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CHAPTER 12
Aggregate Demand II:
Applying the IS-LM Model
A PowerPointTutorial
To Accompany
MACROECONOMICS, 8th Edition
N. Gregory Mankiw
Tutorial written by:
Mannig J. Simidian
B.A. in Economics with Distinction, Duke University
1
M.P.A., Harvard University Kennedy School of Government
M.B.A., Massachusetts Institute of Technology (MIT) Sloan School of Management
Chapter Eleven
®
Now that we’ve assembled the
IS-LM model of aggregate
demand, let’s apply it to three
LM(P0)
issues:
r IS
1) Causes of fluctuations in
national income
r0
2) How IS-LM fits into the
model of aggregate supply and
aggregate demand in Chapter 10
Y0
Y
3) The Great Depression
Chapter Eleven
2
The intersection of the IS curve and the LM
curve determines the level of national income,
and the interest rate for a given price level. If the
IS or LM curve shifts, the short-run equilibrium
of the economy changes, and national income
fluctuates. Let’s examine how changes in policy
and shocks to the economy can cause these
curves to shift.
Chapter Eleven
3
r
IS
Chapter Eleven
LM
y
4
+G
Consider an increase in government purchases.
This will raise the level of income by G/(1- MPC)
r
IS IS´
A
LM
B
Y
The IS curve shifts to the right by G/(1- MPC) which raises income
and the interest rate.
Chapter Eleven
5
-T
Consider a decrease in taxes of T.
This will raise the level of income by
T × MPC/(1- MPC)
r
IS IS´
A
LM
B
Y
The IS curve shifts to the right by T × MPC/(1- MPC) which raises
income and the interest rate.
Chapter Eleven
6
r
IS
Chapter Eleven
LM
y
7
+M
Consider an increase in the money supply.
r IS
LM
LM
A
B
Y
The LM curve shifts downward and lowers the interest rate which raises
income. Why? Because when the Fed increases the supply of money, people
have more money than they want to hold at the prevailing interest rate. As a
result, they start depositing this extra money in banks or use it to buy bonds.
The interest rate r then falls until people are willing to hold all the extra
money that the Fed has created; this brings the money market to a new
equilibrium. The lower interest rate, in turn, has ramifications for the goods
market. A lower interest rate stimulates planned investment, which increases
planned expenditure, production, and income Y.
Chapter Eleven
8
The IS-LM model shows that monetary policy influences income by
changing the interest rate. This conclusion sheds light on our analysis
of monetary policy in Chapter 9. In that chapter we showed that in
the short run, when prices are sticky, an expansion in the money
supply raises income. But we didn’t discuss how a monetary
expansion induces greater spending on goods and services—a process
called the monetary transmission mechanism.
The IS-LM model shows that an increase in the money supply lowers
the interest rate, which stimulates investment and thereby expands the
demand for goods and services.
Chapter Eleven
9
The IS-LM model shows how monetary and fiscal policy influence
the equilibrium level of income. The predictions of the model,
however, are qualitative, not quantitative. The IS-LM model that
shows that increases in government purchases raise GDP and that
increases in taxes lower GDP. But, when economists analyze specific
policy proposals, they must know the direction and size of the effect.
Macroeconometric models describe the economy quantitatively,
rather than just qualitatively.
Chapter Eleven
10
Chapter Eleven
11
You probably noticed from the IS and LM diagrams that r and Y were on
the two axes. Now we’re going to bring a third variable, the price level
(P) into the analysis. We can accomplish this by linking both twodimensional graphs.
LM(P2)
To derive AD, start at point A in the top
r IS
LM(P1) graph. Now increase the price level from P1
to P2.
B
An increase in P lowers the value of real money
A
balances, and Y, shifting LM leftward to point B.
Notice that r increased. Since r increased, we know
Y that investment will decrease, as it just got more
P
costly to take on various investment projects. This
B
P2
sets off a multiplier process since -I causes a –Y.
A
P1
The - Y triggers -C as we move up the IS curve.
AD
The +P triggers a sequence of events that end
Y
with a -Y, the inverse relationship that defines
12
Chapter Eleven
the downward slope of AD.
+G
Suppose there is a +G.
Y = C (Y-T) + I(r) + G
This translates into a rightward shift of the IS and AD curves.
r
In the short run, we move along SRAS from
point A to point B.
But as the output market clears, in the long-run,
the price level will increase from P0 to P2.
This +P decreases the value of real money
balances, which translates into a leftward shift
of the LM curve.
M/ P = L (r, Y)
Chapter Eleven
P
P2
P
0
Finally, this leaves us at point C in both diagrams.
LM (P2)
LM(P0)
IS IS´
C
A
B
LRAS
C
B
A
Y
SRAS
A AD´
D
Y
13
Remember that SR is the movement
from A to B.
Now it’s time to determine the effects on the variables in the economy.
For the variables Y, P, and r, you can read the effects right off the diagrams.
Y +, because Y moved from Y* to Y´
P 0, because prices are sticky in the SR.
r +, because a +Y leads to a rise in r
as IS slides along the LM curve.
C +, because a +Y increases the level of
consumption (C=C(Y-T)).
I – , since r increased, the level of
investment decreased.
Chapter Eleven
r
IS IS´
C
P2
P0
LM(P0)
B
A
P
LM(P2)
LRAS
Y
C
B
A
Y* Y´
SRAS
AD´
AD
Y
14
For the variables Y, P, and r, you can read the effects right off the diagrams.
Remember that LR is the movement from A to C.
r
Y 0, because rising P shifts LM to left, returning
Y to Y* as required by long-run LRAS.
P +, in order to eliminate the excess demand at P .
0
r +, reflecting the leftward shift in LM due
to +P
C 0, since both Y and T are back to their initial
P
levels (C=C(Y-T))
I – – , since r has risen even more due to the
P2
+P.
P0
LM(P2)
IS IS´
C
LM(P0)
B
A
LRAS
C
B
A
Y* Y´
Chapter Eleven
Y
SRAS
A AD´
D
Y
15
Suppose there is a +M.
M/ P = L (r, Y)
Look at the appropriate equation
that captures the M term:
Notice that M/ was increased, thus increasing the value of the real money
supply which translates into a rightward shift of the LM and AD curves.
r IS
LM(P0)
In the short run, we move along SRAS from
LM
point A to point B.
A= C
But as the output market clears, in the long run,
B
the price level will increase from P0 to P2.
This +P decreases the value of the
real money supply which translates into a
leftward shift of the LM curve.
M/ P = L (r, Y)
Chapter Eleven
P
P2
P
0
Finally, this leaves us at point C in both diagrams.
LRAS
Y
C
A
B SRAS
AD´
AD
Y
16
Remember that SR is the
movement from A to B.
Now it’s time to determine the effects on the variables in the economy.
For the variables Y, P, and r, you can read the effects right off the diagrams.
Y +, because Y moved from Y* to Y´
P 0, because prices are sticky in the SR.
r –, because a +Y leads to a decrease in r
as LM slides along the IS curve.
C +, because a +Y increases the level of
consumption (C=C(Y-T)).
I + , since r increased, the level of
investment decreased.
Chapter Eleven
r
IS
A= C
(P2)
LM (P0)
LM 
B
P
LRAS
P2
P0
C
A
Y
B SRAS
AD´
AD
Y* Y´
Y
17
Remember that LR is the movement from A to C.
For the variables Y, P, and r, you can read the effects right off the diagrams.
Y 0, because rising P shifts LM to left, returning
r
Y to Y* as required by LRAS.
P +, in order to eliminate the excess demand at P .
0
r 0, reflecting the leftward shift in LM due
to +P, restoring r to its original level.
C 0, since both Y and T are back to their initial
levels (C=C(Y-T)).
I 0, since Y or r has not changed.
P
Notice that the only LR impact of an
increase in the money supply was an
increase in the price level.
Chapter Eleven
P2
P0
IS
A= C
LM (P0)
LM 
B
LRAS
Y
C
A
Y* Y´
B SRAS
AD´
AD
Y 18
Chapter Eleven
19
r
IS
LM(P2)
1) +C causes the IS curve to shift
LM(P0) right to IS‘.
IS'
C

B
Y = C (Y-T) + I(r) + G
A
P
P2
P0
LRAS
C

A
 B 
Chapter Eleven
2) This leads to a rightward shift in AD
to AD’.
Short Run:
Move from A to B.
Y
Long Run:
Market clears at P0 to P2
from B to C.
3) +P causes LM(P0) to shift leftward
LRAS to LM(P2) due to the lowering of the
real value of the money supply.
AD AD'
Y
M/ P = L (r, Y)
20
r
IS
LM(P2)
LM(P0)
IS'
C 
Short
Run:
B
A
Y
P
P2
C 
P0
A B
Chapter Eleven
Y
P
r
C
I
LRAS
Long
Run:
+
0
+
+
-
0
+
++
+
--
SRAS
AD AD'
Y
21
The spending hypothesis suggests that perhaps the cause of the
decline may have been a contractionary shift of the IS curve.
The money hypothesis attempts to explain the effects of the historical
fall of the money supply of 25 percent from 1929 to 1933, during which
time unemployment rose from 3.2 percent to 25.2 percent.
Some economists say that deflation worsened the Great Depression.
They argue that the deflation may have turned what in 1931 was a
typical economic downturn into an unprecedented period of high
unemployment and depressed income. Because the falling money
supply was possibly responsible for the falling price level, it could
very well have been responsible for the severity of the depression. Let’s
see Chapter
howEleven
changes in the price level affect income in the IS-LM model.
22
A Mankiw
Macroeconomics
Case Study
The Financial Crisis and the
Economic Downturn of 2008 and 2009
In 2008, the economy experienced a financial crisis, followed by
a deep recession stemming mainly from the 20% fall in housing
prices across the nation.
This had four main repercussions:
1)Rise in mortgage defaults and house foreclosures
2) Large losses at the various financial institutions that owned
Mortgage-backed securities
3) Rise in stock market volatility, which led to a decline in
consumer confidence
In January 2009, President Barack Obama proposed to increase
he proposed to increase government spending to stimulate AD.
This is almost surely not going to prevent the economy from
Dipping further into a downward spiral.
Chapter Eleven
23
Developments in the mortgage market led to the rise of subprime
borrowers– those borrowers with higher risk of default based on their
Income and credit history– to get mortgages to buy home.
One of these developments was securitization, the process by
which one makes loans and then sells them to an investment bank
which in turn bundles them together into a variety of
“mortgage-backed securities” and then sells them to a third
financial institution (such as a bank, pension fund, or insurance
company). These securities pay a return as long as homeowners
continue to repay their loans, but they lose value if homeowners
default.
Chapter Eleven
24
In the IS-LM model, falling prices raise income. For any given
supply of money M, a lower price level implies higher real
money balances, M/P. An increase in real money balances causes
an expansionary shift in the LM curve, which leads to higher
income.
Another way in which falling prices increase income is called
the Pigou effect. In the 1930s, economist Arthur Pigou pointed out
that real money balances are part of household wealth. As prices fall
and real money balances rise, households increase their
consumption spending and the IS curve shifts to the right.
Chapter Eleven
25
There are two theories to explain how falling prices could depress
income rather than raise it.
1) Debt-deflation theory, unexpected falls in the price level
2) Effects of expected inflation
Debt-deflation theory redistributes wealth between creditors and
debtors. A fall in the price level raises the real amount of the debt.
The impoverishment of the debtors causes them to spend less, and
creditors to spend more. If their propensities to consume are the same,
there is no aggregate effect. But, if debtors reduce more than
the amount that creditors increase spending, the net effect on aggregate
demand is a reduction. This contracts IS, and reduces national income.
Chapter Eleven
26
interest rate, i
IS
r2
IS´
r1 = i 1
A
i2
B
LM
Y
An expected deflation (a negative value of pe) raises the real interest
rate for any given nominal interest rate, and this depresses investment
spending. The reduction in investment shifts the IS curve downward.
The level of income and the nominal interest rate (i) fall, but the real
interest rate (r) rises.
Chapter Eleven
27
Monetary transmission mechanism
Pigou Effect
Debt-deflation theory
Chapter Eleven
28