2H03

INTERMEDIATE
MACROECONOMICS

Fall-2019
Rizwan Tahir

1
AGGREGATE DEMAND II:
APPLYING THE IS–LM
MODEL

Coverage: Chapter 11

2
 LEARNING OUTCOMES

• 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

Copyright, Worth Publishers (2014) [Modified/Edited by Rizwan Tahir] 3

 EQUILIBRIUM IN THE IS -LM MODEL

The IS curve represents r

equilibrium in the goods LM
market.
Y  C (Y  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.
Copyright, Worth Publishers (2014) [Modified/Edited by Rizwan Tahir] 4
 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 r1
of
•fiscal policy: G and/or T IS
•monetary policy: M Y
Y1

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 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
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 A TAX CUT
Consumers save (1−MPC)
of the tax cut, so the r
initial boost in spending LM
is smaller for ΔT than for
an equal ΔG… r2
2.
and the IS curve shifts by r1

MPC 1. IS2
1. T IS1
1  MPC
Y
Y1 Y2
2. …so the effects on r
2.
and Y are smaller for ΔT
than for an equal ΔG.
Copyright, Worth Publishers (2014) [Modified/Edited by Rizwan Tahir] 7
 EFFECTIVENESS OF FISCAL POLICY:
TWO EXTREME CASES
1. Classical Case:
• Vertical LM curve (Quantity theory of money)
• Totally ineffective fiscal policy
• Complete crowding-out
LM
r = (k/h) Y - 1/h (M/P)
h →0 r2

r1
IS2
IS1
Y1
Copyright, Worth Publishers (2014) [Modified/Edited by Rizwan Tahir] 8
 EFFECTIVENESS OF FISCAL POLICY:
TWO EXTREME CASES
2. Keynesian case
• Horizontal LM curve (Liquidity trap)
• Full multiplier effect
• Zero crowding-out
r = (k/h) Y - 1/h (M/P)
k →0

r1 LM
IS2
IS1
Y1 Y2
Copyright, Worth Publishers (2014) [Modified/Edited by Rizwan Tahir] 9
 MONETARY POLICY: AN INCREASE
IN M

r
1. ΔM > 0 shifts LM1
the LM curve down
(or to the right)
LM2
2. …causing the
r1
interest rate to fall
3. …which increases r2
investment, causing
IS
output & income to
Y
rise. Y1 Y2
Transmission mechanism

Δ M → Δr → ΔI
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 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.

Copyright, Worth Publishers (2014) [Modified/Edited by Rizwan Tahir] 11

 THE B.O.C.’S RESPONSE TO Δ G > 0

• Suppose Govt. increases G.

• Possible B.O.C. responses:
1. hold M constant
2. hold r constant
3. hold Y constant
• In each case, the effects of the ΔG
are different…

Copyright, Worth Publishers (2014) [Modified/Edited by Rizwan Tahir] 12

 RESPONSE 1: HOLD M
CONSTANT

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

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

Copyright, Worth Publishers (2014) [Modified/Edited by Rizwan Tahir] 13

 RESPONSE 2: HOLD R
CONSTANT

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

r  0
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 RESPONSE 3: HOLD Y
CONSTANT

If Govt. raises G, r LM2

the IS curve shifts right. LM1

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

Copyright, Worth Publishers (2014) [Modified/Edited by Rizwan Tahir] 15

 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
ΔC
• change in business or consumer
confidence or expectations
ΔI and/or ΔC

Copyright, Worth Publishers (2014) [Modified/Edited by Rizwan Tahir] 16

 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.

Copyright, Worth Publishers (2014) [Modified/Edited by Rizwan Tahir] 17

 ANALYZE SHOCKS WITH THE IS-LM
MODEL: EXERCISE
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.

Copyright, Worth Publishers (2014) [Modified/Edited by Rizwan Tahir] 18

 ANSWERS, PART 1
HOUSING MARKET CRASH

IS shifts left, causing

r and Y to fall. r
LM1
C falls due to lower
wealth and lower r1
income,
r2
I rises because
r is lower IS1
IS2
u rises because Y
Y2 Y1
Y is lower
(Okun’s law) Copyright, Worth Publishers (2014) [Modified/Edited by Rizwan Tahir]
19
 ANSWERS, PART 2
INCREASE IN MONEY DEMAND

LM shifts left, causing

LM2
r to rise and Y to fall. r
LM1
C falls due to lower r2
income, r1
I falls because
r is higher
IS1
u rises because
Y
Y is lower Y2 Y1
(Okun’s law)
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 Exercise
C = 0.8(1 –t)Y ; t = 0.25
I = 900 – 50i ; G = 800
(M/P)d = 0.25Y – 62.5i
(M/P)s = 500
a) Find equations for IS & LM curves
b) Find out Govt. purchase multiplier
c) Find equilibrium value of i & Y
d) Find out by how much equilibrium i & Y will change as
a result of G increased by 200
e) Find out by how much equilibrium i & Y will change as
a result of (M/P)s increased by 200
Copyright, Worth Publishers (2014) [Modified/Edited by Rizwan Tahir] 21
Exercise C = 0.8(1 –t)Y ; t = 0.25
I = 900 – 50i ; G = 800
(M/P)d = 0.25Y – 62.5i
(M/P)s = 500
a) Find equations for IS & LM curves

Copyright, Worth Publishers (2014) [Modified/Edited by Rizwan Tahir] 22

Exercise C = 0.8(1 –t)Y ; t = 0.25
I = 900 – 50i ; G = 800
(M/P)d = 0.25Y – 62.5i
(M/P)s = 500
a) Find equations for IS & LM curves

Copyright, Worth Publishers (2014) [Modified/Edited by Rizwan Tahir] 23

Exercise C = 0.8(1 –t)Y ; t = 0.25
I = 900 – 50i ; G = 800
(M/P)d = 0.25Y – 62.5i
(M/P)s = 500

b) Find out Govt. purchase multiplier

Copyright, Worth Publishers (2014) [Modified/Edited by Rizwan Tahir] 24

Exercise C = 0.8(1 –t)Y ; t = 0.25
I = 900 – 50i ; G = 800
(M/P)d = 0.25Y – 62.5i
(M/P)s = 500

c) Find equilibrium value of i & Y

Copyright, Worth Publishers (2014) [Modified/Edited by Rizwan Tahir] 25

 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.

Copyright, Worth Publishers (2014) [Modified/Edited by Rizwan Tahir] 26

 DERIVING THE AD CURVE

r LM(P2)
Intuition for slope LM(P1)
r2
of AD curve:
r1
hP g i(M/P )
IS
g LM shifts left Y2 Y1 Y
P
g hr
P2
g iI
P1
g iY
AD
Y2 Y1 Y
Copyright, Worth Publishers (2014) [Modified/Edited by Rizwan Tahir] 27
 MONETARY POLICY AND THE AD
CURVE
r LM(M1/P1)
The B.O.C. can increase
r1 LM(M2/P1)
aggregate demand:
r2
hM g LM shifts right
IS
g ir Y1 Y2 Y
P
g hI
g hY at each P1
value of P AD2
AD1
Y1 Y2 Y
Copyright, Worth Publishers (2014) [Modified/Edited by Rizwan Tahir] 28
 FISCAL POLICY AND THE AD CURVE

r LM
Expansionary fiscal
policy (hG and/or iT) r2
increases agg. demand: r1 IS2
iT g hC IS1
Y1 Y2 Y
g IS shifts right P

g hY at each P1
value of P
AD2
AD1
Y1 Y2 Y
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 IS-LM AND AD-AS
IN THE SHORT RUN & LONG RUN

Recall from Chapter 9: The force that moves the

economy from the short run to the long run
is the gradual adjustment of prices.

In the short-run then over time, the

equilibrium, if price level will
Y Y rise
Y Y fall

Y Y remain constant
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THE SR AND LR EFFECTS OF AN IS SHOCK

r LRAS LM(P )
1
A negative IS shock
shifts IS and AD left,
causing Y to fall.
IS1
IS2
Y Y
P LRAS
P1 SRAS1

AD1
AD2
Y Y
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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

AD1
AD2
Y Y
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 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
Over time, P gradually
falls, causing: P LRAS
•SRAS to move down P1 SRAS1

•M/P to increase,
which causes LM AD1
to move down AD2
Y Y
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THE SR AND LR EFFECTS OF AN IS SHOCK

r LRAS LM(P )
1

Over time, P gradually LM(P2)

falls, causing:
•SRAS to move down IS1
IS2
•M/P to increase, Y
which causes LM Y
to move down P LRAS
P1 SRAS1

P2 SRAS2
AD1
AD2
Y Y
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 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
Y Y
with Y Y P LRAS
P1 SRAS1

P2 SRAS2
AD1
AD2
Y Y
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 ANALYZE SR & LR EFFECTS OF ΔM

a. Draw the IS-LM and AD-AS r LRAS LM(M1/P1)

diagrams as shown here.
b. Suppose B.O.C. increases M.
Show the short-run effects
on your graphs. IS
c. Show what happens in the Y
transition from the short run Y
to the long run. P LRAS
d. How do the new long-run
P1 SRAS1
equilibrium values of the
endogenous variables
compare to their initial AD1
values? Y
Copyright, Worth Publishers (2014) [Modified/Edited by Rizwan Tahir] Y 36
 ANSWERS, PART 1
SHORT-RUN EFFECTS OF ΔM

LM and AD shift right. r LRAS LM(M1/P1)

r1 LM(M2/P1)
r2
r falls, Y rises above Y
IS

Y Y2 Y
P LRAS

P1 SRAS
AD2
AD1
Copyright, Worth Publishers (2014) [Modified/Edited by Rizwan Tahir] Y Y2 Y 37
 ANSWERS, PART 2
TRANSITION FROM SHORT RUN TO LONG RUN

Over time, r LRAS LM(M12/P13)

 P rises r3 = r1 LM(M2/P1)
 SRAS moves upward r2
 M/P falls IS
 LM moves leftward Y
Y Y2
New long-run eq’m
P LRAS
 P higher
P3 SRAS
 all real variables back P1 SRAS
at
their initial values AD2
AD1
Money is neutral in the
Y Y2 Y 38
long run. Copyright, Worth Publishers (2014) [Modified/Edited by Rizwan Tahir]
 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

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 CHAPTER SUMMARY

2. AD curve
• shows relation between P and the IS-LM model’s
equilibrium Y.
• negative slope because
hP g i(M/P) g hr g iI g iY
• 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.

Copyright, Worth Publishers (2014) [Modified/Edited by Rizwan Tahir] 40