+

MACROECONOMICS
Lecturer: DANG HUYEN ANH
Email: Huyenanh098@gmail.com
+

Chapter 6
IS – LM model
 3
IN THIS CHAPTER
•  The Aggregate expenditure function
•  The IS curve, and its relation to
–  the Keynesian cross
•  The LM curve, and its relation to
–  the theory of liquidity preference
•  How the IS-LM model determines income and the interest
rate in the very short run when P is fixed
Context
!  Classical theory: the economy in the long run
!  prices flexible
!  Output (Yn) determined by Aggregate supply (factors of production &
technology)
!  Unemployment equals its natural rate
!  Great depression of the 1930s: In 1933, the worst year: one-fourth of the U.S.
labor force was unemployed: real GDP was 30 percent below its 1929 level

However, from 1929 to 1933, neither the factors of production nor the
available technology changed substantially.

A new model was needed to explain such a large and sudden

economic downturn and to suggest government policies that might
reduce the economic hardship so many people faced.

To interpret the Keynes’s theory, the model of aggregate demand is

developed, called the IS–LM model.
+
Assumptions
In very short run:

!  There is abundance of production resources, AS is available at

any level of Price and AS curve is horizontal

!  Constant price

!  AD (AE) determines total output

 P AS

P0

A right shift of AD
AD

Y
… leads to higher output P

Price unchanged P0 AS
… with a horizontal AS

AD

Y
+ 7

Aggregate Expenditure
(Aggregate demand)
 + Aggregate Expenditures (AE) –
Aggregate Demand (AD)

AE is the level of AD at a given price level

Therefore, components of AE include C,I,G,Nx:
AE = C + I + G + NX

!  Consumption: Demand on consumer goods and services

!  Investment: Demand on capital goods

!  Government spending: Demand on public goods and services

!  Net Exports: demand on exported goods and services minus

demand on imported goods and services
 + 1. Consumption
!  Factors affect consumption:

- Disposable income: YD = Y – T

T: net tax ; T = Tax – Transfer payment (TR)

Marginal Propensity to Consume MPC

! a part of Consumption = MPC x YD
- Other factors affect to consume: population, expectations…

"  C = f (YD, population, expectations ...)

"  C = C + MPC * YD

C: pre-determined consumption
+
Net Tax includes
!  Predetermined Tax (VAT, imports tax…)
!  Income Tax
T=T+tY

t: tax rate
T : tax level predetermined

!  Consumption function
C = C + MPC(Y – T – tY)
+
2. Investment

!  Investment spending
!  Machinery, equipments, structures…
!  New house
!  Inventories

I = I – bxi i: interest rate

I=I
Investment function
if interest rate is
constant
+
3. Government Spending

!  Tools of Fiscal Policy: T, G

!  Planned and pre-determined

G=G
+
4. Net Export = Export -
Import
!  Exports
!  Demand for exported goods by foreigners
!  X = X (Yf, P, Pf, E....)

X=X
!  Import
!  Domestic demand for goods produced abroad
!  IM = (Y, P, Pf, E....)

IM = MPM * Y
+
AE = C + I + G + NX

C = C + MPC ( Y – T – tY)

I=I

G=G
NX = X – MPM*Y

AE = C + I + G + X – MPC*T + [MPC(1-t)-MPM]*Y

AE αxY
Pre-determined Expenditures Income determined Expenditures
AE
450
AE = AE +α Y
AE2
B
AE0
AE1
A
AE

Y1 Y0 Y2 Y (GDP)
 +
Equilibrium

Equilibrium condition
AE = Y

AE = C + I + G + X – MPCxT + [MPC(1-t)-MPM]xY

Equilibrium output:
1
Y = x (C + I + G + X – MPC.T)

1- MPC (1-t) + MPM

+
Now you try!

!  C = 200 + 0,7.Yd

!  I = 207

!  T = 50 + 0,1Y

!  G = 100

!  X = 340

!  M = 0,3.Y

? Determine AE function and calculate the equilibrium

output
+ Increase in
C, I , G, X
and
decrease in
T
AE
450

AE

Δ AE
decrease in
AE C, I , G, X and
Δ AE
increase in T

ΔY ΔY

Y2 Y0 Y1 Y
 +
Example

•  Suppose an economy with exports of bln $ 5 and marginal

propensity to import is 0.14. Predetermined consumption is
bln$ 30, marginal propensity to consume is 0.8. Private
investment is bln $ 5. Government expenditure is bln$ 20
and income tax rate is 20%
•  Question
1.  Calculate the components of Aggregate Expenditure
2.  Write AE function
3.  Draw AE on diagram
4.  Compute the equilibrium output
+
(cont.)

5. Calculate the changes in aggregate expenditure /equilibrium

output /Budget balance if:

a. government spending increases by 20

b. investment reduces by 20
c. predetermined tax increases by 20

d. G and T increase by 20
6. Use diagram to demonstrate the above changes
+
AE = C + I + G + NX

C = 30 + 0.8 ( Y – 0.2Y) = 30 + 0.64 Y

I=5

G = 20
NX = 5 – 0.14*Y

AE = 60+ 0.5 *Y

Equilibrium: AE = Y # Y = 120
+
∆G=20 # ∆Y= 40

AE
450 Budget Balance:
B=T–G
∆T = 0.2 * 40 = +8
AE
∆G = +20
∆B = -12

20
60
20

40 40
Y

80 120 160
+ ∆I=-20 # ∆Y=-40

AE
450 Budget Balance:
B=T–G
∆T = 0.2*(-40) = -8
AE
∆G = 0
∆B = -8

20
60
20

40 40
Y

80 120 160
+ ∆T=20 # ∆Y= -32

AE
450 Budget Balance:
B=T–G
∆T=+20-0.2*32
AE
= +13.6
∆G = 0
∆B = + 13.6
20
60
16

32 40
Y

80 120 160
+ 25

The Keynesian cross

in closed economy
+
Assumptions
Initial assumptions:

!  There is abundance of production resources, AS is

available at any level of Price and AS curve is horizontal

!  Constant price

!  AD (AE) determines total output

Two more Assumption,

- Close economy (Ex = 0; Im = 0)
-  Tax is predetermined and planned (t = 0
The Keynesian Cross: Income (or Output) is determined by
expenditure.

!  Actual expenditure (Y) is the amount households, firms, and the government
spend on goods and services.

!  Planned expenditure (PE) is the amount households, firms, and the

government would like to spend on goods and services

-> Difference between actual & planned expenditure is unplanned inventory in

investment
 28

!  Actual expenditure: Y = real GDP

!  Planned expenditure (in close economy) : PE = C + I + G

Y – PE = unplanned investment in inventory

Therefor,
- If, Actual expenditure = planned expenditure (Y = PE)
$ unplanned inventory (unplanned investment) = 0
(this is equilibrium stage)

- If, Y > PE $ unplanned investment > 0 (accumulation in investment)

- If Y < PE $ unplanned investment < 0 (decumulation in investment)
Planned expenditure function 29
remember assumption:
- Close economy (Ex = 0; Im = 0)
-  Tax is predetermined and planned (t = 0)
PE = C + I + G
C = C + MPC ( Y – T )

I=I

G=G

PE = ( C + I + G – MPC*T ) + MPC*Y

Equilibrium condition: Y = PE
$ Equilibrium output:
Y = (1/(1-MPC)) x (C + I + G – MPC.T)
(1/(1-MPC)) = m, the multiplier; m > 1
+ Graphing PE curve and The equilibrium
value of income

The Keynesian PE
cross shows how PE = Y (45 o)
income Y is
determined for
given levels of
PE =C +I +G
planned investment
I and fiscal policy G
and T

Y0 Y
Equilibrium
income

The Keynesian cross

 The adjustment to equilibrium in the
+ Keynesian cross

PE
PE =Y

PE =C +I +G
EA
A Unplanned
inventory in
At A point: Y > PE
$Unplanned investment
E
accumulation
inventory in
investment
accumulates
$ This causes
income
(output) to fall
$ YA decrease to
Y0 to the
Y
equilibrium
Y0 YA
+ 32

Fiscal policy
 + Tools of Fiscal Policy

!  Government spending
G=G
!  Tax

T = T + t.Y

Expansionary fiscal policy: increase G/ decrease T -> AD increase

Contractionary fiscal policy: decrease G/increase T -> AD decrease
+ Fiscal Policy and the Multiplier
Expansionary fiscal policy: An increase in government
purchases -> PE increase, PE curve shifts upward

PE
At Y1, PE2 =C +I +G2
there is now an
unplanned fall in
inventory…
PE 1=C +I +G1

ΔG
…so firms increase
output, and income
rises toward a new
equilibrium. Y
PE1 = Y1 ΔY PE2 = Y2
 Expansionary fiscal policy
When government increases spending (ΔG)

Y = (1/(1-MPC)) x (C + I + G – MPC.T)

Solve for ΔY :

⎛ 1 ⎞
ΔY = ⎜ ⎟ × ΔG
⎝ 1 − MPC ⎠

Or, ΔY = m. ΔG

m is expenditure multiplier (m > 1)

+ contractionary fiscal policy:
An increase in taxes
PE
Initially, the tax
increase reduces PE1 =C1 +I +G
consumption C, and
therefore PE: PE2=C2 +I +G

ΔC = -MPC ΔT At Y1, there is now an

unplanned
inventory buildup…
…so firms
reduce output,
and income falls Y
toward a new E2 = Y 2 ΔY E1 = Y 1
equilibrium
When government increases tax (ΔT)

Y = (1/(1-MPC)) x (C + I + G – MPC.T)

⎛ − MPC ⎞
ΔY = ⎜ ⎟ × ΔT
⎝ 1 − MPC ⎠

mt = (-MPC)/(1-MPC), ΔY = mt. ΔT
mt is tax multiplier (mt < 0)
 38

Active learning:
!  Use
a graph of the Keynesian cross to show the
effects of an increase in planned investment on the
equilibrium level of income/output.
Active learning - answer:
!  Use a graph of the Keynesian cross to show the effects of an increase in
planned investment on the equilibrium level of income/output.

I increase $ PE
increase
(PE shifts upward)
PE
At Y1, PE2 =C +I2 +G
there is now an
unplanned drop in PE1 =C +I1 +G
inventory…

ΔI
…so firms increase
output, and income
rises toward a new
equilibrium. Y
Y1 ΔY Y2
+ 40

IS – LM model

Assumption:
-  Close economy (Ex = 0; Im = 0)
-  Tax is predetermined and planned (t = 0)
-  Real interest rate ≠ 0 , therefore, I = I(r)
IS stands for
“investment’’ and
“saving’’
LM stands for “liquidity’’
and “money’’

The IS curve represents

what’s going on in the
market for goods and
services

The LM curve represents

what’s happening to the
supply and demand for
money.
The IS curve
The IS curve is a graph of all combinations of
real interest rate and output that result in
goods market equilibrium

Equilibrium condition:
actual expenditure (output) = planned expenditure

$ The equation for the IS curve is:

Y = C (Y − T ) + I (r ) + G
 Deriving the IS curve
(b) The Keynesian cross

PE =Y
If real interest rate falls PE
PE2 =C +I (r2 )+G

↓r ⇒ ↑I PE1 =C +I (r1 )+G

⇒ ↑E ΔI

⇒ ↑Y Y1 Y2 Y
r r
r1 r1
↓
r2 r2
I(r) IS
I1 I2 Y Y1 Y2 Y
↓

(a) The investment function (c) The IS curve

Why the IS curve is negatively sloped

!  A fall in the interest rate motivates firms to increase

investment spending, which drives up planned
spending (PE ).

!  To restore equilibrium in the goods market, output

(actual expenditure, Y ) must increase.
Fiscal Policy and the IS curve

!  We can use the IS-LM model to see

how fiscal policy (G and T ) affects
aggregate demand and output.

!  Let’s start by using the Keynesian cross

to see how fiscal policy shifts the IS curve…

Chapter 5: The IS-LM model

Shifting the IS curve: ΔG

E E =Y E =C +I (r )+G
At any value of r, 1 2

↑G ⇒ ↑E ⇒ ↑Y E =C +I (r1 )+G1
…so the IS curve
shifts to the right.

The horizontal Y1 Y2 Y
r
distance of the
r1
IS shift equals
1 ΔY
ΔY = ΔG IS2
1− MPC IS1
Y1 Y2 Y
In summary

•  The IS curve shows the combinations of the

interest rate and the level of income that are
consistent with equilibrium in the market for
goods and services.

•  The IS curve is drawn for a given fiscal policy.

Changes in fiscal policy that raise the demand for
goods and services shift the IS curve to the right.
Changes in fiscal policy that reduce the demand
for goods and services shift the IS curve to the
left.
 Money market and the LM curve
The Theory of Liquidity Preference: A theory in
which the interest rate is determined by money
supply and money demand.

(Proposed by John Maynard Keynes)

In this chapter,
Money quantity is real variable (M/P)

So, Money demand and money supply do not belong to Price or

value of money
Money supply curve

r
s
The supply of interest (M P )
real money rate
balances
is fixed:
s
(M P) =M P

M/P
M P real money
balances
Money demand
Money demand is
determined by interest
rate (i) and income (Y) r
s
interest (M P )
The nominal interest rate is rate
the opportunity cost of
holding money (instead of
bonds)
So money demand depends
negatively on the nominal
interest rate.

Here, we are assuming the L (r )
price level is fixed, r = i.

M/P
Demand for
M P real money
real money
balances: balances
(M/P)d = L (r,Y)
Equilibrium in money market

The interest r
rate adjusts s

to equate the
interest (M P )
rate
supply and
demand for
money:

r1

M P = L (r ) L (r )

M/P
M P real money
balances
How to raises the interest rate

r
interest
To increase r, rate
Central bank
reduces M
r2
-> MS curve
shift leftward r1
L (r )

M/P
M2 M1 real money
P P balances
The LM curve

The LM curve is a graph of all combinations of

r and Y that equate the supply and demand for
real money balances.
The equation for the LM curve is:

M P = L (r ,Y )
 +
Deriving the LM curve
(a) The market for
(b) The LM curve
real money balances
r r
LM

r2 r2

L (r , Y2 )
r1 r1
L (r , Y1 )

M1 M/P Y1 Y2 Y
P

Chapter 5: The IS-LM model

Why the LM curve is upward sloping

!  An increase in income raises money demand.

!  Since the supply of real balances is fixed, there is now

excess demand in the money market at the initial
interest rate.

!  The interest rate must rise to restore equilibrium in the

money market.
+
How ΔM shifts the LM curve
(a) The market for
(b) The LM curve
real money balances
r r
LM2

LM1
r2 r2

r1 r1
L (r , Y1 )

M2 M1 M/P Y1 Y
P P
In summary

•  The LM curve shows the combinations of the

interest rate and the level of income that are
consistent with equilibrium in the market for real
money balances.

•  The LM curve is drawn for a given supply of real

money balances. Decreases in the supply of real
money balances shift the LM curve upward.
Increases in the supply of real money balances
shift the LM curve downward.
The short-run equilibrium

The short-run equilibrium r

is the combination of r and LM
Y that simultaneously
satisfies the equilibrium
conditions in the goods &
money markets:
Y = C (Y − T ) + I (r ) + G IS
M P = L (r ,Y ) Y
Equilibrium
interest Equilibrium
rate level of
income

Chapter 5: The IS-LM model

 + The Big Picture

Keynesian IS
Cross curve
IS-LM
model Explanation
Theory of LM of short-run
Liquidity curve fluctuations
Preference
Agg.
demand
curve Model of
Agg.
Demand
Agg.
and Agg.
supply
Supply
curve

Chapter 5: The IS-LM model

Equilibrium in the IS -LM model

The IS curve represents r

equilibrium in the goods LM
market.
Y = C (Y − T ) + I (r ) + G
r1
The LM curve represents
money market equilibrium.
IS
M P = L (r ,Y )
Y
Y1
The intersection determines
the unique combination of Y and r
that satisfies equilibrium in both markets.

Chapter 5: The IS-LM model

Policy analysis with the IS -LM model

Y = C (Y − T ) + I (r ) + G r
LM
M P = L (r ,Y )

We can use the IS-LM

model to analyze the r1
effects of
•  fiscal policy: G and/or IS
T
Y
•  monetary policy: M Y1
An increase in government purchases

1. IS curve shifts right r

1 LM
by ΔG
1− MPC
causing output & r2
2.
income to rise. r1
2. This raises money
1. IS2
demand, causing the
interest rate to rise… IS1
Y
3. …which reduces investment, Y1 Y2
so the final increase in Y 3.
1
is smaller than ΔG
1− MPC
 A tax cut

Consumers save (1-MPC) r

of the tax cut, so the initial LM
boost in spending is
smaller for ΔT than for an
r2
equal ΔG… 2.
r1
and the IS curve shifts by
1. IS2
−MPC
1. ΔT IS1
1− MPC
Y
Y1 Y2
2. …so the effects on r 2.
and Y are smaller for ΔT
than for an equal ΔG.
Chapter 5: The IS-LM model
 Monetary policy: An increase in M

r
1. ΔM > 0 shifts LM1
the LM curve down
(or to the right) LM2

r1
2. …causing the
interest rate to fall r2

3. …which increases IS
investment, causing Y
Y1 Y2
output & income to
rise.

Chapter 5: The IS-LM model

Interaction between
monetary & fiscal policy

!  Model:
Monetary & fiscal policy variables
(M, G, and T ) are exogenous.

!  Real world:
Monetary policymakers may adjust M
in response to changes in fiscal policy,
or vice versa.

!  Such interaction may alter the impact of the original

policy change.
The Fed’s response to ΔG > 0

!  Suppose Congress increases G.

!  Possible Fed responses:

1. hold M constant
2. hold r constant
3. hold Y constant

!  In each case, the effects of the ΔG

are different:
 Response 1: Hold M constant

If Congress raises G, r
the IS curve shifts right. LM1

If Fed holds M constant,

r2
then LM curve doesn’t r1
shift.
IS2
Results:
IS1
ΔY = Y 2 − Y1 Y
Y1 Y2
Δr = r2 − r1
 Response 2: Hold r constant

If Congress raises G, r
the IS curve shifts right. LM1
LM2
To keep r constant,
r2
Fed increases M r1
to shift LM curve right.
IS2
Results: IS1
ΔY = Y 3 − Y1 Y
Y1 Y2 Y3

Δr = 0
 Response 3: Hold Y constant

If Congress raises G, r LM2

the IS curve shifts right. LM1

r3
To keep Y constant,
r2
Fed reduces M r1
to shift LM curve left.
IS2
Results: IS1
ΔY = 0 Y
Y1 Y2
Δr = r3 − r1

Chapter 5: The IS-LM model

 Estimates of fiscal policy
multipliers
from the DRI macroeconometric
model
Estimated Estimated
Assumption about value of value of
monetary policy ΔY / ΔG ΔY / ΔT

Fed holds money

0.60 -0.26
supply constant
Fed holds nominal
1.93 -1.19
interest rate constant
Shocks in the IS -LM model

IS shocks: exogenous changes in the demand for goods &

services.
Examples:
! stock market boom or crash
⇒ change in households’ wealth
⇒ ΔC
! change in business or consumer
confidence or expectations
⇒ ΔI and/or ΔC
Shocks in the IS -LM model

LM shocks: exogenous changes in the demand for

money.
Examples:
! a wave of credit card fraud increases
demand for money.
! more ATMs or the Internet reduce
money demand.
 EXERCISE:
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 more frequently in
transactions.
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 5: The IS-LM model
CASE STUDY:
The U.S. recession of 2001

!  During 2001,
!  2.1 million people lost their jobs,
as unemployment rose from 3.9% to 5.8%.
!  GDP growth slowed to 0.8%
(compared to 3.9% average annual growth during
1994-2000).

Chapter 5: The IS-LM model

CASE STUDY:
The U.S. recession of 2001

! Causes: 1) Stock market decline ⇒ ↓C

1500
Standard & Poor’s
Index (1942 = 100)

1200 500

900

600

300
1995 1996 1997 1998 1999 2000 2001 2002 2003

Chapter 5: The IS-LM model

CASE STUDY:
The U.S. recession of 2001

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

!  Causes: 3) Corporate accounting scandals

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

Chapter 5: The IS-LM model

CASE STUDY:
The U.S. recession of 2001

!  Fiscal policy response: shifted IS curve right

!  tax cuts in 2001 and 2003
!  spending increases
!  airline industry bailout
!  NYC reconstruction
!  Afghanistan war

Chapter 5: The IS-LM model

CASE STUDY:
The U.S. recession of 2001
!  Monetary policy response: shifted LM curve
7
right
6
Three-month
T-Bill Rate
5
4
3
2
1
0

Chapter 5: The IS-LM model

 What is the Fed’s policy instrument?

! The news media commonly report the Fed’s

policy changes as interest rate changes, as if
the Fed has direct control over market
interest rates.
! Infact, the Fed targets the federal funds rate –
the interest rate banks charge one another on
overnight loans.
! The Fed changes the money supply and shifts
the LM curve to achieve its target.
! Other short-term rates typically move with
the federal funds rate.
Chapter 5: The IS-LM model
 What is the Fed’s policy instrument?

Why does the Fed target interest rates instead of the money
supply?
1) They are easier to measure than the money supply.
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.
(See end-of-chapter Problem 7 on p.328.)

Chapter 5: The IS-LM model

IS-LM and aggregate demand

!  So far, we’ve been using the IS-LM model to analyze the

short run, when the price level is assumed fixed.
!  However, a change in P would shift LM and therefore
affect Y.
!  The aggregate demand curve: captures this
relationship between P and Y.

Chapter 5: The IS-LM model

Aggregate demand

!  The aggregate demand curve shows the relationship

between the price level and the quantity of output
demanded.

!  For this chapter’s intro to the AD/AS model,

we use a simple theory of aggregate demand based on
the quantity theory of money.

Chapter 5: The IS-LM model

The Quantity Equation as
Aggregate Demand

!  From Chapter 4, recall the quantity equation

MV = PY

!  For given values of M and V,

this equation implies an inverse relationship between P
and Y :

Chapter 5: The IS-LM model

The downward-sloping AD curve

P
An increase in
the price level
causes a fall in
real money
balances (M/P ),
causing a
decrease in the
AD
demand for
goods & Y
services.

Chapter 5: The IS-LM model

Shifting the AD curve

P
An increase in
the money
supply shifts
the AD curve to
the right.
AD2
AD1
Y

Chapter 5: The IS-LM model

Aggregate supply in the long run

!  Recall from Chapter 3:

In the long run, output is determined by
factor supplies and technology

Y = F (K , L )
Y is the full-employment or natural level of
output, the level of output at which the
economy’s resources are fully employed.
“Full employment” means that
unemployment equals its natural rate (not zero).
Chapter 5: The IS-LM model
The long-run aggregate supply curve

P LRAS
Y does not
depend on
P,
so LRAS is
vertical.

Y
Y
= F (K , L )
Chapter 5: The IS-LM model
Long-run effects of an increase in M

P LRAS
An increase
in M shifts
AD to the
right.
In the long P2
run, this
raises the P1 AD2
price level… AD1

…but leaves Y
Y
output the
same.
Chapter 5: The IS-LM model
Aggregate supply in the short run

!  Many prices are sticky in the short run.

!  For now (and through Chap. 12), we assume

!  all prices are stuck at a predetermined level in the short run.
!  firms are willing to sell as much at that price level as their
customers are willing to buy.

!  Therefore, the short-run aggregate supply (SRAS) curve is

horizontal:

Chapter 5: The IS-LM model

 + The short-run aggregate supply
curve
P
The SRAS
curve is
horizontal:

The price
level is fixed SRAS
at a P
predetermine
d level, and
firms sell as Y
much as
buyers
demand.
Chapter 5: The IS-LM model
 Short-run effects of an increase in M

P
In the short …an
run when increase in
prices are aggregate
sticky,… demand…

SRAS
P
AD2
AD1

Y
…causes Y1 Y2
output to rise.

Chapter 5: The IS-LM model

From the short run to the long run

Over time, prices gradually become

“unstuck.” When they do, will they rise or
fall? In the short-run then over time,
equilibrium, if P will…
Y >Y rise
Y <Y fall

Y =Y remain constant

The adjustment of prices is what moves

the economy to its long-run equilibrium.
Chapter 5: The IS-LM model
The SR & LR effects of ΔM > 0

A = initial P LRAS
equilibriu
m
B = new short-
P2 C
run eq’m
after Fed B SRAS
increases P A AD2
M
AD1
C = long-run
equilibriu Y
Y Y2
m

Chapter 5: The IS-LM model

 + The SR & LR effects of ΔM < 0

AD shifts left, P LRAS

depressing
output and
employment
in the short run.
B A SRAS
Over time, P
prices fall and
P2 C AD1
the economy
moves down AD2
its demand Y
curve toward Y2 Y
full-
employment.
Chapter 5: The IS-LM model
 +
Deriving the AD curve
r LM(P2)
Intuition for slope LM(P1)
r2
of AD curve:
r1
↑P ⇒ ↓(M/P )
IS
⇒ LM shifts left Y2 Y1 Y
P
⇒ ↑r
P2
⇒ ↓I
P1
⇒ ↓Y
AD
Y2 Y1 Y

Chapter 5: The IS-LM model

 +
Monetary policy and the AD
curve r LM(M1/P1)
The Fed can increase LM(M2/P1)
aggregate demand: r1
r2
↑M ⇒ LM shifts right
IS
⇒ ↓r
Y1 Y2 Y
P
⇒ ↑I
⇒ ↑Y at each P1
value of P
AD2
AD1
Y1 Y2 Y

Chapter 5: The IS-LM model

 +
Fiscal policy and the AD curve
r LM
Expansionary fiscal
policy (↑G and/or ↓T ) r2
increases agg. demand: r1 IS2
↓T ⇒ ↑C IS1
Y1 Y2 Y
⇒ IS shifts right P
⇒ ↑Y at each value
P1
of P
AD2
AD1
Y1 Y2 Y

Chapter 5: The IS-LM model

 IS-LM and AD-AS
in the short run & long run
The force that moves the economy from the
short run to the long run is the gradual
adjustment of prices.

In the short-run then over time, the

equilibrium, if price level will
Y >Y rise
Y <Y fall

Y =Y remain constant

Chapter 5: The IS-LM model

The SR and LR effects of an IS shock

r LRAS LM(P )
1
A negative IS
shock shifts IS and
AD left, causing Y
IS1
to fall. IS2
Y Y
P LRAS
P1 SRAS1

AD1
AD2
Y Y
Chapter 5: The IS-LM model
The SR and LR effects of an IS shock

r LRAS LM(P )
1

In the new short-run

equilibrium, Y < Y IS1
IS2
Y Y
P LRAS
P1 SRAS1

AD1
AD2
Y Y
Chapter 5: The IS-LM model
The SR and LR effects of an IS shock

r LRAS LM(P )
1

In the new short-run

equilibrium, Y < Y IS1
IS2
Y Y
Over time, P gradually
falls, which causes P LRAS

•  SRAS to move down. P1 SRAS1

•  M/P to increase,
which causes LM AD1
to move down. AD2
Y Y
Chapter 5: The IS-LM model
The SR and LR effects of an IS shock

r LRAS LM(P )
1
LM(P2)

IS1
IS2
Y Y
Over time, P gradually
falls, which causes P LRAS

•  SRAS to move down. P1 SRAS1

•  M/P to increase, P2 SRAS2

which causes LM AD1
to move down. AD2
Y Y
Chapter 5: The IS-LM model
The SR and LR effects of an IS shock

r LRAS LM(P )
1
LM(P2)

This process continues IS1

until economy reaches a IS2
long-run equilibrium with Y Y
Y =Y P LRAS
P1 SRAS1

P2 SRAS2
AD1
AD2
Y Y
Chapter 5: The IS-LM model
 EXERCISE:
Analyze SR & LR effects of ΔM
a.  Draw the IS-LM and AD- r LRAS LM(M /P )
1 1
AS diagrams as shown
here.
b. Suppose Fed increases
M. Show the short-run IS
effects on your graphs.
Y Y
c.  Show what happens in
the transition from the P LRAS
short run to the long run.
d. How do the new long-run P SRAS1
1
equilibrium values of the
endogenous variables
AD1
compare to their initial
values? Y Y
Chapter 5: The IS-LM model
 + The Great Depression

240 30
Unemployment
220 (right scale) 25
billions of 1958 dollars

percent of labor force

200 20

180 15

160 10

140 Real GNP 5

(left scale)
120 0
1929 1931 1933 1935 1937 1939

Chapter 5: The IS-LM model

THE SPENDING HYPOTHESIS:
Shocks to the IS curve

!  asserts that the Depression was largely due to an

exogenous fall in the demand for goods & services – a
leftward shift of the IS curve.

!  evidence:
output and interest rates both fell, which is what a
leftward IS shift would cause.

Chapter 5: The IS-LM model

THE SPENDING HYPOTHESIS:
Reasons for the IS shift

! Stock market crash ⇒ exogenous ↓C

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

! Drop in investment
!  “correction” after overbuilding in the 1920s
!  widespread bank failures made it harder to
obtain financing for investment

! Contractionary fiscal policy

!  Politicians
raised tax rates and cut spending to
combat increasing deficits.
Chapter 5: The IS-LM model
THE MONEY HYPOTHESIS:
A shock to the LM curve

!  asserts that the Depression was largely due to huge fall

in the money supply.

!  evidence:
M1 fell 25% during 1929-33.

!  But, two problems with this hypothesis:

!  P fell even more, so M/P actually rose slightly during
1929-31.
!  nominal interest rates fell, which is the opposite of what a
leftward LM shift would cause.

Chapter 5: The IS-LM model

THE MONEY HYPOTHESIS AGAIN:
The effects of falling prices

!  asserts that the severity of the Depression was due to a

huge deflation:
P fell 25% during 1929-33.

!  This deflation was probably caused by the fall in M, so

perhaps money played an important role after all.

!  In what ways does a deflation affect the economy?

Chapter 5: The IS-LM model

THE MONEY HYPOTHESIS AGAIN:
The effects of falling prices

!  The stabilizing effects of deflation:

! ↓P ⇒ ↑(M/P ) ⇒ LM shifts right ⇒ ↑Y

!  Pigou effect:
↓P ⇒ ↑(M/P )
⇒ consumers’ wealth ↑
⇒ ↑C
⇒ IS shifts right
⇒ ↑Y

Chapter 5: The IS-LM model

THE MONEY HYPOTHESIS AGAIN:
The effects of falling prices

!  The destabilizing effects of expected deflation:

↓π e
⇒ r ↑ for each value of i
⇒I ↓ because I = I (r )
⇒planned expenditure & agg. demand ↓
⇒income & output ↓

Chapter 5: The IS-LM model

THE MONEY HYPOTHESIS AGAIN:
The effects of falling prices

! The destabilizing effects of unexpected

deflation:
debt-deflation theory
↓P (if unexpected)
⇒ transfers purchasing power from borrowers to 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

Chapter 5: The IS-LM model

Why another Depression is unlikely

! Policymakers(or their advisors) now know

much more about macroeconomics:
!  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.

! Federaldeposit insurance makes

widespread bank failures very unlikely.
! Automaticstabilizers make fiscal policy
expansionary during an economic downturn.

Chapter 5: The IS-LM model

Chapter Summary

1.  Keynesian cross

!  basic model of income determination
!  takes fiscal policy & investment as exogenous
!  fiscal policy has a multiplier effect on income.

2.  IS curve
!  comes from Keynesian cross when planned
investment depends negatively on interest
rate
!  shows all combinations of r and Y
that equate planned expenditure with
actual expenditure on goods & services
Chapter 5: The IS-LM model slide 114
Chapter Summary

3.  Theory of Liquidity Preference

!  basic model of interest rate determination
!  takes money supply & price level as
exogenous
!  an increase in the money supply lowers the
interest rate
4.  LM curve
!  comes from liquidity preference theory when
money demand depends positively on
income
!  shows all combinations of r and Y that equate
demand
Chapter 5: The for real money balances with supply
IS-LM model slide 115
Chapter Summary

5.  IS-LM model

!  Intersection of IS and LM curves shows the
unique point (Y, r ) that satisfies equilibrium
in both the goods and money markets.

Chapter 5: The IS-LM model slide 116

Chapter Summary

5. 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

Chapter 5: The IS-LM model slide 117