CHAPTER-12:

AGGREGATE DEMAND-II: APPLYING THE

IS-LM MODEL

COURSE TEACHER:
D R . TA M G I D A H M E D C H O W D H U R Y
A S S O C I AT E P R O F E S S O R , S B E
OBJECTIVES OF THE CHAPTER

• After completing this chapter, students will be able to understand:

– how policies and shocks affect income and the interest rate in the
short run when prices are fixed
– Derivation of the aggregate demand curve
– various explanations for the Great Depression
 EQUILIBRIUM IN THE IS - LM MODEL
The IS curve represents equilibrium r
in the goods market. LM

Y  C (Y  T )  I (r )  G
r1
The LM curve represents 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.
 POLICY ANALYSIS WITH THE IS - LM MODEL

Y  C (Y  T )  I (r )  G r
LM
M P  L (r ,Y )

Policymakers can affect macroeconomic

variables with r1
• fiscal policy: G and/or T
• monetary policy: M
IS
We can use the IS-LM model to analyze Y
the effects of these policies. Y1
 AN INCREASE IN GOVERNMENT PURCHASES
r
1. IS curve shifts right
1 LM
by G
1  MPC
causing output & income to rise. r2
2.
r1
2. This raises money demand, causing the
interest rate to rise… 1. IS2
IS1
Y
3. …which reduces investment, so the final increase in Y Y1 Y2
3.
1
is smaller than G
1  MPC
 A TAX CUT
Because consumers save (1MPC) r
of the tax cut, the initial boost in LM
spending is smaller for T than for
an equal G…
r2
and the IS curve 2.
shifts by r1

1. IS2
MPC
1. T IS1
1  MPC Y
Y1 Y2
2. …so the effects on r and Y are 2.
smaller for a T than for an equal
G.
 MONETARY POLICY: AN INCREASE IN M

r
1. M > 0 shifts LM1
the LM curve down
LM2
(or to the right)

2. …causing the interest rate to fall r1

r2

3. …which increases investment, IS

causing output & income to rise. Y
Y1 Y2
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.
THE CENTRAL BANK’S (BB) RESPONSE TO  G > 0

• Suppose ministries increase G.

• Possible BB responses:
1. hold M constant

2. hold r constant

3. hold Y constant

• In each case, the effects of the G

are different:
RESPONSE 1: HOLD M CONSTANT

r
If ministry raises G,
LM1
the IS curve shifts right

If BB holds M constant, r2
then LM curve doesn’t r1

shift. IS2
Results: IS1
Y
Y  Y 2  Y 1 Y1 Y2

r  r 2  r1
RESPONSE 2: HOLD R CONSTANT

r
If Ministry raises G,
LM1
the IS curve shifts right
LM2

To keep r constant, BB r2
increases M to shift LM r1

curve right. IS2

Results: IS1
Y
Y  Y 3  Y 1 Y1 Y2 Y3

r  0
RESPONSE 3: HOLD Y CONSTANT

r LM2
If Ministry raises G,
LM1
the IS curve shifts right
r3
To keep Y constant, BB r2
reduces M to shift LM curve r1

left. IS2
Results: IS1
Y
Y  0 Y1 Y2

r  r 3  r1
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 makes consumers wealthier.
2. After a wave of credit card fraud, consumers use 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.
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 the LM curve and therefore
affect Y.
• The aggregate demand curve (introduced in chap. 10 ) captures
this relationship between P and Y
DERIVING THE AD CURVE
r LM(P2)
Intuition for slope LM(P1)
r2
of AD curve:
r1
P  (M/P )
IS
 LM shifts left Y2 Y1 Y
P
 r
P2
 I
P1
 Y
AD
Y2 Y1 Y
MONETARY POLICY AND THE AD CURVE

r LM(M1/P1)
The BB can increase aggregate
r1 LM(M2/P1)
demand:
r2
M  LM shifts right
IS
 r
Y1 Y2 Y
 I P

 Y at each
P1
value of P
AD2
AD1
Y1 Y2 Y
FISCAL POLICY AND THE AD CURVE
r LM
Expansionary fiscal policy (G
and/or T ) increases agg. r2
demand: r1 IS2
T  C IS1
 IS shifts right Y1 Y2 Y
P
 Y at each
value of P P1

AD2
AD1
Y1 Y2 Y
THE SR AND LR EFFECTS OF AN IS SHOCK

r LRAS LM(P1)

IS1
A negative IS shock shifts IS IS2
and AD left, causing Y to fall. Y
Y
P LRAS
P1 SRAS1

AD1
AD2
Y Y
THE SR AND LR EFFECTS OF AN IS SHOCK
r LRAS LM(P1)
In the new short-run
equilibrium, Y Y
IS1
IS2
Over time, Y Y
P gradually falls, which causes P LRAS
• SRAS to move down
• M/P to increase, which P1 SRAS1

causes LM
to move down AD1
AD2
Y Y
 THE SR AND LR EFFECTS OF AN IS SHOCK
r LRAS LM(P1)
LM(P2)
This process continues until
economy reaches a long-run IS1
equilibrium with IS2
Y Y Y Y
P LRAS
P1 SRAS1
P2 SRAS2
AD1
AD2
Y Y
EXERCISE: ANALYZE SR & LR EFFECTS OF  M
r LRAS LM(M1/P1)
a. Draw the IS-LM and AD-AS diagrams
as shown here.
b. Suppose Fed increases M. Show the
short-run effects on your graphs. IS
c. Show what happens in the transition
Y Y
from the short run to the long run.
P LRAS
d. How do the new long-run equilibrium
values of the endogenous variables
P1 SRAS1
compare to their initial values?
AD1
Y Y
THE GREAT DEPRESSION
240 30
b illio n s o f 1 9 5 8 d o lla r s Unemployment

p e r c e n t o f la b o r fo r c e
220 (right scale) 25

200 20

180 15

160 10

Real GNP
140 5
(left scale)
120 0
1929 1931 1933 1935 1937 1939
THE SPENDING HYPOTHESIS:
SHOCKS TO THE IS CURVE

• asserts that the Depression was largely due to an exogenous fall in

the demand for goods & services -- a leftward shift of the IS curve
• evidence:
output and interest rates both fell, which is what a leftward IS
shift would cause
THE SPENDING HYPOTHESIS: REASONS FOR THE IS SHIFT

1. Stock market crash  exogenous C

 Oct-Dec 1929: S&P 500 fell 17%
 Oct 1929-Dec 1933: S&P 500 fell 71%
2. Drop in investment
 “correction” after overbuilding in the 1920s
 widespread bank failures made it harder to obtain financing for
investment
3. Contractionary fiscal policy
 in the face of falling tax revenues and increasing deficits, politicians
raised tax rates and cut spending
THE MONEY HYPOTHESIS: A SHOCK TO THE LM CURVE

• asserts that 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, so 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.
WHY ANOTHER DEPRESSION IS UNLIKELY

• Policymakers (or their advisors) now know

much more about macroeconomics:
 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.
 AS AS
P P

E'

E E
P1 P1

AD'

AD AD

Y1/E1 YF Y /E Y1/E1 E2 YF Y /E

Unemployment Unemployment
 r MS1 MS2 r

r1
r1
E

E' r2
r2
Md

M1 M2 Money Balance I1 I2 I