Analyzing Policy Impact on Income & Interest Rates with IS-LM Model, Exams of Economics

Download Analyzing Policy Impact on Income & Interest Rates with IS-LM Model and more Exams Economics in PDF only on Docsity! 1 CHAPTER ELEVEN Aggregate Demand II m ac ro CHAPTER 11 Aggregate Demand II slide 1 Context ß Chapter 9 introduced the model of aggregate demand and supply. ß Chapter 10 developed the IS-LM model, the basis of the aggregate demand curve. ß 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 2 The intersection determines the unique combination of Y and r that satisfies equilibrium in both markets. The LM curve represents money market equilibrium. Equilibrium in the IS-LM Model The IS curve represents equilibrium in the goods market. IS Y r LM r1 Y1 CHAPTER 11 Aggregate Demand II slide 3 Policy analysis with the IS-LM Model Policymakers can affect macroeconomic variables with • fiscal policy: G and/or T • monetary policy: M We can use the IS-LM model to analyze the effects of these policies. IS Y r LM r1 Y1 CHAPTER 11 Aggregate Demand II slide 4 causing output & income to rise. IS1 An increase in government purchases 1. IS curve shifts right ∆G /(1 – MPC) Y r LM r1 Y1 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 3. CHAPTER 11 Aggregate Demand II slide 5 IS1 1. A tax cut Y r LM r1 Y1 IS2 Y2 r2 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 2. 2.…so the effects on r and Y are smaller for a ∆T than for an equal ∆G. 2. 1. ∆T MPC /(1 – MPC) 2 CHAPTER 11 Aggregate Demand II slide 6 2. …causing the interest rate to fall IS Monetary 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. CHAPTER 11 Aggregate Demand II slide 7 Interaction between monetary & fiscal policy ß Model: monetary & fiscal policy variables (M, G and T ) are exogenous ß Real world: Monetary policymakers may adjust M in response to changes in fiscal policy, or vice versa. ß Such interaction may alter the impact of the original policy change. CHAPTER 11 Aggregate Demand II slide 8 The Fed’s response to ∆G > 0 ß Suppose Congress increases G. ß Possible Fed responses: 1. hold M constant 2. hold r constant 3. hold Y constant ß In each case, the effects of the ∆G are different: CHAPTER 11 Aggregate Demand II slide 9 If Congress raises G, the IS curve shifts right IS1 Response 1: hold M constant Y r LM1 r1 Y1 IS2 Y2 r2If Fed holds M constant, then LM curve doesn’t shift. Results? 21rrr∆=− CHAPTER 11 Aggregate Demand II slide 10 If Congress raises G, the IS curve shifts right IS1 Response 2: hold r constant Y r LM1 r1 Y1 IS2 Y2 r2To keep r constant, Fed increases M to shift LM curve right. 0r∆= LM2 Y3 Results? CHAPTER 11 Aggregate Demand II slide 11 If Congress raises G, the IS curve shifts right IS1 Response 3: hold Y constant Y r LM1 r1 IS2 Y2 r2To keep Y constant, Fed reduces M to shift LM curve left. 31rrr∆=− LM2 Results? Y1 r3 5 CHAPTER 11 Aggregate Demand II slide 24 IS-LM and Aggregate Demand ß So far, we’ve been using the IS-LM model to analyze the short run, when the price level is assumed fixed. ß However, a change in P would shift the LM curve and therefore affect Y. ß The aggregate demand curve (introduced in chap. 9 ) captures this relationship between P and Y CHAPTER 11 Aggregate Demand II slide 25 Y1Y2 Deriving the AD curve 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 CHAPTER 11 Aggregate Demand II slide 26 Monetary policy and the AD curve 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 CHAPTER 11 Aggregate Demand II slide 27 Y2 Y2 r2 Y1 Y1 r1 Fiscal policy and the AD curve 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 CHAPTER 11 Aggregate Demand II slide 28 IS-LM and AD-AS in the short run & long run Recall from Chapter 9: The force that moves the economy from the short run to the long run is the gradual adjustment of prices. rise fall remain constant In the short-run equilibrium, if then over time, the price level will Y > Y Y < Y Y = Y CHAPTER 11 Aggregate Demand II slide 29 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 IS1 SRAS1P1 LM(P1) IS2 AD2 AD1 LRAS Y LRAS Y Y Y 6 CHAPTER 11 Aggregate Demand II slide 30 The SR and LR effects of an IS shock Y r Y P LRAS Y LRAS Y IS1 SRAS1P1 LM(P1) IS2 AD2 AD1 In the new short-run equilibrium, Y < Y YY< Y Y CHAPTER 11 Aggregate Demand II slide 31 The SR and LR effects of an IS shock Y r Y P LRAS Y LRAS Y IS1 SRAS1P1 LM(P1) IS2 AD2 AD1 In the new short-run equilibrium, YY< Over time, P gradually falls, which causes • SRAS to move down • M/P to increase, which causes LM to move down Y Y CHAPTER 11 Aggregate Demand II slide 32 AD2 The SR and LR effects of an IS shock 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) Y Y CHAPTER 11 Aggregate Demand II slide 33 AD2 SRAS2P2 LM(P2) The SR and LR effects of an IS shock 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 YY= Y Y CHAPTER 11 Aggregate Demand II slide 34 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 effects on your graphs. c. Show what happens in the transition from the short run to the long run. d. How do the new long-run equilibrium values of the endogenous variables compare to their initial values? Y r Y P LRAS Y LRAS Y IS SRAS1P1 LM(M1/P1) AD1 Y Y CHAPTER 11 Aggregate Demand II slide 35 The Great Depression 120 140 160 180 200 220 240 1929 1931 1933 1935 1937 1939 bi lli on s of 1 95 8 do lla rs 0 5 10 15 20 25 30 pe rc en t o f l ab or fo rc e Unemployment (right scale) Real GNP (left scale) 7 CHAPTER 11 Aggregate Demand II slide 36 The Spending Hypothesis: Shocks to the IS Curve ß asserts that the Depression was largely due to an exogenous fall in the demand for goods & services -- a leftward shift of the IS curve ß evidence: output and interest rates both fell, which is what a leftward IS shift would cause CHAPTER 11 Aggregate Demand II slide 37 The Spending Hypothesis: Reasons for the IS shift 1. Stock market crash ⇒ exogenous ↓C ß Oct-Dec 1929: S&P 500 fell 17% ß 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 38 The Money Hypothesis: A Shock to the LM Curve ß asserts that the Depression was largely due to huge fall in the money supply ß 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 39 The Money Hypothesis Again: The Effects of Falling Prices ß asserts that the severity of the Depression was due to a huge deflation: P fell 25% during 1929-33. ß This deflation was probably caused by the fall in M, so perhaps money played an important role after all. ß In what ways does a deflation affect the economy? CHAPTER 11 Aggregate Demand II slide 40 The Money Hypothesis Again: The Effects of Falling Prices The stabilizing effects of deflation: ♣↓P ⇒ ↑(M/P ) ⇒ LM shifts right ⇒ ↑Y ♣Pigou effect: ↓P ⇒ ↑(M/P ) ⇒ consumers’ wealth ↑ ⇒ ↑C ⇒ IS shifts right ⇒ ↑Y CHAPTER 11 Aggregate Demand II slide 41 The Money Hypothesis Again: The Effects of Falling Prices The destabilizing effects of unexpected deflation: debt-deflation theory ↓P (if unexpected) ⇒ transfers purchasing power from borrowers to lenders ⇒ borrowers spend less, lenders spend more ⇒ if borrowers’ propensity to spend is larger than lenders, then aggregate spending falls, the IS curve shifts left, and Y falls