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Context for Studying Chapter 11
 Chapter 9 introduced the model of aggregate
demand and supply.
 Chapter 10 developed the IS-LM model,
the basis of the aggregate demand curve.
CHAPTER 11
Aggregate Demand II
slide 0
In Chapter 11, you will learn…
 how to use the IS-LM model to analyze the effects
of shocks, fiscal policy, and monetary policy
 how to derive the aggregate demand curve from
the IS-LM model
 several theories about what caused the
Great Depression
CHAPTER 11
Aggregate Demand II
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Equilibrium in the IS -LM model
The IS curve represents
equilibrium in the goods
market.
r
LM
Y  C (Y  T )  I (r )  G
The LM curve represents
money market equilibrium.
r1
M P  L (r ,Y )
Y1
The intersection determines
the unique combination of Y and r
that satisfies equilibrium in both markets.
CHAPTER 11
Aggregate Demand II
IS
Y
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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
• fiscal policy: G and/or T
• monetary policy: M
CHAPTER 11
Aggregate Demand II
IS
Y1
Y
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An increase in government purchases
1. IS curve shifts right
1
by
G
1 MPC
causing output &
income to rise.
2. This raises money
demand, causing the
interest rate to rise…
r
2.
r2
r1
3. …which reduces investment,
so the final increase in Y
1
is smaller than
G
1 MPC
CHAPTER 11
LM
Aggregate Demand II
IS2
1.
IS1
Y1 Y2
Y
3.
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A tax cut
Consumers save
r
(1MPC) of the tax cut,
so the initial boost in
spending is smaller for T
r2
than for an equal G…
2.
r1
and the IS curve shifts by
1.
LM
1.
MPC
T
1 MPC
2. …so the effects on r
and Y are smaller for T
than for an equal G.
CHAPTER 11
Aggregate Demand II
IS2
IS1
Y1 Y2
Y
2.
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Monetary policy: An increase in M
1. M > 0 shifts
the LM curve down
(or to the right)
2. …causing the
interest rate to fall
r
LM2
r1
r2
3. …which increases
investment, causing
output & income to
rise.
CHAPTER 11
LM1
Aggregate Demand II
IS
Y1 Y2
Y
slide 6
Interaction between
monetary & fiscal policy
 Model:
Monetary & fiscal policy variables
(M, G, and T ) are exogenous.
 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.
CHAPTER 11
Aggregate Demand II
slide 7
The B of C’s response to G > 0
 Suppose Parliament increases G.
 Possible B of C responses:
1. hold M constant
2. hold r constant
3. hold Y constant
 In each case, the effects of the G
are different:
CHAPTER 11
Aggregate Demand II
slide 8
Response 1: Hold M constant
If govt raises G,
the IS curve shifts right.
r
If B of C holds M
constant, then LM curve
doesn’t shift.
r2
r1
LM1
IS2
IS1
Results:
Y  Y 2  Y1
r  r2  r1
CHAPTER 11
Aggregate Demand II
Y1 Y2
Y
slide 9
Response 2: Hold r constant
If Congress raises G,
the IS curve shifts right.
r
To keep r constant, B
of C increases M
to shift LM curve right.
r2
r1
LM1
IS2
IS1
Results:
Y  Y 3  Y1
LM2
Y1 Y2 Y3
Y
r  0
CHAPTER 11
Aggregate Demand II
slide 10
Response 3: Hold Y constant
If govt raises G,
the IS curve shifts right.
To keep Y constant, B
of C reduces M
to shift LM curve left.
LM2
LM1
r
r3
r2
r1
IS2
IS1
Results:
Y  0
Y1 Y2
Y
r  r3  r1
CHAPTER 11
Aggregate Demand II
slide 11
Estimates of fiscal policy multipliers
from the DRI macroeconometric model
Assumption about
monetary policy
Estimated
value of
Y / G
Estimated
value of
Y / T
B of C holds money
supply constant
0.60
0.26
B of C holds nominal
interest rate constant
1.93
1.19
CHAPTER 11
Aggregate Demand II
slide 12
Shocks in the IS -LM model
IS shocks: exogenous changes in the
demand for goods & services.
Examples:
 stock market boom or crash
 change in households’ wealth
 C
 change in business or consumer
confidence or expectations
 I and/or C
CHAPTER 11
Aggregate Demand II
slide 13
Shocks in the IS -LM model
LM shocks: exogenous changes in the
demand for money.
Examples:
 a wave of credit card fraud increases
demand for money.
 more ATMs or the Internet reduce money
demand.
CHAPTER 11
Aggregate Demand II
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EXERCISE:
Analyze shocks with the IS-LM model
Use the IS-LM model to analyze the effects of
1. a boom in the stock market that makes
consumers wealthier.
2. after a wave of credit card fraud, consumers
using cash more frequently in transactions.
For each shock,
a. use the IS-LM diagram to show the effects of
the shock on Y and r.
b. determine what happens to C, I, and the
unemployment rate.
CHAPTER 11
Aggregate Demand II
slide 15
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 LM and therefore affect Y.
 The aggregate demand curve
(introduced in Chap. 9) captures this
relationship between P and Y.
CHAPTER 11
Aggregate Demand II
slide 16
Deriving the AD curve
r
Intuition for slope
of AD curve:
P  (M/P )
 LM shifts left
 r
 I
 Y
LM(P2)
LM(P1)
r2
r1
IS
P
Y2
Y
P2
P1
AD
Y2
CHAPTER 11
Y1
Aggregate Demand II
Y1
Y
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Monetary policy and the AD curve
The B of C can increase
aggregate demand:
M  LM shifts right
r
LM(M1/P1)
LM(M2/P1)
r1
r2
IS
 r
 I
P
 Y at each
value of P
P1
Y1
Y1
CHAPTER 11
Aggregate Demand II
Y2
Y2
Y
AD2
AD1
Y
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Fiscal policy and the AD curve
Expansionary fiscal
policy (G and/or T )
increases agg. demand:
r
LM
r2
r1
IS2
T  C
IS1
 IS shifts right
P
Y1
Y2
Y
 Y at each
value
P1
of P
Y1
CHAPTER 11
Aggregate Demand II
Y2
AD2
AD1
Y
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IS-LM and AD-AS
in the short run & long run
Recall from Chapter 9: 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
CHAPTER 11
then over time, the
price level will
Y Y
rise
Y Y
fall
Y Y
remain constant
Aggregate Demand II
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The SR and LR effects of an IS shock
r
A negative IS shock
shifts IS and AD left,
causing Y to fall.
LRAS LM(P )
1
IS2
Y
P
SRAS1
Y
Aggregate Demand II
Y
LRAS
P1
CHAPTER 11
IS1
AD1
AD2
Y
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The SR and LR effects of an IS shock
r
LRAS LM(P )
1
In the new short-run
equilibrium, Y  Y
IS2
Y
P
SRAS1
Y
Aggregate Demand II
Y
LRAS
P1
CHAPTER 11
IS1
AD1
AD2
Y
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The SR and LR effects of an IS shock
r
LRAS LM(P )
1
In the new short-run
equilibrium, Y  Y
IS2
Over time, P gradually
falls, which causes
• SRAS to move down.
• M/P to increase,
Y
P
P1
SRAS1
Y
Aggregate Demand II
Y
LRAS
which causes LM
to move down.
CHAPTER 11
IS1
AD1
AD2
Y
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The SR and LR effects of an IS shock
r
LRAS LM(P )
1
LM(P2)
IS2
Over time, P gradually
falls, which causes
• SRAS to move down.
• M/P to increase,
Y
P
Y
LRAS
P1
SRAS1
P2
SRAS2
which causes LM
to move down.
Y
CHAPTER 11
IS1
Aggregate Demand II
AD1
AD2
Y
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The SR and LR effects of an IS shock
r
LRAS LM(P )
1
LM(P2)
This process continues
until economy reaches a
long-run equilibrium with
Y Y
IS2
Y
P
Y
LRAS
P1
SRAS1
P2
SRAS2
Y
CHAPTER 11
IS1
Aggregate Demand II
AD1
AD2
Y
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