SEVENTH EDITION

MACROECONOMICS
N. Gregory Mankiw
PowerPoint® Slides by Ron Cronovich

CHAPTER

Applying the IS-LM Model

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 Equilibrium in the IS -LM model

The IS curve represents r

equilibrium in the goods LM
market.
Y  C (Y  T )  I (r )  G
r1
The LM curve represents
money market equilibrium.
M P  L (r ,Y ) IS
Y
Y1
The intersection determines
the unique combination of Y and r
that satisfies equilibrium in both markets.
CHAPTER 11 Aggregate Demand II 2
 Policy analysis with the IS -LM model

Y  C (Y T )  I (r )  G r
LM
M P  L (r ,Y )

We can use the IS-LM

model to analyze the r1
effects of
fiscal policy: G and/or T IS
monetary policy: M Y
Y1

CHAPTER 11 Aggregate Demand II 3

 An increase in government purchases
1. IS curve shifts right r
1
by G LM
1 MPC
causing output & r2
income to rise. 2.
r1
2. This raises money
demand, causing the 1. IS2
interest rate to rise… IS1
3. …which reduces investment, Y
Y1 Y2
so the final increase in Y 3.

1
is smaller than G
1 MPC
CHAPTER 11 Aggregate Demand II 4
 A tax cut
Consumers save r
(1MPC) of the tax cut, LM
so the initial boost in
spending is smaller for T
than for an equal G…
r 2
2.
r1
and the IS curve shifts by
MPC 1. IS2
1. T IS1
1 MPC
Y
Y1 Y2
2. …so the effects on r
2.
and Y are smaller for T
than for an equal G.
CHAPTER 11 Aggregate Demand II 5
 Monetary policy: An increase in M

r
1. M > 0 shifts LM1
the LM curve down
LM2
(or to the right)
r1
2. …causing the
interest rate to fall r2

3. …which increases IS
investment, causing Y
Y1 Y2
output & income to
rise.

CHAPTER 11 Aggregate Demand II 6

 Interaction between
monetary & fiscal policy
 Model:
Monetary & fiscal policy variables
(M, G, and T ) are exogenous.
 Real world:
Monetary policymakers may adjust M
in response to changes in fiscal policy,
or vice versa.
 Such interaction may alter the impact of the
original policy change.

CHAPTER 11 Aggregate Demand II 7

 The Central Bank’s response to G > 0

 Suppose there is an increase in G.

 Possible RBI responses:
1. hold M constant
2. hold r constant
3. hold Y constant

 In each case, the effects of the G

are different…

CHAPTER 11 Aggregate Demand II 8

 Response 1: Hold M constant

Rise in G: r
the IS curve shifts right. LM1

If RBI holds M constant,

r2
then LM curve doesn’t r1
shift.
IS2
Results:
IS1
Y  Y 2  Y1 Y
Y1 Y2
r  r 2  r1

CHAPTER 11 Aggregate Demand II 9

 Response 2: Hold r constant

Rise in G, r
the IS curve shifts right. LM1
LM2
To keep r constant,
r2
RBI increases M r1
to shift LM curve right.
IS2
Results: IS1
Y  Y 3  Y1 Y
Y1 Y2 Y3

r  0

CHAPTER 11 Aggregate Demand II 10

 Response 3: Hold Y constant

Rise in G, r LM2
the IS curve shifts right. LM1

r3
To keep Y constant,
r2
RBI reduces M r1
to shift LM curve left.
IS2
Results: IS1
Y  0 Y
Y1 Y2
r  r 3  r1

CHAPTER 11 Aggregate Demand II 11

 Shocks in the IS -LM model

IS shocks: exogenous changes in the

demand for goods & services.
Examples:
 stock market boom or crash
 change in households’ wealth
 C
 change in business or consumer
confidence or expectations
 I and/or C

CHAPTER 11 Aggregate Demand II 12

 Shocks in the IS -LM model

LM shocks: exogenous changes in the

demand for money.
Examples:
 a wave of credit card fraud increases
demand for money.
 more ATMs or the Internet reduce money
demand.

CHAPTER 11 Aggregate Demand II 13

 IS-LM and aggregate demand

 So far, we’ve been using the IS-LM model to

analyze the short run, when the price level is
assumed fixed.
 However, a change in P would shift LM and
therefore affect Y.
 The aggregate demand curve captures this
relationship between P and Y.

CHAPTER 11 Aggregate Demand II 14

 Deriving the AD curve
r LM(P2)
Intuition for slope LM(P1)
r2
of AD curve:
r1
P  (M/P )
IS
 LM shifts left Y2 Y1 Y
P
 r
P2
 I
P1
 Y
AD
Y2 Y1 Y

CHAPTER 11 Aggregate Demand II 15

 Monetary policy and the AD curve
r LM(M1/P1)
The RBI can increase LM(M2/P1)
aggregate demand: r1
r2
M  LM shifts right
IS
 r Y1 Y2 Y
P
 I
 Y at each P1
value of P
AD2
AD1
Y1 Y2 Y

CHAPTER 11 Aggregate Demand II 16

 Fiscal policy and the AD curve
r LM
Expansionary fiscal
policy (G and/or T ) r2
increases agg. demand: r1 IS2
T  C IS1
 IS shifts right Y1 Y2 Y
P
 Y at each
value of P P1

AD2
AD1
Y1 Y2 Y

CHAPTER 11 Aggregate Demand II 17

 The SR and LR effects of an IS shock
r LRAS LM(P )
1
A negative IS shock
shifts IS and AD left,
causing Y to fall. IS1
IS2
Y Y
P LRAS
P1 SRAS1

AD1
AD2
Y Y
CHAPTER 11 Aggregate Demand II 18
 The SR and LR effects of an IS shock
r LRAS LM(P )
1

In the new short-run

equilibrium, Y  Y IS1
IS2
Y Y
P LRAS
P1 SRAS1

AD1
AD2
Y Y
CHAPTER 11 Aggregate Demand II 19
 The SR and LR effects of an IS shock
r LRAS LM(P )
1

In the new short-run

equilibrium, Y  Y IS1
IS2
Y Y
Over time, P gradually
falls, causing P LRAS
• SRAS to move down P1 SRAS1
• M/P to increase,
which causes LM AD1
to move down AD2
Y Y
CHAPTER 11 Aggregate Demand II 20
 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, causing P LRAS
• SRAS to move down P1 SRAS1
• M/P to increase, P2 SRAS2
which causes LM AD1
to move down AD2
Y Y
CHAPTER 11 Aggregate Demand II 21
 The SR and LR effects of an IS shock
r LRAS LM(P )
1
LM(P2)

This process continues IS1

until economy reaches a IS2
long-run equilibrium with Y Y
Y Y P LRAS
P1 SRAS1
P2 SRAS2
AD1
AD2
Y Y
CHAPTER 11 Aggregate Demand II 22
 Disinflation, Deflation,
and the Liquidity Trap
Figure
The Return of Output to
Its Natural Level
Low output leads to a
decrease in the price level.
The decrease in the price
level leads to an increase in
the real money stock. The LM
curve shifts down and
continues to shift down until
output has returned to the
natural level of output.

CHAPTER 11 Aggregate Demand II 23

 Disinflation, Deflation,
and the Liquidity Trap
 Output is now below the natural level of output due to
an adverse shock.

 Because output is below the natural level of output,

price levels decrease over time.

 So long as output remains below its natural level, the

price level continues to fall, and the LM curve
continues to shift down.

CHAPTER 11 Aggregate Demand II 24

 Disinflation, Deflation,
and the Liquidity Trap
The Nominal Interest Rate, the Real Interest Rate,
and Expected Inflation
Recall that:

 What matters for spending decisions, and thus what

enters the IS relation, is the real interest rate—the
interest rate in terms of goods.
Chapter 22: Depressions and Slumps

 What matters for the demand for money, and thus

enters the LM relation, is the nominal interest rate—
the interest rate in terms of dollars.

Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall • Macroeconomics, 5/e • Olivier Blanchard
 Disinflation, Deflation,
and the Liquidity Trap
The Nominal Interest Rate, the Real Interest Rate,
and Expected Inflation
Figure
The Effects of Lower
Inflation on Output
When inflation decreases in
response to low output, there
are two effects: (1) The real
money stock increases,
leading the LM curve to shift
Chapter 22: Depressions and Slumps

down, and (2) expected

inflation decreases, leading
the IS curve to shift to the left.
The result may be a further
decrease in output.

Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall • Macroeconomics, 5/e • Olivier Blanchard
 Disinflation, Deflation,
and the Liquidity Trap
The Liquidity Trap

Figure
Money Demand, Money
Supply, and the Liquidity
Trap
When the nominal interest
rate is equal to zero, and once
people have enough money
for transaction purposes, they
Chapter 22: Depressions and Slumps

become indifferent between

holding money and holding
bonds. The demand for
money becomes horizontal.
This implies that, when the
nominal interest rate is equal
to zero, further increases in
the money supply have no
effect on the nominal interest
rate.

Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall • Macroeconomics, 5/e • Olivier Blanchard
 Disinflation, Deflation,
and the Liquidity Trap
The Liquidity Trap

Now consider the effects of an increase in the money

supply:

 Starting from the equilibrium of Ms and i at point A, an

increase in the money supply leads to a decrease in the
nominal interest rate.
Chapter 22: Depressions and Slumps

 Now consider the case where the money supply is at

point B or C. In either case, the initial nominal interest
rate is zero, and an increase in the money supply has
no effect on the nominal interest rate at this point.

Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall • Macroeconomics, 5/e • Olivier Blanchard
 Disinflation, Deflation,
and the Liquidity Trap
The Liquidity Trap

The liquidity trap describes a situation in which

expansionary monetary policy becomes powerless.
The increase in money falls into a liquidity trap: People
are willing to hold more money (more liquidity) at the
same nominal interest rate.

The central bank can increase “liquidity” but the

Chapter 22: Depressions and Slumps

additional money is willingly held by financial investors

at an unchanged interest rate, namely, zero.

Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall • Macroeconomics, 5/e • Olivier Blanchard
 Disinflation, Deflation,
and the Liquidity Trap
The Liquidity Trap
Figure For low levels of output, the LM curve is a flat segment, with a nominal
The Derivation of the LM interest rate equal to zero. For higher levels of output, it is upward
Curve in the Presence of sloping: An increase in income leads to an increase in the nominal
a Liquidity Trap interest rate.
Chapter 22: Depressions and Slumps

Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall • Macroeconomics, 5/e • Olivier Blanchard
 Disinflation, Deflation,
and the Liquidity Trap
The Liquidity Trap
 The equilibrium is given by point A” in Figure, with
nominal interest rate equal to zero.
 The intersection between the money supply curve and
the money demand curve takes place on the horizontal
portion of the money demand curve. The equilibrium
remains at A”, and the nominal interest rate remains
equal to zero.
Chapter 22: Depressions and Slumps

Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall • Macroeconomics, 5/e • Olivier Blanchard
 Disinflation, Deflation,
and the Liquidity Trap
The Liquidity Trap

Figure
The IS–LM Model and
the Liquidity Trap
In the presence of a liquidity
trap, there is a limit to how
much monetary policy can
increase output. Monetary
policy may not be able to
Chapter 22: Depressions and Slumps

increase output back to its

natural level.

Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall • Macroeconomics, 5/e • Olivier Blanchard
 Disinflation, Deflation,
and the Liquidity Trap
Putting Things Together: The Liquidity
Trap and Deflation
The value of the real interest rate corresponding to a zero
nominal interest rate depends on the rate of expected inflation.
For example, if expected inflation is 10%, then:
 At a negative real interest rate of 10%, consumption and
investment are likely to be very high. The liquidity trap is unlikely to
be a problem when inflation is high.
r  i   e  0 %  1 0 %   1 0%
Chapter 22: Depressions and Slumps

 If a country is in a recession, and the rate of inflation is negative,

say 5%, then even if the nominal interest rate is zero, the real
interest rate remains positive.

r  i   e  0%  ( 5% )  5%
In this situation, there is nothing monetary policy can do to bring output
above the natural level of output.
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 Disinflation, Deflation,
and the Liquidity Trap
Putting Things Together: The Liquidity
Trap and Deflation
Figure
The Liquidity Trap and
Deflation
Suppose the economy is in a
liquidity trap, and there is
deflation. Output below the
natural level of output leads to
more deflation over time, which
Chapter 22: Depressions and Slumps

leads to a further increase in the

real interest rate, and leads to a
further shift of the IS curve to the
left. This shift leads to a further
decrease in output, which leads
to more deflation, and so on.

In words: The economy caught in a vicious cycle: Low output leads to more
deflation. More deflation leads to a higher real interest rate and even lower
output, and there is nothing monetary policy can do about it.
Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall • Macroeconomics, 5/e • Olivier Blanchard
 The Japanese Slump

The robust growth that Japan had experienced since the

end of World War II came to an end in the early 1990s.

Since 1992, the economy has suffered from a long period

of low growth—what is called the Japanese slump.

Low growth has led to a steady increase in unemployment,

and a steady decrease in the inflation rate over time.
Chapter 22: Depressions and Slumps

Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall • Macroeconomics, 5/e • Olivier Blanchard
 The Japanese Slump

Figure
The Japanese Slump:
Output Growth since
1990 (percent)

From 1992 to 2002, average

GDP growth in Japan was
less than 1%.
Chapter 22: Depressions and Slumps

Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall • Macroeconomics, 5/e • Olivier Blanchard
 The Japanese Slump

Figure
Unemployment and
Inflation in Japan since
1990 (percent)
Low growth in output has
led to an increase in
unemployment. Inflation has
turned into deflation.
Chapter 22: Depressions and Slumps

Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall • Macroeconomics, 5/e • Olivier Blanchard
 The Japanese Slump

Table GDP, Consumption, and Investment Growth, Japan, 1988-1993

Year GDP (%) Consumption (%) Investment (%)
1988 6.5 5.1 15.5
1989 5.3 4.7 15.0
1990 5.2 4.6 10.1
1991 3.4 2.9 4.3
1992 1.0 2.6 7.1
1993 0.2 1.4 10.3
Chapter 22: Depressions and Slumps

The numbers in Table 22-4 raise an obvious set of questions:

What triggered Japan’s slump? Why did it last so long? Were
monetary and fiscal policies misused, or did they fail? What are the
factors behind the current recovery?

Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall • Macroeconomics, 5/e • Olivier Blanchard
 The Japanese Slump
The Rise and Fall of the Nikkei
There are two reasons for the increase in a stock price:

 A change in the fundamental value of the stock

price, which depends on the expected present value
of future dividends.

 A speculative bubble: Investors buy at a higher

Chapter 22: Depressions and Slumps

price simply because they expect the price to go

even higher in the future.

Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall • Macroeconomics, 5/e • Olivier Blanchard
 The Japanese Slump
The Rise and Fall of the Nikkei

Figure
Stock Prices and
Dividends in Japan
since 1980
The increase in stock prices
in the 1980s and the
subsequent decrease were
not associated with a
Chapter 22: Depressions and Slumps

parallel movement in
dividends.

Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall • Macroeconomics, 5/e • Olivier Blanchard
 22-3 The Japanese Slump
The Rise and Fall of the Nikkei

The fact that dividends remained flat while stock prices

increased strongly suggests that a large bubble existed in
the Nikkei.

The rapid fall in stock prices had a major impact on

spending—consumption was less affected, but investment
collapsed.
Chapter 22: Depressions and Slumps

Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall • Macroeconomics, 5/e • Olivier Blanchard
 The Japanese Slump
The Failure of Monetary and Fiscal Policy

Figure
The Nominal Interest
Rate and the Real
Interest Rate in Japan
since 1990
Japan has been in a liquidity
trap since the mid-1990s:
The nominal interest rate
Chapter 22: Depressions and Slumps

has been close to zero, and

the inflation rate has been
negative. Even at a zero
nominal interest rate, the
real interest rate has been
positive.

Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall • Macroeconomics, 5/e • Olivier Blanchard
 The Japanese Slump
The Failure of Monetary and Fiscal Policy

Monetary policy was used, but it was used too late,

and when it was used, if faced the twin problems of
the liquidity trap and deflation.

The Bank of Japan (BoJ) cut the nominal interest rate,

but it did so slowly, and the cumulative effect of low
growth was such that inflation had turned to deflation.
Chapter 22: Depressions and Slumps

As a result, the real interest rate was higher than the

nominal interest rate.

Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall • Macroeconomics, 5/e • Olivier Blanchard
 The Japanese Slump
The Failure of Monetary and Fiscal Policy

Fiscal policy was used as well. Taxes decreased at

the start of the slump, and there was a steady
increase in government spending throughout the
decade.

Fiscal policy helped, but it was not enough to increase

spending and output.
Chapter 22: Depressions and Slumps

Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall • Macroeconomics, 5/e • Olivier Blanchard
 The Japanese Slump
The Failure of Monetary and Fiscal Policy

Figure
Government Spending
and Revenues (as a
percentage of GDP) in
Japan since 1990
Government spending
increased and government
revenues decreased
Chapter 22: Depressions and Slumps

steadily throughout the

1990s, leading to steadily
larger deficits.

Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall • Macroeconomics, 5/e • Olivier Blanchard