AD ctd (Ch.11)
Applying the ISIS-LM Model
 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
– explore various explanations for the
Great Depression
Ch. 11
AD II
slide 0
Policy analysis with the ISIS-LM Model
Y  C (Y  T )  I (r )  G
r
LM
M P  L (r ,Y )
r1
Policymakers can affect
macroeconomic variables with
• G and/or T
•M
Ch. 11
IS
Y
Y1
AD II
slide 1
An increase in G
r
1. IS curve shifts right
by
1
G
1  MPC
2.
2. This raises MD
LM
r2
r1
IS2
1.
IS1
3. …which reduces I, final
increase in Y smaller
Ch. 11
AD II
Y1 Y2
Y
3.
slide 2
1
A tax cut
Initial boost in C smaller
for T than for an equal
 G…
r
2.
IS curve shifts by
1.
r2
r1
1.
MPC
T
1  MPC
IS2
IS1
Y1 Y2
2. …so the effects on r and Y
are smaller…
Ch. 11
LM
Y
2.
AD II
slide 3
Monetary Policy: an increase in M
1. M > 0 shifts
the LM curve down
r
LM1
LM2
r1
2. r falls
r2
IS
3. Output rises
Y1 Y2
Ch. 11
AD II
Y
slide 4
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.
Ch. 11
AD II
slide 5
2
The Fed’
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:
Ch. 11
AD II
slide 6
↑G Response 1: hold M constant
Fed keeps M
constant
r
LM1
r2
r1
Results:
Y  Y 2  Y1
IS2
IS1
r  r2  r1
Ch. 11
↑G
Y1 Y2
AD II
Y
slide 7
Response 2: hold r constant
Fed increases M
r
LM1
LM2
r2
r1
IS2
IS1
Results:
Y  Y 3  Y1
Y1 Y2 Y3
Y
r  0
Ch. 11
AD II
slide 8
3
↑G
Response 3: hold Y constant
LM2
LM1
r
Fed reduces M
r3
r2
r1
IS2
IS1
Results:
Y  0
Y1 Y2
Y
r  r3  r1
Ch. 11
AD II
slide 9
Shocks in the ISIS-LM Model
IS shocks: exogenous changes in demand for
goods
Examples:
• stock market boom or crash
 change in households’ wealth
 C
• change in confidence or expectations
 I and/or C
Ch. 11
AD II
slide 10
Shocks in the ISIS-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
Ch. 11
AD II
slide 11
4
What is the Fed’
Fed’s policy instrument?
The Fed targets the Federal Funds rate:
it announces a target value + uses monetary policy to shift
LM to attain target rate.
Why does the Fed target interest rates?
1) r easier to measure
2) Fed might believe that LM shocks are more
prevalent than IS shocks. If so, targeting r
stabilizes Y better than targeting the M.
Ch. 11
AD II
slide 12
ISIS-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.
 The aggregate demand curve
(introduced in chap. 9 ) captures this
relationship between P and Y
Ch. 11
AD II
slide 13
Deriving the AD curve
r
Intuition for slope
of AD curve:
P  (M/P )
 LM shifts left
 r
 I
LM(P2)
LM(P1)
r2
r1
IS
P
Y2
Y1
Y2
Y1
P2
P1
 Y
Ch. 11
AD II
Y
AD
Y
slide 14
5
Monetary policy and the AD curve
The Fed 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
Ch. 11
Y
Y2
AD2
AD1
Y
Y2
AD II
slide 15
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
 Y at each
value of P
P1
Y1
Y1
Ch. 11
Y
Y2
Y2
AD2
AD1
Y
AD II
slide 16
SR and LR effects of a negative IS shock
A negative IS shock
shifts IS and AD left,
causing Y to fall.
r
LRAS LM(P )
1
IS2
Y
P
SRAS1
Y
AD II
Y
LRAS
P1
Ch. 11
IS1
AD1
AD2
Y
slide 17
6
The SR and LR effects of an IS shock
Over time, P falls
(since Y below eq’m
level)
r
LRAS LM(P )
1
LM(P2)
IS1
IS2
This process
continues until
economy reaches a
long-run equilibrium
with Y equal to Ybarl
P
LRAS
P1
SRAS1
P2
SRAS2
AD1
AD2
Y
Y
Ch. 11
Y
Y
AD II
slide 18
The Great Depression
220
billions of 1958 dollars
30
Unemployment
(right scale)
25
200
20
180
15
160
10
Real GNP
(left scale)
140
120
1929
Ch. 11
percent of labor force
240
5
0
1931
1933
1935
1937
1939
AD II
slide 19
The Spending Hypothesis:
Shocks to the IS Curve
LEFTWARD SHIFT of the IS curve
Why?
1.
Stock market crash  exogenous C ( 1929-1933:
S&P 500 fell 71%)
2.
Drop in investment (bank failures made it harder to
3.
Contractionary fiscal policy: politicians raised tax rates
obtain financing for investment)
and cut spending
EVIDENCE: output and interest rates both fell, which is what a
leftward IS shift would cause
Ch. 11
AD II
slide 20
7
The Money Hypothesis:
A Shock to the LM Curve
 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:
1. P fell even more, M/P actually rose
slightly during 1929-31.
2. nominal interest rates fell, which is the
opposite of what would result from a
leftward LM shift.
Ch. 11
AD II
slide 21
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.
 Can deflation be bad?
Ch. 11
AD II
slide 22
The Money Hypothesis Again:
The Effects of Falling Prices
THE GOOD SIDE OF DEFLATION
Pigou effect: P
 (M/P )  C  IS shifts right  Y
THE BAD SIDE
debt-deflation theory: unexpected deflation
P (if unexpected)  transfers purchasing power from borrowers
to lenders  if borrowers’ MPC > lenders MPC  aggregate
spending falls  IS left Y falls
Expected deflation: e  r   I  
Ch. 11
AD II
income & output 
slide 23
8