lecture 14 - aggregate demand ii. applying the is-lm model
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8/12/2019 Lecture 14 - Aggregate Demand II. Applying the is-LM Model
http://slidepdf.com/reader/full/lecture-14-aggregate-demand-ii-applying-the-is-lm-model 1/25
Macroeconomics
Chapter 11 - Aggregate Demand II: Applyingthe IS-LM Model
8/12/2019 Lecture 14 - Aggregate Demand II. Applying the is-LM Model
http://slidepdf.com/reader/full/lecture-14-aggregate-demand-ii-applying-the-is-lm-model 2/25
In this chapter, you will learn
• How to use the IS-LM model to analyze theeffects of shocks, fiscal policy, and monetarypolicy
• How to derive the aggregate demand curvefrom the IS-LM model
• Several theories about what caused the GreatDepression
8/12/2019 Lecture 14 - Aggregate Demand II. Applying the is-LM Model
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The intersection determinesthe unique combination of Y and r that satisfies equilibrium in both markets.
The LM curve representsmoney market equilibrium.
Equilibrium in the IS-LM ModelThe IS curve representsequilibrium in the goodsmarket.
( ) ( )Y C Y T I r G
( , )M P L r Y IS
Y
r LM
r 1
Y 1
8/12/2019 Lecture 14 - Aggregate Demand II. Applying the is-LM Model
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Policy Analysis with the IS-LM Model
We can use the IS-LM modelto 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
r 1
Y 1
8/12/2019 Lecture 14 - Aggregate Demand II. Applying the is-LM Model
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(lump-sum taxation)
causing output andincome to rise
IS 1
Increase in Government Purchases
1. IS curve shifts right
Y
r LM
r 1
Y 1
1by
1 MPCG
IS 2
Y 2
r 2
1.2. This raises moneydemand, causing the
interest rate to rise…
2.
3. …which reduces investment,so the final increase in Y
1is smaller than
1 MPC
G
3.
8/12/2019 Lecture 14 - Aggregate Demand II. Applying the is-LM Model
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IS 1
1.
A Tax Cut
Y
r LM
r 1
Y 1
IS 2
Y 2
r 2
Consumers save(1 MPC ) of the tax cut,so the initial boost inspending is smaller for T than for an equal G …
and the IS curve shifts byMPC
1 MPCT 1.
2.
2.…so the effects on r and Y are smaller for T than for an equal G
2.
8/12/2019 Lecture 14 - Aggregate Demand II. Applying the is-LM Model
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2. …causing theinterest rate to fall
IS
Monetary Policy: An Increase in M
1. M > 0 shiftsthe LM curve down(or to the right)
Y
r LM 1
r 1
Y 1 Y 2
r 2
LM 2
3. …which increases
investment, causingoutput and incometo rise
8/12/2019 Lecture 14 - Aggregate Demand II. Applying the is-LM Model
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Practice: IS-LM
C(Y-T) = 200 + .75(Y-T)MPC = .75
t = 1/3I(r) = 2000 – 50r
G = 1300L(Y,r) = Y – 25r
M = 1000P = 1
Determine the IS and LM curves and then calculate theinterest rate (r) and income (Y) in equilibrium.
8/12/2019 Lecture 14 - Aggregate Demand II. Applying the is-LM Model
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Interaction Between Monetary andFiscal Policy
• Model: Monetary and fiscal policy variables(M , G, and T ) are exogenous
• Real world: Monetary policymakers mayadjust M in response to changes in fiscalpolicy, or vice versa
• Such interaction may alter the impact of theoriginal policy change
8/12/2019 Lecture 14 - Aggregate Demand II. Applying the is-LM Model
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The Fed’s Response to G > 0
• Suppose Congress increases G
• Possible Fed responses:1. hold M constant2. hold r constant
3. hold Y constant
• In each case, the effects of the G aredifferent…
8/12/2019 Lecture 14 - Aggregate Demand II. Applying the is-LM Model
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If Congress raises G ,the IS curve shifts right.
IS 1
Response 1: Hold M Constant
Y
r LM 1
r 1
Y 1
IS 2
Y 2
r 2
If Fed holds M constant,
then LM curve doesn’tshift.
Results:
2 1Y Y Y
2 1r r r
8/12/2019 Lecture 14 - Aggregate Demand II. Applying the is-LM Model
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If Congress raises G ,the IS curve shifts right.
IS 1
Response 2: Hold r Constant
Y
r LM 1
r 1
Y 1
IS 2
Y 2
r 2 To keep r constant,
Fed increases M to shift LM curve right.
3 1Y Y Y
0r
LM 2
Y 3
Results:
8/12/2019 Lecture 14 - Aggregate Demand II. Applying the is-LM Model
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IS 1
Response 3: Hold Y Constant
Y
r LM 1
r 1
IS 2
Y 2
r 2 To keep Y constant,
Fed reduces M to shift LM curve left.
0Y
3 1r r r
LM 2
Results:
Y 1
r 3
If Congress raises G ,the IS curve shifts right.
8/12/2019 Lecture 14 - Aggregate Demand II. Applying the is-LM Model
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Estimates of Fiscal Policy Multipliers
From the DRI macroeconometric model
Assumption aboutmonetary policy
Estimatedvalue of
Y / G
Fed holds nominalinterest rate constant
Fed holds moneysupply constant
1.93
0.60
Estimatedvalue of
Y / T
1.19
0.26
8/12/2019 Lecture 14 - Aggregate Demand II. Applying the is-LM Model
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8/12/2019 Lecture 14 - Aggregate Demand II. Applying the is-LM Model
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Shocks in the IS -LM model
LM shocks : exogenous changes in the demandfor money.
Examples:
– Wave of credit card fraud increases demand formoney
–More ATMs or the Internet reduce moneydemand
8/12/2019 Lecture 14 - Aggregate Demand II. Applying the is-LM Model
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Practice: Analyzing Shocks
Use the IS-LM model to analyze the effects of:1. a boom in the stock market that makes consumers
wealthier.
2. after a wave of credit card fraud, consumers usingcash more frequently in transactions.
For each shock:a. use the IS-LM diagram to show the effects of the shock
on Y and r . b. determine what happens to C , I , and the
unemployment rate.
8/12/2019 Lecture 14 - Aggregate Demand II. Applying the is-LM Model
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CASE STUDY:
The U.S. recession of 2001
• During 2001:
– 2.1 million jobs lost, unemployment rose from3.9% to 5.8%
– GDP growth slowed to 0.8% (compared to 3.9%
average annual growth during 1994-2000)
8/12/2019 Lecture 14 - Aggregate Demand II. Applying the is-LM Model
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CASE STUDY:
The U.S. recession of 2001Causes: 1) Stock market decline C
300
600
900
1200
1500
1995 1996 1997 1998 1999 2000 2001 2002 2003
I n d e
x ( 1 9 4 2
= 1 0
0 ) Standard & Poor’s
500
8/12/2019 Lecture 14 - Aggregate Demand II. Applying the is-LM Model
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CASE STUDY:
The U.S. recession of 2001
Causes: 2) 9/11 – Increased uncertainty
–Fall in consumer and business confidence
– Result: lower spending, IS curve shifted left
Causes: 3) Corporate accounting scandals – Enron, WorldCom, etc . – Reduced stock prices, discouraged investment
8/12/2019 Lecture 14 - Aggregate Demand II. Applying the is-LM Model
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CASE STUDY:
The U.S. recession of 2001
• Fiscal policy response: shifted IS curve right
– Tax cuts in 2001 and 2003
– Spending increases
• Airline industry bailout
• NYC reconstruction• Afghanistan war
8/12/2019 Lecture 14 - Aggregate Demand II. Applying the is-LM Model
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CASE STUDY:
The U.S. recession of 2001Monetary policy response: shifted LM curve right
Three-monthT-Bill Rate
0
1
2
34
5
6
7
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Fed’s Policy Instrument
• The news media commonly report the Fed’s policychanges as interest rate changes, as if the Fed hasdirect control over market interest rates
• In fact, the Fed targets the federal funds rate – theinterest rate banks charge one another on overnightloans
• The Fed changes the money supply and shifts the LM
curve to achieve its target• Other short-term rates typically move with the federal
funds rate
8/12/2019 Lecture 14 - Aggregate Demand II. Applying the is-LM Model
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Fed’s Policy Instrument
Why does the Fed target interest rates instead of themoney supply?
1) They are easier to measure than the moneysupply
2) The Fed might believe that LM shocks are moreprevalent than IS shocks. If so, then targeting the
interest rate stabilizes income better thantargeting the money supply
8/12/2019 Lecture 14 - Aggregate Demand II. Applying the is-LM Model
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IS-LM and Aggregate Demand
• So far, we’ve been using the IS-LM model toanalyze the short run, when the price level isassumed fixed
• However, a change in P would shift LM andtherefore affect Y
• The aggregate demand curve captures thisrelationship between P and Y
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