10/14/2013

Equilibrium in the IS -LM model

The IS curve represents r

LM
Chapter 11: equilibrium in the goods
market.
Aggregate Demand II, Y  C (Y  T )  I (r )  G
Applying the IS-LM Model r1
The LM curve represents
Th t
money market equilibrium.
M P  L (r ,Y ) IS
Y
The intersection determines Y1
the unique combination of Y and r
that satisfies equilibrium in both markets.

CHAPTER 11 Aggregate Demand II 0 CHAPTER 11 Aggregate Demand II 1

Policy analysis with the IS -LM model An increase in government purchases

Y  C (Y  T )  I (r )  G r 1. IS curve shifts right r

LM 1 LM
by G
M P  L (r ,Y ) 1 MPC
causing output & r2
We can use the IS-LM income to rise. 2.
model to analyze the r1 r1
2 Thi
2. This raises
i money
effects of
demand, causing the 1. IS2
• fiscal policy: G and/or T IS interest rate to rise… IS1
• monetary policy: M Y 3. …which reduces investment, Y
Y1 Y1 Y2
so the final increase in Y
3.
1
is smaller than G
1 MPC
CHAPTER 11 Aggregate Demand II 2 CHAPTER 11 Aggregate Demand II 3

A tax cut Monetary policy: An increase in M

Consumers save r r
(1MPC) of the tax cut, 1. M > 0 shifts LM1
LM
so the initial boost in the LM curve down
LM2
spending is smaller for T (or to the right)
than for an equal G… r2
2. 2. …causing the r1
r1
andd th
the IS curve shifts
hift by
b interest rate to fall r2
MPC 1. IS2
1. T IS1 IS
1 MPC 3. …which increases
Y investment, causing Y
Y1 Y2 Y1 Y2
2. …so the effects on r output & income to
2.
and Y are smaller for T rise.
than for an equal G.
CHAPTER 11 Aggregate Demand II 4 CHAPTER 11 Aggregate Demand II 5

1
 10/14/2013

Interaction between The Fed’s response to G > 0

monetary & fiscal policy
 Model:  Suppose Congress increases G.
Monetary & fiscal policy variables  Possible Fed responses:
(M, G, and T ) are exogenous.
1. hold M constant
 Real world: 2. hold r constant
Monetary policymakers may adjust M 3. hold Y constant
in response to changes in fiscal policy,
or vice versa.
 In each case, the effects of the G
are different…
 Such interaction may alter the impact of the
original policy change.

CHAPTER 11 Aggregate Demand II 6 CHAPTER 11 Aggregate Demand II 7

Response 1: Hold M constant Response 2: Hold r constant

If Congress raises G, r If Congress raises G, r

the IS curve shifts right. LM1 the IS curve shifts right. LM1
LM2
If Fed holds M constant, To keep r constant,
r2 r2
then LM curve doesn’t Fed increases M
r1 r1
shift. to shift LM curve right.
IS2 IS2
Results: Results:
IS1 IS1
Y  Y 2  Y1 Y Y  Y 3  Y1 Y
Y1 Y2 Y1 Y2 Y3
r  r2  r1 r  0

CHAPTER 11 Aggregate Demand II 8 CHAPTER 11 Aggregate Demand II 9

Response 3: Hold Y constant Estimates of fiscal policy multipliers

from the DRI macroeconometric model
If Congress raises G, r LM2
the IS curve shifts right. LM1
Estimated Estimated
r3 Assumption about value of value of
To keep Y constant,
r2 monetary policy Y/ G Y/ T
Fed reduces M
r1
to shift LM curve left. Fed holds money
IS2 0.60 0.26
supply constant
Results: IS1
Y  0 Y Fed holds nominal
Y1 Y2 1.93 1.19
interest rate constant
r  r3  r1

CHAPTER 11 Aggregate Demand II 10 CHAPTER 11 Aggregate Demand II 11

2
 10/14/2013

Shocks in the IS -LM model Shocks in the IS -LM model

IS shocks: exogenous changes in the LM shocks: exogenous changes in the

demand for goods & services. demand for money.
Examples: Examples:
 stock market boom or crash  a wave of credit card fraud increases
 change in households’ wealth demand for money.
 C  more ATMs or the Internet reduce money
 change in business or consumer demand.
confidence or expectations
 I and/or C

CHAPTER 11 Aggregate Demand II 12 CHAPTER 11 Aggregate Demand II 13

NOW YOU TRY: CASE STUDY:

Analyze shocks with the IS-LM Model The U.S. recession of 2001
 During 2001,
Use the IS-LM model to analyze the effects of
 2.1 million jobs lost,
1. a boom in the stock market that makes
unemployment rose from 3.9% to 5.8%.
consumers wealthier.
2. after a wave of credit card fraud, consumers using  GDP growth slowed to 0.8%
cashh more ffrequently
tl iin ttransactions.
ti (compared to 3
3.9%
9% average annual growth
during 1994-2000).
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.
CHAPTER 11 Aggregate Demand II 15

CASE STUDY: CASE STUDY:

The U.S. recession of 2001 The U.S. recession of 2001
Causes: 2) 9/11
Causes: 1) Stock market decline  C
 increased uncertainty
1500
 fall in consumer & business confidence
 result: lower spending, IS curve shifted left
Index (1942 = 100)

Standard & Poor’s

1200 500
Causes: 3) Corporate accounting scandals
900  Enron, WorldCom, etc.
 reduced stock prices, discouraged investment
600

300
1995 1996 1997 1998 1999 2000 2001 2002 2003
CHAPTER 11 Aggregate Demand II 16 CHAPTER 11 Aggregate Demand II 17

3
 10/14/2013

CASE STUDY: CASE STUDY:

The U.S. recession of 2001 The U.S. recession of 2001
 Fiscal policy response: shifted IS curve right  Monetary policy response: shifted LM curve right
 tax cuts in 2001 and 2003 7
Three-month
 spending increases 6
T-Bill Rate
5
 airline industry bailout 4
 NYC reconstruction 3
 Afghanistan war 2
1
0

CHAPTER 11 Aggregate Demand II 18 CHAPTER 11 Aggregate Demand II 19

What is the Fed’s policy instrument? What is the Fed’s policy instrument?
 The news media commonly report the Fed’s policy Why does the Fed target interest rates instead of
changes as interest rate changes, as if the Fed the money supply?
has direct control over market interest rates.
1) They are easier to measure than the money
 In fact, the Fed targets the federal funds rate – supply.
th iinterest
the t t rate
t banks
b k charge
h one another
th on
2) The Fed might believe that LM shocks are
overnight loans.
more prevalent than IS shocks. If so, then
 The Fed changes the money supply and shifts the targeting the interest rate stabilizes income
LM curve to achieve its target. better than targeting the money supply.
(See end-of-chapter Problem 7 on p.337.)
 Other short-term rates typically move with the
federal funds rate.
CHAPTER 11 Aggregate Demand II 20 CHAPTER 11 Aggregate Demand II 21

IS-LM and aggregate demand Deriving the AD curve

r
 So far, we’ve been using the IS-LM model to Intuition for slope
LM(P2)
LM(P1)
analyze the short run, when the price level is r2
of AD curve:
assumed fixed. r1
P  (M/P )
 However, a change in P would shift LM and  LM shifts left
IS

therefore affect Y. Y2 Y1 Y
P
 r
 The aggregate demand curve P2
 I
(introduced in Chap. 9) captures this P1
relationship between P and Y.  Y
AD
Y2 Y1 Y

CHAPTER 11 Aggregate Demand II 22 CHAPTER 11 Aggregate Demand II 23

4
 10/14/2013

Monetary policy and the AD curve Fiscal policy and the AD curve
r LM(M1/P1) r LM
The Fed can increase Expansionary fiscal
r1 LM(M2/P1) r2
aggregate demand: policy (G and/or T )
r2 increases agg. demand: r1 IS2
M  LM shifts right
IS T  C IS1
 r
Y1 Y2 Y Y1 Y2 Y
P  IS shifts right P
 I
 Y at each
 Y at each P1 P1
value of P
value of P
AD2 AD2
AD1 AD1
Y1 Y2 Y Y1 Y2 Y

CHAPTER 11 Aggregate Demand II 24 CHAPTER 11 Aggregate Demand II 25

IS-LM and AD-AS The SR and LR effects of an IS shock

in the short run & long run
r LRAS LM(P )
1
Recall from Chapter 9: The force that moves the A negative IS shock
economy from the short run to the long run shifts IS and AD left,
is the gradual adjustment of prices. causing Y to fall. IS1
IS2
In the short
short-run
run then over time,
time the Y Y
equilibrium, if price level will P LRAS
Y Y rise P1 SRAS1

Y Y fall
AD1
Y Y remain constant AD2
Y Y
CHAPTER 11 Aggregate Demand II 26 CHAPTER 11 Aggregate Demand II 27

The SR and LR effects of an IS shock The SR and LR effects of an IS shock

r LRAS LM(P ) r LRAS LM(P )
1 1

In the new short-run In the new short-run

equilibrium, Y  Y IS1 equilibrium, Y  Y IS1
IS2 IS2
Y Y Y Y
Over time, P gradually
P LRAS falls, causing P LRAS
P1 SRAS1 • SRAS to move down P1 SRAS1

• M/P to increase,
AD1 which causes LM AD1
AD2 to move down AD2
Y Y Y Y
CHAPTER 11 Aggregate Demand II 28 CHAPTER 11 Aggregate Demand II 29

5
 10/14/2013

The SR and LR effects of an IS shock The SR and LR effects of an IS shock

r LRAS LM(P ) r LRAS LM(P )
1 1
LM(P2) LM(P2)

IS1 This process continues IS1

IS2 until economy reaches a IS2
Y Y long-run
long run equilibrium with
Y Y
Over time, P gradually
falls, causing P LRAS Y Y P LRAS
• SRAS to move down P1 SRAS1 P1 SRAS1

• M/P to increase, P2 SRAS2 P2 SRAS2

which causes LM AD1 AD1
to move down AD2 AD2
Y Y Y Y
CHAPTER 11 Aggregate Demand II 30 CHAPTER 11 Aggregate Demand II 31

NOW YOU TRY:

Analyze SR & LR effects of M The Great Depression
a. Draw the IS-LM and AD-AS r LRAS LM(M /P ) 240 30
1 1
Unemployment
diagrams as shown here.
(right scale)
958 dollars

220 25

abor force
b. Suppose Fed increases M.
Show the short-run effects IS 200 20
on your graphs.

percent of la
billions of 19

c. Show what happens in the Y Y 180 15

transition from the short run P LRAS 160 10
to the long run.
d. How do the new long-run 140 Real GNP 5
P1 SRAS1
(left scale)
equilibrium values of the
endogenous variables 120 0
AD1 1929 1931 1933 1935 1937 1939
compare to their initial
values? Y Y

THE SPENDING HYPOTHESIS: THE SPENDING HYPOTHESIS:

Shocks to the IS curve Reasons for the IS shift
 asserts that the Depression was largely due to  Stock market crash  exogenous C
an exogenous fall in the demand for goods &  Oct-Dec 1929: S&P 500 fell 17%
services – a leftward shift of the IS curve.  Oct 1929-Dec 1933: S&P 500 fell 71%
 evidence:  Drop in investment
output and interest rates both fell, which is what  “correction” after overbuilding in the 1920s
a leftward IS shift would cause.  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 34 CHAPTER 11 Aggregate Demand II 35

6
 10/14/2013

THE MONEY HYPOTHESIS: THE MONEY HYPOTHESIS AGAIN:

A shock to the LM curve The effects of falling prices
 asserts that the Depression was largely due to  asserts that the severity of the Depression was
huge fall in the money supply. due to a huge deflation:
 evidence: P fell 25% during 1929-33.
M1 fell 25% during 1929-33.  This deflation was probably caused by the fall in
 But, two problems with this hypothesis: M, so perhaps money played an important role
 P fell even more, so M/P actually rose slightly after all.
during 1929-31.
 In what ways does a deflation affect the
 nominal interest rates fell, which is the opposite economy?
of what a leftward LM shift would cause.

CHAPTER 11 Aggregate Demand II 36 CHAPTER 11 Aggregate Demand II 37

THE MONEY HYPOTHESIS AGAIN: THE MONEY HYPOTHESIS AGAIN:

The effects of falling prices The effects of falling prices
 The stabilizing effects of deflation:  The destabilizing effects of expected deflation:
 P  (M/P )  LM shifts right  Y E
 r  for each value of i
 Pigou effect:
 I  because I = I (r )

P  (M/P
 )
 planned expenditure & agg. demand 
 consumers’ wealth 
 income & output 
 C
 IS shifts right
 Y
CHAPTER 11 Aggregate Demand II 38 CHAPTER 11 Aggregate Demand II 39

THE MONEY HYPOTHESIS AGAIN:

The effects of falling prices Why another Depression is unlikely

 The destabilizing effects of unexpected deflation:  Policymakers (or their advisors) now know
debt-deflation theory much more about macroeconomics:
P (if unexpected)  The Fed knows better than to let M fall
 transfers purchasing power from borrowers to so much, especially during a contraction.
l d
lenders  Fiscal policymakers know better than to raise
taxes or cut spending during a contraction.
 borrowers spend less,
lenders spend more  Federal deposit insurance makes widespread
 if borrowers’ propensity to spend is larger than bank failures very unlikely.
lenders’, then aggregate spending falls,  Automatic stabilizers make fiscal policy
the IS curve shifts left, and Y falls expansionary during an economic downturn.
CHAPTER 11 Aggregate Demand II 40 CHAPTER 11 Aggregate Demand II 41

7
 10/14/2013

CASE STUDY Interest rates and house prices

The 2008-09 Financial Crisis & Recession Federal Funds rate
9
 2009: Real GDP fell, u-rate approached 10% 30-year mortgage rate
190
Case-Shiller 20-city composite house price index
8
 Important factors in the crisis:

x, 2000=100
170
7
 early 2000s Federal Reserve interest rate policy

ate (%)
6 150
 sub-prime mortgage crisis

interest ra

House price index

 bursting of house price bubble, 5
130

rising foreclosure rates 4

110
 falling stock prices 3
 failing financial institutions 2
90

 declining consumer confidence, drop in spending 70

1
on consumer durables and investment goods
0 50
CHAPTER 11 Aggregate Demand II 42 2000 2001 2002 2003 2004 2005

Change in U.S. house price index House price change and new foreclosures,
and rate of new foreclosures, 1999-2009 2006:Q3 – 2009Q1
14% 20%
US house price index 1.4
12% 18% Nevada
New foreclosures Florida Illinois
house prices

10% 1.2 16%

Ohio
ortgages

Michigan
closures,
s earlier)

New foreclosurre starts

(% of total morttgages)

8% 14%
1.0 California Georgia
6% 12%
% of all mo
(from 4 quarters
Percent change in h

New forec

0.8 Arizona Colorado

10%
4%
Rhode Island
8% Texas
2% 0.6 New Jersey
6%
0% Hawaii S. Dakota
0.4 4%
Oregon
-2% Wyoming
2% Alaska
0.2 N. Dakota
-4%
0%
-40% -30% -20% -10% 0% 10% 20%
-6% 0.0
1999 2001 2003 2005 2007 2009 Cumulative change in house price index

U.S. bank failures by year, 2000-2009 Major U.S. stock indexes

(% change from 52 weeks earlier)
DJIA
140%
70
120%
S&P 500
60 100% NASDAQ
bank failures

80%
50
60%
40 40%
Number of b

20%
30
0%

20 -20%

-40%
10
-60%

0 -80%
12/28/2001

9/5/2002

6/5/2005

10/20/2006

3/5/2008

11/11/2008
12/6/1999

8/13/2000

4/21/2001

5/14/2003

1/20/2004

9/27/2004

2/11/2006

6/28/2007

7/20/2009

2000 2001 2002 2003 2004 2005 2006 2007 2008 2009*

* as of July 24, 2009.

8
 10/14/2013

Consumer sentiment and growth in consumer Real GDP growth and Unemployment
durables and investment spending 10% 10
20% Real GDP growth rate (left scale)
9
110 8% Unemployment rate (right scale)

ndex, 1966=100
15%
uarters earlier

quaters earlier
8
10% 100 6% 7

% of labor force
5%
90 6
4%
% change from four qu

Consumer Sentiment In

% change from 4 q
0%
5

-5% 80 2%
4

-10% 3
70 0%
-15% 2
Durables
60 -2%
-20% Investment
1
UM Consumer Sentiment Index
-25% 50 -4% 0
1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 1995 1997 1999 2001 2003 2005 2007 2009

Chapter Summary Chapter Summary

1. IS-LM model 2. AD curve
 a theory of aggregate demand  shows relation between P and the IS-LM model’s
 exogenous: M, G, T, equilibrium Y.
P exogenous in short run, Y in long run  negative slope because
 endogenous: r, P  (M/P )  r  I  Y
Y endogenous in short run, P in long run  expansionary fiscal policy shifts IS curve right,
raises income, and shifts AD curve right.
 IS curve: goods market equilibrium
 expansionary monetary policy shifts LM curve
 LM curve: money market equilibrium right, raises income, and shifts AD curve right.
 IS or LM shocks shift the AD curve.