Now that weve assembled the ISLM model of aggregate demand, lets apply it to three issues:

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Now that weve assembled the IS-LM model of
aggregate demand, lets 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 3) The
Great Depression
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Explaining Fluctuations with the IS-LM Model
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. Lets examine how changes in policy
and shocks to the economy can cause these curves
to shift.
IS-LM
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How Fiscal Policy Shifts the IS Curve and
Changes the Short-run Equilibrium
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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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How Monetary Policy Shifts the LM Curve and
Changes the Short-run Equilibrium
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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 didnt 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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IS-LM as a Theory of Aggregate Demand
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From IS-LM to AD
You probably noticed from the IS and LM diagrams
that r and Y were on the two axes. Now were
going to bring a third variable, the price level
(P) into the analysis. We can accomplish this by
linking both two-dimensional graphs.
To derive AD, start at point A in the top graph.
Now increase the price level from P1 to P2.
IS
r
LM(P1)
An increase in P lowers the value of real money
balances, and Y, shifting LM leftward to point B.
A
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.
Y
P
A
P1
The DP triggers a sequence of events that end
with a -DY, the inverse relationship that
defines the downward slope of AD.
AD
Y
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?G
IS
Y C (Y-T) I(r) G
Suppose there is a DG.
This translates into a rightward shift of the IS
and AD curves.
IS
r
In the short-run, we move along SRAS from point A
to point B.
LM(P0)
A
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.
Y
LRAS
P
SRAS
P0
A
LM
M/ P L (r, Y)
AD
Y
Finally, this leaves us at point C in both
diagrams.
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Remember that SR is the movement from A to B.
Short-run Impacts
Now its 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.
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Long-run Impacts
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.
LM(P2)
IS
r
LM(P0)
A
Y
LRAS
P
SRAS
P0
A
AD
Y

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Suppose there is a DM.
Look at the appropriate equation that captures
the M term
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.
In the short-run, we move along SRAS from point A
to point B.
C
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.
C
Finally, this leaves us at point C in both
diagrams.
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Short-run Impacts
Remember that SR is the movement from A to B.
Now its 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.
(P2)
C
C
Y
Y
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Long-run Impacts
Remember that LR is the movement from A to C.
For the variables Y, P and r, you can read the
effects right off the diagrams.
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What if there was an increase in autonomous
consumption spending?
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1) DC causes the IS curve to shift right to IS.
IS
r
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.
Y
LRAS
P
3) DP causes LM(P0) to shift leftward to LM(P2)
due to the lowering of the real value of the
money supply.
P0
LRAS
AD
Y
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LM(P
)
2
r
IS
LM(P
)
0
Y P 0 r C I -
0 --
Y
P
LRAS
P
SRAS
0
AD
Y
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The Great Depression
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 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 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.
Lets see how changes in the price level affect
income in the IS-LM model.
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Expected Deflation in the IS-LM Model
interest rate, i
r2
IS
r1 i1
B
i2
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.
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Key Concepts of Ch. 11
Monetary transmission mechanism Pigou
Effect Debt-deflation theory