CHAPTER

Aggregate Demand II:

Applying the IS -LM Model

MACROECONOMICS
N. GREGORY MANKIW
IS – LM and Aggregate Demand

slide 2
 IS-LM and aggregate demand
 So far, we’ve 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.

slide 3
 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
P2
 I
P1
 Y AD
Y2 Y1 Y

slide 4
 Monetary policy and the AD curve
r LM(M1/P1)
The Fed can increase LM(M2/P1)
aggregate demand: r1
r2
M  LM shifts right
IS
 r Y1 Y2 Y
P
 I
 Y at each P1
value of P
AD2
AD1
Y1 Y2 Y

slide 5
 Fiscal policy and the AD curve
r LM
Expansionary fiscal
policy (G and/or T ) r2
increases agg. demand: r1 IS2
T  C IS1
Y1 Y2 Y
 IS shifts right P
 Y at each
P1
value of P
AD2
AD1
Y1 Y2 Y

slide 6
 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 fall)
Y Y Fall ( Y rise)

Y Y remain constant

slide 7
 The SR and LR effects of an IS shock
r LRAS LM(P )
1
A
A negative
negative ISIS 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
slide 8
 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, Y  Y
equilibrium, IS1
IS2
Y Y
P LRAS
P1 SRAS1

AD1
AD2
Y Y
slide 9
 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, Y  Y
equilibrium, IS1
IS2
Y Y
Over
Over time,
time, P
P gradually
gradually
falls,
falls, which
which causes
causes P LRAS

•• SRAS
SRAS toto move
move down.
down. P1 SRAS1

•• M/P
M/P to
to increase,
increase,
which
which causes
causes LM
LM AD1
to AD2
to move
move down.
down.
Y Y
slide 10
 The SR and LR effects of an IS shock
r LRAS LM(P )
1
LM(P2)

IS1
IS2
Y Y
Over
Over time,
time, P
P gradually
gradually
falls,
falls, which
which causes
causes P LRAS

•• SRAS
SRAS toto move
move down.
down. P1 SRAS1

•• M/P
M/P to
to increase,
increase, P2 SRAS2
which
which causes
causes LM
LM AD1
to AD2
to move
move down.
down.
Y Y
slide 11
 The SR and LR effects of an IS shock
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
slide 12
 IS – LM 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

slide 13
 IS-LM Summary

2. AD curve
 shows relation between P and the IS-LM model’s
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.
slide 14