Mankiw8e_Student_PPTs_Chapter_12

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Chapter Eleven
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CHAPTER 12
Aggregate Demand II: 
Applying the IS-LM Model
®
A PowerPointTutorial
To Accompany 
MACROECONOMICS, 8th Edition
N. Gregory Mankiw
 Tutorial written by:
Mannig J. Simidian
B.A. in Economics with Distinction, Duke University 
M.P.A., Harvard University Kennedy School of Government
M.B.A., Massachusetts Institute of Technology (MIT) Sloan School of Management
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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 aggregate demand in Chapter 10
3) The Great Depression
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IS-LM
The intersection of the IS curve and the LM curve determines the level of national income, and the interest rate for a given price level. If the IS or LM curve 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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Chapter Eleven
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IS
LM
r
y
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The IS curve shifts to the right by G/(1- MPC) which raises income and the interest rate. 
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The IS curve shifts to the right by T × MPC/(1- MPC) which raises income and the interest rate. 
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IS
LM
r
y
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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 extra
money that the Fed has created; this brings the money market to a new 
equilibrium. The lower interest rate, in turn, has ramifications for the goods
market. A lower interest rate stimulates planned investment, which increases
planned expenditure, production, and income Y.
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The IS-LM model shows that monetary policy influences income by
changing the interest rate. This conclusion sheds light on our analysis
of 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 process
called the monetary transmission mechanism.
The IS-LM model shows that an increase in the money supply lowers
the interest rate, which stimulates investment and thereby expands the
demand for goods and services.
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The IS-LM model shows how monetary and fiscal policy influence
the equilibrium level of income. The predictions of the model,
however, are qualitative, not quantitative. The IS-LM model that
shows that increases in government purchases raise GDP and that 
increases in taxes lower GDP. But, when economists analyze specific
policy proposals, they must know the direction and size of the effect.
Macroeconometric models describe the economy quantitatively, 
rather than just qualitatively.
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Chapter Eleven
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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.
r
P
Y
Y
IS
LM(P1)
A
A
AD
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 +DP triggers a sequence of events that end 
with a -DY, 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 -DI causes a –DY.
The - DY triggers -DC as we move up the IS curve.
P1
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Chapter Eleven
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+G
This translates into a rightward shift of the IS and AD curves.
Suppose there is a +DG.
In the short run, we move along SRAS from
point A to point B.
But as the output market clears, in the long-run,
the price level will increase from P0 to P2.
This +DP decreases the value of real money
balances, which translates into a leftward shift of the LM curve.
Finally, this leaves us at point C in both diagrams.
r
P
Y
Y
IS
LM(P0)
AD
P0
SRAS
A
A
LRAS
Y = C (Y-T) + I(r) + G
M/ P = L (r, Y)
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Chapter Eleven
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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.
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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.
r
P
Y
Y
IS
LM(P0)
AD
P0
SRAS
A
A
LRAS
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LM(P2)
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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 +DM.
Look at the appropriate equation
that captures the M term:
In the short run, we move along SRAS from
point A to point B.
But as the output market clears, in the long run,
the price level will increase from P0 to P2.
This +DP 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
= C 
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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.
C
= C
(P2)
Y´
Y*
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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.
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1) +DC causes the IS curve to shift right to IS‘.
LRAS
2) This leads to a rightward shift in AD to AD’.
Short Run: 
Move from A to B.
Long Run:
Market clears at P0 to P2 
from B to C.
3) +DP causes LM(P0) to shift leftward to LM(P2) due to the lowering of the real value of the money supply.
r
Y
P
Y
IS
AD
P0
LRAS
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Y	+
P	0
r	+
C	+
I	-
	
0
+
++
+
--
SRAS
r
Y
P
Y
IS
AD
P
0
LRAS
LM(P
 2
 )
LM(P
 0
 )
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The spending hypothesis suggests that perhaps the cause of the
decline may have been a contractionary shift of the IS curve.
The money hypothesis attempts to explain the effects of the historical
fall of the money supply of 25 percent from 1929 to 1933, during which 
time unemployment rose from 3.2 percent to 25.2 percent.
 
Some economists say that deflation worsened the Great Depression. 
They argue that the deflation may have turned what in 1931 was a
typical economic downturn into an unprecedented period of high
unemployment and depressed income. Because the falling money
supply was possibly responsible for the falling price level, it could
very well have been responsible for the severity of the depression. Let’s
see how changes in the price level affect income in the IS-LM model.
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A Mankiw 
Macroeconomics
Case Study
The Financial Crisis and the 
Economic Downturn of 2008 and 2009
In 2008, the economy experienced a financial crisis, followed by 
a deep recession stemming mainly from the 20% fall in housing 
prices across the nation. 
This had four main repercussions:
1)Rise in mortgage defaults and house foreclosures
2) Large losses at the various financial institutions that owned
Mortgage-backed securities
3)Rise in stock market volatility, which led to a decline in 
consumer confidence
In January 2009, President Barack Obama proposed to increase
he proposed to increase government spending to stimulate AD.
This is almost surely not going to prevent the economy from
Dipping further into a downward spiral.
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Developments in the mortgage market led to the rise of subprime
borrowers– those borrowers with higher risk of default based on their
Income and credit history– to get mortgages to buy home.
One of these developments was securitization, the process by
which one makes loans and then sells them to an investment bank
which in turn bundles them together into a variety of 
“mortgage-backed securities” and then sells them to a third 
financial institution (such as a bank, pension fund, or insurance
company). These securities pay a return as long as homeowners
continue to repay their loans, but they lose value if homeowners
default.
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In the IS-LM model, falling prices raise income. For any given
supply of money M, a lower price level implies higher real
money balances, M/P. An increase in real money balances causes
an expansionary shift in the LM curve, which leads to higher 
income.
Another way in which falling prices increase income is called
the Pigou effect. In the 1930s, economist Arthur Pigou pointed out 
that real money balances are part of household wealth. As prices fall
and real money balances rise, households increase their
consumption spending and the IS curve shifts to the right.
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There are two theories to explain how falling prices could depress
income rather than raise it.
Debt-deflation theory, unexpected falls in the price level
Effects of expected inflation
Debt-deflation theory redistributes wealth between creditors and
debtors. A fall in the price level raises the real amount of the debt.
The impoverishment of the debtors causes them to spend less, and
creditors to spend more. If their propensities to consume are the same,
there is no aggregate effect. But, if debtors reduce more than
the amount that creditors increase spending, the net effect on aggregate
demand is a reduction. This contracts IS, and reduces national income.
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IS´
B
An expected deflation (a negative value of pe) raises the real interest
rate for any given nominal interest rate, and this depresses investment
spending. The reduction in investment shifts the IS curve downward.
The level of income and the nominal interest rate (i) fall, but the real
interest rate (r) rises.
i2
r1 = i1
r2
interest rate, i
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		Monetary transmission mechanism
		Pigou Effect
		Debt-deflation theory