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Aggregate Demand II:
Applying the IS-LM Model
12CHAPTER
1CHAPTER 12 Aggregate Demand II
Context
§ Chapter 10 introduced the model of aggregate
demand and supply.
§ Chapter 11 developed the IS-LM model,
the basis of the aggregate demand curve.
IN THIS CHAPTER, YOU WILL LEARN:
§ 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
2
3CHAPTER 12 Aggregate Demand II
The intersection determines
the unique combination of Y and r
that satisfies equilibrium in both markets.
The LM curve represents
money market equilibrium.
Equilibrium in the IS-LM model
The IS curve represents
equilibrium in the goods
market.
Y C Y T I r G= - + +( ) ( )
( , )M P L r Y= IS
Y
r
LM
r1
Y1
4CHAPTER 12 Aggregate Demand II
Policy analysis with the IS-LM model
We can use the IS-LM
model to analyze the
effects of
• fiscal policy: G and/or T
• monetary policy: M
Y C Y T I r G= - + +( ) ( )
( , )M P L r Y=
IS
Y
r
LM
r1
Y1
5CHAPTER 12 Aggregate Demand II
causing output &
income to rise.
IS1
An increase in government purchases
1. IS curve shifts right
Y
r
LM
r1
Y1
GD
-
1by
1 MPC
IS2
Y2
r2
1.
2. This raises money
demand, causing the
interest rate to rise…
2.
3. …which reduces investment,
so the final increase in Y
GD
-
1is smaller than
1 MPC
3.
6CHAPTER 12 Aggregate Demand II
IS1
1.
A tax cut
Y
r
LM
r1
Y1
IS2
Y2
r2
Consumers save
(1−MPC) of the tax cut,
so the initial boost in
spending is smaller for ΔT
than for an equal ΔG…
and the IS curve shifts by
T- D
-1
MPC
MPC
1.
2.
2.
…so the effects on r
and Y are smaller for ΔT
than for an equal ΔG.
2.
7CHAPTER 12 Aggregate Demand II
2. …causing the
interest rate to fall
IS
Monetary policy: An increase in M
1. ΔM > 0 shifts
the LM curve down
(or to the right)
Y
r LM1
r1
Y1 Y2
r2
LM2
3. …which increases
investment, causing
output & income to
rise.
8CHAPTER 12 Aggregate Demand II
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 interactions may alter the impact of the
original policy change.
9CHAPTER 12 Aggregate Demand II
The Fed’s response to ΔG > 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 ΔG
are different…
10CHAPTER 12 Aggregate Demand II
If Congress raises G,
the IS curve shifts right.
IS1
Response 1: Hold M constant
Y
r
LM1
r1
Y1
IS2
Y2
r2
If Fed holds M constant,
then LM curve doesn’t
shift.
Results:
2 1Y Y YD = -
2 1r r rD = -
11CHAPTER 12 Aggregate Demand II
If Congress raises G,
the IS curve shifts right.
IS1
Response 2: Hold r constant
Y
r
LM1
r1
Y1
IS2
Y2
r2
To keep r constant,
Fed increases M
to shift LM curve right.
3 1Y Y YD = -
0rD =
LM2
Y3
Results:
12CHAPTER 12 Aggregate Demand II
IS1
Response 3: Hold Y constant
Y
r
LM1
r1
IS2
Y2
r2
To keep Y constant,
Fed reduces M
to shift LM curve left.
0YD =
3 1r r rD = -
LM2
Results:
Y1
r3
If Congress raises G,
the IS curve shifts right.
13CHAPTER 12 Aggregate Demand II
Shocks in the IS-LM model
IS shocks: exogenous changes in the
demand for goods & services.
Examples:
§ stock market boom or crash
g change in households’ wealth
g ΔC
§ change in business or consumer
confidence or expectations
g ΔI and/or ΔC
14CHAPTER 12 Aggregate Demand II
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.
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 in transactions more
frequently 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.