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 (1MPC) 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 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 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.