# Aggregate Demand II: Applying the IS-LM Model

### Applying the

SIXTH EDITION SIXTH EDITION ACROECONOMICS M ACROECONOMICS M . REGORY ANKIW

N G M . REGORY ANKIW

N G M ®

®

PowerPoint Slides by Ron Cronovich

PowerPoint Slides by Ron Cronovich

### Context

 Chapter 9 introduced the model of aggregate demand and supply.

 Chapter 10 developed the IS-LM model, the basis of the aggregate demand curve.

### 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

Equilibrium in the model

## IS LM - r

The IS curve represents

### LM

equilibrium in the goods market.

### Y C Y T ( ) I r ( ) G

   

r

1 The LM curve represents money market equilibrium.



### Y Y

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

   

### LM M P L r Y ( , )



We can use the IS-LM

r

model to analyze the 1 effects of

• fiscal policy: G and/or T

### IS Y

• monetary policy: M

Y 1

### An increase in government purchases r

1. IS curve shifts right

1 LM by G

1 MPC  r 2 causing output &amp; 2. income to rise. r 1

2. This raises money 1.

### IS

2 demand, causing the

### IS

1 interest rate to rise…

### Y Y Y

3. …which reduces investment, 1 2 so the final increase in Y

3.

1 G is smaller than 

1 MPC 

### A tax cut

Consumers save r LM

(1MPC) of the tax cut, so the initial boost in spending is smaller for T

r

2 2. than for an equal G

r

1 and the IS curve shifts by 1.

IS

2 MPC  1.



### IS

1

1 MPC  Y Y Y 1 2

…so the effects on r 2.

2. and Y are smaller for T than for an equal G.

### Monetary policy: An increase in M r LM

1. M &gt; 0 shifts 1 the LM curve down LM 2

(or to the right)

r

1

2. …causing the

r

interest rate to fall 2 IS

3. …which increases

### Y

investment, causing

### Y Y

1 2 output &amp; income to rise.

### Interaction between monetary & fiscal policy

 Model: Monetary &amp; 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 interaction may alter the impact of the original policy change.

&gt; 0 G The Fed’s response to

 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:

### Response 1: Hold M constant

r

If Congress raises G,

### LM

1 the IS curve shifts right.

If Fed holds M constant,

r

2

then LM curve doesn’t

r

1

shift.

2 Results:

### IS

1 Y Y Y Y   

2

1 2 r r r

  

2

1

### Response 2: Hold r constant

r

If Congress raises G,

### LM

1 the IS curve shifts right.

### LM

2 To keep r constant, r

2

Fed increases M r

1

to shift LM curve right.

2 Results:

### IS

1 Y Y Y Y   

3

1 1 2 3 r

 

### LM

1 Response 3: Hold Y constant Y

r

LM

1 r

1

IS

2 Y 2 r

2

To keep Y constant,

Fed reduces M to shift LM curve left.

 

3

1 r r r

  

2 Results: Y 1 r

3

If Congress raises G, the IS curve shifts right.

### Estimates of fiscal policy multipliers

from the DRI macroeconometric model

### Assumption about monetary policy Estimated value of

Y /

G

Fed holds nominal interest rate constant

Fed holds money supply constant

1.93

0.60 Estimated value of

Y /

T 1.19 0.26

IS LM - model Shocks in the

IS shocks : exogenous changes in the demand for goods &amp; services.

Examples:

 stock market boom or crash  change in households’ wealth  C

 change in business or consumer confidence or expectations

I   and/or C

IS LM - model Shocks in the

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.

### EXERCISE: Analyze shocks with the IS-LM model

Use the IS-LM model to analyze the effects of 1. a boom in the stock market that makes consumers wealthier.

2. after a wave of credit card fraud, consumers using cash more frequently in transactions.

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.

### CASE STUDY: The U.S. recession of 2001

 During 2001,

 2.1 million people lost their jobs, as unemployment rose from 3.9% to 5.8%.

 GDP growth slowed to 0.8% (compared to 3.9% average annual growth during 1994-2000).

### CASE STUDY: The U.S. recession of 2001

 Causes: 1) Stock market decline  C 1500

) Standard &amp; Poor’s

00 500

1 1200

=

2

94 900

(1 x 600 de In

300 1995 1996 1997 1998 1999 2000 2001 2002 2003

### CASE STUDY: The U.S. recession of 2001

 Causes: 2) 9/11

 increased uncertainty

 fall in consumer &amp; business confidence

 result: lower spending, IS curve shifted left

 Causes: 3) Corporate accounting scandals

 Enron, WorldCom, etc.



reduced stock prices, discouraged investment

### 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

### CASE STUDY: The U.S. recession of 2001

 Monetary policy response: shifted LM curve right

7 Three-month Three-month

6 T-Bill Rate

### T-Bill Rate

5

4

3

2

1

00

00

00

00

01

01

01

01

02

02

02

02

03

03

20

20

20

20

20

20

20

20

20

20

20

20

20

20

1/ 2/ 3/ 3/ 3/ 5/ 6/ 6/ 6/ 8/ 9/ 9/ 9/ 1/

/0 /0 /0 /0 /0 /0 /0 /0 /0 /0 /0 /0 /0 /1

01

04

01

04

07

10

01

04

07

10

01

04

07

10

### 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.

### What is the Fed’s policy instrument?

Why does the Fed target interest rates instead of 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 end-of-chapter Problem 7 on p.328.)

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. 9) captures this relationship between P and Y.

LM( P ) r

2 Intuition for slope LM( P )

1 r

2

r

1

) P  (M/P

IS

shifts left  LM

Y

Y Y

2

1 P

 r

P

2

I

 

P

1

 Y

2

1

### Monetary policy and the AD curve

2 r

1

r

2

The Fed can increase

 Y at each value of P

I

 

 r

2 Y

r

aggregate demand: MLM shifts right

Y

P

IS LM( M 2 /P

1 Y

1 Y

1

Y

1 P

1 /P

1 )

2 Y

Fiscal policy and the curve

r

LM

Expansionary fiscal

r

2

) policy (G and/or T increases agg. demand:

r

1 IS 2 IS

T  C

1 Y Y Y

1

2

shifts right  IS

P

 Y at each

P

1

value of P

1 Y Y Y

1

2

### IS-LM and AD-AS in the short run & long run

Recall from Chapter 9 : The force that moves the economy from the short run to the long run is the gradual adjustment of prices.





### Y Y

 rise fall remain constant In the short-run equilibrium, if then over time, the price level will

### The SR and LR effects of an

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

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

Y r

IS

1 SRAS

1 P 1 LM(P

1 )

IS

1

Y

### IS shock Y r

IS

1 SRAS

1 P 1 LM(P

1 )

IS

1 In the new short-run equilibrium,

In the new short-run equilibrium, Y Y

Y

### The SR and LR effects of an

• SRAS to move down.
• M/P to increase,
• SRAS to move down.
• M/P to increase,

1 In the new short-run equilibrium,

which causes LM to move down.

Over time, P gradually falls, which causes

which causes LM to move down.

Over time, P gradually falls, which causes

In the new short-run equilibrium, Y Y

r

IS

1 )

1 P

1

LM(P

1 SRAS

IS

Y

### IS shock Y

2 )

r

IS

1 SRAS

Over time, P gradually falls, which causes

1 )

IS

Over time, P gradually falls, which causes

• SRAS to move down.
• M/P to increase,
• SRAS to move down.
• M/P to increase,

2 P

2

LM(P

1 SRAS

which causes LM to move down.

1 P

1

LM(P

which causes LM to move down.

2 The SR and LR effects of an

Y

### IS shock Y r



Y Y

This process continues until economy reaches a long-run equilibrium with

1 This process continues until economy reaches a long-run equilibrium with

IS

2 SRAS

1 )

1 P 1 LM(P

1 SRAS

IS

2 )

2 P 2 LM(P

Y

### EXERCISE: 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

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 SRAS

1 P 1 equilibrium values of the endogenous variables

1 compare to their initial values?

Y

### The Great Depression

Unemployment (right scale) Real GNP (left scale)

120 140 160 180 200 220 240

1929 1931 1933 1935 1937 1939 b ill io n s of

1

95

8 d ol la rs

5

10

15

20

25

30 pe rc e nt o f l ab or fo rc e

THE SPENDING HYPOTHESIS:

IS

### Shocks to the curve

 asserts that the Depression was largely due to an exogenous fall in the demand for goods &amp; services – a leftward shift of the IS curve.

 evidence:

output and interest rates both fell, which is what

a leftward IS shift would cause.

THE SPENDING HYPOTHESIS:

 Stock market crash  exogenous C

 Oct-Dec 1929: S&amp;P 500 fell 17%

 Oct 1929-Dec 1933: S&amp;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.

THE MONEY HYPOTHESIS: LM A shock to the 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.

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?

THE MONEY HYPOTHESIS AGAIN: The effects of falling prices

 The stabilizing effects of deflation:

 )  LM shifts right  YP  (M/P

 Pigou effect : ) P  (M/P

 consumers’ wealth   C shifts right  IS

 Y

THE MONEY HYPOTHESIS AGAIN: The effects of falling prices

 The destabilizing effects of expected deflation: e

   r  for each value of i =

### I (r )

 I  because I  planned expenditure &amp; agg. demand   income &amp; output 

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

### Why another Depression is unlikely

 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 Summary 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 Summary Chapter Summary

 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.

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