### Ag. Demand II: Applying the IS-LM model

```Chapter 11: Aggregate Demand
 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
 how the IS-LM model helps us understand recent
events, including the 2001 recession and the
2008-2009 financial crisis & recession
CHAPTER 11
Aggregate Demand II
0
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
1
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
CHAPTER 11
Aggregate Demand II
IS
Y1
Y
2
An increase in government purchases
1. IS curve shifts right
by
r
1
G
1 MPC
causing output &
income to rise.
2. This raises money
demand, causing the
interest rate to rise…
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
LM
IS2
1.
IS1
Y1 Y2
Y
3.
3
A tax cut
Consumers save
r
(1MPC) of the tax cut,
so the initial boost in
spending is smaller for T
r2
than for an equal G…
2.
r1
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.
4
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
5
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
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,
the IS curve shifts right.
r
If Fed holds M constant,
then LM curve doesn’t
shift.
r2
r1
LM1
IS2
IS1
Results:
Y  Y2  Y1
r  r2  r1
CHAPTER 11
Aggregate Demand II
Y1 Y2
Y
8
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
r2
r1
IS2
IS1
Results:
Y  Y3  Y1
LM2
Y1 Y2 Y3
Y
r  0
CHAPTER 11
Aggregate Demand II
9
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
Y1 Y2
Y
r  r3  r1
CHAPTER 11
Aggregate Demand II
10
Estimates of fiscal policy multipliers
from the DRI macroeconometric model
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
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:
 an increase in identity theft increases the
demand for money
 money demand falls as more people
manage their financial accounts online
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 housing market crash that reduces
consumers’ wealth
2. consumers using cash more frequently in
transactions in response to an increase in
identity theft
For each shock,
a. use the IS-LM diagram to determine the effects
on Y and r.
b. figure out what happens to C, I, and the
unemployment rate.
```