Context

11
CHAPTER
 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.

MACROECONOMICS SIXTH EDITION

N. GREGORY MANKIW
PowerPoint® Slides by Ron Cronovich
© 2007 Worth Publishers, all rights reserved 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 Y = C(Y " T ) + I (r) + G
the IS-LM model r1
The LM curve represents
 several theories about what caused the money market equilibrium.
Great Depression M IS
! P = L(r,Y ) Y
The intersection determines
Y1
the unique combination of Y and r
that satisfies equilibrium in both markets.
!
CHAPTER 11 Aggregate Demand II slide 2 CHAPTER 11 Aggregate Demand II slide 3

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
M = L(r,Y ) by !G
P 1" MPC
causing output & r2
We can use the IS-LM 2.
! model to analyze the r1 income to rise. r1
effects of 2. This raises money
1. IS2
! demand, causing the
• fiscal policy: G and/or T IS IS1
interest rate to rise…
• monetary policy: M Y Y
Y1 3. …which reduces investment, Y1 Y2
so the final increase in Y 3.
1
is smaller than !G
1" MPC
CHAPTER 11 Aggregate Demand II slide 4 CHAPTER 11 Aggregate Demand II slide 5

1
 A tax cut Monetary policy: An increase in M
Consumers save (1− r r
1. ΔM > 0 shifts LM1
MPC) of the tax cut, so LM
the LM curve down
the initial boost in LM2
spending is smaller for ΔT (or to the right)
r2
than for an equal ΔG… 2. r1
r1 2. …causing the
and the IS curve shifts by interest rate to fall r2
1. IS2
!MPC
1. "T IS1 IS
1! MPC 3. …which increases
Y investment, causing Y
Y1 Y2 Y1 Y2
2. …so the effects on r 2. output & income to
and Y are smaller for ΔT rise.
than for an equal ΔG.
CHAPTER 11 Aggregate Demand II slide 6 CHAPTER 11 Aggregate Demand II slide 7

Interaction between
The Fed’s response to Δ 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 ΔG
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 r1 Fed increases M 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 slide 10 CHAPTER 11 Aggregate Demand II slide 11

2
 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 ΔY / ΔG ΔY / ΔT
Fed reduces M r1
to shift LM curve left.
Fed holds money
IS2 0.60 −0.26
Results: supply constant
IS1
!Y = 0 Y Fed holds nominal
Y1 Y2 1.93 −1.19
interest rate constant
!r = r3 " r1

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.
⇒ ΔC  more ATMs or the Internet reduce money
 change in business or consumer demand.
confidence or expectations
⇒ ΔI and/or ΔC

CHAPTER 11 Aggregate Demand II slide 14 CHAPTER 11 Aggregate Demand II slide 15

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

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

CASE STUDY: CASE STUDY:

The U.S. recession of 2001 The U.S. recession of 2001
 Monetary policy response: shifted LM curve right
 Fiscal policy response: shifted IS 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 01

03
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0
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00
01
01

1
02
02
02
01 2002
03
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0
/20

/20
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/20
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/20
/
/06

/11
/01
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/06
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04
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10
01
04
07
10
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.
 Other short-term rates typically move with the
federal funds rate.
CHAPTER 11 Aggregate Demand II slide 22 CHAPTER 11 Aggregate Demand II slide 23

4
 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

CHAPTER 11 Aggregate Demand II slide 26 CHAPTER 11 Aggregate Demand II slide 27

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 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 slide 28 CHAPTER 11 Aggregate Demand II slide 29

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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

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, 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 Y Y
CHAPTER 11 Aggregate Demand II slide 30 CHAPTER 11 Aggregate Demand II slide 31

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 Y Y
P LRAS Y =Y P LRAS
falls, which causes
• 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 slide 32 CHAPTER 11 Aggregate Demand II slide 33

EXERCISE:
Analyze SR & LR effects of ΔM Chapter Summary
Draw the IS-LM and AD-AS r LRAS LM(M /P )
1 1
diagrams as shown here. 1. IS-LM model
Suppose Fed increases M.  a theory of aggregate demand
Show the short-run effects
IS  exogenous: M, G, T,
on your graphs.
P exogenous in short run, Y in long run
Show what happens in the Y
transition from the short run
Y  endogenous: r,
to the long run. P LRAS Y endogenous in short run, P in long run
How do the new long-run  IS curve: goods market equilibrium
P1 SRAS1
equilibrium values of the
 LM curve: money market equilibrium
endogenous variables
compare to their initial AD1
values? Y
Y
CHAPTER 11 Aggregate Demand II slide 34 CHAPTER 11 Aggregate Demand II slide 35

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 Chapter Summary The Great Depression
240 30
2. AD curve Unemployment
220 (right scale) 25

billions of 1958 dollars

 shows relation between P and the IS-LM model’s

percent of labor force

equilibrium Y. 200 20
 negative slope because
180 15
↑P ⇒ ↓(M/P ) ⇒ ↑r ⇒ ↓I ⇒ ↓Y
 expansionary fiscal policy shifts IS curve right, 160 10
raises income, and shifts AD curve right.
140 Real GNP 5
 expansionary monetary policy shifts LM curve right, (left scale)
raises income, and shifts AD curve right. 120 0
 IS or LM shocks shift the AD curve. 1929 1931 1933 1935 1937 1939

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

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 38 CHAPTER 11 Aggregate Demand II slide 39

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 slide 40 CHAPTER 11 Aggregate Demand II slide 41

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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 ↓π 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 42 CHAPTER 11 Aggregate Demand II slide 43

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  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 slide 44 CHAPTER 11 Aggregate Demand II slide 45