# Economics questions dealing with LM Model and GDP

If you can not answer these within 7 hours do not bother contacting me.

I have attached the questions

But here is a correction

There is a typo in Q1.  In part (f) the year should be ’09. So the question should read as:(f) Using ‘09 as the base year calculate chain weighted or chain linked real GDP for ’09 and ‘10. Show and explain your calculations”

ECO 583

Assignment 1

Answer all questions. Provide detailed economic reasoning. Show all calculations. Draw graphs
whenever necessary.

1. An economy produces only three products: A, B and C. The prices and quantities for the years 2009,
2010 and 2011 are given below.

Prices Quantities

2009 2010 2011 2009 2010 2011

A \$4 \$6 \$6 200 240 280

B \$20 \$22 \$26 40 60 70

C \$2 \$4 \$4 400 500 600

Using the above information answer the following questions. Show all calculations in an organized
fashion.

(a) Calculate nominal GDP for each year.

(b) Calculate real GDP for each year using ‘09 as the base year.

(c) Calculate the growth rate in real GDP between ‘09 and ’10

(d) Calculate real GDP for each year using ’10 as the base year.

(e) Using the new GDP figures calculate the growth rate in real GDP between ‘09 and ‘10 and ’10 and
‘11.

(f) Using ‘06 as the base year calculate chain weighted or chain linked real GDP for ’09 and ‘10. Show and

(g) Calculate real GDP for each year using ’11 as the base year.

(h) Using the new GDP figures calculate the growth rate in real GDP between ‘10 and ‘11.

(i) Using ’09 as the base year calculate chain weighted or chain linked real GDP for ’11. Show and explain

(j) Using your answers to 1 (a) and (f) above calculate the chain weighted or chain linked GDP deflators
for ‘09 and ’10, when ’09 is the base year. Calculate the resulting inflation rate.

(40)

2. The following information is available for a closed economy with a lump sum tax structure:

(a) Government spending on goods and services, G = 1000, Tax, T = 1000 and Money Supply, M = 1200.
Determine the equations for the IS and LM curves. Calculate the equilibrium values of GDP, Y, interest
rate, i, consumption, C and Investment, I.

(b) Determine the equations for the IS-LM curves if, G increases by 100. Calculate the equilibrium values
of Y and i.

(c) Suppose that following the increase G above, the Fed wants to maintain the same interest rate as in
(i) above. Calculate how it should adjust money supply to achieve that goal. Calculate the resulting level
of GDP. Show and explain your calculation.

(34)

3. Using the IS-LM model explain how the following changes in the economy can separately explain
recession in an economy.

(a) a drop in consumer confidence;

(b) a drop in business confidence and a reduction in need for investment .

(12)

4. Analyze the impact of increased availability and use of credit cards on demand for money. Using a
suitable graph explain how it affects the LM curve. Using the IS-LM model explain its impact on
.

(12)

5. Suppose that Consumption depends on disposable income as well as personal wealth.

For simplicity wealth is given by real money balance

. Using the IS-LM model explain the effect of an

expansionary monetary policy on the IS and LM curves and on
(12)

CHAPTER 5
Goods and Financial
Markets:
The IS–LM Model
Goods and Financial
Markets:
The IS–LM Model
CHAPTER 5
Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall • Macroeconomics, 5/e • Olivier Blanchard

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Chapter 5: Goods and Financial Markets: The IS–LM Model
Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall • Macroeconomics, 5/e • Olivier Blanchard

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Equilibrium in the goods market exists when production, Y, is equal to the demand for goods, Z. This condition is called the IS relation.
In the simple model developed in Chapter 3, the interest rate did not affect the demand for goods. The equilibrium condition was given by:
5-1 The Goods Market and the IS Relation

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Chapter 5: Goods and Financial Markets: The IS–LM Model
Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall • Macroeconomics, 5/e • Olivier Blanchard

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5-1 The Goods Market and the IS Relation
Investment, Sales, and the Interest Rate
Investment depends primarily on two factors:
The level of sales (+)
The interest rate (-)

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Chapter 5: Goods and Financial Markets: The IS–LM Model
Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall • Macroeconomics, 5/e • Olivier Blanchard

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5-1 The Goods Market and the IS Relation
Determining Output
Taking into account the investment relation, the equilibrium condition in the goods market becomes:
For a given value of the interest rate i, demand is an increasing function of output, for two reasons:
An increase in output leads to an increase in income and also to an increase in disposable income.
An increase in output also leads to an increase in investment.

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Chapter 5: Goods and Financial Markets: The IS–LM Model
Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall • Macroeconomics, 5/e • Olivier Blanchard

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5-1 The Goods Market and the IS Relation
Determining Output
Note two characteristics of ZZ:
Because it’s assumed that the consumption and investment relations in Equation (5.2) are linear, ZZ is, in general, a curve rather than a line.
ZZ is drawn flatter than a 45-degree line because it’s assumed that an increase in output leads to a less than one-for-one increase in demand.

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Chapter 5: Goods and Financial Markets: The IS–LM Model
Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall • Macroeconomics, 5/e • Olivier Blanchard

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5-1 The Goods Market and the IS Relation
Determining Output
The demand for goods is an increasing function of output. Equilibrium requires that the demand for goods be equal to output.
Figure 5 – 1
Equilibrium in the Goods Market

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When the ZZ line is flatter than the 45-degree line, an increase in output leads to a less than one-for-one increase in demand.

Chapter 5: Goods and Financial Markets: The IS–LM Model
Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall • Macroeconomics, 5/e • Olivier Blanchard

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5-1 The Goods Market and the IS Relation
Determining Output
Note two characteristics of ZZ:
Because it’s assumed that the consumption and investment relations in Equation (5.2) are linear, ZZ is, in general, a curve rather than a line.
ZZ is drawn flatter than a 45-degree line because it’s assumed that an increase in output leads to a less than one-for-one increase in demand.

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When the ZZ line is flatter than the 45-degree line, an increase in output leads to a less than one-for-one increase in demand.

Chapter 5: Goods and Financial Markets: The IS–LM Model
Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall • Macroeconomics, 5/e • Olivier Blanchard

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5-1 The Goods Market and the IS Relation
Deriving the IS Curve
An increase in the interest rate decreases the demand for goods at any level of output, leading to a decrease in the equilibrium level of output.
Equilibrium in the goods market implies that an increase in the interest rate leads to a decrease in output. The IS curve is therefore downward sloping.
Figure 5 – 2
The Derivation of the IS Curve

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When the ZZ line is flatter than the 45-degree line, an increase in output leads to a less than one-for-one increase in demand.

Chapter 5: Goods and Financial Markets: The IS–LM Model
Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall • Macroeconomics, 5/e • Olivier Blanchard

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5-1 The Goods Market and the IS Relation
Shifts of the IS Curve
We have drawn the IS curve in Figure 5-2, taking as given the values of taxes, T, and government spending, G. Changes in either T or G will shift the IS curve.
To summarize:
Equilibrium in the goods market implies that an increase in the interest rate leads to a decrease in output. This relation is represented by the downward-sloping IS curve.
Changes in factors that decrease the demand for goods, given the interest rate, shift the IS curve to the left. Changes in factors that increase the demand for goods, given the interest rate, shift the IS curve to the right.

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When the ZZ line is flatter than the 45-degree line, an increase in output leads to a less than one-for-one increase in demand.

Chapter 5: Goods and Financial Markets: The IS–LM Model
Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall • Macroeconomics, 5/e • Olivier Blanchard

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5-1 The Goods Market and the IS Relation
Shifts of the IS Curve
An increase in taxes shifts the IS curve to the left.
Figure 5 – 3
Shifts of the IS Curve

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Chapter 5: Goods and Financial Markets: The IS–LM Model
Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall • Macroeconomics, 5/e • Olivier Blanchard

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The interest rate is determined by the equality of the supply of and the demand for money:
M = nominal money stock
\$YL(i) = demand for money
\$Y = nominal income
i = nominal interest rate
5-2 Financial Markets and the LM Relation

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Chapter 5: Goods and Financial Markets: The IS–LM Model
Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall • Macroeconomics, 5/e • Olivier Blanchard

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5-2 Financial Markets and the LM Relation
The equation gives a relation between money, nominal income, and the interest rate.
Real Money, Real Income, and the Interest Rate
The LM relation: In equilibrium, the real money supply is equal to the real money demand, which depends on real income, Y, and the interest rate, i:
From chapter 2, recall that Nominal GDP = Real GDP multiplied by the GDP deflator:
Equivalently:

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Chapter 5: Goods and Financial Markets: The IS–LM Model
Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall • Macroeconomics, 5/e • Olivier Blanchard

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An increase in income leads, at a given interest rate, to an increase in the demand for money. Given the money supply, this increase in the demand for money leads to an increase in the equilibrium interest rate.
Equilibrium in the financial markets implies that an increase in income leads to an increase in the interest rate. The LM curve is therefore upward sloping.
Deriving the LM Curve
5-2 Financial Markets and the LM Relation
Figure 5 – 4
The Derivation of the
LM Curve

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Chapter 5: Goods and Financial Markets: The IS–LM Model
Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall • Macroeconomics, 5/e • Olivier Blanchard

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5-2 Financial Markets and the LM Relation
Deriving the LM Curve
Figure 5-4(b) plots the equilibrium interest rate, i, on the vertical axis against income on the horizontal axis.
This relation between output and the interest rate is represented by the upward sloping curve in Figure 5-4(b). This curve is called the LM curve.

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Chapter 5: Goods and Financial Markets: The IS–LM Model
Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall • Macroeconomics, 5/e • Olivier Blanchard

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5-2 Financial Markets and the LM Relation
Shifts of the LM Curve
An increase in money causes the LM curve to shift down.
Figure 5 – 5
Shifts of the LM curve

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Chapter 5: Goods and Financial Markets: The IS–LM Model
Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall • Macroeconomics, 5/e • Olivier Blanchard

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5-2 Financial Markets and the LM Relation
Shifts of the LM Curve
■ Equilibrium in financial markets implies that, for a given real money supply, an increase in the level of income, which increases the demand for money, leads to an increase in the interest rate. This relation is represented by the upward- sloping LM curve.
■ An increase in the money supply shifts the LM curve down; a decrease in the money supply shifts the LM curve up.

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Chapter 5: Goods and Financial Markets: The IS–LM Model
Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall • Macroeconomics, 5/e • Olivier Blanchard

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5-3 Putting the IS and the LM Relations
Together
Equilibrium in the goods market implies that an increase in the interest rate leads to a decrease in output. This is represented by the IS curve. Equilibrium in financial markets implies that an increase in output leads to an increase in the interest rate. This is represented by the LM curve. Only at point A, which is on both curves, are both goods and financial markets in equilibrium.
Figure 5 – 6
The IS–LM Model

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Chapter 5: Goods and Financial Markets: The IS–LM Model
Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall • Macroeconomics, 5/e • Olivier Blanchard

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Fiscal contraction, or fiscal consolidation, refers to fiscal policy that reduces the budget deficit.
An increase in the deficit is called a fiscal expansion.
Taxes affect the IS curve, not the LM curve.
5-3 Putting the IS and the LM Relations
Together
Fiscal Policy, Activity, and the Interest Rate

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Chapter 5: Goods and Financial Markets: The IS–LM Model
Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall • Macroeconomics, 5/e • Olivier Blanchard

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5-3 Putting the IS and the LM Relations
Together
Fiscal Policy, Activity, and
the Interest Rate
Equilibrium in the goods market implies that an increase in the interest rate leads to a decrease in output. This is represented by the IS curve. Equilibrium in financial markets implies that an increase in output leads to an increase in the interest rate. This is represented by the LM curve. Only at point A, which is on both curves, are both goods and financial markets in equilibrium.
Figure 5 – 7
The IS–LM Model

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Chapter 5: Goods and Financial Markets: The IS–LM Model
Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall • Macroeconomics, 5/e • Olivier Blanchard

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5-3 Putting the IS and the LM Relations
Together
Monetary Policy, Activity, and the Interest Rate
Monetary contraction, or monetary tightening, refers to a decrease in the money supply.
An increase in the money supply is called monetary expansion.
Monetary policy does not affect the IS curve, only the LM curve. For example, an increase in the money supply shifts the LM curve down.

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Chapter 5: Goods and Financial Markets: The IS–LM Model
Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall • Macroeconomics, 5/e • Olivier Blanchard

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5-3 Putting the IS and the LM Relations
Together
Monetary Policy, Activity, and the Interest Rate
A monetary expansion leads to higher output and a lower interest rate.
Figure 5 – 8
The Effects of a Monetary Expansion

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Chapter 5: Goods and Financial Markets: The IS–LM Model
Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall • Macroeconomics, 5/e • Olivier Blanchard

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5-4 Using a Policy Mix
Table 5-1 The Effects of Fiscal and Monetary Policy

Shift of IS Shift of LM Movement
in Output Movement in Interest Rate
Increase in taxes Left None Down Down
Decrease in taxes Right None Up Up
Increase in spending Right None Up Up
Decrease in spending Left None Down Down
Increase in money None Down Up Down
Decrease in money None Up Down Up

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Chapter 5: Goods and Financial Markets: The IS–LM Model
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Deficit Reduction: Good or Bad for Investment?
Investment = Private saving + Public saving
I = S + (T – G)
A fiscal contraction may decrease investment. Or, looking at the reverse policy, a fiscal expansion—a decrease in taxes or an increase in spending—may actually increase investment.

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Chapter 5: Goods and Financial Markets: The IS–LM Model
Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall • Macroeconomics, 5/e • Olivier Blanchard

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5-4 Using a Policy Mix
The combination of monetary and fiscal polices is known as the monetary-fiscal policy mix, or simply, the policy mix.
Sometimes, the right mix is to use fiscal and monetary policy in the same direction.
Sometimes, the right mix is to use the two policies in opposite directions—for example, combining a fiscal contraction with a monetary expansion.

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Chapter 5: Goods and Financial Markets: The IS–LM Model
Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall • Macroeconomics, 5/e • Olivier Blanchard

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The U.S. Recession of 2001
Figure 1 The U.S. Growth Rate, 1999:1 to 2002:4

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Chapter 5: Goods and Financial Markets: The IS–LM Model
Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall • Macroeconomics, 5/e • Olivier Blanchard

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The U.S. Recession of 2001
Figure 2 The Federal Funds Rate, 1999:1 to 2002:4

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Chapter 5: Goods and Financial Markets: The IS–LM Model
Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall • Macroeconomics, 5/e • Olivier Blanchard

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The U.S. Recession of 2001
Figure 3 U.S. Federal Government Revenues and Spending (as Ratios to GDP), 1999:1 to 2002:4

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Chapter 5: Goods and Financial Markets: The IS–LM Model
Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall • Macroeconomics, 5/e • Olivier Blanchard

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The U.S. Recession of 2001
Figure 4 The U.S. Recession of 2001

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Chapter 5: Goods and Financial Markets: The IS–LM Model
Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall • Macroeconomics, 5/e • Olivier Blanchard

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The U.S. Recession of 2001
What happened in 2001 was the following:
The decrease in investment demand led to a sharp shift of the IS curve to the left, from IS to IS’.
The increase in the money supply led to a downward shift of the LM curve, from LM to LM’.
The decrease in tax rates and the increase in spending both led to a shift of the IS curve to the right, from IS’’ to IS’.

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Chapter 5: Goods and Financial Markets: The IS–LM Model
Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall • Macroeconomics, 5/e • Olivier Blanchard

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5-5 How Does the IS-LM Model Fit the Facts?
Introducing dynamics formally would be difficult, but we can describe the basic mechanisms in words.
Consumers are likely to take some time to adjust their consumption following a change in disposable income.
Firms are likely to take some time to adjust investment spending following a change in their sales.

Firms are likely to take some time to adjust investment spending following a change in the interest rate.
Firms are likely to take some time to adjust production following a change in their sales.

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Chapter 5: Goods and Financial Markets: The IS–LM Model
Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall • Macroeconomics, 5/e • Olivier Blanchard

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5-5 How Does the IS-LM Model Fit the Facts?
In the short run, an increase in the federal funds rate leads to a decrease in output and to an increase in unemployment, but it has little effect on the price level.
Figure 5 – 9
The Empirical Effects of an Increase in the Federal Funds Rate

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Chapter 5: Goods and Financial Markets: The IS–LM Model
Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall • Macroeconomics, 5/e • Olivier Blanchard

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5-5 How Does the IS-LM Model Fit the Facts?
The two dashed lines and the tinted space between the dashed lines represents a confidence band, a band within which the true value of the effect lies with 60% probability:
Figure 5-9(a) shows the effects of an increase in the federal funds rate of 1% on retail sales over time. The percentage change in retail sales is plotted on the vertical axis; time, measured in quarters, is on the horizontal axis.
Figure 5-9(b) shows how lower sales lead to lower output.
Figure 5-9(c) shows how lower output leads to lower employment: As firms cut production, they also cut employment.
The decline in employment is reflected in an increase in the unemployment rate, shown in Figure 5-9(d).
Figure 5-9(e) looks at the behavior of the price level.

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Chapter 5: Goods and Financial Markets: The IS–LM Model
Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall • Macroeconomics, 5/e • Olivier Blanchard

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IS curve
LM curve
fiscal contraction, fiscal consolidation
fiscal expansion
monetary expansion
monetary contraction, monetary tightening
monetary–fiscal policy mix, policy mix
confidence band
Key Terms

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