9. ISLM model. Introduction to Economic Fluctuations CHAPTER 9. slide 0

Transcription

1 9. ISLM model slide 0

2 In this lecture, you will learn an introduction to business cycle and aggregate demand the IS curve, and its relation to the Keynesian cross the loanable funds model the LM curve, and its relation to the theory of liquidity preference how the IS-LM model determines income and the interest rate in the short run when P is fixed slide 1

3 Short run In the following lectures, we will study the short- run fluctuations of the economy (business cycles) We focus on three models: ISLM model (lecture 9) Mudell-Fleming model (lecture 10) Model AS-AD AD (lectures 9 and 10) AS (lecture 11) slide 2

4 Facts about the business cycle GDP growth averages percent per year over the long run with large fluctuations in the short run. Consumption and investment fluctuate with GDP, but consumption tends to be less volatile and investment more volatile than GDP. Unemployment rises during recessions and falls during expansions. Okun s Law: the negative relationship between GDP and unemployment. slide 3

5 Percent change from 4 quarters earlier Growth rates of real GDP, consumption Real GDP growth rate Consumption growth rate Average growth rate Introduction to Economic 1985 Fluctuations slide 4

6 Growth rates of real GDP, consumption, investment Percent change from 4 quarters earlier Investment growth rate 20 Real GDP 10 growth rate 0 Consumption -10 growth rate Introduction to Economic 1985 Fluctuations slide 5

7 Unemployment Percent of labor force Introduction to Economic 1985 Fluctuations slide 6

8 Percentage 10 change in Okun s Law Y real GDP = u Y Introduction to Economic Change Fluctuations in unemployment rate slide 7

9 Time horizons in macroeconomics Long run: Prices are flexible, respond to changes in supply or demand. Short run: Many prices are sticky at some predetermined level. The economy behaves much differently when prices are sticky. slide 8

10 Recap of classical macro theory (Chaps. 3-8) Output is determined by the supply side: supplies of capital, labor technology. Changes in demand for goods & services (C, I, G ) only affect prices, not quantities. Assumes complete price flexibility. Applies to the long run. slide 9

11 When prices are sticky output and employment also depend on demand, which is affected by fiscal policy (G and T ) monetary policy (M ) other factors, like exogenous changes in C or I. slide 10

12 The model of aggregate demand and supply the paradigm most mainstream economists and policymakers use to think about economic fluctuations and policies to stabilize the economy shows how the price level and aggregate output are determined shows how the economy s behavior is different in the short run and long run slide 11

13 IS-LM This chapter develops the IS-LM model, the basis of the aggregate demand curve. We focus on the short run and assume the price level is fixed. This lecture focuses on the closed-economy case. Next lecture presents the open-economy case. slide 12

14 The Keynesian Cross A simple closed economy model in which income is determined by expenditure. (due to J.M. Keynes) Notation: I = planned investment E = C + I + G = planned expenditure Y = real GDP = actual expenditure Difference between actual & planned expenditure = unplanned inventory investment slide 13

15 Elements of the Keynesian Cross consumption function: C = C ( Y T ) govt policy variables: G = G, T = T for now, planned investment is exogenous: I = I planned expenditure: E = C ( Y T ) + I + G equilibrium condition: actual expenditure = planned expenditure = Y E slide 14

16 Graphing planned expenditure E planned expenditure E =C +I +G 1 MPC income, output, Y slide 15

17 Graphing the equilibrium condition E planned expenditure E =Y 45º income, output, Y slide 16

18 The equilibrium value of income E planned expenditure E =Y E =C +I +G income, output, Y Equilibrium income slide 17

19 An increase in government purchases At Y 1, there is now an unplanned drop in inventory G E E =C +I +G 2 E =C +I +G 1 so firms increase output, and income rises toward a new equilibrium. E 1 = Y 1 Y E 2 = Y 2 Y slide 18

20 Solving for Y Y = C + I + G equilibrium condition Y = C + I + G = C + G = MPC Y + G in changes because I exogenous because C = MPC Y Collect terms with Y Solve for Y : on the left side of the equals sign: 1 Y = (1 MPC) = Y G 1 MPC G slide 19

21 The government purchases multiplier Definition: the increase in income resulting from a $1 increase in G. In this model, the govt Y 1 purchases multiplier equals = G 1 MPC Example: If MPC = 0.8, then Y 1 = = 5 G An increase in G causes income to increase 5 times as much! slide 20

22 Why the multiplier is greater than 1 Initially, the increase in G causes an equal increase in Y: Y = G. But Y C further Y further C further Y So the final impact on income is much bigger than the initial G. slide 21

23 An increase in taxes Initially, the tax increase reduces consumption, and therefore E: E E =C 1 +I +G E =C 2 +I +G C = MPC T so firms reduce output, and income falls toward a new equilibrium E 2 = Y 2 Y E 1 = Y 1 At Y 1, there is now an unplanned inventory buildup Y slide 22

24 Solving for Y Y = C + I + G eq m condition in changes = C I and G exogenous ( Y T ) = MPC Solving for Y : (1 MPC) Y = MPC T Final result: MPC Y = 1 MPC T slide 23

25 The tax multiplier def: the change in income resulting from a $1 increase in T : Y MPC = T 1 MPC If MPC = 0.8, then the tax multiplier equals Y = = = T slide 24

26 The tax multiplier is negative: A tax increase reduces C, which reduces income. is greater than one (in absolute value): A change in taxes has a multiplier effect on income. is smaller than the govt spending multiplier: Consumers save the fraction (1 MPC) of a tax cut, so the initial boost in spending from a tax cut is smaller than from an equal increase in G. slide 25

27 The IS curve def: a graph of all combinations of r and Y that result in goods market equilibrium i.e. actual expenditure (output) = planned expenditure The equation for the IS curve is: Y = C ( Y T ) + I ( r ) + G slide 26

28 r Deriving the IS curve I E E =Y E =C +I(r 2 )+G E =C +I(r 1 )+G E I Y r Y 1 Y 2 Y r 1 r 2 Y 1 Y 2 IS Y slide 27

29 Why the IS curve is negatively sloped A fall in the interest rate motivates firms to increase investment spending, which drives up total planned spending (E). To restore equilibrium in the goods market, output (a.k.a. actual expenditure, Y) must increase. slide 28

30 The IS curve and the loanable funds model (a) The L.F. model (b) The IS curve r S 2 S 1 r r 2 r 2 r 2 r 1 r I(r ) 1 IS S, I Y Y Y 2 1 slide 29

31 Fiscal Policy and the IS curve We can use the IS-LM model to see how fiscal policy (G and T) affects aggregate demand and output. Let s start by using the Keynesian cross to see how fiscal policy shifts the IS curve slide 30

32 Shifting the IS curve: G At any value of r, G E Y so the IS curve shifts to the right. E E =Y E =C +I(r 1 )+G 2 E =C +I(r 1 )+G 1 The horizontal distance of the IS shift equals r r 1 Y 1 Y 2 Y 1 Y = G 1 MPC Y 1 Y Y 2 IS 1 IS 2 Y slide 31

33 The Theory of Liquidity Preference Due to John Maynard Keynes. A simple theory in which the interest rate is determined by money supply and money demand. slide 32

34 Money supply The supply of real money balances is fixed: r interest rate ( M P ) s ( M P ) s = M P M P M/P real money balances slide 33

35 Money demand Demand for real money balances: d ( M P ) = L( r ) r interest rate ( M P ) s L(r) M P M/P real money balances slide 34

36 Equilibrium The interest rate adjusts to equate the supply and demand for money: M P r interest rate r 1 ( M P ) s = L ( r ) L(r) M P M/P real money balances slide 35

37 How the Fed raises the interest rate To increase r, Fed reduces M r interest rate r 2 r 1 M 2 P M 1 P L(r) M/P real money balances slide 36

38 CASE STUDY: Monetary Tightening & Interest Rates Late 1970s: π > 10% Oct 1979: Fed Chairman Paul Volcker announces that monetary policy would aim to reduce inflation Aug 1979-April 1980: Fed reduces M/P 8.0% Jan 1983: π = 3.7% How do you think this policy change would affect nominal interest rates? slide 37

39 Monetary Tightening & Rates, cont. The effects of a monetary tightening on nominal interest rates model prices prediction short run Liquidity preference (Keynesian) sticky i > 0 long run Quantity theory, Fisher effect (Classical) flexible i < 0 actual 8/1979: i = 10.4% 8/1979: i = 10.4% outcome 4/1980: i = 15.8% 1/1983: i = 8.2%

40 The LM curve Now let s put Y back into the money demand function: ( M P ) d = L( r, Y ) The LM curve is a graph of all combinations of r and Y that equate the supply and demand for real money balances. The equation for the LM curve is: M P = L( r, Y ) slide 39

41 Deriving the LM curve r (a) The market for real money balances r (b) The LM curve LM r 2 r 2 r 1 L(r,Y 2 ) r 1 L(r,Y 1 ) M 1 P M/P Y 1 Y 2 Y slide 40

42 Why the LM curve is upward sloping An increase in income raises money demand. Since the supply of real balances is fixed, there is now excess demand in the money market at the initial interest rate. The interest rate must rise to restore equilibrium in the money market. slide 41

43 How M shifts the LM curve r (a) The market for real money balances r (b) The LM curve LM 2 r 2 2 r 2 r 2 LM 1 r 1 r L(r,Y 1 ) 1 M 2 P M 1 P M/P Y 1 Y slide 42

44 Equilibrium in the IS-LM model The IS curve represents equilibrium in the goods market. Y = C ( Y T ) + I ( r ) + G r LM The LM curve represents money market equilibrium. M P = L ( r, Y ) The intersection determines the unique combination of Y and r that satisfies equilibrium in both markets. r 1 Y 1 IS Y slide 43

45 Policy analysis with the IS-LM model Y = C ( Y T ) + I ( r ) + G M P = L ( r, Y ) r LM We can use the IS-LM model to analyze the effects of r 1 fiscal policy: G and/or T monetary policy: M Y 1 IS Y slide 44

46 An increase in government purchases 1. IS curve shifts right r 1 by G 1 MPC r 2 causing output & income to rise. 2. r 1 2. This raises money demand, causing the interest rate to rise 3. which reduces investment, so the final increase in Y is smaller than 1 G 1 MPC 1. Y 1 Y 2 3. LM IS 2 IS 1 Y slide 45

47 A tax cut Consumers save (1 MPC) of the tax cut, so the initial boost in spending is smaller for T than for an equal G and the IS curve shifts by 1. MPC 1 MPC T so the effects on r and Y are smaller for T than for an equal G. 2. r r 2 r 1 Y 1 Y LM 1. IS 2 IS 1 Y slide 46

48 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 r r 1 r 2 LM 1 LM 2 3. which increases investment, causing output & income to rise. Y 1 Y 2 IS Y slide 47

49 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 interaction may alter the impact of the original policy change. slide 48

50 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: slide 49

51 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 r 2 r 1 LM 1 Results: IS 1 IS 2 Y = Y Y Y 2 1 r = r r 2 1 Y 1 Y 2 slide 50

52 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 r 2 r 1 LM 1 LM 2 Results: Y = Y Y 3 1 Y 3 r = 0 Y 1 Y 2 IS 1 IS 2 Y slide 51

53 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. r r 3 r 2 r 1 LM 2 LM 1 Results: Y = 0 r = r r 3 1 Y 1 Y 2 IS 1 IS 2 Y slide 52

54 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 Fed holds nominal interest rate constant slide 53

55 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. 9) captures this relationship between P and Y. slide 54

56 Deriving the AD curve Intuition for slope of AD curve: P (M/P) LM shifts left r I Y r LM(P 2 ) r 2 r 1 P P 2 P 1 Y 2 Y 1 Y 2 Y 1 LM(P 1 ) IS Y AD Y slide 55

57 Monetary policy and the AD curve The Fed can increase aggregate demand: M LM shifts right r I r r 1 r 2 P LM(M 1 /P 1 ) LM(M 2 /P 1 ) IS Y 1 Y 2 Y Y at each P 1 value of P Y 1 Y 2 AD 2 AD 1 Y slide 56

58 Fiscal policy and the AD curve Expansionary fiscal policy ( G and/or T) increases agg. demand: r r 2 r 1 LM IS 2 T C IS shifts right P Y 1 Y 2 IS 1 Y Y at each of P AD 2 value P 1 Y 1 Y 2 AD 1 2 Y slide 57

59 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 equilibrium, if Y Y then over time, the price level will > Y rise < Y fall Y = Y remain constant slide 58

60 The Big Picture Keynesian Cross Theory of Liquidity Preference IS curve LM curve IS-LM model Explanation of short-run fluctuations Agg. demand curve Agg. supply curve Model of Agg. Demand and Agg. Supply slide 59

61 Chapter Summary 1. Keynesian cross basic model of income determination takes fiscal policy & investment as exogenous fiscal policy has a multiplier effect on income. 2. IS curve comes from Keynesian cross when planned investment depends negatively on interest rate shows all combinations of r and Y that equate planned expenditure with actual expenditure on goods & services CHAPTER 10 Aggregate Demand I slide 60

62 Chapter Summary 3. Theory of Liquidity Preference basic model of interest rate determination takes money supply & price level as exogenous an increase in the money supply lowers the interest rate 4. LM curve comes from liquidity preference theory when money demand depends positively on income shows all combinations of r and Y that equate demand for real money balances with supply CHAPTER 10 Aggregate Demand I slide 61

63 Chapter Summary 5. IS-LM model Intersection of IS and LM curves shows the unique point (Y, r ) that satisfies equilibrium in both the goods and money markets. CHAPTER 10 Aggregate Demand I slide 62

64 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. CHAPTER 11 Aggregate Demand II slide 63

65 APPENDIX: The Great Depression slide 64

66 The Great Depression dollar rs billio ons of Unemployment (right scale) 140 Real GNP (left scale) per rcent of labo or force slide 65

67 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. slide 66

68 THE 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 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. slide 67

69 THE 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 But, two problems with this hypothesis: P fell even more, so M/P actually rose slightly during nominal interest rates fell, which is the opposite of what a leftward LM shift would cause. slide 68

70 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 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? slide 69

71 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 slide 70

72 THE MONEY HYPOTHESIS AGAIN: The effects of falling prices The destabilizing effects of expected deflation: π e r for each value of i I because I = I(r ) planned expenditure & agg. demand income & output slide 71

73 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 slide 72