PowerPoint® Slides by Ron Cronovich
CHAPTER
11
Aggregate Demand II:
Applying the IS-LM Model
© 2010 Worth Publishers, all rights reserved
SEVENTH EDITION
MACROECONOMICS
Context
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
2
In this chapter, 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
3
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
4
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 r1 effects of
fiscal policy: G and/or T
monetary policy: M
CHAPTER 11
Aggregate Demand II
IS
Y1
Y
5
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
LM
2.
r2 r1 3. …which reduces investment, so the final increase in Y
1
is smaller than
G
1 MPC
CHAPTER 11
Aggregate Demand II
1.
IS2
IS1
Y1 Y2
Y
3.
6
A tax cut
Consumers save r (1MPC) of the tax cut, so the initial boost in spending is smaller for T r than for an equal G…
2.
r21 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.
7
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. CHAPTER 11
Aggregate Demand II
r
LM1
LM2
r1 r2 IS
Y1 Y2
Y
8
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
9
The 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…
CHAPTER 11
Aggregate Demand II
10
Response 1:
Hold M constant
If Congress raises G, the IS curve shifts right.
r
LM
1
If Fed holds M constant, then LM curve doesn’t shift. r2 r1 IS2
IS1
Results:
Y Y2 Y1
Y1 Y2
Y
r r2 r1
CHAPTER 11
Aggregate Demand II
11
Response 2:
Hold r constant
If Congress raises G, the IS curve shifts right.
r
LM
1
To keep r constant,
Fed increases M to shift LM curve right.
2
r2 r1 IS2
IS1
Results:
Y Y3 Y1
LM
Y1 Y2 Y3
Y
r 0
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Aggregate Demand II
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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.
LM
2
LM
r
1
r3 r2 r1
IS2
IS1
Results:
Y 0
Y1 Y2
Y
r r3 r1
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Aggregate Demand II
13
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
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Aggregate Demand II
14
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