IS - LM

AGGREGATE DEMAND IN SHORT RUN

SESSION -12
LEARNING OBJECTIVE

AGGREGATE DEMAND FROM IS-LM

LIQUIDITY
KEYNESIAN CROSS
PREFERENCE

GOODS & SERVICE MKT REAL MONEY MKT

MONETARY & NON-

INVENTORY
MONETARY ASSETS
BRINGS
BRINGS
EQUILIBRIUM
EQUILIBRIUM

IS CURVE LM CURVE
LERNING OBJECTIVE

Business cycles and aggregate demand

the IS curve, and its the Keynesian cross

relation to the loanable funds model

the LM curve, and its the theory of liquidity

relation to preference

how the IS-LM model determines income and the

interest rate in the short run when P is fixed
STIMULUS TO DEMAND
 SHORT RUN

• In the following lectures, we will study the short-run fluctuations of the

economy (business cycles)
• We focus on three models:
• ISLM model Mudell-Fleming model Model AS-AD
• AD
• AS
 FACTS ABOUT THE BUSINESS CYCLE

• GDP growth averages 3–3.5 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.
• Okun’s Law: the negative relationship between GDP and
unemployment.
 GROWTH RATES OF REAL GDP, CONSUMPTION
Percent 10
change Real GDP
from 4 8
growth rate
quarters Consumption
earlier 6 growth rate

Average 4
growth
rate 2

-2

-4
1970 1975 1980 1985 1990 1995 2000 2005
 GROWTH RATES OF REAL GDP, CONSUMPTION, INVESTMENT

Percent 40
change Investment
from 4 30 growth rate
quarters
earlier 20
Real GDP
10 growth rate

0
Consumption
-10 growth rate

-20

-30
1970 1975 1980 1985 1990 1995 2000 2005
 UNEMPLOYMENT
Percent 12
of labor
force
10

0
1970 1975 1980 1985 1990 1995 2000 2005
 OKUN’S LAW

Percentage 10 Y
change in 1951 1966  3.5  2 u
real GDP 8
Y
1984
6
2003
4

2 1987

0 1975
2001
-2 1982
1991
-4
-3 -2 -1 0 1 2 3 4
Change in unemployment rate
TIME HORIZONS IN
MACROECONOMICS
• Long run:
Prices are flexible, respond to changes in supply or demand.
• Short run:
Many prices are “sticky” at some predetermined level.

The economy behaves much differently

when prices are sticky.
RECAP OF CLASSICAL MACRO
THEORY
• Output is determined by the supply side:
• supplies of capital, labor
• technology.

• Changes in demand for goods & services

(C, I, G ) only affect prices, not quantities.
• Assumes complete price flexibility.
• Applies to the long run.
WHEN PRICES ARE STICKY…

…output and employment also depend on demand, which is

affected by
• fiscal policy (G and T )
• monetary policy (M )
• other factors, like exogenous changes in
C or I.
 THE MODEL OF
AGGREGATE DEMAND AND SUPPLY

• the paradigm most mainstream economists

and policymakers use to think about economic fluctuations and policies to
stabilize the economy
• shows how the price level and aggregate output are determined
• shows how the economy’s behavior is different
in the short run and long run
 IS-LM
• This chapter develops the IS-LM model,
the basis of the aggregate demand curve.
• We focus on the short run and assume the price level is fixed.
• This lecture focuses on the closed-economy case.
• Next lecture presents the open-economy case.
 THE KEYNESIAN CROSS
• A simple closed economy model in which income is
determined by expenditure.
(due to J.M. Keynes)
• Notation:
I = planned investment
E = C + I + G = planned expenditure
Y = real GDP = actual expenditure

• Difference between actual & planned expenditure =

unplanned inventory investment
 ELEMENTS OF THE KEYNESIAN
CROSS function:
consumption C  C (Y  T )
govt policy variables: G  G , T T
for now, planned
investment is exogenous: I I

planned expenditure: E  C (Y  T )  I  G

equilibrium condition:
actual expenditure = planned expenditure
Y  E
GRAPHING PLANNED
EXPENDITURE
E

planned E = C + I +G
expenditure
MPC
1

income, output, Y
GRAPHING THE EQUILIBRIUM
CONDITION
E E =Y

planned

expenditure

45º

income, output, Y
THE EQUILIBRIUM VALUE OF
INCOME
E E =Y

planned E = C + I +G
expenditure

income, output, Y
Equilibrium
income
 AN INCREASE IN GOVERNMENT
PURCHASES
E Y

=
At Y1, E E =C +I +G2
there is now an
unplanned drop E =C +I +G1
in inventory…

G

…so firms
increase output,
and income rises Y
toward a new
equilibrium. E1 = Y 1 Y E2 = Y2
 SOLVING FOR Y
Y  C  I  G equilibrium condition

Y  C  I  G in changes

 C  G because I exogenous

 MPC  Y  G because C = MPC Y

Collect terms with Y on Solve for Y :

the left side of the equals
sign:  1 
Y     G
(1  MPC)  Y  G  1  MPC 
 THE GOVERNMENT PURCHASES
MULTIPLIER
Definition: the increase in income resulting from a $1
increase in G.
In this model, the govt Y 1

purchases multiplier equals G 1  MPC

Example: If MPC = 0.8, then

Y 1 An
An increase
increase in
in G
G
  5 causes
causes income
income to
to
G 1  0.8
increase
increase 55 times
times
as
as much!
much!
WHY THE MULTIPLIER IS GREATER THAN 1

• Initially, the increase in G causes an equal increase in Y:

Y = G.
• But Y  C
 further Y
 further C
 further Y
• So the final impact on income is much bigger than the initial
G.
 AN INCREASE IN TAXES
E Y

=
Initially, the tax E E =C1 +I +G
increase reduces
consumption, and E =C2 +I +G
therefore E:

C = MPC T At Y1, there is now an

unplanned
…so firms reduce inventory buildup…
output, and
income falls Y
toward a new E2 = Y 2 Y E1 = Y 1
equilibrium
 SOLVING FOR Y
eq’m condition in
Y  C  I  G
changes
 C I and G exogenous

 MPC   Y  T 
Solving for Y : (1  MPC)  Y   MPC  T

  MPC 
Final result: Y     T
 1  MPC 
 THE TAX MULTIPLIER
def: the change in income resulting from
a $1 increase in T :
Y  MPC

T 1  MPC

If MPC = 0.8, then the tax multiplier equals

Y  0.8  0.8
   4
T 1  0.8 0.2
 THE TAX MULTIPLIER

…is negative:
A tax increase reduces C,
which reduces income.
…is greater than one
(in absolute value):
A change in taxes has a
multiplier effect on income.
…is smaller than the govt spending multiplier:
Consumers save the fraction (1 – MPC) of a tax cut,
so the initial boost in spending from a tax cut is
smaller than from an equal increase in G.
 THE IS CURVE

def: a graph of all combinations of r and Y that result in

goods market equilibrium
i.e. actual expenditure (output)
= planned expenditure

The equation for the IS curve is:

Y  C (Y  T )  I (r )  G
 DERIVING THE IS CURVE
E E =Y E =C +I (r )+G
2

r  I E =C +I (r1 )+G

 E I

 Y Y1 Y2 Y
r
r1

r2
IS
Y1 Y2 Y
WHY THE IS CURVE IS
NEGATIVELY SLOPED
• A fall in the interest rate motivates firms to increase
investment spending, which drives up total planned
spending (E ).
• To restore equilibrium in the goods market, output (a.k.a.
actual expenditure, Y )
must increase.
 THE IS CURVE AND THE
LOANABLE FUNDS MODEL
(a) The L.F. model (b) The IS curve

r S2 S1 r

r2 r2

r1 r1
I (r )
IS
S, I Y2 Y1 Y
FISCAL POLICY AND THE IS
CURVE
• We can use the IS-LM model to see
how fiscal policy (G and T ) affects
aggregate demand and output.
• Let’s start by using the Keynesian cross
to see how fiscal policy shifts the IS curve…
 SHIFTING THE IS CURVE: G
E E =Y E =C +I (r )+G
At any value of r, G 1 2

 E  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 Y
Y  G IS2
1 MPC IS1
Y1 Y2 Y
THE THEORY OF LIQUIDITY
PREFERENCE
• Due to John Maynard Keynes.
• A simple theory in which the interest rate
is determined by money supply and
money demand.
 MONEY SUPPLY
r
M P
s
The supply of interest
rate
real money
balances
is fixed:
M P M P
s

M/P
M P
real money
balances
 MONEY DEMAND
r
M P
s
Demand for interest
rate
real money
balances:
 M P   L (r )
d

L (r )

M/P
M P
real money
balances
 EQUILIBRIUM
r
M P
s
The interest rate interest
adjusts rate
to equate the
supply and
demand for
r1
money:
M P  L (r ) L (r )

M/P
M P
real money
balances
 HOW THE FED RAISES THE
INTEREST RATEr
interest
To increase r, Fed rate
reduces M
r2

r1
L (r )

M/P
M2 M1
real money
P P balances
 CASE STUDY:
MONETARY TIGHTENING & INTEREST
RATES
• Late 1970s:  > 10%
• Oct 1979: Fed Chairman Paul Volcker announces that monetary
policy
would aim to reduce inflation
• Aug 1979-April 1980:
Fed reduces M/P 8.0%

• Jan 1983:  = 3.7%

How
How do
do you
you think
think this
this policy
policy change
change
would
would affect
affect nominal
nominal interest
interest rates?
rates?
 MONETARY TIGHTENING & RATES,
CONT.
The effects of a monetary tightening
on nominal interest rates

short run long run

Quantity theory,
Liquidity preference
model Fisher effect
(Keynesian)
(Classical)

prices sticky flexible

prediction i > 0 i < 0

actual 8/1979: i = 10.4% 8/1979: i = 10.4%

outcome 4/1980: i = 15.8% 1/1983: i = 8.2%
 THE LM CURVE

Now let’s put Y back into the money demand function:

M P
d
 L (r ,Y )

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 )
 DERIVING THE LM CURVE
(a) The market for
(b) The LM curve
real money balances
r r
LM

r2 r2

L (r , Y2 )
r1 r1
L (r , Y1 )
M1 M/P Y1 Y2 Y
P
WHY THE LM CURVE IS UPWARD
SLOPING

• An increase in income raises money demand.

• Since the supply of real balances is fixed, there is now
excess demand in the money market at the initial interest
rate.
• The interest rate must rise to restore equilibrium in the
money market.
 HOW M 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 , Y1 )

M2 M1 M/P Y1 Y
P P
 POLICY ANALYSIS WITH THE IS -LM
Y  C (MODEL
Y  T )  I (r )  G r
LM
M P  L (r ,Y )

We can use the IS-LM model

to analyze the effects of r1

• 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
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 G
1 MPC
 A TAX CUT

Consumers save r
(1MPC) of the tax cut, LM
so the initial boost in
spending is smaller for T r2
than for an equal G… 2.
r1
and the IS curve shifts by
1. IS2
MPC
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

1. M > 0 shifts r
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 FED’S 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:
 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
Y  Y 2  Y1 Y
Y1 Y2
r  r 2  r1
 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
Y  Y 3  Y1 Y
Y1 Y2 Y3

r  0
 RESPONSE 3: HOLD Y CONSTANT

If Congress raises G, r LM2

the IS curve shifts right. LM1

r3
To keep Y constant,
r2
Fed reduces M r1
to shift LM curve left.
IS2
Results: IS1
Y  0 Y
Y1 Y2
r  r 3  r1
 ESTIMATES OF FISCAL POLICY
MULTIPLIERS
from the DRI macroeconometric model

Estimated Estimated
Assumption about value of value of
monetary policy Y / G Y / T

Fed holds money

0.60 0.26
supply constant
Fed holds nominal
1.93 1.19
interest rate constant
 IS-LM AND AGGREGATE
• So far, DEMAND
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
(introduced in Chap. 9) 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
P2
 I
P1
 Y
AD
Y2 Y1 Y
 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
 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
 IS-LM AND AD-AS
IN THE SHORT RUN & LONG RUN
Recall from Chapter 9: 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
 THE BIG PICTURE

Keynesian
Keynesian IS
IS
Cross
Cross curve
curve
IS-LM
IS-LM
model Explanation
Explanation
Theory
Theory of
of model
LM
LM of
of short-run
short-run
Liquidity
Liquidity curve fluctuations
curve fluctuations
Preference
Preference
Agg.
Agg.
demand
demand
curve
curve Model
Model of
of
Agg.
Agg.
Demand
Demand
Agg.
Agg. and
and Agg.
Agg.
supply
supply Supply
Supply
curve
curve
 CHAPTER SUMMARY
1. Keynesian cross
• basic model of income determination
• takes fiscal policy & investment as exogenous
• fiscal policy has a multiplier effect on income.
2. IS curve
• comes from Keynesian cross when planned investment
depends negatively on interest rate
• shows all combinations of r and Y
that equate planned expenditure with
actual expenditure on goods & services
CHAPTER 10 Aggregate Demand I slide 63
 CHAPTER SUMMARY
3. Theory of Liquidity Preference
• basic model of interest rate determination
• takes money supply & price level as exogenous
• an increase in the money supply lowers the interest rate
4. LM curve
• comes from liquidity preference theory when
money demand depends positively on income
• shows all combinations of r and Y that equate demand
for real money balances with supply

CHAPTER 10 Aggregate Demand I slide 64

 CHAPTER SUMMARY
5. IS-LM model
• Intersection of IS and LM curves shows the unique point
(Y, r ) that satisfies equilibrium in both the goods and
money markets.

CHAPTER 10 Aggregate Demand I slide 65

 CHAPTER 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.
CHAPTER 11 Aggregate Demand II slide 66
APPENDIX: The Great Depression
 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 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
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 
 THE MONEY HYPOTHESIS AGAIN:
THE EFFECTS OF FALLING
• The destabilizing
PRICES 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