Aggregate Demand I: Building the IS - LM Model

1. 10 Aggregate Demand I:Building the IS-LM Model

2. CHAPTER 10 Aggregate Demand I The IS curve def: a graph of all combinations of r and Y that result in goods market equilibrium i.e. actual expenditure (output) = planned expenditure The equation for the IS curve is:

3. CHAPTER 10 Aggregate Demand I E I Y r Y Deriving the IS curve E =Y E =C +I(r2)+G r  I E =C +I(r1)+G  E  Y Y1 Y2 r1 r2 IS Y1 Y2

4. CHAPTER 10 Aggregate Demand I Why the IS curve is negatively sloped • A fall in the interest rate motivates firms to increase investment spending, which drives up total planned spending (E). • To restore equilibrium in the goods market, output (a.k.a. actual expenditure, Y) must increase.

5. CHAPTER 10 Aggregate Demand I The LM curve Now let’s put Y back into the money demand function: The LMcurve is a graph of all combinations of r and Y that equate the supply and demand for real money balances. The equation for the LMcurve is:

6. CHAPTER 10 Aggregate Demand I r r LM L(r,Y2) L(r,Y1) Y M/P Y1 Y2 Deriving the LM curve (a) The market for real money balances (b) The LM curve r2 r2 r1 r1

7. CHAPTER 10 Aggregate Demand I Why the LM curve is upward sloping • An increase in income raises money demand. • Since the supply of real balances is fixed, there is now excess demand in the money market at the initial interest rate. • The interest rate must rise to restore equilibrium in the money market.

8. CHAPTER 10 Aggregate Demand I LM1 r LM2 r1 r2 IS Y2 Y1 Y Monetary policy: An increase in M 1. M > 0 shifts the LM curve down(or to the right) 2. …causing the interest rate to fall 3. …which increases investment, causing output & income to rise.

9. CHAPTER 10 Aggregate Demand I Interaction between monetary & fiscal policy • Model: Monetary & fiscal policy variables (M, G, and T) are exogenous. • Real world: Monetary policymakers may adjust Min response to changes in fiscal policy, or vice versa. • Such interaction may alter the impact of the original policy change.

10. CHAPTER 10 Aggregate Demand I The Fed’s response to G > 0 • Suppose Congress increases G. • Possible Fed responses: 1.hold M constant 2.hold r constant 3.hold Y constant • In each case, the effects of the Gare different:

11. CHAPTER 10 Aggregate Demand I LM1 r r2 r1 IS2 IS1 Y1 Y2 Y Response 1: Hold M constant If Congress raises G, the IS curve shifts right. If Fed holds M constant, then LM curve doesn’t shift. Results:

12. CHAPTER 10 Aggregate Demand I LM1 r LM2 IS2 IS1 Y3 Y1 Y2 Y Response 2: Hold r constant If Congress raises G, the IScurve shifts right. To keep r constant, Fed increases Mto shift LM curve right. r2 r1 Results:

13. CHAPTER 10 Aggregate Demand I LM2 LM1 r r3 r1 IS2 IS1 Y1 Y2 Y Response 3: Hold Y constant If Congress raises G, the IScurve shifts right. To keep Y constant, Fed reduces Mto shift LM curve left. r2 Results:

14. CHAPTER 10 Aggregate Demand I 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

15. CHAPTER 10 Aggregate Demand I 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.

16. CHAPTER 10 Aggregate Demand I EXERCISE:Analyze shocks with the IS-LM model Use the IS-LM model to analyze the effects of 1.a boom in the stock market that makes consumers wealthier. 2.after a wave of credit card fraud, consumers using cash more frequently in transactions. For each shock, a.use the IS-LM diagram to show the effects of the shock on Y and r. b.determine what happens to C, I, and the unemployment rate.

17. CHAPTER 10 Aggregate Demand I CASE STUDY: The U.S. recession of 2001 • During 2001, • 2.1 million people lost their jobs, as unemployment rose from 3.9% to 5.8%. • GDP growth slowed to 0.8% (compared to 3.9% average annual growth during 1994-2000).

18. CHAPTER 10 Aggregate Demand I 1500 Standard & Poor’s 500 1200 Index (1942 = 100) 900 600 300 1995 1996 1997 1998 1999 2000 2001 2002 2003 CASE STUDY: The U.S. recession of 2001 • Causes: 1) Stock market decline  C

19. CHAPTER 10 Aggregate Demand I CASE STUDY: The U.S. recession of 2001 • Causes: 2) 9/11 • increased uncertainty • fall in consumer & business confidence • result: lower spending, IS curve shifted left • Causes: 3) Corporate accounting scandals • Enron, WorldCom, etc. • reduced stock prices, discouraged investment

20. CHAPTER 10 Aggregate Demand I CASE STUDY: The U.S. recession of 2001 • Fiscal policy response: shifted IS curve right • tax cuts in 2001 and 2003 • spending increases • airline industry bailout • NYC reconstruction • Afghanistan war

21. CHAPTER 10 Aggregate Demand I 7 Three-month T-Bill Rate 6 5 4 3 2 1 0 01/01/2000 04/02/2000 01/03/2001 04/05/2001 07/06/2001 10/06/2001 01/06/2002 04/08/2002 07/09/2002 01/09/2003 04/11/2003 07/03/2000 10/03/2000 10/09/2002 CASE STUDY: The U.S. recession of 2001 • Monetary policy response: shifted LM curve right

22. CHAPTER 10 Aggregate Demand I What is the Fed’s policy instrument? • The news media commonly report the Fed’s policy changes as interest rate changes, as if the Fed has direct control over market interest rates. • In fact, the Fed targets the federal funds rate – the interest rate banks charge one another on overnight loans. • The Fed changes the money supply and shifts the LM curve to achieve its target. • Other short-term rates typically move with the federal funds rate.

23. CHAPTER 10 Aggregate Demand I What is the Fed’s policy instrument? Why does the Fed target interest rates instead of the money supply? 1) They are easier to measure than the money supply. 2) The Fed might believe that LM shocks are more prevalent than IS shocks. If so, then targeting the interest rate stabilizes income better than targeting the money supply.

24. CHAPTER 10 Aggregate Demand I IS-LM and aggregate demand • So far, we’ve been using the IS-LMmodel 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(introduced Thursday) captures this relationship between P and Y.

25. CHAPTER 10 Aggregate Demand I P r LM(P2) LM(P1) r2 r1 IS Y Y P2 P1 Deriving the AD curve Intuition for slope of AD curve: P  (M/P)  LM shifts left  r  I  Y Y1 Y2 AD Y2 Y1

26. CHAPTER 10 Aggregate Demand I r P LM(M1/P1) LM(M2/P1) r1 r2 IS Y Y Y2 Y1 P1 AD2 AD1 Y1 Y2 Monetary policy and the AD curve The Fed can increase aggregate demand: M  LM shifts right  r  I  Y at each value of P

27. CHAPTER 10 Aggregate Demand I P r LM r2 r1 IS2 IS1 Y Y Y2 Y1 P1 AD2 AD1 Y1 Y2 Fiscal policy and the AD curve Expansionary fiscal policy (G and/or T) increases agg. demand: T  C  IS shifts right  Y at each value of P

28. CHAPTER 10 Aggregate Demand I IS-LM and AD-AS in the short run & long run Recall from Chapter 9: 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 then over time, the price level will rise fall remain constant

29. CHAPTER 10 Aggregate Demand I LRAS r P LM(P1) IS1 IS2 Y Y LRAS SRAS1 P1 AD1 AD2 The SR and LR effects of an IS shock A negative IS shock shifts IS and AD left, causing Y to fall.

30. CHAPTER 10 Aggregate Demand I LRAS r P LM(P1) IS2 Y Y SRAS1 P1 AD2 The SR and LR effects of an IS shock In the new short-run equilibrium, IS1 LRAS AD1

31. CHAPTER 10 Aggregate Demand I LRAS r P LM(P1) IS2 Y Y SRAS1 P1 AD2 The SR and LR effects of an IS shock In the new short-run equilibrium, IS1 Over time, P gradually falls, which causes • SRAS to move down. • M/P to increase, which causes LMto move down. LRAS AD1

32. CHAPTER 10 Aggregate Demand I LRAS r P LM(P2) IS2 Y Y SRAS2 P2 AD2 The SR and LR effects of an IS shock LM(P1) IS1 Over time, P gradually falls, which causes • SRAS to move down. • M/P to increase, which causes LMto move down. LRAS SRAS1 P1 AD1

33. CHAPTER 10 Aggregate Demand I LRAS r P LM(P2) IS2 Y Y SRAS2 P2 AD2 The SR and LR effects of an IS shock LM(P1) This process continues until economy reaches a long-run equilibrium with IS1 LRAS SRAS1 P1 AD1

34. CHAPTER 10 Aggregate Demand I LRAS r P IS Y Y LRAS SRAS1 P1 AD1 EXERCISE:Analyze SR & LR effects of M LM(M1/P1) • Draw the IS-LM and AD-AS diagrams as shown here. • Suppose Fed increases M. Show the short-run effects on your graphs. • Show what happens in the transition from the short run to the long run. • How do the new long-run equilibrium values of the endogenous variables compare to their initial values?

35. CHAPTER 10 Aggregate Demand I Unemployment (right scale) Real GNP(left scale) The Great Depression 240 30 220 25 200 20 billions of 1958 dollars 180 15 percent of labor force 160 10 140 5 120 0 1929 1931 1933 1935 1937 1939

36. CHAPTER 10 Aggregate Demand I THE SPENDING HYPOTHESIS: Shocks to the IS curve • asserts that the Depression was largely due to an exogenous fall in the demand for goods & services – a leftward shift of the IScurve. • evidence: output and interest rates both fell, which is what a leftward IS shift would cause.

37. CHAPTER 10 Aggregate Demand I THE SPENDING HYPOTHESIS: Reasons for the IS shift • 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 made it harder to obtain financing for investment • Contractionary fiscal policy • Politicians raised tax rates and cut spending to combat increasing deficits.

38. CHAPTER 10 Aggregate Demand I THE MONEY HYPOTHESIS: A shock to the LM curve • 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/Pactually rose slightly during 1929-31. • nominal interest rates fell, which is the opposite of what a leftward LMshift would cause.

39. CHAPTER 10 Aggregate Demand I THE MONEY HYPOTHESIS AGAIN: The effects of falling prices • 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?

40. CHAPTER 10 Aggregate Demand I THE MONEY HYPOTHESIS AGAIN: The effects of falling prices • The stabilizing effects of deflation: • P  (M/P)  LMshifts right  Y • Pigou effect: P  (M/P)  consumers’ wealth   C  IS shifts right  Y

41. CHAPTER 10 Aggregate Demand I THE MONEY HYPOTHESIS AGAIN: The effects of falling prices • The destabilizing effects of expected deflation: e  r  for each value of i  I  because I= I(r)  planned expenditure & agg. demand   income & output 

42. CHAPTER 10 Aggregate Demand I THE MONEY HYPOTHESIS AGAIN: The effects of falling prices • 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

43. CHAPTER 10 Aggregate Demand I 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.

44. CHAPTER 10 Aggregate Demand I Chapter Summary • Keynesian cross • basic model of income determination • takes fiscal policy & investment as exogenous • fiscal policy has a multiplier effect on income. • IScurve • comes from Keynesian cross when planned investment depends negatively on interest rate • shows all combinations of r and Ythat equate planned expenditure with actual expenditure on goods & services CHAPTER 10 Aggregate Demand I slide 43

45. CHAPTER 10 Aggregate Demand I Chapter Summary • Theory of Liquidity Preference • basic model of interest rate determination • takes money supply & price level as exogenous • an increase in the money supply lowers the interest rate • LMcurve • comes from liquidity preference theory when money demand depends positively on income • shows all combinations of rand Y that equate demand for real money balances with supply CHAPTER 10 Aggregate Demand I slide 44

46. CHAPTER 10 Aggregate Demand I Chapter Summary 1. IS-LMmodel • a theory of aggregate demand • exogenous: M, G, T,P exogenous in short run, Y in long run • endogenous: r,Y endogenous in short run, P in long run • IScurve: goods market equilibrium • LM curve: money market equilibrium CHAPTER 11 Aggregate Demand II slide 45

47. CHAPTER 10 Aggregate Demand I Chapter Summary 2. AD curve • shows relation between Pand the IS-LMmodel’s equilibrium Y. • negative slope because P  (M/P )  r  I  Y • expansionary fiscal policy shifts IScurve right, raises income, and shifts ADcurve right. • expansionary monetary policy shifts LMcurve right, raises income, and shifts ADcurve right. • ISor LMshocks shift the ADcurve. CHAPTER 11 Aggregate Demand II slide 46

48. 13 Aggregate Supply and the Short-run Tradeoff Between Inflation and Unemployment

49. In this chapter, you will learn… • three models of aggregate supply in which output depends positively on the price level in the short run • about the short-run tradeoff between inflation and unemployment known as the Phillips curve

50. the expected price level agg. output a positive parameter natural rate of output the actual price level Three models of aggregate supply • The sticky-wage model • The imperfect-information model • The sticky-price model All three models imply: