Macroeconomics chapter 12

1. Chapter Eleven 1
•CHAPTER 12
•Aggregate Demand II:
•Applying the IS-LM Model
Daw Chan Myae July
17.07.21

2. Chapter Eleven 2
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.
Chapter 12

3. Chapter Eleven 3
IS
LM
r
y
Chapter 12

4. Chapter Eleven 4
LM
r
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.
Chapter 12

5. Chapter Eleven 5
LM
r
Y
IS
A
-T Consider a decrease in taxes of T.
This will raise the level of income by
T × MPC/(1- MPC)
IS´
B
The IS curve shifts to the right by T × MPC/(1- MPC) which raises
income and the interest rate.
Chapter 12

6. Chapter Eleven 6
IS
LM
r
y
Chapter 12

7. Chapter Eleven 7
IS
r
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 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.
Chapter 12

8. Chapter Eleven 8
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.
Chapter 12

9. Chapter Eleven 9
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.
Chapter 12

10. Chapter Eleven 10
Chapter 12

11. Chapter Eleven 11
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 +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(P2)
B
B
P2
P1
Chapter 12

12. Chapter Eleven 12
+G
This 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 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(P0)
A
D
P
0
AD´
IS´
SRAS
A
A
B
B
P2
C
C
LRAS
Y = C (Y-T) + I(r) + G
M/ P = L (r, Y)

13. Chapter Eleven 13
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 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.
Y
P
r
C
I
r
P
Y
Y
IS LM(P0)
AD
P0
AD´
IS´
SRAS
A
A
B
B
P2
C
C
LRAS
*
Y Y´
LM(P2)
Chapter 12

14. Chapter Eleven 14
+, 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.
Y
P
r
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.
r
P
Y
Y
IS LM(P0)
A
D
P0
AD´
IS´
SRAS
A
A
B
B
P2
C
C
LRAS
*
Y Y´
LM(P2)
Chapter 12

15. Chapter Eleven 15
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(P0)
P
0
SRAS
A
A
LRAS
= C
P2
M/ P = L (r, Y)
M/ P = L (r, Y)

16. Chapter Eleven 16
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.
Y
P
r
C
I
LM
B
AD´
B
C
AD
IS
r
P
Y
Y
LM(P0)
P0
SRAS
A
A
LRAS
= C
P2
(P2)
Y´
Y*
Chapter 12

17. Chapter Eleven 17
+, 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.
Y
P
r
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)
P0
SRAS
A
A
LRAS
Y´
Y*