Macroeconomics. Lecture 4: IS-LM model: A theory of aggregate demand. IES (Summer 2017/2018)

Transcription

1 Lecture 4: IS-LM model: A theory of aggregate demand IES (Summer 2017/2018)

2 Section 1 Introduction

3 Why we study business cycles Recall the discussion about economy in the long-run Does it apply to e.g. the Great Depression or the recent crisis? As a result of the Great Depression, economists began to be interested in economic fluctuations (beginning with Keynes); Classical theory was not insufficient to explain the Great depression Currently, there are two points of view: in the long run prices are considered flexible, in the short run sticky; Let s start the analysis with a leading interpretation of Keynes s theory - IS-LM model: : market for goods and services relationship between (i)nvestment and (s)aving LM curve: market for money (l)iquidity and (m)oney

4 Section 2

5 Keynesian cross: Planned vs. actual expenditures Actual: the amount households, government and firms spend on goods and services (GDP); Planned: what they would like to spend Why can they differ? E.g.: 1 firms may sell less of their product as planned the inventory will rise; 2 firms may sell more as planned the inventory will fall.

6 Determinants of planned expenditures Recall the expenditure method of computing GDP (in the closed economy): PE = C + I + G Let s assume consumption function C = C(Y T ), fixed investment I = I, and fixed policy G = G and T = T This implies that: PE = C ( Y T ) + I + G

7 Equilibrium Introduction Y = PE

8 Government-purchases multiplier vs. tax multiplier GPM: by how much will the income rise if government raises expenditures by G? dy dg = 1 1 MPC TM: by how much will the income rise if government decreases taxes by T? dy dt = MPC 1 MPC Supply side/demand side arguments

9 Interest rate and investment I = I (r)

10 Shifting the How does the fiscal policy affect the?

11 Section 3

12 Liquidity preference Supply of real money balances is determined by the CB: ( M ) s P = M P Recall that demand for real money balances is: ( M ) d P = L (r, Y ) What is the effect of a monetary tightening on interest rates in the short run In the short run LP theory predicts lower real money balances and higher interest rates

13 Income and money demand (M/P) d = L (r, Y )

14 The effect of monetary policy How does the monetary policy affect the LM curve?

15 The effect of monetary policy on interest rates What is the effect of a monetary tightening on interest rates in the short run vs. in the long run? Recall that the Fisher effect suggests that in the long run this will cause lower inflation and in turn lower nominal interest rates In the short run LP theory predicts lower real money balances and higher interest rates

16 The effect of monetary policy Volcker case

17 Section 4

18 Two equations of the model 1 IS: Y = C(Y T ) + I (r) + G 2 LM: M/P = L (r, Y ) Short-run equilibrium of this system (r and Y that solve these two equations, treating P as fixed) leads to another definition of the aggregate demand curve Long-run equilibrium: r and P has to adapt to keep Y fixed

19 Section 5

20 Summary Introduction IS-LM model describes market for money and market for goods and services and has the following blocks: 1 Keynesian cross as a basic model of income determination as a relationship between the interest rate and national income. It determines the as a negative relationship between income and interest rate 2 Liquidity preference as a basic model of the determination of the interest rate. It determines the positive relationship between income and interest rate Equilibrium is such a pair of interest rate and income that satisfies both IS and LM equations, in other words it s a place where IS and LM curves cross The equilibrium determines the aggregate demand curve