slides topic 10 lec 09 short

8/13/2019 Slides Topic 10 Lec 09 Short

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macroeconomicsfifth edition

N. Gregory Mankiw

PowerPointSlides

by Ron Cronovich

CHAPTER ELEVEN

Aggregate Demand II

macro

2002 Worth Publishers, all rights reserved

Topic 10:

Aggregate Demand II(chapter 11) updated 11/17/09


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m

CHAPTER 11 Aggregate Demand II slide 1

Context

Chapter 9 introduced the model of aggregatedemand and supply.

Chapter 10 developed the IS-LM model, thebasis of the aggregate demand curve.

In Chapter 11, we will use the IS-LM model to

see how policies and shocks affect incomeand the interest rate in the short run when

prices are fixed derive the aggregate demand curve

explore various explanations for theGreat Depression


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The intersection determines

the unique combination of Y and r

that satisfies equilibrium in both markets.

The LMcurve represents

money market equilibrium.

Equilibrium in the IS-LMModel

The IScurve representsequilibrium in the goods

market.

( ) ( )Y C Y T I r G

( , )M P L r Y IS

Y

rLM

r1

Y1


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Policy analysis with the IS-LMModel

Policymakers can affect

macroeconomic variableswith

fiscal policy: G and/or T

monetary policy: M

We can use the IS-LM

model to analyze the

effects of these policies.

( ) ( )Y C Y T I r G

( , )M P L r Y

IS

Y

rLM

r1

Y1


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causing output &

income to rise.

IS1

An increase in government purchases

1. IScurve shifts right

Y

rLM

r1

Y1

1by

1 MPCG

IS2

Y2

r2

1.2. This raises money

demand, causing theinterest rate to rise

2.

3. which reduces investment,so the final increase in Y

1is smaller than

1 MPCG

3.


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IS1

1.

A tax cut

Y

rLM

r1

Y1

IS2

Y2

r2

Because consumers save

(1MPC) of the tax cut,

the initial boost in

spending is smaller for T

than for an equal G

and the IScurve

shifts by

MPC

1 MPCT

1.

2.

2.so the effects on r and Y

are smaller for a T than

for an equal G.

2.


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2. causing theinterest rate to fall

IS

Monetary Policy: an increase in M

1. M> 0 shiftsthe LMcurve down(or to the right)

Y

r LM1

r1

Y1 Y2

r2

LM2

3. which increases

investment, causingoutput & income torise.


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Shocks in the IS-LMModel

IS shocks: exogenous changes in thedemand for goods & services.

Examples:

stock market boom or crashchange in households wealth C

change in business or consumer

confidence or expectations I and/or C


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Shocks in the IS-LMModel

LM shocks: exogenous changes in thedemand for money.

Examples:

a wave of credit card fraud increasesdemand for money

more ATMs or the Internet reduce moneydemand


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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 andshifted the IS curve left.


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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 target11 times during 2001, from 6.5% to 1.75%

Money growth increased, interest rates fell


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What is the Feds 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 fell0.5 points.

The Fed targetsthe Federal Funds rate:

it announces a target value,and uses monetary policy to shift the LM curve

as needed to attain its target rate.


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What is the Feds policy instrument?

Why does the Fed target interest ratesinstead of the money supply?

1) They are easier to measure than themoney supply

2) The Fed might believe that LM shocksare more prevalent than IS shocks. Ifso, then targeting the interest rate

stabilizes income better than targetingthe money supply.


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Recession of 2008-9

Questions:1) How severe is the recession? Is it still

going on?

2) Can we tell what caused it: IS or LMcurve shift?

3) Can we see evidence of the governmentsresponse, in fiscal and monetary policy?


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Recession of 2008-9

Quarterly GDP Growth Rates:

-8

-6

-4

-2

0

2

4

6


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Recession of 2008-9

Unemployment rate:


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Recession of 2008-9

0

1

2

3

4

5

6

Jan-04

Apr-04

Jul-04

Oct-04

Jan-05

Apr-05

Jul-05

Oct-05

Jan-06

Apr-06

Jul-06

Oct-06

Jan-07

Apr-07

Jul-07

Oct-07

Jan-08

Apr-08

Jul-08

Oct-08

Jan-09

Apr-09

Jul-09

Oct-09

Federal funds interest rate


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Recession of 2008-9

Government saving (2004 to 2008)

-1200

-1000

-800

-600

-400

-200

0


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IS1

Recall: IS curve

Def: equilibrium points in

the Goods market:

Story: fall in r raises I,which raises E and Y.

Shifted right by:Fiscal policy: raise G or cut T;Shocks: exogenous rise in Cor I (rise in Consumer orBusiness confidence).

Shift in IS leads to: a rise in Y, which raises moneydemand and bids up r (move along LM).

Y

rLM

r1

Y1

IS2

Y2

r2


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IS

Recall: LM Curve

Def: equilibrium pointsin the money market.

Story: rise in Y raises moneydemand, which bids up r.

Shifted right by:Monetary policy: rise in M;Shocks:fall in exogenous

money demand.

Shift in LM leads to fall in r, raises I, hence raises E and Y(movement along IS curve).

Y

r LM1

r1

Y1 Y2

r2

LM2


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IS-LM and Aggregate Demand

So far, weve been using the IS-LMmodelto analyze the short run, when the pricelevel is assumed fixed.

However, a change in P would shift theLMcurve and therefore affect Y.

The aggregate demand curve(introduced in chap. 9 )captures thisrelationship between P and Y


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Y1Y2

Deriving the ADcurve

Y

r

Y

P

IS

LM(P1)

LM(P2)

AD

P1

P2

Y2 Y1

r2

r1

Intuition for slope

ofAD curve:

P (M/P)

LMshifts left

r

I

Y


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Monetary policy and the ADcurve

Y

P

IS

LM(M2/P1)

LM(M1/P

1)

AD1

P1

Y1

Y1

Y2

Y2

r1

r2

The Fed can increaseaggregate demand:

M LMshifts right

AD2

Y

r

r

I

Y at each

value of P


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Y2

Y2

r2

Y1

Y1

r1

Fiscal policy and the ADcurve

Y

r

Y

P

IS1

LM

AD1

P1

Expansionary fiscal policy(G and/or T )

increases agg. demand:

T

CIS shifts right

Y at each

value

of P AD2

IS2


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Policy Effectiveness

Fiscal policy is effective (Ywill rise much) when:LM flatter

As the rise in Graises Y,

the increase in money demand

does not raise rmuch:so investment is not crowdedout as much.

LM

Y2

2

Y2

IS2

2

LM

Y1

IS1r

1


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Policy Effectiveness

Monetary policy is effective (Ywill rise much) when:IS flatter

As a rise in Mlowers theinterest rate (r),

investment rises more inresponse to the fall in r,

so output rises more.Y

2

LM2

2

Y1

LM1

r

1

Y2

2

IS

IS


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IS-LMand AD-ASin the short run & long run

Recall from Chapter 9: The force that movesthe economy from the short run to the long run

is the gradual adjustment of prices.

Y Y

Y Y

Y Y

rise

fall

remain constant

In the short-runequilibrium, if

then over time,the price level will


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Quiz #4

Y

r

Y

P LRAS

Y

LRAS

Y

IS1

SRAS1P1

LM(P1)

IS2

AD2AD1

Suppose a fall in G leads to a

leftward shift in the IS curve.

What is the short run effecton the following variables(rise, fall, no change)?

1) Y

2) r

3) C

4) IPlease also write your name

and section day/time


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Answers to Quiz #4

Y

r

Y

P LRAS

Y

LRAS

Y

SRAS1P1

LM(P1)

IS2

AD2

Suppose a fall in G leads to a

leftward shift in the IS curve.

What is the short run effecton the following variables(rise, fall, no change)?

1) Y falls

2) r falls

3) C(Y-T) falls

4) I(r ) rises


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The SR and LR effects of an ISshock

A negative IS shock

shifts ISandAD left,causing Y to fall.

Y

r

Y

P LRAS

Y

LRAS

Y

IS1

SRAS1P1

LM(P1)

IS2

AD2AD1


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Y

r

Y

P LRAS

Y

LRAS

Y

IS1

SRAS1P1

LM(P1

)

IS2

AD2AD1

In the new short-runequilibrium, Y Y


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Y

r

Y

P LRAS

Y

LRAS

Y

IS1

SRAS1P1

LM(P1

)

IS2

AD2AD1

In the new short-runequilibrium, Y Y

Over time,P gradually falls,which causes

SRAS to move down

M/P to increase,which causes LMto move down


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AD2


Y

r

Y

P LRAS

Y

LRAS

Y

IS1

SRAS1P1

LM(P1

)

IS2

AD1

Over time,P gradually falls,which causes

SRAS to move down

M/P to increase,which causes LMto move down

SRAS2P2

LM(P2)


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AD2

SRAS2P2

LM(P2)


Y

r

Y

P LRAS

Y

LRAS

Y

IS1

SRAS1P1

LM(P1

)

IS2

AD1

This process continuesuntil economy reachesa long-run equilibrium

with Y Y


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EXERCISE:

Analyze SR & LR effects of Ma. Drawing the IS-LMandAD-

ASdiagrams as shown here,

b. show the short run effect ofa Fed increases in M. Labelpoints and show curve shifts

with arrows.c. Show what happens in the

transition from the short runto the long run. Label points.

d. How do the new long-runequilibrium values compareto their initial values?

Y

r

Y

P LRAS

Y

LRAS

Y

IS

SRAS1P1

LM(M1

/P1

)

AD1


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Short run for r ise in M

Y

r

Y

P LRAS

Y

LRAS

Y

IS

SRAS1P1

LM(M1

/P1

)

AD1

LM(M2/P1)

AD2

Short run:

Rise in M raises real money

supply in money market

and shifts LM curve right.

Also shifts AD curve right.

Equilibrium moves from

point 0 to point 1.

Output rises to Y1.Note that interest rate

falls from r0to r1.

Y1

Y1

r1

r0

10

01


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Long run: for r ise in M

Y

r

Y

P LRAS

Y

LRAS

Y

IS

SRAS1P1

LM(M2

/P2

)

AD1

LM(M2/P1)

AD2

Price rises in proportion to M,

from P1to P2,

So real money supply

returns to original level:

M2/P2= M1/P1.

So LM curve returns to

original position.

Equilibrium moves from

point 1 to point 2.

Output and interest rate

return to original levels.

Y1

Y1

r1

r0 0,2

2

1

1

0

SRAS2P2


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The Great Depression

120

140

160

180

200

220

240

1929 1931 1933 1935 1937 1939

billionso

f19

58

dollars

0

5

10

15

20

25

30

percentofla

borforce

Unemployment

(right scale)

Real GNP

(left scale)


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Great Depression: Observations

Real side of economy: Output: falling Consumption: falling

Investment: falling much

Gov. purchases: fall (with a delay)


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Great Depression: Observations

Nominal side: Nominal interest rate: falling Money supply (nominal): falling

Price level: falling (deflation)

The Spending Hypothesis:


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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 ISshift would cause



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Reasons for the IS sh if t

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 ratesand cut spending

The Money Hypothesis:


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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/Pactually rose

slightly during 1929-31.

2. nominal interest rates fell, which is theopposite of what would result from a

leftward LMshift.


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A revision to the Money Hypothesis

There was a big deflation: P fell 25% 1929-33.

A sudden fall in expected inflation means the ex-

ante real interest rate rises for any given nominal

rate (i)

ex ante real interest rate = ie

This could have discouraged the investment

expenditure and helped cause the depression.

Since the deflation likely was caused by fall in M,

monetary policy may have played a role here.


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Why ano ther Depression is unl ikely

Policymakers (or their advisors) now knowmuch more about macroeconomics:

The Fed knows better than to let M fallso much, especially during a contraction.

Fiscal policymakers know better than to raisetaxes or cut spending during a contraction.

Federal deposit insurance makes widespread

bank failures very unlikely.Automatic stabilizersmake fiscal policy

expansionary during an economic downturn.


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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


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Chapter summary

2.AD curve

shows relation between Pand the IS-LM

models equilibrium Y.

negative slope because

P (M/P ) r I Y

expansionary fiscal policy shifts IScurve right,

raises income, and shiftsADcurve right

expansionary monetary policy shifts LMcurveright, raises income, and shiftsADcurve right

ISor LMshocks shift theADcurve

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