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CHAPTER 11 Aggregate Demand II

A PowerPoint Tutorial

To Accompany

MACROECONOMICS, 6th. ed.
N. Gregory Mankiw
By
Chapter Eleven

Mannig J. Simidian

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r IS

Now that we’ve assembled the IS-LM model of aggregate demand, let’s apply it to three LM(P0) issues: 1) Causes of fluctuations in national income

r0 2) How IS-LM fits into the model of aggregate supply and aggregate demand in Chapter 9
Y0

Y 3) The Great Depression

Chapter Eleven

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If the IS or LM curve shifts. Let’s examine how changes in policy and shocks to the economy can cause these curves to shift. and national income fluctuates. and the interest rate for a given price level.The intersection of the IS curve and the LM curve determines the level of national income. the short-run equilibrium of the economy changes. Chapter Eleven 3 .

r IS LM Chapter Eleven y 4 .

MPC) which raises income and the interest rate. This will raise the level of income by G/(1.MPC) r IS IS´ A B LM Y The IS curve shifts to the right by G/(1.+G Consider an increase in government purchases. Chapter Eleven 5 .

Chapter Eleven 6 .MPC) which raises income and the interest rate.-T Consider a decrease in taxes of T. This will raise the level of income by T × MPC/(1.MPC) IS IS´ A B r LM Y The IS curve shifts to the right by T × MPC/(1.

r IS LM Chapter Eleven y 7 .

which increases planned expenditure. A lower interest rate stimulates planned investment. The interest rate r then falls until people are willing to hold all the extra money that the Fed has created. and income Y. As a result. people have more money than they want to hold at the prevailing interest rate. has ramifications for the goods market. they start depositing this extra money in banks or use it to buy bonds. this brings the money market to a new equilibrium. Why? Because when the Fed increases the supply of money. production. in turn.+M Consider an increase in the money supply. The lower interest rate. Chapter Eleven 8 . r IS LM LM A B Y The LM curve shifts downward and lowers the interest rate which raises income.

But we didn’t discuss how a monetary expansion induces greater spending on goods and services—a process called the monetary transmission mechanism. when prices are sticky. The IS-LM model shows that an increase in the money supply lowers the interest rate. an expansion in the money supply raises income.The IS-LM model shows that monetary policy influences income by changing the interest rate. In that chapter we showed that in the short run. which stimulates investment and thereby expands the demand for goods and services. This conclusion sheds light on our analysis of monetary policy in Chapter 9. Chapter Eleven 9 .

when economists analyze specific policy proposals.The IS-LM model shows how monetary and fiscal policy influence the equilibrium level of income. rather than just qualitatively. Macroeconometric models describe the economy quantitatively. But. The predictions of the model. are qualitative. Chapter Eleven 10 . however. not quantitative. The IS-LM model that shows that increases in government purchases raise GDP and that increases in taxes lower GDP. they must know the direction and size of the effect.

Chapter Eleven 11 .

Since r increased. Now we’re going to bring a third variable. we know Y that investment will decrease. the inverse relationship that defines 12 Chapter Eleven the downward slope of AD. AD The +P triggers a sequence of events that end Y with a -Y. . Notice that r increased. A P1 The . and Y. shifting LM leftward to point B. as it just got more P costly to take on various investment projects. LM(P2) To derive AD. the price level (P) into the analysis. B An increase in P lowers the value of real money A balances.You probably noticed from the IS and LM diagrams that r and Y were on the two axes. This B P2 sets off a multiplier process since -I causes a –Y. Now increase the price level from P1 to P2. We can accomplish this by linking both twodimensional graphs.Y triggers -C as we move up the IS curve. start at point A in the top r IS LM(P1) graph.

This +P decreases the value of real money balances. M/ P = L (r. Y) Chapter Eleven IS IS´ C A B LM (P2) LM(P0) P P2 P 0 LRAS C B Y A SRAS A AD´ 13 D Y Finally. Y = C (Y-T) + I(r) + G This translates into a rightward shift of the IS and AD curves.+G Suppose there is a +G. . this leaves us at point C in both diagrams. which translates into a leftward shift of the LM curve. r In the short run. But as the output market clears. in the long-run. the price level will increase from P0 to P2. we move along SRAS from point A to point B.

For the variables Y. Now it’s time to determine the effects on the variables in the economy. r +. P P2 P0 LRAS C B A Y SRAS AD´ AD Chapter Eleven Y* Y´ Y 14 . C +.Remember that SR is the movement from A to B. you can read the effects right off the diagrams. I – . P. since r increased. and r. because prices are sticky in the SR. because Y moved from Y* to Y´ P 0. because a +Y leads to a rise in r as IS slides along the LM curve. r IS IS´ C A B LM(P2) LM(P0) Y +. the level of investment decreased. because a +Y increases the level of consumption (C=C(Y-T)).

since both Y and T are back to their initial P levels (C=C(Y-T)) I – – . reflecting the leftward shift in LM due to +P C 0. P. since r has risen even more due to the P2 +P. because rising P shifts LM to left. returning Y to Y* as required by long-run LRAS. Remember that LR is the movement from A to C. you can read the effects right off the diagrams. P0 IS IS´ C A B LM(P2) LM(P0) LRAS C B A Y* Y´ Y SRAS A AD´ D Y 15 Chapter Eleven . in order to eliminate the excess demand at P .For the variables Y. 0 r +. and r. r Y 0. P +.

This +P decreases the value of the real money supply which translates into a leftward shift of the LM curve. M/ P = L (r. thus increasing the value of the real money supply which translates into a rightward shift of the LM and AD curves. Y) Look at the appropriate equation that captures the M term: Notice that M/ was increased. A= C But as the output market clears. .Suppose there is a +M. M/ P = L (r. r IS LM(P0) In the short run. in the long run. we move along SRAS from LM point A to point B. Y) Chapter Eleven P LRAS C A Y P2 P 0 B SRAS AD´ AD Y 16 Finally. B the price level will increase from P0 to P2. this leaves us at point C in both diagrams.

P.Remember that SR is the movement from A to B. since r increased. C +. the level of investment decreased. because prices are sticky in the SR. r IS A= C B (P2) LM (P0) LM  P P2 P0 LRAS C A Y B SRAS AD´ AD Y 17 Chapter Eleven Y* Y´ . and r. Y +. you can read the effects right off the diagrams. because a +Y increases the level of consumption (C=C(Y-T)). because Y moved from Y* to Y´ P 0. Now it’s time to determine the effects on the variables in the economy. I + . For the variables Y. because a +Y leads to a decrease in r as LM slides along the IS curve. r –.

you can read the effects right off the diagrams. P IS A= C B LRAS C A Y* Y ´ LM (P0) LM  Y Notice that the only LR impact of an increase in the money supply was an increase in the price level. C 0. in order to eliminate the excess demand at P .Remember that LR is the movement from A to C. I 0. because rising P shifts LM to left. and r. P. 0 r 0. since both Y and T are back to their initial levels (C=C(Y-T)). restoring r to its original level. returning r Y to Y* as required by LRAS. Chapter Eleven P2 P0 B SRAS AD´ AD Y 18 . reflecting the leftward shift in LM due to +P. since Y or r has not changed. Y 0. For the variables Y. P +.

Chapter Eleven 19 .

Short Run: Move from A to B.r IS IS' C LM(P2) 1) +C causes the IS curve to shift LM(P0) right to IS‘. AD AD' Y M/ P = L (r.  B A Y = C (Y-T) + I(r) + G 2) This leads to a rightward shift in AD to AD’. 3) +P causes LM(P0) to shift leftward LRAS to LM(P2) due to the lowering of the real value of the money supply. Y Long Run: Market clears at P0 to P2 from B to C. Y) 20 P P2 P0 LRAS C  A  B  Chapter Eleven .

r IS IS' C  LM(P2) LM(P0) A B Short Run: Long Run: P P2 Y LRAS C  Y P r C I SRAS + 0 + + - P0 A B 0 + ++ + -- Chapter Eleven AD AD' Y 21 .

22 . it could very well have been responsible for the severity of the depression. Let’s see Chapter howEleven changes in the price level affect income in the IS-LM model. during which time unemployment rose from 3.The spending hypothesis suggests that perhaps the cause of the decline may have been a contractionary shift of the IS curve. Because the falling money supply was possibly responsible for the falling price level.2 percent. They argue that the deflation may have turned what in 1931 was a typical economic downturn into an unprecedented period of high unemployment and depressed income.2 percent to 25. The money hypothesis attempts to explain the effects of the historical fall of the money supply of 25 percent from 1929 to 1933. Some economists say that deflation worsened the Great Depression.

economist Arthur Pigou pointed out that real money balances are part of household wealth. Chapter Eleven 23 . In the 1930s. For any given supply of money M. An increase in real money balances causes an expansionary shift in the LM curve. a lower price level implies higher real money balances. falling prices raise income. As prices fall and real money balances rise. which leads to higher income. Another way in which falling prices increase income is called the Pigou effect. M/P. households increase their consumption spending and the IS curve shifts to the right.In the IS-LM model.

This contracts IS.There are two theories to explain how falling prices could depress income rather than raise it. 1) Debt-deflation theory. The impoverishment of the debtors causes them to spend less. A fall in the price level raises the real amount of the debt. If their propensities to consume are the same. But. unexpected falls in the price level 2) Effects of expected inflation Debt-deflation theory redistributes wealth between creditors and debtors. if debtors reduce more than the amount that creditors increase spending. and reduces national income. there is no aggregate effect. the net effect on aggregate demand is a reduction. Chapter Eleven 24 . and creditors to spend more.

Chapter Eleven 25 . The reduction in investment shifts the IS curve downward. i IS r2 IS´ r1 = i 1 A i2 B LM Y An expected deflation (a negative value of pe) raises the real interest rate for any given nominal interest rate. but the real interest rate (r) rises.interest rate. and this depresses investment spending. The level of income and the nominal interest rate (i) fall.

Monetary transmission mechanism Pigou Effect Debt-deflation theory Chapter Eleven 26 .