© 2016 Worth Publishers, all rights reserved
Aggregate Demand II:
Applying the IS-LM Model
12CHAPTER
1CHAPTER 12 Aggregate Demand II
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.
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
2
3CHAPTER 12 Aggregate Demand II
The intersection determines
the unique combination of Y and r
that satisfies equilibrium in both markets.
The LM curve represents
money market equilibrium.
Equilibrium in the IS-LM model
The IS curve represents
equilibrium in the goods
market.
Y C Y T I r G= - + +( ) ( )
( , )M P L r Y= IS
Y
r
LM
r1
Y1
4CHAPTER 12 Aggregate Demand II
Policy analysis with the IS-LM model
We can use the IS-LM
model to analyze the
effects of
• fiscal policy: G and/or T
• monetary policy: M
Y C Y T I r G= - + +( ) ( )
( , )M P L r Y=
IS
Y
r
LM
r1
Y1
5CHAPTER 12 Aggregate Demand II
causing output &
income to rise.
IS1
An increase in government purchases
1. IS curve shifts right
Y
r
LM
r1
Y1
GD
-
1by
1 MPC
IS2
Y2
r2
1.
2. This raises money
demand, causing the
interest rate to rise…
2.
3. …which reduces investment,
so the final increase in Y
GD
-
1is smaller than
1 MPC
3.
6CHAPTER 12 Aggregate Demand II
IS1
1.
A tax cut
Y
r
LM
r1
Y1
IS2
Y2
r2
Consumers save
(1−MPC) of the tax cut,
so the initial boost in
spending is smaller for ΔT
than for an equal ΔG…
and the IS curve shifts by
T- D
-1
MPC
MPC
1.
2.
2.
…so the effects on r
and Y are smaller for ΔT
than for an equal ΔG.
2.
7CHAPTER 12 Aggregate Demand II
2. …causing the
interest rate to fall
IS
Monetary policy: An increase in M
1. ΔM > 0 shifts
the LM curve down
(or to the right)
Y
r LM1
r1
Y1 Y2
r2
LM2
3. …which increases
investment, causing
output & income to
rise.
8CHAPTER 12 Aggregate Demand II
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.
9CHAPTER 12 Aggregate Demand II
The Fed’s response to ΔG > 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 ΔG
are different…
10CHAPTER 12 Aggregate Demand II
If Congress raises G,
the IS curve shifts right.
IS1
Response 1: Hold M constant
Y
r
LM1
r1
Y1
IS2
Y2
r2
If Fed holds M constant,
then LM curve doesn’t
shift.
Results:
2 1Y Y YD = -
2 1r r rD = -
11CHAPTER 12 Aggregate Demand II
If Congress raises G,
the IS curve shifts right.
IS1
Response 2: Hold r constant
Y
r
LM1
r1
Y1
IS2
Y2
r2
To keep r constant,
Fed increases M
to shift LM curve right.
3 1Y Y YD = -
0rD =
LM2
Y3
Results:
12CHAPTER 12 Aggregate Demand II
IS1
Response 3: Hold Y constant
Y
r
LM1
r1
IS2
Y2
r2
To keep Y constant,
Fed reduces M
to shift LM curve left.
0YD =
3 1r r rD = -
LM2
Results:
Y1
r3
If Congress raises G,
the IS curve shifts right.
13CHAPTER 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
g change in households’ wealth
g ΔC
§ change in business or consumer
confidence or expectations
g ΔI and/or ΔC
14CHAPTER 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.
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.
15
ANSWERS, PART 1
Housing market crash
16
IS1
Y
r
LM1
r1
Y1
IS2
Y2
r2
IS shifts left, causing
r and Y to fall.
C falls due to lower
wealth and lower
income,
I rises because
r is lower
u rises because
Y is lower
(Okun’s law)
ANSWERS, PART 2
Increase in money demand
17
IS1
Y
r
LM1
r1
Y1Y2
r2
LM2
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
(Okun’s law)
18CHAPTER 12 Aggregate Demand II
CASE STUDY:
The U.S. recession of 2001
§ During 2001:
§ 2.1 million jobs lost,
unemployment rose from 3.9% to 5.8%.
§ GDP growth slowed to 0.8%
(compared to 3.9% average annual growth
during 1994–2000).
19CHAPTER 12 Aggregate Demand II
CASE STUDY:
The U.S. recession of 2001
Causes: 1) Stock market decline g iC
300
600
900
1,200
1,500
1995 1996 1997 1998 1999 2000 2001 2002 2003
In
de
x
(1
94
2
=
10
0) Standard & Poor’s
500
20CHAPTER 12 Aggregate Demand II
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
21CHAPTER 12 Aggregate Demand II
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
22CHAPTER 12 Aggregate Demand II
CASE STUDY:
The U.S. recession of 2001
Monetary policy response: shifted LM curve right
Three-month
T-Bill rate
0
1
2
3
4
5
6
7
23CHAPTER 12 Aggregate Demand II
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.
24CHAPTER 12 Aggregate Demand II
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 problem 8 on p.364.)
25CHAPTER 12 Aggregate Demand II
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. 10) captures this
relationship between P and Y.
26CHAPTER 12 Aggregate Demand II
Y1Y2
Deriving the AD curve
Y
r
Y
P
IS
LM(P1)
LM(P2)
AD
P1
P2
Y2 Y1
r2
r1
Intuition for slope
of AD curve:
hP g i(M/P )
g LM shifts left
g hr
g iI
g iY
27CHAPTER 12 Aggregate Demand II
Monetary policy and the AD curve
Y
P
IS
LM(M2/P1)
LM(M1/P1)
AD1
P1
Y1
Y1
Y2
Y2
r1
r2
The Fed can increase
aggregate demand:
hM g LM shifts right
AD2
Y
r
g ir
g hI
g hY at each
value of P
28CHAPTER 12 Aggregate Demand II
Y2
Y2
r2
Y1
Y1
r1
Fiscal policy and the AD curve
Y
r
Y
P
IS1
LM
AD1
P1
Expansionary fiscal
policy (hG and/or iT)
increases agg. demand:
iT g hC
g IS shifts right
g hY at each
value of P
AD2
IS2
29CHAPTER 12 Aggregate Demand II
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.
Y Y>
Y Y<
Y Y=
rise
fall
remain constant
In the short-run
equilibrium, if
then over time, the
price level will
30CHAPTER 12 Aggregate Demand II
The SR and LR effects of an IS shock
A negative IS shock
shifts IS and AD left,
causing Y to fall.
Y
r
Y
P LRAS
Y
LRAS
Y
IS1
SRAS1P1
LM(P1)
IS2
AD2
AD1
31CHAPTER 12 Aggregate Demand II
The SR and LR effects of an IS shock
Y
r
Y
P LRAS
Y
LRAS
Y
IS1
SRAS1P1
LM(P1)
IS2
AD2
AD1
In the new short-run
equilibrium, Y Y<
32CHAPTER 12 Aggregate Demand II
The SR and LR effects of an IS shock
Y
r
Y
P LRAS
Y
LRAS
Y
IS1
SRAS1P1
LM(P1)
IS2
AD2
AD1
In the new short-run
equilibrium, Y Y<
Over time, P gradually
falls, causing:
• SRAS to move down
• M/P to increase,
which causes LM
to move down
33CHAPTER 12 Aggregate Demand II
AD2
The SR and LR effects of an IS shock
Y
r
Y
P LRAS
Y
LRAS
Y
IS1
SRAS1P1
LM(P1)
IS2
AD1
SRAS2P2
LM(P2)
Over time, P gradually
falls, causing:
• SRAS to move down
• M/P to increase,
which causes LM
to move down
34CHAPTER 12 Aggregate Demand II
AD2
SRAS2P2
LM(P2)
The SR and LR effects of an IS shock
Y
r
Y
P LRAS
Y
LRAS
Y
IS1
SRAS1P1
LM(P1)
IS2
AD1
This process continues
until economy reaches a
long-run equilibrium with
Y Y=
NOW YOU TRY
Analyze SR & LR effects of ΔM
35
a. Draw the IS-LM and AD-AS
diagrams as shown here.
b. Suppose Fed increases M.
Show the short-run effects
on your graphs.
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?
Y
r
Y
P LRAS
Y
LRAS
Y
IS
SRAS1P1
LM(M1/P1)
AD1
ANSWERS, PART 1
Short-run effects of ΔM
36
LM and AD shift right.
r falls, Y rises above
Y
r
Y
P LRAS
Y
LRAS
Y
IS
SRASP1
LM(M1/P1)
AD1
LM(M2/P1)
AD2
Y2
Y2
r2
r1
Y
ANSWERS, PART 2
Transition from short run to long run
37
Over time,
§ P rises
§ SRAS moves upward
§ M/P falls
§ LM moves leftward
New long-run eq’m
§ P higher
§ all real variables back at
their initial values
Money is neutral in the long run.
Y
r
Y
P LRAS
Y
LRAS
Y
IS
SRASP1
LM(M1/P1)
AD1
LM(M2/P1)
AD2
Y2
Y2
r2
r1
2 3
SRASP3
r3 =
The Great Depression
Unemployment
(right scale)
Real GNP
(left scale)
120
140
160
180
200
220
240
1929 1931 1933 1935 1937 1939
bi
llio
ns
o
f 1
95
8
do
lla
rs
0
5
10
15
20
25
30
pe
rc
en
t o
f l
ab
or
fo
rc
e
39CHAPTER 12 Aggregate Demand II
THE SPENDING HYPOTHESIS:
Shocks to the IS curve
§ Asserts 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.
40CHAPTER 12 Aggregate Demand II
THE SPENDING HYPOTHESIS:
Reasons for the IS shift
§ Stock market crash reduced consumption
§ Oct 1929–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.
41CHAPTER 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 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.
42CHAPTER 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 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?
43CHAPTER 12 Aggregate Demand II
THE MONEY HYPOTHESIS AGAIN:
The effects of falling prices
§ The stabilizing effects of deflation:
§ iP g h(M/P) g LM shifts right g hY
§ Pigou effect:
iP g h(M/P )
g consumers’ wealth h
g hC
g IS shifts right
g hY
44CHAPTER 12 Aggregate Demand II
THE MONEY HYPOTHESIS AGAIN:
The effects of falling prices
§ The destabilizing effects of expected deflation:
iEπ
g r h for each value of i
g I i because I = I (r)
g planned expenditure & agg. demand i
g income & output i
45CHAPTER 12 Aggregate Demand II
THE MONEY HYPOTHESIS AGAIN:
The effects of falling prices
§ The destabilizing effects of unexpected deflation:
debt-deflation theory
iP (if unexpected)
g transfers purchasing power from borrowers to
lenders
g borrowers spend less,
lenders spend more
g if borrowers’ propensity to spend is larger than
lenders’, then aggregate spending falls,
the IS curve shifts left, and Y falls
46CHAPTER 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
expansionary during an economic downturn.
47CHAPTER 12 Aggregate Demand II
CASE STUDY
The 2008–09 financial crisis & recession
§ 2009: Real GDP fell, u-rate approached 10%
§ Important factors in the crisis:
§ early 2000s Federal 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 spending
on consumer durables and investment goods
Interest rates and house prices
50
70
90
110
130
150
170
190
0
1
2
3
4
5
6
7
8
9
2000 2001 2002 2003 2004 2005
H
ou
se
p
ric
e
in
de
x,
2
00
0
=
10
0
in
te
re
st
ra
te
(%
)
Federal Funds rate
30-year mortgage rate
Case-Shiller 20-city composite house price index
Change in U.S. house price index
and rate of new foreclosures, 1999–2009
0.0
0.2
0.4
0.6
0.8
1.0
1.2
1.4
-6%
-4%
-2%
0%
2%
4%
6%
8%
10%
12%
14%
1999 2001 2003 2005 2007 2009
N
ew
fo
re
cl
os
ur
e
st
ar
ts

(%
o
f t
ot
al
m
or
tg
ag
es
)
Pe
rc
en
t c
ha
ng
e
in
h
ou
se
p
ric
es

(fr
om
4
q
ua
rt
er
s
ea
rli
er
)
US house price index
New foreclosures
House price change and new foreclosures,
2006:Q3–2009:Q1
0%
2%
4%
6%
8%
10%
12%
14%
16%
18%
20%
-40% -30% -20% -10% 0% 10% 20%
N
ew
fo
re
cl
os
ur
es
,
%
o
f a
ll
m
or
tg
ag
es
Cumulative change in house price index
Nevada
Georgia
Colorado
Texas
Alaska Wyoming
Arizona
California
Florida
S. Dakota
Illinois
Michigan
Rhode Island
Wisconsin Oregon
Ohio
New Jersey
Hawaii
U.S. bank failures by year, 2000–2011
0
20
40
60
80
100
120
140
160
2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011
N
um
be
r o
f b
an
k
fa
ilu
re
s
Major U.S. stock indexes
(% change from 52 weeks earlier)
-80%
-60%
-40%
-20%
0%
20%
40%
60%
80%
100%
120%
140%
12
/6
/1
99
9
8/
13
/2
00
0
4/
21
/2
00
1
12
/2
8/
20
01
9/
5/
20
02
5/
14
/2
00
3
1/
20
/2
00
4
9/
27
/2
00
4
6/
5/
20
05
2/
11
/2
00
6
10
/2
0/
20
06
6/
28
/2
00
7
3/
5/
20
08
11
/1
1/
20
08
7/
20
/2
00
9
DJIA
S&P 500
NASDAQ
Consumer sentiment and growth in consumer
durables and investment spending
50
60
70
80
90
100
110
-25%
-20%
-15%
-10%
-5%
0%
5%
10%
15%
20%
1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009
C
on
su
m
er
S
en
tim
en
t I
nd
ex
, 1
96
6
=
10
0
%
c
ha
ng
e
fr
om
fo
ur
q
ua
rt
er
s
ea
rli
er
Durables
Investment
UM Consumer Sentiment Index
Real GDP growth and unemployment
0
2
4
6
8
10
-6
-4
-2
0
2
4
6
8
10
12
1995 1997 1999 2001 2003 2005 2007 2009 2011
%
o
f l
ab
or
fo
rc
e
%
c
ha
ng
e
fr
om
4
q
ua
rt
er
s
ea
rli
er
Real GDP growth rate (left scale)
Unemployment rate (right scale)
C H A P T E R S U M M A R Y
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
55
C H A P T E R S U M M A R Y
2. AD curve
§ shows relation between P and the IS-LM model’s
equilibrium Y.
§ negative slope because
hP g i(M/P) g hr g iI g iY
§ 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.
56