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1 Demand II:
Aggregate
Applying the IS -LM Model
3. …which increases IS
investment, causing Y
Y1 Y2
output & income to
rise.
If Congress raises G, r
the IS curve shifts right. LM
1
If Congress raises G, r
the IS curve shifts right. LM
1 LM
To keep r constant, 2
r2
Fed increases M r1
to shift LM curve right.
IS2
Results: IS1
Y Y3 Y1 Y
Y1 Y2 Y3
r 0
If Congress raises G, r LM
the IS curve shifts right. 2 LM
1
r3
To keep Y constant,
r2
Fed reduces M r1
to shift LM curve left.
IS2
Results: IS1
Y 0 Y
Y1 Y2
r r3 r1
Estimated Estimated
Assumption about value of value of
monetary policy ∆Y / ∆G ∆Y / ∆T
1500
Standard & Poor’s
Index (1942 = 100)
1200 500
900
600
300
1995 1996 1997 1998 1999 2000 2001 2002 2003
CHAPTER 11 Aggregate Demand II slide 19
CASE STUDY:
The U.S. recession of 2001
Causes: 2) 9/11
increased uncertainty
fall in consumer & business confidence
result: lower spending, IS curve shifted left
Causes: 3) Corporate accounting scandals
Enron, WorldCom, etc.
reduced stock prices, discouraged investment
02
00
03
00
01
02
02
02
03
01
00
01
00
/20
/20
/20
/20
/20
/20
/20
/20
/20
/20
/20
/20
/20
/20
/01
/03
/09
/02
/05
/06
/08
/09
/11
/06
/06
/09
/03
/03
04
04
01
04
01
07
10
10
01
01
07
04
07
10
Y Y remain constant
AD1
AD2
Y Y
CHAPTER 11 Aggregate Demand II slide 30
The SR and LR effects of an IS
shock
r LRAS LM(P )
1
AD1
AD2
Y Y
CHAPTER 11 Aggregate Demand II slide 31
The SR and LR effects of an IS
shock
r LRAS LM(P )
1
• M/P to increase,
which causes LM AD1
to move down. AD2
Y Y
CHAPTER 11 Aggregate Demand II slide 32
The SR and LR effects of an IS
shock
r LRAS LM(P )
1
LM(P2)
IS1
IS2
Y Y
Over time, P gradually
falls, which causes P LRAS
180 15
160 10
1. IS-LM model
a theory of aggregate demand
exogenous: M, G, T,
P exogenous in short run, Y in long run
endogenous: r,
Y endogenous in short run, P in long run
IS curve: goods market equilibrium
LM curve: money market equilibrium
2. AD curve
shows relation between P and the IS-LM model’s
equilibrium Y.
negative slope because
↑P ⇒ ↓(M/P ) ⇒ ↑r ⇒ ↓I ⇒ ↓Y
expansionary fiscal policy shifts IS curve right,
raises income, and shifts AD curve right.
expansionary monetary policy shifts LM curve right,
raises income, and shifts AD curve right.
IS or LM shocks shift the AD curve.
CHAPTER 11 Aggregate Demand II slide 46