CHAPTER 13: Aggregate Demand II: Applying the IS–LM Model

Key points:

1. We know from Chapter 11 that fluctuations in aggregate demand can cause fluctuations in
output. This occurs to the extent that prices are "sticky."
2. This chapter demonstrates that we can use the IS-LM model to gain additional understanding
of aggregate demand determination.
3. When the price level (P) changes, this shifts the LM curve and causes movement along the AD
curve. A lower price level shifts LM right and moves down and right along AD. A higher
price level shifts LM left and moves up and left along AD.
4. Anything other than a change in P that shifts the LM curve also shifts AD. LM and AD shift
right with increases in the money supply and with exogenous decreases in money demand.
LM and AD shift left with decreases in the money supply and exogenous increases in money
demand. [An exogenous change in money demand is a change not caused by Y or r.
Exogenous changes in money demand might be caused by technological improvements in
the payments system -- which would decrease money demand, or by fears of a stock market
crash --which would increase money demand.]
5. Anything that shifts the IS curve also shifts the AD curve. Things that shift IS right also shift
AD right. Things that shift IS left also shift AD left. IS and AD shift right with increases in G,
decreases in T, and exogenous increases in C or I. IS and AD shift left with decreases in G,
increases in T, and exogenous decreases in C or I. [An exogenous change in C or I is a
change not caused by Y or r, such as a decrease in C caused by a collapse in consumer
confidence or an increase in I caused by the enactment of an investment tax credit.]
6. Monetary transmission mechanism indicates that increasing the money supply leads to a
decrease in the interest rate, which in turn stimulates investment and expands the demand
for goods and services.
7. We can use the IS-LM model to explain why the Great Depression occurred:
- Spending hypothesis: The primary cause of the Great Depression is attributed to a
decrease in spending on goods and services from external factors.
- Debt-deflation theory: This theory describes the impact of unexpected decreases in the
price level. An unexpected deflation benefits creditors and puts debtors at a
disadvantage, affecting spending on goods and services. If debtors have a higher
propensity to consume than creditors, the overall effect is a reduction in spending,
resulting in a contradictory shift in the IS curve.
- Money hypothesis: The primary cause of the Great Depression is attributed to the
significant reduction in the money supply allowed by the US Central Bank.
- Pigou effect: When prices fall and real money balances increase, consumers tend to feel
wealthier and spend more, leading to an expansionary shift in the IS curve and higher
income.
 Important points to note and illustrative examples:

Recall from Chapter 12:

Factors that determine the slope of the IS schedule

• The slope of the IS curve depends on how responsive consumption and investment
expenditures are to changes in interest rates and on the size of the multiplier.
• The more responsive are C and I, the flatter is the IS curve
• To get the IS “curve”, we plot the relationship between r and Y that is implied by equation.
The downward slope of IS curve reflects this chain: r ↓→ Ip ↑→ Y↑ (where Ip is planned
investment).
• The first link goes under the name of the interest-elasticity of investment, meaning the
degree to which investment spending responds when the rate of interest changes.
• The second link, from Ip to Y, depends on the multiplier.
• So, if the interest-elasticity of investment is strong and/or the multiplier is large, this will
make the IS curve relatively flat: even a fairly small change in r will have a big effect on Y.
• Conversely, if investment doesn’t respond much to the interest rate or the multiplier is small,
the IS curve will be relatively steep (not much effect on Y when r changes)

Factors that shift the IS schedule

A change in autonomous factors that are unrelated to the interest rate will cause the IS
curve to shift. E.g.,
• Changes in autonomous consumer expenditure
• Changes in planned investment spending unrelated to the interest rate
• Changes in government spending
• Changes in taxes
• Changes in net exports unrelated to the interest rate

Factors that determine the slope of the LM schedule

• The slope of the LM curve depends on how responsive is the demand for money to
changes in interest rates
• Changes in income (ΔY) and interest elasticity of money demand thus determine the slope of
the LM curve.
• The income elasticity of the demand for money:
• This determines the extent to which monetary demand increases following a given
increase in real income, Y.
• If the income elasticity of the demand for money is high, money demand will increase
(shift) a lot following an increase in Y, and the interest rate will have to be a lot higher to
restore equilibrium in the money market. This would make the LM curve relatively steep.
• If monetary demand is relatively insensitive to changes in Y, the LM curve will be relatively
flat.
• The interest rate elasticity of the demand for money:
• The interest-elasticity of the demand for money is the degree to which the demand for money
responds to changes in the rate of interest.
• Following a given increase in money demand (a shift to the right due to a higher Y), this
elasticity determines by how much the interest rate would have to increase to choke off the
excess demand for money in the money market (for the existing money supply).
• If the demand for money reacts strongly to interest rate changes – the interest elasticity of
money demand is high – a relatively small interest rate increase would be sufficient to restore
money market equilibrium. As a result, the LM curve would be relatively flat.
• If the interest elasticity of money demand is low, a relatively large interest rate increase
would be necessary to restore money market equilibrium. Consequently, the LM curve
would be relatively steep.
 To summarise:
Elasticity of money demand Effect on slope of the LM curve
Low income elasticity of money demand Flatter
High income elasticity of money demand Steeper
Low interest elasticity of money demand Steeper
High interest elasticity of money demand Flatter

Two special cases need attention: namely when the interest elasticity is zero and when the interest
elasticity is relatively high.

Two basic elements of a liquidity trap are:

• Interest rate extremely low, possibly zero, and
• The LM curve is completely flat at that low interest rate.

Factors that shift the LM schedule

• Changes in the money supply
• Shifts in the money demand function
Note:

Fiscal policy in the IS-LM model

The effect of an increase in G:
– After the change in G, the IS curve will shift, real income must change by ΔG/(1 – c)
– For example, an increase in G, will increase Y, the interest rate increases.
• The reason is that an increase in income will increase money demand for a given level of
money supply, creating an excess of money demand in the money market
• This will increase the interest rate.
– An increase in r will decrease I and so the initial increase in G will partly offset by this
decreasing in I
• Equilibrium income will increase but by less than ΔG/(1 – c) because of the crowding out
effect.

Monetary policy in the IS-LM model

• For a given slope of the IS curve, monetary policy (expansionary or restrictive) is more
effective in affecting the level of real income the less elastic is the LM curve.
• Given the slope of the LM curve, monetary policy (expansionary or restrictive) is more
effective in affecting the level of real income the more elastic is the IS curve.

Recall from the textbook:

Suppose that the government increases G.

• Possible responses by the central bank:
• Hold M constant
• Hold r constant
• Hold Y constant
• In each case, the effects of the ΔG are different:
Case 1: Holding M constant
• If Government raises G, the IS curve shifts right. If the central bank holds M constant, then
LM curve doesn’t shift.
• Result: Income increases and interest rate increases.
Case 2: Holding r constant
• To keep r constant, the central bank increases M to shift the LM curve to the right.
• Result: Income increases more than in the case where the LM is fixed and the interest rate
does not change.
Case 3: Holding Y constant
• In this case the central bank must decrease M to compensate the increase in G. LM curve
shifts to the left.
• Result: Income does not change and the interest rate increases more than in the case where
the LM remains fixed.

Relative effectiveness of the policies

Monetary policy Fiscal policy
IS schedule LM schedule IS schedule LM schedule
Steep Ineffective Effective Effective Ineffective
Flat Effective Ineffective Ineffective Effective

Note:
In previous chapters, the government-purchases multiplier described the impact of a change in
government spending on output. A question thus arises of whether the multiplier effect in the IS-
LM model is larger or smaller than in the simple Keynesian-cross model.

In the IS-LM model, the government multiplier effect is smaller due to the crowding out of
investment. An increase in government spending will shift out the IS curve and result in higher
interest rates. The higher interest rates will lower investment spending, thereby lowering the boost
to output. The difference in multipliers can be seen on the IS-LM graph. If the interest rate is held
constant (by a flat LM curve), and increase in government spending will have a large effect on
output. If the LM curve is upward sloping, the output boost due to the government spending is
diminished by the interest rate increase.

Note:
Given the tight fiscal environment, one might wonder why the government spends money
surveying consumers and firms on their current level of confidence in the economy. One might
also wonder how the SARB might react to a sudden drop in consumer confidence.

The following paragraph explains why the government undertakes such surveys and how the
SARB might react.

Consumer and producer confidence surveys provide a good gauge for expectations. If people
suddenly become pessimistic, they may decrease consumption. This will lead to a fall in output,
and the consumer pessimism will have led to a downturn in the economy. The SARB, however,
can react to confidence surveys by changing the money supply to prevent the undesirable
movements in output.

Note:
• The independent SARB has responsibility for monetary policy and sees it operating policy to
achieve a set inflation target.
• The target rate of CPI inflation is between 3% and 6%.
• Policy is set by the Monetary Policy Committee (MPC) where eight people vote on the
interest rate they think will bring about the inflation rate target.
• The transmission mechanism is the process by which monetary policy decisions are
transmitted throughout the economy to the inflation rate.
• The transmission mechanism is characterised by long, variable and uncertain time lags. As
such it is difficult to predict the precise effect of monetary policy actions on the economy and
price level.
• However, to be successful in conducting monetary policy, the monetary authorities must
have as accurate an assessment as is possible of the timing and effect of their policies on
the economy, thus requiring an understanding of the mechanisms through which monetary
policy affects the economy.
• The chart below provides a schematic illustration of the main transmission channels of
monetary policy decisions.
Note:
The transmission mechanism has various channels
• interest rate channel
• exchange rate channel
• asset price channel
• credit channel

The various channels through which a change in the repo rate can affect real output and inflation
can be summarised as follows (using an increase in the repo rate as an example)

The interest rate channel

The SARB raises the repo rate:
• Market interest rates (i) increase.
• Investment spending (I) and consumption spending (C) decrease.
• Aggregate demand (AD) decreases.
• The relative impact on the price level (P) and real output (Y) depends on aggregate supply
(AS) conditions.

The exchange rate channel

The SARB raises the repo rate:
• Market interest rates (i) increase.
• If foreign interest rates remain unchanged, there will be an increase in net capital inflows
(stimulated by the increase in domestic interest rates).
• The rand appreciates against other currencies (because of the greater demand for rand).
• Exports decline and imports increase.
• Aggregate demand (AD) decreases.
• The relative impact on P and Y depends on AS conditions.

The asset price channel

The SARB raises the repo rate:
• Market interest rates (i) increase.
• Equity (share) prices and property prices fall.
• Firms and consumers become (or feel) poorer and spend less – in other words, there is a
decline in investment spending and consumer spending via the wealth effect.
• Aggregate demand (AD) decreases.
• The relative impact on P and Y depends on AS conditions.

The credit channel

The SARB raises the repo rate:
• Market interest rates (i) increase.
• Bank loans decrease.
• Investment spending (I) and consumption spending (C) decrease.
• Aggregate demand (AD) decreases.
• The relative impact on P and Y depends on AS conditions.

In all these channels expectations may have a significant (albeit often uncertain) effect.

Four aspects of this modern view of the monetary transmission mechanism have to be
emphasised:
• The link between the interest rate and investment spending, discussed in the previous
subsection, is still a crucial part of the mechanism.
• It is a complex transmission mechanism which works through various channels (in contrast to
the relatively simple transmission mechanism explained earlier).
• The outcome of the process is uncertain (more so than in the case of the simpler
 transmission mechanism).
• The time lag between the policy action (a change in the repo rate) and its eventual impact on
the price level (P) and real output (Y) is also variable and uncertain.

Note:
Keynes called the exogenous and perhaps self-fulfilling wave of optimism and pessimism animal
spirits.
For example, suppose firms become pessimistic about the future of economy. Then investment (rises;
falls), and (IS LM) curve shifts (right; left). This fall in equilibrium output in part validates the firms’
initial pessimism (and makes it self-fulfilling). Next firms become more pessimistic, output falls more,
and so on (vicious spiral).
One job of policymakers is to use the policy tools to offset the effect of animal spirits (since it can
cause vicious spiral). In some sense this counter-animal-spirits action of government belongs to
expectation management.

Test your current level of understanding by attempting these questions:

Questions for Review

1. Question 1 on p. 359 (10th edition) / Question 1, p. 330 (11th edition).

The aggregate demand curve represents the negative relationship between the price level
and the level of national income. In Chapter 10, we looked at a simplified theory of aggregate
demand based on the quantity theory. In this chapter, we explore how the IS–LM model
provides a more complete theory of aggregate demand. We can see why the aggregate
demand curve slopes downward by considering what happens in the IS–LM model when the
price level changes. As Figure 12-1(A) illustrates, for a given money supply, an increase in
the price level from P1 to P2 shifts the LM curve upward because real money balances
decline; this reduces income from Y1 to Y2. The aggregate demand curve in Figure 12-1(B)
summarises this relationship between the price level and income that results from the IS–LM
model.
2. Question 2 on p. 359 (10th edition) / Question 2, p. 330 (11th edition).
The tax multiplier in the Keynesian-cross model tells us that, for any given interest rate, the
tax increase causes income to change by ΔT * [–MPC/(1 – MPC)]. The IS curve shifts to the
left by this amount, as in Figure 12-2. The equilibrium of the economy moves from point A to
point B. The tax increase reduces the interest rate from r1 to r2 and reduces national income
from Y1 to Y2. Consumption falls because disposable income falls; investment rises
because the interest rate falls.

Note that the decrease in income in the IS–LM model is smaller than that in the Keynesian-
cross model because the IS–LM model takes into account the fact that investment rises
when the interest rate falls.

3. Question 3 on p. 359 (10th edition) / Question 3, p. 330 (11th edition).

For a given price level, a decrease in the money supply decreases real money balances.
The theory of liquidity preference shows that, for any given level of income, a decrease in
real money balances leads to a higher interest rate. Thus, the LM curve shifts upward, as in
 Figure 12-3. The equilibrium moves from point A to point B. The decrease in the money
supply reduces income and raises the interest rate. Consumption falls because disposable
income falls, and investment falls because the interest rate rises.

4. Question 4 on p. 359 (10th edition) / Question 4, p. 330 (11th edition).

Falling prices can either increase or decrease equilibrium income. There are two ways in
which falling prices can increase income. First, an increase in real money balances shifts the
LM curve downward, thereby increasing income. Second, the IS curve shifts to the right
because of the Pigou effect: real money balances are part of household wealth, so an
increase in real money balances makes consumers wealthier, which increases consumption.
This shifts the IS curve to the right, thereby increasing income.
There are two ways in which falling prices can reduce income. The first is the debt-deflation
theory. An unexpected decrease in the price level redistributes wealth from debtors to
creditors. If debtors have a higher propensity to consume than creditors, then this
redistribution causes debtors to decrease their spending by more than creditors increase
theirs. As a result, aggregate consumption falls, shifting the IS curve to the left and reducing
income. The second way in which falling prices can reduce income is through the effects of
expected deflation. Recall that the real interest rate r equals the nominal interest rate i minus
the expected inflation rate Eπ: r = i – Eπ. If the public expects the price level to fall in the
future (i.e., Eπ is negative), then for any given nominal interest rate, the real interest rate is
higher. A higher real interest rate depresses investment and shifts the IS curve to the left,
reducing income.

Problems and Applications

1. Question 1 on p. 359 (10th edition) / Question 1, p. 330 (11th edition).

a. If the central bank increases the money supply, then the LM curve shifts downward, as
shown in Figure 12-4. Income increases, and the interest rate falls. The increase in
disposable income causes consumption to rise, and the fall in the interest rate causes
investment to rise as well.
b. If government purchases increase, then the government-purchases multiplier tells us that the
IS curve shifts to the right by an amount equal to [1/(1 – MPC)]ΔG. This is shown in Figure
12-5. Income and the interest rate both increase. The increase in disposable income causes
consumption to rise, while the increase in the interest rate causes investment to fall.

c. If the government increases taxes, then the tax multiplier tells us that the IS curve shifts to the
left by an amount equal to [–MPC/(1 – MPC)]ΔT. This is shown in Figure 12-6. Income and
the interest rate both fall. Disposable income falls because income is lower and taxes are
higher; this causes consumption to fall. The fall in the interest rate causes investment to rise.
d. We can determine the shift in the IS curve in response to an equal increase in government
purchases and taxes by adding together the two multiplier effects that we used in parts (b)
and (c):
ΔY = [(1/(1 – MPC)]ΔG + [–MPC/(1 – MPC)]ΔT.
Because government purchases and taxes increase by the same amount, ΔG = ΔT.
Therefore, we can express the above equation as
ΔY = [1/(1 – MPC) – MPC/(1 – MPC)]ΔG = ΔG.
This expression tells us how output changes, holding the interest rate constant. It says that
an equal increase in government purchases and taxes shifts the IS curve to the right by the
amount by which G increases.
This shift is shown in Figure 12-7. Output increases but by less than the amount that G and
T increase, so disposable income Y – T falls. As a result, consumption also falls. The
interest rate rises, causing investment to fall.

2. Question 2 on p. 359 (10th edition) / Question 2, pp. 330 - 331 (11th edition).
a. The invention of a new high-speed chip increases investment demand, meaning that at every
interest rate, firms want to invest more. The increased demand for investment goods shifts
the IS curve outward, raising income and the interest rate, as shown in Figure 12-8.

While the new chip increases investment for any given interest rate, the higher interest rate
decreases investment, so output does not rise by the full amount of the rightward shift in the IS
curve. The increase in disposable income causes consumption to rise. Overall, income, the
interest rate, consumption, and investment all rise. If the Fed wants to keep income at its
initial level, then it must decrease the money supply, shifting the LM curve upward. This
raises the interest rate further, completely offsetting the initial increase in investment
demand.

b. The increased demand for cash shifts the LM curve upward. This happens because, for any
given money supply and level of income, the interest rate must rise to offset the increased
money demand. The upward shift in the LM curve lowers income and raises the interest
rate, as shown in Figure 12-9. Consumption falls because disposable income falls, and
investment falls because the interest rate rises. If the Fed wants to keep income at its initial
level, then it must increase the money supply, returning the LM curve to its original position.

c. At any given level of income, consumers now wish to save more and consume less. This
downward shift in the consumption function causes the IS curve to shift inward. As Figure
12-10 shows, income and the interest rate both fall.
 Consumption falls both because of the shift in the consumption function and because
disposable income falls. Investment rises because of the lower interest rate, partially
offsetting the effect on output of the fall in consumption. If the Fed wants to keep income at
its initial level, then it must increase the money supply, shifting the LM curve downward and
causing the interest rate to fall further. This returns output to its original level, though
consumption is lower and investment is higher relative to the initial equilibrium.

d. An increase in expected inflation reduces the demand for money, shifting the LM curve
downward, as illustrated in Figure 12-11.

The interest rate falls, leading to an increase in investment, and income rises, leading to an
increase in consumption. If the Fed wants to keep income at its initial level, then it must
decrease the money supply, returning the LM curve to its initial position.

3. Question 3 on p. 360 (10th edition) / Question 3, p. 331 (11th edition).

a. The IS curve satisfies
Y = C(Y – T) + I(r) + G.
We can plug in the consumption and investment functions and values for G and T as given in
the problem and then proceed as follows:
Y = 300 + 0.6(Y – 500) + 700 – 80r + 500
0.4Y = 1 200 – 80r
Y = 3 000 – 200r.
This IS equation is graphed in Figure 12-12 for r ranging from 0 to 8.
 Figure 12-12

b. The LM curve is determined by equating the supply of and demand for real money balances.
The supply of real balances is M/P = 3 000/3 = 1 000. Setting this equal to the given money
demand function, we have
1 000 = Y – 200r.
Y = 1 000 + 200r
This LM curve is graphed in Figure 12-12 for r ranging from 0 to 8.

c. The IS and LM equations give us two equations in two unknowns, Y and r. We found the
following equations in parts (a) and (b):
IS: Y = 3 000 – 200r
LM: Y = 1 000 + 200r.
We can combine these and solve for r:
3 000 – 200r = 1 000 + 200r
2 000 = 400r
r = 5.
We then obtain Y = 2 000 by substituting r = 5 into either the IS or LM equation. Therefore,
the equilibrium interest rate is 5% and the equilibrium level of output is 2 000, as depicted in
Figure 12-12.

d. If government purchases increase from 500 to 700, then the IS equation becomes
Y = 300 + 0.6(Y – 500) + 700 – 80r + 700.
Simplifying, we obtain
Y = 3 500 – 200r.
This IS curve is graphed as IS2 in Figure 12-13. We see that the IS curve shifts to the right
by 500.

Figure 12-13
 By equating output in the new IS curve with output in the LM curve derived in part (b), we can
solve for the new equilibrium interest rate:
3 500 – 200r = 1 000 + 200r
2 500 = 400r
r = 6.25.
We can then substitute r = 6.25 into either the IS or LM equation to find that Y = 2 250.
Therefore, the increase in government purchases causes the equilibrium interest rate to rise
from 5% to 6.25%, while output increases from 2 000 to 2 250. This is depicted in Figure 12-
13.

e. If the money supply increases from 3 000 to 4 500, then the LM equation becomes 4 500/3 =
Y – 200r
Y = 1 500 + 200r.
This LM curve is graphed as LM2 in Figure 12-14. We see that the LM curve shifts to the
right by 500 because of the increase in real money balances.
Figure 12-14

To determine the new equilibrium interest rate and level of output, we equate output from the
IS curve from part (a) with output from the new LM curve derived above:
3 000 – 200r = 1 500 + 200r
1 500 = 400r
r = 3.75.
Substituting this into either the IS or LM equation, we find that Y = 2 250. Therefore, the
increase in the money supply causes the interest rate to fall from 5% to 3.75% and output to
increase from 2 000 to 2 250. This is depicted in Figure 12-14.

f. If the price level rises from 3 to 5, then real money balances fall from 1 000 to 3 000/5 =
600. The LM equation becomes Y = 600 + 200r.
As shown in Figure 12-15, the LM curve shifts to the left by 400 because the increase in the
 price level reduces real money balances.
Figure 12-15

To determine the new equilibrium interest rate, we equate output from the IS curve from part
(a) with output from the new LM curve above:
3 000 – 200r = 600 + 200r
2 400 = 400r
r = 6.
Substituting this interest rate into either the IS or LM equation, we find that Y = 1 800.
Therefore, the new equilibrium interest rate is 6 percent, and the new equilibrium level of
output is 1 800, as depicted in Figure 12-15.

g. The aggregate demand curve is the relationship between the price level and income. To
derive the aggregate demand curve, we use the IS and LM equations to solve for Y as a
function of P. That is, we want to eliminate the interest rate. We can do this by rearranging
the equations as follows:

IS: Y = 3 000 – 200r

200r = 3 000 – Y
LM: M/P = Y – 200r
200r = Y – M/P.
Combining these two equations, we have 3 000 – Y = Y – M/P
2Y = 3 000 + M/P
Y = 1 500 + (M/P)/2.
Since the nominal money supply is M = 3 000, this becomes
Y = 1 500 + 1 500/P.
This aggregate demand equation is graphed in Figure 12-16.

Figure 12-16
 How does the expansionary fiscal policy of part (d) affect the aggregate demand curve? We
derive the aggregate demand curve by using the IS equation from part (d) and the LM
equation from part (b):
IS: Y = 3 500 – 200r
200r = 3 500 – Y.
LM: 3 000/P = Y – 200r
200r = Y – 3 000/P.
Combining and solving for Y, we have 3 500 – Y = Y – 3 000/P
2Y = 3 500 + 3 000/P
Y = 1 750 + 1 500/P.
By comparing this new aggregate demand equation to the one previously derived, we can
see that an increase in government purchases of 200 shifts the aggregate demand curve to
the right by 250. How does the expansionary monetary policy of part (e) affect the aggregate
demand curve? Since the AD curve is Y = 1 500 + (M/P)/2, increasing the money supply
from 3 000 to 4 500 gives us
Y = 1 500 + 2 250/P.
By comparing this new aggregate demand curve to the one originally derived, we see that
the increase in the money supply shifts the aggregate demand curve to the right.

4. Question 4 on p. 360 (10th edition) / Question 4, p. 331 (11th edition).

a. The IS curve satisfies
Y = C(Y – T) + I(r) + G.
To obtain the IS curve, we plug in the consumption and investment functions and values for
G and T as given in the problem and then solve for Y in terms of r:
Y = 500 + 0.75(Y – 1 000) + 1 000 – 50r + 1 000
0.25Y = 1 750 – 50r
Y = 7 000 – 200r.
The LM curve is determined by equating the supply of and demand for real money balances.
The supply of real balances is M/P = 6 000/2 = 3 000. Setting this equal to money demand,
we obtain
3 000 = Y – 200r.
Y = 3 000 + 200r.
Combining the IS and LM equations to eliminate Y, we can solve for r:
7 000 – 200r = 3 000 + 200r
4 000 = 400r
r = 10.
Now that we know r, we can solve for Y by substituting it into either the IS or LM equation.
 We find that Y = 5 000. Therefore, the equilibrium interest rate is 10% and the equilibrium
level of output is 5 000. This is labelled as point A in Figure 12-17 in part (e) below.

b. If taxes fall by 20%, then T = 800 and we derive the new IS curve as follows:
Y = 500 + 0.75(Y – 800) + 1 000 – 50r + 1 000
0.25Y = 1 900 – 50r
Y = 7 600 – 200r.
Combining the new IS and old LM equations, we find that the interest rate satisfies
7 600 – 200r = 3 000 + 200r
4 600 = 400r
r = 11.5.
Now that we know r, we can solve for Y by substituting it into either the IS or LM equation to
find that Y = 5 300. Therefore, the equilibrium interest rate is 11.5%, and the equilibrium level
of output is 5 300. The decrease in taxes shifts the IS curve to the right. The new
equilibrium is labelled as point B in Figure 12-17 in part (e) below. The tax multiplier is the
change in equilibrium output divided by the change in taxes: 300/(–200) = –1.5.

c. To find the value of the money supply that keeps the interest rate at its original level of 10%
after the tax cut, we express the LM equation as
M/2 = Y – 200r
Y = M/2 + 200r.
Next we combine this new equation for the LM curve with the new equation for the IS curve,
plug in r = 10 for the interest rate, and solve for the money supply M:
7 600 – 200r = M/2 + 200r
7 600 – 200(10) = M/2 + 200(10)
M = 7 200.
This money supply then implies that output is Y = 5 600. The increase in the money supply
shifts the LM curve to the right. The new equilibrium is labelled as point C in Figure 12-17 in
part (e) below. The tax multiplier measures the change in equilibrium output divided by the
change in taxes: 600/(– 200) = –3.

d. The central bank wants to keep output at Y = 5 000 after the tax cut. First, using the IS
equation, we plug in this value and solve for the interest rate:
Y = 7 600 – 200r
5 000 = 7 600 – 200r
200r = 2 600
r = 13.
Then we use the LM equation to solve for M:
M/2 = Y – 200r
M/2 = 5 000 – 200(13)
M = 4 800.
The decrease in the money supply shifts the LM curve to the left. The new equilibrium is at
point D in Figure 12-17 in part (e) below. Since output does not change here, the tax
multiplier is zero.
e. The four equilibrium points are illustrated in Figure 12-17.

Figure 12-17

5. Question 5 on p. 360 (10th edition) / Question 5, pp. 331 – 332 (11th edition).
a. This statement is false. Investment is part of planned expenditure, so changes in investment
affect the IS curve, not the LM curve.

b. This statement is true. The IS curve represents the relationship between the interest rate
and the level of income that arises from equilibrium in the market for goods and services.
That is, it describes the combinations of income and the interest rate that satisfy the equation
Y = C(Y – T) + I(r) + G.
If investment does not depend on the interest rate, then this equation implies that output is
independent of the interest rate. Thus, the IS curve is vertical, as shown in Figure 12-18.

In this case, monetary policy has no effect on output, only on the interest rate. In contrast,
fiscal policy has an even greater effect on output, since it changes by the full amount that the
IS curve shifts.
This statement is false. Money demand affects the money market and thus the LM curve,
not the IS curve.

c. This statement is true. The LM curve represents the combinations of income and the interest
rate at which the money market is in equilibrium. If money demand does not depend on the
interest rate, we can express equilibrium in the money market as
M/P = L(Y).
For any given level of real money balances M/P, there is only one level of income for which
the money market is in equilibrium. Thus, the LM curve is vertical, as shown in Figure 12-19.
 Fiscal policy now has no effect on output; it only affects the interest rate. Monetary policy
has a greater effect on output: a shift in the LM curve changes output by the full amount of
the shift.

d. This statement is true. If money demand does not depend on income, then equilibrium in the
money market is given by
M/P = L(r).
For any given level of real money balances M/P, there is only one interest rate at which the
money market is in equilibrium. Hence, the LM curve is horizontal, as shown in Figure 12-
20.

Fiscal policy is very effective: output increases by the full amount that the IS curve shifts.
Monetary policy is also effective: an increase in the money supply causes the interest rate to
fall, so the LM curve shifts down and output rises, as shown in Figure 12-20.
This statement is true if we say nearly horizontal. The LM curve gives the combinations of
income and the interest rate at which the supply of and demand for real money balances are
equal:
M/P = L(r, Y).
Suppose income Y increases by $1. How much must the interest rate change to keep the
money market in equilibrium? The increase in Y increases money demand. If money
demand is extremely sensitive to the interest rate, then it takes only a very small increase in
the interest rate to reduce money demand and restore equilibrium in the money market.
Hence, the LM curve is nearly horizontal, as shown in Figure 12-21.
 An example may make this clearer. Consider a linear version of the LM equation:
M/P = eY – fr.
As f increases, money demand becomes increasingly sensitive to the interest rate.
Rearranging this equation to solve for r, we find that
r = (e/f)Y – (1/f)(M/P).
We want to focus on how changes in each of the variables are related to changes in the
other variables. Hence, it is convenient to write this equation in terms of changes:
Δr = (e/f)ΔY – (1/f)Δ(M/P).
The slope of the LM equation tells us how much r changes when Y changes, holding M fixed.
If Δ(M/P) = 0, then the slope is Δr/ΔY = e/f. As f gets very large, this slope gets close to zero,
which implies a nearly horizontal LM curve.
If money demand is very sensitive to the interest rate, then fiscal policy is very effective:
output changes by almost the full amount by which the IS curve shifts. Monetary policy is
now ineffective: a change in the money supply barely shifts the LM curve. We see this in our
example by considering what happens if M increases. For any given Y (so ΔY = 0),
Δr/Δ(M/P) = –1/f; this tells us how much the LM curve shifts down. As f gets larger, this shift
gets smaller and approaches zero. (This is in contrast to the horizontal LM curve in part (c),
which does shift down.)

6. Question 6 on pp. 360 – 361 (10th edition) / Question 6, p. 332 (11th edition).
a. To raise investment while keeping output constant, the government should adopt
expansionary monetary policy, which shifts the LM curve to the right, and contractionary
fiscal policy, which shifts the IS curve to the left, as shown in Figure 12-22. In the new
equilibrium at point B, the interest rate is lower, so investment is higher. The contractionary
fiscal policy offsets the effect of the increase in investment on output.
b. The policy mix in the early 1980s did exactly the opposite. Fiscal policy was expansionary,
while monetary policy was contractionary. Such a policy mix shifts the IS curve to the right
and the LM curve to the left, as in Figure 12-23. The real interest rate rises, and investment
falls.

7. Question 7 on p. 361 (10th edition) / Question 7, p. 332 (11th edition).

a. An increase in the money supply shifts the LM curve to the right in the short run. This moves
the economy from point A to point B in Figure 12-24: the interest rate falls from r1 to r2, and
output rises from 𝑌𝑌� 𝑡𝑡𝑡𝑡 𝑌𝑌2 . The increase in output occurs because the lower interest rate
stimulates investment, which increases output.

Since the level of output is now above its long-run level, prices begin to rise. A rising price
level lowers real money balances, which raises the interest rate. As indicated in Figure 12-
24, the LM curve shifts back to the left. Prices continue to rise until the economy returns to
its original position at point A. The interest rate returns to its original level, as does
investment. Thus, in the long run, there is no impact on real variables from an increase in
the money supply. (This is what we called monetary neutrality in Chapter 5.)

b. An increase in government purchases shifts the IS curve to the right, moving the economy
from point A to point B in Figure 12-25. In the short run, output increases from 𝑌𝑌� 𝑡𝑡𝑡𝑡 𝑌𝑌2 and the
interest rate increases from r1 to r2.
 The increase in the interest rate reduces investment and crowds out part of the expansionary
effect of the increase in government purchases. Initially, the LM curve is not affected
because government spending does not enter the LM equation. After the increase in
government purchases, output is above its long-run equilibrium level, so prices begin to rise.
The rise in prices reduces real money balances, which shifts the LM curve to the left. The
interest rate rises even more than in the short run. This process continues until the long-run
level of output is again reached. At the new equilibrium, point C, interest rates have risen to
r3, and the price level is permanently higher. Like monetary policy, fiscal policy cannot
change the long-run level of output. Unlike monetary policy, however, it can change the
composition of output: the level of investment at point C is lower than it is at point A.

b. An increase in taxes reduces disposable income for consumers, shifting the IS curve to the
left, as shown in Figure 12-26. In the short run, output and the interest rate decline as the

economy moves from point A to point B. Initially, the LM curve is not affected. In the long
run, prices begin to decline because output is below its long-run equilibrium level, and the LM
curve then shifts to the right due to the increase in real money balances. Interest rates fall
even further, increasing investment and income. The economy eventually achieves long-run
equilibrium at point C. Output is at its long-run level, the price level and interest rate are
lower, and the decrease in consumption is offset by the increase in investment.

8. Question 8 on p. 361 (10th edition) / Question 8, p. 332 (11th edition).

Figure 12-27(A) depicts the IS–LM model for the case in which the Fed holds the money
supply constant. Figure 12-27(B) depicts the model for the case in which the Fed adjusts the
money supply to hold the interest rate constant; this policy makes the effective LM curve
horizontal.
a. If all shocks to the economy arise from exogenous changes in the demand for goods and
services, then all shocks shift the IS curve. Suppose a shock causes the IS curve to shift
from IS1 to IS2. Figure 12-28 shows the effect of this under the two policies. With a
constant money supply (panel A), the change in the interest rate partially offsets the change
in output. With a constant interest rate (panel B), this offsetting effect is absent, so output
fluctuates more. Thus, if all shocks are to the IS curve, then the Fed should follow a policy of
keeping the money supply constant.

b. If all shocks in the economy arise from exogenous changes in the demand for money, then all
shocks shift the LM curve. Figure 12-29 shows the effects under the two policies. With the
money supply held constant (panel A), shifts in the LM curve lead to changes in output. With
the interest rate held constant (panel B), the LM curve does not shift in response to money
demand shocks because the Fed immediately adjusts the money supply to satisfy demand at
the given interest rate. There is no effect on output. Thus, if all shocks are to the LM curve,
the Fed should adjust the money supply to hold the interest rate constant, thereby stabilising
output.
9. Question 9 on p. 361 (10th edition) / Question 9, p. 332 (11th edition).
a. The analysis of changes in government purchases is unaffected by making money demand
dependent on disposable income instead of total expenditure. The money market is still
unaffected by a change in government purchases, so an increase in government purchases
shifts the IS curve to the right and leaves the LM curve unchanged. Thus, the analysis is the
same as before; this is shown in Figure 12-30.

b. A tax cut increases consumption for any given level of income, so the IS curve shifts to the
right, as in the standard case. This is shown in Figure 12-31. If money demand depends on
disposable income, however, then the tax cut increases money demand, so the LM curve
shifts upward, as shown in the figure. Thus, the analysis of a change in taxes is altered by
making money demand dependent on disposable income. Depending on the magnitudes of
the shifts in the IS and LM curves, output can increase, decrease, or remain the same. The
figure illustrates the case where a tax cut is contractionary.
10. Question 10 on p. 361 (10th edition) / Question 10, p. 332 (11th edition).
a. The goods market is in equilibrium when output is equal to planned expenditure, or Y = PE.
Starting with this equilibrium condition, and making the substitutions from the information
given in the problem, we obtain an expression for equilibrium output Y:
Y = C(Y – T) + I(r) + G
Y = a + b(Y – T) + c – dr + G
(1 – b)Y = a -bT + c – dr + G
𝑎𝑎−𝑏𝑏𝑏𝑏+𝑐𝑐−𝑑𝑑𝑑𝑑+𝐺𝐺
𝑌𝑌 =
1−𝑏𝑏
b. Using the expression from part (a), we obtain the slope of the IS curve as follows:
∆𝑟𝑟 1 1 1−𝑏𝑏
= = =
∆𝑌𝑌 ∆𝑌𝑌 / ∆𝑟𝑟 −𝑑𝑑/(1−𝑏𝑏) 𝑑𝑑
As d increases, the absolute value of the slope of the IS curve decreases, making the IS curve
flatter. Intuitively, a flatter IS curve makes output more sensitive to changes in the interest
rate. This is driven by the increased sensitivity of investment to the interest rate.

c. A $100 increase in government spending will cause a larger horizontal shift in the IS curve
than a $100 tax cut. The equation for equilibrium output in part (a) shows that the
government spending multiplier is 1/(1 – b) and the tax multiplier is –b/(1 – b). Since the
marginal propensity to consume satisfies 0 < b < 1, the government spending multiplier is
larger in absolute value. Intuitively, this makes sense because the entire $100 increase in
government spending will be spent, whereas part of the tax cut will be saved.

d. The money market is in equilibrium when the supply of real money balances equals the
demand for real money balances. Using the given functional form for demand, we can solve
for the equilibrium interest rate as follows:
𝑀𝑀⁄𝑃𝑃 = 𝑒𝑒𝑒𝑒 − 𝑓𝑓𝑓𝑓
𝑓𝑓𝑓𝑓 = 𝑒𝑒𝑒𝑒 − 𝑀𝑀⁄𝑃𝑃
𝑒𝑒𝑒𝑒 − 𝑀𝑀⁄𝑃𝑃
𝑟𝑟 =
𝑓𝑓

e. Using the expression from part (d), the slope of the LM curve is
∆𝑟𝑟 𝑒𝑒
=
∆𝑌𝑌 𝑓𝑓
As f increases, the slope of the LM curve decreases, making it flatter. Intuitively, a flatter LM
curve makes the interest rate less sensitive to changes in output. This is driven by money
demand being more responsive to changes in the interest rate, so a given change in income
does not require as large a change in the interest rate to restore equilibrium in the money
market.
f. Consider the horizontal shift in the LM curve—the change in output—caused by a change in
the money supply. We can rearrange the equation in part (d) to see that output can be
expressed as
𝑀𝑀⁄𝑃𝑃 + 𝑓𝑓𝑓𝑓
𝑌𝑌 =
𝑒𝑒
This implies that the change in output for a given change in the money supply is ΔY = ΔM/e.
As e increases, a given change in the money supply has a smaller effect on output. In other
words, as money demand becomes more sensitive to income, a given change in the money
supply does not require as large a change in output for the change in money demand to
match it. The parameter f has no effect on the size of the horizontal shift in the LM curve
caused by a change in the money supply. It does matter, however, for the size of the vertical
shift, since it measures the sensitivity of money demand to the interest rate.

g. To derive the aggregate demand curve, we substitute the equation from part (d) into the
equation from part (a) and solve for Y:
𝑎𝑎 − 𝑏𝑏𝑏𝑏 + 𝑐𝑐 + 𝐺𝐺 𝑑𝑑 𝑒𝑒𝑒𝑒 − 𝑀𝑀⁄𝑃𝑃
𝑌𝑌 = − � �
1 − 𝑏𝑏 1 − 𝑏𝑏 𝑓𝑓
𝑑𝑑𝑑𝑑 𝑎𝑎 − 𝑏𝑏𝑏𝑏 + 𝑐𝑐 + 𝐺𝐺 𝑑𝑑 𝑀𝑀⁄𝑃𝑃
�1 + � 𝑌𝑌 = +
(1 − 𝑏𝑏)𝑓𝑓 1 − 𝑏𝑏 (1 − 𝑏𝑏)𝑓𝑓
(1 − 𝑏𝑏)𝑓𝑓 + 𝑑𝑑𝑑𝑑 (𝑎𝑎 − 𝑏𝑏𝑏𝑏 + 𝑐𝑐 + 𝐺𝐺)𝑓𝑓 + 𝑑𝑑 𝑀𝑀⁄𝑃𝑃
� � 𝑌𝑌 =
(1 − 𝑏𝑏)𝑓𝑓 (1 − 𝑏𝑏)𝑓𝑓
(𝑎𝑎 − 𝑏𝑏𝑏𝑏 + 𝑐𝑐 + 𝐺𝐺)𝑓𝑓 + 𝑑𝑑 𝑀𝑀⁄𝑃𝑃
𝑌𝑌 =
(1 − 𝑏𝑏)𝑓𝑓 + 𝑑𝑑𝑑𝑑
h. The aggregate demand curve has a negative slope, as can be seen from the equation in part
(g). An increase in the price level P decreases real money balances M/P, and output Y is
clearly increasing in real money balances, so output falls.

i. An increase in government spending, an increase in the money supply, and a decrease in

taxes all shift the aggregate demand curve to the right—output increases for any given price
level—as can be seen from the equation for the aggregate demand curve found in part (g). It
is straightforward to see that in this case ΔY = ΔG/(1 – b), ΔY = ΔM/e, and ΔY = – bΔT/(1 –
b) are all positive. If f = 0, then the aggregate demand curve is given by Y = M/(eP). This
can be rearranged as M/P = eY, which is simply the quantity theory of money from Chapter
10. In this case, the LM curve is vertical, so changes in fiscal policy that shift the IS curve
have no effect on output. Monetary policy is still effective in stabilising output, as an increase
in the money supply still shifts the aggregate demand curve to the right.

Extra Questions

1. Assume that the economy is at full employment. The government decides to cut taxes to
give the economy an extra boost.
a. Show the short run effect of this tax cut using the IS-LM model. What will happen to output
and the interest rate?
b. What will happen in the long run?
c. If the SARB is following a policy of price stability, how should they react to the tax increase?
If the SARB’s action is implemented, will the tax cut succeed in boosting output?

a. The tax cut will shift out the IS curve. Output and interest rates will rise.
b. In the long run, prices will rise due to the fact that output is above the full-employment level.
This decreases the real money supply (M/P), and results in an inward shift of the LM curve.
c. If the SARB wanted to avoid the price increase, then it should decrease the money supply in
the short run. This will shift in the LM curve and output will return to the full employment
level. Thus, there was no boost to output.

4. Describe how the following events change the aggregate demand curve:
a. a decrease in money demand caused by the introduction of a new electronic money card.
b. a decrease in the money supply.
c. an increase in the price level.
d. an increase in government taxes.

a. A decrease in money demand will shift the LM curve outward. The aggregate demand curve
should also shift outward because there will now be a higher output level at any given price.
b. A decrease in the money supply will shift the LM curve inward and decrease output. This
translates into an inward shift of the aggregate demand curve.
c. An increase in the price level is displayed by a movement along the aggregate demand
curve.
d. An increase in government taxes will shift in the IS curve and reduce output. The aggregate
demand curve will shift in to reflect the lower output at any given price.
5. Explain the Pigou effect and why economists thought this would help end the Great
Depression. Why did this theory fail to improve the economy? What actions should fiscal and
monetary authorities have taken to end the depression sooner?
The Pigou effect is the prediction that falling prices will expand income due to the increase in
real money balances (M/P). Consumers should feel wealthier since their money will now buy
more goods than before. Therefore, they should increase spending. Unfortunately, the
Pigou effect was dominated by other problems in the economy and output continued to fall.
Some of these problems included debt deflation and the effects of a fall in price expectations.
The Federal Reserve could have helped the situation by increasing the money supply to
avoid the destabilising deflation. Increased government spending would have reduced
unemployment and helped increase aggregate demand.

6. Consider the economy of Slugikistan.

a. The consumption function is given by C = 200+0.75(Y -T). The investment function is I =
200-25r. Government purchases and taxes are both 100. For this economy, graph the IS
curve for r ranging from 0 to 8.
b. The money demand function in Slugikistan is (M/P)d = Y – 100r. The money supply M is 1
000 and the price level P is 2. For this economy, graph the LM curve for r ranging from 0 to
8.
c. Find the equilibrium interest rate r and the equilibrium level of income Y.
d. Suppose that government purchases are raised from 100 to 150. How does the IS curve
shift? What are the new equilibrium interest rate and level of income?
e. Suppose instead that the supply is raised from 1 000 to 1 200. How much does the LM
curve shift? What are the new equilibrium interest rate and level of income?
f. With the initial values for monetary and fiscal policy, suppose that the price level rises from 2
to 4. What happens? What are the new equilibrium interest rate and level of income?

a. The IS curve is given by: Y = C(Y - T) + I(r) + G. We can plug in the consumption and
investment functions and values for G and T as given in the question and then rearrange to
solve for the IS curve for this economy:
Y = 200 + 0.75(Y - 100) + 200 - 25r + 100
Y – 0.75Y = 425 - 25r
1Y – 0.75Y = 425 - 25r
0.25Y = 425 - 25r
Y = 1 700 - 100r
This IS equation is graphed in the figure below for r ranging from 0 to 8.
b. The LM curve is determined by equating the demand for and supply of real money balances.
The supply of real balances is 1 000/2 = 500. Setting this equal to money demand, we find:
500 = Y - 100r and Y = 500 + 100r.
This LM curve is graphed in the above figure (shown in part (a)) for r ranging from 0 to 8.

c. If we take the price level as given, then the IS and the LM equations give us two equations in
two unknowns, Y and r. We found the following equations in parts (a) and (b):
IS: Y = 1 700-100r and
LM: Y = 500 + 100r.
Equating these, we can solve for r:
1 700 - 100r = 500 + 100r
or
1 200 = 200r, and
r = 6.
Now that we know r, we can solve for Y by substituting it into either the IS or the LM
equation. We find Y = 1 100. Therefore, the equilibrium interest rate is 6% and the
equilibrium level of output is 1 100, as depicted in the figure shown in part (a).

d. If government purchases increase from 100 to 150, then the IS equation becomes: Y = 200 +
0.75(Y -100) + 200 - 25r + 150.
Simplifying, we find: Y = 1 900 - 100r.
This IS curve is graphed as IS2 in the figure below. We see that the IS curve shifts to the
right by 200.
 By equating the new IS curve with the LM curve derived in part (b), we can solve for the new
equilibrium interest rate:
1 900 - 100r = 500 + 100r
or 1 400 = 200r,
and 7 = r.
We can now substitute r into either the IS or the LM equation to find the new level of output.
We find Y = 1 200. Therefore, the increase in government purchases causes the equilibrium
interest rate to rise from 6% to 7%, while output increases from 1 100 to 1 200. This is
depicted in the figure above.

e. If the money supply increases from 1 000 to 1 200, then the LM equation becomes: (1 200/2)
= Y -100r, or
Y = 600+100r.
This LM curve is graphed as LM2 in the figure below. We see that the LM curve shifts to the
right by 100 because of the increase in real money balances.

To determine the new equilibrium interest rate and level of output, equate the IS curve from
part (a) with the new LM curve derived above:
1 700 - 100r = 600+100r or
1 100 = 200r, and
 5.5 = r.
Substituting this into either the IS or the LM equation, we find Y = 1 150. Therefore, the
increase in the money supply causes the interest rate to fall from 6% to 5.5%, while output
increases from 1 100 to 1 150. This is depicted in the figure above.

f. If the price level rises from 2 to 4, then real money balances fall from 500 to 1 000/4 = 250.
The LM equation becomes: Y = 250 + 100r. As shown in the figure below, the LM curve
shifts to the left by 250 because the increase in the price level reduces real money balances.

7. Consider the following closed economy. The consumption function is given by C=250 + 0.75(Y-
T); investment by I=300 - 25r; and government purchases and taxes are both 100. Additionally,
money demand reads L(r,Y)=Y - 100r. Money supply is 12000 and the price level is 6.

a. For this economy, derive the expressions for the IS and LM curves (so derive 2 expressions
where Y is a function of r).
b. Determine the equilibrium interest rate and income.
c. Derive the expression for the AD curve (relationship between Y and P).

a. For this economy, derive the expressions for the IS and LM curves (so derive 2 expressions
where Y is a function of r).
IS curve:
Y=C+I+G
Y = [250 + 0.75(Y – 100)] + (300 – 25r) + 100
Y = (250 + 0.75Y – 75) + (300 – 25r) + 100
1Y = 0.75Y + 575 – 25r
1Y – 0.75Y = 575 – 25r
0.25Y = 575 – 25r
Y = 2300 – 100r (IS curve’s relationship)

LM curve:
Md/P = Ms/P
Y – 100r = 12000/6
Y – 100r = 2000
Y = 2000 + 100r

b. Determine the equilibrium interest rate and income

IS = LM
 2300 – 100r = 3000 + 100r
2300 – 2000 = 100r + 100r
300 = 200r
r = 1.5
IS: 2300 – 100(1.5)
Y = 2 150

c. Derive the expression for the AD curve (relationship between Y and P).
Set LM equal to IS equation, so we have Y as a function of M and P
Use the form of the LM curve for an unspecified value of P
Also make “r” the subject of the formula
LM:
L(r,Y)=Y - 100r
MS = 12000/P
Y – 100r = 12000/P
-100r = 12000/P – Y
100r = Y – 12000/P
IS:
Y = 2300 – 100r
100r = 2300 – Y
In this case the “r” values are the same (doesn’t have to be)
Since both the IS and LM equations give expressions for r, we can eliminate r by setting them
equal to each other:
Now,
Y – 12000/P = 2300 – Y
2Y = 2300 + 12000/P
AD equation:
Y = 1150 + 6000/P

Graphical derivation:
Step 1: Show the IS-LM model traces out a negative relationship between P,Y. Intuition: ceteris
paribus, as P increases, M/P decreases, thus r increases, I decreases, and hence Y decreases.
Step 2: Position – anything other than P that causes either the IS or LM curves to shift causes
the AD curve to shift.
Step 3: Determinants of slope:-- The flatter is IS, the flatter is AD (output is more responsive to
price changes).--The flatter is LM, the steeper is AD-- The larger is M, the flatter is AD (since the
larger is M, the larger will be the impact on M/P of a change in P).

8. What does it mean that a country is in a liquidity trap?

A country is in a liquidity trap when the nominal interest rate hits the 0 lower bound, so that
standard monetary policy is powerless. If the SARB conducts more open market purchases, it
injects more money in the economy, but the interest rate won’t change. When the nominal
interest rate on government bonds is 0, then they are a perfect substitute for money, so that
there is no extra incentive in holding wealth in bonds. People will then be willing to hold as much
money as the SARB injects in the economy and won’t buy more government bonds because
they will never accept a negative nominal interest rate on bonds. Hence a standard monetary
policy will not change the nominal interest rate on non-monetary assets and hence won’t have an
expansionary effect on the real economy.

9. Suppose a liquidity trap exists. Graphically illustrate and explain the effects of an increase in
money supply using the IS-LM model.
Given that the liquidity trap already exists, we know that the equilibrium in the IS-LM model
occurs where the IS curve intersects the LM curve on the horizontal portion of the LM curve.
When M increases, any increase in the money supply will simply be held by individuals and i will
not fall.
10. Use the IS–LM model to predict the short-run impact on the interest rate and output if the SARB
pushes interest rates down at the same time that both consumption and investment fall due to a
financial crisis. Illustrate your answer graphically. Be sure to label: i. the axes; ii. the curves; iii.
the initial equilibrium; and iv. the direction the curves shift. Explain your answer in words.
[Hint: when you have a question that has two events happening draw two separate diagrams to
analyse what is happening in each case. You can then make a conclusion about what is
happening to the variable on the y-axis and what is happening to the variable on the x-axis.]

As a single diagram:

Starting from A with interest rate r1 and income Y1 , the reduction in interest rates by the SARB
moves the LM curve to the right. The fall in consumption and investment spending moves the IS
curve to the left. At the new equilibrium the interest rate will be lower, but the impact on output
will depend on the relative magnitudes of the shifts. If the IS curve shifts relatively more than the
LM curve, output will be lower. If the LM curve shifts relatively more than the IS curve, output will
increase.

11. How does an automatic stabiliser interfere with fiscal policy? Discuss possible positive and
negative effects.
Automatic stabilisers are countercyclical; they tend to stimulate the economy in recessions and
to slow it down in booms. If government actions were timely and well designed, automatic
stabilisers should reduce the magnitude of changes in government spending or taxation.
 However, government actions tend to come later than necessary and their effects tend to last
longer than necessary. In such a case, automatic stabilisers may undesirably enhance the
effects of fiscal policies.

12.
a. Graph the effects of expansionary monetary policy in the money market, loanable funds market,
and AD-AS model. (Assume an upward sloping SRAS curve.)
b. Explain how these are connected.

b. An increase in the money supply leads to increased savings, which translates into an increase in
the supply of loanable funds. In both the money market and loanable funds market, the effect is
lower interest rates. In the AD-AS model, the increase in money supply results in greater
consumer spending – and the lower interest rates leads to greater investment spending. Both
are components of AD, which shifts to the right.

13. How have economists used the IS-LM model to explain the causes of the Great Depression?
 See Section 12-3 of the 10th edition / Section 13-3 of the 11th edition.

14. Illustrate and explain the crowding out effect (using the money market and the AD curve).

The crowding-out effect

(a) The Money Market (b) The Aggregate-Demand Curve
Interest 2. . . . the increase in Price
rate Money level 1. When an increase in government
supply spending increases purchases
money demand . . .
4. . . which in turn
partly offsets the
r2 R20 billion
initial increase in
3. . . . which increases aggregate demand.
the equilibrium
interest
r1
MD2

AD2
AD3
Money demand, MD1 Aggregate demand, AD1

0 Quantity fixed Quantity 0 Quantity

by the SARB of money of output

Panel (a) shows the money market. When the government increases its purchases of goods and
services, the resulting increase in income raises the demand for money from MD1 to MD2, and
this causes the equilibrium interest rate to rise from r1 to r2. Panel (b) shows the effects on
aggregate demand. The initial impact of the increase in government purchases shifts the
aggregate-demand curve from AD1 to AD2. Yet because the interest rate is the cost of
borrowing, the increase in the interest rate tends to reduce the quantity of goods and services
35
demanded, particularly for investment goods. This crowding out of investment partially offsets
the impact of the fiscal expansion on aggregate demand. In the end, the aggregate-demand
curve shifts only to AD3.

15. You are presented with the following data from Ursa Minor:

Year Nominal interest rate Real GDP Potential GDP

2016 0.5 R9 000 R8 000
2017 0.3 R10 000 R8 000

Based on this information, is it possible for Ursa Minor’s central bank to engage in monetary
policy to achieve equilibrium? Justify your answer.

Yes, the central bank can engage in monetary policy to achieve the medium run equilibrium.
The economy is in a liquidity trap / zero lower bound. Some might argue that the level of interest
rate has fallen almost to zero and that monetary policy is no longer effective. Nominal interest
rates can’t fall below zero: rather than make a loan at a negative nominal interest rate, a person
would just hold cash. In this environment, expansionary monetary policy increases the supply of
money, making the public’s asset portfolio more liquid, but because interest rates can’t fall any
further, the extra liquidity may not have any effect. Aggregate demand, production and
employment may be “trapped” at low levels. However, Ursa Minor has a positive output gap,
(output > potential output), so inflation keeps increasing. Therefore, Ursa Minor central bank’s
 policy will be to increase the interest rate so as to decrease output back to potential. Since for
an economy in a liquidity trap, there is no upper bound for the level of interest rate, the central
bank can engage in monetary policy to achieve the medium run equilibrium.

16. Consider the economy of Hicksonia:

𝐶𝐶 = 100 + 0.8(𝑌𝑌 − 𝑇𝑇) (𝐼𝐼 = 180 − 20𝑟𝑟) 𝑇𝑇 = 0.25𝑌𝑌 𝑀𝑀𝑀𝑀 = 800

𝑀𝑀𝑀𝑀 1 𝐺𝐺 = 120 𝑃𝑃 = 2
= 𝐿𝐿(𝑟𝑟, 𝑌𝑌) = 200 + 𝑌𝑌 − 10𝑟𝑟
𝑃𝑃 3

Use the information provided in the table above to derive the IS and LM equations. Then
calculate the equilibrium real output and interest rate in Hicksonia. [Note: the real interest rate
should be expressed as a “whole” number.]

Calculate the equilibrium real output and interest rate.

IS relation  Y = C + I + G
Y = (100 + 0.8(Y – 0.25Y)) + (180 – 20r) + (120)
Y = 100 + 0.8(0.75Y) + 180 – 20r + 120
Y = 100 + 0.6Y + 300 – 20r
Y = 400 + 0.6Y – 20r
1Y – 0.6Y = 400 – 20r
0.4Y = 400 – 20r
Y = 400/0.4 – 20r/0.4
IS  Y = 1000 – 50r
Or
50r = 1000 – Y
r = 20 – 0.02Y

LM relation  Ms/P = L(r,Y) (real money supply = real money demand)

800/2 = 200 + ⅓Y – 10r
400 = 200 + ⅓Y – 10r
-⅓Y = 200 – 400 – 10r
-⅓Y = -200 – 10r
LM  Y = 600 + 30r
Or
30r = -600 + Y
r = -20 + (1/30)Y

IS = LM
1000 – 50r = 600 + 30r
1000 – 600 = 30r + 50r
400 = 80r
r=5

Therefore, Y = 1000 – 50r Therefore, Y = 600 + 30r

Y = 1000 – 50(5) Y = 600 + 30(5)
So, Y = 750 So, Y = 750

17. Is it true that the presence of the Pigou effect implies that deflation is less harmful to an
economy? Justify your answer.

Yes, it is true that the presence of the Pigou effect implies that deflation is less harmful to an
economy.
 The real balance effect (or ‘Pigou effect’) implies that real money balances M/P have a positive
influence on consumption through a wealth effect. A falling price level, P, increases the real
value of M, leading to a rise in consumption and a rightward shift of the IS curve. The increase
in aggregate demand helps to alleviate the deflationary pressure. This mechanism is operative
even when the economy is in a liquidity trap where the LM curve is horizontal: thus the problem
of deflation and the liquidity trap is less of a concern since deflation is self-correcting through the
demand stimulus implied by the real balance effect.

18. Discuss the sequence of events as described by Arthur Pigou explaining how deflation impacts
income and employment.
A fall in prices leads to a rise in real balances.
The rise in real balances leads to an increase in consumers wealth.
The increase in consumers wealth leads to increase consumption.
This causes the IS curve to shift up and toward the right.
The new equilibrium is at a higher level of income and higher levels of employment.

19. Is it true that when a liquidity trap exists in the context of the IS-LM model, an expansion of the
money supply will lower the nominal interest rate? A fully-labelled diagram should form part of
your answer.

No, it is not true that in a liquidity trap, an expansion of the money supply will lower the nominal
interest rate according to the IS–LM model.
In a liquidity trap, the demand for money becomes perfectly interest elastic as agents are
indifferent between holding money and bonds.
Discussion of either MS and MD or IS-LM model can now be used as an explanation:
Discussion of MS and MD model
This means that the money demand curve is horizontal in a liquidity trap. A monetary expansion
shifts the money supply curve to the right in the money market.
However, since the money demand curve is horizontal (or has a horizontal section extending to
the right), the increase in the money supply has no effect on the equilibrium nominal interest
rate.
At an interest rate of zero, since bonds cease to be an attractive alternative to money, which is at
least useful for transactions purposes, there would be a liquidity trap.
Discussion of IS-LM model
This means that the LM curve is horizontal in a liquidity trap. Any attempt by the SARB to boost
the money-supply with lower interest rates (i.e. shifting the LM curve to the right to a new
intercept point with the IS curve) is impossible.

This situation can arise only in times when the interest rate is already at or near to zero, because
at any other time the central bank can always cut the “repo rate” if it chooses to do so.
However, when the rate is already as low as it can go, shifting a horizontal curve to the right will
always intercept the IS curve at the same point, with the same income/output level, and the
same interest rate.

A monetary expansion does not lower the nominal interest rate in a liquidity trap because agents
are indifferent between holding bonds or money, they are willing to hold additional units of
money without any change in interest rates.
20. Is it true that fiscal policy cannot affect the level of GDP if money demand does not depend on
the interest rate? Justify your answer.

Yes, this is true. When money demand does not depend on the interest rate, the LM curve is
vertical, meaning that output is set on the financial market, no matter what the conditions on the
goods market are. Fiscal policy moves the IS curve, and this will have no effect on output with a
vertical LM curve: any increase in demand due to an increase in government spending is totally
offset by an increase in the interest rate (which depresses investment).