N. Gregory Mankiw: Macroeconomics

SEVENTH EDITIO
MACROECONOMICS
N. Gregory Mankiw
PowerPoint Slides by Ron Cronovich
CHAPT
ER
Applying the IS-LM Model
2010 Worth Publishers, all rights reserved

Equilibrium in the IS -LM model
The IS curve represents r

equilibrium in the goods LM
market.
Y C (Y T ) I (r ) G
r1
The LM curve represents
money market equilibrium.
IS
M P L(r ,Y )
Y
Y1
The intersection determines
the unique combination of Y and r
that satisfies equilibrium in both markets.
CHAPTER 11 Aggregate Demand II 2

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

An increase in government
purchases
1. IS curve shifts right r
1 LM
by G
1 MPC
causing output & r2
income to rise. 2.
r1
2. This raises money
demand, causing the 1. IS2
interest rate to rise IS1
3. which reduces investment, Y
Y1 Y2
so the final increase in Y
3.
1
is smaller than G
1 MPC
A tax cut
Consumers save r
(1MPC) of the tax cut, LM
so the initial boost in
spending is smaller for T
than for an equal G r
2.
r21
and the IS curve shifts by
MPC 1. IS2
1. T IS1
1 MPC
Y
Y1 Y2
2. so the effects on r
2.
and Y are smaller for T
than for an equal G.
Monetary policy: An increase
in M
r
1. M > 0 shifts LM1
the LM curve down
(or to the right) LM2
r1
2. causing the
interest rate to fall r2
3. which increases IS
investment, causing Y
Y1 Y2
output & income to
rise.

Interaction between
monetary & fiscal policy
Model:
Monetary & fiscal policy variables
(M, G, and T ) are exogenous.
Real world:
Monetary policymakers may adjust M
in response to changes in fiscal policy,
or vice versa.
Such interaction may alter the impact of the
original policy change.

The Central Banks response to G
>0
Suppose there is an increase in G.

Possible RBI responses:
1. hold M constant
2. hold r constant
3. hold Y constant
In each case, the effects of the G
are different

Response 1: Hold M constant
Rise in G: r
the IS curve shifts right. LM
1
If RBI holds M constant,

r2
then LM curve doesnt r1
shift.
IS2
Results:
IS1
Y Y2 Y1 Y
Y1 Y2
r r2 r1

Response 2: Hold r constant
Rise in G, r
the IS curve shifts right. LM
1 LM
To keep r constant, 2
r2
RBI increases M r1
to shift LM curve right.
IS2
Results: IS1
Y Y3 Y1 Y
Y1 Y2 Y3
r 0

Response 3: Hold Y constant
Rise in G, r LM
the IS curve shifts right. 2 LM
1
To keep Y constant, r3
r2
RBI reduces M r1
to shift LM curve left.
IS2
Results: IS1
Y 0 Y
Y1 Y2
r r3 r1

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

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.

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.

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

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

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

The SR and LR effects of an IS shock
r LRAS LM(P )
1
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. IS1
IS2
Y Y
P LRAS
P1 SRAS1
AD1
AD2
Y Y
r LRAS LM(P )
1
In
In the
the new
new short-run
short-run
equilibrium, Y Y
equilibrium, IS1
IS2
Y Y
P LRAS
P1 SRAS1
AD1
AD2
Y Y
r LRAS LM(P )
1
In
In the
the new
new short-run
short-run
equilibrium, Y Y
equilibrium, IS1
IS2
Y Y
Over
Over time,
time, P P gradually
gradually
falls,
falls, causing
causing P LRAS
SRAS
SRAS to to move
move down
down P1 SRAS1
M/P
M/P toto increase,
increase,
which
which causes
causes LMLM AD1
to
to move
move down
down AD2
Y Y
r LRAS LM(P )
1
LM(P2)
IS1
IS2
Y Y
Over
Over time,
time, P P gradually
gradually
falls,
falls, causing
causing P LRAS
SRAS
SRAS to to move
move down
down P1 SRAS1
M/P
M/P toto increase,
increase, P2 SRAS2
which
which causes
causes LMLM AD1
to
to move
move down
down AD2
Y Y
r LRAS LM(P )
1
LM(P2)
This
This process
process continues
continues IS1
until
until economy
economy reaches
reaches aa IS2
long-run
long-run equilibrium
equilibrium with
with Y
Y
Y Y P LRAS
P1 SRAS1
P2 SRAS2
AD1
AD2
Y Y
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

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.

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.

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.

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?

The stabilizing effects of deflation:
P (M/P ) LM shifts right Y
Pigou effect:
P (M/P )
consumers wealth
C
IS shifts right
Y

The destabilizing effects of expected deflation:
E
r for each value of i
I because I = I (r )
planned expenditure & agg. demand
income & output

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

Why another Depression is
unlikely
Policymakers (or their advisors) now know
much more about macroeconomics:
The Fed knows better than to let M fall
so much, especially during a contraction.
Fiscal policymakers know better than to raise
taxes or cut spending during a contraction.
Federal deposit insurance makes widespread
bank failures very unlikely.
Automatic stabilizers make fiscal policy
expansionary during an economic downturn.

CASE STUDY
The 2008-09 Financial Crisis &
Recession
2009: Real GDP fell, u-rate approached 10%
Important factors in the crisis:
early 2000s Federal Reserve interest rate policy
sub-prime mortgage crisis
bursting of house price bubble,
rising foreclosure rates
falling stock prices
failing financial institutions
declining consumer confidence, drop in spending
on consumer durables and investment goods

Interest rates and house prices
Federal Funds rate

30-year mortgage rate
Case-Shiller 20-city composite house price index
House price index, 2000=100
interest rate (%)
CHAPTER 1 The Science of Macroeconomics 33

Change in U.S. house price index
and rate of new foreclosures, 1999-2009
US house price index

New foreclosures
Percent change in house prices (from 4 quarters earlier)

House price change and new
foreclosures, 2006:Q3 2009Q1
20%
18% Nevada
Florida Illinois
16%
Michigan Ohio
% of all mortgages
New foreclosures,
14%
California Georgia
12%
Arizona Colorado
10%
Rhode Island
8% Texas
New Jersey
6%
Hawaii S. Dakota
4%
Oregon
Wyoming
2% Alaska
N. Dakota
0%
-35% -30% -25% -20% -15% -10% -5% 0% 5% 10% 15%
CHAPTER 1 Cumulative
The Science change in house price index
of Macroeconomics 35
U.S. bank failures by year, 2000-2009
70
60
Number of bank failures
50
40
30
20
10
0
2000 2001 2002 2003 2004 2005 2006 2007 2008 2009*
* as of July 24, 2009.

Major U.S. stock indexes
(% change from 52 weeks earlier)
140%
DJIA
120%
S&P 500
100%
NASDAQ
80%
60%
40%
20%
0%
-20%
-40%
-60%
-80%
8/13/2000 12/28/2001 5/14/2003 9/27/2004 2/11/2006 6/28/2007 11/11/2008
12/6/1999 4/21/2001 9/5/2002 1/20/2004 6/5/2005 10/20/2006 3/5/2008 7/20/2009

Consumer sentiment and growth in
consumer durables and investment
spending
% change from four quarters earlier Consumer Sentiment Index, 1966=100
Durables
The Science of Macroeconomics

Investment
CHAPTER 1 UM Consumer Sentiment Index 38

Real GDP growth and Unemployment
Real GDP growth rate (left scale)

Unemployment rate (right scale)
% change from 4 quaters

% of
earlier
labor force

Disinflation, Deflation,
and the Liquidity Trap
Figure
The Return of Output to
Its Natural Level
Low output leads to a
decrease in the price level.
The decrease in the price
level leads to an increase in
the real money stock. The LM
curve shifts down and
continues to shift down until
output has returned to the
natural level of output.

Output is now below the natural level of output due to
an adverse shock.
Because output is below the natural level of output,

price levels decrease over time.
So long as output remains below its natural level, the

price level continues to fall, and the LM curve
continues to shift down.

The Nominal Interest Rate, the Real Interest Rate,
and Expected Inflation
Recall that:
What matters for spending decisions, and thus what

enters the IS relation, is the real interest ratethe
interest rate in terms of goods.
Chapter 22: Depressions and Slumps
What matters for the demand for money, and thus

enters the LM relation, is the nominal interest rate
the interest rate in terms of dollars.
Copyright 2009 Pearson Education, Inc. Publishing as Prentice Hall Macroeconomics, 5/e Olivier Blanchard
The Nominal Interest Rate, the Real Interest Rate,
and Expected Inflation
Figure
The Effects of Lower
Inflation on Output
When inflation decreases in
response to low output, there
are two effects: (1) The real
money stock increases,
leading the LM curve to shift
down, and (2) expected

inflation decreases, leading
the IS curve to shift to the left.
The result may be a further
decrease in output.
The Liquidity Trap
Figure
Money Demand, Money
Supply, and the Liquidity
Trap
When the nominal interest
rate is equal to zero, and once
people have enough money
for transaction purposes, they
become indifferent between
holding money and holding

bonds. The demand for
money becomes horizontal.
This implies that, when the
nominal interest rate is equal
to zero, further increases in
the money supply have no
effect on the nominal interest
rate.
The Liquidity Trap
Now consider the effects of an increase in the money

supply:
Starting from the equilibrium of Ms and i at point A, an

increase in the money supply leads to a decrease in the
nominal interest rate.
Now consider the case where the money supply is at

point B or C. In either case, the initial nominal interest
rate is zero, and an increase in the money supply has
no effect on the nominal interest rate at this point.
The Liquidity Trap
The liquidity trap describes a situation in which

expansionary monetary policy becomes powerless.
The increase in money falls into a liquidity trap: People
are willing to hold more money (more liquidity) at the
same nominal interest rate.
The central bank can increase liquidity but the

additional money is willingly held by financial investors

at an unchanged interest rate, namely, zero.
The Liquidity Trap
Figure For low levels of output, the LM curve is a flat segment, with a nominal
The Derivation of the LM interest rate equal to zero. For higher levels of output, it is upward
Curve in the Presence of sloping: An increase in income leads to an increase in the nominal
a Liquidity Trap interest rate.
The Liquidity Trap
The equilibrium is given by point A in Figure, with
nominal interest rate equal to zero.
The intersection between the money supply curve and
the money demand curve takes place on the horizontal
portion of the money demand curve. The equilibrium
remains at A, and the nominal interest rate remains
equal to zero.
The Liquidity Trap
Figure
The ISLM Model and
the Liquidity Trap
In the presence of a liquidity
trap, there is a limit to how
much monetary policy can
increase output. Monetary
policy may not be able to
increase output back to its
natural level.
Putting Things Together: The Liquidity
Trap and Deflation
The value of the real interest rate corresponding to a zero
nominal interest rate depends on the rate of expected inflation.
For example, if expected inflation is 10%, then:
At a negative real interest rate of 10%, consumption and
investment are likely to be very high. The liquidity trap is unlikely to
be a problem when inflation is high.
r i e
0% 10% 10%
If a country is in a recession, and the rate of inflation is negative,

say 5%, then even if the nominal interest rate is zero, the real
interest rate remains positive.
r i e
0% (5% ) 5%
In this situation, there is nothing monetary policy can do to bring output
above the natural level of output.
Putting Things Together: The Liquidity
Trap and Deflation
Figure
The Liquidity Trap and
Deflation
Suppose the economy is in a
liquidity trap, and there is
deflation. Output below the
natural level of output leads to
more deflation over time, which
leads to a further increase in the
real interest rate, and leads to a

further shift of the IS curve to the
left. This shift leads to a further
decrease in output, which leads
to more deflation, and so on.
In words: The economy caught in a vicious cycle: Low output leads to more
deflation. More deflation leads to a higher real interest rate and even lower
output, and there is nothing monetary policy can do about it.
The Japanese Slump
The robust growth that Japan had experienced since the

end of World War II came to an end in the early 1990s.
Since 1992, the economy has suffered from a long period

of low growthwhat is called the Japanese slump.
Low growth has led to a steady increase in unemployment,

and a steady decrease in the inflation rate over time.
The Japanese Slump
Figure
The Japanese Slump:
Output Growth since
1990 (percent)
From 1992 to 2002, average

GDP growth in Japan was
less than 1%.
The Japanese Slump
Figure
Unemployment and
Inflation in Japan since
1990 (percent)
Low growth in output has
led to an increase in
unemployment. Inflation has
turned into deflation.
The Japanese Slump
Table GDP, Consumption, and Investment Growth, Japan, 1988-1993

Year GDP (%) Consumption (%) Investment (%)
1988 6.5 5.1 15.5
1989 5.3 4.7 15.0
1990 5.2 4.6 10.1
1991 3.4 2.9 4.3
1992 1.0 2.6 7.1

1993 0.2 1.4 10.3

The numbers in Table 22-4 raise an obvious set of questions:
What triggered Japans slump? Why did it last so long? Were
monetary and fiscal policies misused, or did they fail? What are the
factors behind the current recovery?
The Japanese Slump
The Rise and Fall of the Nikkei
There are two reasons for the increase in a stock price:
A change in the fundamental value of the stock

price, which depends on the expected present value
of future dividends.
A speculative bubble: Investors buy at a higher

price simply because they expect the price to go

even higher in the future.
The Japanese Slump
Figure
Stock Prices and
Dividends in Japan
since 1980
The increase in stock prices
in the 1980s and the
subsequent decrease were
not associated with a
parallel movement in
dividends.
22-3 The Japanese Slump
The fact that dividends remained flat while stock prices

increased strongly suggests that a large bubble existed in
the Nikkei.
The rapid fall in stock prices had a major impact on

spendingconsumption was less affected, but investment
collapsed.
The Japanese Slump
The Failure of Monetary and Fiscal Policy
Figure
The Nominal Interest
Rate and the Real
Interest Rate in Japan
since 1990
Japan has been in a liquidity
trap since the mid-1990s:
The nominal interest rate
has been close to zero, and
the inflation rate has been

negative. Even at a zero
nominal interest rate, the
real interest rate has been
positive.
The Japanese Slump
Monetary policy was used, but it was used too late,

and when it was used, if faced the twin problems of
the liquidity trap and deflation.
The Bank of Japan (BoJ) cut the nominal interest rate,

but it did so slowly, and the cumulative effect of low
growth was such that inflation had turned to deflation.
As a result, the real interest rate was higher than the

nominal interest rate.
The Japanese Slump
Fiscal policy was used as well. Taxes decreased at

the start of the slump, and there was a steady
increase in government spending throughout the
decade.
Fiscal policy helped, but it was not enough to increase

spending and output.
The Japanese Slump
Figure
Government Spending
and Revenues (as a
percentage of GDP) in
Japan since 1990
Government spending
increased and government
revenues decreased
steadily throughout the
1990s, leading to steadily

larger deficits.

N. Gregory Mankiw: Macroeconomics

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SEVENTH EDITIO

Applying the IS-LM Model

2010 Worth Publishers, all rights reserved

The IS curve represents r

CHAPTER 11 Aggregate Demand II 2

We can use the IS-LM

CHAPTER 11 Aggregate Demand II 3

CHAPTER 11 Aggregate Demand II 6

CHAPTER 11 Aggregate Demand II 7

Suppose there is an increase in G.

CHAPTER 11 Aggregate Demand II 8

If RBI holds M constant,

CHAPTER 11 Aggregate Demand II 9

CHAPTER 11 Aggregate Demand II 10

CHAPTER 11 Aggregate Demand II 11

IS shocks: exogenous changes in the

CHAPTER 11 Aggregate Demand II 12

LM shocks: exogenous changes in the

CHAPTER 11 Aggregate Demand II 13

So far, weve been using the IS-LM model to

CHAPTER 11 Aggregate Demand II 14

CHAPTER 11 Aggregate Demand II 15

CHAPTER 11 Aggregate Demand II 16

CHAPTER 11 Aggregate Demand II 17

percent of labor force

140 Real GNP 5

CHAPTER 11 Aggregate Demand II 23

CHAPTER 11 Aggregate Demand II 24

CHAPTER 11 Aggregate Demand II 25

CHAPTER 11 Aggregate Demand II 26

CHAPTER 11 Aggregate Demand II 27

CHAPTER 11 Aggregate Demand II 28

CHAPTER 11 Aggregate Demand II 29

CHAPTER 11 Aggregate Demand II 30

CHAPTER 11 Aggregate Demand II 31

CHAPTER 11 Aggregate Demand II 32

Federal Funds rate

House price index, 2000=100

interest rate (%)

CHAPTER 1 The Science of Macroeconomics 33

US house price index

Percent change in house prices (from 4 quarters earlier)

CHAPTER 1 The Science of Macroeconomics 34

* as of July 24, 2009.

CHAPTER 1 The Science of Macroeconomics 37

% change from four quarters earlier Consumer Sentiment Index, 1966=100

The Science of Macroeconomics

CHAPTER 1 UM Consumer Sentiment Index 38

Real GDP growth rate (left scale)

% change from 4 quaters

CHAPTER 1 The Science of Macroeconomics 39

CHAPTER 11 Aggregate Demand II 40

Because output is below the natural level of output,

So long as output remains below its natural level, the

CHAPTER 11 Aggregate Demand II 41

What matters for spending decisions, and thus what

What matters for the demand for money, and thus

down, and (2) expected

holding money and holding

Now consider the effects of an increase in the money

Starting from the equilibrium of Ms and i at point A, an

Now consider the case where the money supply is at

The liquidity trap describes a situation in which