aggregate demand ii is-lm model eva hromádková, 22.3 2010 macroeconomics eco 110/1, aau lecture 7
TRANSCRIPT
AGGREGATE DEMAND IIIS-LM MODEL
Eva Hromádková, 22.3 2010
Macroeconomics ECO 110/1, AAULecture 7
Overview of Lecture 7
IS-LM model of AD curve: Model for AD curve => analysis of
stabilization policies IS curve – goods market
Fiscal policy – expenditures and taxes LM curve – money market
Monetary policy – money supply Equilibrium – interest rates
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IS-LM modelContext
3
We have already introduced the model of aggregate demand (QTM) 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
IS-LM modelContext II
4
Today we will develop IS-LM model, the theory that explains the aggregate demand curve
First, we focus on the short run and assume hat price level is fixed
Then, we allow price to be flexible, and derive AD curve
Finally, we analyze the effect of fiscal and monetary policy on the most important macroeconomic aggregates – output and unemployment
IS curveKeynesian cross
5
A simple closed economy model in which income is determined by expenditure. (due to J.M. Keynes)
Notation: I = planned investmentE = C + I + G = planned expenditureY = real GDP = actual expenditure
Difference between actual & planned expenditure: unplanned inventory investment
IS curveElements of the Keynesian cross
6
Consumption function: C = MPC*(Y-T)
Govt. policy variables: G, T
Investment: I = I(r)
Planned expenditure: E = C(Y-T) + I(r) + G
Equilibrium: Y = E
IS curveGraphing planned expenditure
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income, output, Y
E
planned
expenditure
E =C +I +G
Slope is MPC
IS curveGraphing the equilibrium condition
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income, output, Y
E
planned
expenditure
E =Y
45º
IS curveEquilibrium value of income
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E>Y: depleting inventories => produce more
E<Y: accumulating inventories=> produce less
income, output, Y
E
planned
expenditure
E =Y
E>Y
E<Y
IS curveFiscal policy
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Fiscal stimulus: Increase in government expenditures Cut taxes Increase transfer payments
Fiscal restraint: Decrease in government expenditures Increased taxes Decreased transfer payments
IS curveIncrease in government purchases
11
Y
E
E =Y
E =C +I +G1
E1 = Y1
E =C +I +G2
E2 = Y2
Y
GLooks like Y>G
IS curveWhy is change in Y > change in G?
12
Def: Government purchases multiplier:
Initially, the increase in G causes an equal increase in Y: Y = G.
But Y C (Y-T) further Y further C further Y
So the government purchases multiplier will be greater than one.
YG
IS curveChange in G - Sum up changes in expenditure
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Y G MPC G MPC MPC G
MPC MPC MPC G ...
1 2 3G MPC G MPC G MPC G ...
11
GMPC
So the multiplier is:
11 for 0 < MPC < 1
1YG MPC
This is a standard geometric series from algebra:
IS curveIncrease in taxes
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Y
E
E =Y
E =C2 +I +G
E2 = Y2
E =C1 +I +G
E1 = Y1
Y
At Y1, there is now
an unplanned inventory buildup……so firms
reduce output, and income falls toward a new equilibrium
C = MPC T
IS curveChange in T - Sum up changes in expenditure
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Y C I G
MPC Y T
C
(1 MPC) MPCY T
equilibrium condition in changesI and G exogenous
Solving for Y :
MPC1 MPC
Y T
Final result:
IS curveTax multiplier
Question: how is this different from the government spending multiplier considered previously?
The tax multiplier:…is negative: An increase in taxes reduces consumer spending, which reduces equilibrium income.…is smaller than the govt spending multiplier: (in absolute value) 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.
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IS curveHow to derive the IS curve I
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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) + GThe IS curve is negatively sloped. Intuition: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.
Y2Y1
Y2Y1
IS curveHow to derive the IS curve II
r I
Y
E
r
Y
E =C +I (r1 )+G
E =C +I (r2 )+G
r1
r2
E =Y
IS
I E
Y
Y2Y1
Y2Y1
IS curveFiscal policy and IS curve – ex. of increase in G
At given value of
r, G E Y
Y
E
r
Y
E =C +I (r1 )+G1
E =C +I (r1 )+G2
r1
E =Y
IS1
The horizontal distance of the
IS shift equals IS2
…so the IS curve shifts to the right.
11 MPC
Y G
Y
LM curveHow to build the LM curve
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The theory of liquidity preference:
Developed by John Maynard Keynes.
A simple theory in which the interest rate
is determined by money supply and money demand.
LM curveMoney supply
M/P
real money balances
r
interestrate
sM P
M P
The supply of real money balances is fixed.
LM curveMoney demand
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M/P
real money balances
r
interestrate sM P
M P
L
(r,Y )
The demand for real money balances is negatively dependent on interest rate.
LM curveEquilibrium
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M/P
real money balances
r
interestrate
sM P
M P
L (r,Y ) r1
The interest rate adjusts to equate the supply and demand for money
LM curveMonetary policy
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LM curveMonetary policy – How can CB affect the interest rate?
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M/P
real money balances
r
interestrate
1M
P
L
(r ,Y)
r1
r2
2M
P
To reduce r, central bank reduces M.In reality, this is hardly he case. More used technique = change of discount rate.
LM curveHow to derive LM curve?
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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:
The LM curve is positively sloped. Intuition: 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.
( , )M P L r Y
LM curveHow to derive LM curve II
M/P
r
1M
P
L (r , Y1 ) r1
r2
r
YY1
r1
r2
LM1
(a) The market for real money balances
(b) The LM curve
2M
P
LM2
IS-LM modelEquilibrium
The short-run equilibrium is the combination of r and Y that simultaneously satisfies the equilibrium conditions in the goods & money markets:
( ) ( )Y C Y T I r G Y
r
( , )M P L r Y
IS
LM
Equilibriuminterestrate
Equilibriumlevel ofincome
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causing output & income to rise.
IS1
IS-LM modelFiscal policy: An increase in government purchases
1. IS curve shifts right
Y
rLM
r1
Y1
1by
1 MPCG
IS2
Y2
r2
1.2. This raises money
demand, causing the interest rate to rise…
2.
3. …which reduces investment, so the final increase in Y
1is smaller than
1 MPCG
3.
slide 30
IS1
1.
IS-LM modelFiscal policy: A tax cut
Y
r
LM
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 IS curve 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.
slide 31
2. …causing the interest rate to fall
IS
IS-LM modelMonetary Policy: an increase in M
1. M > 0 shifts the LM curve down(or to the right)
Y
r LM1
r1
Y1 Y2
r2
LM2
3. …which increases investment, causing output & income to rise.
IS-LM modelShocks I
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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 banking reduce
money demand
IS-LM modelShocks II
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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
Aggregate demandHow to get from IS-LM to AD
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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
Y1Y2
Aggregate demandHow to get from IS-LM to AD II
Y
r
Y
P
IS
LM(P1)
LM(P2)
AD
P1
P2
Y2 Y1
r2
r1
Intuition for slope of AD curve:
P (M/P )
LM shifts left
r
I
Y
Aggregate demandEffect of monetary policy
Y
P
IS
LM(M2/P1)
LM(M1/P1)
AD1
P1
Y1
Y1
Y2
Y2
r1
r2
The Fed can increase aggregate demand:
M LM shifts right
AD2
Y
r
r
I
Y at each value of P
Y2
Y2
r2
Y1
Y1
r1
Aggregate demandEffect of fiscal policy
Y
r
Y
P
IS1
LM
AD1
P1
Expansionary fiscal policy (G and/or T ) increases agg. demand:
T C
IS shifts right
Y at each value of P AD2
IS2
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Aggregate demandWhen is fiscal policy more effective?
Fiscal policy is effective (Y will rise much) when:
LM flatter
As the rise in G raises Y,
the increase in money demand does not raise r much:
so investment is not crowded out as much.
LM’
Y2’
2’
Y2
IS2
2
LM
Y1
IS1r
1
slide 39
Aggregate demandWhen is monetary policy more effective?
Monetary policy is effective (Y will rise much) when:
IS flatter
As a rise in M lowers the interest rate (r),
investment rises more in response to the fall in r,
so output rises more.Y2
LM2
2
Y1
LM1
r
1
Y2’
2’
IS
IS’
slide 40
IS-LM and AD-AS modelcombination of short & long run
Y Y
Y Y
Y Y
rise
fall
remain constant
In the short-run equilibrium, if
then over time, the price level
will
IS-LM and AD-AS modelshort & long run effect of IS shock I
A negative IS shock shifts IS and AD left, causing Y to fall.
Y
r
Y
PLRAS
Y
LRAS
Y
IS1
SRAS1P1
LM(P1)
IS2
AD2
AD1
IS-LM and AD-AS modelshort & long run effect of IS shock II
Y
r
Y
P LRAS
Y
LRAS
Y
IS1
SRAS1P1
LM(P1)
IS2
AD2
AD1
In the new short-run equilibrium, Y Y
IS-LM and AD-AS modelshort & long run effect of IS shock II
Y
r
Y
P LRAS
Y
LRAS
Y
IS1
SRAS1P1
LM(P1)
IS2
AD2
AD1
In the new short-run equilibrium, Y Y
Over time, P gradually falls, which causes• SRAS to move
down• M/P to increase,
which causes LM to move down
AD2
IS-LM and AD-AS modelshort & long run effect of IS shock III
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 LM to move down
SRAS2P2
LM(P2)
AD2
SRAS2P2
LM(P2)
IS-LM and AD-AS modelshort & long run effect of IS shock IV
Y
r
Y
P LRAS
Y
LRAS
Y
IS1
SRAS1P1
LM(P1)
IS2
AD1
This process continues until economy reaches a long-run equilibrium with
Y Y
The Great DepressionCASE STUDY
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1929 1931 1933 1935 1937 1939
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1929 1931 1933 1935 1937 1939
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Unemployment (right scale)
Real GNP(left scale)
slide 47
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The Great DepressionCASE STUDY
Real side of economy: Output: falling Consumption: falling Investment: falling much Gov. purchases: fall (with a delay)
slide 49
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The Great DepressionCASE STUDY
Nominal side: Nominal interest rate: falling Money supply (nominal): falling Price level: falling
(deflation)
slide 51
The Great DepressionCASE STUDY
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
slide 52
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 investment3. Contractionary fiscal policy
in the face of falling tax revenues and increasing deficits, politicians raised tax rates and cut spending
slide 53
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.
slide 54
The Money Hypothesis: Revision
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 = i – e
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.