increases, resulting in Y2>Y1 and r2Y1 and r2Y1 and r2>r1 Increased Y at constant P indicates an increase in AD Fiscal Policy Interest Rate Price LM1 r2 P A B r1 IS2 AD1 IS1 Y1 Y2 Income Y1 Y2 Income AD2 Long-run Equilibrium Initial equilibrium: IS1 = LM1 with Y1 and r1, but Y1