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Equilibrium in the IS -LM model

r

The IS curve represents

equilibrium in the goods
market.

Chapter 11:
Aggregate Demand II,
Applying the IS-LM Model

LM

Y C (Y T ) I (r ) G
r1

The LM curve represents

Th
t
money market equilibrium.

IS

M P L (r ,Y )

Y1
The intersection determines
the unique combination of Y and r
that satisfies equilibrium in both markets.
CHAPTER 11

Aggregate Demand II

We can use the IS-LM

model to analyze the
effects of

LM

r1
IS

fiscal policy: G and/or T

monetary policy: M

CHAPTER 11

1. IS curve shifts right

1
G
by
1 MPC
causing output &
income to rise.
2 Thi
2.
This raises
i
money
demand, causing the
interest rate to rise

M P L (r ,Y )

Y1

Aggregate Demand II

CHAPTER 11

Aggregate Demand II

LM
2.

CHAPTER 11

r2
r1
IS2

1.

IS1
Y1 Y2

3.

Aggregate Demand II

1. M > 0 shifts
the LM curve down
(or to the right)

LM

1.

MPC
T
1 MPC

and Y are smaller for T

than for an equal G.

Monetary policy: An increase in M

Consumers save
r
(1MPC) of the tax cut,
so the initial boost in
spending is smaller for T
r2
than for an equal G
2.
r1
and
d th
the IS curve shifts
hift by
b

2. so the effects on r

3. which reduces investment,

so the final increase in Y
1
is smaller than
G
1 MPC

A tax cut

1.

Aggregate Demand II

An increase in government purchases

Policy analysis with the IS -LM model

Y C (Y T ) I (r ) G

CHAPTER 11

Y1 Y2

IS2
IS1

2. causing the
interest rate to fall
3. which increases
investment, causing
output & income to
rise.

2.

CHAPTER 11

Aggregate Demand II

LM1
LM2

r1
r2
IS
Y1 Y2

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Interaction between
monetary & fiscal policy
Model:

The Feds response to G > 0

Suppose Congress increases G.

Possible Fed responses:

Monetary & fiscal policy variables

(M, G, and T ) are exogenous.

1. hold M constant

Real world:

2. hold r constant

Monetary policymakers may adjust M

in response to changes in fiscal policy,
or vice versa.

3. hold Y constant

In each case, the effects of the G

are different

Such interaction may alter the impact of the

original policy change.
CHAPTER 11

Aggregate Demand II

If Fed holds M constant,

then LM curve doesnt
shift.

r2
r1
IS2
IS1

Y Y 2 Y1

Y1 Y2

r r2 r1
CHAPTER 11

If Congress raises G,
the IS curve shifts right.

LM1

Results:

To keep r constant,
Fed increases M
to shift LM curve right.

Aggregate Demand II

LM2

r2
r1
IS2
IS1
Y1 Y2 Y3

CHAPTER 11

Aggregate Demand II

Estimates of fiscal policy multipliers

from the DRI macroeconometric model

LM2
LM1

r
r3
r2
r1

IS2
IS1
Y1 Y2

r r3 r1
CHAPTER 11

LM1

r 0

Results:

Y 0

Y Y 3 Y1

Response 3: Hold Y constant

To keep Y constant,
Fed reduces M
to shift LM curve left.

Results:

Aggregate Demand II

If Congress raises G,
the IS curve shifts right.

Aggregate Demand II

Response 2: Hold r constant

Response 1: Hold M constant

If Congress raises G,
the IS curve shifts right.

CHAPTER 11

10

Assumption about
monetary policy

Estimated
value of
Y/ G

Estimated
value of
Y/ T

Fed holds money

supply constant

0.60

0.26

Fed holds nominal

interest rate constant

1.93

1.19

CHAPTER 11

Aggregate Demand II

11

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Shocks in the IS -LM model

Shocks in the IS -LM model

IS shocks: exogenous changes in the

demand for goods & services.

LM shocks: exogenous changes in the

demand for money.

Examples:
stock market boom or crash
change in households wealth
C
change in business or consumer
confidence or expectations
I and/or C

Examples:
a wave of credit card fraud increases
demand for money.
more ATMs or the Internet reduce money
demand.

CHAPTER 11

Aggregate Demand II

12

CHAPTER 11

Aggregate Demand II

13

CASE STUDY:

NOW YOU TRY:

Analyze shocks with the IS-LM Model

Use the IS-LM model to analyze the effects of
1. a boom in the stock market that makes
consumers wealthier.
2. after a wave of credit card fraud, consumers using
cash
h more ffrequently
tl iin ttransactions.
ti

The U.S. recession of 2001

During 2001,
2.1 million jobs lost,
unemployment rose from 3.9% to 5.8%.

GDP growth slowed to 0.8%

(compared to 3
3.9%
9% average annual growth
during 1994-2000).

For each shock,

a. use the IS-LM diagram to show the effects of the
shock on Y and r.
b. determine what happens to C, I, and the
unemployment rate.
CHAPTER 11

Aggregate Demand II

CASE STUDY:

The U.S. recession of 2001

The U.S. recession of 2001

Causes: 1) Stock market decline C

Causes: 2) 9/11
increased uncertainty
fall in consumer & business confidence
result: lower spending, IS curve shifted left

Index (1942 = 100)

CASE STUDY:

1500

Standard & Poors

500

1200

15

Causes: 3) Corporate accounting scandals

Enron, WorldCom, etc.
reduced stock prices, discouraged investment

900
600
300
1995

CHAPTER 11

1996

1997

1998

Aggregate Demand II

1999

2000

2001

2002

2003
16

CHAPTER 11

Aggregate Demand II

17

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CASE STUDY:

CASE STUDY:

The U.S. recession of 2001

Fiscal policy response: shifted IS curve right

The U.S. recession of 2001

Monetary policy response: shifted LM curve right

tax cuts in 2001 and 2003

spending increases

Three-month
T-Bill Rate

6
5

airline industry bailout

NYC reconstruction
Afghanistan war

4
3
2
1
0

CHAPTER 11

Aggregate Demand II

18

What is the Feds policy instrument?

CHAPTER 11

Aggregate Demand II

19

What is the Feds policy instrument?

The news media commonly report the Feds policy

Why does the Fed target interest rates instead of

the money supply?

changes as interest rate changes, as if the Fed

has direct control over market interest rates.

1) They are easier to measure than the money

supply.

In fact, the Fed targets the federal funds rate

th iinterest
the
t
t rate
t banks
b k charge
h
one another
th on
overnight loans.

2) The Fed might believe that LM shocks are

more prevalent than IS shocks. If so, then
targeting the interest rate stabilizes income
better than targeting the money supply.

The Fed changes the money supply and shifts the

LM curve to achieve its target.

(See end-of-chapter Problem 7 on p.337.)

Other short-term rates typically move with the

federal funds rate.
CHAPTER 11

Aggregate Demand II

20

IS-LM and aggregate demand

21

Intuition for slope

of AD curve:

analyze the short run, when the price level is

assumed fixed.

P (M/P )

However, a change in P would shift LM and

LM shifts left

therefore affect Y.

The aggregate demand curve

(introduced in Chap. 9) captures this

relationship between P and Y.

Aggregate Demand II

Aggregate Demand II

Deriving the AD curve

So far, weve been using the IS-LM model to

CHAPTER 11

CHAPTER 11

22

CHAPTER 11

Aggregate Demand II

LM(P2)
LM(P1)

r2
r1

IS

Y2

Y1

Y2

Y1

P2
P1
AD

Y
23

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Monetary policy and the AD curve

The Fed can increase
aggregate demand:
M LM shifts right

LM(M1/P1)
LM(M2/P1)

r1
r2

Y at each
value of P

P1

Y1

Y1

Y2

Y2

Expansionary fiscal
policy (G and/or T )
increases agg. demand:

LM

r2
r1

IS2

T C

IS

CHAPTER 11

Fiscal policy and the AD curve

IS shifts right

Y at each
value of P

P1

AD2
AD1
Y

Aggregate Demand II

Y1

Y1
24

IS-LM and AD-AS

CHAPTER 11

IS1
Y2

Y2

AD2
AD1
Y

Aggregate Demand II

25

The SR and LR effects of an IS shock

in the short run & long run

Recall from Chapter 9: The force that moves the

economy from the short run to the long run
is the gradual adjustment of prices.

A negative IS shock
shifts IS and AD left,
causing Y to fall.

LRAS LM(P )
1

IS2

In the short
short-run
run
equilibrium, if

CHAPTER 11

then over time,

time the
price level will

Y Y

rise

P1

Y Y

fall

Y Y

remain constant

The SR and LR effects of an IS shock

Y
P

CHAPTER 11

LRAS LM(P )
1

In the new short-run

equilibrium, Y Y

IS1

IS2

Over time, P gradually

falls, causing

SRAS to move down

M/P to increase,

SRAS1

27

LRAS

P1

AD1
AD2
Y

Aggregate Demand II

LRAS LM(P )
1

IS2

Aggregate Demand II

SRAS1

The SR and LR effects of an IS shock

In the new short-run

equilibrium, Y Y

CHAPTER 11

LRAS

Y
26

Aggregate Demand II

IS1

Y
P
P1

SRAS1

Y
28

CHAPTER 11

Aggregate Demand II

LRAS

which causes LM
to move down

AD1
AD2
Y

IS1

AD1
AD2
Y
29

10/14/2013

The SR and LR effects of an IS shock

LRAS LM(P )
1

LRAS LM(P )
1

LM(P2)

IS2

Over time, P gradually

falls, causing

SRAS to move down

M/P to increase,

LRAS

P1

SRAS1

P2

SRAS2

P2

SRAS2

AD1
AD2
Y

LRAS LM(M /P )
1
1

b. Suppose Fed increases M.

IS

Show the short-run effects

on your graphs.

equilibrium values of the

endogenous variables
compare to their initial
values?

Y
P

LRAS

P1

Aggregate Demand II

31

SRAS1

30

Unemployment
(right scale)

220

25

200

20

180

15

160

10

Real GNP
(left scale)

140
120
1929

AD1

240

billions of 19
958 dollars

diagrams as shown here.

c. Show what happens in the

CHAPTER 11

The Great Depression

Analyze SR & LR effects of M

r

AD1
AD2
Y

Y
30

NOW YOU TRY:

d. How do the new long-run

LRAS

SRAS1

transition from the short run

to the long run.

IS1
Y

Y Y

Aggregate Demand II

a. Draw the IS-LM and AD-AS

IS2

P1

which causes LM
to move down
CHAPTER 11

This process continues

until economy reaches a
long-run
long
run equilibrium with

IS1
Y

LM(P2)

percent of la
abor force

The SR and LR effects of an IS shock

0
1931

1933

1935

1937

1939

THE SPENDING HYPOTHESIS:

THE SPENDING HYPOTHESIS:

asserts that the Depression was largely due to

Stock market crash exogenous C

Shocks to the IS curve

Reasons for the IS shift

Oct-Dec 1929: S&P 500 fell 17%
Oct 1929-Dec 1933: S&P 500 fell 71%

an exogenous fall in the demand for goods &

services a leftward shift of the IS curve.

evidence:

Drop in investment
correction after overbuilding in the 1920s
widespread bank failures made it harder to obtain

output and interest rates both fell, which is what

a leftward IS shift would cause.

financing for investment

Contractionary fiscal policy

Politicians raised tax rates and cut spending to
combat increasing deficits.
CHAPTER 11

Aggregate Demand II

34

CHAPTER 11

Aggregate Demand II

35

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THE MONEY HYPOTHESIS:

THE MONEY HYPOTHESIS AGAIN:

A shock to the LM curve

The effects of falling prices

asserts that the Depression was largely due to

asserts that the severity of the Depression was

huge fall in the money supply.

due to a huge deflation:

P fell 25% during 1929-33.

evidence:
M1 fell 25% during 1929-33.

This deflation was probably caused by the fall in

But, two problems with this hypothesis:

P fell even more, so M/P actually rose slightly

M, so perhaps money played an important role

after all.

during 1929-31.

In what ways does a deflation affect the

nominal interest rates fell, which is the opposite

economy?

of what a leftward LM shift would cause.

CHAPTER 11

Aggregate Demand II

36

CHAPTER 11

Aggregate Demand II

THE MONEY HYPOTHESIS AGAIN:

THE MONEY HYPOTHESIS AGAIN:

The effects of falling prices

The effects of falling prices

The stabilizing effects of deflation:

The destabilizing effects of expected deflation:

P (M/P ) LM shifts right Y

Pigou effect:

(M/P

)
consumers wealth
C

37

r for each value of i

I because I = I (r )
planned expenditure & agg. demand
income & output

IS shifts right
Y
CHAPTER 11

Aggregate Demand II

38

THE MONEY HYPOTHESIS AGAIN:

39

Policymakers (or their advisors) now know

The destabilizing effects of unexpected deflation:

much more about macroeconomics:

debt-deflation theory
P (if unexpected)
transfers purchasing power from borrowers to
l d
lenders
borrowers spend less,
lenders spend more
if borrowers propensity to spend is larger than
lenders, then aggregate spending falls,
the IS curve shifts left, and Y falls
Aggregate Demand II

Aggregate Demand II

Why another Depression is unlikely

The effects of falling prices

CHAPTER 11

CHAPTER 11

The Fed knows better than to let M fall

so much, especially during a contraction.

Fiscal policymakers know better than to raise

taxes or cut spending during a contraction.

Federal deposit insurance makes widespread

bank failures very unlikely.

Automatic stabilizers make fiscal policy

expansionary during an economic downturn.
40

CHAPTER 11

Aggregate Demand II

41

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Interest rates and house prices

The 2008-09 Financial Crisis & Recession

2009: Real GDP fell, u-rate approached 10%

Important factors in the crisis:

early 2000s Federal Reserve interest rate policy
sub-prime mortgage crisis
bursting of house price bubble,

Aggregate Demand II

interest ra
ate (%)

130

4
110
90
2
70

1
0
2000

42

2001

2002

2003

50
2005

2004

House price change and new foreclosures,

2006:Q3 2009Q1

14%

20%

US house price index

12%

1.4

Nevada

18%

New foreclosures

Illinois

Florida
1.2

8%

1.0

6%
0.8

4%

0.6

2%
0%

0.4

16%

New forec
closures,
% of all mo
ortgages

10%

New foreclosurre starts

(% of total morttgages)

14%

California

Georgia

12%

Colorado

Arizona

10%

Rhode Island
New Jersey

8%

Texas
S. Dakota

Hawaii
4%

Oregon
Alaska

-2%
2%

0.2

-4%
-6%
1999

0%
-40%

0.0
2001

2003

2005

2007

-30%

-20%

-10%

Wyoming
N. Dakota

0%

10%

Major U.S. stock indexes

(% change from 52 weeks earlier)

DJIA

140%

70
60

20%

Cumulative change in house price index

2009

U.S. bank failures by year, 2000-2009

Ohio

Michigan

6%

120%

S&P 500

100%

NASDAQ

80%

50

60%

40

40%
20%

30

0%
-20%

20

-40%

10

-60%
7/20/2009

3/5/2008

11/11/2008

6/28/2007

10/20/2006

6/5/2005

2/11/2006

9/27/2004

1/20/2004

5/14/2003

9/5/2002

12/28/2001

* as of July 24, 2009.

4/21/2001

2000 2001 2002 2003 2004 2005 2006 2007 2008 2009*

8/13/2000

-80%

12/6/1999

Percent change in h
house prices
(from 4 quarters
s earlier)

150

Change in U.S. house price index

and rate of new foreclosures, 1999-2009

Number of b
bank failures

170

rising foreclosure rates

falling stock prices
failing financial institutions
declining consumer confidence, drop in spending
on consumer durables and investment goods
CHAPTER 11

Federal Funds rate

30-year mortgage rate
190
Case-Shiller 20-city composite house price index
House price index
x, 2000=100

CASE STUDY

10/14/2013

Consumer sentiment and growth in consumer

durables and investment spending

Real GDP growth and Unemployment

10

10%

Real GDP growth rate (left scale)

100

5%
90
0%
80

-5%
-10%

70

-15%

Durables

-20%

Investment

60

UM Consumer Sentiment Index

-25%
1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009

50

8
6%

7
6

4%

5
2%

4
3

0%

2
-2%
1
-4%
1995

0
1997

Chapter Summary
1. IS-LM model

a theory of aggregate demand

exogenous: M, G, T,
P exogenous in short run, Y in long run

endogenous: r,
Y endogenous in short run, P in long run

IS curve: goods market equilibrium

LM curve: money market equilibrium

Unemployment rate (right scale)

% of labor force

10%

8%

% change from 4 q
quaters earlier

110

15%

Consumer Sentiment In
ndex, 1966=100

% change from four qu

uarters earlier

20%

1999

2001

2003

2005

2007

2009

Chapter Summary
2. AD curve

shows relation between P and the IS-LM models

equilibrium Y.

negative slope because

P (M/P ) r I Y

expansionary fiscal policy shifts IS curve right,

raises income, and shifts AD curve right.

expansionary monetary policy shifts LM curve

right, raises income, and shifts AD curve right.

IS or LM shocks shift the AD curve.