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Equilibrium in the IS -LM model
r
The IS curve represents
equilibrium in the goods
market.
Chapter 11:
Aggregate Demand II,
Applying the IS-LM Model
LM
Y  C (Y  T )  I (r )  G
r1
The LM curve represents
Th
t
money market equilibrium.
IS
M P  L (r ,Y )
Y
Y1
The intersection determines
the unique combination of Y and r
that satisfies equilibrium in both markets.
CHAPTER 11
Aggregate Demand II
0
We can use the IS-LM
model to analyze the
effects of
LM
r1
IS
• fiscal policy: G and/or T
• monetary policy: M
CHAPTER 11
1. IS curve shifts right
1
G
by
1 MPC
causing output &
income to rise.
2 Thi
2.
This raises
i
money
demand, causing the
interest rate to rise…
r
M P  L (r ,Y )
Y
Y1
Aggregate Demand II
2
CHAPTER 11
Aggregate Demand II
LM
2.
CHAPTER 11
r2
r1
IS2
1.
IS1
Y1 Y2
Y
3.
Aggregate Demand II
1. M > 0 shifts
the LM curve down
(or to the right)
LM
1.
MPC
T
1 MPC
and Y are smaller for T
than for an equal G.
r
3
Monetary policy: An increase in M
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
d th
the IS curve shifts
hift by
b
2. …so the effects on r
1
3. …which reduces investment,
so the final increase in Y
1
is smaller than
G
1 MPC
A tax cut
1.
Aggregate Demand II
An increase in government purchases
Policy analysis with the IS -LM model
Y  C (Y  T )  I (r )  G
CHAPTER 11
Y1 Y2
IS2
IS1
2. …causing the
interest rate to fall
3. …which increases
investment, causing
output & income to
rise.
Y
2.
4
CHAPTER 11
Aggregate Demand II
r
LM1
LM2
r1
r2
IS
Y1 Y2
Y
5
1
10/14/2013
Interaction between
monetary & fiscal policy
 Model:
The Fed’s response to G > 0
 Suppose Congress increases G.
 Possible Fed responses:
Monetary & fiscal policy variables
(M, G, and T ) are exogenous.
1. hold M constant
 Real world:
2. hold r constant
Monetary policymakers may adjust M
in response to changes in fiscal policy,
or vice versa.
3. hold Y constant
 In each case, the effects of the G
are different…
 Such interaction may alter the impact of the
original policy change.
CHAPTER 11
Aggregate Demand II
6
r
If Fed holds M constant,
then LM curve doesn’t
shift.
r2
r1
IS2
IS1
Y  Y 2  Y1
Y1 Y2
r  r2  r1
CHAPTER 11
If Congress raises G,
the IS curve shifts right.
LM1
Results:
To keep r constant,
Fed increases M
to shift LM curve right.
Y
8
Aggregate Demand II
LM2
r2
r1
IS2
IS1
Y1 Y2 Y3
Y
CHAPTER 11
Aggregate Demand II
9
Estimates of fiscal policy multipliers
from the DRI macroeconometric model
LM2
LM1
r
r3
r2
r1
IS2
IS1
Y1 Y2
Y
r  r3  r1
CHAPTER 11
LM1
r  0
Results:
Y  0
r
Y  Y 3  Y1
Response 3: Hold Y constant
To keep Y constant,
Fed reduces M
to shift LM curve left.
7
Results:
Aggregate Demand II
If Congress raises G,
the IS curve shifts right.
Aggregate Demand II
Response 2: Hold r constant
Response 1: Hold M constant
If Congress raises G,
the IS curve shifts right.
CHAPTER 11
10
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
CHAPTER 11
Aggregate Demand II
11
2
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Shocks in the IS -LM model
Shocks in the IS -LM model
IS shocks: exogenous changes in the
demand for goods & services.
LM shocks: exogenous changes in the
demand for money.
Examples:
 stock market boom or crash
 change in households’ wealth
 C
 change in business or consumer
confidence or expectations
 I and/or C
Examples:
 a wave of credit card fraud increases
demand for money.
 more ATMs or the Internet reduce money
demand.
CHAPTER 11
Aggregate Demand II
12
CHAPTER 11
Aggregate Demand II
13
CASE STUDY:
NOW YOU TRY:
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
h more ffrequently
tl iin ttransactions.
ti
The U.S. recession of 2001
 During 2001,
 2.1 million jobs lost,
unemployment rose from 3.9% to 5.8%.
 GDP growth slowed to 0.8%
(compared to 3
3.9%
9% average annual growth
during 1994-2000).
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
CASE STUDY:
The U.S. recession of 2001
The U.S. recession of 2001
Causes: 1) Stock market decline  C
Causes: 2) 9/11
 increased uncertainty
 fall in consumer & business confidence
 result: lower spending, IS curve shifted left
Index (1942 = 100)
CASE STUDY:
1500
Standard & Poor’s
500
1200
15
Causes: 3) Corporate accounting scandals
 Enron, WorldCom, etc.
 reduced stock prices, discouraged investment
900
600
300
1995
CHAPTER 11
1996
1997
1998
Aggregate Demand II
1999
2000
2001
2002
2003
16
CHAPTER 11
Aggregate Demand II
17
3
10/14/2013
CASE STUDY:
CASE STUDY:
The U.S. recession of 2001
 Fiscal policy response: shifted IS curve right
The U.S. recession of 2001
 Monetary policy response: shifted LM curve right
 tax cuts in 2001 and 2003
 spending increases
7
Three-month
T-Bill Rate
6
5
 airline industry bailout
 NYC reconstruction
 Afghanistan war
4
3
2
1
0
CHAPTER 11
Aggregate Demand II
18
What is the Fed’s policy instrument?
CHAPTER 11
Aggregate Demand II
19
What is the Fed’s policy instrument?
 The news media commonly report the Fed’s policy
Why does the Fed target interest rates instead of
the money supply?
changes as interest rate changes, as if the Fed
has direct control over market interest rates.
1) They are easier to measure than the money
supply.
 In fact, the Fed targets the federal funds rate –
th iinterest
the
t
t rate
t banks
b k charge
h
one another
th on
overnight loans.
2) The Fed might believe that LM shocks are
more prevalent than IS shocks. If so, then
targeting the interest rate stabilizes income
better than targeting the money supply.
 The Fed changes the money supply and shifts the
LM curve to achieve its target.
(See end-of-chapter Problem 7 on p.337.)
 Other short-term rates typically move with the
federal funds rate.
CHAPTER 11
Aggregate Demand II
20
IS-LM and aggregate demand
21
r
Intuition for slope
of AD curve:
analyze the short run, when the price level is
assumed fixed.
P  (M/P )
 However, a change in P would shift LM and
 LM shifts left
therefore affect Y.
 r
 The aggregate demand curve
 I
(introduced in Chap. 9) captures this
relationship between P and Y.
Aggregate Demand II
Aggregate Demand II
Deriving the AD curve
 So far, we’ve been using the IS-LM model to
CHAPTER 11
CHAPTER 11
 Y
22
CHAPTER 11
Aggregate Demand II
LM(P2)
LM(P1)
r2
r1
IS
P
Y2
Y1
Y2
Y1
Y
P2
P1
AD
Y
23
4
10/14/2013
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
 I
P
 Y at each
value of P
P1
Y1
Y1
Y
Y2
Y2
Expansionary fiscal
policy (G and/or T )
increases agg. demand:
r
LM
r2
r1
IS2
T  C
IS
 r
CHAPTER 11
Fiscal policy and the AD curve
 IS shifts right
P
 Y at each
value of P
P1
AD2
AD1
Y
Aggregate Demand II
Y1
Y1
24
IS-LM and AD-AS
CHAPTER 11
IS1
Y2
Y2
Y
AD2
AD1
Y
Aggregate Demand II
25
The SR and LR effects of an IS shock
in the short run & long run
r
Recall from Chapter 9: The force that moves the
economy from the short run to the long run
is the gradual adjustment of prices.
A negative IS shock
shifts IS and AD left,
causing Y to fall.
LRAS LM(P )
1
IS2
In the short
short-run
run
equilibrium, if
CHAPTER 11
then over time,
time the
price level will
P
Y Y
rise
P1
Y Y
fall
Y Y
remain constant
The SR and LR effects of an IS shock
Y
P
CHAPTER 11
LRAS LM(P )
1
In the new short-run
equilibrium, Y  Y
IS1
IS2
Y
Over time, P gradually
falls, causing
• SRAS to move down
• M/P to increase,
SRAS1
Y
27
r
LRAS
P1
AD1
AD2
Y
Aggregate Demand II
LRAS LM(P )
1
IS2
Aggregate Demand II
SRAS1
The SR and LR effects of an IS shock
In the new short-run
equilibrium, Y  Y
CHAPTER 11
LRAS
Y
26
r
Y
Y
Aggregate Demand II
IS1
Y
P
P1
SRAS1
Y
28
CHAPTER 11
Aggregate Demand II
Y
LRAS
which causes LM
to move down
AD1
AD2
Y
IS1
AD1
AD2
Y
29
5
10/14/2013
The SR and LR effects of an IS shock
r
LRAS LM(P )
1
LRAS LM(P )
1
LM(P2)
IS2
Over time, P gradually
falls, causing
• SRAS to move down
• M/P to increase,
P
LRAS
P1
SRAS1
P2
SRAS2
P2
SRAS2
AD1
AD2
Y
LRAS LM(M /P )
1
1
b. Suppose Fed increases M.
IS
Show the short-run effects
on your graphs.
equilibrium values of the
endogenous variables
compare to their initial
values?
Y
Y
P
LRAS
P1
Aggregate Demand II
31
SRAS1
30
Unemployment
(right scale)
220
25
200
20
180
15
160
10
Real GNP
(left scale)
140
120
1929
AD1
Y
240
billions of 19
958 dollars
diagrams as shown here.
c. Show what happens in the
CHAPTER 11
The Great Depression
Analyze SR & LR effects of M
r
AD1
AD2
Y
Y
30
NOW YOU TRY:
d. How do the new long-run
LRAS
SRAS1
Y
transition from the short run
to the long run.
P
IS1
Y
Y
Y Y
Aggregate Demand II
a. Draw the IS-LM and AD-AS
IS2
P1
which causes LM
to move down
CHAPTER 11
This process continues
until economy reaches a
long-run
long
run equilibrium with
IS1
Y
Y
LM(P2)
5
percent of la
abor force
r
The SR and LR effects of an IS shock
0
1931
1933
1935
1937
1939
Y
THE SPENDING HYPOTHESIS:
THE SPENDING HYPOTHESIS:
 asserts that the Depression was largely due to
 Stock market crash  exogenous C
Shocks to the IS curve
Reasons for the IS shift
 Oct-Dec 1929: S&P 500 fell 17%
 Oct 1929-Dec 1933: S&P 500 fell 71%
an exogenous fall in the demand for goods &
services – a leftward shift of the IS curve.
 evidence:
 Drop in investment
 “correction” after overbuilding in the 1920s
 widespread bank failures made it harder to obtain
output and interest rates both fell, which is what
a leftward IS shift would cause.
financing for investment
 Contractionary fiscal policy
 Politicians raised tax rates and cut spending to
combat increasing deficits.
CHAPTER 11
Aggregate Demand II
34
CHAPTER 11
Aggregate Demand II
35
6
10/14/2013
THE MONEY HYPOTHESIS:
THE MONEY HYPOTHESIS AGAIN:
A shock to the LM curve
The effects of falling prices
 asserts that the Depression was largely due to
 asserts that the severity of the Depression was
huge fall in the money supply.
due to a huge deflation:
P fell 25% during 1929-33.
 evidence:
M1 fell 25% during 1929-33.
 This deflation was probably caused by the fall in
 But, two problems with this hypothesis:
 P fell even more, so M/P actually rose slightly
M, so perhaps money played an important role
after all.
during 1929-31.
 In what ways does a deflation affect the
 nominal interest rates fell, which is the opposite
economy?
of what a leftward LM shift would cause.
CHAPTER 11
Aggregate Demand II
36
CHAPTER 11
Aggregate Demand II
THE MONEY HYPOTHESIS AGAIN:
THE MONEY HYPOTHESIS AGAIN:
The effects of falling prices
The effects of falling prices
 The stabilizing effects of deflation:
 The destabilizing effects of expected deflation:
 P  (M/P )  LM shifts right  Y
E
 Pigou effect:





P
 (M/P

)
 consumers’ wealth 
 C
37
r  for each value of i
I  because I = I (r )
planned expenditure & agg. demand 
income & output 
 IS shifts right
 Y
CHAPTER 11
Aggregate Demand II
38
THE MONEY HYPOTHESIS AGAIN:
39
 Policymakers (or their advisors) now know
 The destabilizing effects of unexpected deflation:
much more about macroeconomics:
debt-deflation theory
P (if unexpected)
 transfers purchasing power from borrowers to
l d
lenders
 borrowers spend less,
lenders spend more
 if borrowers’ propensity to spend is larger than
lenders’, then aggregate spending falls,
the IS curve shifts left, and Y falls
Aggregate Demand II
Aggregate Demand II
Why another Depression is unlikely
The effects of falling prices
CHAPTER 11
CHAPTER 11
 The Fed knows better than to let M fall
so much, especially during a contraction.
 Fiscal policymakers know better than to raise
taxes or cut spending during a contraction.
 Federal deposit insurance makes widespread
bank failures very unlikely.
 Automatic stabilizers make fiscal policy
expansionary during an economic downturn.
40
CHAPTER 11
Aggregate Demand II
41
7
10/14/2013
Interest rates and house prices
The 2008-09 Financial Crisis & Recession
 2009: Real GDP fell, u-rate approached 10%
9
 Important factors in the crisis:
 early 2000s Federal Reserve interest rate policy
 sub-prime mortgage crisis
 bursting of house price bubble,
8
Aggregate Demand II
interest ra
ate (%)
6
130
4
110
90
2
70
1
0
2000
42
2001
2002
2003
50
2005
2004
House price change and new foreclosures,
2006:Q3 – 2009Q1
14%
20%
US house price index
12%
1.4
Nevada
18%
New foreclosures
Illinois
Florida
1.2
8%
1.0
6%
0.8
4%
0.6
2%
0%
0.4
16%
New forec
closures,
% of all mo
ortgages
10%
New foreclosurre starts
(% of total morttgages)
14%
California
Georgia
12%
Colorado
Arizona
10%
Rhode Island
New Jersey
8%
Texas
S. Dakota
Hawaii
4%
Oregon
Alaska
-2%
2%
0.2
-4%
-6%
1999
0%
-40%
0.0
2001
2003
2005
2007
-30%
-20%
-10%
Wyoming
N. Dakota
0%
10%
Major U.S. stock indexes
(% change from 52 weeks earlier)
DJIA
140%
70
60
20%
Cumulative change in house price index
2009
U.S. bank failures by year, 2000-2009
Ohio
Michigan
6%
120%
S&P 500
100%
NASDAQ
80%
50
60%
40
40%
20%
30
0%
-20%
20
-40%
10
-60%
7/20/2009
3/5/2008
11/11/2008
6/28/2007
10/20/2006
6/5/2005
2/11/2006
9/27/2004
1/20/2004
5/14/2003
9/5/2002
12/28/2001
* as of July 24, 2009.
4/21/2001
2000 2001 2002 2003 2004 2005 2006 2007 2008 2009*
8/13/2000
-80%
0
12/6/1999
Percent change in h
house prices
(from 4 quarters
s earlier)
150
5
3
Change in U.S. house price index
and rate of new foreclosures, 1999-2009
Number of b
bank failures
170
7
rising foreclosure rates
 falling stock prices
 failing financial institutions
 declining consumer confidence, drop in spending
on consumer durables and investment goods
CHAPTER 11
Federal Funds rate
30-year mortgage rate
190
Case-Shiller 20-city composite house price index
House price index
x, 2000=100
CASE STUDY
8
10/14/2013
Consumer sentiment and growth in consumer
durables and investment spending
Real GDP growth and Unemployment
10
10%
Real GDP growth rate (left scale)
100
5%
90
0%
80
-5%
-10%
70
-15%
Durables
-20%
Investment
60
UM Consumer Sentiment Index
-25%
1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009
50
8
6%
7
6
4%
5
2%
4
3
0%
2
-2%
1
-4%
1995
0
1997
Chapter 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
9
Unemployment rate (right scale)
% of labor force
10%
8%
% change from 4 q
quaters earlier
110
15%
Consumer Sentiment In
ndex, 1966=100
% change from four qu
uarters earlier
20%
1999
2001
2003
2005
2007
2009
Chapter 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.
9