Chapter Eleven

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A PowerPointTutorialto Accompany macroeconomics, 5th ed.

N. Gregory Mankiw

Mannig J. Simidian

®

CHAPTER ELEVENAggregate Demand II

Chapter Eleven

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Now that we’ve assembled the IS-LM model of aggregate demand, let’s apply it to three issues:

1) Causes of fluctuations in national income

2) How IS-LM fits into the model of aggregate supply and aggregatedemand

3) The Great Depression

Now that we’ve assembled the IS-LM model of aggregate demand, let’s apply it to three issues:

1) Causes of fluctuations in national income

2) How IS-LM fits into the model of aggregate supply and aggregatedemand

3) The Great Depression

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IS-L

M

The intersection of the IS curve and the LM curve determines the level of national income. When one of these curves shifts, the short-run

equilibrium of the economy changes, and national income fluctuates. Let’s examine how

changes in policy and shocks to the economy can cause these curves to shift.

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LMr

Y

IS

A

+G Consider an increase in government purchases.This will raise the level of income by G/(1- MPC)

IS´

B

The IS curve shifts to the right by G/(1- MPC) which raises income and the interest rate.

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ISr

Y

LM

A LM

B

+M Consider an increase in the money supply.

The LM curve shifts downward and lowers the interest rate which raises income. Why? Because when the Fed increases the supply of money, people have more money than they want to hold at the prevailing interest rate. As a result, they start depositing this extra money in banks or use it to buy bonds.The interest rate r then falls until people are willing to hold all the extramoney that the Fed has created; this brings the money market to a new equilibrium. The lower interest rate, in turn has ramifications for the goodsmarket. A lower interest rate stimulates planned investment, which increasesplanned expenditure, production, and income Y.

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The IS-LM model shows that monetary policy influences income bychanging the interest rate. This conclusion sheds light on our analysisof monetary policy in Chapter 9. In that chapter we showed that in the short run, when prices are sticky, an expansion in the money supply raises income. But, we didn’t discuss how a monetary expansion induces greater spending on goods and services--a processcalled the monetary transmission mechanism.

The IS-LM model shows that an increase in the money supply lowersthe interest rate, which stimulates investment and thereby expands thedemand for goods and services.

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You probably noticed from the IS and LM diagrams that r and Y were on the two axes. Now we’re going to bring a third variable, the price level

(P) into the analysis. We can accomplish this by linking both two-dimensional graphs.

rr

PP YY

YY

ISIS

LM(PLM(P11))

AA

AA

ADAD

To derive AD, start at point A in the top graph. Now increase the price level from P1 to P2. An increase in P lowers the value of real money

balances, and Y, shifting LM leftward to point B.

The +P triggers a sequence of events that end with a -Y, the inverse relationship that defines the downward slope of AD.

Notice that r increased. Since r increased, we know that investment will decrease as it just got more costly to take on various investment projects. This sets off a multiplier process since -I causes a –Y.The - Y triggers -C as we move up the IS curve.

LM(PLM(P22))

BB

BBP2

P1

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+GThis translates into a rightward shift of the IS and AD curves.

LM (P2)

Suppose there is a +G.

In the short-run, we move along SRAS frompoint A to point B.But as the output market clears, in the long-run,the price level will increase from P0 to P2.

This +P decreases the value of real moneybalances, which translates into a leftward shift of the LM curve.

Finally, this leaves us at point C in both diagrams.

r

PY

Y

ISLM(P0)

AD

P0AD´

IS´

SRASA

A

B

B

P2C

C

LRAS

Y = C (Y-T) + I(r) + G

M/ P = L (r, Y)

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Now it’s time to determine the effects on the variables in the economy.For the variables Y, P, and r, you can read the effects right off the diagrams.

Remember that SR is the movement from A to B.Remember that SR is the movement from A to B.

+, because Y moved from Y* to Y´

0, because prices are sticky in the SR. +, because a +Y leads to a rise in ras IS slides along the LM curve.+, because a +Y increases the level ofconsumption (C=C(Y-T)).– , since r increased, the level ofinvestment decreased.

YY

PP

rr

CC

II

r

PY

Y

IS LM(P0)

AD

P0

AD´

IS´

SRASA

A

B

B

P2C

C

LRAS

*Y Y´

LM(P2)

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+, in order to eliminate the excess demand at P0.

0, because rising P shifts LM to left, returningY to Y* as required by long-run LRAS.

+, reflecting the leftward shift in LM due to +P0, since both Y and T are back to their initiallevels (C=C(Y-T))– – , since r has risen even more due to the +P.

YY

PP

rr

CC

II

For the variables Y, P and r, you can read the effects right off the diagrams.

Remember that LR is the movement from A to C.Remember that LR is the movement from A to C.

r

PY

Y

IS LM(P0)

AD

P0

AD´

IS´

SRASA

A

B

B

P2C

C

LRAS

*Y Y´

LM(P2)

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LM

B

AD´B

Notice that M\ was increased, thus increasing the value of the real money supply which translates into a rightward shift of the LM and AD curves.

Suppose there is a +M.

Look at the appropriate equationthat captures the M term:

In the short-run, we move along SRAS frompoint A to point B.But as the output market clears, in the long-run,the price level will increase from P0 to P2.

This +P decreases the value of the real money supply which translates into a leftward shift of the LM curve.

Finally, this leaves us at point C in both diagrams.

C

AD

ISr

PY

Y

LM(P0)

P0SRAS

A

A

LRAS

= C

P2

M/ P = L (r, Y)

M/ P = L (r, Y)

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Now it’s time to determine the effects on the variables in the economy.

For the variables Y, P, and r, you can read the effects right off the diagrams.

Remember that SR is the movement from A to B.

+, because Y moved from Y* to Y´

0, because prices are sticky in the SR. –, because a +Y leads to a decrease in ras LM slides along the IS curve.+, because a +Y increases the level ofconsumption (C=C(Y-T)).+ , since r increased, the level ofinvestment decreased.

YY

PP

rr

CC

II

LM

B

AD´B

C

AD

ISr

PY

Y

LM(P0)

P0 SRASA

A

LRAS

= C

P2

(P2)

Y´Y*

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+, in order to eliminate the excess demand at P0.

0, because rising P shifts LM to left, returningY to Y* as required by LRAS.

0, reflecting the leftward shift in LM due to +P, restoring r to its original level.0, since both Y and T are back to their initiallevels (C=C(Y-T)).0, since Y or r has not changed.

YY

PP

rr

CC

I

For the variables Y, P and r, you can read the effects right off the diagrams.

Remember that LR is the movement from A to C.

Notice that the only LR impact of an increase in the money supply was an

increase in the price level.

LM

B

AD´B

C

= C

P2

AD

ISr

PY

Y

LM(P0)

P0 SRASA

A

LRAS

Y´Y*

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LM(P0)1) +1) +CC causes the IS curve to shift causes the IS curve to shift

right to IS‘.right to IS‘.

LRAS

2) This leads to a rightward shift in AD 2) This leads to a rightward shift in AD to AD’.to AD’.

Short Run: Short Run: Move from A to B.Move from A to B.

Long Run:Long Run:Market clears at PMarket clears at P00 to P to P22

from B to C.from B to C.3) +3) +P causes LM(PP causes LM(P00) to shift leftward ) to shift leftward

to LM(Pto LM(P22) due to the lowering of the ) due to the lowering of the

real value of the money supply.real value of the money supply.

rr

YYPP

YY

IS

AD

IS'

P0

AD'

LRAS

LM(P2)

P2

C

C

Y = C (Y-T) + I(r) + G

IS-L

M

M/ P = L (r, Y)

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Short Run:

Y +P 0r +C +I -

Long Run:

0+

+++--

SRAS

r

YP

Y

IS

AD

IS'

P 0

AD'

LRAS

LM(P 2 )

P 2

C

C

LM(P 0 )

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The spending hypothesis suggests that perhaps the cause of thedecline may have been a contractionary shift of the IS curve.

The money hypothesis attempts to explain the effects of the historicalfall of the money supply of 25% from 1929 to 1933 during which time unemployment rose from 3.2% to 25.2.%. Some economists say that deflation worsened the Great Depression. They argue that the deflation may have turned what in 1931 was atypical economic downturn into an unprecedented period of highunemployment and depressed income. Because the falling moneysupply was possibly responsible for the falling price level, it couldvery well have been responsible for the severity of the depression. Let’ssee how changes in the price level affect income in the IS-LM model.

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LM

Y

IS

AIS´

B

An expected deflation (a negative value of e) raises the real interestrate for any given nominal interest rate, and this depresses investmentspending. The reduction in investment shifts the IS curve downward.The level of income and the nominal interest rate (i) fall, but the realinterest rate (r) rises.

i2

r1 = i1

r2

interest rate, i

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Monetary transmission mechanismPigou EffectDebt-deflation theory

Monetary transmission mechanismPigou EffectDebt-deflation theory