chap11(agg demand ii)0

7/31/2019 Chap11(Agg Demand II)0

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CHAPTER 11 Aggregate Demand II slide 0

Ch. 11: Aggregate Demand II 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 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


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The intersection determinesthe unique combination of Y and r that satisfies equilibrium in both markets.

The LM curve representsmoney market equilibrium.

Equilibrium in the IS -LM Model

The IS curve representsequilibrium in the goodsmarket.

( ) ( )Y C Y T I r G

( , )M P L r Y IS Y

r LM

r 1

Y 1


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Policy analysis with the IS -LM Model

Policymakers can affect

macroeconomic variableswith fiscal policy: G and/or T monetary policy: M

We can use the IS-LM model to analyze theeffects of these policies.

( ) ( )Y C Y T I r G

( , )M P L r Y

IS

Y

r LM

r 1

Y 1


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causing output &

income to rise.

IS 1

An increase in government purchases

1. IS curve shifts right

Y

r LM

r 1

Y 1

1by

1 MPCG

IS 2

Y 2

r 2

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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IS 1

1.

A tax cut

Y

r LM

r 1

Y 1

IS 2

Y 2

r 2

Because consumers save(1 MPC) of the tax cut,the initial boost inspending is smaller for T than for an equal G

and the IS curveshifts by

MPC1 MPC

T 1.

2.

2.so the effects on r and Y are smaller for a T thanfor 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 LM curve down(or to the right)

Y

r LM 1

r 1

Y 1 Y 2

r 2

LM 2

3. which increases

investment, causingoutput & income torise.


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Interaction betweenmonetary & 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.


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The Feds response to G > 0

Suppose Congress increases G .Possible Fed responses:

1. hold M constant2. hold r constant3. hold Y constant

In each case, the effects of the G are different:


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If Congress raises G ,the IS curve shiftsright

IS 1

Response 1: hold M constant

Y

r LM 1

r 1

Y 1

IS 2

Y 2

r 2 If Fed holds M constant, then LM curve doesnt shift.

Results:

2 1Y Y Y

2 1r r r


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IS 1

Response 2: hold r constant

Y

r LM 1

r 1

Y 1

IS 2

Y 2

r 2 To keep r constant,Fed increases M toshift LM curve right.

3 1Y Y Y

0r

LM 2

Y 3

Results:


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IS 1

Response 3: hold Y constant

Y

r LM 1

r 1

IS 2

Y 2

r 2 To keep Y constant,Fed reduces M toshift LM curve left.

0Y

3 1r r r

LM 2

Results:

Y 1

r 3


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Estimates of fiscal policy multipliers

from the DRI macroeconometric model

Assumption aboutmonetary policy

Estimatedvalue of

Y / G

Fed holds nominalinterest rate constant

Fed holds moneysupply constant

1.93

0.60

Estimatedvalue of

Y / T

1.19

0.26


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Shocks in the IS -LM Model

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

Examples:

stock market boom or crash change in households wealth C

change in business or consumerconfidence or expectations

I and/or C


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Shocks in the IS -LM Model

LM shocks : exogenous changes in thedemand for money.

Examples:

a wave of credit card fraud increasesdemand for money more ATMs or the Internet reduce money

demand


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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 makesconsumers 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.


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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 rateDec 2000: 3.9%Dec 2001: 5.8%

The number of unemployed peoplerose by 2.1 million during 2001!


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~ 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.


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~ 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


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~ The recovery ~

The recession officially ended in November2001.

Real GDP recovered, growing2.3% 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 beresponding: 5.6% for the first half of 2004.


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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 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.


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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 the

money supply

2) The Fed might believe that LM shocks aremore prevalent than IS shocks. If so, thentargeting the interest rate stabilizes incomebetter than targeting the money supply.

(See Problem 7 on p.306)


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IS-LM and Aggregate Demand

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

However, a change inP

would shift theLM curve and therefore affect Y .

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


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Y 1Y 2

Deriving the AD curve

Y

r

Y

P

IS

LM (P 1 )

LM (P 2)

AD

P 1

P 2

Y 2 Y 1

r 2r 1

Intuition for slopeof AD curve:

P (M / P )

LM shifts left

r

I

Y


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Monetary policy and the AD curve

Y

P

IS

LM (M 2 /P 1 )

LM (M 1/P

1)

AD 1

P 1

Y 1

Y 1

Y 2

Y 2

r 1r 2

The Fed can increaseaggregate demand:

M LM shifts right

AD 2

Y

r

r I

Y at each

value of P


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Y 2

Y 2

r 2

Y 1

Y 1

r 1

Fiscal policy and the AD curve

Y

r

Y

P

IS 1

LM

AD 1

P 1

Expansionary fiscal policy( G and/or T )increases agg. demand:

T

C

IS shifts right

Y at eachvalue

of P AD 2

IS 2


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IS-LM and AD-AS in the short run & long run

Recall from Chapter 9 : The force that movesthe economy from the short run to the long runis the gradual adjustment of prices.

Y Y

Y Y

Y Y

rise

fallremain constant

In the short-runequilibrium, if then over time,the price level will


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The SR and LR effects of an IS shock

A negative IS shock shifts IS and AD left,causing Y to fall.

Y

r

Y

P LRAS

Y

LRAS

Y

IS 1

SRAS 1P 1

LM (P 1)

IS 2

AD 2AD 1


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Y

r

Y

P LRAS

Y

LRAS

Y

IS 1

SRAS 1P 1

LM (P 1)

IS 2

AD 2AD 1

In the new short-runequilibrium, Y Y


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AD 2


Y

r

Y

P LRAS

Y

LRAS

Y

IS 1

SRAS 1P 1

LM (P 1)

IS 2

AD 1

Over time,P gradually falls,which causes SRAS to move down M / P to increase,

which causes LM to move down

SRAS 2P 2

LM (P 2)


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AD 2

SRAS 2P 2

LM (P 2)


Y

r

Y

P LRAS

Y

LRAS

Y

IS 1

SRAS 1P 1

LM (P 1)

IS 2

AD 1

This process continuesuntil economy reachesa long-run equilibriumwith Y Y


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EXERCISE: Analyze SR & LR effects of M

a. Draw the IS-LM and AD-AS diagrams as shown here.

b. Suppose Fed increases M .Show the short-run effectson your graphs.

c. Show what happens in thetransition from the shortrun to the long run.

d. How do the new long-runequilibrium values of theendogenous variablescompare to their initialvalues?

Y

r

Y

P LRAS

Y

LRAS

Y

IS

SRAS 1P 1

LM (M 1 / P

1)

AD 1


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The Great Depression

120

140

160

180

200

220

240

1929 1931 1933 1935 1937 1939

b i l l i

o n s

o f 1 9 5 8

d o

l l a r s

0

5

10

15

20

25

30

p e r c e n

t o

f l a b

o r

f o r c e

Unemployment (right scale)

Real GNP

(left scale)


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The Spending Hypothesis:Shocks to the IS Curve

asserts that the Depression was largely dueto an exogenous fall in the demand forgoods & services -- a leftward shift of the IS curve

evidence:output and interest rates both fell, which iswhat a leftward IS shift would cause


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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 toobtain financing for investment

3. Contractionary fiscal policyin the face of falling tax revenues andincreasing deficits, politicians raised tax ratesand cut spending


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The Money Hypothesis:A Shock to the LM Curve

asserts that the Depression was largely dueto huge fall in the money supplyevidence: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 theopposite of what would result from aleftward LM shift.


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The Money Hypothesis Again:The Effects of Falling Prices

asserts that the severity of the Depressionwas due to a huge deflation:P fell 25% during 1929-33.

This deflation was probably caused bythe fall in M , so perhaps money playedan important role after all.

In what ways does a deflation affect theeconomy?

h h


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The stabilizing effects of deflation:P (M / P ) LM shifts right Y

Pigou effect :P (M / P )

consumers wealth C

IS shifts right Y

h h i i


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The destabilizing effects of unexpected deflation:debt-deflation theory

P (if unexpected)transfers purchasing power from borrowersto lendersborrowers spend less,lenders spend more

if borrowers propensity to spend is largerthan lenders, then aggregate spending falls,the IS curve shifts left, and Y falls

Th M H h i A i


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The destabilizing effects of expected deflation: e

r for each value of i

I because

I =

I (r

)planned expenditure & agg. demand income & output


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Why another Depression is unlikely

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 stabilizers make fiscal policyexpansionary during an economic downturn.


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Chapter summary2. AD curve

shows relation between P and the IS-LM models equilibrium Y .

negative slope becauseP (M / P ) r I Y

expansionary fiscal policy shifts IS curve right,raises income, and shifts AD curve right

expansionary monetary policy shifts LM curveright, raises income, and shifts AD curve rightIS or LM shocks shift the AD curve

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