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Aggregate Demand II: Applying the IS-LM Model MACROECONOMICS N. Gregory Mankiw Power. Point ® Slides by Ron Cronovich © 2013 Worth Publishers, all rights reserved 1 2

Context § Chapter 10 introduced the model of aggregate demand supply. § Chapter 11 developed the IS-LM model, the basis of the aggregate demand curve. CHAPTER 12 Aggregate Demand II 1

IN THIS CHAPTER, YOU WILL LEARN: § how to use the IS-LM model to analyze the effects of shocks, fiscal policy, and monetary policy § how to derive the aggregate demand curve from the IS-LM model § several theories about what caused the Great Depression 2

Equilibrium in the IS -LM model The IS curve represents equilibrium in the goods market. The LM curve represents money market equilibrium. r LM r 1 IS The intersection determines the unique combination of Y and r that satisfies equilibrium in both markets. CHAPTER 12 Aggregate Demand II Y 1 Y 3

Policy analysis with the IS -LM model r LM We can use the IS-LM model to analyze the effects r 1 of • fiscal policy: G and/or T • monetary policy: M CHAPTER 12 Aggregate Demand II IS Y 1 Y 4

An increase in government purchases 1. IS curve shifts right causing output & income to rise. 2. This raises money demand, causing the interest rate to rise… r 2 r 1 3. …which reduces investment, so the final increase in Y CHAPTER 12 Aggregate Demand II LM IS 2 1. IS 1 Y 2 Y 3. 5

A tax cut Consumers save r (1 MPC) of the tax cut, so the initial boost in spending is smaller for T r 2 than for an equal G… 2. r 1 and the IS curve shifts by LM 1. IS 1 2. …so the effects on r and Y are smaller for T than for an equal G. CHAPTER 12 IS 2 Aggregate Demand II Y 1 Y 2. 6

Monetary policy: An increase in M 1. M > 0 shifts the LM curve down (or to the right) 2. …causing the interest rate to fall 3. …which increases investment, causing output & income to rise. CHAPTER 12 Aggregate Demand II r LM 1 LM 2 r 1 r 2 IS Y 1 Y 2 Y 7

Interaction between monetary & 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 interactions may alter the impact of the original policy change. CHAPTER 12 Aggregate Demand II 8

The Fed’s response to G > 0 § Suppose Congress increases G. § Possible Fed responses: 1. hold M constant 2. hold r constant 3. hold Y constant § In each case, the effects of the G are different… CHAPTER 12 Aggregate Demand II 9

Response 1: Hold M constant If Congress raises G, the IS curve shifts right. If Fed holds M constant, then LM curve doesn’t shift. r LM 1 r 2 r 1 IS 2 IS 1 Results: Y 1 Y 2 CHAPTER 12 Aggregate Demand II Y 10

Response 2: Hold r constant If Congress raises G, the IS curve shifts right. To keep r constant, Fed increases M to shift LM curve right. r LM 1 r 2 r 1 IS 2 IS 1 Results: Y 1 Y 2 Y 3 CHAPTER 12 Aggregate Demand II LM 2 Y 11

Response 3: Hold Y constant If Congress raises G, the IS curve shifts right. To keep Y constant, Fed reduces M to shift LM curve left. LM 2 LM 1 r r 3 r 2 r 1 IS 2 IS 1 Results: Y 1 Y 2 CHAPTER 12 Aggregate Demand II Y 12

Estimates of fiscal policy multipliers from the DRI macroeconometric model Assumption about monetary policy Estimated value of Y / G Estimated value of Y / T Fed holds money supply constant 0. 60 0. 26 Fed holds nominal interest rate constant 1. 93 1. 19 CHAPTER 12 Aggregate Demand II 13

Shocks in the IS -LM model 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 CHAPTER 12 Aggregate Demand II 14

Shocks in the IS -LM model 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 reduce money demand. CHAPTER 12 Aggregate Demand II 15

NOW YOU TRY Analyze shocks with the IS-LM model Use the IS-LM model to analyze the effects of 1. a housing market crash that reduces consumers’ wealth 2. consumers using cash in transactions more frequently in response to an increase in identity theft For each shock, a. use the IS-LM diagram to determine the effects on Y and r. b. figure out what happens to C, I, and the unemployment rate. 16

ANSWERS, PART 1 Housing market crash IS shifts left, causing r and Y to fall. C falls due to lower wealth and lower income, I rises because r LM 1 r 2 r is lower u rises because Y is lower (Okun’s law) IS 2 Y 1 IS 1 Y 17

ANSWERS, PART 2 Increase in money demand LM shifts left, causing r to rise and Y to fall. C falls due to lower income, I falls because LM 2 r LM 1 r 2 r 1 r is higher u rises because Y is lower (Okun’s law) IS 1 Y 2 Y 18

CASE STUDY: The U. S. recession of 2001 § During 2001: § 2. 1 million jobs lost, unemployment rose from 3. 9% to 5. 8%. § GDP growth slowed to 0. 8% (compared to 3. 9% average annual growth during 1994– 2000). CHAPTER 12 Aggregate Demand II 19

CASE STUDY: The U. S. recession of 2001 Index (1942 = 100) Causes: 1) Stock market decline C 1, 500 Standard & Poor’s 500 1, 200 900 600 300 1995 CHAPTER 12 1996 1997 1998 Aggregate Demand II 1999 2000 2001 2002 2003 20

CASE STUDY: The U. S. recession of 2001 Causes: 2) 9/11 § increased uncertainty § fall in consumer & business confidence § result: lower spending, IS curve shifted left Causes: 3) Corporate accounting scandals § Enron, World. Com, etc. § reduced stock prices, discouraged investment CHAPTER 12 Aggregate Demand II 21

CASE STUDY: The U. S. recession of 2001 Fiscal policy response: shifted IS curve right § tax cuts in 2001 and 2003 § spending increases § airline industry bailout § NYC reconstruction § Afghanistan war CHAPTER 12 Aggregate Demand II 22

CASE STUDY: The U. S. recession of 2001 Monetary policy response: shifted LM curve right 7 6 Three-month T-Bill rate 5 4 3 2 1 CHAPTER 12 Aggregate Demand II 03 /20 03 04 /11 /20 02 01 /09 /20 02 10 /09 /20 02 07 /09 /20 02 04 /08 /20 01 01 /06 /20 01 10 /06 /20 01 07 /06 /20 01 04 /05 /20 00 01 /03 /20 00 10 /03 /20 07 /02 04 01 /20 00 0 23

What is the Fed’s policy instrument? § The news media commonly report the Fed’s policy changes as interest rate changes, as if the Fed has direct control over market interest rates. § In fact, the Fed targets the federal funds rate—the interest rate banks charge one another on overnight loans. § The Fed changes the money supply and shifts the LM curve to achieve its target. § Other short-term rates typically move with the federal funds rate. CHAPTER 12 Aggregate Demand II 24

What is the Fed’s policy instrument? Why does the Fed target interest rates instead of the money supply? 1) They are easier to measure than the money supply. 2) The Fed might believe that LM shocks are more prevalent than IS shocks. If so, then targeting the interest rate stabilizes income better than targeting the money supply. (See problem 7 on p. 353. ) CHAPTER 12 Aggregate Demand II 25

IS-LM and aggregate demand § 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 LM and therefore affect Y. § The aggregate demand curve (introduced in Chap. 10) captures this relationship between P and Y. CHAPTER 12 Aggregate Demand II 26

Deriving the AD curve r Intuition for slope of AD curve: P (M/P ) LM shifts left r I Y LM(P 2) LM(P 1) r 2 r 1 IS P Y 2 Aggregate Demand II Y P 2 P 1 AD Y 2 CHAPTER 12 Y 1 Y 27

Monetary policy and the AD curve The Fed can increase aggregate demand: M LM shifts right r Y at each value of P LM(M 2/P 1) r 1 r 2 IS r I LM(M 1/P 1) P Y 1 Aggregate Demand II Y P 1 Y 1 CHAPTER 12 Y 2 AD 1 Y 28

Fiscal policy and the AD curve Expansionary fiscal policy ( G and/or T ) increases agg. demand: r LM r 2 r 1 IS 2 T C IS 1 IS shifts right P Y at each value of P Y 1 Y 2 Y P 1 Y 1 CHAPTER 12 Aggregate Demand II Y 2 AD 1 Y 29

IS-LM and AD-AS in the short run & long run Recall from Chapter 10: The force that moves the economy from the short run to the long run is the gradual adjustment of prices. In the short-run equilibrium, if then over time, the price level will rise fall remain constant CHAPTER 12 Aggregate Demand II 30

The SR and LR effects of an IS shock r A negative IS shock shifts IS and AD left, causing Y to fall. LRAS LM(P ) 1 IS 2 IS 1 Y P P 1 LRAS SRAS 1 AD 2 Y CHAPTER 12 Aggregate Demand II 31

The SR and LR effects of an IS shock r LRAS LM(P ) 1 In the new short-run equilibrium, IS 2 IS 1 Y P P 1 LRAS SRAS 1 AD 2 Y CHAPTER 12 Aggregate Demand II 32

The SR and LR effects of an IS shock r LRAS LM(P ) 1 In the new short-run equilibrium, IS 2 Over time, P gradually falls, causing: • SRAS to move down • M/P to increase, which causes LM to move down CHAPTER 12 Aggregate Demand II IS 1 Y P P 1 LRAS SRAS 1 AD 2 Y 33

The SR and LR effects of an IS shock r LRAS LM(P ) 1 LM(P 2) IS 2 Over time, P gradually falls, causing: • SRAS to move down • M/P to increase, which causes LM to move down CHAPTER 12 Aggregate Demand II IS 1 Y P LRAS P 1 SRAS 1 P 2 SRAS 2 AD 1 AD 2 Y 34

The SR and LR effects of an IS shock r LRAS LM(P ) 1 LM(P 2) This process continues until economy reaches a long-run equilibrium with IS 2 IS 1 Y P LRAS P 1 SRAS 1 P 2 SRAS 2 AD 1 AD 2 Y CHAPTER 12 Aggregate Demand II 35

NOW YOU TRY Analyze SR & LR effects of M a. Draw the IS-LM and AD- r LRAS LM(M /P ) 1 1 AS diagrams as shown here. b. Suppose Fed increases IS M. Show the short-run effects on your graphs. Y 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? P P 1 LRAS SRAS 1 AD 1 Y 36

ANSWERS, PART 1 Short-run effects of M LM and AD shift right. r falls, Y rises above r LRAS LM(M /P ) 1 1 LM(M 2/P 1) r 1 r 2 IS Y 2 P P 1 Y LRAS SRAS AD 2 AD 1 Y 2 Y 37

ANSWERS, PART 2 Transition from short run to long run Over time, § § r LRAS LM(M /P ) 1 1 2 3 LM(M 2/P 1) r 3 = r 1 r 2 SRAS moves upward P rises IS M/P falls LM moves leftward New long-run eq’m § P higher § all real variables back at Y 2 P P 3 P 1 their initial values Money is neutral in the long run. Y LRAS SRAS AD 2 AD 1 Y 2 Y 38

The Great Depression Unemployment (right scale) 220 30 25 200 20 180 15 160 10 Real GNP (left scale) 140 120 1929 5 0 1931 1933 1935 1937 1939 percent of labor force billions of 1958 dollars 240

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. CHAPTER 12 Aggregate Demand II 40

THE SPENDING HYPOTHESIS: Reasons for the IS shift § Stock market crash exogenous C § Oct 1929–Dec 1929: S&P 500 fell 17% § Oct 1929–Dec 1933: S&P 500 fell 71% § Drop in investment § Correction after overbuilding in the 1920 s. § Widespread bank failures made it harder to obtain financing for investment. § Contractionary fiscal policy § Politicians raised tax rates and cut spending to combat increasing deficits. CHAPTER 12 Aggregate Demand II 41

THE MONEY HYPOTHESIS: A shock to the LM curve § Asserts that the Depression was largely due to huge fall in the money supply. § Evidence: M 1 fell 25% during 1929– 33. § But, two problems with this hypothesis: § P fell even more, so M/P actually rose slightly during 1929– 31. § nominal interest rates fell, which is the opposite of what a leftward LM shift would cause. CHAPTER 12 Aggregate Demand II 42

THE MONEY HYPOTHESIS AGAIN: The effects of falling prices § Asserts that the severity of the Depression was due to a huge deflation: P fell 25% during 1929– 33. § This deflation was probably caused by the fall in M, so perhaps money played an important role after all. § In what ways does a deflation affect the economy? CHAPTER 12 Aggregate Demand II 43

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 12 Aggregate Demand II 44

THE MONEY HYPOTHESIS AGAIN: The effects of falling prices § The destabilizing effects of expected deflation: E r for each value of i I because I = I (r ) planned expenditure & agg. demand income & output CHAPTER 12 Aggregate Demand II 45

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 CHAPTER 12 Aggregate Demand II 46

Why another Depression is unlikely § Policymakers (or their advisers) now know much more about macroeconomics: § The Fed knows better than to let M fall so much, especially during a contraction. § Fiscal policymakers know better than to raise taxes or cut spending during a contraction. § Federal deposit insurance makes widespread bank failures very unlikely. § Automatic stabilizers make fiscal policy expansionary during an economic downturn. CHAPTER 12 Aggregate Demand II 47

CASE STUDY The 2008– 09 financial crisis & recession § 2009: Real GDP fell, u-rate approached 10% § Important factors in the crisis: § early 2000 s Federal Reserve interest rate policy § subprime mortgage crisis § bursting of house price bubble, § § § rising foreclosure rates falling stock prices failing financial institutions declining consumer confidence, drop in spending on consumer durables and investment goods CHAPTER 12 Aggregate Demand II 48

Interest rates and house prices 9 8 170 interest rate (%) 7 6 150 5 130 4 110 3 90 2 70 1 0 2001 2002 2003 2004 50 2005 House price index, 2000 = 100 Federal Funds rate 30 -year mortgage rate 190 Case-Shiller 20 -city composite house price index

Change in U. S. house price index and rate of new foreclosures, 1999– 2009 14% 1. 4 10% 1. 2 8% 1. 0 6% 0. 8 4% 2% 0. 6 0% 0. 4 -2% 0. 2 -4% -6% 1999 0. 0 2001 2003 2005 2007 2009 New foreclosure starts (% of total mortgages) Percent change in house prices (from 4 quarters earlier) 12% US house price index New foreclosures

House price change and new foreclosures, 2006: Q 3– 2009: Q 1 20% New foreclosures, % of all mortgages 18% Nevada Florida 16% 14% Illinois Michigan Ohio California Georgia 12% 10% 8% 6% Arizona Colorado Rhode Island New Jersey S. Dakota Hawaii 4% Oregon Alaska 2% 0% -40% Texas -30% -20% -10% 0% Wyoming N. Dakota 10% Cumulative change in house price index 20%

U. S. bank failures by year, 2000– 2011

100% 7/20/2009 120% 11/11/2008 140% 3/5/2008 (% change from 52 weeks earlier) 6/28/2007 10/20/2006 2/11/2006 6/5/2005 9/27/2004 1/20/2004 5/14/2003 9/5/2002 12/28/2001 4/21/2001 8/13/2000 12/6/1999 Major U. S. stock indexes DJIA S&P 500 NASDAQ 80% 60% 40% 20% 0% -20% -40% -60% -80%

Consumer sentiment and growth in consumer durables and investment spending 110 15% 100 5% 90 0% 80 -5% -10% 70 -15% Durables -20% Investment 60 UM Consumer Sentiment Index -25% 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 50 Consumer Sentiment Index, 1966 = 100 % change from four quarters earlier 20%

Real GDP growth and unemployment 10 10 Real GDP growth rate (left scale) Unemployment rate (right scale) 8 8 6 6 4 2 4 0 -2 2 -4 -6 1995 1997 1999 2001 2003 2005 2007 2009 0 2011 % of labor force % change from 4 quarters earlier 12

CHAPTER SUMMARY 1. IS-LM model § 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 § IS curve: goods market equilibrium § LM curve: money market equilibrium 56

CHAPTER SUMMARY 2. AD curve § shows relation between P and the IS-LM model’s equilibrium Y. § negative slope because P (M/P ) r I Y § expansionary fiscal policy shifts IS curve right, raises income, and shifts AD curve right. § expansionary monetary policy shifts LM curve right, raises income, and shifts AD curve right. § IS or LM shocks shift the AD curve. 57