Mankiw Chapter 12. Aggregate Demand II. Applying the IS-LM Model
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1 Mankiw Chapte 12 Applying the IS-LM Model 0
2 Context Chapte 10 intoduced the model of aggegate demand and supply. Chapte 11 developed the IS-LM model, the basis of the aggegate demand cuve. 1
3 IN THIS CHAPTER, WE WILL COVER: how to use the IS-LM model to analyze the effects of shocks, fiscal policy, and monetay policy how to deive the aggegate demand cuve fom the IS-LM model 2
4 Equilibium in the IS -LM model The IS cuve epesents equilibium in the goods maket. = C( T ) + I ( ) + G LM The LM cuve epesents money maket equilibium. M P = L(, ) The intesection detemines the unique combination of and that satisfies equilibium in both makets. 1 1 IS 3
5 Policy analysis with the IS -LM model = C( T ) + I ( ) + G M P = L(, ) LM We can use the IS-LM model to analyze the effects of 1 fiscal policy: G and/o T monetay policy: M 1 IS 4
6 An incease in govenment puchases 1. IS cuve shifts ight 1 by ΔG 1 MPC causing output & income to ise. 2. This aises money demand, causing the inteest ate to ise 3. which educes investment, 1 so the final incease in 3. 1 is smalle than ΔG 1 MPC LM IS 2 IS 1 5
7 A tax cut Consumes save (1-MPC) of the tax cut, so the initial boost in spending is smalle fo ΔT than fo an equal ΔG and the IS cuve shifts by MPC 1 MPC ΔT so the effects on and ae smalle fo ΔT than fo an equal ΔG LM IS 2 IS 1 6
8 Monetay policy: An incease in M 1. ΔM > 0 shifts the LM cuve down (o to the ight) 2. causing the inteest ate to fall 1 2 LM 1 LM 2 3. which inceases investment, causing output & income to ise. 1 2 IS 7
9 Inteaction between monetay & fiscal policy Model: Monetay & fiscal policy vaiables (M, G, and T ) ae exogenous. Real wold: Monetay policymakes may adjust M in esponse to changes in fiscal policy, o vice vesa. Such inteactions may alte the impact of the oiginal policy change. 8
10 The Fed s esponse to ΔG > 0 Suppose Congess inceases G. Possible Fed esponses: 1. hold M constant 2. hold constant 3. hold constant In each case, the effects of the ΔG ae diffeent 9
11 Response 1: Hold M constant If Congess aises G, the IS cuve shifts ight. LM 1 If Fed holds M constant, then LM cuve doesn t shift. 2 1 Results: Δ = 2 1 Δ = IS 1 IS 2 10
12 Response 2: Hold constant If Congess aises G, the IS cuve shifts ight. LM 1 To keep constant, Fed inceases M to shift LM cuve ight. 2 1 LM 2 Results: Δ = IS 2 IS 1 Δ = 0 11
13 Response 3: Hold constant If Congess aises G, the IS cuve shifts ight. LM 2 LM 1 To keep constant, Fed educes M to shift LM cuve left Results: Δ = 0 Δ = IS2 IS 1 12
14 Estimates of fiscal policy multiplies fom the DRI macoeconometic model Assumption about monetay policy Fed holds money supply constant Fed holds nominal inteest ate constant Estimated value of Δ / ΔG Estimated value of Δ / ΔT
15 Shocks in the IS -LM model IS shocks: exogenous changes in the demand fo goods & sevices. Examples: stock maket boom o cash change in households wealth ΔC change in business o consume confidence o expectations ΔI and/o ΔC 14
16 Shocks in the IS -LM model LM shocks: exogenous changes in the demand fo money. Examples: A wave of cedit cad faud inceases demand fo money. Moe ATMs o the Intenet educe money demand. 15
17 EXAMPLE Analyze shocks with the IS-LM model Use the IS-LM model to analyze the effects of 1. a housing maket cash that educes consumes wealth 2. consumes using cash in tansactions moe fequently in esponse to an incease in identity theft Fo each shock, a. use the IS-LM diagam to detemine the effects on and. b. figue out what happens to C, I, and the unemployment ate. 16
18 ANSWERS, PART 1 Housing maket cash IS shifts left, causing and to fall. LM 1 C falls due to lowe wealth and lowe income, I ises because is lowe u ises because is lowe (Okun s law) IS 1 IS
19 ANSWERS, PART 2 Incease in money demand LM shifts left, causing to ise and to fall. LM 2 LM 1 C falls due to lowe income, I falls because is highe u ises because is lowe (Okun s law) IS 1 18
20 CASE STUD: The U.S. ecession of 2001 Duing 2001: 2.1 million jobs lost, unemployment ose fom 3.9% to 5.8%. GDP gowth slowed to 0.8% (compaed to 3.9% aveage annual gowth duing ). 19
21 CASE STUD: The U.S. ecession of 2001 Causes: 1) Stock maket decline C Index (1942 = 100) 1,500 1, Standad & Poo s
22 CASE STUD: The U.S. ecession of 2001 Causes: 2) 9/11 inceased uncetainty fall in consume & business confidence esult: lowe spending, IS cuve shifted left Causes: 3) Copoate accounting scandals Enon, WoldCom, etc. educed stock pices, discouaged investment 21
23 CASE STUD: The U.S. ecession of 2001 Fiscal policy esponse: shifted IS cuve ight tax cuts in 2001 and 2003 spending inceases ailine industy bailout NC econstuction Afghanistan wa 22
24 CASE STUD: The U.S. ecession of 2001 Monetay policy esponse: shifted LM cuve ight Thee-month T-Bill ate 23
25 What is the Fed s policy instument? The news media commonly epot the Fed s policy changes as inteest ate changes, as if the Fed has diect contol ove maket inteest ates. In fact, the Fed tagets the fedeal funds ate the inteest ate banks chage one anothe on ovenight loans. The Fed changes the money supply and shifts the LM cuve to achieve its taget. Othe shot-tem ates typically move with the fedeal funds ate. 24
26 What is the Fed s policy instument? Why does the Fed taget inteest ates instead of the money supply? 1) They ae easie to measue than the money supply. 2) The Fed might believe that LM shocks ae moe pevalent than IS shocks. If so, then tageting the inteest ate stabilizes income bette than tageting the money supply. 25
27 IS-LM and aggegate demand So fa, we ve been using the IS-LM model to analyze the shot un, when the pice level is assumed fixed. Howeve, a change in P would shift LM and theefoe affect. The aggegate demand cuve (intoduced in Chap. 10) captues this elationship between P and. 26
28 Deiving the AD cuve LM(P 2 ) Intuition fo slope of AD cuve: 2 LM(P 1 ) P (M/P ) 1 IS LM shifts left P 2 1 I P 2 P 1 AD
29 Monetay policy and the AD cuve The Fed can incease aggegate demand: 1 LM(M 1 /P 1 ) LM(M 2 /P 1 ) M LM I shifts ight 2 P 1 2 IS at each value of P P 1 AD AD 1 28
30 Fiscal policy and the AD cuve Expansionay fiscal policy ( G and/o T ) inceases agg. demand: 2 1 LM IS 2 T C IS shifts ight P 1 2 IS 1 at each value of P P AD 2 AD 1 29
31 IS-LM and AD-AS in the shot un & long un Recall fom Chapte 10: The foce that moves the economy fom the shot un to the long un is the gadual adjustment of pices. In the shot-un equilibium, if > < = then ove time, the pice level will ise fall emain constant 30
32 The SR and LR effects of an IS shock A negative IS shock shifts IS and AD left, causing to fall. P P 1 LRAS LM(P 1 ) IS 1 IS 2 LRAS SRAS 1 AD 1 AD 2 31
33 The SR and LR effects of an IS shock LRAS LM(P 1 ) In the new shot-un equilibium, < IS 1 IS 2 P LRAS P 1 SRAS 1 AD 1 AD 2 32
34 The SR and LR effects of an IS shock LRAS LM(P 1 ) In the new shot-un equilibium, < IS 1 IS 2 Ove time, P gadually falls, causing: SRAS to move down M/P to incease, which causes LM to move down P P 1 LRAS SRAS 1 AD 1 AD 2 33
35 The SR and LR effects of an IS shock LRAS LM(P 1 ) LM(P 2 ) IS 1 IS 2 Ove time, P gadually falls, causing: SRAS to move down M/P to incease, which causes LM to move down P P 1 P 2 LRAS SRAS 1 SRAS 2 AD 1 AD 2 34
36 The SR and LR effects of an IS shock LRAS LM(P 1 ) LM(P 2 ) This pocess continues until economy eaches a long-un equilibium with = P LRAS IS 2 IS 1 P 1 SRAS 1 P 2 SRAS 2 AD 1 AD 2 35
37 EXAMPLE Analyze SR & LR effects of ΔM a. Daw the IS-LM and AD-AS diagams as shown hee. LRAS LM(M 1 /P 1 ) b. Suppose Fed inceases M. Show the shot-un effects on you gaphs. IS c. Show what happens in the tansition fom the shot un to the long un. P LRAS d. How do the new long-un equilibium values of the endogenous vaiables compae to thei initial values? P 1 SRAS 1 AD 1 36
38 ANSWERS, PART 1 Shot-un effects of ΔM LM and AD shift ight. falls, ises above 1 2 LRAS LM(M 1 /P 1 ) LM(M 2 /P 1 ) IS P LRAS 2 P 1 SRAS AD 2 2 AD 1 37
39 ANSWERS, PART 2 Tansition fom shot un to long un Ove time, P ises SRAS moves upwad M/P falls LM moves leftwad New long-un eq m P highe all eal vaiables back at thei initial values 3 = Money is neutal in the long un. LRAS LM(M 12 /P 13 ) LM(M 2 /P 1 ) 1 2 P P 3 P 1 LRAS 2 2 IS SRAS SRAS AD 2 AD 1 38
40 CHAPTER SUMMAR 1. IS-LM model a theoy of aggegate demand exogenous: M, G, T, P exogenous in shot un, in long un endogenous:, endogenous in shot un, P in long un IS cuve: goods maket equilibium LM cuve: money maket equilibium 39
41 2. AD cuve CHAPTER SUMMAR shows elation between P and the IS-LM model s equilibium. negative slope because P (M/P ) I expansionay fiscal policy shifts IS cuve ight, aises income, and shifts AD cuve ight. expansionay monetay policy shifts LM cuve ight, aises income, and shifts AD cuve ight. IS o LM shocks shift the AD cuve. 40
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