12

Aggregate Demand II:

Applying the IS-LM
Model

MACROECONOMICS
N. Gregory Mankiw

Modified for EC 204

by Bob Murphy

PowerPoint Slides by Ron Cronovich

2013 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

IN THIS CHAPTER, YOU WILL

LEARN:
! how to use the IS-LM model to analyze the
effects of shocks, fiscal policy, and monetary
! how
policyto derive the aggregate demand curve
from the IS-LM model

! several theories about what caused the

Great Depression

Equilibrium in the IS -LM model

The IS curve represents
equilibrium in the
goods market.

The LM curve represents

money market
equilibrium.

r
L
M
r1

Y1
The intersection determines
the unique combination of Y and r
that satisfies equilibrium in both markets.
CHAPTER 12

Aggregate Demand II

IS
Y

Policy analysis with the IS -LM model

r
L
M

We can use the IS-LM

model to analyze the effects r1
of
fiscal policy: G and/or T
monetary policy: M

CHAPTER 12

Aggregate Demand II

IS
Y1

An increase in government purchases

1. IS curve shifts right

causing output &

income to rise.
2. This raises money
demand, causing the
interest rate to
rise
3. which reduces
investment, so the final
increase in Y
CHAPTER 12

r
L
M

r
2
.

Aggregate Demand II

1
.

Y1 Y2
3.

IS2
IS1
Y

A tax cut
Consumers save (1MPC)
of the tax cut, so the
initial boost in spending is
smaller for T than for
an equal G
and the IS curve shifts by

r
L
M
r2
2.

1
.

1
.
2.

so the effects on r and

Y are smaller for T
than for an equal G.

CHAPTER 12

Aggregate Demand II

Y1
Y2
2.

IS2
IS1

Monetary policy:An increase in

M
1. M > 0 shifts
the LM curve down
(or to the right)
2. causing the
interest rate to fall

LM
1

r2

3. which increases
investment, causing
output & income to
rise.
CHAPTER 12

Aggregate Demand II

LM

IS
Y1 Y 2

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

The Feds response to G > 0

! Suppose Congress increases G.

! Possible Fed responses:
1. hold M

constant

2. hold rconstant
3. hold Y

constant

! In each case, the effects of the G

are different

CHAPTER 12

Aggregate Demand II

Response 1: Hold M
consta
nt
r

If Congress raises G,
the IS curve shifts right.

LM
1

If Fed holds M constant,

then LM curve doesnt
shift.
Results:

r
2

IS2
IS1

Y1
Y2

CHAPTER 12

Aggregate Demand II

Response 2: Holdconsta
r
nt
r

If Congress raises G,
the IS curve shifts right.

LM
1

To keep r constant, Fed

increases M
to shift LM curve right.
Results:

r
2

IS2
IS1

Y1 Y2
Y3

CHAPTER 12

Aggregate Demand II

LM

Response 3: Hold consta

Y
nt

To keep Y constant,
Fed reduces M
to shift LM curve left.

LM
2
LM

If Congress raises G,
the IS curve shifts right.

r
3

r
2

Results:

IS2
IS1

r
1

Y1
Y2

CHAPTER 12

Aggregate Demand II

Estimates of fiscal policy

multipliers
from the DRI macroeconometric model

Assumption about
monetary policy

Estimated
value of
Y / G

Estimated
value of
Y / T

Fed holds money

supply constant

0.60

0.26

Fed holds nominal

interest rate constant

1.93

1.19

CHAPTER 12

Aggregate Demand II

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

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

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.
17

ANSWERS, PART 1

Housing market crash

IS shifts left, causing
r and Y
fall.

to

C falls due to lower

wealth and
lower income,
I rises because
r is lower
u rises because
Y is lower
(Okuns law)

r
LM
1

r1
r2
IS2
Y2 Y1

IS1
Y

18

ANSWERS, PART 2

Increase in money demand

LM shifts left, causing
r to rise and Y to fall.
C falls due to lower
income,
I falls because
r is higher
u rises because
Y is lower
(Okuns law)

LM

LM
1

r2
r1

IS1
Y2 Y1

19

CASE
STUDY:
The U.S.

recessionof

2001
2.1 million jobs lost,
!
During 2001:
!

unemployment rose from 3.9% to 5.8%.

! GDP growth slowed to 0.8%
(compared to 3.9% average annual growth
during 19942000).

CHAPTER 12

Aggregate Demand II

CASE STUDY:

The U.S. recessionof 2001

Index (1942 = 100)

Causes: 1) Stock market decline

C
1,500

Standard & Poors

500

1,200
900
600
300
1995

CHAPTER 12

1996

1997

1998

Aggregate Demand II

1999

2000

2001

2002

2003

CASE
STUDY:
The U.S.

recessionof 2001

Causes: 2) 9/11
! increased uncertainty
! fall in consumer & business confidence
lower spending, IS curve shifted left
! result:
Causes: 3) Corporate accounting scandals
! Enron, WorldCom, etc.
! reduced stock prices, discouraged investment

CHAPTER 12

Aggregate Demand II

CASE
STUDY:
The U.S.

recessionof 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

1/2
00
3

01
/01
/20
04
00
/02
/
07 2000
/03
/20
10
00
/03
/
01 2000
/03
/2 0
04
01
/05
/20
07
/06 01
/20
10
01
/06
/
01 2001
/06
/20
04
02
/08
/
07 2002
/09
/2 0
10
02
/09
/
01 2002
/09
/20
03
04
/1

CASE STUDY:

The U.S. recessionof 2001

Monetary policy response: shifted LM curve right
7

CHAPTER 12

Three-month
T-Bill rate

Aggregate Demand II

What is the Feds policy

instrument?

! The news media commonly report the Feds 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 ratethe
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

What is the Feds 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

IS-LM and aggregate demand

! So far, weve 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

Deriving the AD curve

Intuition for slope
of AD curve:
P
(M/P )
LM
shifts left

LM(P2)

LM(P1)

r2
r1

IS
P

Y2

Y1

P2

r
I
Y
CHAPTER 12

Aggregate Demand II

AD

P1
Y2

Y1

Monetary policy and the AD curve

The Fed can increase
aggregate demand:
M LM shifts right

Y
each

r2
IS
P

at

LM(M2/P1)

r1

r
I

LM(M1/P1)

Y1

Y2

Y2

AD2
AD1
Y

P1

value of
P
CHAPTER 12

Y1
Aggregate Demand II

Fiscalpolicy and the AD curve

Expansionary fiscal policy
(G and/or T ) increases

LM

r2

IS2

agg. demand:

r1

T C

IS shifts right
Y

at each
value

of P
CHAPTER 12

Y1

Y2

Y2

AD2
AD1
Y

P1

Y1
Aggregate Demand II

IS1

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
equilibrium, if

then over time, the

price level will
rise
fall
remain constant

CHAPTER 12

Aggregate Demand II

The SR and LR effects of an IS shock

r

A negative IS shock
shifts IS and AD left,
causing Y to fall.

LRAS LM(P )
1

IS2

IS1
Y

LRAS
SRAS1

P
1

CHAPTER 12

Aggregate Demand II

AD1
AD2
Y

The SR and LR effects of an IS shock

r

LRAS LM(P )
1

In the new short-run

equilibrium,
IS2

IS1
Y

LRAS
SRAS1

P
1

CHAPTER 12

Aggregate Demand II

AD1
AD2
Y

The SR and LR effects of an IS shock

r

LRAS LM(P )
1

In the new short-run

equilibrium,
IS2

Over time, P gradually

falls, causing:
SRAS to move
down
to increase,
M/P
causes LM
which
to move down
CHAPTER 12

Aggregate Demand II

IS1
Y

LRAS
SRAS1

P
1

AD1
AD2
Y

The SR and LR effects of an IS shock

r

LRAS LM(P )
1

LM(P2)

IS2

Over time, P gradually

falls, causing:
SRAS to move
down
to increase,
M/P
causes LM
which
to move down

Y
P

Aggregate Demand II

LRAS

SRAS1

SRAS2

P
2

CHAPTER 12

IS1

AD1
AD2
Y

The SR and LR effects of an IS shock

r

LRAS LM(P )
1

LM(P2)

This process continues

until economy reaches a
long-run equilibrium
with

IS2

Y
P

SRAS1

SRAS2

Aggregate Demand II

LRAS

P
P

CHAPTER 12

IS1

AD1
AD2
Y

NOW YOU TRY

Analyze SR & LR effects of M

r

a. Draw the IS-LM and AD-AS

diagrams as shown here.

LRAS LM(M /P
1
1

b. Suppose Fed increases M.

Show the short-run effects on

your graphs.

IS

c. Show what happens in the

transition from the short

run to the long run.
d. How do the new long-

run equilibrium values

of the endogenous
variables compare to
their initial values?

P
P

LRAS
SRAS1

AD1
Y
37

ANSWERS, PART 1

Short-run effects of M
r

LM and AD shift right.

r falls, Yrises
above

LRAS

LM(M1/P1)
LM(M2/P1
)

r1
r2

IS
Y2
P
P
1

LRAS
SRAS

AD2
AD1
Y2 Y
38

ANSWERS, PART 2

Transition from short run tolong run

r

Over time,

! P rises
! SRAS moves upward
! M/P falls
! LM moves leftward
New long-run eqm

! P higher
! all real variables back at
their initial values
Money is neutral in the
long run.

LRAS

LM(M12/P13)
LM(M2/P1
)

r3 1
= r r2

Y2
P

IS
Y

LRAS
SRAS

P
P
1

SRAS

Y2

AD2
AD1
Y
39

The Great Depression

Unemployment
(right scale)

220

30
25

200

20

180

15

160

10

Real GNP
(left
scale)

140
120
1929

1931

1933

1935

1937

5
0
1939

percent of labor force

billions of 1958 dollars

240

Table 12.2 What Happened During the Great Depression?

Mankiw: Macroeconomics, Eighth Edition
Copyright 2012 by Worth Publishers

UNTABLE 12.1
Mankiw: Macroeconomics, Eighth Edition
Copyright 2012 by Worth Publishers

THE SPENDING
HYPOTHESIS:
Shocks to

the IS curve

! Asserts that the Depression was largely due to

an exogenous fall in the demand for goods &
servicesa 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

THE SPENDING
HYPOTHESIS:
Reasonsfor the

IS shift

! Stock market crash exogenous C

! Oct 1929Dec 1929:

S&P 500 fell 17%

! Oct 1929Dec 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

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 192933.

! But, two problems with this hypothesis:

! P fell even more, so M/P actually rose slightly
during 192931.
! nominal interest rates fell, which is the
opposite of what a leftward LM shift would
cause.
CHAPTER 12

Aggregate Demand II

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 192933.

! 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

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

CHAPTER 12

Aggregate Demand II

THE MONEY HYPOTHESIS

AGAIN:
The effects of falling

prices

! The destabilizing effects of expected

deflation:

r for each value of i

planned expenditure & agg. demand

income & output

CHAPTER 12

I because I = I (r )

Aggregate Demand II

Figure 12.8 Expected Deflation in the ISLM Model

Mankiw: Macroeconomics, Eighth Edition
Copyright 2012 by Worth Publishers

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

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

CHAPTER
12 Aggregateduring
Demandan
II
expansionary

economic downturn.

CASE
STUDY
The 200809 financial crisis &

recession
factors
in the
2009: Real
GDP
fell, crisis:
u-rate approached
!! Important
early
2000s
Federal
!
10%

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
onDemand
consumer
durables and investment
CHAPTER spending
12 Aggregate
II
goods

Interest rates and house prices

9
8

170

interest rate (%)

7
6

150

130

4
110
3
90
2
70

1
0
2000

2001

2002

2003

2004

50
2005

House price index, 2000 = 100

Federal Funds rate

30-year mortgage rate
190
Case-Shiller 20-city composite house price index

Change in U.S. house price index

and rate of new foreclosures, 19992009
14%
1.4

10%

1.2

8%

1.0

6%
0.8

4%
2%

0.6

0%

0.4

-2%
0.2

-4%
-6%
1999

0.0
2001

2003

2005

2007

2009

New foreclosure starts

(% of total mortgages)

Percent change in house prices

(from 4 quarters earlier)

12%

US house price index

New foreclosures

House price change and new

foreclosures,
2006:Q3 2009Q1

New foreclosures,
% of all mortgages

Nevada

Florida

Illinois

Michigan

Ohio

California

Georgia

Arizona

Colorado

Rhode Island
New
Jersey
H
a
w
a
ii

Texa
s
S. Dakota
Oregon
Alaska

Wyoming
N. Dakota

Cumulative change in house price index

U.S. bank failures by year, 20002011

160

Number of bank failures

140
120
100
80
60
40
20
0
2
0
0
0
2
0
0
1

12/28/200
1
9/5/2002
5/14/2003
1/20/2004
9/27/2004
6/5/2005
2/11/2006

11/11/2008
7/20/2009

DJIA

3/5/2008

S&P 500

6/28/2007

NASDAQ

10/20/200
6

Major U.S. stock indexes

4/21/2001

(% change from 52 weeks

earlier)

8/13/2000

120%
140%

100%

80%

60%

40%

20%

0%

-20%

-40%

-60%

-80%
12/6/1999

110

15%
10%

100

5%
90
0%
80

-5%
-10%
-15%
-20%

70

Durables
60

Investment

UM
Consumer
-25%
1999 Sentiment
Index
20002001
2002 2003
2004 2005

50
2006 2007 2008 2009

Consumer Sentiment Index, 1966 = 100

% change from four quarters earlier

Consumer sentiment and growth in

consumer durables and investment
spending
20%

10

Real GDP growth rate (left scale)

Unemployment rate (right scale)

10

6
6

4
2

4
0
-2

-4
-6
1995

1997

1999

2001

2003

2005

2007

2009

0
2011

% of labor force

% change from 4 quarters earlier

Real GDP growth and

12
unemployment

CHAPT ER
Y

SUMMAR

1. IS-LM model

! a theory of aggregate demand

! exogenous:
M, G, T,
P

exogenous in short run, Yin long

run

! endogenous:
Y

! IS
! LM

r,

endogenous in short run, P

long run
curve:
curve:

in

goods market equilibrium

money market equilibrium
57

CHAPT ER
Y

SUMMAR

2. AD curve

! shows relation between P and the IS-LM models

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.
58