Chapter 11: Aggregate Demand II: Applying the IS -LM Model*

MACROECONOMICS Seventh Edition N. Gregory Mankiw

* Slides based on Ron Cronovich's slides, adjusted for course in Study Abroad Program at the Chapter 11: Aggregate Demand II: Applying the IS–LM Model 0/56 Wang Yanan Institute for Studies in Economics at Xiamen University.

Learning Objectives This chapter introduces you to understanding: explaining fluctuations with the IS–LM model using IS–LM as a theory of aggregate demand the great depression

Chapter 11: Aggregate Demand II: Applying the IS–LM Model

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11.1) Explaining Fluctuations: IS–LM
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: Applying the IS–LM Model

IS Y

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11.1) Explaining Fluctuations: IS–LM
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

IS Y1

Chapter 11: Aggregate Demand II: Applying the IS–LM Model

Y

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11.1) Explaining Fluctuations: IS–LM
An Increase in Government Purchases 1. IS curve shifts right 1 ∆G by 1− MPC causing output & income to rise. 2. This raises money demand, causing the interest rate to rise…

r LM r2 2.

r1

3. …which reduces investment, so the final increase in Y 1 ∆G is smaller than 1− MPC

1.

IS2 IS1

Y1 Y2

Chapter 11: Aggregate Demand II: Applying the IS–LM Model

Y

3.

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11.1) Explaining Fluctuations: IS–LM
A Tax Cut Consumers save (1−MPC) r of the tax cut, so the initial boost in spending is smaller for ∆T than for an r2 equal ∆G… 2. r1 and the IS curve shifts by 1.

LM

1.

−MPC ∆T 1− MPC

2. …so the effects on r

IS2

IS1 Y1 Y2

and Y are smaller for ∆T than for an equal ∆G. Chapter 11: Aggregate Demand II: Applying the IS–LM Model

Y

2.

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11.1) Explaining Fluctuations: IS–LM
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 3. …which increases investment, causing output & income to rise.

r

LM1 LM2

r1 r2 IS Y Y1 Y2

Chapter 11: Aggregate Demand II: Applying the IS–LM Model

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11.1) Explaining Fluctuations: IS–LM
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: Applying the IS–LM Model

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11.1) Explaining Fluctuations: IS–LM
The Fed’s Response to ∆G > 0 • Suppose Congress increases G. • Possible Fed responses: 1. wants to hold M constant 2. wants to hold r constant 3. wants to hold Y constant • In each case, the effects of the ∆G are different:

Chapter 11: Aggregate Demand II: Applying the IS–LM Model

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11.1) Explaining Fluctuations: IS–LM
Response 1: Hold M Constant If Congress raises G, the IS curve shifts right. If Fed holds M constant, then LM curve doesn’t shift.

r LM1 r2 r1 IS2 IS1

Results:

∆Y = Y 2 − Y1

Y1 Y2

Y

∆r = r2 − r1 Chapter 11: Aggregate Demand II: Applying the IS–LM Model

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11.1) Explaining Fluctuations: IS–LM
Response 2: Hold r Constant If Congress raises G, the IS curve shifts right. To keep r constant, Fed increases M to shift LM curve right.

r LM1 LM2 r2 r1 IS2 IS1

Results:

∆Y = Y 3 − Y1 ∆r = 0

Y1 Y2 Y3

Chapter 11: Aggregate Demand II: Applying the IS–LM Model

Y

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11.1) Explaining Fluctuations: IS–LM
Response 3: Hold Y Constant If Congress raises G, the IS curve shifts right. To keep Y constant, Fed reduces M to shift LM curve left.

LM2 LM1

r

r3 r2 r1 IS2 IS1

Results:

∆Y = 0 ∆r = r 3 − r1

Y1 Y2

Chapter 11: Aggregate Demand II: Applying the IS–LM Model

Y

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11.1) Explaining Fluctuations: IS–LM
Estimates of Fiscal Policy Multipliers from the DRI Macroeconometric model

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: Applying the IS–LM Model

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11.1) Explaining Fluctuations: IS–LM
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: Applying the IS–LM Model

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11.1) Explaining Fluctuations: IS–LM
Shocks in the IS-LM Model (cont.) 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: Applying the IS–LM Model

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11.1) Explaining Fluctuations: IS–LM
该你们了: 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: Applying the IS–LM Model

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11.1) Explaining Fluctuations: IS–LM
CASE STUDY: The U.S. Recession of 2001 • During 2001, – 2.1 million people lost their jobs, as unemployment rose from 3.9% to 5.8%. – GDP growth slowed to 0.8% (compared to 3.9% average annual growth during 1994-2000).

Chapter 11: Aggregate Demand II: Applying the IS–LM Model

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11.1) Explaining Fluctuations: IS–LM
CASE STUDY: The U.S. Recession of 2001

Index (1942 = 100)

• Causes: 1) Stock market decline ⇒ ↓C 1500 1200

Standard & Poor’s 500

900 600 300 1995

1996

1997

1998

1999

2000

Chapter 11: Aggregate Demand II: Applying the IS–LM Model

2001

2002

2003 17/56

11.1) Explaining Fluctuations: IS–LM
CASE STUDY: The U.S. Recession of 2001 • Causes: 2) 9/11 – increased uncertainty – fall in consumer & business confidence – result: lower spending, IS curve shifted left • Causes: 3) Corporate accounting scandals – Enron, WorldCom, etc. – reduced stock prices, discouraged investment

Chapter 11: Aggregate Demand II: Applying the IS–LM Model

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11.1) Explaining Fluctuations: IS–LM
CASE STUDY: The U.S. Recession of 2001 • Fiscal policy response: shifted IS curve right – tax cuts in 2001 and 2003 – spending increases • airline industry bailout • NYC reconstruction • Afghanistan war

Chapter 11: Aggregate Demand II: Applying the IS–LM Model

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11.1) Explaining Fluctuations: IS–LM
CASE STUDY: The U.S. Recession of 2001 • Monetary policy response: shifted LM curve right 7 6 5

Three-month T-Bill Rate

4 3 2 1 0

Chapter 11: Aggregate Demand II: Applying the IS–LM Model

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Learning Objectives This chapter introduces you to understanding: explaining fluctuations with the IS–LM model using IS–LM as a theory of aggregate demand the great depression

Chapter 11: Aggregate Demand II: Applying the IS–LM Model

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11.2) IS-LM as Theory of Agg. Demand
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.

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11.2) IS-LM as Theory of Agg. Demand
Deriving the AD Curve LM(P2)

r

Intuition for slope of AD curve: ↑P ⇒ ↓(M/P ) ⇒ LM shifts left ⇒ ↑r ⇒ ↓I

LM(P1)

r2 r1

IS P

Y2

Y1

Y

P2 P1

⇒ ↓Y

AD Y2

Chapter 11: Aggregate Demand II: Applying the IS–LM Model

Y1

Y 23/56

11.2) IS-LM as Theory of Agg. Demand
Monetary Policy and the AD Curve The Fed can increase aggregate demand: ↑M ⇒ LM shifts right ⇒ ↓r ↓

LM(M1/P1)

r

LM(M2/P1)

r1 r2

IS

⇒ ↑I

P

⇒ ↑Y for a given value of P

P1

Y1

Y1 Chapter 11: Aggregate Demand II: Applying the IS–LM Model

Y2

Y2

Y

AD2 AD1 Y 24/56

11.2) IS-LM as Theory of Agg. Demand
Fiscal Policy and the AD Curve Expansionary fiscal policy (↑G and/or ↓T ) increases agg. demand:

r

LM

r2 r1

↓T ⇒ ↑C

IS2 IS1

⇒ IS shifts right

P

⇒ ↑Y for a given value of P

P1

Y1

Y1 Chapter 11: Aggregate Demand II: Applying the IS–LM Model

Y2

Y2

Y

AD2 AD1 Y 25/56

11.2) IS-LM as Theory of Agg. Demand
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

then over time, the price level will

Y > Y

rise

Y < Y

fall

Y = Y

remain constant

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11.2) IS-LM as Theory of Agg. Demand
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

IS1 Y

LRAS SRAS1

P1

Chapter 11: Aggregate Demand II: Applying the IS–LM Model

Y

AD1 AD2 Y 27/56

11.2) IS-LM as Theory of Agg. Demand
The SR and LR effects of an IS shock r

In the new shortrun equilibrium, Y