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A PowerPointTutorial
to Accompany macroeconomics, 5th ed.
N. Gregory Mankiw
CHAPTER ELEVEN
Aggregate Demand II
Mannig J. Simidian
Chapter Eleven
1
Now that we’ve assembled the IS-LM model of aggregate demand,
let’s apply it to three issues:
1) Causes of fluctuations in national income
2) How IS-LM fits into the model of aggregate supply and aggregate
demand
3) The Great Depression
Chapter Eleven
2
The intersection of the IS curve and the LM
curve determines the level of national income.
When one of these curves 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
Chapter Eleven
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
Chapter Eleven
6
+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
7
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
8
Chapter Eleven
9
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
10
Chapter Eleven
the downward slope of AD.
+G
Y = C (Y-T) + I(r) + G
Suppose there is a +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.
P
P2
P0
M/ P = L (r, Y)
Chapter Eleven
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
AD´
AD
11Y
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
SRAS
AD´
AD
Y* Y´ Y 12
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
Y
C
B
A
SRAS
AD´
AD
Y* Y´ Y
Chapter Eleven
13
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.
LM(P0)
In the short-run, we move along SRAS from r IS
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.
P
P2
P0
M/ P = L (r, Y)
Chapter Eleven
Finally, this leaves us at point C in both diagrams.
LRAS Y
C
A
B SRAS
AD´
AD
Y
14
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.
r
A= C
(P2)
LM(P0)
LM
B
P
P2
P0
Chapter Eleven
IS
LRAS Y
C
A
B SRAS
AD´
AD
Y* Y´
Y
15
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
B SRAS
AD´
AD
Y* Y´ Y 16
Chapter Eleven
17
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)
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r
IS
LM(P2)
LM(P0)
IS'
C 
B
A
Y
P
r
C
I
Y
P
P2
C 
P0
A B
Chapter Eleven
Short
Run:
LRAS
Long
Run:
+
0
+
+
-
0
+
++
+
--
SRAS
AD AD'
Y
19
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% from 1929 to 1933 during which
time unemployment rose from 3.2% to 25.2.%.
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.
20
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
21
Monetary transmission mechanism
Pigou Effect
Debt-deflation theory
Chapter Eleven
22