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MACROECONOMICS
Lecturer: Doan Ngoc Thang

Chapter 5
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

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Context
n Classical theory: the economy in the long run
n prices flexible
n Output (Yn) determined by Aggregate supply (factors of production & technology)
n Unemployment equals its natural rate
n 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 ver y short run:

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

any level of Price and AS curve is horizontal

n Constant price

n 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

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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
n Consumption: Demand on consumer goods and services
n Investment: Demand on capital goods

n Government spending: Demand on public goods and services

n Net Exports: demand on exported goods and services minus
demand on imported goods and services

+ 1. Consumption
n Factors affect consumption:

- Disposable income: YD = Y – T

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

Marginal Propensity to Consume MPC

à a part of Consumption = MPC x Y D
- Other factors affect to consume: population, expectations…

ØC = f (YD, population, expectations ...)

ØC = C + MPC * YD

C: pre-determined consumption

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Net Tax includes
n Predetermined Tax (VAT, imports tax…)
n Income Tax
T=T+tY

t: tax rate
T : tax level predetermined

n Consumption function
C = C + MPC(Y – T – tY)

10

+
2. Investment

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

I = I – bxi i: interest rate

I=I
Investment function if
interest rate is constant

11

+
3. Government Spending

n Tools of Fiscal Policy: T, G

n Planned and pre-determined

G=G

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4. Net Export = Export -
Import
n Exports
n Demand for exported goods by foreigners
n X = X (Y f, P, P f, E....)

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

IM = MPM * Y
13

+
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 a x Y
Pre-determined Expenditures Income determined Expenditures

14

AE
450
AE = AE +a Y
AE2
B
AE0
AE1
A
AE

Y1 Y0 Y2 Y (GDP)

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Equilibrium

Equilibrium condition
AE = Y

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

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

1- MPC (1-t) + MPM

16

c=200+0,75( Y-T)
a, the equilibrium level ò Y is calculated below:
Y=C+I +G=200+0,75(Y- 100)+100+100=325+0,75Y
+ 0,25Y=325. Y=1300
Now you try!
c=200+0,75( Y-T)

n C = 200 + 0,7.Yd

n I = 207

n T = 50 + 0,1Y

n G = 100

n X = 340

n M = 0,3.Y

? Determine AE function and calculate the equilibrium output

17

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

AE

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

DY DY

Y Y0 Y Y
2 1

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+
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

19

+
(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

20

+
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 à Y = 120

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+
∆G=20 à ∆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

22

+ ∆I=-20 à ∆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

23

+ ∆T=20 à ∆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

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The Keynesian cross

in closed economy

25

+
Assumptions
Initial assumptions:

n There is abundance of production resources, AS is

available at any level of Price and AS curve is horizontal

n Constant price

n AD (AE) determines total output

Two more Assumption,

- Close economy (Ex = 0; Im = 0)
- Tax is predetermined and planned (t = 0

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The Keynesian Cross: Income (or Output) is determined by

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

n 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

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n Actual expenditure: Y = real GDP

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

Y – PE = unplanned investment in inventory

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

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

- If Y < PE è unplanned investment < 0 (decumulation in investment)

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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
è Equilibrium output:
Y = (1/(1-MPC)) x (C + I + G – MPC.T)
(1/(1-MPC)) = m, the multiplier; m > 1

29

+ Graphing PE curve and The equilibrium value of

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

Y0 Y
Equilibrium
income

The Keynesian cross

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The adjustment to equilibrium in the

+ Keynesian cross

PE
PE =Y

PE =C +I +G
EA
At A point: Y > PE
A Unplanned
inventory in
èUnplanned investment
accumulation
inventory in E
investment
accumulates
è This causes
income (output)
to fall
è YA decrease to Y 0
to the
Y
equilibrium Y0 YA

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+ 32

Fiscal policy

32

+ Tools of Fiscal Policy

n Government spending
G=G
n Tax

T = T + t.Y

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

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

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+ Fiscal Policy and the Multiplier

Expansionary fiscal policy: An increase in government
purchases -> PE increase, PE curve shifts upward

PE Y

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

DG
…so firms increase
output, and income
rises toward a new
equilibrium. Y
PE1 = Y1 DY PE2 = Y2

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Expansionary fiscal policy

When government increases spending (ΔG)

Y = (1/(1-MPC)) x (C + I + G – MPC.T)

Solve for DY :

æ 1 ö
DY = ç ÷ ´ DG
è 1 - MPC ø

Or, ΔY = m. ΔG

m is expenditure multiplier (m > 1)

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+ contractionary fiscal policy:

An increase in taxes
Initially, the tax
PE Y
=

increase reduces PE PE1 =C1 +I +G

consumption C,
and therefore PE: PE2=C2 +I +G

DC = -MPC DT At Y1, there is now an

unplanned
inventory buildup…
…so firms
reduce output,
and income falls Y
toward a new E2 = Y2 DY E1 = Y1
equilibrium

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When government increases tax (ΔT)

Y = (1/(1-MPC)) x (C + I + G – MPC.T)

æ - MPC ö
DY = ç ÷ ´ DT
è 1 - MPC ø

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

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38

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

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Active learning - answer:

n 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 è PE
increase
(PE shifts upward)
PE Y
=

At Y 1, PE PE 2 = C + I 2 + G
there is now an
unplanned drop in PE 1 = C + I 1 + G
inventory…

DI
…so firms increase
output, and income
rises toward a new
equilibrium. Y
Y1 DY Y2

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+ 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)

40

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.

41

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

è The equation for the IS curve is:

Y = C (Y - T ) + I (r ) + G

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Deriving the IS curve

(b) The Keynesian cross

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

¯r Þ ­I PE1 =C +I (r1 )+G

Þ ­E DI

Þ ­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

43

Why the IS curve is negatively sloped

n A fall in the interest rate motivates firms to increase

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

n To restore equilibrium in the goods market, output (actual

expenditure, Y ) must increase.

44

Fiscal Policy and the IS curve

n We can use the IS-LM model to see

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

n Let’s start by using the Keynesian cross

to see how fiscal policy shifts the IS curve…

Chapter 5: The IS-LM model

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Shifting the IS curve: DG

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

­G Þ ­E Þ ­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 DY
DY = DG IS2
1- MPC IS1
Y1 Y2 Y

46

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.

47

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

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Money supply curve

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

(M P) =M P
s

M/P
M P
real money
balances

49

Money demand
Money demand is
determined by interest
rate (i) and income (Y) r
(M P)
s
interest
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.

Demand for M/P

M P
real money real money
balances: balances
(M/P)d = L (r,Y)

50

Equilibrium in money market

The interest r
rate adjusts (M P)
s
interest
to equate the rate
supply and
demand for
money:

r1

M P = L (r ) L (r )
M/P
M P
real money
balances

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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

52

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 )

53

+ Deriving the LM curve

(a) The market for

(b) The LM curve
real money balances
r r
LM

r2 r2

L (r , Y 2 )
r1 r1
L (r , Y 1 )
M1 M/P Y1 Y2 Y
P

Chapter 5: The IS-LM model

54

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Why the LM curve is upward sloping

n An increase in income raises money demand.

n Since the supply of real balances is fixed, there is now excess

demand in the money market at the initial interest rate.

n The interest rate must rise to restore equilibrium in the

money market.

55

+
How DM 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 , Y 1 )

M2 M1 M/P Y1 Y
P P

56

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.

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The short-run equilibrium

The short-run equilibrium is r

the combination of r and Y LM
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

58

+ 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

59

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.
M P = L (r ,Y ) IS
Y
Y1
The intersection determines
the unique combination of Y and r
that satisfies equilibrium in both markets.

Chapter 5: The IS-LM model

60

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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 T IS
• monetary policy: M Y
Y1

61

An increase in government purchases

1. IS curve shifts right r

1 LM
by DG
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 DG
1- MPC

62

A tax cut

Consumers save r
(1-MPC) of the tax cut, LM
so the initial boost in
spending is smaller for DT r2
than for an equal DG… 2.
r1
and the IS curve shifts by
1. IS2
-MPC
1. DT IS1
1- MPC
Y
Y1 Y2
2. …so the effects on r 2.
and Y are smaller for DT
than for an equal DG.
Chapter 5: The IS-LM model

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Monetary policy: An increase in M

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

2. …causing the r1
interest rate to fall r2

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

Chapter 5: The IS-LM model

64

Interaction between
monetary & fiscal policy

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

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

n Such interaction may alter the impact of the original policy

change.

65

The Fed’s response to DG > 0

n Suppose Congress increases G.

n Possible Fed responses:

1. hold M constant

2. hold r constant

3. hold Y constant

n In each case, the effects of the DG

are different:

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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
DY = Y 2 - Y1 Y
Y1 Y2
Dr = r2 - r1

67

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
DY = Y 3 - Y1 Y
Y1 Y2 Y3

Dr = 0

68

Response 3: Hold Y constant

If Congress raises G, r LM2

the IS curve shifts right. LM1

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

Chapter 5: The IS-LM model

69

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Estimates of fiscal policy multipliers

from the DRI macroeconometric model

Estimated Estimated
Assumption about value of value of
monetary policy DY/ DG DY/ DT

Fed holds money

0.60 -0.26
supply constant
Fed holds nominal
1.93 -1.19
interest rate constant

70

Shocks in the IS-LM model

IS shocks: exogenous changes in the demand for goods &

services.
Examples:
n stock market boom or crash
Þ change in households’ wealth
Þ DC
n change in business or consumer
confidence or expectations
Þ DI and/or DC

71

Shocks in the IS-LM model

LM shocks: exogenous changes in the demand for money.

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

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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

73

CASE STUDY:
The U.S. recession of 2001

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

Chapter 5: The IS-LM model

74

CASE STUDY:
The U.S. recession of 2001
n Causes: 1) Stock market decline Þ ¯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

75

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CASE STUDY:
The U.S. recession of 2001

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

n Causes: 3) Corporate accounting scandals

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

Chapter 5: The IS-LM model

76

CASE STUDY:
The U.S. recession of 2001

n Fiscal policy response: shifted IS curve right

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

Chapter 5: The IS-LM model

77

CASE STUDY:
The U.S. recession of 2001
n Monetary policy response: shifted LM curve right
7
Three-month
6
T-Bill Rate
5
4
3
2
1
0
00

00
00

00
01

01
01

01
02

02
02

02
03
03
/2 0

/2 0
/2 0

/2 0
/2 0

/2 0
/2 0

/2 0
/2 0

/2 0
/2 0

/2 0
/2 0
/2 0
/0 1

/0 2
/0 3

/0 3
/0 3

/0 5
/0 6

/0 6
/0 6

/0 8
/0 9

/0 9
/0 9

/11
01

04
07

10
01

04
07

10
01

04
07

10
01

04

Chapter 5: The IS-LM model

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What is the Fed’s policy instrument?

n 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.
n In fact, the Fed targets the federal funds rate – the
interest rate banks charge one another on
overnight loans.
n The Fed changes the money supply and shifts the
LM curve to achieve its target.
n Other short-term rates typically move with the
federal funds rate.
Chapter 5: The IS-LM model

79

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

80

IS-LM and aggregate demand

n So far, we’ve been using the IS-LM model to analyze the short
run, when the price level is assumed fixed.
n However, a change in P would shift LM and therefore affect Y.
n The aggregate demand curve: captures this
relationship between P and Y.

Chapter 5: The IS-LM model

81

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Aggregate demand

n The aggregate demand curve shows the relationship

between the price level and the quantity of output
demanded.

n 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

82

The Quantity Equation as

Aggregate Demand

n From Chapter 4, recall the quantity equation

MV = PY

n For given values of M and V,

this equation implies an inverse relationship between P and
Y:

Chapter 5: The IS-LM model

83

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
& services. Y

Chapter 5: The IS-LM model

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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

85

Aggregate supply in the long run

n 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).
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86

The long-run aggregate supply curve

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

Y
Y
= F (K , L )
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Long-run effects of an increase in M

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

…but leaves Y
Y
output the same.

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88

Aggregate supply in the short run

n Many prices are sticky in the short run.

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

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

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

horizontal:

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89

+ The short-run aggregate supply curve

P
The SRAS curve
is horizontal:
The price level
is fixed at a
predetermined SRAS
level, and firms P
sell as much as
buyers
demand. Y

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Short-run effects of an increase in M

In the short run P

…an increase
when prices are
in aggregate
sticky,…
demand…

SRAS
P
AD2
AD1
Y
…causes Y1 Y2
output to rise.

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91

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.
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92

The SR & LR effects of DM > 0

A = initial P LRAS
equilibrium

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

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+ The SR & LR effects of DM < 0

AD shifts left, P LRAS

depressing
output and
employment
in the short run.
B A SRAS
Over time, P
prices fall and
the economy P2 C AD1
moves down its AD2
demand curve Y
toward full- Y2 Y
employment.
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94

+
Deriving the AD curve
r LM(P2)
Intuition for slope LM(P1)
r2
of AD curve:
r1
­P Þ ¯(M/P)
IS
Þ LM shifts left Y2 Y1 Y
P
Þ ­r
P2
Þ ¯I
P1
Þ ¯Y AD
Y2 Y1 Y

Chapter 5: The IS-LM model

95

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

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96

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

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97

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

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98

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 to fall. IS1
IS2
Y Y
P LRAS

P1 SRAS1

AD1
AD2
Y Y
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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
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100

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
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101

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

SRAS2
• M/P to increase, P2
which causes LM AD1
to move down. AD2
Y Y
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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

103

EXERCISE:
Analyze SR & LR effects of DM
a. Draw the IS-LM and AD-AS r LRAS LM(M /P )
1 1
diagrams as shown here.
b. Suppose Fed increases M.
Show the short-run effects
on your graphs. IS
c. Show what happens in the
Y Y
transition from the short run
to the long run. P LRAS
d. How do the new long-run
equilibrium values of the P1 SRAS1
endogenous variables
compare to their initial AD1
values?
Y Y
Chapter 5: The IS-LM model

104

+ 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

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THE SPENDING HYPOTHESIS:

Shocks to the IS curve

n asserts that the Depression was largely due to an exogenous

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

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

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106

THE SPENDING HYPOTHESIS:

Reasons for the IS shift
n Stock market crash Þ exogenous ¯C
n Oct-Dec 1929: S&P 500 fell 17%
n Oct 1929-Dec 1933: S&P 500 fell 71%

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

n Contractionary fiscal policy

n Politicians raised tax rates and cut spending to
combat increasing deficits.
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107

THE MONEY HYPOTHESIS:

A shock to the LM curve

n asserts that the Depression was largely due to huge fall in the
money supply.

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

n But, two problems with this hypothesis:

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

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THE MONEY HYPOTHESIS AGAIN:

The effects of falling prices

n asserts that the severity of the Depression was due to a huge

deflation:
P fell 25% during 1929-33.

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

perhaps money played an important role after all.

n In what ways does a deflation affect the economy?

Chapter 5: The IS-LM model

109

THE MONEY HYPOTHESIS AGAIN:

The effects of falling prices

n The stabilizing effects of deflation:

n¯P Þ ­(M/P) Þ LM shifts right Þ ­Y

n Pigou effect:
¯P Þ ­(M/P)
Þ consumers’ wealth ­
Þ ­C
Þ IS shifts right
Þ ­Y
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110

THE MONEY HYPOTHESIS AGAIN:

The effects of falling prices

n The destabilizing effects of expected deflation:

¯p e
Þ r ­ for each value of i
Þ I ¯ because I = I (r )
Þplanned expenditure & agg. demand ¯
Þincome & output ¯

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THE MONEY HYPOTHESIS AGAIN:

The effects of falling prices

n The destabilizing effects of unexpected deflation:

debt-deflation theory
¯P (if unexpected)
Þ transfers purchasing power from borrowers to lenders
Þ borrowers spend less, lenders spend more
Þ 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

112

Why another Depression is unlikely

n Policymakers(or their advisors) now know

much more about macroeconomics:
n The Fed knows better than to let M fall
so much, especially during a contraction.
n Fiscal policymakers know better than to raise taxes or cut spending
during a contraction.

n Federal deposit insurance makes widespread

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

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113

Chapter Summary

1. Keynesian cross
n basic model of income determination
n takes fiscal policy & investment as exogenous
n fiscal policy has a multiplier effect on income.

2. IS curve
n comes from Keynesian cross when planned
investment depends negatively on interest rate
n shows all combinations of r and Y
that equate planned expenditure with
actual expenditure on goods & services

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Chapter Summary

3. Theory of Liquidity Preference

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

Chapter 5: The IS-LM model slide 115

115

Chapter Summary

5. IS-LM model
n 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

116

Chapter Summary

5. IS-LM model
na theory of aggregate demand
nexogenous: M, G, T,
P exogenous in short run, Y in long run
nendogenous: r,
Y endogenous in short run, P in long run
nIS curve: goods market equilibrium
nLM curve: money market equilibrium

Chapter 5: The IS-LM model slide 117

117

39