Chapter 2

Aggregate Demand:
Applying the IS-LM Model
 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 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
Y1
The intersection determines the unique combination
of Y and r that satisfies equilibrium in both markets.
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 effects of r1
• Fiscal Policy: G and/or T
• Monetary Policy: M IS
Y
Y1
 An increase in Government Purchases
1. IS curve shifts right r
1 LM
by G
1 MPC
causing output & r2
income to rise. 2.
r1
2. This raises money
demand, causing the 1. IS2
interest rate to rise… IS1
3. …which reduces investment, so Y
Y1 Y2
the final increase in Y 3.
1
is smaller than G
1 MPC
A Tax Cut
Consumers save (1MPC) r
of the tax cut, so the initial LM
boost in spending is smaller
for T than for an equal
G…
r2
2.
r1
and the IS curve shifts by
MPC 1. IS2
1. T IS1
1 MPC
Y
Y1 Y2
2. …so the effects on r
2.
and Y are smaller for T
than for an equal G.
Monetary policy: An increase in M

r
1. M > 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.
Interaction between Monetary & Fiscal Policy

 Model:
Monetary & fiscal policy variables (M, G, and T )
are exogenous.
 Real world:
Monetary policy makers may adjust M in response
to changes in fiscal policy, or vice versa.
 Such interaction may alter the impact of the original
policy change.
The central bank (CB)’s Response to 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 G are
different…
Response 1: Hold M constant

If Congress raises G, r
LM1
the IS curve shifts right.
If CB holds M constant,
r2
then LM curve doesn’t shift. r1
Results: IS2
IS1
Y  Y 2  Y 1 Y
Y1 Y2
r  r 2  r1
Response 2: Hold r constant

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

r  0
Response 3: Hold Y constant

r LM2
If Congress raises G,
LM1
the IS curve shifts right.
r3
To keep Y constant, Fed
r2
reduces M to shift LM r1
curve left.
IS2
Results: IS1
Y  0 Y
Y1 Y2
r  r3  r1
Shocks in the IS -LM model

IS shocks: exogenous changes in the demand for

goods & services.
Examples:
 Change in business or consumer confidence or
expectations
 I and/or C
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 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.
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 captures this

relationship between P and Y.

 Aggregate Demand: the amounts of real domestic

output which domestic consumers, businesses,
governments, and foreign buyers collectively will
desire to purchase at each possible price level
Deriving the AD curve
r LM(P2)
Intuition for slope of AD LM(P1)
r2
curve:
r1
P  (M/P )
IS
 LM shifts left Y2 Y1 Y
P
 r
P2
 I
P1
 Y AD
Y2 Y1 Y
Monetary policy and the AD curve
r LM(M1/P1)
The CB can increase LM(M2/P1)
aggregate demand: r1
r2
M  LM shifts right
IS
 r
Y1 Y2 Y
P
 I
 Y at each P1
value of P
AD2
AD1
Y1 Y2 Y
Fiscal policy and the AD curve
r LM
Expansionary fiscal policy
(G and/or T ) increases r2
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

ETL
Aggregate supply (AS) curve: the level of real domestic
output available at each possible price level

AS
PI
Classical
Range

Intermediate Range

Keynesian Range

RGDP
The Ranges of AS
 Keynesian Range (short run)
 Horizontal at short run fixed price
 Large amounts of unemployment make it so
that increases in aggregate demand have no
affect on wages or prices.
 Classical Range (long run AS)
 Vertical at full employment level
 Full employment makes it so that increases in
aggregate demand only increase wages or
prices
 Intermediate Range (short run)
 Some sectors of the economy reach full
employment more quickly than others.
IS-LM and AD-AS
in the short run & long run
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
The SR and LR effects of an IS shock
r LRAS LM(P1)
A negative IS shock
shifts IS and AD left,
causing Y to fall. IS1
IS2
Y Y
P LRAS

P1 SRAS1

AD1
AD2
Y Y
The SR and LR effects of an IS shock
r LRAS LM(P1)

In the new short-run

equilibrium, Y  Y IS1
IS2
Y Y
P LRAS

P1 SRAS1

AD1
AD2
Y Y
The SR and LR effects of an IS shock
r LRAS LM(P1)

In the new short-run

equilibrium, Y  Y IS1
IS2
Y Y
Over time, P gradually
falls, causing P LRAS

• SRAS to move down P1 SRAS1

• M/P to increase, which

causes LM to move AD1
down AD2
Y Y
The SR and LR effects of an IS shock
r LRAS LM(P1)
LM(P2)

IS1
IS2
Y Y
Over time, P gradually
falls, causing P LRAS

• SRAS to move down P1 SRAS1

• M/P to increase, which P2 SRAS2

causes LM AD1
to move down AD2
Y Y
The SR and LR effects of an IS shock
r LRAS LM(P1)
LM(P2)

This process continues IS1

until economy reaches a IS2
long-run equilibrium with Y Y
Y Y P LRAS

P1 SRAS1

P2 SRAS2
AD1
AD2
Y Y
NOW YOU TRY:
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 IS
on your graphs.
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 P1 SRAS1
equilibrium values of the
endogenous variables AD1
compare to their initial
values? Y Y
 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
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.
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.
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.
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:
 P  (M/P )  LM shifts right  Y
 Pigou effect:
P  (M/P )
 consumers’ wealth 
 C
 IS shifts right
 Y
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 )
 planned expenditure & agg. demand 
 income & 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
 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.
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
 sub-prime 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
Change in U.S. house price index
and rate of new foreclosures, 1999-2009
 House price change and new foreclosures,
2006:Q3 – 2009Q1

Nevada
Florida Illinois
Michigan Ohio
% of all mortgages
New foreclosures,

California Georgia

Arizona Colorado
Rhode Island
Texas
New Jersey
Hawaii S. Dakota
Oregon
Wyoming
Alaska
N. Dakota

Cumulative change in house price index

U.S. bank failures by year, 2000-2009

* as of July 24, 2009.

Major U.S. stock indexes
(% change from 52 weeks earlier)
Consumer sentiment and growth in consumer
durables and investment spending
Real GDP growth and Unemployment
 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
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.