Aggregate Demand II: Applying the IS–LM Model

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Science is a parasite: the greater the patient population the better the advance in physiology and pathology; and out of pathology arises therapy. The year 1932 was the trough of the great depression, and from its rotten soil was belatedly begot a new subject that today we call macroeconomics.

—Paul Samuelson

In Chapter 11 we assembled the pieces of the IS–LM model as a step toward understanding short-run economic fluctuations. We saw that the IS curve represents the equilibrium in the market for goods and services, that the LM curve represents the equilibrium in the market for real money balances, and that the IS and LM curves together determine the interest rate and national income in the short run when the price level is fixed. Now we turn our attention to applying the IS–LM model to analyze three issues.

First, we examine the potential causes of fluctuations in national income. We use the IS–LM model to see how changes in the exogenous variables (-government purchases, taxes, and the money supply) influence the endogenous variables (the interest rate and national income) for a given price level. We also examine how various shocks to the goods market (the IS curve) and the money market (the LM curve) affect the interest rate and national income in the short run.

Second, we discuss how the IS–LM model fits into the model of aggregate supply and aggregate demand we introduced in Chapter 10. In particular, we examine how the IS–LM model provides a theory to explain the slope and position of the aggregate demand curve. Here we relax the assumption that the price level is fixed and show that the IS–LM model implies a negative relationship between the price level and national income. The model can also tell us what events shift the aggregate demand curve and in what direction.

Third, we examine the Great Depression of the 1930s. As this chapter’s opening quotation indicates, this episode gave birth to short-run macroeconomic theory, for it led Keynes and his many followers to argue that aggregate demand was the key to understanding fluctuations in national income. With the benefit of hindsight, we can use the IS–LM model to discuss the various explanations of this traumatic economic downturn.

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The IS–LM model has played a central role in the history of economic thought, and it offers a powerful lens through which to view economic history, but it has much modern significance as well. Throughout this chapter we will see that the model can also be used to shed light on more recent fluctuations in the economy; two case studies in the chapter use it to examine the recessions that began in 2001 and 2008. Moreover, as we will see in Chapter 15, the logic of the IS–LM model provides a good foundation for understanding newer and more sophisticated theories of the business cycle.