11

CHAPTER

Aggregate Demand II:

Applying the IS -LM Model
University of Wisconsin
Charles Engel
 Equilibrium in the IS -LM model
The IS curve represents r
equilibrium in the goods LM
market.
Y = C (Y - T ) + I (r ) + G
r1
The LM curve represents
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 11.01 slide 2
 Policy analysis with the IS -LM model
Y = C (Y - T ) + I (r ) + G r
LM
M P = L (r ,Y )

We can use the IS-LM

model to analyze the r1
effects of
• fiscal policy: G and/or T IS
• monetary policy: M Y
Y1

CHAPTER 11.01 slide 3

 An increase in government purchases
1. IS curve shifts right r
1 LM
by DG
1- MPC
causing output & r2
2.
income to rise. r1
2. This raises money
1. IS2
demand, causing the
interest rate to rise… IS1
Y
3. …which reduces investment, Y1 Y2
so the final increase in Y 3.
1
is smaller than DG
1- MPC
CHAPTER 11.01 slide 4
 A tax cut
r
The IS curve shifts by LM

r2
-MPC 2.
1. DT r1
1- MPC
1. IS2
…r rises so the final increase IS1
in Y is smaller than the direct
Y
effect of a tax cut. Y1 Y2
2. 2.

CHAPTER 11.01 slide 5

 Monetary policy: An increase in M
r
1. DM > 0 shifts LM1
the LM curve down
(or to the right) LM2

r1
2. …causing the
interest rate to fall r2

3. …which increases IS
investment, causing Y
Y1 Y2
output & income to
rise.

CHAPTER 11.01 slide 6

 The Housing Boom - Krainer

 Housing investment is one of the most interest

sensitive components of overall investment.
 Between May, 2000 and June, 2003, the Fed
lowered the “Fed funds rate” 13 times from 6.5%
to 1.0%.
 Krainer: housing investment depends not only
on interest rates, but also on the level of GDP.
 What does our model say happens to housing
investment when the money supply increases?
CHAPTER 11.01 slide 7
 When is a Rate Hike Not Tighter
Policy? -- Altig
 Between June, 2003 and June, 2006, the Fed
raised the Fed funds rate 17 times from 1.0% to
5.25%.
 Does this necessarily indicate tighter policy by
the Fed? That is, is the LM curve necessarily
shifting to the left?

CHAPTER 11.01 slide 8

 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 interaction may alter the impact of the
original policy change.
CHAPTER 11.01 slide 9
 The Fed’s response to D G > 0

 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 DG

are different:

CHAPTER 11.01 slide 10

 Response 1: Hold M constant

If Congress raises G, r
the IS curve shifts right. LM1

If Fed holds M constant,

r2
then LM curve doesn’t r1
shift.
IS2
Results:
IS1
DY = Y 2 - Y1 Y
Y1 Y2
Dr = r 2 - r1

CHAPTER 11.01 slide 11

 Response 2: Hold r constant

If Congress raises G, r
the IS curve shifts right. LM1
LM2
To keep r constant,
r2
Fed increases M r1
to shift LM curve right.
IS2
Results: IS1
DY = Y 3 - Y1 Y
Y1 Y2 Y3

Dr = 0

CHAPTER 11.01 slide 12

 Response 3: Hold Y constant

If Congress raises G, r LM2

the IS curve shifts right. LM1

To keep Y constant, r3
r2
Fed reduces M r1
to shift LM curve left.
IS2
Results: IS1
DY = 0 Y
Y1 Y2
Dr = r3 - r1

CHAPTER 11.01 slide 13

 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
 DC
 change in business or consumer
confidence or expectations
 D I and/or DC
CHAPTER 11.01 slide 14
 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 11.01 slide 15

 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.
CHAPTER 11.01 slide 16
 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).

CHAPTER 11.01 slide 17

 CASE STUDY:
The U.S. recession of 2001
 Causes: 1) Stock market decline  C

1500
Standard & Poor’s
Index (1942 = 100)

1200 500

900

600

300
1995 1996 1997 1998 1999 2000 2001 2002 2003
CHAPTER 11.01 slide 18
 CASE STUDY:
The U.S. recession of 2001
 Causes: 2) 9/11
 increased uncertainty
 fall in consumer & business confidence
 result: lower spending, IS curve shifted left
 Causes: 3) Corporate accounting scandals
 Enron, WorldCom, etc.
 reduced stock prices, discouraged investment

CHAPTER 11.01 slide 19

 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

CHAPTER 11.01 slide 20

 CASE STUDY:
The U.S. recession of 2001
 Monetary policy response: shifted LM curve right
7
6
Three-month
Three-month
T-Bill
T-Bill Rate
Rate
5
4
3
2
1
0
00

01

02

03
00

01

01

02
02
02
00
00

01

03
/20

/20

/20
/20

/20
/20

/20

/20
/2 0

/20
/20
/20
/20

/20
/01
/02

/03
/05

/06
/08
/09

/09
/06
/06

/09
/03
/03

/11
04
04

04

01
04

01
01

01

07
10

07
10
07
10

CHAPTER 11.01 slide 21

 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.
CHAPTER 11.01 slide 22
 What is the Fed’s 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 end-of-chapter Problem 7 on p.328.)

CHAPTER 11.01 slide 23

 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.

CHAPTER 11.01 slide 24

 Deriving the AD curve
r LM(P2)
Intuition for slope LM(P1)
r2
of AD curve:
r1
P  (M/P )
IS
 LM shifts left Y2 Y1 Y
P
 r
P2
 I
P1
 Y
AD
Y2 Y1 Y
CHAPTER 11.01 slide 25
 Monetary policy and the AD curve
r LM(M1/P1)
The Fed can increase
r1 LM(M2/P1)
aggregate demand:
r2
M  LM shifts right
IS
 r
Y1 Y2 Y
P
 I
 Y at each P1
value of P
AD2
AD1
Y1 Y2 Y
CHAPTER 11.01 slide 26
 Fiscal policy and the AD curve
r LM
Expansionary fiscal
policy (G and/or T ) r2
increases agg. demand: r1 IS2
T  C IS1
Y1 Y2 Y
 IS shifts right P
 Y at each
P1
value
of P AD2
AD1
Y1 Y2 Y
CHAPTER 11.01 slide 27
 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.

In the short-run then over time, the

equilibrium, if price level will
Y >Y rise
Y <Y fall

Y =Y remain constant

CHAPTER 11.01 slide 28

 The SR and LR effects of an IS shock
r LRAS LM(P )
1
A
A negative
negative IS
IS shock
shock
shifts
shifts IS
IS and
and AD
AD left,
left,
causing
causing Y Y to
to fall.
fall. IS1
IS2
Y Y
P LRAS
P1 SRAS1

AD1
AD2
Y Y
CHAPTER 11.01 slide 29
 The SR and LR effects of an IS shock
r LRAS LM(P )
1

In
In the
the new
new short-run
short-run
equilibrium, Y < Y
equilibrium, IS1
IS2
Y Y
P LRAS
P1 SRAS1

AD1
AD2
Y Y
CHAPTER 11.01 slide 30
 The SR and LR effects of an IS shock
r LRAS LM(P )
1

In
In the
the new
new short-run
short-run
equilibrium, Y < Y
equilibrium, IS1
IS2
Y Y
Over
Over time,
time, P
P gradually
gradually
falls,
falls, which
which causes
causes P LRAS

•• SRAS
SRAS toto move
move down.
down. P1 SRAS1

•• M/P
M/P to
to increase,
increase,
which
which causes
causes LM
LM AD1
to AD2
to move
move down.
down.
Y Y
CHAPTER 11.01 slide 31
 The SR and LR effects of an IS shock
r LRAS LM(P )
1
LM(P2)

IS1
IS2
Y Y
Over
Over time,
time, P
P gradually
gradually
falls,
falls, which
which causes
causes P LRAS

•• SRAS
SRAS toto move
move down.
down. P1 SRAS1

•• M/P
M/P to
to increase,
increase, P2 SRAS2
which
which causes
causes LM
LM AD1
to AD2
to move
move down.
down.
Y Y
CHAPTER 11.01 slide 32
 The SR and LR effects of an IS shock
r LRAS LM(P )
1
LM(P2)

This
This process
process continues
continues IS1
until
until economy
economy reaches
reaches aa IS2
long-run
long-run equilibrium
equilibrium with
with Y
Y
Y =Y P LRAS
P1 SRAS1
P2 SRAS2
AD1
AD2
Y Y
CHAPTER 11.01 slide 33
 EXERCISE:
Analyze SR & LR effects of D 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
IS
on your graphs.
c. Show what happens in the Y
Y
transition from the short run
to the long run. P LRAS

d. How do the new long-run

P1 SRAS1
equilibrium values of the
endogenous variables
compare to their initial AD1
values? Y Y
CHAPTER 11.01 slide 34
 The Great Depression
240 30
Unemployment
220 (right scale) 25
billions of 1958 dollars

percent of labor force

200 20

180 15

160 10

140 Real GNP 5

(left scale)
120 0
1929 1931 1933 1935 1937 1939
CHAPTER 11.01 slide 35
 THE SPENDING HYPOTHESIS:
Shocks to the IS curve
 asserts that the Depression was largely due to
an exogenous fall in the demand for goods &
services – a leftward shift of the IS curve.
 evidence:
output and interest rates both fell, which is what
a leftward IS shift would cause.

CHAPTER 11.01 slide 36

 THE SPENDING HYPOTHESIS:
Reasons for the IS shift
 Stock market crash  exogenous C
 Oct-Dec 1929: S&P 500 fell 17%
 Oct 1929-Dec 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 11.01 slide 37
 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 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.

CHAPTER 11.01 slide 38

 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?

CHAPTER 11.01 slide 39

 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
 Y
CHAPTER 11.01 slide 40
 THE MONEY HYPOTHESIS AGAIN:
The effects of falling prices
 The destabilizing effects of expected deflation:
 e
 r  for each value of i
I  because I = I (r )
 IS shifts to the left
 planned expenditure & agg. demand 
 income & output 

CHAPTER 11.01 slide 41

 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 11.01 slide 42
 Why another Depression is
unlikely
 Policymakers (or their advisors) 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 expansionary
during an economic downturn.

CHAPTER 11.01 slide 43

 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 11 Aggregate Demand II slide 44

 Chapter Summary

2. AD curve
 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.
CHAPTER 11 Aggregate Demand II slide 45