Transcript Mankiw 6e PowerPoints

12
Aggregate Demand II:
Applying the IS-LM Model
MACROECONOMICS
N. Gregory Mankiw
PowerPoint ® Slides by Ron Cronovich
© 2013 Worth Publishers, all rights reserved
Context
 Chapter 10 introduced the model of aggregate
demand and supply.
 Chapter 11 developed the IS-LM model,
the basis of the aggregate demand curve.
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Aggregate Demand II
1
IN THIS CHAPTER, YOU WILL LEARN:
 how to use the IS-LM model to analyze the effects
of shocks, fiscal policy, and monetary policy
 how to derive the aggregate demand curve from
the IS-LM model
 several theories about what caused the
Great Depression
2
Equilibrium in the IS -LM model
The IS curve represents
equilibrium in the goods
market.
r
LM
Y  C (Y  T )  I (r )  G
The LM curve represents
money market equilibrium.
r1
M P  L(r ,Y )
Y1
The intersection determines
the unique combination of Y and r
that satisfies equilibrium in both markets.
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Aggregate Demand II
IS
Y
3
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
effects of
r1
• fiscal policy: G and/or T
• monetary policy: M
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Aggregate Demand II
IS
Y1
Y
4
An increase in government purchases
1. IS curve shifts right
1
by
G
1  MPC
causing output &
income to rise.
2. This raises money
demand, causing the
interest rate to rise…
r
2.
r2
r1
3. …which reduces investment,
so the final increase in Y
1
is smaller than
G
1  MPC
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Aggregate Demand II
LM
IS2
1.
IS1
Y1 Y2
Y
3.
5
A tax cut
Consumers save (1MPC)
r
of the tax cut, so the initial
boost in spending is
smaller for T than for an
r2
equal G…
2.
r1
and the IS curve shifts by
1.
LM
1.
MPC
T
1  MPC
2. …so the effects on r
and Y are smaller for T
than for an equal G.
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Aggregate Demand II
IS2
IS1
Y1 Y2
Y
2.
6
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.
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Aggregate Demand II
r
LM1
LM2
r1
r2
IS
Y1 Y2
Y
7
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 interactions may alter the impact of the
original policy change.
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Aggregate Demand II
8
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 G
are different…
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Aggregate Demand II
9
Response 1: Hold M constant
If Congress raises G,
the IS curve shifts right.
r
If Fed holds M constant,
then LM curve doesn’t
shift.
r2
r1
LM1
IS2
IS1
Results:
Y  Y2  Y1
r  r2  r1
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Aggregate Demand II
Y1 Y2
Y
10
Response 2: Hold r constant
If Congress raises G,
the IS curve shifts right.
To keep r constant,
Fed increases M
to shift LM curve right.
r
LM1
r2
r1
IS2
IS1
Results:
Y  Y3  Y1
LM2
Y1 Y2 Y3
Y
r  0
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Aggregate Demand II
11
Response 3: Hold Y constant
If Congress raises G,
the IS curve shifts right.
To keep Y constant,
Fed reduces M
to shift LM curve left.
LM2
LM1
r
r3
r2
r1
IS2
IS1
Results:
Y  0
Y1 Y2
Y
r  r3  r1
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Aggregate Demand II
12
Estimates of fiscal policy multipliers
from the DRI macroeconometric model
Assumption about
monetary policy
Estimated
value of
Y / G
Estimated
value of
Y / T
Fed holds money
supply constant
0.60
0.26
Fed holds nominal
interest rate constant
1.93
1.19
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Aggregate Demand II
13
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
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Aggregate Demand II
14
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.
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Aggregate Demand II
15
NOW YOU TRY
Analyze shocks with the IS-LM model
Use the IS-LM model to analyze the effects of
1. a housing market crash that reduces
consumers’ wealth
2. consumers using cash in transactions more
frequently in response to an increase in identity
theft
For each shock,
a. use the IS-LM diagram to determine the effects
on Y and r.
b. figure out what happens to C, I, and the
unemployment rate.
16
ANSWERS, PART 1
Housing market crash
IS shifts left, causing
r and Y to fall.
C falls due to lower
wealth and lower
income,
I rises because
r
LM1
r1
r2
r is lower
u
rises because
Y is lower
(Okun’s law)
IS2
Y2 Y1
IS1
Y
17
ANSWERS, PART 2
Increase in money demand
LM shifts left, causing
C falls due to lower
income,
I falls because
LM2
r
r to rise and Y to fall.
LM1
r2
r1
r is higher
u
rises because
Y is lower
(Okun’s law)
IS1
Y2 Y1
Y
18
CASE STUDY:
The U.S. recession of 2001
 During 2001:
 2.1 million jobs lost,
unemployment rose from 3.9% to 5.8%.
 GDP growth slowed to 0.8%
(compared to 3.9% average annual growth
during 1994–2000).
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Aggregate Demand II
19
CASE STUDY:
The U.S. recession of 2001
Index (1942 = 100)
Causes: 1) Stock market decline  C
1,500
Standard & Poor’s
500
1,200
900
600
300
1995
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1996
1997
1998
Aggregate Demand II
1999
2000
2001
2002
2003
20
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
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Aggregate Demand II
21
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
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Aggregate Demand II
22
CASE STUDY:
The U.S. recession of 2001
Monetary policy response: shifted LM curve right
7
6
Three-month
T-Bill rate
5
4
3
2
1
0
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Aggregate Demand II
23
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.
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Aggregate Demand II
24
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.
(See problem 7 on p.353.)
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Aggregate Demand II
25
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
(introduced in Chap. 10) captures this
relationship between P and Y.
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Aggregate Demand II
26
Deriving the AD curve
r
Intuition for slope
of AD curve:
P  (M/P )
 LM shifts left
 r
 I
 Y
LM(P2)
LM(P1)
r2
r1
IS
P
Y2
Aggregate Demand II
Y
P2
P1
AD
Y2
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Y1
Y1
Y
27
Monetary policy and the AD curve
The Fed can increase
aggregate demand:
M  LM shifts right
r
LM(M1/P1)
LM(M2/P1)
r1
r2
IS
 r
 I
P
 Y at each
value of P
P1
Y1
Y1
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Aggregate Demand II
Y2
Y2
Y
AD2
AD1
Y
28
Fiscal policy and the AD curve
Expansionary fiscal
policy (G and/or T )
increases agg. demand:
r
LM
r2
r1
IS2
T  C
IS1
 IS shifts right
P
 Y at each
value of P
P1
Y1
Y1
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Aggregate Demand II
Y2
Y2
Y
AD2
AD1
Y
29
IS-LM and AD-AS
in the short run & long run
Recall from Chapter 10: 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
CHAPTER 12
then over time, the
price level will
Y Y
Y Y
rise
Y Y
remain constant
Aggregate Demand II
fall
30
The SR and LR effects of an IS shock
r
A negative IS shock
shifts IS and AD left,
causing Y to fall.
LRAS LM(P )
1
IS2
Y
P
SRAS1
Y
Aggregate Demand II
Y
LRAS
P1
CHAPTER 12
IS1
AD1
AD2
Y
31
The SR and LR effects of an IS shock
r
LRAS LM(P )
1
In the new short-run
equilibrium, Y  Y
IS2
Y
P
SRAS1
Y
Aggregate Demand II
Y
LRAS
P1
CHAPTER 12
IS1
AD1
AD2
Y
32
The SR and LR effects of an IS shock
r
LRAS LM(P )
1
In the new short-run
equilibrium, Y  Y
IS2
Over time, P gradually
falls, causing:
• SRAS to move down
• M/P to increase,
Y
P
P1
SRAS1
Y
Aggregate Demand II
Y
LRAS
which causes LM
to move down
CHAPTER 12
IS1
AD1
AD2
Y
33
The SR and LR effects of an IS shock
r
LRAS LM(P )
1
LM(P2)
IS2
Over time, P gradually
falls, causing:
• SRAS to move down
• M/P to increase,
Y
P
P1
SRAS1
P2
SRAS2
Y
Aggregate Demand II
Y
LRAS
which causes LM
to move down
CHAPTER 12
IS1
AD1
AD2
Y
34
The SR and LR effects of an IS shock
r
LRAS LM(P )
1
LM(P2)
This process continues
until economy reaches a
long-run equilibrium with
Y Y
IS2
Y
P
Aggregate Demand II
Y
LRAS
P1
SRAS1
P2
SRAS2
Y
CHAPTER 12
IS1
AD1
AD2
Y
35
NOW YOU TRY
Analyze SR & LR effects of M
a. Draw the IS-LM and AD-AS
r
LRAS LM(M /P )
1
1
diagrams as shown here.
b. Suppose Fed increases M.
IS
Show the short-run effects
on your graphs.
Y
c. Show what happens in the
transition from the short run
to the long run.
d. How do the new long-run
equilibrium values of the
endogenous variables
compare to their initial
values?
P
Y
LRAS
P1
SRAS1
AD1
Y
Y
36
ANSWERS, PART 1
Short-run effects of M
LM and AD shift right.
r falls, Y rises above Y
r
LRAS LM(M /P )
1
1
LM(M2/P1)
r1
r2
IS
Y Y2
P
Y
LRAS
P1
SRAS
Y
AD2
AD1
Y2 Y
37
ANSWERS, PART 2
Transition from short run to long run
Over time,




r
LRAS LM(M /P )
1
1
2
3
LM(M2/P1)
r3 = r1
r2
SRAS moves upward
P rises
IS
M/P falls
LM moves leftward
New long-run eq’m
Y Y2
P
P3
P1
 P higher
 all real variables back at
their initial values
Money is neutral in the long run.
Y
LRAS
SRAS
SRAS
Y
AD2
AD1
Y2 Y
38
The Great Depression
30
Unemployment
(right scale)
220
25
200
20
180
15
160
10
Real GNP
(left scale)
140
120
1929
5
0
1931
1933
1935
1937
1939
percent of labor force
billions of 1958 dollars
240
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 IS curve.
 Evidence:
output and interest rates both fell, which is what
a leftward IS shift would cause.
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Aggregate Demand II
40
THE SPENDING HYPOTHESIS:
Reasons for the IS shift
 Stock market crash  exogenous C
 Oct 1929–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.
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Aggregate Demand II
41
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/P actually rose slightly
during 1929–31.
 nominal interest rates fell, which is the opposite
of what a leftward LM shift would cause.
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Aggregate Demand II
42
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?
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Aggregate Demand II
43
THE MONEY HYPOTHESIS AGAIN:
The effects of falling prices
 The stabilizing effects of deflation:
 P  (M/P )  LM shifts right  Y
 Pigou effect:
P
 (M/P )
 consumers’ wealth 
 C
 IS shifts right
 Y
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Aggregate Demand II
44
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 
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Aggregate Demand II
45
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
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Aggregate Demand II
46
Why another Depression is unlikely
 Policymakers (or their advisers) 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.
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Aggregate Demand II
47
CASE STUDY
The 2008–09 financial crisis & recession
 2009: Real GDP fell, u-rate approached 10%
 Important factors in the crisis:
 early 2000s Federal Reserve interest rate policy
 subprime 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
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Aggregate Demand II
48
Interest rates and house prices
9
8
170
interest rate (%)
7
6
150
5
130
4
110
3
90
2
70
1
0
2000
2001
2002
2003
2004
50
2005
House price index, 2000 = 100
Federal Funds rate
30-year mortgage rate
190
Case-Shiller 20-city composite house price index
Change in U.S. house price index
and rate of new foreclosures, 1999–2009
14%
1.4
10%
1.2
8%
1.0
6%
0.8
4%
2%
0.6
0%
0.4
-2%
0.2
-4%
-6%
1999
0.0
2001
2003
2005
2007
2009
New foreclosure starts
(% of total mortgages)
Percent change in house prices
(from 4 quarters earlier)
12%
US house price index
New foreclosures
House price change and new foreclosures,
2006:Q3–2009:Q1
20%
New foreclosures,
% of all mortgages
18%
Nevada
Florida
16%
14%
Illinois
Michigan
Ohio
California
Georgia
12%
10%
8%
6%
Arizona
Colorado
Rhode Island
New Jersey
S. Dakota
Hawaii
4%
Oregon
Alaska
2%
0%
-40%
Texas
-30%
-20%
-10%
0%
Wyoming
N. Dakota
10%
Cumulative change in house price index
20%
U.S. bank failures by year, 2000–2011
160
Number of bank failures
140
120
100
80
60
40
20
0
2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011
100%
7/20/2009
120%
11/11/2008
140%
3/5/2008
(% change from 52 weeks earlier)
6/28/2007
10/20/2006
2/11/2006
6/5/2005
9/27/2004
1/20/2004
5/14/2003
9/5/2002
12/28/2001
4/21/2001
8/13/2000
12/6/1999
Major U.S. stock indexes
DJIA
S&P 500
NASDAQ
80%
60%
40%
20%
0%
-20%
-40%
-60%
-80%
Consumer sentiment and growth in consumer
durables and investment spending
110
15%
10%
100
5%
90
0%
80
-5%
-10%
70
-15%
Durables
-20%
Investment
60
UM Consumer Sentiment Index
-25%
1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009
50
Consumer Sentiment Index, 1966 = 100
% change from four quarters earlier
20%
Real GDP growth and unemployment
10
10
Real GDP growth rate (left scale)
Unemployment rate (right scale)
8
8
6
6
4
2
4
0
-2
2
-4
-6
1995
1997
1999
2001
2003
2005
2007
2009
0
2011
% of labor force
% change from 4 quarters earlier
12
CHAPTER SUMMARY
1. IS-LM model
 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
 IS curve: goods market equilibrium
 LM curve: money market equilibrium
56
CHAPTER SUMMARY
2. AD curve
 shows relation between P and the IS-LM model’s
equilibrium Y.
 negative slope because
P  (M/P )  r  I  Y
 expansionary fiscal policy shifts IS curve right,
raises income, and shifts AD curve right.
 expansionary monetary policy shifts LM curve right,
raises income, and shifts AD curve right.
 IS or LM shocks shift the AD curve.
57