12

Aggregate Demand II:

Applying the IS-LM Model

MACROECONOMICS
N. Gregory Mankiw
Fall 2013
PowerPoint Slides by Ron Cronovich
®
update
© 2014 Worth Publishers, all rights reserved
 Context

 Chapter 10 introduced the model of aggregate

demand and supply.
 Chapter 11 developed the IS-LM model,
the basis of the aggregate demand curve.

CHAPTER 12 Aggregate Demand II 2

 IN THIS CHAPTER, YOU WILL LEARN:

 how to use the IS-LM model to analyze the effects

of shocks, fiscal policy, and monetary policy
 how to derive the aggregate demand curve from
the IS-LM model
 several theories about what caused the
Great Depression

CHAPTER 12 Aggregate Demand II 3

 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.
M P  L (r ,Y ) IS
Y
Y1
The intersection determines
the unique combination of Y and r
that satisfies equilibrium in both markets.
CHAPTER 12 Aggregate Demand II 4
 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

CHAPTER 12 Aggregate Demand II 5

 An increase in government purchases
1. IS curve shifts right r
1
by G LM
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
CHAPTER 12 Aggregate Demand II 6
 A tax cut
Consumers save r
(1MPC) of the tax cut, LM
so the initial boost in
spending is smaller for T
than for an equal G…
r 2
2.
r1
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.
CHAPTER 12 Aggregate Demand II 7
 Monetary policy: An increase in M

r
1. M > 0 shifts LM1
the LM curve down
LM2
(or to the right)
r1
2. …causing the
interest rate to fall r2

3. …which increases IS
investment, causing Y
Y1 Y2
output & income to
rise.

CHAPTER 12 Aggregate Demand II 8

 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 interactions may alter the impact of the
original policy change.

CHAPTER 12 Aggregate Demand II 9

 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…

CHAPTER 12 Aggregate Demand II 10

 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

CHAPTER 12 Aggregate Demand II 11

 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

CHAPTER 12 Aggregate Demand II 12

 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

CHAPTER 12 Aggregate Demand II 13

 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

CHAPTER 12 Aggregate Demand II 14

 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 12 Aggregate Demand II 15

 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 12 Aggregate Demand II 16

 NOW YOU TRY
Analyze shocks with the IS-LM model
Use the IS-LM model to analyze the effects of
1. a housing market crash that reduces
consumers’ wealth
2. consumers using cash in transactions more
frequently in response to an increase in identity
theft
For each shock,
a. use the IS-LM diagram to determine the effects
on Y and r.
b. figure out what happens to C, I, and the
unemployment rate.
CHAPTER 12 Aggregate Demand II 17
 ANSWERS, PART 1
Housing market crash
IS shifts left, causing
r and Y to fall. r
LM1
C falls due to lower
wealth and lower r1
income,
r2
I rises because
r is lower IS1
IS2
u rises because Y
Y2 Y1
Y is lower
(Okun’s law)
CHAPTER 12 Aggregate Demand II 18
 ANSWERS, PART 2
Increase in money demand
LM shifts left, causing
LM2
r to rise and Y to fall. r
LM1
C falls due to lower r2
income, r1
I falls because
r is higher
IS1
u rises because
Y is lower Y
Y2 Y1
(Okun’s law)
CHAPTER 1 The Science of Macroeconomics 19
 CASE STUDY:
The U.S. recession of 2001
 During 2001:
 2.1 million jobs lost,
unemployment rose from 3.9% to 5.8%.
 GDP growth slowed to 0.8%
(compared to 3.9% average annual growth
during 1994–2000).

CHAPTER 12 Aggregate Demand II 20

 CASE STUDY:
The U.S. recession of 2001
Causes: 1) Stock market decline  C

1,500
Index (1942 = 100)

Standard & Poor’s

1,200 500

900

600

300
1995 1996 1997 1998 1999 2000 2001 2002 2003
CHAPTER 12 Aggregate Demand II 21
 CASE STUDY:
The U.S. recession of 2001
Causes: 2) 9/11
 increased uncertainty
 fall in consumer & business confidence
 result: lower spending, IS curve shifted left
Causes: 3) Corporate accounting scandals
 Enron, WorldCom, etc.
 reduced stock prices, discouraged investment

CHAPTER 12 Aggregate Demand II 22

 CASE STUDY:
The U.S. recession of 2001
Fiscal policy response: shifted IS curve right
 tax cuts in 2001 and 2003
 spending increases
 airline industry bailout
 NYC reconstruction
 Afghanistan war

CHAPTER 12 Aggregate Demand II 23

 01
/01

0
1
2
3
4
5
6
7

CHAPTER 12
/20
04 00
/02
/20
07 00
/ 03
/20
10 00
CASE STUDY:

/ 03
/20
01 00
/03
/20
04 01
/05
/ 20

Aggregate Demand II
07 01
/06
/20
10 01
/06
/2 0
01 01
/06
/ 20
04 02
/08
The U.S. recession of 2001

/20
T-Bill rate

07 02
/09
Three-month

/2 0
10 02
/ 09
/ 20
01 02
/09
/20
Monetary policy response: shifted LM curve right

04 03
/11
/20
03
24
 What is the Fed’s policy instrument?
 The news media commonly report the Fed’s policy
changes as interest rate changes, as if the Fed
has direct control over market interest rates.
 In fact, the Fed targets the federal funds rate—the
interest rate banks charge one another on
overnight loans.
 The Fed changes the money supply and shifts the
LM curve to achieve its target.
 Other short-term rates typically move with the
federal funds rate.
CHAPTER 12 Aggregate Demand II 25
 What is the Fed’s policy instrument?

Why does the Fed target interest rates instead of

the money supply?
1) They are easier to measure than the money
supply.
2) The Fed might believe that LM shocks are
more prevalent than IS shocks. If so, then
targeting the interest rate stabilizes income
better than targeting the money supply.
(See problem 7 on p.353.)

CHAPTER 12 Aggregate Demand II 26

 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
(introduced in Chap. 10) captures this
relationship between P and Y.

CHAPTER 12 Aggregate Demand II 27

 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

CHAPTER 12 Aggregate Demand II 28

 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

CHAPTER 12 Aggregate Demand II 29

 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

CHAPTER 12 Aggregate Demand II 30

 IS-LM and AD-AS
in the short run & long run
Recall from Chapter 10: 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

CHAPTER 12 Aggregate Demand II 31

 The SR and LR effects of an IS shock
r LRAS LM(P )
1
A negative IS shock
shifts IS and AD left,
causing Y to fall. IS1
IS2
Y Y
P LRAS
P1 SRAS1

AD1
AD2
Y Y
CHAPTER 12 Aggregate Demand II 32
 The SR and LR effects of an IS shock
r LRAS LM(P )
1

In the new short-run

equilibrium, Y  Y IS1
IS2
Y Y
P LRAS
P1 SRAS1

AD1
AD2
Y Y
CHAPTER 12 Aggregate Demand II 33
 The SR and LR effects of an IS shock
r LRAS LM(P )
1

In the new short-run

equilibrium, Y  Y IS1
IS2
Y Y
Over time, P gradually
falls, causing: P LRAS
• SRAS to move down P1 SRAS1
• M/P to increase,
which causes LM AD1
to move down AD2
Y Y
CHAPTER 12 Aggregate Demand II 34
 The SR and LR effects of an IS shock
r LRAS LM(P )
1
LM(P2)

IS1
IS2
Y Y
Over time, P gradually
falls, causing: P LRAS
• SRAS to move down P1 SRAS1
• M/P to increase, P2 SRAS2
which causes LM AD1
to move down AD2
Y Y
CHAPTER 12 Aggregate Demand II 35
 The SR and LR effects of an IS shock
r LRAS LM(P )
1
LM(P2)

This process continues IS1

until economy reaches a IS2
long-run equilibrium with Y Y
Y Y P LRAS
P1 SRAS1
P2 SRAS2
AD1
AD2
Y Y
CHAPTER 12 Aggregate Demand II 36
 NOW YOU TRY
Analyze SR & LR effects of M
a. Draw the IS-LM and AD-AS
r LRAS LM(M /P )
1 1
diagrams as shown here.
b. Suppose Fed increases M.
Show the short-run effects IS
on your graphs.
c. Show what happens in the Y Y
transition from the short run P LRAS
to the long run.
d. How do the new long-run SRAS1
P1
equilibrium values of the
endogenous variables
AD1
compare to their initial
values? Y Y
CHAPTER 1 The Science of Macroeconomics 37
 ANSWERS, PART 1
Short-run effects of M
r LRAS LM(M /P )
LM and AD shift right. 1 1

r1 LM(M2/P1)
r2
r falls, Y rises above Y
IS

Y Y2 Y
P LRAS

P1 SRAS
AD2
AD1
Y Y2 Y
CHAPTER 12 Aggregate Demand II 38
 ANSWERS, PART 2
Transition from short run to long run
r LRAS LM(M /P )
Over time, 1
2 1
3

 P rises r3 = r1 LM(M2/P1)
 SRAS moves upward r2
IS
 M/P falls
 LM moves leftward Y2 Y
Y
P LRAS
New long-run eq’m P3 SRAS
 P higher P1 SRAS
 all real variables back at
AD2
their initial values AD1
Money is neutral in the long run. Y Y2 Y
CHAPTER 12 Aggregate Demand II 39
 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

CHAPTER 12 Aggregate Demand II 40

 THE SPENDING HYPOTHESIS:
Shocks to the IS curve
 Asserts 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 12 Aggregate Demand II 41

 THE SPENDING HYPOTHESIS:
Reasons for the IS shift
 Stock market crash  exogenous C
 Oct 1929–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 12 Aggregate Demand II 42

 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 12 Aggregate Demand II 43

 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 12 Aggregate Demand II 44

 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 12 Aggregate Demand II 45
 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 12 Aggregate Demand II 46

 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 12 Aggregate Demand II 47
 Why another Depression is unlikely
 Policymakers (or their advisers) 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.
CHAPTER 12 Aggregate Demand II 48
 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
 subprime 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

CHAPTER 12 Aggregate Demand II 49

 Interest rates and house prices
Federal Funds rate
9 30-year mortgage rate
190
Case-Shiller 20-city composite house price index
8

170

House price index, 2000 = 100

7
interest rate (%)

6 150

5
130

4
110
3
90
2

70
1

0 50
2000 12
CHAPTER Aggregate
2001 Demand
2002 II 2003 2004 2005 50
 Change in U.S. house price index
and rate of new foreclosures, 1999–2009
14%
US house price index 1.4
12%
New foreclosures
10% 1.2
Percent change in house prices
(from 4 quarters earlier)

(% of total mortgages)
8%

New foreclosure starts

1.0
6%
0.8
4%

2% 0.6

0%
0.4
-2%
0.2
-4%

-6% 0.0
CHAPTER1999
12 Aggregate
2001 Demand
2003 II 2005 2007 2009 51
 House price change and new foreclosures,
2006:Q3–2009:Q1
20%

18%
Nevada Florida Illinois
16%
% of all mortgages

Ohio
New foreclosures,

14%
Michigan
California Georgia
12%
Arizona Colorado
10%

8%
Rhode Island
Texas
New Jersey
6%
Hawaii S. Dakota
4%
Oregon
2% Wyoming
Alaska
N. Dakota
0%
-35% -30% -25% -20% -15% -10% -5% 0% 5% 10% 15%
CHAPTER 12 AggregateCumulative
Demand IIchange in house price index 52
 U.S. bank failures by year, 2000–2011
160

140
Number of bank failures

120

100

80

60

40

20

0
2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011
CHAPTER 12 Aggregate Demand II 53
 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%

6/28/2007
12/6/1999

8/13/2000

4/21/2001

12/28/2001

9/5/2002

5/14/2003

1/20/2004

9/27/2004

6/5/2005

2/11/2006

10/20/2006

3/5/2008

7/20/2009
11/11/2008
CHAPTER 12 Aggregate Demand II 54
 Consumer sentiment and growth in consumer
durables and investment spending
1200%
110

Consumer Sentiment Index, 1966 = 100

% change from four quarters earlier

1000%
100

800%
90

600%
80

400%
70

Durables
200% 60
Investment
UM Consumer Sentiment Index
0% 50
1999
CHAPTER 12 2000 2001 2002
Aggregate 2003 II2004 2005 2006 2007 2008 2009
Demand 55
 Real GDP growth and unemployment
12
Real GDP growth rate (left scale) 10
10
Unemployment rate (right scale)
% change from 4 quarters earlier

8 8

% of labor force
6

4 6

2
4
0

-2
2
-4

-6 0
19 1219
CHAPTER 19 19 19 2Demand
Aggregate 0 20 20 II20 20 20 20 20 20 20 20 20 20 56
 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 12 Aggregate Demand II 57

 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 12 Aggregate Demand II 58