Lecture 12: Aggregate Demand (chapter 11)

Transcription

1 Lectue : Aggegate Demand (chapte ) Lectue notes: 0/05 (evised /8/00) topics: -LM AD Long un vesus shot un Geat Depession ) -LM Recall two makets: : Equilibium in goods maket: planned expenditue equals actual expenditue. Rise in inteest ate lowes investment, this lowes planned expenditue, which lowes equilibium output. LM: demand fo eal money balances equals supply. A ise in income aises eal money demand, which causes the equilibium inteest ate to ise in the money maket (too keep eal money demand consistent with eal money supply at the given pice level). Need to conside both cuves at the same time, because we equie equilibium both in the goods and money makets. a) Monetay policy: incease money supply LM LM Money maket: said incease MS shifts LM ight: Theoy of liquidity pefeence says fo a given level of income, ise in money supply means money maket will lowe inteest ate so money demand ise to equal money supply. Now look at goods maket, : new equilibium at point. Moving along. Idea: says that as inteest ate falls, this will stimulate investment and hence income. This is movement along cuve. Monetay tansmission mechanism: means by which ise in money supply aises income - woks though inteests ate s effect on investment expenditue. Note what is happening in the money maket: the fact that income is inceasing leads to aise in money demand, so the equilibium inteest ate does not need to fall so much to make money demand equal the existing money supply.

2 b) Fiscal Policy: Incease govenment expenditue: LM Incease G by G. Keynesian coss says at any given, incease G will incease income by multiplie G x (/(-MPC)). shifts to ight by this amount. But need to be on LM: Move along LM, so equilibium is at, with highe and less than full multiplie effect. What LM doing: LM says the incease in income being geneated by the fiscal policy will aise money demand. But need to keep money demand consistent with constant money supply, so need inteest ate to ise. Rise in will discouage investment expenditue. Patial cowding out of investment by govenment expenditue. Not total cowding out, as in classical economy. And will detact fom ise in total expenditue, and hence on income So incease is less that full multiplie effect shown in Keynesian Coss - which took investment level as fixed, did not conside feedback effect of on and then on I. Simila effect fo tax cut, but shift to ight by tax multiplie: T x (MPC/(-MPC)). Patial cowding out of investment by consumption. c) Exogenous shocks: and LM cuves not only shifted by policies, but also by shocks: Shift left: ) Exogenous fall in investment demand. Conside if people become pessimistic about economy. Think will not sell much next couple yeas, so not invest in new factoies. Fall in investment expenditue will lowe income -can lead to selffulfilling expectations. ) Exogenous fall in consumption demand: fall in consume confidence: they may fea they may lose thei job, so cut back on puchases. Shifts left. Lowes expenditue and income, so it may become moe likely they will indeed lose job. Shift LM left: exogenous ise in money demand. Rise in money demand fo a given level of o. Requies that fo a given money supply equilibium will need highe. shifts LM left, aise and fall.

3 a) Deiving Aggegate Demand Have been assuming a fixed pice level hee. Lets see what happens when pice level begins to adjust. Effect of change in pice level A highe pice level, P, means the level of eal money supply has fallen, fo a given nominal level of money supply. So ise P fom P to P shifts LM left. LM(P) LM(P) P P AD Move up along. Rise in R fall in fom to. If plot pais of P and, find downwad sloping AD cuve: lowe output associated with highe pice. Logic: a highe pice implies that the REAL money supply is lowe, lowe than eal money demand at the given inteest ate and income level. As people go to the bank to ty to boow moe money to satisfy thei money demand, they bid up the inteest ate. But this has an effect on the goods maket: as the inteest ate ises, it also becomes moe expensive to take out loans fo investment pojects. So the investment component of planned expenditue falls, and equilibium output falls. b) Shifting the AD cuve: This is movement along AD cuve: shift in LM due to ise in P. What shifts it: shift in o LM fo easons othe than ise in P. If due to ise in P can show it in gaph because P is on vetical axis. If thee is a ise in govenment puchases, this will shift ight, and aise fo any given P, so it also shifts the AD cuve ight. Also, if thee is an incease in the money supply, the esulting ightwad shift in LM will also shift the AD cuve ight. LM LM P AD AD Conclude: A change in in -LM esulting fom change in P epesents a movement along AD cue. A change in -LM fo a fixed pice level is a shift in AD cuve.

4 c) Do math fo deiving the AD cuve: (skip this in Econ 05) Goods Maket: C = a + b(-t), I = c - d, T = Tba, G= Gba : = C + I + G = a + b(-tba) + c - d + Gba - b = a - btba + c - d + Gba = [(a+c)/(-b)] + [/(-b)]gba + [-b/(-b)]tba + [-d/(-b)] Like Keynesian coss did befoe, but now allow I be function of. so see how elate to. See fo a given, G affect by spending multiplie, and T by tax multiplie but all fo a given. and ae endogenous vaiables. Gba and Tba ae exogenous (detemined outside the model). If want to solve fo, need a fomula o equation with on left, and only exogenous vaiables on ight. Need to substitute out of equation. Use LM: Money Maket: (M/P) d = e - f (M/P) s = Mba/Pba LM: Mba/Pba = e - f = (e/f) - (/f)mba/pba This is a line, slope = e/f, slope up Now combine the two: plug fom LM into in : = [(a+c)/(-b)] + [/(-b)]gba + [-b/(-b)]tba + [-d/(-b)] [(e/f) - (/f)mba/pba] Fo convenience, define the following: z = f/[f + de/(-b)] between 0 and. Then we can eaange the equation above to say: = [z(a+c)/(-b)] + [z/(-b)]gba + [-zb/(-b)]tba + [d /((-b)[f + de/(-b)]] Mba/Pba Now have a fomula fo how to compute what equilibium must be if we ae given levels of exogenous vaiables. But this equation takes pice level as an exogenous vaiable (Pba). This was ou exteme assumption that pice is fixed completely at shot un. If willing to allow pice to be influenced by economic events, then must egad it also as an endogenous vaiable. Then the equation above becomes a elationship between and P, in othe wods, an AD cuve. 4

5 d) Policy effectiveness: Economists debate whethe monetay o fiscal policy moe effective means of aising output: Fiscal policy is effective when: ) if LM flatte: (f lage o e small, so z nea ) incease money demand not aise much, so I not cowded out as much. LM LM ) if steepe: (d is small so z is nea ) investment not espond much to ising. Means z is small, so multiplie not much dampened. LM Monetay policy is effective when: ) if flatte: fall in stimulates I much. (d lage) LM LM ) if LM steepe: (small f) takes big dop in to aise money demand to clea money maket. (See in math; Had to gaph because small f affects size of LM shift.) 5

6 ) Long un and Shot un. a) Money shocks In the long un, we think that pices have the time they need to adjust to clea makets. We have told the stoy of the shot un vesus the long un using the SRAS and the LRAS cuves. We can now see bette the tansition fom the shot un to the long un by consideing the and LM cuves. Note what happens to the LM cuve as the pice level, P, adjusts to clea the money maket instead of the inteest ate doing this job. Conside the effects of a cut in money supply. In the shot un with the pice level fixed, a cut in the nominal money supply implies a cut in the eal money supply. This shifts the LM and AD cuves left, as we have seen befoe. This aises the inteest ate and cuts investment and equilibium output. But in the long un, the pice level adjusts in popotion to the cut in nominal money supply. So the eal money supply (the ation of nominal money to pice level) etuns to its oiginal level. The LM cuve etuns to its oiginal position, so the inteest ate and output etun to thei oiginal equilibium levels. So in the long un, a cut in money supply only leads to a popotional fall in pice level, with no changes in eal vaiables, which is consistent with the classical dichotomy. LM(M/P) LM(M/P) = LM(M/P), ba P LRAS P SRAS P AD AD ba 6

7 b) Goods-maket shocks Conside next the effects of a cut in govenment puchases. In the shot un a cut in govenment puchases lowes planned expenditue and shifts the and AD cuves left. The equilibium level of inteest ate and output falls. Recall the inteest ate falls because lowe income implies a lowe eal money demand, and given that pices ae fixed, the inteest ate adjusts to equate money demand to the existing money supply But in the long un, the pice level adjusts to clea the money maket instead of the inteest ate. The pice level will fall. This in tun implies a ise in the eal money supply (even though nothing is happening to the level of money supply in nominal tems). This causes the LM cuve to shift ight, and acts like expansionay monetay policy, although it happens automatically as the pice level adjusts. This will continue to the point that output is estoed to the oiginal level at yba. This is a movement along the AD cuve. LM(M/P) LM(M/P) ba P LRAS P SRAS P AD AD ba ) Case Study fo class discussion: Geat Depession 7