Apply the IS

Apply the IS-LM Model
Ask Yourself
• Short run or long run?
• Supply side or demand side?
US Recession in 2001
• Case study on page 313
• A fall in aggregate demand (planned
• Decline in stock market → reduced wealth →
→ Falling C and I → IS curve shifts to left
• 911 attack → rising uncertainty→ Falling C and
I → IS curve shifts to left
• Accounting scandals → Falling C and I → IS
curve shifts to left
• Tax cut → IS curve shifts to right
• Rising government expenditure to help banks
and airline industry → IS curve shifts to right
• Expansionary monetary policy (rising money
supply) → LM curve shifts to right
• Result: the 2001 recession is short, and
interest rate remained low
Animal Spirit
• Self-fulfilling wave of optimism and pessimism
• For example, pessimism causes consumption
and investment to fall
• Then GDP falls, making the pessimism selffulfilling
• Optimism will cause bubble
Example of animal spirit
Boom in Housing Market
• Low interest rate
• But the high price (bubble) is not sustainable
2008 Recession
• After housing price fell, there is rise in
mortgage default and home foreclosures
• Financial institutions that owned mortgagebacked securities see large losses
• Stock market and consumer confidence fell
• All pushed IS curve to the left
• Fed cut interest rate (how?) What happens to
LM curve?
• Treasury used $700 billion to rescue banks
(Bail out). What happens to IS curve?
• Result: GDP recovered, but employment did
What’s Wrong in Labor Market
• There is a trend in labor market caused by
automation, globalization and falling
educational attainment
Ineffective Policy
• Fiscal policy is ineffective when LM curve is
steep (crowding out is big)
• Monetary policy is ineffective when nominal
interest rate is close to zero (liquidity trap)
Liquidity Trap (LT)
• LT happens when nominal interest rate is close
to zero
• How to get out of LT?
• The idea of QE3 is to generate expectation of
inflation (so real interest rate can fall and
investment can rise), and depreciation of
dollar (so export can rise)
Is Deflation Good
• It depends
• Deflation can move Y back to 
• Deflation can also move Y further away from 
Case Study: Japan
Aging population
Demand is shrinking
Deflation is persistent
Pessimistic animal spirit
Expansionary fiscal policy is limited by huge
government debt
• Expansionary monetary policy is limited by
liquidity trap
Case Study: Eurozone
• Huge government debt
• Austerity is necessary
• But austerity would cause IS curve to shift to
left, and recession
• US faces similar dilemma (tradeoff)
• A policymaker needs to determine the
priority: balancing budget or stimulating
• Essentially, this is long-run versus short run
What Causes US Huge Debt?
Entitlement program and rising health cost
Dollar is special
Every four years we have a new president

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