Transcript Mankiw 5/e Chapter 11: Aggregate Demand II
Econ 101: Intermediate Macroeconomic Theory Larry Hu
Lecture 12: Application of IS-LM Model and Great Depression
CHAPTER 11
Aggregate Demand II slide 0
Equilibrium in the IS-LM Model
The IS curve represents equilibrium in the goods market.
Y
)
G r
The LM curve represents money market equilibrium.
r 1 M P
The intersection determines the unique combination of
Y
and
r Y 1
that satisfies equilibrium in both markets.
CHAPTER 11
Aggregate Demand II
LM IS Y
slide 1
Interaction between monetary & fiscal policy
Model: monetary & fiscal policy variables (
M
,
G
and
T
) are exogenous Real world: Monetary policymakers may adjust in response to changes in fiscal policy, or vice versa.
M
Such interaction may alter the impact of the original policy change.
CHAPTER 11
Aggregate Demand II slide 2
The Fed’s response to
G > 0
Suppose Congress increases
G
.
Possible Fed responses: 1.
hold constant 2.
hold
M r
constant 3.
hold
Y
constant In each case, the effects of the are different:
G CHAPTER 11
Aggregate Demand II slide 3
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:
Y
Y
2
Y
1
r
2
r
1
r 2 r 1 r Y 1 Y 2 LM 1 IS 2 IS 1 Y CHAPTER 11
Aggregate Demand II slide 4
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.
Results:
Y
Y
3 0
Y
1
r 2 r 1 r LM 1 LM 2 Y 1 Y 2 Y 3 IS 2 IS 1 Y CHAPTER 11
Aggregate Demand II slide 5
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.
Results:
Y
0
r
3
r
1
r 3 r 2 r 1 r Y 1 Y 2 LM 2 LM 1 IS 2 IS 1 Y CHAPTER 11
Aggregate Demand II slide 6
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 more prevalent than IS targeting the interest rate stabilizes income better than targeting the money supply. (See Problem 7 on p.306) LM shocks are shocks. If so, then
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Aggregate Demand II slide 7
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Aggregate Demand II slide 8
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Aggregate Demand II slide 9
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Aggregate Demand II slide 10
IS-LM and Aggregate Demand
So far, we’ve been using the level is assumed fixed. IS-LM model to analyze the short run, when the price However, a change in
P
would shift the curve and therefore affect
Y
. LM The
aggregate demand curve
( introduced in chap. 9 ) relationship between captures this
P
and
Y CHAPTER 11
Aggregate Demand II slide 11
Deriving the AD curve
Intuition for slope of AD curve:
P
( M/P ) LM shifts left
r
I
Y r r 2 r 1 P
P
2
P
1
Y
2
Y
2 LM(
P
2 ) LM(
P
1 )
Y
1
Y
1
IS
Y
AD
Y CHAPTER 11
Aggregate Demand II slide 12
Monetary policy and the AD curve
The Fed can increase aggregate demand:
M
LM
r
shifts right
I
Y
at each value of
P r r 1 r 2 P
P
1
Y
1 LM(M 1 /P 1 ) LM(
M
2 /P 1 )
Y
2
IS
Y
Y
1
Y
2
AD
2
AD
1 Y CHAPTER 11
Aggregate Demand II slide 13
Fiscal policy and the AD curve
Expansionary fiscal policy (
G
and/or
T
) increases agg. demand:
T
C
of
P
IS shifts right
Y
at each value
r r 2 r 1 P
P
1
Y
1
LM Y
2
IS
1
IS
2 Y
Y
1
Y
2
AD
2
AD
1 Y CHAPTER 11
Aggregate Demand II slide 14
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
Y Y
Y Y Y
Y
then over time, the price level will rise fall remain constant
CHAPTER 11
Aggregate Demand II slide 15
The SR and LR effects of an IS shock r
LRAS LM
(
P
1 ) A negative shifts IS causing
Y
IS and shock AD left, to fall.
P P
1
CHAPTER 11
Aggregate Demand II IS 1
Y
LRAS
IS 2
Y
SRAS
1
Y
AD
1
AD
2
Y
slide 16
The SR and LR effects of an IS shock r
LRAS LM
(
P
1 ) In the new short-run equilibrium,
Y Y P P
1 IS 1
Y
LRAS
IS 2
Y
SRAS
1
CHAPTER 11
Aggregate Demand II
Y
AD
1
AD
2
Y
slide 17
The SR and LR effects of an IS shock r
LRAS LM
(
P
1 ) In the new short-run equilibrium,
Y Y
Over time,
P
gradually falls, which causes • • SRAS M/P to move down to increase, which causes LM to move down
P P
1 IS 1
Y
LRAS
IS 2
Y
SRAS
1
Y
AD
1
AD
2
Y CHAPTER 11
Aggregate Demand II slide 18
The SR and LR effects of an IS shock r
LRAS LM
(
P
1 )
LM
(
P
2 ) Over time,
P
gradually falls, which causes • • SRAS M/P to move down to increase, which causes LM to move down
P P
1
P
2
CHAPTER 11
Aggregate Demand II IS 1
Y
LRAS
IS 2
Y Y
SRAS
1
SRAS
2
AD
1
AD
2
Y
slide 19
The SR and LR effects of an IS shock r
LRAS LM
(
P
1 )
LM
(
P
2 ) This process continues until economy reaches a long-run equilibrium with
Y Y CHAPTER 11 P P
1
P
2 Aggregate Demand II IS 1
Y
LRAS
IS 2
Y Y
SRAS
1
SRAS
2
AD
1
AD
2
Y
slide 20
240 220 200 180 160 140 120 1929
The Great Depression
Unemployment (right scale)
1931 1933
Real GNP (left scale)
1935 1937 1939 30 10 5 0 25 20 15
CHAPTER 11
Aggregate Demand II slide 21
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 11
Aggregate Demand II slide 22
The Spending Hypothesis:
Reasons for the IS shift
1.
Stock market crash exogenous Oct-Dec 1929: S&P 500 fell 17%
C
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 11
Aggregate Demand II slide 23
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.
CHAPTER 11
Aggregate Demand II slide 24
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 slide 25
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 11
Aggregate Demand II slide 26
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 11
Aggregate Demand II slide 27
The Money Hypothesis Again:
The Effects of Falling Prices
The destabilizing effects of expected deflation: e
r I
for each value of
i
because
I
=
I
(
r
) planned expenditure & agg. demand income & output
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Aggregate Demand II slide 28
Liquidity Trap
IS-LM: monetary policy increase investment by reducing interest rate When interest rate is low, it may not work, just like today
r
IS
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Aggregate Demand II LM
Y
slide 29
Liquidity Trap
The policy maker can create inflation expectation
i
=
r
+ IS
r
Nominal interest rate never below zero If inflation is zero, real interest rate never falls below zero If inflation if 3%, real interest rate can be 3%
CHAPTER 11
Aggregate Demand II IS LM 1 LM 2
Y
slide 30