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```					Chapter 11 Applying IS-LM Model
 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
Equilibrium in the IS -LM model

The IS curve represents           r
equilibrium in the goods                         LM
market.
Y
Y  C (  T )  I (r )  G
r1
The LM curve represents
money market equilibrium.
M P  L (r ,Y )                               IS
Y
The intersection determines                 Y1
the unique combination of Y and r
that satisfies equilibrium in both markets.

CHAPTER 11   Aggregate Demand II                            1
Policy analysis with the IS -LM model

Y  C (  T )  I (r )  G
Y                         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               IS
• monetary policy: M                           Y
Y1

CHAPTER 11   Aggregate Demand II                      2
An increase in government purchases
1. IS curve shifts right             r
1                                        LM
by          G
1 MPC
causing output &                 r2
income to rise.             2.
r1
2. This raises money
demand, causing the                         1.         IS2
interest rate to rise…                           IS1
3. …which reduces investment,                               Y
Y1 Y2
so the final increase in Y
3.
1
is smaller than            G
1 MPC
CHAPTER 11   Aggregate Demand II                                3
A tax cut
Consumers save                  r
(1MPC) of the tax cut,                         LM
so the initial boost in
spending is smaller for T
than for an equal G…         r2
2.
r1
and the IS curve shifts by
MPC                           1.     IS2
1.             T                            IS1
1 MPC
Y
Y1 Y2
2. …so the effects on r
2.
and Y are smaller for T
than for an equal G.
CHAPTER 11    Aggregate Demand II                             4
Monetary policy: An increase in M

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

2. …causing the                 r1
interest rate to fall        r2

3. …which increases                            IS
investment, causing                                Y
Y1 Y2
output & income to
rise.

CHAPTER 11   Aggregate Demand II                            5
Interaction between
monetary & fiscal policy
 Model:
Monetary & fiscal policy variables
(M, G, and T ) are exogenous.
 Real world:
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                   6
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           7
Response 1: Hold M constant

If Congress raises G,            r
the IS curve shifts right.                   LM1

If Fed holds M constant,
r2
then LM curve doesn’t
r1
shift.
IS2
Results:
IS1
Y  Y 2  Y 1                                  Y
Y1 Y2
r  r2  r1

CHAPTER 11   Aggregate Demand II                            8
Response 2: Hold r constant

If Congress raises G,            r
the IS curve shifts right.                      LM1
LM2
To keep r constant,
r2
Fed increases M                r1
to shift LM curve right.
IS2
Results:                                       IS1
Y  Y 3  Y 1                                     Y
Y1 Y2 Y3

r  0

CHAPTER 11   Aggregate Demand II                               9
Response 3: Hold Y constant

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

To keep Y constant,             r3
r2
Fed reduces M
r1
to shift LM curve left.
IS2
Results:                                     IS1
Y  0                                           Y
Y1 Y2
r  r3  r1

CHAPTER 11   Aggregate Demand II                             10
Estimates of fiscal policy multipliers
from the DRI macroeconometric model

Estimated    Estimated
Assumption about               value of     value of
monetary policy                Y / G      Y / T

Fed holds money
0.60            0.26
supply constant
Fed holds nominal
1.93            1.19
interest rate constant

CHAPTER 11   Aggregate Demand II                             11
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         12
Shocks in the IS -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.

CHAPTER 11   Aggregate Demand II               13
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 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.
CASE STUDY:
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 3.9% average annual growth
during 1994-2000).

CHAPTER 11   Aggregate Demand II                  15
CASE STUDY:
The U.S. recession of 2001
Causes: 1) Stock market decline  C

1500
Standard & Poor’s
Index (1942 = 100)

1200             500

900

600

300
1995    1996   1997   1998   1999   2000   2001   2002   2003
CHAPTER 11                    Aggregate Demand II                                     16
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                      17
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                    18
CASE STUDY:
The U.S. recession of 2001
 Monetary policy response: shifted LM curve right
7
6
Three-month
T-Bill Rate
5
4
3
2
1
0

CHAPTER 11   Aggregate Demand II                       19
What is the Fed’s policy instrument?
 The news media commonly report the Fed’s policy
changes as interest rate changes, as if the Fed
has direct control over market interest rates.
 In fact, the Fed targets the federal funds rate –
the interest rate banks charge one another on
overnight loans.
 The Fed changes the money supply and shifts the
LM curve to achieve its target.
 Other short-term rates typically move with the
federal funds rate.
CHAPTER 11   Aggregate Demand II                        20
What is the Fed’s policy instrument?

Why does the Fed target interest rates instead of
the money supply?
1) They are easier to measure than the money
supply.
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.
(See end-of-chapter Problem 7 on p.337.)

CHAPTER 11   Aggregate Demand II                       21
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.

CHAPTER 11   Aggregate Demand II                      22
r         LM(P2)
Intuition for slope                               LM(P1)
r2
r1
P  (M/P )
IS
 LM shifts left               Y2   Y1        Y
P
 r
P2
 I
P1
 Y
Y2   Y1        Y

CHAPTER 11   Aggregate Demand II                               23
Monetary policy and the AD curve
r         LM(M1/P1)
The Fed can increase
r1             LM(M2/P1)
aggregate demand:
r2
M  LM shifts right
IS
 r
Y1   Y2         Y
P
 I
 Y at each               P1
value of P
Y1   Y2     Y

CHAPTER 11   Aggregate Demand II                            24
Fiscal policy and the AD curve
r              LM
Expansionary fiscal
policy (G and/or T )           r2
increases agg. demand:           r1               IS2
T  C                                     IS1
Y1   Y2           Y
 IS shifts right           P
 Y at each
value of P            P1

Y1   Y2       Y

CHAPTER 11   Aggregate Demand II                              25
in the short run & long run
Recall from Chapter 9: The force that moves the
economy from the short run to the long run

In the short-run    then over time, the
equilibrium, if      price level will
Y  Y                   rise
Y  Y                    fall

Y  Y             remain constant

CHAPTER 11   Aggregate Demand II                         26
The SR and LR effects of an IS shock
r    LRAS LM(P )
1
A negative IS shock
causing Y to fall.                               IS1
IS2
Y             Y
P    LRAS
P1                SRAS1

Y         Y
CHAPTER 11   Aggregate Demand II                             27
The SR and LR effects of an IS shock
r    LRAS LM(P )
1

In the new short-run
equilibrium, Y  Y                              IS1
IS2
Y             Y
P    LRAS
P1                SRAS1

Y         Y
CHAPTER 11   Aggregate Demand II                             28
The SR and LR effects of an IS shock
r    LRAS LM(P )
1

In the new short-run
equilibrium, Y  Y                              IS1
IS2
Y             Y
falls, causing                   P    LRAS
• SRAS to move down             P1                SRAS1

• M/P to increase,
Y         Y
CHAPTER 11   Aggregate Demand II                             29
The SR and LR effects of an IS shock
r    LRAS LM(P )
1
LM(P2)

IS1
IS2
Y             Y
falls, causing                   P    LRAS
• SRAS to move down             P1                SRAS1

• M/P to increase,              P2                SRAS2
Y         Y
CHAPTER 11   Aggregate Demand II                             30
The SR and LR effects of an IS shock
r    LRAS LM(P )
1
LM(P2)

This process continues                               IS1
until economy reaches a                       IS2
long-run equilibrium with
Y             Y
Y Y                  P    LRAS
P1                SRAS1

P2                SRAS2
Y         Y
CHAPTER 11   Aggregate Demand II                             31
NOW YOU TRY:
Analyze SR & LR effects of M
a. Draw the IS-LM and AD-AS       r    LRAS LM(M /P )
1  1
diagrams as shown here.
b. Suppose Fed increases M.
Show the short-run effects                   IS
c. Show what happens in the            Y       Y
transition from the short run   P    LRAS
to the long run.
d. How do the new long-run
P1          SRAS1
equilibrium values of the
endogenous variables
compare to their initial
values?                              Y       Y
The Great Depression
240                                            30
Unemployment
(right scale)
billions of 1958 dollars

220                                            25

percent of labor force
200                                            20

180                                            15

160                                            10

140                      Real GNP              5
(left scale)
120                                            0
1929   1931   1933   1935    1937     1939
The Great Depression

CHAPTER 11   Aggregate Demand II   34
The Great Depression

CHAPTER 11   Aggregate Demand II   35
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.

CHAPTER 11   Aggregate Demand II                          36
THE SPENDING HYPOTHESIS:
Reasons for the IS shift
 Stock market crash  exogenous C
 Oct-Dec 1929: S&P 500 fell 17%
 Oct 1929-Dec 1933: S&P 500 fell 71%
 Drop in investment
 “correction” after overbuilding in the 1920s
financing for investment
 Contractionary fiscal policy
 Politicians raised tax rates and cut spending to
combat increasing deficits.
CHAPTER 11   Aggregate Demand II                            37
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:
 P fell even more, so M/P actually rose slightly
during 1929-31.
 nominal interest rates fell, which is the opposite
of what a leftward LM shift would cause.

CHAPTER 11   Aggregate Demand II                             38
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.
 In what ways does a deflation affect the
economy?

CHAPTER 11   Aggregate Demand II                        39
THE MONEY HYPOTHESIS AGAIN:
The effects of falling prices
 The stabilizing effects of deflation:
 P  (M/P )  LM shifts right  Y
 Pigou effect:
P        (M/P )
 consumers’ wealth 
 C
 IS shifts right
 Y
CHAPTER 11   Aggregate Demand II            40
THE MONEY HYPOTHESIS AGAIN:
The effects of falling prices
 The destabilizing effects of expected deflation:
E
   r  for each value of i
   I  because I = I (r )
   planned expenditure & agg. demand 
   income & output 

CHAPTER 11   Aggregate Demand II                       41
THE MONEY HYPOTHESIS AGAIN:
The effects of falling prices
 The destabilizing effects of unexpected deflation:
debt-deflation theory
P (if unexpected)
 transfers purchasing power from borrowers to
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
CHAPTER 11   Aggregate Demand II                          42
Why another Depression is unlikely
 Policymakers (or their advisors) now know
 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.
CHAPTER 11   Aggregate Demand II                       43
CASE STUDY
The 2008-09 Financial Crisis & Recession
 2009: Real GDP fell, u-rate approached 10%
 Important factors in the crisis:
 early 2000s Federal Reserve interest rate policy
 sub-prime mortgage crisis
 bursting of house price bubble,
rising foreclosure rates
 falling stock prices
 failing financial institutions
 declining consumer confidence, drop in spending
on consumer durables and investment goods
CHAPTER 11   Aggregate Demand II                          44
Interest rates and house prices
Federal Funds rate
9              30-year mortgage rate
190
Case-Shiller 20-city composite house price index
8

House price index, 2000=100
170
7
interest rate (%)

6                                                         150

5
130

4
110
3
90
2

70
1

0                                                         50
2000   2001   2002         2003         2004         2005
Change in U.S. house price index
and rate of new foreclosures, 1999-2009
14%
US house price index                        1.4
12%
New foreclosures
Percent change in house prices

10%                                                   1.2
(from 4 quarters earlier)

New foreclosure starts
(% of total mortgages)
8%
1.0
6%
0.8
4%

2%                                                    0.6

0%
0.4
-2%
0.2
-4%

-6%                                                   0.0
1999    2001       2003       2005   2007   2009
House price change and new foreclosures,
2006:Q3 – 2009Q1
20%

Florida         Illinois
16%
Ohio
% of all mortgages

Michigan
New foreclosures,

14%
California                                        Georgia
12%
10%
Rhode Island
8%                                                               Texas
New Jersey
6%
Hawaii                               S. Dakota
4%
Oregon
Wyoming
N. Dakota
0%
-40%       -30%      -20%          -10%          0%      10%       20%
Cumulative change in house price index
U.S. bank failures by year, 2000-2009

*

* as of July 24, 2009.
0%

-60%
-40%
-20%
20%
40%
60%
80%

-80%
100%
120%
140%
12/6/1999

8/13/2000

4/21/2001

12/28/2001

9/5/2002

5/14/2003

1/20/2004
Major U.S. stock indexes

9/27/2004

6/5/2005
(% change from 52 weeks earlier)

2/11/2006

10/20/2006

6/28/2007
DJIA

3/5/2008
S&P 500
NASDAQ

11/11/2008

7/20/2009
Consumer sentiment and growth in consumer
durables and investment spending
20%
110

Consumer Sentiment Index, 1966=100
15%
% change from four quarters earlier

10%                                                          100

5%
90
0%

-5%                                                          80

-10%
70

-15%
Durables
60
-20%     Investment
UM Consumer Sentiment Index
-25%                                                         50
1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009
Real GDP growth and Unemployment
10%                                                                10
Real GDP growth rate (left scale)
9
8%        Unemployment rate (right scale)
% change from 4 quaters earlier

8

6%                                                                 7

% of labor force
6
4%
5
2%
4

0%                                                                 3

2
-2%
1

-4%                                                                0
1995   1997     1999     2001     2003     2005   2007   2009
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
Chapter Summary
 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.

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