Macroeconomics I

Chapter 12
Aggregate Demand II: Applying the IS-LM Model

Professor Deokwoo Nam

Department of Economics and Finance
Hanyang University

Page: 1
1. INTRODUCTION

1 Introduction

In this chapter, you will learn:

1. How to use the IS-LM model to analyze the e¤ects of (a) …scal policy, (2) monetary policy, and (c) shocks
to the economy.
2. How to derive the aggregate demand (AD) curve from the IS-LM model.
3. Several theories about what caused the Great Depression

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 2. EXPLAINING FLUCTUATIONS WITH THE IS–LM MODEL

2 Explaining Fluctuations with the IS–LM Model

The intersection of the IS curve and the LM curve determines the unique combination of the level of income
Y and the interest rate r that satis…es equilibrium both in the goods market and in the market for money:

1. The IS curve represents equilibrium in the goods market:

IS : Y =C Y T + I (r) + G (2.1)

2. The LM curve represents equilibrium in the market for money:

LM : M =P = L (r; Y ) (2.2)
in the IS -LM model
presents r
e goods LM

 I (r )  G
r1
epresents
quilibrium.
,Y ) IS
Y
determines Y1
bination of Y and r
uilibrium in both markets.
When one of these curves shifts, the "short-run" equilibrium of the economy changes: that is, national
ate Demand IIincome Y ‡uctuates and the interest rate r also varies.
3

– In this section we examine how (a) changes in policy and (b) shocks to the economy can cause
these curves to shift:
1. Fiscal policy: changes in G and/or T .
2. Monetary policy: changes in M .
3. Shocks to the economy: shocks (i.e., exogenous events) that shift the IS curve or the LM curve.

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2. EXPLAINING FLUCTUATIONS WITH THE IS–LM MODEL

2.1 How Fiscal Policy Shifts the IS Curve and Changes the Short-Run Equilibrium

Recall that changes in …scal policy (G and T ) in‡uence planned expenditure and thereby shift the IS curve.
Let’s …rst consider an increase in government purchases of G > 0.

1. The government-purchases multiplier in the Key- to a higher interest rate.

nesian cross tells us that this change in …scal pol-
icy raises the level of income Y at any given inter- – Thus, the increase in income in response
est rate by 1=(1 M P C) G, thereby shifting to a …scal expansion is smaller in the IS–
the IS curve to the right by 1=(1 M P C) LM model than it is in the Keynesian cross
G: (where investment is assumed to be …xed):
1 1
Y " by G Y increases less than G
(1 M P C) (1 M P C)
An increase in government purchases
2. This increase in income raises the money demand
curve in the market for money, causing the inter-
est rate r to rise: 1. IS curve shifts right r
1 LM
by
r" G
1  MPC
3. The higher interest ratecausing output
arising in the &
money mar- r2
ket, in turn, has rami…cations
income backtoinrise.
the goods 2.
market. That is, the higher interest rate reduces r1
investment: 2. This raises money
demand, causing the 1. IS2
I (rinterest
") # rate to rise… IS1
– This fall in investment partially o¤sets the ex- Y
pansionary e¤ect of G. Y1 Y2
3.
The "crowding out" of investment due

CHAPTER 12 Aggregate Demand II Page: 4 5

 2. EXPLAINING FLUCTUATIONS WITH THE IS–LM MODEL

Let’s now consider a tax cut of T < 0.

1. Consumers save (1 M P C) of the tax cut, so the "initial" boost in spending is smaller for T < 0 than
for an equal G > 0, and the IS curve shifts to the right by M P C=(1 M P C) T.

2. So the tax cut raises both income and the interest rate.
– There is also the crowding out of investment due to a higher interest rate.
– Note that the e¤ects on r and Y are smaller for T < 0 than for an equal G > 0.
t
save r
the tax LM
nitial boost
is smaller
for an r2
2.
r1
urve shifts
PC 1. IS2
T IS1
PC
Y
effects on
Y1 Y2
2.

re smaller
han for an
gregate Demand II 6
G.

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2. EXPLAINING FLUCTUATIONS WITH THE IS–LM MODEL

2.2 How Monetary Policy Shifts the LM Curve and Changes the Short-Run Equilibrium

Recall that a change in the money supply M alters the interest rate that equilibrates the money market for
any given level of income and, thus, shifts the LM curve.
Let’s consider an increase in the money supply of M.

– The increase in M shifts the LM curve down-
ward, lowering the interest rate and raising
the level of income.
1. When the Fed increases M , 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.
Then, r 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:
Monetaryr # initally policy: An
also has rami…cations in the market for money:
that is, the "initial" fall in the interest rate
is dampened.
Y ") r"
– Thus, the IS–LM model shows that monetary pol-
icy in‡uences income by changing the interest
rate, which is called the monetary transmission
mechanism:
An increase in the money supply lowers the
interest rate, which stimulates investment and
thereby expands the demand for goods and ser-
vices.
increase in M

2. The lower interest rate, in turn, has rami…ca-

1. M > 0 shifts
r LM1
tions for the goods market.
the LM curve down
LM2
A lower interest(or
rateto the right)
stimulates planned in-
vestment I2.
(r), …causing
which increases the
planned ex- r1
penditure, production, and income
interest rate toY : fall r2
I (r #) " ) Y " IS
3.…which increases
investment, causing Y
3. The higher income arising in the goods market Y1 Y2
output & income to
rise.
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2. EXPLAINING FLUCTUATIONS WITH THE IS–LM MODEL

2.3 The Interaction Between Monetary and Fiscal Policy

In the model, monetary and …scal policy variables (M and G=T ) are exogenous.
– In the real world, however, monetary policymakers may adjust M in response to changes in …scal policy
G=T , or vice versa.

– Thus, such interactions may alter the impact of the original policy change.
For example, suppose Congress raises taxes by T > 0. What e¤ect will this policy have on the economy?

– According to the IS–LM model, the answer depends on how the Fed responds to the tax increase.
– Here are three of many possible Fed responses:
1. The Fed wants to hold the money supply M constant.
2. The Fed wants to hold the interest rate r constant.
3. The Fed wants to hold the level of income Y constant.
– In each case, the e¤ects of the tax increase are di¤erent.

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2. EXPLAINING FLUCTUATIONS WITH THE IS–LM MODEL

The …gure shows the outcomes of these three possible Fed responses, given the fact that the tax increase
shifts the IS curve to the left.
1. If the Fed holds M constant, then LM curve The higher taxes depress consumption,
doesn’t shift. while the lower interest rate stimulates in-
vestment. Income is not a¤ected because
– Y falls (because higher taxes reduce consumer these two e¤ects exactly balance.
spending), and r falls (because lower income
reduces the demand for money)— the fall in FIGURE 11-4

income indicates that the tax hike causes a re- (a) Fed Holds Money Supply Constant The Res
Tax Incr
Interest rate, r
cession. 1. A tax
2. ... but because the Fed
holds the money supply
constant, the LM curve LM
respond
how the
panel (a
increase stays the same. supply c
shifts the holds th
2. To keep r constant, the Fed decreases M to IS curve . . . reducing
(c) the F
A constant
shift LM curve left. B
In each c
from po
IS1

– Y falls by a larger amount than if the Fed had

IS2
held M constant. Income, output, Y

(b) Fed Holds Interest Rate Constant

Interest rate, r
Whereas in panel (a) the lower interest rate 2. ... and to hold the
interest rate constant,
LM2

the Fed contracts the

stimulated investment and partially o¤set 1. A tax
increase
shifts the
money supply.
LM1

the contractionary e¤ect of the tax hike, in IS curve . . .

panel (b) the Fed "deepens" the reces- B

A

sion by keeping the interest rate high. IS1

IS2
3. To keep Y constant, the Fed increases M to Income, output, Y

shift LM curve right. Interest rate, r

(c) Fed Holds Income Constant

2. ... and to hold LM1

1. A tax income constant, the
increase Fed expands the

– The tax increase causes a large fall in r. shifts the

IS curve . . .
money supply.
LM2

– Although Y is not changed, the combination of

a tax increase and a monetary expansion does B IS1

change the allocation of the economy’s re- IS2

sources: Income, output, Y

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2. EXPLAINING FLUCTUATIONS WITH THE IS–LM MODEL

From this example we can see that the impact of a change in …scal policy depends on the policy the Fed
pursues, that is, on whether it holds the money supply, the interest rate, or the level of income constant.
– More generally, whenever analyzing a change in one policy, we must make an assumption about its e¤ect
on the other policy.
The most appropriate assumption depends on the case at hand and the many political considerations
that lie behind economic policymaking.

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2. EXPLAINING FLUCTUATIONS WITH THE IS–LM MODEL

2.4 Shocks in the IS–LM Model

We can use the IS–LM model to examine how various economic "disturbances" a¤ect income Y in the
short run.
– So far we have seen how changes in …scal policy shift the IS curve and how changes in monetary policy
shift the LM curve.
– Similarly, we can group other disturbances into two categories:
1. Shocks to the IS curve are exogenous changes in the "demand" for goods and services.
Stock market boom or crash ) change in households’wealth ) C , shifting the IS curve.

Changes in business or consumer con…dence/expectations about the future of the economy ) I

or C , shifting the IS curve.
2. Shocks to the LM curve arise from exogenous changes in the "demand" for money.
A wave of credit card fraud increases demand for money, thereby shifting the LM curve.
More ATMs or the Internet reduce money demand, thereby shifting the LM curve.
In summary, several kinds of events can cause economic ‡uctuations (i.e., changes in income Y ) by
shifting the IS curve or the LM curve.
– Such ‡uctuations are not inevitable.
– So policymakers can try to use the tools of monetary and …scal policy to o¤set exogenous shocks.
If policymakers are su¢ ciently quick and skillful (admittedly, a big if ), shocks to the IS or LM curves
need not lead to ‡uctuations in income or employment.

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 2. EXPLAINING FLUCTUATIONS WITH THE IS–LM MODEL

Let’s now use the IS-LM model to analyze the e¤ects of the following shocks:
1. A housing market crash that reduces consumers’wealth.
– This shock shifts the IS curve to the left, causing r and Y to fall.
(a) C falls due to lower wealth and lower income.
(b) I rises because r is lower.
RS, PART 1
ng market crash
u (c) rises, because …rms need less labor when they are producing less output (recall Okun’s Law).
ifts left, causing
d Y to fall. r
LM1
s due to lower
alth and lower r1
ome,
r2
es because
s lower IS1
IS2
es because Y2 Y1 Y
s lower
kun’s law)
17

2. Consumers using cash in transactions more frequently in response to an increase in identity

theft— this shock increases money demand.
– This shock shifts the LM curve to the left, causing r to rise and Y to fall.
(a) C falls due to lower income.
(b) I falls because r is higher.
RS, PART 2
se in money demand
(c) u rises because Y is lower (Okun’s law).
hifts left, causing
LM2
se and Y to fall. r
LM1
s due to lower r2
ome, r1
s because
higher
IS1
s because
lower Y2 Y1 Y
un’s law)
18

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2. EXPLAINING FLUCTUATIONS WITH THE IS–LM MODEL

2.5 What Is the Fed’s Policy Instrument— The Money Supply or the Interest Rate?

Our analysis of monetary policy has been based on the assumption that the Fed in‡uences the economy by
controlling the money supply M .
– By contrast, when the media report on changes in Fed policy, they often just say that the Fed has raised
or lowered interest rates i (i = r under sticky prices).
– Which is right?
Even though these two views may seem di¤erent, both are correct.
Why are both views correct?
– In recent years, the Fed has used the federal funds rate (i.e., the interest rate that banks charge one
another for overnight loans) as its short-term policy instrument.
When the Federal Open Market Committee meets every six weeks to set monetary policy, it votes on
a "target" for this interest rate that will apply until the next meeting.
After the meeting is over, the Fed’s bond traders (who are located in New York) are told to conduct
the open-market operations necessary to hit that target.
These open market operations change the money supply M and shift the LM curve so that the
equilibrium interest rate r (determined by the intersection of the IS and LM curves) equals
the target interest rate that the Federal Open Market Committee has chosen.
– As a result of this operating procedure, Fed policy is often discussed in terms of changing interest rates.
Keep in mind, however, that behind these changes in interest rates r are the necessary changes in the
money supply M .
In some ways, setting the money supply and setting the interest rate are two sides of the
same coin.

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2. EXPLAINING FLUCTUATIONS WITH THE IS–LM MODEL

Why has the Fed chosen to use an interest rate, rather than the money supply, as its short-term
policy instrument?
– Interest rates are easier to measure than the money supply.

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3. IS–LM AS A THEORY OF AGGREGATE DEMAND

3 IS–LM as a Theory of Aggregate Demand

We have been using the IS–LM model to explain national income Y in the short run when the price level P
is …xed.
We now examine what happens to Y in the IS–LM model if P is allowed to change— note that a change
in P would shift LM and therefore a¤ect Y .
– This examination derives a downward-sloping aggregate demand (AD) curve that describes a rela-
tionship between the price level P and the level of national income Y .

3.1 From the IS–LM Model to the Aggregate Demand Curve

To understand the determinants of aggregate demand more fully, we now use the IS–LM model to derive the
aggregate demand (AD) curve.
1. First, we use the IS–LM model to show why Y falls as P rises, that is, why the AD curve is downward
sloping.
2. Second, we examine what causes the AD curve to shift.
(a) Changes in policies"
i. Monetary policy (M ), which shifts the LM curve.
ii. Fiscal policy (G=T ), which shifts the IS curve.
(b) Anything that changes income in the IS–LM model other than a change in the price level:
i. Shocks to the IS curve
ii. Shocks to the LM curve

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3. IS–LM AS A THEORY OF AGGREGATE DEMAND

3.1.1 The Downward-Sloping AD Curve

Let’s …rst derive the downward-sloping aggregate demand (AD) curve. Here is the intuition for the
slope of the AD curve:
M
P " ) # ) LM shifts to the left ) r " ) I # ) Y # (3.1)
|{z} P |{z}

– The position of the LM curve depends on the – The lower panel shows the aggregate demand
value of the supply of real money balances, curve summarizing this relationship between the
(M=P ). price level and income:
M is an exogenous policy variable: M = M . The higher the price level, the lower the
level of income.
So, if P isDeriving (M=P ) isAD
low (like P1 ), then the rela- curve
tively high, so the LM curve is over toward the
right. If P is high (like P2 ), then (M=P ) is r LM(P2)
relatively low,Intuition
so the LM curve
for is more toward
slope LM(P1)
the left. r2
of AD curve:
r1
Because theP
valueof P(M/P
a¤ects the
) position
of the LM curve, we label the LM curves in IS
the upper panel as
LMLM (P1 ) shifts
and LM left
(P2 ). Y2 Y1 Y
P
– The upper panel shows 
the r
IS–LM model:
P2
 I
An increase in the price level from P1 to P2 P1
 Y
lowers real money balances and thus shifts the
LM curve upward. This shift in the LM curve AD
lowers income from Y1 to Y2 . Y2 Y1 Y
CHAPTER 12 Aggregate Demand II 27

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 3. IS–LM AS A THEORY OF AGGREGATE DEMAND

3.1.2 Shifts in the AD Curve

What causes the aggregate demand 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.
An increase in the money supply raises income in the IS–LM model for any given price level, thereby shifting
the AD curve to the right:
M
M " ) " ) LM shifts to the right ) r # ) I " ) Y " at each value of P (3.2)
|{z} P |{z}
An increase in government purchases or a decrease in taxes raises income in the IS–LM model for a given price
level, thereby shifting the AD curve to the right:
G " or T # ) IS shifts to the right ) Y " at each value of P (3.3)
| {z } |{z}
Fiscal
licy and the policy and the AD curve
AD curve
r 1 LM(M /P )
1 r LM
ease Expansionary fiscal
d: r1 LM(M2/P1)
policy (G and/or T ) r2
r2 increases agg. demand: r1 IS2
ight
T  C IS IS1
Y1 Y2
 IS
Y Y1 Y2 Y
P shifts right P
 Y at each
h P1 P1
value of P
of P
AD2 AD2
AD1 AD1
Y1 Y2 Y Y1 Y2 Y
Demand II CHAPTER 12 Aggregate Demand
28 II 29

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3. IS–LM AS A THEORY OF AGGREGATE DEMAND

Anything that changes income in the IS–LM model other than a change in the price level causes a shift in
the aggregate demand curve.
– The factors shifting aggregate demand include not only monetary and …scal policy but also shocks to
the goods market (the IS curve) and shocks to the money market (the LM curve).

3.1.3 Summary on the AD Curve

We can summarize these results as follows:

1. A change in income in the IS–LM model resulting from a change in the price level represents a movement
along the aggregate demand curve.
2. A change in income in the IS–LM model for a given price level represents a shift in the aggregate
demand curve.

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3. IS–LM AS A THEORY OF AGGREGATE DEMAND

3.2 The IS–LM Model in the Short Run and Long Run

Recall from Chapter 10 that:

– How does the economy make the transition from the short run to the long run? The force that
moves the economy from the short run to the long run is the gradual adjustment of prices:

In the short-run equilibrium,

if its output Y > Y ; P will rise over time.

if its output Y < Y ; P will fall
if its output Y = Y ; P will remain constant

where Y is the long-run equilibrium output level.

Keeping it in mind, we now use the IS-LM model to describe the economy in the long run when the
price level adjusts to ensure that the economy produces at its natural rate. Let’s consider the short-run and
long-run e¤ects of a negative IS shock.
– In the short run, the economy responds to a negative IS SR
The shock:
and LR effects of an IS shock
The SR and LR effects of an IS shock
r LRAS LM(P ) r LRAS LM(P )
1 1

IS1 IS1
A negative IS shock shifts IS and IS2 In the new short-run equilibrium, IS2
AD to the left, causing Y to fall. Y Y Y
Y Y Y
P LRAS P LRAS

P1 SRAS1 P1 SRAS1

AD1 AD1
AD2 AD2
Y Y Y Y
CHAPTER 12 Aggregate Demand II 31 CHAPTER 12 Aggregate Demand II 32

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3. IS–LM AS A THEORY OF AGGREGATE DEMAND

– Over
Thetime, prices
SR and gradually
LR effects IS shock
of anfalls: The SR and LR effects of an IS shock
r LRAS LM(P ) r LRAS LM(P )
1 1
LM(P2)
In the new short-run equilibrium,
Y Y IS1 Over time, P gradually falls, causing: IS1
IS2 • SRAS to move down IS2
Y Y • M/P to increase, which causes Y Y
Over time, P gradually falls, causing: LM to move down
P LRAS P LRAS
• SRAS to move down
• M/P to increase, which causes P1 SRAS1 P1 SRAS1
LM to move down P2 SRAS2
AD1 AD1
AD2 AD2
Y Y Y Y
CHAPTER 12 Aggregate Demand II 33 CHAPTER 12 Aggregate Demand II 34

The SR
– In the and
long LR effects
run, of an ISsettles
the economy shockat a new long-run
The SR and LRwith
equilibrium effects
Y = IS shock
of Yanand a lower price P2 :

r LRAS LM(P ) r LRAS LM(P )

1 1
LM(P2) LM(P2)

This process continues until the

Over time, P gradually falls, causing: IS1 economy reaches a long-run IS1
• SRAS to move down IS2 equilibrium with
IS2
• M/P to increase, which causes Y Y Y Y
Y Y
LM to move down
P LRAS ,but a lower price level. P LRAS

P1 SRAS1 P1 SRAS1

P2 SRAS2 P2 SRAS2
AD1 AD1
AD2 AD2
Y Y Y Y
CHAPTER 12 Aggregate Demand II 34 CHAPTER 12 Aggregate Demand II 35

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3. IS–LM AS A THEORY OF AGGREGATE DEMAND

From this transition of the economy, we can now see the key di¤erence between the Keynesian and
classical approaches to the determination of national income Y .
1. The Keynesian assumption is that the price level is stuck.
– Depending on monetary policy, …scal policy, and the other determinants of aggregate demand, output
may deviate from its natural level (Y 6= Y ).
2. The classical assumption is that the price level is fully ‡exible.
– The price level adjusts to ensure that national income is always at its natural level (Y = Y ).

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4. THE GREAT DEPRESSION

4 The Great Depression

Now that we have developed the model of aggregate demand, let’s use it to address the question that originally
motivated Keynes: What caused the Great Depression?
The Great Depression
240 30
Unemployment
(right scale)
billions of 1958 dollars

220 25

percent of labor force

200 20

180 15

160 10

140 Real GNP 5

(left scale)
120 0
1929 1931 1933 1935 1937 1939

– See the magnitude of the fall in output and increase in unemployment.

In 1933, the unemployment rate is over 25%.
– There’s a very strong negative correlation between output and unemployment.
Even today, more than half a century after the event, economists continue to debate the causes of this major
economic downturn.
1. caused by an IS shift?
2. caused by an LM shift?
3. caused by something else?
The Great Depression provides an extended "case study" to show how economists use the IS–LM
model to analyze economic ‡uctuations.

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4. THE GREAT DEPRESSION

4.1 The Spending Hypothesis: Shocks to the IS Curve

The view called the spending hypothesis asserts that the Depression was largely due to an exogenous
fall in the demand for goods and services— a leftward shift of the IS curve.
– It is "supported" by the evidence that output and interest rates both fell, which is what a left-
ward IS shift would cause.
Economists have attempted to explain this decline in spending in several ways.
1. A downward shift in the consumption function caused the contractionary shift in the IS curve.
– The stock market crash of 1929 may have been partly responsible for this shift: by reducing wealth and
increasing uncertainty about the future prospects of the U.S. economy, the crash may have induced
consumers to save more of their income rather than spend it.
2. The decline in spending was due to the large drop in investment in housing.
– The residential investment boom of the 1920s was excessive and that once this “overbuilding” became
apparent, the demand for residential investment declined drastically.
– Widespread bank failures made it harder to obtain …nancing for investment
3. The contractonary …scal policy of the 1930s caused a contractionary shift in the IS curve.
– Politicians at that time were more concerned with balancing the budget than with using …scal policy
to keep production and employment at their natural levels:
In the midst of historically high unemployment, policymakers searched for ways to raise taxes and
reduce government spending.
There may be no single explanation for the decline in spending.
– It is possible that all of these changes coincided and that together they led to a massive reduction in
spending.
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4. THE GREAT DEPRESSION

4.2 The Money Hypothesis: A Shock to the LM Curve

The money hypothesis, which places primary blame for the Depression on the Federal Reserve, asserts that
the Depression was largely due to huge fall in the money supply.
– It is "supported" by the evidence that money supply (M1) fell 25 percent from 1929 to 1933,
during which time the unemployment rate rose from 3.2 percent to 25.2 percent.
– Friedman and Schwartz argue that contractions in the money supply have caused most economic down-
turns and that the Great Depression is a particularly vivid example.
Using the IS-LM model, we might interpret the money hypothesis as explaining the Depression by a contrac-
tionary shift in the LM curve. Seen in this way, however, the money hypothesis runs into two "problems:"
1. The …rst problem is the behavior of real money balances (M=P ).
– Monetary policy leads to a contractionary shift in the LM curve only if real money balances fall.
– Yet real money balances rose slightly from 1929 to 1931, because the fall in the money supply was
accompanied by an even greater fall in the price level:
M # M
) "
P + P

2. The second problem for the money hypothesis is the behavior of interest rates.
– If a contractionary shift in the LM curve triggered the Depression, we should have observed higher
interest rates.
– Yet nominal interest rates fell continuously from 1929 to 1933:
i#
These two reasons appear su¢ cient to "reject" the view that the Depression was instigated by a
contractionary shift in the LM curve.

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4. THE GREAT DEPRESSION

4.3 The Money Hypothesis Again: The E¤ects of Falling Prices

We now turn to "another mechanism" through which monetary policy might have been responsible for the
severity of the Depression:
– It asserts that the severity of the Depression was due to a huge "de‡ation" of the 1930s.
The price level P fell 25% during 1929–33.
This de‡ation was probably caused by the fall in the money supply M , so perhaps money played
an important role after all.
In what ways does a "de‡ation" a¤ect the economy (i.e., income)?
1. The Stabilizing E¤ects of De‡ation
(a) In the IS–LM model we have developed so far, falling prices raise income: for a given M ,
P #) M =P " ) LM shifts right ) Y "

(b) Another channel through which falling prices expand income is called the Pigou e¤ect— he pointed
out that real money balances are part of households’wealth:
P #) M =P " ) consumers’wealth " ) C " ) IS shifts right ) Y "
These two reasons led some economists in the 1930s to believe that falling prices would help stabilize
the economy, that is, raise income.
– That is, they thought that a decline in the price level would automatically push the economy back
toward full employment.
– Yet other economists were less con…dent in the economy’s ability to correct itself, and they pointed
to other e¤ects of falling prices: the destablizaing e¤ects of de‡ation (i.e., falling prices could depress
income rather than raise it).

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4. THE GREAT DEPRESSION

2. The Destabilizing E¤ects of De‡ation

(a) The destabilizing e¤ects of "expected" de‡ation:
E [ ] # ) r " for each value i ) I # ) IS shifts left ) Y #

(b) The debt-de‡ation theory describes the e¤ects of "unexpected" falls in the price level:

"Unexpectedly" P #
) Transfers purchasing power from borrowers to lenders
) Borrowers spend less & lenders spend more.
If borrowers’propensity to spend is larger than lenders’one,
)
then aggregate spending falls, IS shifts left.
) Y #

where it follows from Chapter 4 that unanticipated changes in the price level redistribute wealth
between debtors and creditors.
– If a debtor owes a creditor $1; 000, then the real amount of this debt is $1; 000=P .
– A fall in the price level raises the real amount of this debt (i.e., the amount of purchasing power
the debtor must repay the creditor).
– Therefore, an unexpected de‡ation enriches creditors and impoverishes debtors.
In both, falling prices depress national income by causing a contractionary shift in the IS curve.
– Because a de‡ation of the size observed from 1929 to 1933 is unlikely except in the presence of a
major contraction in the money supply, these two explanations assign some of the responsibility
for the Depression— especially its severity— to the Fed.
– In other words, if falling prices are destabilizing, then a contraction in the money supply can lead to a
fall in income, even without a decrease in real money balances or a rise in nominal interest rates.

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4. THE GREAT DEPRESSION

4.4 Could the Depression Happen Again?

Economists study the Depression both because of its intrinsic interest as a major economic event and to provide
guidance to policymakers so that it will not happen again.
– Policymakers (or their advisers) now know much more about macroeconomics:
1. The Fed knows better than to let the money supply fall so much, especially during a con-
traction.
2. Fiscal policymakers know better than to raise taxes or cut spending during a contraction.
– Federal deposit insurance makes widespread bank failures very unlikely.
– Automatic stabilizers make …scal policy expansionary during an economic downturn.

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5. CONCLUSION

5 Conclusion

The purpose of this chapter and the previous one has been to "deepen" our understanding of aggregate
demand.
– We now have the tools to analyze the e¤ects of monetary and …scal policy in the long run and in the
short run.
1. In the long run, prices are ‡exible, and we use the classical analysis of earlier chapters.
2. In the short run, prices are sticky, and we use the IS–LM model to examine how changes in policy
in‡uence the economy.
The aggregate demand model in this and the previous chapter provides the basic framework for analyzing the
economy in the short run, but it is not the whole story.
– In Chapter 14, we examine the theory behind short-run aggregate supply.
– In Chapter 15, we bring these various elements of aggregate demand and aggregate supply together to
study more precisely the dynamic response of the economy over time.

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