Transcript Mankiw 5/e Chapter 10: Aggregate Demand I

macro
CHAPTER TEN
Aggregate Demand I
macroeconomics
fifth edition
N. Gregory Mankiw
PowerPoint® Slides
by Ron Cronovich
© 2004 Worth Publishers, all rights reserved
The Big Picture
Keynesian
Cross
Theory of
Liquidity
Preference
IS
curve
LM
curve
IS-LM
model
Agg.
demand
curve
Agg.
supply
curve
CHAPTER 10
Aggregate Demand I
Explanation
of short-run
fluctuations
Model of
Agg.
Demand
and Agg.
Supply
slide 1
Context
 Chapter 9 introduced the model of aggregate
demand and aggregate supply.
 Long run
– prices flexible
– output determined by factors of production &
technology
– unemployment equals its natural rate
 Short run
– prices fixed
– output determined by aggregate demand
– unemployment is negatively related to output
CHAPTER 10
Aggregate Demand I
slide 3
Context
 This chapter develops the IS-LM model,
the theory that yields the aggregate demand
curve.
 We focus on the short run and assume the
price level is fixed.
 This chapter (and chapter 11) focus on the
closed-economy case. Chapter 12 presents
the open-economy case.
CHAPTER 10
Aggregate Demand I
slide 4
The Keynesian Cross
 A simple closed economy model in which
income is determined by expenditure.
(due to J.M. Keynes)
 Notation:
I = planned investment
E = C + I + G = planned expenditure
Y = real GDP = actual expenditure
 Difference between actual & planned
expenditure: unplanned inventory investment
CHAPTER 10
Aggregate Demand I
slide 5
Elements of the Keynesian Cross
consumption function:
C  C (Y T )
govt policy variables:
G  G , T T
for now, planned
investment is exogenous:
planned expenditure:
I I
E  C (Y T )  I  G
Equilibrium condition:
Actual expenditure  Planned expenditure
Y  E
CHAPTER 10
Aggregate Demand I
slide 6
Graphing planned expenditure
E
planned
expenditure
E =C +I +G
MPC
1
income, output, Y
CHAPTER 10
Aggregate Demand I
slide 7
Graphing the equilibrium condition
E
E =Y
planned
expenditure
45º
income, output, Y
CHAPTER 10
Aggregate Demand I
slide 8
The equilibrium value of income
E
E =Y
planned
expenditure
E =C +I +G
income, output, Y
Equilibrium
income
CHAPTER 10
Aggregate Demand I
slide 9
An increase in government purchases
E
At Y1,
there is now an
unplanned drop
in inventory…
E =C +I +G2
E =C +I +G1
G
…so firms
increase output,
and income
rises toward a
new equilibrium
CHAPTER 10
Y
E1 = Y1
Y
Aggregate Demand I
E2 = Y 2
slide 10
Solving for Y
Y  C  I  G
equilibrium condition
Y  C  I  G
in changes

C
 G
 MPC  Y  G
Collect terms with Y
on the left side of the
equals sign:
(1  MPC) Y  G
CHAPTER 10
because I exogenous
because C = MPC Y
Finally, solve for Y :


1
Y  
  G
 1  MPC 
Aggregate Demand I
slide 11
The government purchases multiplier
Definition: the increase in income resulting
from a $1 increase in G.
In this model, the govt purchases
multiplier equals Y
1

G
1  MPC
Example: If MPC = 0.8, then
An increase in G
Y
1

 5
causes income to
G
1  0.8
increase by 5 times
as much!
CHAPTER 10
Aggregate Demand I
slide 12
Why the multiplier is greater than 1
 Initially, the increase in G causes an equal
increase in Y:
 Y =  G.
 But Y
 C
 further Y
 further C
 further Y
 So the final impact on income is much
bigger than the initial G.
CHAPTER 10
Aggregate Demand I
slide 13
An increase in taxes
E
Initially, the tax
increase reduces
consumption, and
therefore E:
E =C1 +I +G
E =C2 +I +G
At Y1, there is now
an unplanned
inventory buildup…
C = MPC T
…so firms
reduce output,
and income falls
toward a new
equilibrium
CHAPTER 10
Y
E2 = Y2
Y
Aggregate Demand I
E1 = Y1
slide 14
Solving for Y
eq’m condition in
changes
Y  C  I  G
 C
I and G exogenous
 MPC   Y  T
Solving for Y :
Final result:
CHAPTER 10

(1  MPC) Y   MPC  T
  MPC 
Y  
  T
 1  MPC 
Aggregate Demand I
slide 15
The Tax Multiplier
def: the change in income resulting from
a $1 increase in T :
Y
 MPC

T
1  MPC
If MPC = 0.8, then the tax multiplier equals
Y
 0.8
 0.8


 4
T
1  0.8
0.2
CHAPTER 10
Aggregate Demand I
slide 16
The Tax Multiplier
…is negative:
A tax hike reduces
consumer spending,
which reduces income.
…is greater than one
(in absolute value):
A change in taxes has a
multiplier effect on income.
…is smaller than the govt spending multiplier:
Consumers save the fraction (1-MPC) of a tax cut,
so the initial boost in spending from a tax cut is
smaller than from an equal increase in G.
CHAPTER 10
Aggregate Demand I
slide 17
Exercise:
 Use a graph of the Keynesian Cross
to show the impact of an increase in
planned investment on the equilibrium
level of income/output.
CHAPTER 10
Aggregate Demand I
slide 18
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:
Y  C (Y T )  I (r )  G
CHAPTER 10
Aggregate Demand I
slide 19
Deriving the IS curve
E =Y E =C +I (r )+G
2
E
E =C +I (r1 )+G
 r  I
 E
 Y
I
r
Y1
Y
Y2
r1
r2
IS
Y1
CHAPTER 10
Y2
Aggregate Demand I
Y
slide 20
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.
CHAPTER 10
Aggregate Demand I
slide 21
The IS curve and the Loanable Funds model
(b) The IS curve
(a) The L.F. model
r
S2
r
S1
r2
r2
r1
r1
I (r )
S, I
CHAPTER 10
Aggregate Demand I
IS
Y2
Y1
Y
slide 22
Fiscal Policy and the IS curve
 We can use the IS-LM model to see
how fiscal policy (G and T ) can affect
aggregate demand and output.
 Let’s start by using the Keynesian Cross
to see how fiscal policy shifts the IS
curve…
CHAPTER 10
Aggregate Demand I
slide 23
Shifting the IS curve: G
At any value of r,
G  E  Y
…so the IS curve
shifts to the right.
The horizontal
distance of the
IS shift equals
E =Y E =C +I (r )+G
1
2
E
E =C +I (r1 )+G1
r
Y1
r1
1
Y 
G
1  MPC
Y
Y1
CHAPTER 10
Y
Y2
IS1
Y2
Aggregate Demand I
IS2
Y
slide 24
Exercise: Shifting the IS curve
 Use the diagram of the Keynesian Cross
or Loanable Funds model to show how
an increase in taxes shifts the IS curve.
CHAPTER 10
Aggregate Demand I
slide 25
The Theory of Liquidity Preference
 due to John Maynard Keynes.
 A simple theory in which the interest rate
is determined by money supply and
money demand.
CHAPTER 10
Aggregate Demand I
slide 26
Money Supply
The supply of
real money
balances
is fixed:
M
r
interest
rate
M
P
s
P M P
s
M P
CHAPTER 10
Aggregate Demand I
M/P
real money
balances
slide 27
Money Demand
r
Demand for
real money
balances:
M
P
d
interest
rate
M
P
s
 L (r )
L (r )
M P
CHAPTER 10
Aggregate Demand I
M/P
real money
balances
slide 28
Equilibrium
The interest
rate adjusts
to equate the
supply and
demand for
money:
M P  L(r )
r
interest
rate
M
P
r1
L (r )
M P
CHAPTER 10
s
Aggregate Demand I
M/P
real money
balances
slide 29
How the Fed raises the interest rate
r
interest
rate
To increase r,
Fed reduces M
r2
r1
L (r )
M2
P
CHAPTER 10
Aggregate Demand I
M1
P
M/P
real money
balances
slide 30
CASE STUDY
Volcker’s Monetary Tightening
 Late 1970s:  > 10%
 Oct 1979: Fed Chairman Paul Volcker
announced that monetary policy
would aim to reduce inflation.
 Aug 1979-April 1980:
Fed reduces M/P 8.0%
 Jan 1983:  = 3.7%
How do you think this policy change
would affect interest rates?
CHAPTER 10
Aggregate Demand I
slide 31
Volcker’s Monetary Tightening, cont.
The effects of a monetary tightening
on nominal interest rates
model
short run
long run
Liquidity Preference
Quantity Theory,
Fisher Effect
(Keynesian)
(Classical)
prices
sticky
flexible
prediction
i > 0
i < 0
actual
outcome
8/1979: i = 10.4%
4/1980: i = 15.8%
1/1983: i = 8.2%
CHAPTER 10
Aggregate Demand I
slide 32
The LM curve
Now let’s put Y back into the money demand
function:
d
M
P
 L (r ,Y )
The LM curve is a graph of all combinations of
r and Y that equate the supply and demand
for real money balances.
The equation for the LM curve is:
M P  L(r ,Y )
CHAPTER 10
Aggregate Demand I
slide 33
Deriving the LM curve
(a) The market for
r
real money balances
(b) The LM curve
r
LM
r2
r2
L (r , Y2 )
r1
r1
L (r , Y1 )
M1
P
CHAPTER 10
M/P
Aggregate Demand I
Y1
Y2
Y
slide 34
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.
CHAPTER 10
Aggregate Demand I
slide 35
How M shifts the LM curve
(a) The market for
r
real money balances
(b) The LM curve
r
LM2
LM1
r2
r2
r1
r1
L ( r , Y1 )
M2
P
CHAPTER 10
M1
P
M/P
Aggregate Demand I
Y1
Y
slide 36
Exercise: Shifting the LM curve
 Suppose a wave of credit card fraud
causes consumers to use cash more
frequently in transactions.
 Use the Liquidity Preference model
to show how these events shift the
LM curve.
CHAPTER 10
Aggregate Demand I
slide 37
The short-run equilibrium
The short-run equilibrium is
the combination of r and Y
that simultaneously satisfies
the equilibrium conditions in
the goods & money markets:
r
Y  C (Y T )  I (r )  G
LM
IS
Y
M P  L(r ,Y )
Equilibrium
interest
rate
CHAPTER 10
Aggregate Demand I
Equilibrium
level of
income
slide 38
The Big Picture
Keynesian
Cross
Theory of
Liquidity
Preference
IS
curve
LM
curve
IS-LM
model
Agg.
demand
curve
Agg.
supply
curve
CHAPTER 10
Aggregate Demand I
Explanation
of short-run
fluctuations
Model of
Agg.
Demand
and Agg.
Supply
slide 39
Chapter summary
1. Keynesian Cross
 basic model of income determination
 takes fiscal policy & investment as exogenous
 fiscal policy has a multiplier effect on income.
2. IS curve
 comes from Keynesian Cross when planned
investment depends negatively on interest rate
 shows all combinations of r and Y
that equate planned expenditure with
actual expenditure on goods & services
CHAPTER 10
Aggregate Demand I
slide 40
Chapter summary
3. 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
4. LM curve
 comes from Liquidity Preference Theory when
money demand depends positively on income
 shows all combinations of r andY that equate
demand for real money balances with supply
CHAPTER 10
Aggregate Demand I
slide 41
Chapter summary
5. IS-LM model
 Intersection of IS and LM curves shows the
unique point (Y, r ) that satisfies equilibrium
in both the goods and money markets.
CHAPTER 10
Aggregate Demand I
slide 42
Preview of Chapter 11
In Chapter 11, we will
 use the IS-LM model to analyze the impact
of policies and shocks
 learn how the aggregate demand curve
comes from IS-LM
 use the IS-LM and AD-AS models together
to analyze the short-run and long-run
effects of shocks
 use our models to learn about
the Great Depression
CHAPTER 10
Aggregate Demand I
slide 43
CHAPTER 10
Aggregate Demand I
slide 44
macro
CHAPTER TEN
Aggregate Demand I
macroeconomics
fifth edition
N. Gregory Mankiw
PowerPoint® Slides
by Ron Cronovich
© 2004 Worth Publishers, all rights reserved
Context
 Chapter 9 introduced the model of aggregate
demand and supply.
 Chapter 10 developed the IS-LM model, the
basis of the aggregate demand curve.
 In Chapter 11, we will use the IS-LM model to
– see how policies and shocks affect income
and the interest rate in the short run when
prices are fixed
– derive the aggregate demand curve
– explore various explanations for the
Great Depression
CHAPTER 10
Aggregate Demand I
slide 46
Equilibrium in the IS-LM Model
The IS curve represents
equilibrium in the goods
market.
Y  C (Y T )  I (r )  G
r
LM
The LM curve represents r1
money market equilibrium.
IS
M P  L(r ,Y )
Y1
The intersection determines
the unique combination of Y and r
that satisfies equilibrium in both markets.
CHAPTER 10
Aggregate Demand I
Y
slide 47
Policy analysis with the IS-LM Model
Y  C (Y T )  I (r )  G
r
LM
M P  L(r ,Y )
Policymakers can affect
macroeconomic variables
r1
with
• fiscal policy: G and/or T
• monetary policy: M
We can use the IS-LM
model to analyze the
effects of these policies.
CHAPTER 10
Aggregate Demand I
IS
Y1
Y
slide 48
An increase in government purchases
r
1. IS curve shifts right
1
by
G
1  MPC
causing output &
income to rise.
2. This raises money
2.
LM
r2
r1
3. …which reduces investment,
so the final increase in Y
1
is smaller than
G
1  MPC
CHAPTER 10
Aggregate Demand I
IS2
1.
demand, causing the
interest rate to rise…
IS1
Y1 Y2
Y
3.
slide 49
A tax cut
Because consumers save
(1MPC) of the tax cut,
the initial boost in
spending is smaller for T
than for an equal G…
and the IS curve
shifts by
MPC
1.
T
1  MPC
r
r2
2.
r1
2. …so the effects on r and Y
are smaller for a T than
for an equal G.
CHAPTER 10
LM
Aggregate Demand I
1.
IS2
IS1
Y1 Y2
Y
2.
slide 50
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
r
LM2
r1
r2
3. …which increases
investment, causing
output & income to
rise.
CHAPTER 10
LM1
Aggregate Demand I
IS
Y1 Y2
Y
slide 51
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 interaction may alter the impact of
the original policy change.
CHAPTER 10
Aggregate Demand I
slide 52
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:
CHAPTER 10
Aggregate Demand I
slide 53
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.
r
LM1
r2
r1
IS2
IS1
Results:
Y  Y2  Y1
Y1 Y2
Y
r  r2  r1
CHAPTER 10
Aggregate Demand I
slide 54
Response 2: hold r constant
If Congress raises G,
the IS curve shifts
right
r
To keep r constant,
Fed increases M to
shift LM curve right.
r2
r1
LM1
IS2
IS1
Results:
Y  Y3  Y1
LM2
Y1 Y2 Y3
Y
r  0
CHAPTER 10
Aggregate Demand I
slide 55
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
CHAPTER 10
Aggregate Demand I
slide 56
Estimates of fiscal policy multipliers
from the DRI macroeconometric model
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
Assumption about
monetary policy
CHAPTER 10
Aggregate Demand I
slide 57
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
CHAPTER 10
Aggregate Demand I
slide 58
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
CHAPTER 10
Aggregate Demand I
slide 59
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 makes
consumers wealthier.
2. After a wave of credit card fraud, consumers
use 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.
CHAPTER 10
Aggregate Demand I
slide 60
CASE STUDY
The U.S. economic slowdown of 2001
~What happened~
1. Real GDP growth rate
1994-2000: 3.9% (average annual)
2001: 0.8% for the year,
March 2001 determined to be the end of
the longest expansion on record.
2. Unemployment rate
Dec 2000: 3.9%
Dec 2001: 5.8%
The number of unemployed people
rose by 2.1 million during 2001!
CHAPTER 10
Aggregate Demand I
slide 61
CASE STUDY
The U.S. economic slowdown of 2001
~Shocks that contributed to the slowdown~
1. Falling stock prices
From Aug 2000 to Aug 2001: -25%
Week after 9/11: -12%
2. The terrorist attacks on 9/11
• increased uncertainty
• fall in consumer & business confidence
Both shocks reduced spending and
shifted the IS curve left.
CHAPTER 10
Aggregate Demand I
slide 62
CASE STUDY
The U.S. economic slowdown of 2001
~The policy response~
1. Fiscal policy
• large long-term tax cut,
immediate $300 rebate checks
• spending increases:
aid to New York City & the airline industry,
war on terrorism
2. Monetary policy
• Fed lowered its Fed Funds rate target
11 times during 2001, from 6.5% to 1.75%
• Money growth increased, interest rates fell
CHAPTER 10
Aggregate Demand I
slide 63
CASE STUDY
The U.S. economic slowdown of 2001
~The recovery~
 The recession officially ended in November
2001.
 Real GDP recovered, growing
2.3% in 2002 and 4.4% in 2003.
 The unemployment rate lagged:
5.8% in 2002, 6.0% in 2003.
 The Fed cut interest rates in 11/02 and 6/03.
 Unemployment finally appears to be
responding: 5.6% for the first half of 2004.
CHAPTER 10
Aggregate Demand I
slide 64
What is the Fed’s policy instrument?
What the newspaper says:
“the Fed lowered interest rates by one-half point today”
What actually happened:
The Fed conducted expansionary monetary policy to
shift the LM curve to the right until the interest rate fell
0.5 points.
The Fed targets the Federal Funds rate:
it announces a target value,
and uses monetary policy to shift the LM curve
as needed to attain its target rate.
CHAPTER 10
Aggregate Demand I
slide 65
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.306)
CHAPTER 10
Aggregate Demand I
slide 66
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 the LM
curve and therefore affect Y.
 The aggregate demand curve
(introduced in chap. 9 ) captures this
relationship between P and Y
CHAPTER 10
Aggregate Demand I
slide 67
Deriving the AD curve
Intuition for slope
of AD curve:
P  (M/P )
 LM shifts left
 r
 I
 Y
r
LM(P2)
LM(P1)
r2
r1
IS
P
Y2
Y
P2
P1
AD
Y2
CHAPTER 10
Y1
Aggregate Demand I
Y1
Y
slide 68
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
CHAPTER 10
Aggregate Demand I
Y2
Y2
Y
AD2
AD1
Y
slide 69
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
Y1
Y2
Y
 Y at each
value
P1
of P
Y1
CHAPTER 10
Aggregate Demand I
Y2
AD2
AD1
Y
slide 70
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
Y Y
Y Y
rise
Y Y
remain constant
CHAPTER 10
fall
Aggregate Demand I
slide 71
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 I
Y
LRAS
P1
CHAPTER 10
IS1
AD1
AD2
Y
slide 72
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 I
Y
LRAS
P1
CHAPTER 10
IS1
AD1
AD2
Y
slide 73
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,
which causes
• SRAS to move down
• M/P to increase,
which causes LM
to move down
CHAPTER 10
Y
P
Y
LRAS
P1
Aggregate Demand I
IS1
SRAS1
Y
AD1
AD2
Y
slide 74
The SR and LR effects of an IS shock
r
LRAS LM(P )
1
LM(P2)
IS2
Over time,
P gradually falls,
which causes
• SRAS to move down
• M/P to increase,
which causes LM
to move down
CHAPTER 10
Y
P
IS1
Y
LRAS
P1
SRAS1
P2
SRAS2
Aggregate Demand I
Y
AD1
AD2
Y
slide 75
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
Y
LRAS
P1
SRAS1
P2
SRAS2
Y
CHAPTER 10
IS1
Aggregate Demand I
AD1
AD2
Y
slide 76
EXERCISE:
Analyze SR & LR effects of M
a. Draw the IS-LM and AD-AS r
diagrams as shown here.
LRAS LM(M /P )
1
1
b. Suppose Fed increases M.
Show the short-run effects
on your graphs.
c. Show what happens in the
transition from the short
P
run to the long run.
d. How do the new long-run
P1
equilibrium values of the
endogenous variables
compare to their initial
values?
CHAPTER 10
Aggregate Demand I
IS
Y
Y
LRAS
SRAS1
AD1
Y
Y
slide 77
The Great Depression
220
billions of 1958 dollars
30
Unemployment
(right scale)
25
200
20
180
15
160
10
Real GNP
(left scale)
140
120
1929
percent of labor force
240
5
0
1931
CHAPTER 10
1933
1935
Aggregate Demand I
1937
1939
slide 78
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
CHAPTER 10
Aggregate Demand I
slide 79
The Spending Hypothesis:
Reasons for the IS shift
1. Stock market crash  exogenous C
 Oct-Dec 1929: S&P 500 fell 17%
 Oct 1929-Dec 1933: S&P 500 fell 71%
2. Drop in investment
 “correction” after overbuilding in the 1920s
 widespread bank failures made it harder to
obtain financing for investment
3. Contractionary fiscal policy
 in the face of falling tax revenues and
increasing deficits, politicians raised tax rates
and cut spending
CHAPTER 10
Aggregate Demand I
slide 80
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:
1. P fell even more, so M/P actually rose
slightly during 1929-31.
2. nominal interest rates fell, which is the
opposite of what would result from a
leftward LM shift.
CHAPTER 10
Aggregate Demand I
slide 81
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?
CHAPTER 10
Aggregate Demand I
slide 82
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
CHAPTER 10
Aggregate Demand I
slide 83
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
CHAPTER 10
Aggregate Demand I
slide 84
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 
CHAPTER 10
Aggregate Demand I
slide 85
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.
CHAPTER 10
Aggregate Demand I
slide 86
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
CHAPTER 10
Aggregate Demand I
slide 87
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
CHAPTER 10
Aggregate Demand I
slide 88
CHAPTER 10
Aggregate Demand I
slide 89
macro
CHAPTER TWELVE
CHAPTER TEN
Aggregate
AggregateDemand
Demand I
in the Open Economy
macroeconomics
fifth edition
N. Gregory Mankiw
PowerPoint® Slides
by Ron Cronovich
© 2004 Worth Publishers, all rights reserved
Learning objectives
 The Mundell-Fleming model:
IS-LM for the small open economy
 Causes and effects of interest rate
differentials
 Arguments for fixed vs. floating
exchange rates
 The aggregate demand curve for the
small open economy
CHAPTER 10
Aggregate Demand I
slide 91
The Mundell-Fleming Model
 Key assumption:
Small open economy with perfect capital
mobility.
r = r*
 Goods market equilibrium---the IS* curve:
Y  C (Y T )  I (r *)  G  NX (e )
where
e = nominal exchange rate
= foreign currency per unit of domestic
currency
CHAPTER 10
Aggregate Demand I
slide 92
The IS* curve: Goods Market Eq’m
Y  C (Y T )  I (r *)  G  NX (e )
The IS* curve is
drawn for a given
value of r*.
e
Intuition
forNX
the 
slope:
e  
Y
IS*
Y
CHAPTER 10
Aggregate Demand I
slide 93
The LM* curve: Money Market Eq’m
M P  L (r *,Y )
The LM* curve
 is drawn for a given
value of r*
 is vertical because:
given r*, there is
only one value of Y
e
that equates money
demand with
supply,
regardless
of e.
CHAPTER
10 Aggregate
Demand I
LM*
Y
slide 94
Equilibrium in the Mundell-Fleming model
Y  C (Y T )  I (r *)  G  NX (e )
M P  L (r *,Y )
e
LM*
equilibrium
exchange
rate
equilibrium
level of
income
CHAPTER 10
Aggregate Demand I
IS*
Y
slide 95
Floating & fixed exchange rates
 In a system of floating exchange rates,
e is allowed to fluctuate in response to
changing economic conditions.
 In contrast, under fixed exchange
rates, the central bank trades domestic
for foreign currency at a predetermined
price.
 We now consider fiscal, monetary, and
trade policy: first in a floating exchange
rate system, then in a fixed exchange rate
system.
CHAPTER 10 Aggregate Demand I
slide 96
Fiscal policy under floating exchange rates
Y  C (Y T )  I (r *)  G  NX (e )
M P  L (r *,Y )
At any given value of e,
a fiscal expansion
increases Y,
shifting IS* to the right.
e
LM1*
e2
e1
IS 2*
Results:
e > 0, Y = 0
CHAPTER 10
Aggregate Demand I
IS 1*
Y1
Y
slide 97
Lessons about fiscal policy
 In a small open economy with perfect capital
mobility, fiscal policy cannot affect real GDP.
 “Crowding out”
• closed economy:
Fiscal policy crowds out investment by
causing the interest rate to rise.
• small open economy:
Fiscal policy crowds out net exports by
causing the exchange rate to appreciate.
CHAPTER 10
Aggregate Demand I
slide 98
Mon. policy under floating exchange rates
Y  C (Y T )  I (r *)  G  NX (e )
M P  L (r *,Y )
e
An increase in M
shifts LM* right
because Y must rise
to restore eq’m in the
money
Results:market.
e1
e2
e < 0, Y > 0
CHAPTER 10
LM1*LM 2*
Aggregate Demand I
IS 1*
Y1 Y2
Y
slide 99
Lessons about monetary policy
 Monetary policy affects output by affecting
one (or more) of the components of aggregate
demand:
closed economy: M  r  I  Y
small open economy: M  e  NX 
Y
 Expansionary mon. policy does not raise world
aggregate demand, it shifts demand from
foreign to domestic products.
Thus, the increases in income and employment
at home come at the expense of losses
CHAPTER 10
Aggregate Demand I
slide 100
Trade policy under floating exchange rates
Y  C (Y T )  I (r *)  G  NX (e )
M P  L (r *,Y )
At any given value of e,
a tariff or quota reduces
imports, increases NX,
and shifts IS* to the
right.
Results:
e
e2
e1
e > 0, Y = 0
CHAPTER 10
LM1*
Aggregate Demand I
IS 2*
IS 1*
Y1
Y
slide 101
Lessons about trade policy
 Import restrictions cannot reduce a trade deficit.
 Even though NX is unchanged, there is less
trade:
– the trade restriction reduces imports
– the exchange rate appreciation reduces exports
Less trade means fewer ‘gains from trade.’
 Import restrictions on specific products save jobs
in the domestic industries that produce those
products, but destroy jobs in export-producing
sectors.
Hence, import restrictions fail to increase total
employment.
CHAPTER 10 Aggregate Demand I
Worse yet, import restrictions create “sectoral slide 102
Fixed exchange rates
 Under a system of fixed exchange rates, the
country’s central bank stands ready to buy or
sell the domestic currency for foreign
currency at a predetermined rate.
 In the context of the Mundell-Fleming model,
the central bank shifts the LM* curve as
required to keep e at its preannounced rate.
 This system fixes the nominal exchange rate.
In the long run, when prices are flexible,
the real exchange rate can move
even if the nominal rate is fixed.
CHAPTER 10
Aggregate Demand I
slide 103
Fiscal policy under fixed exchange rates
Under floating rates,
a fiscal
expansion
fiscal
policy
ineffective
would raiseate.
To keep eoutput.
changing
from rising,
the
central
Under
fixedbank
rates,must
sell
fiscaldomestic
policy is very
currency,
effective at changing
which
output.increases M
and
shifts LM* right.
Results:
e
LM1*LM 2*
e1
e = 0, Y >
IS 2*
IS 1*
Y1 Y2
Y
0
CHAPTER 10
Aggregate Demand I
slide 104
Mon. policy under fixed exchange rates
An
increase
in M
would
Under
floating
rates,
shift
LM* right
reduce
monetary
policyand
is very
e
at changing
eeffective
.To prevent
the fall in e,
output.
the central bank must
Under
fixed rates,
buy domestic
currency,
monetary
policyMcannot
e1
which reduces
and
be
used
to affect
output.
shifts
LM*
back left.
Results:
e = 0, Y = 0
CHAPTER 10
Aggregate Demand I
LM1*LM 2*
IS 1*
Y1
Y
slide 105
Trade policy under fixed exchange rates
Under
floating on
rates,
A restriction
import
restrictions
do not
imports
puts upward
affect
Y oron
NXe..
pressure
e
To keep
from rising,
Under
fixede rates,
import
restrictions
the central
bank must
increase
Y and NX.
sell domestic
e1
currency,
But,
these gains come at
increases
M
thewhich
expense
of other
countries,
asLM*
the policy
and
shifts
right.
Results:
merelye
shifts
= 0,demand
Y >
from foreign to domestic
0
goods.
CHAPTER 10 Aggregate Demand I
LM1*LM 2*
IS 2*
IS 1*
Y1 Y2
Y
slide 106
M-F: summary of policy effects
type of exchange rate regime:
floating
fixed
impact on:
Policy
Y
e
NX
Y
e
NX
fiscal expansion
0



0
0
mon. expansion



0
0
0
import restriction
0

0

0

CHAPTER 10
Aggregate Demand I
slide 107
Interest-rate differentials
Two reasons why r may differ from r*
 country risk:
The risk that the country’s borrowers will default
on their loan repayments because of political or
economic turmoil.
Lenders require a higher interest rate to
compensate them for this risk.
 expected exchange rate changes:
If a country’s exchange rate is expected to fall,
then its borrowers must pay a higher interest
rate to compensate lenders for the expected
currency depreciation.
CHAPTER 10
Aggregate Demand I
slide 108
Differentials in the M-F model
r  r * 
where  is a risk premium.
Substitute the expression for r into the
IS* and LM* equations:
Y  C (Y T )  I (r *   )  G  NX (e )
M P  L (r *   ,Y )
CHAPTER 10
Aggregate Demand I
slide 109
The effects of an increase in 
IS* shifts left,
because
   r  I
LM* shifts right,
because
   r  (M/P )d,
so Y must rise to
restore money market
Results:
eq’m.
e < 0, Y > 0
CHAPTER 10
e
LM1*LM 2*
e1
e2
Aggregate Demand I
Y1 Y2
IS 1*
IS 2*
Y
slide 110
The effects of an increase in 
 The fall in e is intuitive:
An increase in country risk or an expected
depreciation makes holding the country’s
currency less attractive.
Note: an expected depreciation is a
self-fulfilling prophecy.
 The increase in Y occurs because
the boost in NX
(from the depreciation)
is even greater than the fall in I
(from the rise in r ).
CHAPTER 10
Aggregate Demand I
slide 111
Why income might not rise
 The central bank may try to prevent the
depreciation by reducing the money
supply
 The depreciation might boost the price of
imports enough to increase the price level
(which would reduce the real money
supply)
 Consumers might respond to the
increased risk by holding more money.
Each of the above would shift LM*
CHAPTER 10 Aggregate Demand I
leftward.
slide 112
CASE STUDY:
The Mexican Peso Crisis
U.S. Cents per Mexican Peso
35
30
25
20
15
10
7/10/94
8/29/94
CHAPTER 10
10/18/94
12/7/94
Aggregate Demand I
1/26/95
3/17/95
5/6/95
slide 113
CASE STUDY:
The Mexican Peso Crisis
U.S. Cents per Mexican Peso
35
30
25
20
15
10
7/10/94
8/29/94
CHAPTER 10
10/18/94
12/7/94
Aggregate Demand I
1/26/95
3/17/95
5/6/95
slide 114
The Peso Crisis didn’t just hurt Mexico
 U.S. goods more expensive to Mexicans
– U.S. firms lost revenue
– Hundreds of bankruptcies along
U.S.-Mex border
 Mexican assets worth less in dollars
– Affected retirement savings of
millions of U.S. citizens
CHAPTER 10
Aggregate Demand I
slide 115
Understanding the crisis
In the early 1990s, Mexico was an attractive
place for foreign investment.
During 1994, political developments caused
an increase in Mexico’s risk premium ( ):
• peasant uprising in Chiapas
• assassination of leading presidential
candidate
Another factor:
The Federal Reserve raised U.S. interest
rates several times during 1994 to prevent
U.S. inflation. (So, r* > 0)
CHAPTER 10
Aggregate Demand I
slide 116
Understanding the crisis
 These events put downward pressure on
the peso.
 Mexico’s central bank had repeatedly
promised foreign investors that it
would not allow the peso’s value to fall,
so it bought pesos and sold dollars to
“prop up” the peso exchange rate.
 Doing this requires that Mexico’s central
bank have adequate reserves of dollars.
Did it?
CHAPTER 10
Aggregate Demand I
slide 117
Dollar reserves of
Mexico’s
bank $28
December
1993central
………………
billion
August 17, 1994 ………………
billion
$17
December 1, 1994 ……………
billion
$9
December 15, 1994 …………
$7
billion
During 1994, Mexico’s central bank hid the
fact that its reserves were being depleted.
CHAPTER 10
Aggregate Demand I
slide 118
 the disaster 
 Dec. 20: Mexico devalues the peso by 13%
(fixes e at 25 cents instead of 29 cents)
 Investors are shocked ! ! !
…and realize the central bank must be
running out of reserves…
 , Investors dump their Mexican assets
and pull their capital out of Mexico.
 Dec. 22: central bank’s reserves nearly
gone.
It abandons the fixed rate and lets e float.
10 Aggregate
I 30%.
CHAPTER
In a week,
e fallsDemand
another
slide 119
The rescue package
 1995: U.S. & IMF set up $50b line of
credit to provide loan guarantees to
Mexico’s govt.
 This helped restore confidence in Mexico,
reduced the risk premium.
 After a hard recession in 1995, Mexico
began a strong recovery from the crisis.
CHAPTER 10
Aggregate Demand I
slide 120
Floating vs. Fixed Exchange Rates
Argument for floating rates:
 allows monetary policy to be used to
pursue other goals (stable growth, low
inflation)
Arguments for fixed rates:
 avoids uncertainty and volatility, making
international transactions easier
 disciplines monetary policy to prevent
excessive money growth & hyperinflation
CHAPTER 10
Aggregate Demand I
slide 122
Mundell-Fleming and the AD curve
 So far in M-F model, P has been fixed.
 Next: to derive the AD curve, consider the
impact of a change in P in the M-F model.
 We now write the M-F equations as:
(IS* )
Y  C (Y T )  I (r *)  G  NX (ε )
(LM* )
M P  L(r *,Y )
(Earlier in this chapter, P was fixed, so we
could write NX as a function of e instead of
.)
CHAPTER 10
Aggregate Demand I
slide 123
Deriving the AD curve
Why AD curve has
negative slope:
P  (M/P
)
 LM shifts
left
 
 NX
 Y

LM*(P2) LM*(P1)
2
1
IS*
P
Y2
Y
P2
P1
AD
Y2
CHAPTER 10
Y1
Aggregate Demand I
Y1
Y
slide 124
From the short run to the long run
If Y1  Y ,
then there is
downward pressure
on prices.
Over time, P will
move down,
causing
(M/P )


LM*(P1) LM*(P2)
1
2
IS*
P
Y
LRAS
Y
P1
SRAS1
P2
SRAS2
AD
NX 
Y1
Y
CHAPTER 10
Y1
Aggregate Demand I
Y
Y
slide 125
Large: between small and closed
 Many countries - including the U.S. - are
neither closed nor small open economies.
 A large open economy is in between the
polar cases of closed & small open.
 Consider a monetary expansion:
• Like in a closed economy,
M > 0  r  I (though not as much)
• Like in a small open economy,
M > 0    NX (though not as
much)
CHAPTER 10
Aggregate Demand I
slide 126
Chapter summary
1. Mundell-Fleming model
 the IS-LM model for a small open economy.
 takes P as given
 can show how policies and shocks affect
income and the exchange rate
2. Fiscal policy
 affects income under fixed exchange rates,
but not under floating exchange rates.
CHAPTER 10
Aggregate Demand I
slide 127
Chapter summary
3. Monetary policy
 affects income under floating exchange rates.
 Under fixed exchange rates, monetary policy
is not available to affect output.
4. Interest rate differentials
 exist if investors require a risk premium to
hold a country’s assets.
 An increase in this risk premium raises
domestic interest rates and causes the
country’s exchange rate to depreciate.
CHAPTER 10
Aggregate Demand I
slide 128
Chapter summary
5. Fixed vs. floating exchange rates
 Under floating rates, monetary policy is
available for can purposes other than
maintaining exchange rate stability.
 Fixed exchange rates reduce some of the
uncertainty in international transactions.
CHAPTER 10
Aggregate Demand I
slide 129
CHAPTER 10
Aggregate Demand I
slide 130
macro
CHAPTER TEN
Aggregate Demand I
macroeconomics
fifth edition
N. Gregory Mankiw
PowerPoint® Slides
by Ron Cronovich
© 2004 Worth Publishers, all rights reserved
Chapter objectives
 difference between short run & long run
 introduction to aggregate demand
 aggregate supply in the short run & long
run
 see how model of aggregate supply and
demand can be used to analyze short-run
and long-run effects of “shocks”
CHAPTER 10
Aggregate Demand I
slide 132
Percent change from previous
quarter, at annual rate
Real GDP Growth in the U.S., 1960-2004
15
Average growth
rate = 3.4%
10
5
0
-5
-10
1960 1965 1970 1975 1980 1985 1990 1995 2000 2005
CHAPTER 10
Aggregate Demand I
slide 133
Time horizons
 Long run:
Prices are flexible, respond to changes in
supply or demand
 Short run:
many prices are “sticky” at some
predetermined level
The economy behaves much
differently when prices are sticky.
CHAPTER 10
Aggregate Demand I
slide 135
In Classical Macroeconomic Theory,
(what we studied in chapters 3-8)
 Output is determined by the supply side:
– supplies of capital, labor
– technology
 Changes in demand for goods & services
(C, I, G ) only affect prices, not quantities.
 Complete price flexibility is a crucial
assumption,
so classical theory applies in the long run.
CHAPTER 10
Aggregate Demand I
slide 136
When prices are sticky
…output and employment also depend on
demand for goods & services,
which is affected by
 fiscal policy (G and T )
 monetary policy (M )
 other factors, like exogenous changes
in C or I.
CHAPTER 10
Aggregate Demand I
slide 137
The model of
aggregate demand and supply
 the paradigm that most mainstream
economists & policymakers use to think
about economic fluctuations and policies
to stabilize the economy
 shows how the price level and aggregate
output are determined
 shows how the economy’s behavior is
different in the short run and long run
CHAPTER 10
Aggregate Demand I
slide 138
Aggregate demand
 The aggregate demand curve shows the
relationship between the price level and the
quantity of output demanded.
 For this chapter’s intro to the AD/AS model,
we use a simple theory of aggregate
demand based on the Quantity Theory of
Money.
 Chapters 10-12 develop the theory of
aggregate demand in more detail.
CHAPTER 10
Aggregate Demand I
slide 139
The Quantity Equation as Agg. Demand
 From Chapter 4, recall the quantity equation
MV = PY
 For given values of M and V, these
equations imply an inverse relationship
between P and Y:
CHAPTER 10
Aggregate Demand I
slide 140
The downward-sloping AD curve
An increase in the
price level causes
a fall in real
money balances
(M/P ),
P
causing a
decrease in the
demand for goods
& services.
AD
Y
CHAPTER 10
Aggregate Demand I
slide 141
Shifting the AD curve
P
An increase in
the money
supply shifts
the AD curve
to the right.
AD2
AD1
Y
CHAPTER 10
Aggregate Demand I
slide 142
Aggregate Supply in the Long Run
 Recall from chapter 3:
In the long run, output is determined by
factor supplies and technology
Y  F (K , L )
Y
is the full-employment or natural level of
output, the level of output at which the
economy’s resources are fully employed.
“Full employment” means that
unemployment equals its natural rate.
CHAPTER 10
Aggregate Demand I
slide 143
Aggregate Supply in the Long Run
 Recall from chapter 3:
In the long run, output is determined by
factor supplies and technology
Y  F (K , L )
 Full-employment output does not depend
on the price level,
so the long run aggregate supply (LRAS)
curve is vertical:
CHAPTER 10
Aggregate Demand I
slide 144
The long-run aggregate supply curve
P
LRAS
The LRAS curve
is vertical at the
full-employment
level of output.
Y
CHAPTER 10
Aggregate Demand I
Y
slide 145
Long-run effects of an increase in M
P
LRAS
P2
In the long run,
this increases
the price level…
An increase
in M shifts
the AD curve
to the right.
P1
AD2
AD1
…but leaves
output the same.
CHAPTER 10
Aggregate Demand I
Y
Y
slide 146
Aggregate Supply in the Short Run
 In the real world, many prices are sticky in
the short run.
 For now (and throughout Chapters 9-12),
we assume that all prices are stuck at a
predetermined level in the short run…
 …and that firms are willing to sell as much
at that price level as their customers are
willing to buy.
 Therefore, the short-run aggregate supply
(SRAS) curve is horizontal:
CHAPTER 10
Aggregate Demand I
slide 147
The short run aggregate supply curve
P
The SRAS curve
is horizontal:
The price level
is fixed at a
predetermined
level, and firms
sell as much as
buyers demand.
CHAPTER 10
P
Aggregate Demand I
SRAS
Y
slide 148
Short-run effects of an increase in M
P
In the short run
when prices are
sticky,…
…an increase
in aggregate
demand…
SRAS
AD2
AD1
P
…causes output
to rise.
CHAPTER 10
Aggregate Demand I
Y1
Y2
Y
slide 149
From the short run to the long run
Over time, prices gradually become “unstuck.”
When they do, will they rise or fall?
In the short-run
equilibrium, if
then over time,
the price level will
Y Y
Y Y
rise
Y Y
remain constant
fall
This adjustment of prices is what moves
the economy to its long-run equilibrium.
CHAPTER 10
Aggregate Demand I
slide 150
The SR & LR effects of M > 0
A = initial
equilibrium
B = new shortrun eq’m
after Fed
increases M
P
C
P2
P
C = long-run
equilibrium
CHAPTER 10
LRAS
B
A
Y
Aggregate Demand I
Y2
SRAS
AD2
AD1
Y
slide 151
How shocking!!!
 shocks: exogenous changes in aggregate
supply or demand
 Shocks temporarily push the economy away
from full-employment.
 An example of a demand shock:
exogenous decrease in velocity
 If the money supply is held constant, then a
decrease in V means people will be using their
money in fewer transactions, causing a
decrease in demand for goods and services:
CHAPTER 10
Aggregate Demand I
slide 152
The effects of a negative demand shock
The shock shifts
AD left, causing
output and
employment to fall
in the short run
Over time, prices
fall and the
economy moves
down its demand
curve toward fullemployment.
CHAPTER 10
P
P
LRAS
B
P2
A
SRAS
C
AD1
AD2
Y2
Aggregate Demand I
Y
Y
slide 153
Supply shocks
A supply shock alters production costs,
affects the prices that firms charge.
(also called price shocks)
Examples of adverse supply shocks:
 Bad weather reduces crop yields, pushing up
food prices.
 Workers unionize, negotiate wage increases.
 New environmental regulations require firms to
reduce emissions. Firms charge higher prices to
help cover the costs of compliance.
(Favorable supply shocks lower costs and prices.)
CHAPTER 10
Aggregate Demand I
slide 154
CASE STUDY:
The 1970s oil shocks
 Early 1970s: OPEC coordinates a reduction
in the supply of oil.
 Oil prices rose
11% in 1973
68% in 1974
16% in 1975
 Such sharp oil price increases are supply
shocks because they significantly impact
production costs and prices.
CHAPTER 10
Aggregate Demand I
slide 155
CASE STUDY:
The 1970s oil shocks
The oil price shock
shifts SRAS up,
causing output and
employment to fall.
In absence of
further price
shocks, prices will
fall over time and
economy moves
back toward full
employment.
CHAPTER 10
P
P2
LRAS
B
SRAS2
A
P1
SRAS1
AD
Y2
Aggregate Demand I
Y
Y
slide 156
CASE STUDY:
The 1970s oil shocks
70%
12%
Predicted effects of
the oil price shock:
• inflation 
• output 
• unemployment 
60%
…and then a
gradual recovery.
10%
50%
10%
40%
8%
30%
20%
6%
0%
1973
4%
1974
1975
1976
1977
Change in oil prices (left scale)
Inflation rate-CPI (right scale)
Unemployment rate (right scale)
CHAPTER 10
Aggregate Demand I
slide 157
CASE STUDY:
The 1970s oil shocks
60%
Late 1970s:
As economy
was recovering,
oil prices shot up
again, causing
another huge
supply shock!!!
14%
50%
12%
40%
10%
30%
8%
20%
6%
10%
0%
1977
1978
1979
1980
4%
1981
Change in oil prices (left scale)
Inflation rate-CPI (right scale)
Unemployment rate (right scale)
CHAPTER 10
Aggregate Demand I
slide 158
CASE STUDY:
The 1980s oil shocks
40%
1980s:
A favorable
supply shock-a significant fall
in oil prices.
As the model
would predict,
inflation and
unemployment
fell:
10%
30%
8%
20%
10%
6%
0%
-10%
4%
-20%
-30%
2%
-40%
-50%
1982
1983
1984
1985
1986
0%
1987
Change in oil prices (left scale)
Inflation rate-CPI (right scale)
Unemployment rate (right scale)
CHAPTER 10
Aggregate Demand I
slide 159
Stabilization policy
 def: policy actions aimed at reducing the
severity of short-run economic fluctuations.
 Example: Using monetary policy to
combat the effects of adverse supply
shocks:
CHAPTER 10
Aggregate Demand I
slide 160
Stabilizing output with
monetary policy
The adverse
supply shock
moves the
economy to
point B.
P
P2
LRAS
B
SRAS2
A
P1
SRAS1
AD1
Y2
CHAPTER 10
Aggregate Demand I
Y
Y
slide 161
Stabilizing output with
monetary policy
P
But the Fed
accommodates
the shock by
raising agg.
demand.
P2
results:
P is permanently
higher, but Y
remains at its fullemployment level.
CHAPTER 10
LRAS
B
C
SRAS2
A
P1
AD1
Y2
Aggregate Demand I
Y
AD2
Y
slide 162
Chapter summary
1. Long run: prices are flexible, output and
employment are always at their natural
rates, and the classical theory applies.
Short run: prices are sticky, shocks can
push output and employment away from
their natural rates.
2. Aggregate demand and supply:
a framework to analyze economic
fluctuations
CHAPTER 10
Aggregate Demand I
slide 163
Chapter summary
3. The aggregate demand curve slopes
downward.
4. The long-run aggregate supply curve is
vertical, because output depends on
technology and factor supplies, but not
prices.
5. The short-run aggregate supply curve is
horizontal, because prices are sticky at
predetermined levels.
CHAPTER 10
Aggregate Demand I
slide 164
Chapter summary
6. Shocks to aggregate demand and supply
cause fluctuations in GDP and employment
in the short run.
7. The Fed can attempt to stabilize the
economy with monetary policy.
CHAPTER 10
Aggregate Demand I
slide 165
CHAPTER 10
Aggregate Demand I
slide 166