Section Appendix 4.2.

Applying the IS-LM

Model
• In this section the IS-LM model is used to examine how an economy copes with
disturbances or shocks in the short run and the long run by looking at

1. The Great Depression of the 1930s.

2. The Liquidity trap and Japan’s experience.
3. The US recession of 2001.
4. The Financial Crisis and Economic Downturn of 2008 and 2009.

• It is noted that the IS-LM model presented here is linear. This differs to the log-linear
model considered previously but yields the same results.

1
Case Study One: The Liquidity
Trap and the Experience of
Japan

2
• A depression is a deep and long-lasting recession.

• A slump is a long period of low or no growth, longer than a typical

recession, but less deep than a depression.

• In the case of a slump output is below the natural level of output.

• 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.
3
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.

4
• Suppose output is below the natural level of output – equivalently, the unemployment rate is
higher than the natural rate of unemployment.

• With the unemployment rate above the natural rate, inflation falls over time.

• As long as output is below its natural level, inflation falls, and the LM curve continues to shift down.

• The built-in mechanism that can lift economies out of recessions is:

1. Output below the natural level of output leads to lower inflation.

2. Lower inflation leads in turn to higher real money growth.

3. Higher real money growth leads to an increase in output over time.

• This mechanism, however, is not foolproof.

5
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
down, and (2) expected
inflation decreases, leading
the IS curve to shift to the left.
The result may be a further
decrease in output.

6
• Because output is below the natural level of output, inflation falls. The decrease in
inflation now has two effects:

1. The first effect is to increase the real money stock and shift the LM curve down, this shift
tends to increase output.

2. The second effect is for a given nominal interest rate, the decrease in expected inflation
increases the real interest rate.

• The demand for money is as shown in the following figure.

• As the nominal interest rate decreases, people want to hold more money.

• As the nominal interest rate becomes equal to zero, people want to hold an amount of
money at least equal to the distance OB: This is what they need for transaction purposes.
7
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
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.

8
• 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.

• 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.

• 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 additional money is willingly held by financial
investors at an unchanged interest rate, namely, zero.

9
The Derivation of the LM For low levels of output, the LM curve is a flat segment, with a nominal
Curve in the Presence of interest rate equal to zero. For higher levels of output, it is upward
a Liquidity Trap sloping: An increase in income leads to an increase in the nominal
interest rate.

10
• To derive the LM curve, panel (a) of the above figure details equilibrium in
the financial markets for a given value of the real money stock and draws
three money demand curves, each corresponding to a different level of
income:

• The combination of income, Y, and nominal interest rate, i, gives us the first
point on the LM curve, point A in panel (b).

• Lower income means fewer transactions and therefore a lower demand for
money at any interest rate. This combination of income, Y’, and nominal
interest rate, R’, gives us the second point on the LM curve, point A’ in panel
(b).

11
• The equilibrium is given by point A” in panel (a), with nominal interest
rate equal to zero. Point A” in panel (b) corresponds to A” in panel (a).

• 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.

12
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
increase output back to its
natural level.

13
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  R    0%  10%  10%
• 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  R    0%  (5%)  5%
• In this situation, there is nothing monetary policy can do to bring output above the natural
level of output.
14
 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
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.
15
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.

16
The Japanese Slump:
Output Growth since
1990 (percent)

From 1992 to 2002, average

GDP growth in Japan was
less than 1%.

17
Unemployment and
Inflation in Japan since
1990 (percent)
Low growth in output has
led to an increase in
unemployment. Inflation has
turned into deflation.

18
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

• The numbers in the table 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?

19 of 43
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 price simply because they expect the price to
go even higher in the future.

• 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.

20
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
parallel movement in
dividends.

21
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
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.

22
• 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. As a result, the real interest rate was higher than the nominal
interest rate.

• 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.

23
Government Spending
and Revenues (as a
percentage of GDP) in
Japan since 1990
Government spending
increased and government
revenues decreased
steadily throughout the
1990s, leading to steadily
larger deficits.

24
• Output growth has been higher since 2003, and most economists cautiously predict that the recovery will
continue. This raises the last set of questions. What are the factors behind the current recovery?

• There appear to be two main factors.

1. A Regime Change in Monetary Policy

• It is suggested that even if the nominal interest rate is already equal to zero and thus cannot be reduced
further, the central bank might still be able to lower the real interest rate by affecting inflation
expectations.

2. The Cleanup of the Banking System

• It became clear in the 1990s that the banking system in Japan was in trouble. Since 2002, the government
has put increasing pressure on banks to reduce bad loans, and banks, in turn, have put increasing pressure
on bad firms to restructure or close.

25
 Case Study Two:
The U.S. Recession of 2001

26
 The U.S. Recession of 2001
Unemployment
7.0

• 3.9% on 9/00
6.0

• 4.9% on 8/01
5.0

4.0
• 6.3% on 6/03
3.0
• 5.0% on 7/05
2.0

1.0

0.0
1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1
8 -0 1-0 2-0 5-0 8-0 1-0 2-0 5-0 8-0 1-0 2-0 5-0 8-0 1-0 2-0 5-0 8-0 1-0 2-0 5-0
-0 -1 -0 -0 -0 -1 -0 -0 -0 -1 -0 -0 -0 -1 -0 -0 -0 -1 -0 -0
0 0 0 000 001 0 01 00 1 001 002 0 02 002 0 02 003 00 3 003 00 3 0 04 00 4 004 00 4 00 5 005
2 2 2 2 2 2 2 2 2 2 2 2 2 2 2 2 2 2 2 2

27
• Growth of GDP
was negative in GDP growth rate
the 1st and 3rd 10.0

quarters of
2001 (a fall
8.0

before 9/11). 6.0

4.0

2.0

0.0
2 3 4 1 2 3 4 1 2 3 4 1 2 3 4 1 2 3 4 1 2 3
0 0q 0 0q 00q 01q 01q 0 1q 01q 02q 02q 02q 0 2q 03q 0 3q 0 3q 03q 04q 0 4q 0 4q 0 4q 05q 05q 0 5q
2 0 20 20 2 0 2 0 20 20 2 0 2 0 2 0 20 2 0 20 20 20 2 0 20 20 20 20 2 0 20
-2.0

28
• Why did the recession occur?
• Demand shocks moved the IS
curve left r
• The “tech bubble” ended and LM
stocks fell 25% between 8/00
and 8/01
• 9/11 attacks led to a 12% fall in
stock prices in one week and a r1
huge rise in uncertainty
• Scandals at Enron, WorldCom
and other corporations led to
stock price declines and a
IS
decline in trust and a rise in Y
uncertainty Y1
• Lower household wealth
reduced C and higher
uncertainty reduced I.
29
 Stock market decline  C

1500
Standard & Poor’s
Index (1942 = 100)

1200 500

900

600

300
1995 1996 1997 1998 1999 2000 2001 2002 2003
30
• Fiscal stimulus moved IS curve right
• Major tax cuts were enacted in
2001 and 2003
• Government spending was r
boosted LM1
• to rebuild NYC, and LM2
• to bail out the airline industry
• Fed injected money into the economy
and moved LM curve right r1
• Interest rate on 3-month Treasury
bills fell IS2
• 6.4% in 11/00 IS1
• 3.3% in 8/01
Y1 Y3 Y
• 0.9% in 7/03

All three tools—G, T and M—were used

32
 01
/0

0
1
2
3
4
5
6
7

1/2
00
04
/0 0
2/2
07 00
/03 0
/20
10 00
/03
/2 0
01
/03 00
/20
04 01
/0 5
/20
07
/ 06 01
/20
10 01
/06
/2 0
01
/ 0 6 01
/20
04 02
/08
/2 0
07
T-Bill Rate

/09 02
Three-month

/2 0
10 02
/09
/20
01
• Monetary policy response: shifted LM curve right

/09 02
/2 0
04 03
/11
/2 0
03
33
Case Study Three: The Great
Depression

34
 The Great Depression
240 30
Unemployment
billions of 1958 dollars 220 (right scale) 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

35
• The Spending Hypothesis
asserts that the Depression
r
was largely due to an
LM
exogenous fall in the
demand for goods and
services – a leftward shift of
the IS curve. r1
• Evidence: output and
interest rates both fell in IS
early 1930s, which is what a
leftward IS shift would Y1 Y
cause.

36
• Stock market crash  exogenous C
• Oct-Dec 1929: S&P 500 fell 17%
• Oct 1929-Dec 1933: S&P 500 fell 71%
• Drop in investment
• “correction” after overbuilding in the 1920s
• widespread bank failures in early 1930s made it harder to obtain financing for investment
• Contractionary fiscal policy
• Politicians raised tax rates in 1932 and cut spending to combat increasing deficits.
• The Money Hypothesis asserts that the Depression was largely due to huge fall in
the money supply.
• Evidence: M1 fell 25% during 1929-33.
• But, two problems with this hypothesis:
• P fell even more, so M/P actually rose slightly during 1929-31.
• nominal interest rates fell, which is the opposite of what a leftward LM shift would cause.

37
• The Spending Hypothesis asserts that the severity of the Depression was due to a
huge deflation:
• P fell 25% during 1929-33.
• This deflation was probably caused by the fall in M, so perhaps money played an
important role after all.
• In what ways does a deflation affect the economy?
• The stabilizing effects of deflation:
• P  (M/P )  LM shifts right  Y

P  (M/P )
 consumers’ wealth 
 C
 IS shifts right
 Y
38
• The destabilizing effects of
expected deflation: 
• LM curve shifts left r
LM
 r  and I (r ) 
 planned expenditure
 r1
 income and output 
• Also, the nominal interest IS
rate decreases R↓): Y1 Y

39
• The destabilizing effects of unexpected deflation: debt-
deflation theory
P (if unexpected)
 transfers purchasing power from borrowers to lenders
 borrowers spend less, lenders spend more
 if borrowers’ propensity to spend is larger than lenders’,
then aggregate spending falls, the IS curve shifts left,
and Y falls

40
The Evidence on Output and Nominal Interest Rates

• Note that, other than the money hypothesis, all the other
hypotheses—the spending hypothesis, the debt-deflation
hypothesis, and the deflationary expectations hypothesis—predict
falling real GDP and falling nominal interest rates
• This is exactly what happened in the early stages of the Great
Depression
• The spending hypothesis and the debt-deflation hypothesis both
predict falling real interest rates, whereas the deflationary
expectations hypothesis predicts rising real interest rates
• Therefore, evidence on real interest rates is crucial in identifying
suitable explanations for the Great Depression
41
Why another Depression is Unlikely

• Policymakers (or their advisors) now know much more about

macroeconomics:
• The Fed knows better than to let M fall so much, especially
during a contraction.
• 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 fiscal policy expansionary during an
economic downturn.

42
Case Study Four: The Financial
Crisis and Economic Downturn
of 2008 and 2009

43
• 2009: Real GDP fell, unemployment rate approached 10%
• Important factors in the crisis:

• early 2000s Federal Reserve interest rate policy

• sub-prime mortgage crisis
• bursting of house price bubble, rising foreclosure rates
• falling stock prices
• failing financial institutions
• declining consumer confidence, drop in spending on consumer
durables and investment goods

44
A Simple Explanation of the Downturn

• The price of housing had risen to unsustainable levels.

• When home prices inevitably crashed, people suddenly felt poor and cut back their spending
plans.

• This fall in planned expenditure brought about the Great Recession of 2008-09.

• The S&P Case-Shiller 20-City Home Price Index went from

• 100 in Jan 2000, to
• 206.54 in April 2006, to
• 140.95 in May 2009, to
• 142.16 in Dec 2010

• Why did the housing bubble inflate?

45
Reasons for the Housing Bubble

• The Fed kept the interest rates too low for too long
• Securitization technology got a lot fancier in the mortgage bond market
• The government regulators were sleeping
• Pretty much everybody believed that home prices could never fall
• The Fed had reduced the Federal Funds Rate to fight the Recession of 2001.
• After that recession ended, the Fed continued to keep interest rates low
until 2004
• The Fed was watching inflation, which remained tame. Consequently, the Fed saw
little reason to raise interest rates.
• The Fed did not believe that housing prices had formed a bubble … until it was
blindingly obvious

46
• In the past, people with money did not like to lend money to home
buyers because such loans were risky and had unreliable returns

• But the advent of new financial technologies called securitization and

tranching made people with money suddenly eager to lend to home
buyers.

• The financial sector was regulated by people who were ideologically

opposed to regulation.

• They turned a blind eye to even the worst lending practices.

47
• The Fed’s low-interest policy and financial innovation made it easy for home
buyers to borrow money.
• Lax regulation allowed subprime lending.
• That is, lending to people who had few assets and/or prospects that would make
repayment likely.
• The belief that home prices would keep rising made it unnecessary to worry
about the credit worthiness of borrowers.
• After mid-2006, home prices started to fall.
• Home owners began to default on their loans.
• Foreclosures increased.
• This flooded the market with more homes for sale.
• Which led to further declines in home prices.
• These cascading and self-reinforcing home price declines made people feel poor.
• Consumption spending fell.

48
• After mid-2006, home prices started to fall.

• The financial institutions that had made mortgage loans faced huge losses
when borrowers began to default.
• These institutions began to second guess their ability to spot good borrowers.
So, they reduced lending.
• Even financial institutions that had not made bad loans were scared to lend
because they feared that the borrower may have made bad investments and
would soon go bankrupt.
• Business investment spending collapsed.

49
• After mid-2006, home prices started to fall.
• Financial institutions were revealed to have suffered huge losses.
• Non-financial businesses were not getting loans and were shutting down.
• But a lack of transparency meant that it was not possible to figure out which
companies would collapse next.
• This caused great uncertainty.
• People with money sold off their stocks and bonds.
• The decline in stock prices made people feel poor.
• Consumption spending fell.
• The collapse of the housing bubble led, through a complex chain of
causation, to major declines in consumption and investment spending.
• One can think of all this as a shift of the IS curve to the left.
• This brings about a recession, with falling output and rising
unemployment.
50
The Fed’s Response

• The Federal Reserve reduced the Federal Funds Rate

• from 5.25% in Sept 2007
• to essentially zero in Dec 2008
• The Fed had reached the zero lower bound and could not go any further
• The Fed is now trying less orthodox measures, called quantitative easing, to
reduce long-term interest rates.
• In October 2008, the outgoing Bush administration enacted the Troubled Assets
Recovery Program (TARP) that spent $700 billion to revive Wall Street
• In January 2009, the incoming Obama administration enacted the American
Recovery and Reinvestment Act (ARRA), which consisted of $800 billion in tax
cuts and spending initiatives to spread over two years.

51
• The Great Recession officially ended in June 2009.
• But the recovery has been very slow.
• Real GDP grew at 3.1% in the fourth quarter of 2010.
• The unemployment rate was at 8.9% in February 2011.

52
 Interest Rates and House Prices
Federal Funds rate
9 30-year mortgage rate
190
Case-Shiller 20-city composite house price index
8

170

House price index, 2000=100

7
interest rate (%)

6 150

5
130

4
110
3
90
2

70
1

0 50
2000 2001 2002 2003 2004 2005 53
 Change in U.S. House Price Index and Rate of New
Foreclosures, 1999-2009
14%
US house price index 1.4
12%
New foreclosures
10% 1.2
Percent change in house prices
(from 4 quarters earlier)

(% of total mortgages)
8%

New foreclosure starts

1.0
6%
0.8
4%

2% 0.6

0%
0.4
-2%
0.2
-4%

-6% 0.0
1999 2001 2003 2005 2007 2009 54
U.S. Bank Failures by Year 2000-2009

* as of July 24, 2009.

55
 Consumer Sentiment and Growth in Consumer
Durables and Investment Spending
1200%
110

Consumer Sentiment Index, 1966=100

% change from four quarters earlier
1000%
100

800%
90

600%
80

400%
70

Durables
200% 60
Investment
UM Consumer Sentiment Index
0% 50
1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 56
 Real GDP Growth and Unemployment
10% 10
Real GDP growth rate (left scale)
9
8% Unemployment rate (right scale)
8
% change from 4 quaters earlier

6% 7

% of labor force
6
4%
5
2%
4

0% 3

2
-2%
1

-4% 0
1995 1997 1999 2001 2003 2005 2007 2009 57
The Fed Tried: M/P Kept Rising

58
But the Fed hit the Zero Lower Bound

59
Falling Mortgage Rates Helped

Mortgage rates were very low Note that there is a

between ‘04 and ‘06. They link between the two
may have contributed to the rates, though weak
housing bubble

In hindsight, the FFR

should have been
higher in 2003-06.
But inflation was low.

60
Record Low Mortgage Rates

Mortgage rates are

even lower now. But
The unusually low credit standards have
mortgage rates may have been tightened. In
helped to inflate the any case, the
housing bubble. economy is still
weak. So, don’t
expect another
housing bubble.

61
The Housing Bubble Inflates and then Deflates

62
In 2007, it becomes
clear that banks would
get hit by the collapse
of the housing bubble

63
The “Fear Index” Spikes

64
Consumption Spending Falls

In 2007, the growth

rate of consumption
slowed faster than
GDP did. This was
unusual.

65
From 2007,
investment, which
includes new housing,
absolutely crashed.

66
Unemployment Increases

67
 Inflation Fell Sharply

The Fed pays more attention to the “core

inflation rate,” which ignores food and energy.
Now you see why. The downward trend in core
inflation is a worry: we don’t need deflation.

68
Has government spending risen at an
unusually rapid rate? Not really.

The main budgetary problem has

been caused by the crashing tax
revenues.

69
Has government spending
risen at an unusually rapid
rate? Not really.

The main budgetary problem has

been caused by the crashing tax
revenues.

70
Has government spending risen at an
unusually rapid rate? Not really.

The main budgetary problem has been

caused by the crashing tax revenues.

71