Chapter 11: Aggregate Demand II: Applying the IS LM Model* · PDF fileMACROECONOMICS Chapter...
-
Upload
truongngoc -
Category
Documents
-
view
244 -
download
3
Transcript of Chapter 11: Aggregate Demand II: Applying the IS LM Model* · PDF fileMACROECONOMICS Chapter...
MACROECONOMICS
Chapter 11: Aggregate Demand II:Applying the IS -LM Model*
Chapter 11: Aggregate Demand II: Applying the IS–LM Model 0/56
Seventh Edition
N. Gregory Mankiw
* Slides based on Ron Cronovich's slides, adjusted for course in Study Abroad Program at the Wang Yanan Institute for Studies in Economics at Xiamen University.
Learning Objectives
This chapter introduces you to understanding:
explaining fluctuations with the IS–LM model
using IS–LM as a theory of aggregate demand
Chapter 11: Aggregate Demand II: Applying the IS–LM Model 1/56
using IS–LM as a theory of aggregate demand
the great depression
11.1) Explaining Fluctuations: IS –LM� Equilibrium in the IS -LM Model
The IS curve represents equilibrium in the goods market.
( ) ( )Y C Y T I r G= − + +
r
LM
r
Chapter 11: Aggregate Demand II: Applying the IS–LM Model 2/56
The intersection determines the unique combination of Y and rthat satisfies equilibrium in both markets.
The LM curve represents money market equilibrium.
( , )M P L r Y= IS
Y
r1
Y1
11.1) Explaining Fluctuations: IS –LM� Policy Analysis with the IS -LM Model
We can use the IS-LMmodel to analyze the
( ) ( )Y C Y T I r G= − + +
( , )M P L r Y=
r
LM
Chapter 11: Aggregate Demand II: Applying the IS–LM Model 3/56
model to analyze the effects of
• fiscal policy: G and/or T
• monetary policy: M
IS
Y
r1
Y1
11.1) Explaining Fluctuations: IS –LM� An Increase in Government Purchases
causing output & income to rise.
1. IS curve shifts right r
LM
r1
1by
1 MPCG∆
−r2
2.
Chapter 11: Aggregate Demand II: Applying the IS–LM Model 4/56
income to rise.
IS1
Y
r1
Y1
IS2
Y2
1.2. This raises money
demand, causing the interest rate to rise…
3. …which reduces investment, so the final increase in Y
1is smaller than
1 MPCG∆
−
3.
11.1) Explaining Fluctuations: IS –LM� A Tax Cut
r
LM
r
r2
Consumers save (1−MPC) of the tax cut, so the initial boost in spending is smaller for ∆∆∆∆T than for an equal ∆∆∆∆G… 2.
Chapter 11: Aggregate Demand II: Applying the IS–LM Model 5/56
IS1
1.
Y
r1
Y1
IS2
Y2
equal ∆∆∆∆G…
and the IS curve shifts by
MPC1 MPC
T− ∆−
1.
2.
2.…so the effects on rand Y are smaller for ∆∆∆∆Tthan for an equal ∆∆∆∆G.
2.
11.1) Explaining Fluctuations: IS –LM� Monetary Policy: An Increase in M
2. …causing the
1. ∆∆∆∆M > 0 shifts the LM curve down(or to the right)
rLM1
r1
LM2
Chapter 11: Aggregate Demand II: Applying the IS–LM Model 6/56
2. …causing the interest rate to fall
IS
YY1
Y2
r2
3. …which increases investment, causing output & income to rise.
11.1) Explaining Fluctuations: IS –LM� Interaction between Monetary & Fiscal Policy
• Model: Monetary & fiscal policy variables (M, G, and T ) are exogenous.
• Real world: Monetary policymakers may adjust M
Chapter 11: Aggregate Demand II: Applying the IS–LM Model 7/56
Monetary policymakers may adjust Min response to changes in fiscal policy, or vice versa.
• Such interaction may alter the impact of the original policy change.
11.1) Explaining Fluctuations: IS –LM� The Fed’s Response to ∆G > 0
• Suppose Congress increases G.
• Possible Fed responses:
1. wants to hold M constant
2. wants to hold r constant
Chapter 11: Aggregate Demand II: Applying the IS–LM Model 8/56
2. wants to hold r constant
3. wants to hold Y constant
• In each case, the effects of the ∆∆∆∆Gare different:
11.1) Explaining Fluctuations: IS –LM� Response 1: Hold M Constant
If Congress raises G, the IS curve shifts right.
r
LM1
r
r2If Fed holds M
Chapter 11: Aggregate Demand II: Applying the IS–LM Model 9/56
IS1
Y
r1
Y1
IS2
Y2
constant, then LMcurve doesn’t shift.
Results:
2 1Y Y Y∆ = −
2 1r r r∆ = −
11.1) Explaining Fluctuations: IS –LM� Response 2: Hold r Constant
If Congress raises G, the IS curve shifts right.
r
LM1
r
r2To keep r constant,
LM2
Chapter 11: Aggregate Demand II: Applying the IS–LM Model 10/56
IS1
Y
r1
Y1
IS2
Y2
Fed increases Mto shift LM curve right.
3 1Y Y Y∆ = −
0r∆ =
Y3
Results:
11.1) Explaining Fluctuations: IS –LM� Response 3: Hold Y Constant
r
LM1
r
r2To keep Y constant,
LM2
r3
If Congress raises G, the IS curve shifts right.
Chapter 11: Aggregate Demand II: Applying the IS–LM Model 11/56
IS1
Y
r1
IS2
Y2
To keep Y constant, Fed reduces Mto shift LM curve left.
0Y∆ =3 1
r r r∆ = −
Results:Y1
11.1) Explaining Fluctuations: IS –LM�Estimates of Fiscal Policy Multipliers
from the DRI Macroeconometric model
Assumption about monetary policy
Estimated value of ∆∆∆∆Y / ∆∆∆∆G
Estimated value of ∆∆∆∆Y / ∆∆∆∆T
Chapter 11: Aggregate Demand II: Applying the IS–LM Model 12/56
monetary policy ∆∆∆∆Y / ∆∆∆∆G
Fed holds nominal interest rate constant
Fed holds money supply constant
1.93
0.60
∆∆∆∆Y / ∆∆∆∆T
−−−−1.19
−−−−0.26
11.1) Explaining Fluctuations: IS –LM�Shocks in the IS-LM Model
IS shocks : exogenous changes in the demand for goods & services.
Examples:
– stock market boom or crash
Chapter 11: Aggregate Demand II: Applying the IS–LM Model 13/56
– stock market boom or crash⇒ change in households’ wealth⇒ ∆∆∆∆C
– change in business or consumer confidence or expectations ⇒ ∆∆∆∆I and/or ∆∆∆∆C
11.1) Explaining Fluctuations: IS –LM�Shocks in the IS-LM Model (cont.)
LM shocks : exogenous changes in the demand for money.
Examples:
– a wave of credit card fraud increases demand
Chapter 11: Aggregate Demand II: Applying the IS–LM Model 14/56
– a wave of credit card fraud increases demand for money.
– more ATMs or the Internet reduce money demand.
11.1) Explaining Fluctuations: IS –LM� 该你们了: Analyze Shocks with the IS-LM Model
Use the IS-LM model to analyze the effects of1. a boom in the stock market that makes
consumers wealthier.2. after a wave of credit card fraud, consumers
using cash more frequently in transactions.
Chapter 11: Aggregate Demand II: Applying the IS–LM Model 15/56
using 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.
11.1) Explaining Fluctuations: IS –LM� CASE STUDY: The U.S. Recession of 2001
• During 2001,
– 2.1 million people lost their jobs, as unemployment rose from 3.9% to 5.8%.
– GDP growth slowed to 0.8%
Chapter 11: Aggregate Demand II: Applying the IS–LM Model 16/56
– GDP growth slowed to 0.8% (compared to 3.9% average annual growth during 1994-2000).
11.1) Explaining Fluctuations: IS –LM� CASE STUDY: The U.S. Recession of 2001
• Causes: 1) Stock market decline ⇒ ↓C
1200
1500
Inde
x (1
942
= 1
00) Standard & Poor’s 500
Chapter 11: Aggregate Demand II: Applying the IS–LM Model 17/56
300
600
900
1200
1995 1996 1997 1998 1999 2000 2001 2002 2003
Inde
x (1
942
= 1
00)
500
11.1) Explaining Fluctuations: IS –LM� 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
Chapter 11: Aggregate Demand II: Applying the IS–LM Model 18/56
– result: lower spending, IS curve shifted left
• Causes: 3) Corporate accounting scandals
– Enron, WorldCom, etc.
– reduced stock prices, discouraged investment
11.1) Explaining Fluctuations: IS –LM� 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
Chapter 11: Aggregate Demand II: Applying the IS–LM Model 19/56
• airline industry bailout• NYC reconstruction • Afghanistan war
11.1) Explaining Fluctuations: IS –LM� CASE STUDY: The U.S. Recession of 2001
• Monetary policy response: shifted LM curve right
Three-month T-Bill Rate
Three-month T-Bill Rate
4
5
6
7
Chapter 11: Aggregate Demand II: Applying the IS–LM Model 20/56
0
1
2
3
4
Learning Objectives
This chapter introduces you to understanding:
explaining fluctuations with the IS–LM model
using IS–LM as a theory of aggregate demand
Chapter 11: Aggregate Demand II: Applying the IS–LM Model 21/56
using IS–LM as a theory of aggregate demand
the great depression
11.2) IS-LM as Theory of Agg. Demand� 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
Chapter 11: Aggregate Demand II: Applying the IS–LM Model 22/56
• However, a change in P would shift LM and therefore affect Y.
• The aggregate demand curve(introduced in Chap. 9) captures this relationship between P and Y.
11.2) IS-LM as Theory of Agg. Demand� Deriving the AD Curve
r
IS
LM(P1)
LM(P2)
r2
r1
Intuition for slope of AD curve:
↑P ⇒ ↓(M/P )
Chapter 11: Aggregate Demand II: Applying the IS–LM Model 23/56
Y1Y2Y
Y
P
IS
AD
P1
P2
Y2 Y1
⇒ LM shifts left
⇒ ↑r
⇒ ↓I
⇒ ↓Y
IS
LM(M2/P1)
LM(M1/P1)
r1
r2
The Fed can increase aggregate demand:
↑M ⇒ LM shifts right
r
⇒ ↓
11.2) IS-LM as Theory of Agg. Demand� Monetary Policy and the AD Curve
Chapter 11: Aggregate Demand II: Applying the IS–LM Model 24/56
Y
P
IS
AD1
P1
Y1
Y1
Y2
Y2
AD2
Y⇒ ↓r
⇒ ↑I
⇒ ↑Y for a givenvalue of P
r2
r1
r
IS1
LMExpansionary fiscal policy (↑G and/or ↓T ) increases agg. demand:
↓T ⇒ ↑C
IS2
11.2) IS-LM as Theory of Agg. Demand� Fiscal Policy and the AD Curve
Chapter 11: Aggregate Demand II: Applying the IS–LM Model 25/56
Y2
Y2
Y1
Y1
Y
Y
P
IS1
AD1
P1
↓T ⇒ ↑C
⇒ IS shifts right
⇒ ↑Y for a givenvalue of P
AD2
11.2) IS-LM as Theory of Agg. Demand� 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.
In the short-run then over time, the
Chapter 11: Aggregate Demand II: Applying the IS–LM Model 26/56
Y Y>Y Y<
Y Y=
rise
fall
remain constant
In the short-run equilibrium, if
then over time, the price level will
11.2) IS-LM as Theory of Agg. Demand� The SR and LR Effects of an IS Shock
A negative IS shock shifts IS and AD left, A negative IS shock shifts IS and AD left,
r LRAS
IS1
LM(P1)
IS2
Chapter 11: Aggregate Demand II: Applying the IS–LM Model 27/56
shifts IS and AD left, causing Y to fall.shifts IS and AD left, causing Y to fall.
Y
Y
P LRAS
Y
Y
SRAS1P1
AD2
AD1
r LRAS
IS1
LM(P1)
IS2In the new short-In the new short-
11.2) IS-LM as Theory of Agg. Demand� The SR and LR effects of an IS shock
Chapter 11: Aggregate Demand II: Applying the IS–LM Model 28/56
Y
Y
P LRAS
Y
Y
SRAS1P1
AD2
AD1
run equilibrium, run equilibrium, Y Y<
r LRAS
IS1
LM(P1)
IS2
In the new short-run equilibrium, In the new short-run equilibrium, Y Y<
Over time, P gradually Over time, P gradually
11.2) IS-LM as Theory of Agg. Demand� The SR and LR Effects of an IS Shock
Chapter 11: Aggregate Demand II: Applying the IS–LM Model 29/56
Y
Y
P LRAS
Y
Y
SRAS1P1
AD2
AD1
Over time, P gradually falls, which causes
• SRAS to move down.
• M/P to increase, which causes LMto move down.
Over time, P gradually falls, which causes
• SRAS to move down.
• M/P to increase, which causes LMto move down.
r LRAS
IS1
LM(P1)
IS2
LM(P2)
Over time, P gradually falls, which causes
• SRAS to move down.
Over time, P gradually falls, which causes
• SRAS to move down.
11.2) IS-LM as Theory of Agg. Demand� The SR and LR Effects of an IS Shock
Chapter 11: Aggregate Demand II: Applying the IS–LM Model 30/56
AD2
Y
Y
P LRAS
Y
Y
SRAS1P1
AD1
SRAS2P2
• SRAS to move down.
• M/P to increase, which causes LMto move down.
• SRAS to move down.
• M/P to increase, which causes LMto move down.
LM(P2)
r LRAS
IS1
LM(P1)
IS2
This process continues until economy reaches This process continues until economy reaches
11.2) IS-LM as Theory of Agg. Demand� The SR and LR Effects of an IS Shock
Chapter 11: Aggregate Demand II: Applying the IS–LM Model 31/56
AD2
SRAS2P2
Y
Y
P LRAS
Y
Y
SRAS1P1
AD1
until economy reaches a long-run equilibrium with
until economy reaches a long-run equilibrium with Y Y=
a. Draw the IS-LM and AD-ASdiagrams as shown here.
b. Suppose Fed increases M.Show the short-run effects on your graphs.
r LRAS
IS
LM(M1/P1)
11.2) IS-LM as Theory of Agg. Demand� 该你们了: Analyze SR & LR Effects of ∆M
Chapter 11: Aggregate Demand II: Applying the IS–LM Model 32/56
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 r, P and Y compare to their initial values?
Y
Y
P LRAS
Y
Y
SRAS1P1
AD1
Learning Objectives
This chapter introduces you to understanding:
explaining fluctuations with the IS–LM model
using IS–LM as a theory of aggregate demand
Chapter 11: Aggregate Demand II: Applying the IS–LM Model 33/56
using IS–LM as a theory of aggregate demand
the great depression
11.3) The Great Depression� Figure
Unemployment (right scale)
200
220
240
billi
ons
of 1
958
dolla
rs
20
25
30
perc
ent o
f lab
or fo
rce
Chapter 11: Aggregate Demand II: Applying the IS–LM Model 34/56
Real GNP(left scale)
120
140
160
180
1929 1931 1933 1935 1937 1939
billi
ons
of 1
958
dolla
rs
0
5
10
15
perc
ent o
f lab
or fo
rce
11.3) The Great Depression� 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
Chapter 11: Aggregate Demand II: Applying the IS–LM Model 35/56
output and interest rates both fell, which is what a leftward IS shift would cause.
11.3) The Great Depression� Spending Hypothesis: Reasons for the IS Shift
• Stock market crash ⇒ exogenous ↓C
– Oct-Dec 1929: S&P 500 fell 17%
– Oct 1929-Dec 1933: S&P 500 fell 71%
• Drop in investment
Chapter 11: Aggregate Demand II: Applying the IS–LM Model 36/56
• Drop in investment
– “correction” after overbuilding in the 1920s
– 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.
11.3) The Great Depression� 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.
Chapter 11: Aggregate Demand II: Applying the IS–LM Model 37/56
• 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.
11.3) The Great Depression� Money Hypothesis: 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.
Chapter 11: Aggregate Demand II: Applying the IS–LM Model 38/56
so perhaps money played an important role after all.
• In what ways does a deflation affect the economy?
11.3) The Great Depression� Money Hypothesis: The Effects of Falling Prices
The stabilizing effects of deflation:
• ↓P ⇒ ↑(M/P ) ⇒ LM shifts right ⇒ ↑Y
• Pigou effect :
↓P ⇒ ↑(M/P )
Chapter 11: Aggregate Demand II: Applying the IS–LM Model 39/56
↓P ⇒ ↑(M/P )
⇒ consumers’ wealth ↑
⇒ ↑C
⇒ IS shifts right
⇒ ↑Y
11.3) The Great Depression� Money Hypothesis: The Effects of Falling Prices
The destabilizing effects of expected deflation:
↓π e
⇒ r ↑ (Fisher equation r=i-π e)
Chapter 11: Aggregate Demand II: Applying the IS–LM Model 40/56
⇒ I ↓ because I = I (r )
⇒ planned expenditure & agg. demand ↓↓↓↓
⇒ income & output ↓↓↓↓
11.3) The Great Depression� Money Hypothesis: The Effects of Falling Prices
• The destabilizing effects of unexpected deflation:debt-deflation theory
↓P (if unexpected)
⇒ transfers purchasing power from borrowers to
Chapter 11: Aggregate Demand II: Applying the IS–LM Model 41/56
⇒ transfers purchasing power from borrowers to lenders
⇒ borrowers spend more, lenders spend less
⇒ if borrowers’ propensity to spend is larger than lenders’, then aggregate spending falls, the IScurve shifts left, and Y falls
11.3) The Great Depression� Why Another Depression is Unlikely
• Policymakers (or their advisors) now know much more about macroeconomics:
– Central banks know better than to let M fall so much, especially during a contraction.
Chapter 11: Aggregate Demand II: Applying the IS–LM Model 42/56
– 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.
• 2009: Real GDP fell, u-rate approached 10%
• Important factors in the crisis:
– early 2000s Federal Reserve interest rate policy
– sub-prime mortgage crisis
11.4) The 2008-09 Financial Crisis
Chapter 11: Aggregate Demand II: Applying the IS–LM Model 43/56
– sub-prime 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
11.4) The 2008-09 Financial Crisis� Interest Rates and House Prices
Chapter 11: Aggregate Demand II: Applying the IS–LM Model 44/56
11.4) The 2008-09 Financial Crisis� House Price Index and Rate of Foreclosures
Chapter 11: Aggregate Demand II: Applying the IS–LM Model 45/56
New
fore
clos
ures
, %
of a
ll m
ortg
ages
Nevada
Georgia
ColoradoArizona
California
Florida Illinois
Michigan Ohio
11.4) The 2008-09 Financial Crisis� House Price Change and Foreclosures Q3.06-Q1.09
Chapter 11: Aggregate Demand II: Applying the IS–LM Model 46/56
New
fore
clos
ures
, %
of a
ll m
ortg
ages
Cumulative change in house price index
Colorado
Texas
AlaskaWyoming
Arizona
S. Dakota
Rhode Island
N. Dakota
Oregon
New Jersey
Hawaii
11.4) The 2008-09 Financial Crisis� U.S. Bank Failures 2000 - 2009
Chapter 11: Aggregate Demand II: Applying the IS–LM Model 47/56
* as of July 24, 2009.
*
11.4) The 2008-09 Financial Crisis� Major U.S. Stocks, YOY-% Change
Chapter 11: Aggregate Demand II: Applying the IS–LM Model 48/56
11.4) The 2008-09 Financial Crisis� Consumer Sentiment and Growth in Durables and Investment Spending
Chapter 11: Aggregate Demand II: Applying the IS–LM Model 49/56
11.4) The 2008-09 Financial Crisis� Real GDP Growth And Unemployment
Chapter 11: Aggregate Demand II: Applying the IS–LM Model 50/56
Chapter SummaryChapter Summary
1. IS-LM model
– a theory of aggregate demand
– exogenous: M, G, T,P exogenous in short run, Y in long run
Chapter 11: Aggregate Demand II: Applying the IS–LM Model 51/56
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
Chapter SummaryChapter Summary2. AD curve
– shows relation between P and the IS-LM model’s equilibrium Y.
– negative slope because
Chapter 11: Aggregate Demand II: Applying the IS–LM Model 52/56
– 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.