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Chapter 12/11
Aggregate Demand II:
Applying the IS-LM Model
The Great Depression
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Unemployment
(right scale)
220
25
200
20
180
15
160
10
Real GNP
(left scale)
140
120
1929
5
0
1931
1933
1935
1937
1939
percent of labor force
billions of 1958 dollars
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Great Depression: Observations
 Real side of economy:
 Output:
falling
 Consumption:
falling
 Investment:
falling a lot
 Gov. purchases: fall (with a delay)
Great Depression: Observations
 Nominal side:
 Nominal interest rate:
falling
 Money supply (nominal):
falling
 Price level:
falling (deflation)
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.
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.
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. (M/P increased from 52.6 to
54.5)
 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
 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
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 and 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
THE MONEY HYPOTHESIS AGAIN:
The effects of falling prices
 There was a big deflation: P fell 25% 1929-33.
 A sudden fall in expected inflation means the ex-ante
real interest rate rises for any given nominal rate (i )
ex ante real interest rate = i – e
 This could have discouraged the investment expenditure
and helped cause the depression.
g planned expenditure & agg. demand i
g income & output i
 Since the deflation likely was caused by fall in M,
monetary policy may have played a role here.
New Stuff: IS-LM Model with e ≠0
Y = C(Y – T) + I(i - e) + G : IS-Curve
M/P = L( i, Y) : LM-Curve
Expect inflation enters the model in the
IS-curve
πe ≠ 0, i on the vertical axis
Expected deflation shifts the IS-curve to the
left
IS (π < 0)
IS (π = 0)
i
2
e
1
e
LM
r2
A
r1 = i 1
πe
B
i2
Y2
Y1
Y
The IS-curve is drawn for a given expected inflation.
At point A, πe = 0, on IS1 and r1 = i1
πe < 0 shifts IS to IS2, at B, r2 = i2 - πe => r2 = i2 - (-πe).
πe ≠ 0, i on the vertical axis
Expected inflation shifts the IS-curve to the
right
IS (π = 0)
IS (π > 0)
i
1
e
2
e
LM
B
i2
A
r = i1
πe
r2
Y1
Y2
Y
The IS-curve is drawn for a given expected inflation.
At point A, πe = 0, on IS1 and r1 = i1
πe > 0 shifts IS to IS2, at B, r2 = i2 - πe
Unconventional Monetary Policy in a
Liquidity Trap
πe ≠0
i
IS1 (πe =2%)
IS2 (πe =4%)
Y0
LM
YF
Y
The Fed increases inflation and inflationary expectations.
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.
CASE STUDY
The 2008–09 financial crisis & recession
 2009: Real GDP fell to about 6% below potential,
unemployment 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
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
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CHAPTER SUMMARY
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.
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