Transcript Mankiw 5/e Chapter 11: Aggregate Demand II

macro
CHAPTER ELEVEN
Aggregate Demand II
macroeconomics
fifth edition
N. Gregory Mankiw
PowerPoint® Slides
by Ron Cronovich
© 2004 Worth Publishers, all rights reserved
Context
 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 11
Aggregate Demand II
slide 1
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 11
Aggregate Demand II
IS
Y1
Y
slide 2
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 11
Aggregate Demand II
slide 3
The Fed’s response to G > 0
 Suppose Congress increases G.
 Possible Central Bank responses:
1. hold M constant
2. hold r constant
3. hold Y constant
 In each case, the effects of the G
are different:
CHAPTER 11
Aggregate Demand II
slide 4
Response 1: hold M constant
If Congress raises G,
the IS curve shifts
right
If Central Bank 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 11
Aggregate Demand II
slide 5
Response 2: hold r constant
If Congress raises G,
the IS curve shifts
right
r
To keep r constant,
CB increases M to
shift LM curve right.
r2
r1
LM1
IS2
IS1
Results:
Y  Y3  Y1
LM2
Y1 Y2 Y3
Y
r  0
CHAPTER 11
Aggregate Demand II
slide 6
Response 3: hold Y constant
If Congress raises G,
the IS curve shifts
right
To keep Y constant,
CB 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 11
Aggregate Demand II
slide 7
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 11
Aggregate Demand II
slide 8
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.
CHAPTER 11
Aggregate Demand II
slide 9
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 11
Aggregate Demand II
slide 10
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 11
Y1
Aggregate Demand II
Y1
Y
slide 11
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 11
Aggregate Demand II
Y2
Y2
Y
AD2
AD1
Y
slide 12
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 11
Aggregate Demand II
Y2
AD2
AD1
Y
slide 13
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 11
IS1
AD1
AD2
Y
slide 14
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 11
IS1
AD1
AD2
Y
slide 15
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 11
Y
P
Y
LRAS
P1
Aggregate Demand II
IS1
SRAS1
Y
AD1
AD2
Y
slide 16
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 11
Y
P
IS1
Y
LRAS
P1
SRAS1
P2
SRAS2
Aggregate Demand II
Y
AD1
AD2
Y
slide 17
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 11
IS1
Aggregate Demand II
AD1
AD2
Y
slide 18
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 11
Aggregate Demand II
IS
Y
Y
LRAS
SRAS1
AD1
Y
Y
slide 19
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 11
1933
1935
Aggregate Demand II
1937
1939
slide 20
CHAPTER 11
Aggregate Demand II
slide 21
CHAPTER 11
Aggregate Demand II
slide 22
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 23
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 11
Aggregate Demand II
slide 24
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 11
Aggregate Demand II
slide 25
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 11
Aggregate Demand II
slide 26
Simple algebra of IS-LM model
IS : Y  C (Y  T )  I (r )  G, where
C  a  m pc(Y-T)
I  c-dr
Solving for Y as a function of r, and exogenous parameters G and T yields
ac
1
b
d
Y

G
T
r
1  m pc 1  m pc
1  m pc
1  m pc
The algebra of the LM curve
M / P  L(r , Y )  eY  fr , or
r  (e / f )Y  (1 / f ) M / P
CHAPTER 11
Aggregate Demand II
slide 27
The Aggregate Demand Equation
z (a  c)
z
z mpc
d
M

G
T
, where
1  mpc 1  mpc
1  mpc
(1  mpc)[ f  de /(1  mpc)] P
z  f /[ f  de /(1  mpc)]
Y
For homework #2, please derive this equation
CHAPTER 11
Aggregate Demand II
slide 28
Effectiveness of monetary and fiscal policy
 Which policy variables are more powerful
instruments to influence aggregate
demand depends on the parameters of
the IS and LM curves
 If d is small then z is big. IS is almost
vertical, and monetary policy has small
impact on income Y
 If f is small then z is small. The LM curve
is almost vertical, and fiscal policy has
small impact on Y
CHAPTER 11
Aggregate Demand II
slide 29
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 11
Aggregate Demand II
slide 30
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 11
Aggregate Demand II
slide 31
CHAPTER 11
Aggregate Demand II
slide 32