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CHAPTER 11
Extending the Sticky-Price Model:
IS-LM, International Side,
and AS-AD
11-1
Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
Questions
• What is money-market equilibrium?
• What is the LM curve?
• What determines the equilibrium level
of real GDP when the central bank
policy is to keep the money supply
constant?
• What is the IS-LM framework?
11-2
Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
Questions
• What is an IS shock?
• What is an LM shock?
• What is the relationship between
shifts in the equilibrium on the IS-LM
diagram and changes in the real
exchange rate?
11-3
Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
Questions
• What is the relationship between
shifts in the equilibrium on the IS-LM
diagram and changes in the balance
of trade?
• What is the aggregate supply curve?
• What is the aggregate demand curve?
11-4
Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
The Demand for Money
• Three facts about business and
household demand for money
– money demand is proportional to total
nominal income (PY)
– money demand has a time trend, the
result of slow changes in the banking
sector structure and technology
– money demand is inversely related to the
nominal interest rate
11-5
Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
The Demand for Money
• Money demand is inversely related to
the nominal interest rate (i=r+)
because the nominal interest rate is
the opportunity cost of holding money
– money balances lose purchasing power at
the rate of inflation ()
– if money balances were placed in some
other asset, they would earn the
prevailing market real interest rate (r)
11-6
Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
The Demand for Money
• To keep our model simple, we will
ignore the time trend in velocity
• The demand for money can be
expressed as
d
M
Y

P
V0  Vi  (r  e )
• Money demand is proportional to real
GDP and a decreasing function of the
nominal interest rate
11-7
Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
Money Market Equilibrium
• In a sticky-price model, the price level
is predetermined
– it cannot move instantly to make money
supply equal to money demand
• The nominal interest rate must adjust
to keep the money market in
equilibrium
 (Y  P)   V

s
0
M 

e
i  (r   ) 
Vi
11-8
Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
Figure 11.1 - Money Demand and
Money Supply
11-9
Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
Money Market Equilibrium
• If money supply < money demand
– businesses and households want to hold
larger money balances and try to borrow
to increase their cash holdings
– banks respond by raising interest rates
– as the nominal interest rate rises, the
quantity of money demanded falls
– this process continues until the quantity
of money demanded is equal to the
money supply
11-10
Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
Money Market Equilibrium
• If money supply > money demand
11-11
– businesses and households are holding
larger money balances than they want so
they deposit them at the bank
– banks want to increase loans and thus
respond by lowering interest rates
– as the nominal interest rate falls, the
quantity of money demanded rises
– this process continues until the quantity
of money demanded is equal to the
money supply
Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
The LM Curve
• Because the demand for money
depends on the level of real GDP, if
the money stock is constant, the
equilibrium nominal interest rate will
vary whenever real GDP varies
11-12
Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
Figure 11.2 - Money Demand Varies as Total
Income Y Varies
11-13
Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
The LM Curve
• The LM curve shows the relationship
between the level of real GDP and the
equilibrium nominal interest rate that
clears the money market
• The LM curve slopes upward
– at a higher level of real GDP, money
demand is higher and therefore the
equilibrium nominal interest rate is higher
11-14
Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
Figure 11.3 - From Money Demand to the
LM Curve
11-15
Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
The LM Curve
• The equation for the LM curve is
M
Y  [V0  Vi  (r   )]   
P
e
• Increases in the money supply shift
the LM curve to the right
• A decline in the price level shifts the
LM curve to the right
11-16
Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
The IS-LM Framework
• As long as we know the expected
inflation rate, we can plot the IS and
LM curves on the same axis
• The equilibrium levels of real GDP and
the interest rate occur at the point
where the IS and LM curves intersect
– the economy is in equilibrium in both the
goods market and the money market
11-17
Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
Figure 11.4 - The IS-LM Diagram
11-18
Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
IS-LM Equilibrium
• Example (assume that  is constant at
3%)
– IS curve: Y = $10,000 - $20,000r
– LM curve: Y = $1,000 + $100,000(r+)
$10,000 - $20,000r  $1,000  $100,000(r  3)
$6,000  $120,000r
r  0.05  5%
Y  $9,000 billion
11-19
Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
Figure 11.5 - IS-LM Equilibrium Example
11-20
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IS Shocks
• Any change in economic policy or the
economic environment that increases
autonomous spending shifts the IS
curve to the right
– the new equilibrium will have a higher
level of real GDP and a higher real
interest rate
– how the total effect is divided between
increased interest rates and increased
real GDP depends on the slope of the LM
curve
11-21
Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
Figure 11.6 - Effect of a Positive IS Shock
11-22
Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
• Example
An IS Shock
– initial IS curve: Y = $10,000 - $20,000r
– LM curve: Y = $1000 + $100,000(r+3)
– initial equilibrium: r=5%; Y = $9,000
– autonomous spending increases
– new IS curve: Y = $10,300 - $20,000r
$10,300 - $20,000r  $1,000  $100,000(r  3)
r  0.0525  5.25%
Y  $9,250 billion
11-23
Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
Figure 11.7 - Calculating the Effect of an
IS Shift
11-24
Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
LM Shocks
• An increase in the money stock will
shift the LM curve to the right
– the new equilibrium position will have a
higher level of equilibrium real GDP and a
lower interest rate
11-25
Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
Figure 11.8 - Effect of an Expansionary
LM Shock
11-26
Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
• Example
An LM Shock
– IS curve: Y = $10,000 - $20,000r
– initial LM curve: Y=$1000+$100,000(r+3)
– initial equilibrium: r=5%; Y=$9,000
– the money supply increases
– new LM curve: Y=$2200 + $100,000(r+3)
$10,000 - $20,000r  $2200  $100,000(r  3)
r  0.04  4%
Y  $9,200 billion
11-27
Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
Figure 11.9 - An Expansionary Shift in the
LM Curve
11-28
Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
Interest Rate Targets
• The case in which the central bank is
targeting the interest rate can be
viewed in the IS-LM framework
• An interest rate target can be seen as
a flat, horizontal LM curve at the
target level of the interest rate
11-29
Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
Figure 11.10 - IS-LM Framework with an
Interest Rate Target
11-30
Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
Changes that Affect the
LM Curve
• Any change in the nominal money
stock, in the price level, or in the
trend velocity of money will shift the
LM curve
• Any change in the interest sensitivity
of money demand will change the
slope of the LM curve
11-31
Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
Changes that Affect the
LM Curve
• The IS-LM diagram is drawn with the
long-term, risky, real interest rate on
the vertical axis
• The LM curve is a relationship
between the short-run nominal
interest rate and the level of real GDP
at a fixed level of the money supply
11-32
Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
Changes that Affect the
LM Curve
• As long as the spread between the
short-term, safe, nominal interest rate
and the long-term, risky, real interest
rate is constant, there are no
complications in drawing the LM curve
onto the same diagram as the IS
curve
11-33
Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
Changes that Affect the
LM Curve
• If the expected rate of inflation, the
risk premium, or the term premium
between short- and long-term interest
rates changes, the LM curve will shift
– changes in financial market expectations
of future Federal Reserve policy, future
interest rates, or changes in the risk
tolerance of bond traders will shift the LM
curve
11-34
Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
Figure 11.11 - An Increase in Expected
Inflation Moves the LM Curve Downward
11-35
Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
Changes that Affect the
IS Curve
• Shifts in the IS curve are more
frequent than shifts in the LM curve
• Any change in the interest sensitivity
of investment, the sensitivity of
exports to the exchange rate, or the
sensitivity of the exchange rate to the
domestic interest rate will change the
slope of the IS curve
11-36
Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
Changes that Affect the
IS Curve
• Anything that affects MPE will change
the slope and the position of the IS
curve
– this includes changes in the MPC, tax
rates, and the propensity to import
• Any change in autonomous spending
will shift the IS curve
11-37
Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
The IS-LM Framework and
the Exchange Rate
• In the sticky-price model, the real
exchange rate () is equal to
  0 - r (r - r f )
• As long as the domestic real interest
rate does not change, domestic
conditions will have no impact on the
exchange rate
11-38
Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
The IS-LM Framework and
the Exchange Rate
• Changes in the IS and LM curves that
change the domestic real interest rate
will alter the real exchange rate by an
amount equal to (r  r)
– a rightward shift in the IS curve or a
leftward shift in the LM curve will lower
the real exchange rate
– a leftward shift in the IS curve or a
rightward shift in the LM curve will raise
the real exchange rate
11-39
Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
Figure 11.12 - IS-LM and the Exchange Rate
11-40
Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
The IS-LM Framework and
the Balance of Trade
• Changes in the domestic interest rate
affect the real exchange rate which
affects gross exports
• Changes in total income affect imports
• The effect on net exports is the
difference between these two effects
NX  GX - IM
NX  (r  r) - (IMy  Y)
11-41
Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
Figure 11.13 - Effect of a Change in
Domestic Conditions on the Exchange Rate
and the Balance of Trade
11-42
Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
An LM Shock and the
Balance of Trade
• Example
– initial IS curve: Y=$10,000 - $20,000r
– initial LM curve: Y=$1000+$100,000(r+3)
– initial equilibrium: r=5%; Y=$9,000
– the money supply increases
– new LM curve: Y=$2200+$100,000(r+3)
– new equilibrium: r=4%; Y=$9,200
11-43
Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
Figure 11.14 - Effects of Expansionary
Monetary Policy
11-44
Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
An LM Shock and the
Balance of Trade
• Example (continued)
– the decrease in the real interest rate
increases the exchange rate by [(-r  r)=
-10  (-.01)=0.10] and the rise in the real
exchange rate increases gross exports by
[(X  )=$200  0.1=$20]
– the increase in real national income
increases imports by [(IMy  Y)=$0.15 
$200=$30]
– net exports falls by $10
11-45
Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
International Shocks
• Three types of international shocks
will affect the IS-LM equilibrium
– a shift in foreign demand for exports
– a shift in the foreign real interest rate
– a change in foreign exchange speculators’
view about the fundamental value of the
exchange rate
11-46
Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
International Shocks
• An increase in export demand is an
increase in autonomous spending (A0)
– the IS curve shifts rightward by an
amount equal to A0/(1-MPS)
– equilibrium real GDP rises and the real
interest rate rises as well (if the LM curve
is upward sloping)
11-47
Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
Figure 11.15 - Effect of an Increase in
Foreign Demand for Exports
11-48
Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
International Shocks
• An increase in the foreign interest rate
raises the value of the exchange rate
and boosts exports
– the IS curve shifts to the right
– equilibrium real GDP rises and the real
interest rate also increases (if the LM
curve is upward sloping)
11-49
Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
International Shocks
• If foreign exchange speculators lose
confidence in their home currency, the
exchange rate will rise
– the IS curve will shift to the right
– equilibrium real GDP will rise and the real
interest rate will increase (assuming that
the LM curve is upward sloping)
11-50
Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
International Shocks
• Example
– LM curve: Y = $1000 + $100,000(r+3)
– initial IS curve: Y = $10,000 - $20,000r
– initial equilibrium: r=5%; Y= $9,000
– foreign exchange speculators lose
confidence in the value of home currency
– new IS curve: Y = $10,120 - $20,000r
– new equilibrium: r=5.1%; Y = $9,100
11-51
Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
Aggregate Demand
• If the nominal money supply is fixed,
an increase in the price level shifts the
LM curve to the left
– the equilibrium real interest rate rises
– the equilibrium level of real GDP falls
• If we plot the level of equilibrium real
GDP for each possible price level, we
will get the aggregate demand curve
– it will be downward sloping
11-52
Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
Figure 11.16 - An Increase in the Price Level
Shifts the LM Curve Left (If the Nominal
Money Supply is Fixed)
11-53
Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
Figure 11.17 - From the IS-LM Diagram to
the Aggregate Demand Curve
11-54
Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
Monetary Policy and
Aggregate Demand
• Modern central banks alter the money
supply in response to changes in the
economy
– when inflation rises, the central bank
tends to increase the real interest rate
11-55
Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
Monetary Policy and
Aggregate Demand
• The Taylor rule is a simple model of
how central banks act
– the central bank has a target value of
inflation (’) and an estimate of what the
normal real interest rate should be (r*)
– if inflation is higher than ’, the central
bank raises the real interest rate
– if inflation is lower than ’, the central
bank lowers the real interest rate
11-56
Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
Monetary Policy and
Aggregate Demand
• The Taylor rule can be expressed in
equation form:
r  r * "( - ' )
• where ” determines how aggressively
the central bank reacts to inflation
11-57
Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
Monetary Policy and
Aggregate Demand
• The Taylor rule can be substituted
into the equation for the IS curve
Ir  X  r
 A0
 "(Ir  X  r )
Y

 r * 
 ( - ' )
1 - MPE
1 - MPE 1 - MPE

• Simplifying, we get
Y  Y0  '( - ' )
11-58
Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
Monetary Policy and
Aggregate Demand
Y  Y0  '( - ' )
• The monetary policy function is a
relationship between the inflation rate
and real GDP
– it assumes that the Federal Reserve is
engaged in the economy trying to keep
inflation close to its target
11-59
Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
Figure 11.18 - The Monetary Policy Reaction
Function
11-60
Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
Aggregate Supply
• When real GDP is greater than
potential output, inflation is likely to
be higher than previously anticipated
– inflation will like accelerate
• When real GDP is lower than potential
output, inflation is likely to be lower
than previously anticipated
– the inflation rate will likely fall (may even
end up with deflation)
11-61
Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
Aggregate Supply
• The relationship between real GDP
(relative to potential output) and the
rate of inflation (relative to its
previously-expected value) is the
short-run aggregate supply curve
11-62
Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
Aggregate Supply
• The short-run aggregate supply curve
can be expressed in equation form
 P - Pe 
Y-Y*
    e 
Y*
 P 
Y-Y*
   ( - e )
Y*
11-63
Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
Figure 11.19 - Output Relative to Potential
and the Inflation Rate
11-64
Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
Aggregate Supply and
Aggregate Demand
• Where the aggregate supply and
aggregate demand curves cross is the
current level of real GDP and the
current inflation rate
11-65
Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
Figure 11.20 - Aggregate Supply and
Aggregate Demand
11-66
Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
Short-Run Aggregate Supply
• High levels of real GDP are associated
with high inflation and a high price
level for many reasons
– when demand for products is stronger
than anticipated, firms raise their prices
– when aggregate demand is higher than
potential output, some industries may
reach the limits of capacity
11-67
Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
Chapter Summary
• The money market is in equilibrium
when the level of total incomes and of
the short-term nominal interest rate is
just right to make households and
businesses want to hold all the real
money balances that exist in the
economy
11-68
Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
Chapter Summary
• When the central bank’s policy keeps
the money supply fixed--or when
there is no central bank--the LM curve
consists of those combinations of
interest rates and real GDP levels at
which money demand equals money
supply
11-69
Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
Chapter Summary
• When the central bank’s policy keeps
the money supply fixed--or when
there is no central bank--then the
point at which the IS and LM curves
cross determines the equilibrium level
of real GDP and the interest rate
11-70
Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
Chapter Summary
• The IS-LM framework consists of two
equilibrium conditions
– the IS curve shows those combinations of
interest rates and real GDP levels at
which aggregate demand is equal to total
production
– the LM curve shows those combinations
of interest rates and real GDP levels at
which money demand is equal to money
supply
11-71
Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
Chapter Summary
• An IS shock is any shock to the level
of total spending as a function of the
domestic real interest rate
– an IS shock shifts the position of the IS
curve
– an expansionary IS shock raises real GDP
and the real interest rate
11-72
Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
Chapter Summary
• An LM shock is a shock to money
demand or money supply
– an LM shock shifts the position of the LM
curve
– an expansionary LM shock raises real
GDP and lowers the real interest rate
11-73
Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
Chapter Summary
• Anything that affects the level of the
real interest rate on the IS-LM
diagram affects the real exchange
rate
– increases in the real interest rate reduce
the value of the real exchange rate,
holding other things constant
11-74
Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
Chapter Summary
• A number of different international
shocks can also affect the real
exchange rate
– a collapse in foreign exchange speculator
confidence in the currency raises the real
exchange rate
– an increase in the real interest rate
abroad also raises the real exchange rate
11-75
Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
Chapter Summary
• The aggregate supply curve captures
the relationship between aggregate
demand and the price level
– the higher is real GDP, the higher the
price level and inflation rate are likely to
be
11-76
Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
Chapter Summary
• The aggregate demand relationship
arises because changes in the price
level and inflation rates cause shifts in
the determinants of aggregate
demand--either directly as changes in
the price level change the money
stock, or indirectly as changes in the
inflation rate change the interest rate
target of the central bank
11-77
Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
Chapter Summary
• Together, the aggregate demand and
aggregate supply curves make up the
AS-AD framework, which allows us to
analyze the impact of changes in
economic policy and the economic
environment not just on real GDP but
also on the price level and the
inflation rate as well
11-78
Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.