Mankiw8e_Student_PPTs_Chapter 12.ppt

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

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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

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 r

Y

LM(P₀) IS

r₀

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IS-L M

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

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IS LM

r

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LM r

Y IS

A

+

G

This will raise the level of income by G/(1- MPC)

IS´

B

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LM r

Y IS

A

-



T

T × MPC/(1- MPC)

IS´

B

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IS LM

r

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IS r

Y LM A LM

B

+

M

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

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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.

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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,

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

r

P

P YY

Y

Y

IS

IS

LM(P

LM(P₁₁))

A A A A AD 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 +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(P

LM(P₂₂))

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+

G

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

LM _(P

2)

Suppose there is a +G.

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 +P 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_(P 0) A D P₀ AD´ IS´ SRAS A A B B

P₂ C C

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

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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 r

as IS slides along the LM curve.

+, because a +Y increases the level of consumption (C=C(Y-T)).

– , since r increased, the level of investment decreased. YY P P r r C C I I r P Y Y IS _LM(P 0) AD P₀ AD´ IS´ SRAS A A B B

P₂ C

C

LRAS

*

Y Y´

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+, in order to eliminate the excess demand at P₀. 0, because rising P shifts LM to left, returning

Y to Y* as required by long-run LRAS.

+, reflecting the leftward shift in LM due to +P

0, since both Y and T are back to their initial levels (C=C(Y-T))

– – , since r has risen even more due to the +P. YY P P r r C C I 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.

Remember that LR is the movement from A to C.

r P Y Y IS _LM(P 0) A D P₀ AD´ IS´ SRAS A A B B

P₂ C

C

LRAS

*

Y Y´

Chapter Eleven 16 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 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 +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 IS r P Y Y LM_(P 0)

P_{0 A} SRAS A

LRAS = C

P₂

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 r as LM slides along the IS curve.

+, because a +Y increases the level of consumption (C=C(Y-T)).

+ , since r increased, the level of investment decreased. YY P P r r C C I I LM  B AD´ B C AD IS r P Y Y LM _(P0)

P_{0 A} SRAS A

LRAS = C

P₂

(P2)

Y´

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

0, because rising P shifts LM to left, returning

Y 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 initial levels (C=C(Y-T)).

0, since Y or r has not changed.

YY P P r r C C 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 IS r P Y Y

LM_(P0)

P_{0 A} SRAS A

LRAS

Y´

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LM(P₀)

1) +

1) +CCcauses the causes the IS IS curve to shift curve to shift right to

right to ISIS‘.‘.

LRAS

2) This leads to a rightward shift in

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

to AD’.AD’.

Short Run:

Short Run:

Move from

Move from AA to B.to B.

Long Run:

Long Run:

Market clears at

Market clears at PP₀₀ to to PP₂₂

from

from BB to to C.C.

3) +

3) +PP causes causes LM(PLM(P₀₀) to shift leftward ) to shift leftward to

to LM(PLM(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. r r Y Y P P Y Y IS AD IS' P₀ AD' LRAS

LM(P₂)

       P₂   C C

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

IS-L M

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Y

+

P

0

r

+

C

+

I

0

+

++

+

LM(P 2 )

       P₂   C C

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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

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Macroeconomics Case Study

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

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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

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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

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There are two theories to explain how falling prices could depress income rather than raise it.

1) Debt-deflation theory, unexpected falls in the price level

2) 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

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LM

Y IS

A IS´

B

An expected deflation (a negative value of e) 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

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Monetary transmission mechanism Pigou Effect

Debt-deflation theory

Monetary transmission mechanism Pigou Effect