Download 9. IS-LM and Aggregate Demand

National Income &
Business Cycles
Ohio Wesleyan University
Goran Skosples
9. IS-LM and Aggregate Demand
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Context & Objectives
 Chapter 11 (10) developed the IS-LM model, the
basis of the aggregate demand curve.
 In Chapter 12 (11), we will use the IS-LM model
to
• see how policies and shocks affect income and
the interest rate in the short run when prices are
fixed
• derive the aggregate demand curve
 We will analyze the short- and long-run effects of
monetary and fiscal policies
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Equilibrium in the IS -LM Model
The IS curve represents
equilibrium in the goods
market.
r
The LM curve represents
money market equilibrium.
LM
IS
Y
The intersection determines
the unique combination of __ and __
that satisfies equilibrium in both markets.
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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
IS
• fiscal policy:
• monetary policy:
Y1
Y
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An increase in government purchases
1. IS curve shifts ____
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by
G
1  MPC
causing output &
income to rise.
r
LM
2. This _____ money
demand, causing the
interest rate to ____…
IS1
3. …which _______ investment,
so the final increase in Y
1
is smaller than
G
1  MPC
Result:
G 
r
&
Y
Y
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Monetary Policy: an increase in M
1. M > 0 shifts
the LM curve _____
2. …causing the
interest rate to ____
r
r1
IS
3. …which _________
investment, causing
output & income to
______.
Result:  M 
LM1
Y
Y1
r
and
Y
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Interaction between
monetary & fiscal policy
 Model:
Monetary & fiscal policy variables
(M, G, and T ) are ______________.
 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.
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The Fed’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…
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Response 1: Hold M constant
If Congress raises G,
the IS curve shifts ____.
If Fed holds M constant,
then LM curve _______
_____.
r
LM1
r1
Results:
IS1
Y1
Y
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Response 2: Hold r constant
If Congress raises G,
the IS curve shifts right.
r
To keep r constant,
Fed __________ M
to shift LM curve ____.
r2
r1
LM1
IS2
IS1
Results:
Y1 Y2
Y
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Response 3: Hold Y constant
If Congress raises G,
the IS curve shifts right.
To keep Y constant,
Fed ________ M
to shift LM curve ___.
r
LM1
r2
r1
IS2
IS1
Results:
Y2
Y
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Estimates of fiscal policy multipliers
from the DRI macroeconometric model
Assumption about
monetary policy
Estimated
value of
Y / G
Estimated
value of
Y / T
Fed holds money
supply constant
0.60
0.26
Fed holds nominal
interest rate constant
1.93
1.19
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Estimates of fiscal policy multipliers
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Estimates of fiscal policy multipliers
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Shocks in the IS -LM Model
IS shocks: exogenous changes in the demand for
goods & services.
• stock market boom or crash  change in
households’ wealth 
• change in business or consumer confidence or
expectations (“animal spirits”) 
LM shocks: exogenous changes in the demand
for money.
• a wave of credit card fraud __ demand for money
• more ATMs or the Internet __ money demand
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Exercise:
Analyze shocks with the IS-LM model
 Use the IS-LM model to analyze the effects of
• A boom in the stock market makes consumers
wealthier.
• After a wave of credit card fraud, consumers
use cash more frequently in transactions.
 For each shock,
• use the IS-LM diagram to show the effects of
the shock on Y and r .
• determine what happens to C, I, and the
unemployment rate.
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Exercise: A boom in the stock market makes
consumers wealthier
r
Which curve shifts
and why?
LM
___, because of
Effects on:
r
Y
C
I
U/L
r1
IS
Y1
Y
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Exercise: After a wave of credit card fraud,
consumers use cash more frequently in
transactions
r
Which curve shifts and
why?
LM
___, because of ______
Effects on:
r
Y
C
I
U/L
r1
IS
Y2
Y1
Y
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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).
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CASE STUDY:
The U.S. recession of 2001
Index (1942 = 100)
 Causes: 1) Stock market decline 
1500
1200
C
Standard & Poor’s
500
900
600
300
1995
1996
1997
1998
1999
2000
2001
2002
2003
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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
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CASE STUDY:
The U.S. recession of 2001
 Fiscal policy response: shifted IS curve ______
• tax cuts in 2001 and 2003
• spending increases
- airline industry bailout
- NYC reconstruction
- Afghanistan war
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CASE STUDY:
The U.S. recession of 2001
 Monetary policy response: shifted LM curve _____
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6
5
Three-month
T-Bill Rate
4
3
2
1
0
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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 ____________ rate –
the interest rate banks charge one another on
overnight loans.
 The Fed changes the money supply and shifts the
_____ curve to achieve its target.
 Other short-term rates typically move with the
federal funds rate.
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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 the LM
curve and therefore affect Y. Why?
 The aggregate demand curve captures this
relationship between P and Y
 Definition: Aggregate demand indicates the
quantity demanded at a given price level
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Deriving the AD curve
Intuition for slope
of AD curve:
r
P 
r1
(M/P )
LM(P1)
IS
 LM shifts ___

r

I

Y
P
Y1
Y
P1
AD
Y1
Y
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Monetary policy and the AD curve
The Fed can increase
aggregate demand:
r
LM(M1/P1)
r1
M  LM shifts ____

r
 I
 Y at each
value of P
IS
P
Y1
Y
Y1
AD1
Y
P1
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Fiscal policy and the AD curve
Expansionary fiscal
policy (G and/or T )
increases AD:
T 
LM
r1
IS1
C
 ___ shifts _____

r
Y at each
value
P
Y1
Y
Y1
AD1
Y
P1
of P
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Aggregate Supply in the Long Run
Recall from chapter 3: In the long-run, output is
determined by factor supplies and technology
Y
is the full-employment or natural level of
output, the level of output at which the
economy’s resources are _____ employed.
“Full employment” means that
unemployment equals its _______ rate.
Y
does not depend on the price level, so the long
run aggregate supply (LRAS) curve is _______:
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The long-run aggregate supply curve
P
The LRAS
curve is vertical
at the fullemployment
level of output.
Y
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Aggregate Supply in the Short Run
 In the real world, many prices are _____ in the
short run.
 If we assume that all prices are stuck at a
predetermined level in the short run…
…and that firms are willing to sell as much as
their customers are willing to buy at that price
level.
...then, the short-run aggregate supply (SRAS)
curve is _________:
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The short run aggregate supply curve
The SRAS curve
is horizontal:
P
The price level
is fixed at a
predetermined
level, and firms
sell as much as
buyers demand.
Y
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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
equilibrium, if
then over time,
the price level will
Y Y
Y Y
Y Y
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Fiscal policy: Increase in G
r
LM0 (M0/P0)
r0
IS1
Y0
P
Y
LRAS
Po
SRAS0
Y0
AD0
Y
G  IS shifts _____

Y &
r
 AD shifts ____
now,
Y1 Y0  P
P   LM ______
_____________
 SRAS shifts ___
until the new
equilibrium is reached:
Y0 & P1
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Effects of a fiscal policy over time
Y
r
t0
time
P
time
t0
FP has real effects in
the SR and in the LR in
this model
t0
time
SR:
Y,
LR: Y
r, P
,
r, P
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Fiscal policy in the long run
 Point: FP has real effects in the SR and in the LR
in this model.
 In this example “crowding out” occurs. The
increase in government expenditure (G)
stimulates Y in the SR. In the LR, however, Y is
fixed. Thus, the increase in the real interest rate
(r ) causes private investment to decrease to
offset the increase in G. Private investment is
“crowded out” by government spending and Y
remains fixed at Y0 = F(K,L).
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Exercise: Analyze SR & LR effects of M
a. Suppose Fed increases M. Show the SR
effects on your graphs.
b. Show what happens in the transition from
the SR to the LR.
c. How do the new LR equilibrium values of
the endogenous variables compare to their
initial values?
Use the graphs provided on the next slide.
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Monetary policy: Increase in M
r
LM0 (M0/P0)
r0
IS1
Y
Y0
LRAS
P
Po
M  __ shifts _____
 Y & r
 __ shifts _____
now,
Y1 Y0  P
P   LM ______
______________
 ____ shifts ___
SRAS1
AD0
Y0
Y
until the new
equilibrium is reached:
Y0 and P1
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Effects of a monetary policy over time
Y
r
t0
time
P
time
t0
MP is effective in the SR
but ineffective in the LR
in this model
SR:
t0
time
Y,
LR: Y
r, P
,r
,P
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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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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
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Summary
3. Short- and long-run effects of FP and MP
• Fiscal policy has real effects in the SR and in
•
the LR in this model (real interest rate
increases in the LR government spending
crowds out private investment)
Monetary policy is effective in the SR but
ineffective in the LR in this model
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