1. 9
1

2. Policy Analysis with the IS/LM
Model
A Closer Look at Monetary and Fiscal Policy
Fiscal Policy and Crowding Out
Monetary Policy and the Liquidity Trap
Real World Monetary and Fiscal Policy
Problems of Using IS/LM in the Real World
Interpretation Problems
Implementation Problems
2

3. Effects of Monetary and Fiscal
Policy in the IS/LM Model
Fiscal Policy
Expansionary fiscal policy shifts the IS curve to
the right
Contractionary fiscal policy shifts the IS curve
to the left
Monetary Policy
Expansionary monetary policy shifts the LM
curve to the right
Contractionary monetary policy shifts the LM
curve to the left
3

4. Fiscal Policy and Crowding Out
When government expenditures increase,
output and income begin to increase.
The increase in income increases the demand
for money.
The increase in money demand increases the
interest rate.
Higher interest rates cause a decrease in
investment, offsetting some of the
expansionary effect of the increase in
government spending.
4

5. Real Interest Rate (%)
1. The multiplier is 2 and
government spending increases by
$500, so the IS increases by $1000.
2. The increase in income
increases money demand
which increases interest
rates from 4% to 5%.
LM
3. The increase in the interest
rate causes a decrease in
investment so that the increase
in income is only $600, less that
the full multiplier effect.
$1000
5%
4%
IS1
IS0
$6000
$6600
$7000
Aggregate Output
5

6. Real Interest Rate (%)
1. The multiplier is 2 and
government spending increases by
$500, so the IS increases by $1000.
LM
9%
$1000
2. If the demand for money
is totally insensitive to the
interest rate, the interest rate
increases from 4% to 9%.
3. The increase in the interest
rate causes a decrease in
investment that completely offsets
the increase in government spending.
4%
IS1
IS0
$6000
$7000
Aggregate Output
6

7. Ineffective Fiscal Policy
When complete crowding out occurs, fiscal
policy is ineffective, changing only interest
rates, not output.
Crowding out is greater if:
Money demand is very sensitive to income
changes
Money demand is not very sensitive to interest
rate changes
7

8. The IS-LM model shows that monetary policy influences income
by
changing the interest rate. 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.

9. +∆ M
Consider an increase in the money supply.
r IS
LM
LM′
A
B
Y
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.

10. Real Interest Rate (%)
The Fed increases the
money supply which
decreases interest rates
and increases investment
and output.
LM0
LM1
r0
r1
IS
Y0
Y1
Aggregate Output
10

11. Ineffective Monetary Policy
Investment is not sensitive to the interest rate
If investment does not respond to interest rate
changes (the IS curve is steep), monetary policy
in ineffective in changing output.
Liquidity trap
If increases in the money supply fail to lower
interest rates, monetary policy is ineffective in
increasing output.
11

12. 12

13. 13

14. Contractionary fiscal policy
decreases interest rates and
decreases output.
LM1
LM0
r1
r0
Real Interest Rate (%)
Real Interest Rate (%)
Contractionary monetary
policy raises interest rates
and reduces output.
LM
r0
IS0
r2
IS
Y1
Y0 Aggregate Output
potential
output
IS1
Y1
Y0 Aggregate Output
potential
output
14

15. Real Interest Rate (%)
2. Accomodative monetary policy
increases output even further and
offsets the rise in interest rates.
LM0
LM1
B
•
r1
r0
C
•
IS0
•
IS1
1. Expansionary fiscal
policy increases output
and interest rates.
A
Y0
Y1
Y2
Aggregate Output
15

16. Real Interest Rate (%)
1. Contractionary monetary policy
lowers output and increases
interest rates.
LM1
LM0
B
•
r1
A
C
r0
•
•
IS1
Y2
Y1
IS0
2. Contractionary
fiscal policy further
reduces output and
offsets the increase
in interest rates.
Y0 Aggregate Output
16

17. Real Interest Rate (%)
2. Expansionary monetary policy
further reduces the interest rate
and offsets the decline in output.
LM0
A
•
r0
B
IS0
•
r1
LM1
•
C
Y1
IS1
1. Contractionary fiscal
policy lowers the interest
rate and output.
Aggregate Output
17

18. Real Interest Rate (%)
2. The Fed accomodated the
expansionary fiscal policy to keep
interest rates constant.
LM1
LM0
r1
IS1
r0
1. Government increased
defense expenditures
during World War II.
IS0
Y0=
potential
Y1
Y2
Aggregate Output
18

19. Real Interest Rate (%)
LM1
LMo
r1
The Fed uses
contractionary
monetary
policy to fight
inflation.
IS0
r0
Y1=
potential
Y0
Aggregate Output
19

20. Real Interest Rate (%)
1. The Fed fought inflation by
reducing the money supply.
LM1
LM0
r2
r1
IS1
2. And
government
spending rose.
r0
IS0
Y1 Y2
Y0
Aggregate Output
20

21. 21

22. 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.
LM(P2)
To derive AD, start at point A in the top
r IS
LM(P1) graph. Now increase the price level from
P1 to P2.
B
An increase in P lowers the value of real money
A
balances, and Y, shifting LM leftward to point
B.
Notice that r increased. Since r increased, we know
Y that investment will decrease, as it just got more
P
costly to take on various investment projects. This
B
P2
sets off a multiplier process since -∆ I causes a –∆ Y
A
P1
The - ∆ Y triggers -∆ C as we move up the IS curve
AD
The +∆ P triggers a sequence of events that end
Y
with a -∆ Y, the inverse relationship that defines
the downward slope of AD.

23. + ∆G
Y = C (Y-T) + I(r) + G
Suppose there is a
+∆ G.
This translates into a rightward shift of the IS and AD curves.
r
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
P
balances, which translates into a leftward
shift of the LM curve.
P2
P0
M/ P = L (r, Y)
Finally, this leaves us at point C in both diagrams.
LM (P2)
LM(P0)
IS IS´
C
A
B
LRAS
C
B
A
Y
SRAS
A AD´
D
Y

24. Remember that SR is the
movement from A to B.
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
Y +, because Y moved from Y* to Y´
P 0, because prices are sticky in the SR.
r +, because a +∆ Y leads to a rise in r
as IS slides along the LM curve.
C +, because a +∆ Y increases the level of
consumption (↑ C=C(↑ Y-T)).
I – , since r increased, the level of
investment decreased.
r
IS IS´
C
P2
P0
LM(P0)
B
A
P
LM(P2)
LRAS
C
A
B
Y
SRAS
AD´
AD
Y* Y´ Y

25. or 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 IS´
r
LM(P0)
C
Y 0, because rising P shifts LM to left, returning
Y to Y* as required by long-run LRAS.
B
A
P +, in order to eliminate the excess demand at P .
0
r +, reflecting the leftward shift in LM due
to +∆ P
LRAS Y
C 0, since both Y and T are back to their initial
P
levels (C=C(Y-T))
I – – , since r has risen even more due to the
C
P2
B
+∆ P.
SRAS
P0
A
A AD´
D
Y* Y´ Y

26. Suppose there is a
M/ P = L (r, Y)
+∆ M.
Look at the appropriate
equation
that that M/ was M term:
Notice captures theincreased, thus increasing the value of the real mone
supply which translates into a rightward shift of the LM and AD curves
LM(P )
In the short run, we move along SRAS from r IS
0
LM′
point A to point B.
A= C
But as the output market clears, in the long run,
B
the price level will increase from P0 to P2.
This +∆ P decreases the value of the
real money supply which translates into a P
leftward shift of the LM curve.
P2
P0
M/ P = L (r, Y)
Finally, this leaves us at point C in both diagrams.
LRAS
C
A
Y
B SRAS
AD´
AD
Y

27. Remember that SR is the
movement from A to B.
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
Y +, because Y moved from Y* to Y´.
P 0, because prices are sticky in the SR.
r –, because a +∆ Y leads to a decrease in r
as LM slides along the IS curve.
C +, because a +∆ Y increases the level of
consumption (↑C=C(↑ Y-T)).
I + , since r increased, the level of
investment decreased.
r
IS
A= C
(P2)
LM (P0)
LM ′
B
P
LRAS
P2
P0
C
A
Y
B SRAS
AD´
AD
Y* Y´
Y

28. Remember that LR is the movement from A to
C.
or the variables Y, P, and r, you can read the effects right off the diagrams.
Y 0, because rising P shifts LM to left, returning
r
Y to Y* as required by LRAS.
P +, in order to eliminate the excess demand at P .
0
r 0, reflecting the leftward shift in LM due
to +∆ P, restoring r to its original level.
C 0, since both Y and T are back to their initial
levels (C=C(Y-T)).
I 0, since Y or r has not changed.
P
Notice that the only LR impact of an
increase in the money supply was an
increase in the price level.
P2
P0
IS
A= C
LM (P0)
LM′
B
LRAS
C
A
Y
B SRAS
AD´
AD
Y* Y´
Y

30. C
•
Β•
Α •
P
P2
P0
Y = C (Y-T) + I(r) + G
2) This leads to a rightward shift in
AD to AD’.
Short Run:
Move from A to B.
Y
Long Run:
LRAS
Market clears at P0 to P2
C
•
from B to C.
3) +∆ P causes LM(P0) to shift
Α
SRAS leftward to LM(P2) due to the
• Β •
lowering of the real value of the
money supply.
AD AD'
M/ P = L (r, Y)
Y
LM
IS
LM(P2)
1) +∆ C causes the IS curve to shift
LM(P0) right to IS‘.
IS
-
r
IS
'

31. r IS
LM(P2)
LM(P0)
IS'
C •
Β•
Α•
Short
Run:
Y
P
r
C
I
Y
P
P2
C •
P0
Α• Β•
LRAS
SRAS
AD AD'
Y
Long
Run:
+
0
+
+
-
0
+
++
+
--

32. 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.

33. A Mankiw
A Mankiw
Macroeconomics
Macroeconomics
Case Study
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.