AGGREGATE DEMAND II:

APPLYING THE IS–LM

MODEL
CHAPTER 11
EXPLAINING FLUCTUATIONS WITH THE IS–LM
MODEL
• The intersection of the IS curve and the LM curve determines the level
of national income.
• When one of these curves shifts, the short-run equilibrium of the
economy changes, and national income fluctuates.
• In this section we examine how changes in policy and shocks to the
economy can cause these curves to shift.
HOW FISCAL POLICY SHIFTS THE IS CURVE
AND
CHANGES THE SHORT-RUN EQUILIBRIUM
• We begin by examining how changes in fiscal policy (government
purchases and taxes) alter the economy’s short-run equilibrium.
• Recall that changes in fiscal policy influence planned expenditure and
thereby shift the IS curve.
• The IS–LM model shows how these shifts in the IS curve affect income
and the interest rate.
CHANGES IN GOVERNMENT PURCHASES
CHANGES IN GOVERNMENT PURCHASES

• Consider an increase in government purchases of ΔG.

• The government-purchases multiplier in the Keynesian cross tells us
that this change in fiscal policy raises the level of income at any given
interest rate by ΔG/(1 − MPC).
• Therefore, as Figure above shows, the IS curve shifts to the right by this
amount.
• The equilibrium of the economy moves from point A to point B.
• The increase in government purchases raises both income and the
interest rate.
 CHANGES IN GOVERNMENT PURCHASES

• When the government increases its purchases of goods and services, the
economy’s planned expenditure rises (from Keynesian Cross).
• The increase in planned expenditure stimulates the production of goods and
services, which causes total income Y to rise.
• Because the economy’s demand for money depends on income, the rise in
total income increases the quantity of money demanded at every interest rate
(theory of liquidity preference).
• The supply of money has not changed, however, so higher money demand
causes the equilibrium interest rate r to rise.
 CHANGES IN GOVERNMENT PURCHASES

• The higher interest rate arising in the money market, in turn, has ramifications back in the
goods market.
• When the interest rate rises, firms cut back on their investment plans.
• This fall in investment partially offsets the expansionary effect of the increase in
government purchases.
• Thus, the increase in income in response to a fiscal expansion is smaller in the IS–LM
model than it is in the Keynesian cross (where investment is assumed to be fixed).
• The horizontal shift in the IS curve equals the rise in equilibrium income in the Keynesian cross.
• This amount is larger than the increase in equilibrium income here in the IS–LM model.
• The difference is explained by the crowding out of investment due to a higher interest
rate.
 CHANGES IN TAXES

• In the IS–LM model, changes in taxes affect the economy much the same as changes in
government purchases do, except that taxes affect expenditure through consumption.
• Consider, for instance, a decrease in taxes of ΔT.
• The tax cut encourages consumers to spend more and, therefore, increases planned
expenditure.
• The tax multiplier in the Keynesian cross tells us that this change in policy raises the level of
income at any given interest rate by ΔT × MPC/(1 − MPC).
• Therefore, as Figure below illustrates, the IS curve shifts to the right by this amount.
• The equilibrium of the economy moves from point A to point B.
• The tax cut raises both income and the interest rate.
• Once again, because the higher interest rate depresses investment, the increase in income is
smaller in the IS–LM model than it is in the Keynesian cross.
CHANGES IN TAXES

A Decrease in
Taxes in the IS–
LM Model

A decrease in taxes
shifts the IS curve
to the right.

The equilibrium
move from point A
to point B.

Income rises from

Y1 to Y2, and the
interest rate rises
from r1 to r2.
HOW MONETARY POLICY SHIFTS THE LM
CURVE
AND CHANGES THE SHORT-RUN EQUILIBRIUM
• An increase in M leads to an increase in real money balances M/P,
because the price level P is fixed in the short run.
• The theory of liquidity preference shows that for any given level of
income, an increase in real money balances leads to a lower
interest rate.
• Therefore, the LM curve shifts downward, as in Figure below.
• The equilibrium moves from point A to point B.
• The increase in the money supply lowers the interest rate and
raises the level of income.
HOW MONETARY POLICY SHIFTS THE LM
CURVE
An Increase in the
AND CHANGES THE SHORT-RUN EQUILIBRIUM
Money Supply in
the IS–LM Model

An increase in the
money supply shifts
the LM curve
downward.

The equilibrium
moves from point A
to point B.

Income rises from

Y1 to Y2, and the
interest rate falls
from r1 to r2.
 HOW MONETARY POLICY SHIFTS THE LM
CURVE
AND CHANGES THE SHORT-RUN EQUILIBRIUM
• When the Central Bank 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 using it to buy
bonds.
• The interest rate r then falls until people are willing to hold all the extra
money that the CB 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.
 HOW MONETARY POLICY SHIFTS THE LM
CURVE
AND CHANGES THE SHORT-RUN EQUILIBRIUM
• Thus, the IS–LM model shows that monetary policy influences income by
changing the interest rate.
• Monetary expansion induces greater spending on goods and services, a
process called the monetary transmission mechanism.
• The IS–LM model shows an important part of that mechanism: an increase in
the money supply lowers the interest rate, which stimulates
investment and thereby expands the demand for goods and services.
THE INTERACTION BETWEEN MONETARY AND
FISCAL POLICY
• When analyzing any change in monetary or fiscal policy, it is
important to keep in mind that the policymakers who control
these policy tools are aware of what the other policymakers
are doing.
• For example, suppose Government raises taxes.
• What effect will this policy have on the economy?
• According to the IS–LM model, the answer depends on how the CB
responds to the tax increase.
THE INTERACTION BETWEEN MONETARY AND
FISCAL POLICY In panel (a), the Fed holds
the money supply
constant.

The tax increase shifts the

IS curve to the left.

Income falls (because

higher taxes reduce
consumer spending), and
the interest rate falls
(because lower income
reduces the demand for
money).

The fall in income

indicates that the tax hike
causes a recession.
THE INTERACTION BETWEEN MONETARY AND
FISCAL POLICY
In panel (b), the Fed wants to hold the interest
rate constant. In this case, when the tax
increase shifts the IS curve to the left, the Fed
must decrease the money supply to keep the
interest rate at its original level.

This fall in the money supply shifts the LM

curve upward.
The interest rate does not fall, but income
falls by a larger amount than if the Fed had
held the money supply constant.

Whereas in panel (a) the lower interest rate

stimulated investment and partially offset the
contractionary effect of the tax hike, in panel
(b) the Fed deepens the recession by keeping
the interest rate high.
THE INTERACTION BETWEEN MONETARY AND
FISCAL POLICY
In panel (c), the Fed wants to prevent the tax increase from
lowering income.

It must, therefore, raise the money supply and shift the LM

curve downward enough to offset the shift in the IS curve.

In this case, the tax increase does not cause a recession, but it
does cause a large fall in the interest rate.

Although the level of income is not changed, the combination

of a tax increase and a monetary expansion does change the
allocation of the economy’s resources.

The higher taxes depress consumption, while the lower

interest rate stimulates investment. Income is not affected
because these two effects exactly balance.
THE INTERACTION BETWEEN MONETARY AND
FISCAL POLICY
• From this example we can see that the impact of a change in fiscal
policy depends on the policy the CB pursues, that is, on whether it
holds the money supply, the interest rate, or the level of income
constant.
• Whenever analyzing a change in one policy, we must make an
assumption about its effect on the other policy.
IS–LM AS A THEORY OF AGGREGATE DEMAND

• We have been using the IS–LM model to explain national income in the
short run when the price level is fixed.
• To see how the IS–LM model fits into the model of AS and AD, we now
examine what happens in the IS–LM model if the price level is
allowed to change.
• IS–LM model: a theory to explain the position and slope of the AD
curve.
FROM THE IS–LM MODEL TO THE AGGREGATE
DEMAND CURVE
• To understand the determinants of AD more fully, we now use the IS–
LM model.
• First, we use the IS–LM model to show why national income falls as
the price level rises, that is, why the AD curve is downward
sloping.
• Second, we examine what causes the AD curve to shift.
 FROM THE IS–LM MODEL TO THE AGGREGATE
DEMAND CURVE
• To explain why the AD curve slopes downward, we examine what happens in the IS–LM
model when the price level changes.
• For any given money supply M, a higher price level P reduces the supply of real money
balances M/P.
• A lower supply of real money balances shifts the LM curve upward, which raises the
equilibrium interest rate and lowers the equilibrium level of income, as shown in panel
(a).
• Here the price level rises from P1 to P2, and income falls from Y1 to Y2.
• The AD curve in panel (b) plots this negative relationship between national income and the
price level.
• In other words, the AD curve shows the set of equilibrium points that arise in the IS–LM model
as we vary the price level and see what happens to income.
FROM THE IS–LM MODEL TO THE AGGREGATE
DEMAND CURVE

Deriving the Aggregate Demand Curve with the IS–LM Model

Panel (a) shows the IS–LM model: an increase in the price level from P1
to P2 lowers real money balances and thus shifts the LM curve upward.
The shift in the LM curve lowers income from Y1 to Y2.
Panel (b) shows the aggregate demand curve summarizing this
relationship between the price level and income: the higher the price
FROM THE IS–LM MODEL TO THE AGGREGATE
DEMAND CURVE
• What causes the AD curve to shift?
• Because the AD curve summarizes the results from the IS–LM model,
events that shift the IS curve or the LM curve (for a given price level) cause
the AD curve to shift.
• For instance, an increase in the money supply raises income in the
IS–LM model for any given price level; it thus shifts the AD curve to the
right, as shown in panel (a) of Figure below.
• Similarly, an increase in government purchases or a decrease in taxes
raises income in the IS–LM model for a given price level; it also shifts the
aggregate demand curve to the right, as shown in panel (b) of Figure below.
FROM THE IS–LM MODEL TO THE AGGREGATE
DEMAND CURVE

Panel (a) shows a monetary expansion. For any given price level, an
increase in the money supply raises real money balances, shifts the LM
curve downward, and raises income. Hence, an increase in the money
FROM THE IS–LM MODEL TO THE AGGREGATE
DEMAND CURVE

Panel (b) shows a fiscal expansion, such as an increase in

government purchases or a decrease in taxes.
The fiscal expansion shifts the IS curve to the right and, for any
given price level, raises income.
Hence, a fiscal expansion shifts the aggregate demand curve to
the right.
 FROM THE IS–LM MODEL TO THE AGGREGATE
DEMAND CURVE
• Conversely, a decrease in the money supply, a decrease in government purchases, or an
increase in taxes lowers income in the IS–LM model and shifts the aggregate demand curve
to the left.
• Anything that changes income in the IS–LM model other than a change in the
price level causes a shift in the AD curve.
• The factors shifting AD include not only monetary and fiscal policy but also shocks to
the goods market (the IS curve) and shocks to the money market (the LM curve).
• A change in income in the IS–LM model resulting from a change in the price level
represents a movement along the AD curve.
• A change in income in the IS–LM model for a given price level represents a shift
in the AD curve.
THE IS–LM MODEL IN THE SHORT RUN AND
LONG RUN
• The IS–LM model is designed to explain the economy in the short run
when the price level is fixed.
• Yet, now that we have seen how a change in the price level influences
the equilibrium in the IS–LM model, we can also use the model to
describe the economy in the long run when the price level adjusts
to ensure that the economy produces at its natural rate.
• By using the IS–LM model to describe the long run, we can show clearly
how the Keynesian model of income determination differs from the
classical model.
 THE IS–LM MODEL IN THE SHORT RUN AND
LONG RUN

The Short-Run and Long-Run Equilibria

We can compare the short-run and long-run equilibria using either the IS–LM diagram in panel (a) or
the aggregate supply–aggregate demand diagram in panel (b). In the short run, the price level is
stuck at P1.
The short-run equilibrium of the economy is therefore point K. In the long run, the price level adjusts
so that the economy is at the natural level of output. The long-run equilibrium is therefore point C.
THE IS–LM MODEL IN THE SHORT RUN AND
LONG RUN
• We can now see the key difference between the Keynesian and
classical approaches to the determination of national income.
• The Keynesian assumption (represented by point K) is that the price
level is stuck.
• Depending on monetary policy, fiscal policy, and the other
determinants of aggregate demand, output may deviate from its
natural level.
• The classical assumption (represented by point C) is that the price level
is fully flexible.
• The price level adjusts to ensure that national income is always at its
natural level.
 THE STABILIZING EFFECTS OF DEFLATION

• In the IS–LM model we have developed so far, falling prices raise income.
• An increase in real money balances causes an expansionary shift in the
LM curve, which leads to higher income.
• A channel through which falling prices expand income is called the Pigou effect.
• As prices fall and real money balances rise, consumers should feel wealthier
and spend more.
• This increase in consumer spending should cause an expansionary shift in
the IS curve, also leading to higher income.
THE DESTABILIZING EFFECTS OF DEFLATION

• Economists have proposed two theories to explain how falling prices

could depress income rather than raise it.
• The first, called the debt-deflation theory, describes the effects of
unexpected falls in the price level.
• The second explains the effects of expected deflation.