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Aggregate Demand II: Applying the IS-LM Model

Part 2

Chapter 12

Some argue: if the Fed chooses an interest

rate target and adjusts the money supply to

achieve it, then draw a horizontal LM curve.

IS

LM

Y

r1

Note: if Y = Yf, the interest rate consistent

with full employment is call the “natural” rate

or the “neutral” rate. In chapter 15 called ρ.

IS

Yf

ρ=r*

Where do you think we get natural rate r*?

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Shocks in the IS -LM model

IS shocks: exogenous changes in the demand for

goods & services.

Examples:

stock market boom or crash

g change in households’ wealth

g ΔC (ΔC0 in the consumption function)

change in business or consumer

confidence or expectations

g ΔI and/or ΔC (Δ C0 or ΔI0)

Shocks in the IS -LM model

LM shocks: exogenous changes in the

demand for money.

Examples:

A wave of credit card fraud increases

demand for money.

More ATMs or the Internet reduce money

demand.

NOW YOU TRY:

Analyze shocks with the IS-LM Model

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 using

cash 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.

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NOW YOU TRY

Analyze shocks with the IS-LM model

Use the IS-LM model to analyze the effects of

1. a housing market crash that reduces

consumers’ wealth (2008)

For this shock,

a. use the IS-LM diagram to determine the effects

on Y and r.

b. figure out what happens to C, I, and the

unemployment rate.

6

Case Study: Housing market crash

7

IS1

Y

r

LM1

r1

Y1

IS2

Y2

r2

IS shifts left, causing

r and Y to fall.

Why?

C falls due to lower wealth

(a falls) and lower income,

I rises because

r is lower

u rises because

Y is lower

(Okun’s law)

Case Study: The U.S. Recession of

2001

3.9% on 9/00

4.9% on 8/01

6.3% on 6/03

5.0% on 7/05

0.0

1.0

2.0

3.0

4.0

5.0

6.0

7.0

Unemployment

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The U.S. Recession of 2001

Growth of

GDP was

negative in

the 1st and 3rd

quarters of

2001

essentially

before 9/11 -2.0

0.0

2.0

4.0

6.0

8.0

10.0

GDP growth rate

The U.S. Recession of 2001

Why?

Demand shocks moved the IS curve left The “tech bubble” ended and

stocks fell 25% between 8/00 and 8/01

9/11 attacks led to a 12% fall in stock prices in one week and a huge rise in uncertainty

Scandals at Enron, WorldCom and other corporations led to stock price declines and a decline in trust and a rise in uncertainty

Lower household wealth reduced Co and higher uncertainty reduced Io

IS

Y

r

LM

r1

Y1

CASE STUDY:

The U.S. recession of 2001

Tech Bubble Ended => Stock market decline C

300

600

900

1200

1500

1995 1996 1997 1998 1999 2000 2001 2002 2003

Inde

x (

194

2 =

100

) Standard & Poor’s

500

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The U.S. Recession of 2001

Fiscal stimulus moved IS curve right (IS1 to IS2) Major tax cuts were enacted in

2001 and 2003

Government spending was boosted to rebuild NYC, and

to bail out the airline industry

Fed printed money and moved LM curve right (LM1 to LM2) Interest rate on 3-month

Treasury bills fell 6.4% in 11/00

3.3% in 8/01

0.9% in 7/03

IS1

Y

r

LM1

r1

Y1

IS2

LM2

Y3

All three tools—G, T and M—were

used

CASE STUDY:

The U.S. recession of 2001

Monetary policy response: shifted LM curve right

Three-month

T-Bill Rate

0

1

2

3

4

5

6

7

Policy “shocks” - defined

Monetary Policy:

Decrease in i − increase in M

− monetary

expansion

Increase in i − decrease in M

− monetary

contraction (monetary tightening)

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Policy “Shocks” - defined

Fiscal Policy:

Increase in (T–G) − fiscal contraction

−

also called fiscal consolidation

Decrease in (T–G) − fiscal expansion

What is the Fed’s policy instrument?

The news media commonly report the Fed’s policy

changes as interest rate changes, as if the Fed

has direct control over market interest rates.

In fact, the Fed targets the federal funds rate—the

interest rate banks charge one another on

overnight loans.

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.

What is the Fed’s policy instrument?

Why does the Fed target interest rates instead of

the money supply?

1) They are easier to measure than the money

supply.

2) The Fed might believe that LM shocks are

more prevalent than IS shocks. If so, then

targeting the interest rate stabilizes income

better than targeting the money supply.

(See problem 8 on p.364.)

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Some argue: If Fed chooses the interest rate

target and adjusts the money supply to

achieve it, draw a horizontal LM curve.

IS

LM

Y

r1

Case Study : Interest rate target, Horizontal LM curve

and an Increase in Spending at Full Employment

If IS2 represents a permanent increase in spending, Y1 – Yf is a positive output gap which exerts upward pressure on inflation. The Fed responds by increasing r from r1 to r2.

IS1

LM1

Yf

r1

IS2

Y1

Case Study : interest rate target, horizontal LM curve

and an increase in spending at full employment

The LM shifts up to LM2. How does the Fed increase r?

IS1

LM1

Yf

r1

IS2

Y1

LM2 r2

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Suppose the IS curve is not stable.

IS0

LM money supply target

Y

r1

IS1

IS2

LM’interest rate target

How Does the IS-LM Model Fit the Facts?

Adjustment in RGDP(output) takes time, need to look at

dynamics:

Consumers are likely to take time to adjust their consumption

following a change in disposable income due to a change in

taxes.

Firms are likely to take time to adjust investment spending

following a change in their sales.

Firms are likely to take time to adjust investment spending

following a change in the interest rate.

Firms are likely to take time to adjust production following a

change in their sales.

How Does the IS-LM Model Fit the Facts? From Blanchard

The Empirical

Effects of an

Increase in the

Federal Funds

Rate - tight

money.

In the short run, an increase in the federal funds rate leads to a decrease in output and to an increase in unemployment, but it has little effect on the price level.

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How Does the IS-LM Model Fit the Facts?

The Empirical

Effects of an

Increase in the

Federal Funds

Rate - tight

money.