MACROECONOMICS-CH11

Topic 10: Aggregate Demand II (chapter 11)

Equilibrium in the IS - LM Model ,[object Object],The intersection determines the unique combination of Y and r that satisfies equilibrium in both markets. The LM curve represents money market equilibrium. r 1 Y 1 IS Y r LM

Policy analysis with the IS - LM Model ,[object Object],[object Object],[object Object],[object Object],IS Y r LM r 1 Y 1

An increase in government purchases ,[object Object],causing output & income to rise. 2. This raises money demand, causing the interest rate to rise… 3. …which reduces investment, so the final increase in Y IS 1 Y r r 1 Y 1

A tax cut Because consumers save (1  MPC) of the tax cut, the initial boost in spending is smaller for  T than for an equal  G … and the IS curve shifts by … so the effects on r and Y are___________________ _________________. IS 1 1. Y r LM r 1 Y 1 IS 2 Y 2 r 2 1. 2. 2. 2.

Monetary Policy: an increase in M ,[object Object],2. …causing the interest rate to fall 3. …which increases investment, causing output & income to rise. Y r LM 1 r 1 Y 1

Shocks in the IS - LM Model ,[object Object],[object Object],[object Object],[object Object]

CASE STUDY The U.S. economic slowdown of 2001 ,[object Object],[object Object],[object Object],[object Object],[object Object],[object Object],[object Object]

What is the Fed’s policy instrument? ,[object Object],[object Object],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.

What is the Fed’s policy instrument? ,[object Object],[object Object],[object Object]

IS-LM and Aggregate Demand ,[object Object],[object Object],[object Object]

Deriving the AD curve Y 1 AD Y 1 Intuition for slope of AD curve:  P   ( M / P )  LM shifts left       Y r Y P IS LM ( P 1 ) P 1 r 1

Monetary policy and the AD curve The Fed can increase aggregate demand:  M  LM shifts right       Y P IS LM ( M 1 / P 1 ) AD 1 P 1 Y 1 Y 1 r 1 Y r

Fiscal policy and the AD curve Expansionary fiscal policy (  G and/or  T ) increases agg. demand:  T      Y at each value of P Y 1 Y 1 r 1 Y r Y P IS 1 LM AD 1 P 1

Deriving AD curve with algebra ,[object Object]

Deriving AD curve with algebra Use the goods market equilibrium condition Y = C + I + G Solve for Y: Can see multipliers here: rise in Y taking r as given. But r is an endogenous variable and it will change… A line relating Y to r with slope ___________

Deriving AD curve with algebra Use the money market to find a value for r : As done for the LM curve previously, Equilibrium in money market requires: Line with slope = _____ suppose the money market is characterized by:

Deriving AD curve with algebra Now combine the two, substituting in for r: Solve for Y. For convenience, define a term:

Deriving AD curve with algebra This implies a negative relationship between output ( Y ) and price level ( P ): an Aggregate Demand curve. P Y AD This math can help reveal under what conditions monetary and fiscal policies will be most effective…

Policy Effectiveness ,[object Object],1) _________( __ large or __ small, so z near 1) As the rise in G raises Y, the increase in money demand does not raise r much: -small e :M d not responsive to Y -large f : M d is responsive to r so investment is not crowed out as much. LM’ Y 2 ’ 2’ Y 2 IS 2 2 LM Y 1 IS 1 r 1

Policy Effectiveness ,[object Object],2) _______ ( __ small: ___________, z near 1) As the rise in G raises Y : investment does not respond much to the rising r coming from the money market, so investment is not crowed out as much. Y 2 IS 2 2 LM Y 1 IS 1 r 1 IS 2 ’ Y 2 ’ 2’ IS 1 ’

Policy Effectiveness ,[object Object],1) _______ ( __ large: Investment __________) As a rise in M lowers the interest rate ( r ), investment rises more in response to the fall in r , so output rises more. Y 2 LM 2 2 Y 1 LM 1 r 1 IS IS’ Y 2 ’ 2’

Policy Effectiveness ,[object Object],2) _____________________________ A rise in M requires a large fall in the interest rate ( r ) to make people willing to hold the extra cash. The large fall in r raises investment expenditure much, and this raises output much. (This is hard to show graphically, because f affects shift as well as slope.)

IS-LM and AD-AS in the short run & long run ,[object Object],rise fall remain constant In the short-run equilibrium, if then over time, the price level will

The SR and LR effects of an IS shock ,[object Object],In the new short-run equilibrium, Over time P falls, which causes M / P to increase, causing LM to move down. Economy eventually reaches a long-run equilibrium with Y r Y P LRAS LRAS IS 1 SRAS 1 P 1 LM ( P 1 ) AD 1

EXERCISE: Analyze SR & LR effects of  M ,[object Object],[object Object],[object Object],[object Object],LM ( M 1 / P 1 ) Y r Y P LRAS LRAS IS SRAS 1 P 1 AD 1

Great Depression: Observations ,[object Object],[object Object],[object Object],[object Object],[object Object],[object Object],[object Object],[object Object],[object Object]

The Spending Hypothesis: Shocks to the IS Curve ,[object Object],[object Object]

The Spending Hypothesis: Reasons for the IS shift ,[object Object],[object Object],[object Object],[object Object],[object Object]

The Money Hypothesis: A Shock to the LM Curve ,[object Object],[object Object],[object Object]

A revision to the Money Hypothesis ,[object Object],[object Object],[object Object],[object Object],[object Object]

Why another Depression is unlikely ,[object Object],[object Object],[object Object],[object Object],[object Object],[object Object]

Chapter summary ,[object Object],[object Object],[object Object],[object Object],[object Object],[object Object]

MACROECONOMICS-CH11

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