This document provides an overview of the IS-LM model of aggregate demand. It begins by discussing how Keynes criticized classical economic theory and proposed that low aggregate demand is responsible for economic downturns. It then introduces the IS curve, which plots the relationship between interest rates and income in goods markets, and the LM curve, which plots the relationship between interest rates and income in money markets. The intersection of the IS and LM curves determines aggregate demand and income in the economy. Shifts in these curves due to factors like fiscal policy changes, money supply changes, and price level changes cause fluctuations in equilibrium income.

1. Chapter Ten 1
Aggregate Demand 1:
Building the IS-LM Model
®
A PowerPointTutorial
To Accompany
MACROECONOMICS, 7th. 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

2. Chapter Ten 2
The Great Depression caused many economists to question the
validity of classical economic theory (from Chapters 3-6). They
believed they needed a new model to explain such a pervasive
economic downturn and to suggest that government policies might
ease some of the economic hardship that society was experiencing.
In 1936, John Maynard Keynes wrote The General Theory of
Employment, Interest, and Money. In it, he proposed a new way to
analyze the economy, which he presented as an alternative to
the classical theory.
Keynes proposed that low aggregate demand is responsible for the low
income and high unemployment that characterize economic downturns.
He criticized the notion that aggregate supply alone determines national
income.

3. Chapter Ten 3
In 2008 and 2009, as the United States and Europe descended into a recession, the Keynesian
theory of the business cycle was often in the news. Policymakers around the world debated how
best to increase aggregate demand with both monetary and fiscal policy.

4. Chapter Ten 4
“Keynesian” means different things to different
people. It’s useful to think of the basic textbook
Keynesian model as an elaboration and extension
of the “classical theory.” Its variable velocity
of money and “sticky” prices reflects Keynes’s
belief that the Classical model’s shortcomings arose
from its overly-strict assumptions of constant
velocity and highly flexible wages and prices.
The model of aggregate demand (AD) can be split into two parts:
IS model of the “goods market” and the
LM model of the “money market.” “IS stands for Investment Saving,
Whereas LM stands for Liquidity Money.”

5. Chapter Ten 5
Price level, P
Income, Output, Y
SRAS
AD
Y* Y*'
AD'
AD''
Y*''
In the short run, when the price level is fixed, shifts in
the aggregate demand curve lead to changes in
national income, Y.
The model of aggregate demand developed in this chapter called
the IS-LM is the leading interpretation of Keynes’ work. The IS-LM
model takes the price level as given and shows what causes income to
change. It shows what causes AD to shift.
The Keynesian model can be viewed as showing what
causes the aggregate demand curve to shift.

6. Chapter Ten 6
IS (investment and saving)
model of the
‘goods market’
LM (liquidity and money)
model of the ‘money market

7. Chapter Ten 7
The IS curve (which stands for investment
saving) plots the relationship between the
interest rate and the level of income that
arises in the market for goods and services.
The LM curve (which stands for liquidity and
money) plots the relationship between the
interest rate and the level of income that
arises in the money market.

8. Chapter Ten 8
In the General Theory of Money, Interest and Employment (1936),
Keynes proposed that an economy’s total income was, in the short
run, determined largely by the desire to spend by households, firms,
and the government. The more people want to spend, the more goods
and services firms can sell. The more firms can sell, the more
output they will choose to produce and the more workers they will
choose to hire. Thus, the problem during recessions and depressions,
according to Keynes, was inadequate spending.
The Keynesian cross is an attempt to model this insight.
Because the interest rate influences both investment and money
demand, it is the variable that links the two parts of the IS-LM model.
The model shows how interactions between these markets determine
the position and slope of the aggregate demand curve, and therefore,
the level of national income in the short run.

9. Chapter Ten 9
The Keynesian cross shows how income Y is determined for given levels
of planned investment I and fiscal policy G and T. We can use this
model to show how income changes when one of the exogenous
variables change. Actual expenditure is the amount households, firms
and the government spend on goods and services (GDP). Planned
expenditure is the amount households, firms, and the government
would like to spend on goods and services. The economy is in
equilibrium when: Actual Expenditure = Planned Expenditure or Y = E
Expenditure, E
Income, output, Y
Actual expenditure, Y=E
Planned expenditure,
E = C + I + G
Y YY*

10. Chapter Ten 10
Expenditure, E
Income, output, Y
Actual expenditure, Y = E
Planned expenditure,
E = C + I + G
Y2 Y1Y*
The 45-degree line (Y=E) plots the points where this condition holds.
With the addition of the planned-expenditure function, this diagram
becomes the Keynesian cross.
How does the economy get to this equilibrium? Inventories play an
important role in the adjustment process. Whenever the economy is
not in equilibrium, firms experience unplanned changes in inventories,
and this induces them to change production levels. Changes in
production in turn influence total income and expenditure, moving the
economy toward equilibrium.

11. Chapter Ten 11
Consider how changes in government purchases affect the economy.
Because government purchases are one component of expenditure,
higher government purchases result in higher planned expenditure,
for any given level of income.
Expenditure, E
Income, output, Y
Actual expenditure, Y=E
Planned expenditure,
E = C + I + G
Y1Y*
DG
An increase in government purchases of DG raises planned expenditure
by that amount for any given level of income. The equilibrium moves
from A to B and income rises. Note that the increase in income Y
exceeds the increase in government purchases DG.
Thus, fiscal policy has a multiplied effect on income.
A
B

12. Chapter Ten 12
If government spending were to increase by $1, then you might expect
equilibrium output (Y) to also rise by $1.
But it doesn’t! The multiplier shows that the change in demand for
output (Y) will be larger than the initial change in spending. Here’s why:
When there is an increase in government spending (DG), income rises by
DG as well. The increase in income will raise consumption by MPC 
DG, where MPC is the marginal propensity to consume. The increase in
consumption raises expenditure and income again. The second increase
in income of MPC  DG again raises consumption, this time by MPC 
(MPC  DG), which again raises income and so on.
So, the multiplier process helps explain fluctuations in the demand for
output. For example, if something in the economy decreases investment
spending, then people whose incomes have decreased will spend less,
thereby driving equilibrium demand down even further.

13. Chapter Ten 13
The government-purchases multiplier is:
DY/DG = 1 + MPC + MPC2 + MPC3 + …
DY/DG = 1 / 1 - MPC
The tax multiplier is:
DY/DT = - MPC / (1 - MPC)

14. Chapter Ten 14
A Mankiw
Macroeconomics
Case Study
Increasing Government
Purchases to Stimulate the
Economy:
The Obama Spending Plan
When President Obama took office in 2009, the economy was undergoing a significant recession.
He proposed a package that would cost the government about $800 billion, or about 5% of annual
GDP. The package included some tax cuts and higher transfer payments, but much of it was made
up of increases in government purchases of goods and services.

15. Chapter Ten 15
Let’s now add the relationship between the interest rate and investment
to our model, writing the level of planned investment as: I = I (r).
On the next slide, the investment function is graphed downward
sloping showing the inverse relationship between investment
and the interest rate. To determine how income changes when the
interest rate changes, we combine the investment function with the
Keynesian-cross diagram.
The IS curve summarizes this relationship between the interest rate
and the level of income. In essence, the IS curve combines the interaction
between I and Y demonstrated by the Keynesian cross. Because an
increase in the interest rate causes planned investment to fall, which in
turn causes income to fall, the IS curve slopes downward.

16. Chapter Ten 16
E
Income, output, Y
Y = E
Planned expenditure,
E = C + I + G
r
Income, output, Y
r
Investment, I
I(r) IS
An increase in the interest
rate (in graph a), lowers
planned investment,
which shifts planned
expenditure downward (in
graph b) and lowers
income (in graph c).
(a)
(b)
(c)

17. Chapter Ten 17
In summary, the IS curve shows the combinations of the interest rate
and the level of income that are consistent with equilibrium in the
market for goods and services. The IS curve is drawn for a given fiscal
policy. Changes in fiscal policy that raise the demand for goods and
services shift the IS curve to the right. Changes in fiscal policy that
reduce the demand for goods and services shift the IS curve to the left.

18. Chapter Ten 18
r
M/PM/P
Supply
Now that we’ve derived the IS part of AD, it’s now time to complete the
model of AD by adding a money market equilibrium schedule, the LM
curve. To develop this theory, we begin with the supply of real money
balances (M/P); both of these variables are taken to be exogenously
given. This yields a vertical supply curve.
Now, consider the demand for real money balances,
L. The theory of liquidity preference suggests
that a higher interest rate lowers the quantity of
real balances demanded, because r is the
opportunity cost of holding money.
Demand, L (r)
The supply and demand for real money balances
determine the interest rate. At the equilibrium
interest rate, the quantity of money balances
demanded equals the quantity supplied.

19. Chapter Ten 19
Money Demand equals Real Money Balances
L(r) = M/P

20. Chapter Ten 20
(M/P)d = L (r,Y)
The quantity of real money balances demanded is negatively related
to the interest rate (because r is the opportunity cost of holding money)
and positively related to income (because of transactions demand).

21. Chapter Ten 21
r
M/PM/P
Supply
Demand, L (r,Y)
Since the price level is fixed, a reduction in the money supply reduces
the supply of real balances. Notice the equilibrium interest rate rose.
A Reduction in the
Money Supply: -DM/P
Supply'

22. Chapter Ten 22
r
M/PM/P
Supply
L (r,Y)'
L (r,Y)
r1
r2
r
Y
LM
An increase in income raises money demand, which increases the
interest rate; this is called an increase in transactions demand
for money. The LM curve summarizes these changes in the money
market equilibrium.

23. Chapter Ten 23
r
M/P
L (r,Y)
r
Y
LM
M/P
Supply
A contraction in the money supply raises the interest rate that equilibrates
the money market. Why? Because a higher interest rate is needed to
convince people to hold a smaller quantity of real balances.
As a result of the decrease in the money supply, LM shifts upward.
r1 r1
M´/P
Supply'
LM'
r2 r2

24. Chapter Ten 24
r
Y
LM(P0)IS
r0
Y0
The intersection of the IS curve/equation, Y= C (Y-T) + I(r) + G and
the LM curve/equation M/P = L(r, Y) determines the level of aggregate
demand. The intersection of the IS and LM curves represents
simultaneous equilibrium in the market for goods and services and in
the market for real money balances for given values of government
spending, taxes, the money supply, and the price level.

25. Chapter Ten 25
Aggregate Demand II:
Applying the IS-LM Model
®
A PowerPointTutorial
To Accompany
MACROECONOMICS, 7th. 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

26. Chapter Ten 26
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 9
3) The Great Depression
r
Y
LM(P0)IS
r0
Y0

27. Chapter Ten 27
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.

28. Chapter Ten 28
IS
LM
r
y

29. Chapter Ten 29
LMr
Y
IS
A
+DG Consider an increase in government purchases.
This will raise the level of income by DG/(1- MPC).
IS´
B
The IS curve shifts to the right by DG/(1- MPC) which raises income
and the interest rate.

30. Chapter Ten 30
LMr
Y
IS
A
-DT Consider a decrease in taxes of DT.
This will raise the level of income by
DT × MPC/(1- MPC).
IS´
B
The IS curve shifts to the right by DT × MPC/(1- MPC) which raises
income and the interest rate.

31. Chapter Ten 31
IS
LM
r
y

32. Chapter Ten 32
ISr
Y
LM
A
LM
B
+DM 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.

33. Chapter Ten 33
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.

34. Chapter Ten 34
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.

35. Chapter Ten 35

36. Chapter Ten 36
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.
LM(P2)
B
BP2
P1

37. Chapter Ten 37
+DG
This translates into a rightward shift of the IS and AD curves.
LM (P2)
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)
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)

38. Chapter Ten 38
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 +DY leads to a rise in r
as IS slides along the LM curve.
+, because a +DY 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)

39. Chapter Ten 39
+, 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 +DP
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
+DP.
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)

40. Chapter Ten 40
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 +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
AD
ISr
P
Y
Y
LM(P0)
P
0
SRAS
A
A
LRAS
= C
P2
M/ P = L (r, Y)
M/ P = L (r, Y)

41. Chapter Ten 41
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 +DY leads to a decrease in r
as LM slides along the IS curve.
+, because a +DY 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
ISr
P
Y
Y
LM(P0)
P0
SRAS
A
A
LRAS
= C
P2
(P2)
Y´Y*

42. Chapter Ten 42
+, 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 +DP, 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
ISr
P
Y
Y
LM(P0)
P0
SRAS
A
A
LRAS
Y´Y*

43. Chapter Ten 43

44. Chapter Ten 44
LM(P0)
1) +DC causes the IS curve to shift
right to IS‘.
SRAS
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
IS'
P0
AD'
LRAS
LM(P2)
A 

A
B
B
P2

C
C
Y = C (Y-T) + I(r) + G
M/ P = L (r, Y)

45. Chapter Ten 45
Short
Run:
Y +
P 0
r +
C +
I -
Long
Run:
0
+
++
+
--
SRAS
r
Y
P
Y
IS
AD
IS'
P0
AD'
LRAS
LM(P2)
A
A
B
B
P2 
C
C
LM(P0)

46. Chapter Ten 46
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.

47. Chapter Ten 47
A Mankiw
Macroeconomics
Case Study
The Financial Crisis and the
Economic Downturn of 2008 and 2009
In 2008, the economy experienced a financial crisis 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.

48. Chapter Ten 48
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.

49. Chapter Ten 49
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
the amount that creditors increase spending, the net effect on
aggregate demand is a reduction. This contracts IS, and reduces
national income.

50. Chapter Ten 50
LM
Y
IS
A
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

51. Chapter Ten 51
Monetary transmission mechanism
Pigou Effect
Debt-deflation theory