Context

12  Chapter 9 introduced the model of aggregate

demand and supply.
Aggregate Demand II:  Chapter 10 developed the IS-LM model,
Applying the IS -LM Model the basis of the aggregate demand curve.

CHAPTER 11 Aggregate Demand II slide 1

In this chapter, you will learn… Equilibrium in the IS -LM model

The IS curve represents r
 how to use the IS-LM model to analyze the effects equilibrium in the goods LM
of shocks, fiscal policy, and monetary policy market.
 how to derive the aggregate demand curve from
the IS-LM model r1
The LM curve represents
 several theories about what caused the money market equilibrium.
Great Depression IS
Y
The intersection determines Y1
the unique combination of Y and r
that satisfies equilibrium in both markets.

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 Policy analysis with the IS -LM model An increase in government purchases
r 1. IS curve shifts right r
LM LM

causing output & r2

We can use the IS-LM
income to rise. 2.
model to analyze the r1 r1
effects of 2. This raises money
demand, causing the
1. IS2
• fiscal policy: G and/or T IS IS1
interest rate to rise…
• monetary policy: M Y Y
Y1 3. …which reduces investment, Y 1 Y2
so the final increase in Y 3.

CHAPTER 11 Aggregate Demand II slide 4 CHAPTER 11 Aggregate Demand II slide 5

A tax cut Monetary policy: An increase in M

Consumers save r r
1. M > 0 shifts LM1
(1MPC) of the tax cut, LM
the LM curve down
so the initial boost in LM2
spending is smaller for T (or to the right)
r2
than for an equal G… 2. 2. …causing the r1
r1
and the IS curve shifts by interest rate to fall r2
1. IS2
1. IS1 IS
3. …which increases
Y investment, causing Y
Y1 Y2 Y1 Y 2
2. …so the effects on r 2.
output & income to
and Y are smaller for T rise.
than for an equal G.
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 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 slide 8 CHAPTER 11 Aggregate Demand II slide 9

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
Y 1 Y2 Y1 Y2 Y3

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 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, monetary policy
r2 Y / G Y / T
Fed reduces M r1
to shift LM curve left. Fed holds money
IS2 0.60 0.26
Results: supply constant
IS1
Y Fed holds nominal
Y 1 Y2 1.93 1.19
interest rate constant

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

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

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 EXERCISE: CASE STUDY:
Analyze shocks with the IS-LM model The U.S. recession of 2001
Use the IS-LM model to analyze the effects of
 During 2001,
1. a boom in the stock market that makes
consumers wealthier.  2.1 million people lost their jobs,
2. after a wave of credit card fraud, consumers as unemployment rose from 3.9% to 5.8%.
using cash more frequently in transactions.  GDP growth slowed to 0.8%
(compared to 3.9% average annual growth
For each shock,
during 1994-2000).
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 slide 16 CHAPTER 11 Aggregate Demand II slide 17

CASE STUDY: CASE STUDY:

The U.S. recession of 2001 The U.S. recession of 2001
 Causes: 1) Stock market decline  C  Causes: 2) 9/11
 increased uncertainty
1500
Standard & Poor’s  fall in consumer & business confidence
Index (1942 = 100)

1200 500  result: lower spending, IS curve shifted left

900
 Causes: 3) Corporate accounting scandals
 Enron, WorldCom, etc.
600
 reduced stock prices, discouraged investment
300
1995 1996 1997 1998 1999 2000 2001 2002 2003
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 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
7
 tax cuts in 2001 and 2003 6
Three-month
T-Bill Rate
 spending increases 5
4
 airline industry bailout
3
 NYC reconstruction 2
 Afghanistan war 1
0

CHAPTER 11 Aggregate Demand II slide 20 CHAPTER 11 Aggregate Demand II slide 21

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.
the interest rate banks charge one another 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.328.)
 Other short-term rates typically move with the
federal funds rate.
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 IS-LM and aggregate demand Deriving the AD curve
r LM(P2)
 So far, we’ve been using the IS-LM model to Intuition for slope LM(P1)
analyze the short run, when the price level is r2
of AD curve:
assumed fixed. r1
P  (M/P )
IS
 However, a change in P would  LM shifts left Y2 Y1 Y
shift LM and therefore affect Y. P
 r
 The aggregate demand curve  I
P2
(introduced in Chap. 9) captures this P1
relationship between P and Y.  Y
AD
Y2 Y1 Y

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

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
value of P
AD2 of P AD2
AD1 AD1
Y1 Y2 Y Y1 Y2 Y

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 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-run then over time, the Y
equilibrium, if price level will P LRAS
rise P1 SRAS1

fall
AD1
remain constant AD2
Y
CHAPTER 11 Aggregate Demand II slide 28 CHAPTER 11 Aggregate Demand II slide 29

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, IS1 equilibrium, IS1
IS2 IS2
Y Y
Over time, P gradually
P LRAS falls, which causes 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
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 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 long-run equilibrium with Y
Over time, P gradually
falls, which causes P LRAS 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
CHAPTER 11 Aggregate Demand II slide 32 CHAPTER 11 Aggregate Demand II slide 33

EXERCISE:
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
diagrams as shown here. Unemployment
220 (right scale) 25

billions of 1958 dollars

b. Suppose Fed increases M.

percent of labor force

Show the short-run effects
on your graphs.
IS 200 20

c. Show what happens in the Y 180 15

transition from the short run
to the long run. P LRAS 160 10
d. How do the new long-run
SRAS1 140 Real GNP 5
equilibrium values of the P1
(left scale)
endogenous variables
120 0
compare to their initial AD1
1929 1931 1933 1935 1937 1939
values? Y
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 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 slide 36 CHAPTER 11 Aggregate Demand II slide 37

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.

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 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
 Pigou effect:  r  for each value of i
P  (M/P )  I  because I = I (r )
 planned expenditure & agg. demand 
 consumers’ wealth 
 income & output 
 C
 IS shifts right
 Y
CHAPTER 11 Aggregate Demand II slide 40 CHAPTER 11 Aggregate Demand II slide 41

THE MONEY HYPOTHESIS AGAIN: Why another Depression is

The effects of falling prices 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.
lenders  Fiscal policymakers know better than to raise
 borrowers spend less, taxes or cut spending during a contraction.
lenders spend more
 if borrowers’ propensity to spend is larger than
lenders’, then aggregate spending falls,
the IS curve shifts left, and Y falls
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 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,
 IS curve: goods market equilibrium raises income, and shifts AD curve right.
 expansionary monetary policy shifts LM curve right,
 LM curve: money market equilibrium
raises income, and shifts AD curve right.
 IS or LM shocks shift the AD curve.
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