N.

Gregory Mankiw
PowerPoint Slides by Ron Cronovich
CHAPT
ER

11

Aggregate Demand II:

Applying the IS-LM Model
2010 Worth Publishers, all rights reserved

SEVENTH EDITIO

MACROECONOMICS

Equilibrium in the IS -LM model

The IS curve represents
equilibrium in the goods
market.

r
LM

Y C (Y T ) I (r ) G
The LM curve represents
money market equilibrium.

r1

M P L(r ,Y )
Y1
The intersection determines
the unique combination of Y and r
that satisfies equilibrium in both markets.
CHAPTER 11

Aggregate Demand II

IS
Y

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
effects of

fiscal policy: G and/or T

monetary policy: M

CHAPTER 11

Aggregate Demand II

r1
IS
Y1

An increase in government
purchases
1. IS curve shifts right
1
by
G
1 MPC
causing output &
income to rise.
2. This raises money
demand, causing the
interest rate to rise

r
LM

2.

r2
r1

3. which reduces investment,

so the final increase in Y

1
is smaller than
G
MPC II
CHAPTER 11 Aggregate1Demand

1.

IS2
IS1

Y1 Y2

3.

A tax cut
Consumers save
r
(1MPC) of the tax cut,
so the initial boost in
spending is smaller for T
r
than for an equal G
2.
r21
and the IS curve shifts by
1.

LM

1.

MPC
T
1 MPC

2. so the effects on r

and Y are smaller for T

than for an equal G.

CHAPTER 11

Aggregate Demand II

IS2

IS1
Y1 Y2

2.

Monetary policy: An increase

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

2. causing the
interest rate to fall
3. which increases
investment, causing
output & income to
rise.
CHAPTER 11

Aggregate Demand II

LM1
LM2

r1
r2
IS
Y1 Y2

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

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

Such interaction may alter the impact of the

original policy change.
CHAPTER 11

Aggregate Demand II

The Feds response to G > 0

Suppose Congress increases G.

Possible Fed responses:
1. hold M constant
2. hold r constant
3. hold Y constant

In each case, the effects of the G

are different

CHAPTER 11

Aggregate Demand II

Response 1:

Hold M constant

If Congress raises G,
the IS curve shifts right.

r
LM
1

If Fed holds M constant,

then LM curve doesnt
shift.

r2
r1
IS2
IS1

Results:

Y Y2 Y1

Y1 Y2

r r2 r1
CHAPTER 11

Aggregate Demand II

Response 2:

Hold r constant

If Congress raises G,
the IS curve shifts right.

r
LM
1

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

r2
r1

IS2
IS1

Results:

Y Y3 Y1

LM

Y1 Y2 Y3

r 0
CHAPTER 11

Aggregate Demand II

10

Response 3:

Hold Y constant

If Congress raises G,
the IS curve shifts right.
To keep Y constant,
Fed reduces M
to shift LM curve left.

LM
2
LM

r3
r2
r1

IS2
IS1

Results:

Y 0

Y1 Y2

r r3 r1
CHAPTER 11

Aggregate Demand II

11

Estimates of fiscal policy multipliers

from the DRI macroeconometric model

Assumption about
monetary policy

Estimated
value of
Y / G

Estimated
value of
Y / T

Fed holds money

supply constant

0.60

0.26

Fed holds nominal

interest rate constant

1.93

1.19

CHAPTER 11

Aggregate Demand II

12

Shocks in the IS -LM model

IS shocks: exogenous changes in the
demand for goods & services.
Examples:
stock market boom or crash
change in households wealth
C
change in business or consumer
confidence or expectations
I and/or C
CHAPTER 11

Aggregate Demand II

13

Shocks in the IS -LM model

LM shocks: exogenous changes in the
demand for money.
Examples:
a wave of credit card fraud increases
demand for money.
more ATMs or the Internet reduce money
demand.

CHAPTER 11

Aggregate Demand II

14

NOW YOU TRY:

Analyze shocks with the IS-LM

Model

Use the IS-LM model to analyze the effects of

1. a boom in the stock market that makes
consumers wealthier.
2. after a wave of credit card fraud, consumers
using cash 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.

IS-LM and aggregate demand

So far, weve been using the IS-LM model to
analyze the short run, when the price level is
assumed fixed.

However, a change in P would shift LM and

therefore affect Y.

The aggregate demand curve

captures this relationship between P and Y.

CHAPTER 11

Aggregate Demand II

16

Deriving the AD curve

LM(P2)

Intuition for slope

of AD curve:
P (M/P )
LM shifts left
r
I
Y

LM(P1)

r2
r1

IS
P

Y2

Aggregate Demand II

P2
P1
AD
Y2

CHAPTER 11

Y1

Y1

Y
17

Monetary policy and the AD

curve
The Fed can increase
aggregate demand:
M LM shifts right

LM(M1/P1)

LM(M2/P1)

r1
r2

IS

r
I

Y at each
value of P

P1

Y1

Y1
CHAPTER 11

Aggregate Demand II

Y2

Y2

AD2
AD1
Y
18

Fiscal policy and the AD curve

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

LM

r2
r1

IS2

T C

IS1

IS shifts right

Y at each
value of P

P1

Y1

Y1
CHAPTER 11

Aggregate Demand II

Y2

Y2

AD2
AD1
Y
19

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
equilibrium, if

CHAPTER 11

then over time, the

price level will

Y Y

rise

Y Y

fall

Y Y

remain constant

Aggregate Demand II

20

The SR and LR effects of an IS shock

r

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

LRAS LM(P )
1

IS2

Y
P

SRAS1

Y
Aggregate Demand II

LRAS

P1

CHAPTER 11

IS1

AD1
AD2
Y
21

The SR and LR effects of an IS shock

r

LRAS LM(P )
1

In
In the
the new
new short-run
short-run
equilibrium,
equilibrium, Y Y
IS2

Y
P

SRAS1

Y
Aggregate Demand II

LRAS

P1

CHAPTER 11

IS1

AD1
AD2
Y
22

The SR and LR effects of an IS shock

r

LRAS LM(P )
1

In
In the
the new
new short-run
short-run
equilibrium,
equilibrium, Y Y
IS2

Over
Over time,
time, P
P gradually
gradually
falls,
falls, causing
causing
SRAS
SRAS to
to move
move down
down

Y
P

IS1
Y

LRAS
SRAS1

P1

M/P
M/P to
to increase,
increase,

which
which causes
causes LM
LM
to
to move
move down
down

CHAPTER 11

Aggregate Demand II

AD1
AD2
Y
23

The SR and LR effects of an IS shock

r

LRAS LM(P )
1

LM(P2)

IS2

Over
Over time,
time, P
P gradually
gradually
falls,
falls, causing
causing
SRAS
SRAS to
to move
move down
down

M/P
M/P to
to increase,
increase,

which
which causes
causes LM
LM
to
to move
move down
down

CHAPTER 11

Aggregate Demand II

Y
P

IS1
Y

LRAS

P1

SRAS1

P2

SRAS2

AD1
AD2
Y
24

The SR and LR effects of an IS shock

r

LRAS LM(P )
1

LM(P2)

This
This process
process continues
continues
until
until economy
economy reaches
reaches aa
long-run
long-run equilibrium
equilibrium with
with
Y Y

IS2

Y
P

Aggregate Demand II

LRAS

P1

SRAS1

P2

SRAS2

Y
CHAPTER 11

IS1

AD1
AD2
Y
25

NOW YOU TRY:

Analyze SR & LR effects of M

a. Draw the IS-LM and AD-AS

diagrams as shown here.

LRAS LM(M /P )
1
1

b. Suppose Fed increases M.

Show the short-run effects

on your graphs.

IS

c. Show what happens in the

transition from the short run

to the long run.
d. How do the new long-run

equilibrium values of the

endogenous variables
compare to their initial
values?

Y
P

LRAS
SRAS1

P1

AD1

Facts about the business cycle

GDP growth averages 33.5 percent per year over
the long run with large fluctuations in the short run.

Consumption and investment fluctuate with GDP,

but consumption tends to be less volatile and
investment more volatile than GDP.

Unemployment rises during recessions and falls

during expansions.

Okuns Law: the negative relationship between

GDP and unemployment.

CHAPTER 1

The Science of Macroeconomics

27

Growth rates of real GDP, consumption

Percent
change
from 4
quarters
earlier

Real GDP
growth rate
Consumption
growth rate

Average
growth
rate

CHAPTER 1

The Science of Macroeconomics

28

Growth rates of real GDP, consump.,

investment
Percent
change
from 4
quarters
earlier

Investment
growth rate

Real GDP
growth rate

Consumption
growth rate

CHAPTER 1

The Science of Macroeconomics

29

Unemployment
Percent
of labor
force

CHAPTER 1

The Science of Macroeconomics

30

Okuns Law
Percentage
change in
real GDP

1951

Y
3 2 u
Y

1966

1984
2003
1971

1987

2008
1975

2001
1991

CHAPTER 1

1982

Change in unemployment rate31

The Science of Macroeconomics

The Great Depression

Unemployment
(right scale)

220

30
25

200

20

180

15

160

10

Real GNP
(left scale)

140
120
1929

5
0

1931

1933

1935

1937

1939

percent of labor force

billions of 1958 dollars

240

Great Depression

CHAPTER 11

Aggregate Demand II

33

Great Depression

CHAPTER 11

Aggregate Demand II

34

THE SPENDING HYPOTHESIS:

Shocks to the IS curve

asserts that the Depression was largely due to
an exogenous fall in the demand for goods &
services a leftward shift of the IS curve.

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

CHAPTER 11

Aggregate Demand II

35

THE SPENDING HYPOTHESIS:

Reasons for the IS shift

Stock market crash exogenous C
Oct-Dec 1929: S&P 500 fell 17%
Oct 1929-Dec 1933: S&P 500 fell 71%

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

Contractionary fiscal policy

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

Aggregate Demand II

36

THE MONEY HYPOTHESIS:

A shock to the LM curve

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

evidence:
M1 fell 25% during 1929-33.

But, two problems with this hypothesis:

P fell even more, so M/P actually rose slightly
during 1929-31.
nominal interest rates fell, which is the opposite
of what a leftward LM shift would cause.
CHAPTER 11

Aggregate Demand II

37

THE MONEY HYPOTHESIS AGAIN:

The effects of falling prices

asserts that the severity of the Depression was
due to a huge deflation:
P fell 25% during 1929-33.

This deflation was probably caused by the fall in

M, so perhaps money played an important role
after all.

In what ways does a deflation affect the

economy?

CHAPTER 11

Aggregate Demand II

38

THE MONEY HYPOTHESIS AGAIN:

The effects of falling prices

The stabilizing effects of deflation:

P (M/P ) LM shifts right Y

Pigou effect:
P

(M/P )

consumers wealth
C
IS shifts right
Y
CHAPTER 11

Aggregate Demand II

39

THE MONEY HYPOTHESIS AGAIN:

The effects of falling prices

The destabilizing effects of expected deflation:
E

r for each value of i

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

CHAPTER 11

Aggregate Demand II

40

THE MONEY HYPOTHESIS AGAIN:

The effects of falling prices

The destabilizing effects of unexpected deflation:
debt-deflation theory
P (if unexpected)
transfers purchasing power from borrowers to
lenders
borrowers spend less,
lenders spend more
if borrowers propensity to spend is larger than
lenders, then aggregate spending falls,
the IS curve shifts left, and Y falls
CHAPTER 11

Aggregate Demand II

41

Chapter Summary
1. IS-LM model

a theory of aggregate demand

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

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

IS curve: goods market equilibrium

LM curve: money market equilibrium

Chapter Summary
2. AD curve

shows relation between P and the IS-LM models

equilibrium Y.

negative slope because

P (M/P ) r I Y
expansionary fiscal policy shifts IS curve right,
raises income, and shifts AD curve right.
expansionary monetary policy shifts LM curve
right, raises income, and shifts AD curve right.
IS or LM shocks shift the AD curve.