PP556. Topics to cover. Policy Goals in the Short Run: Applying the IS-LM Model. Crowding Out. Equilibrium in the IS-LM model

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1 556 olicy Goals in the Shot Run: Applying the - Model Topics to cove how to use the - model to analyze the effects of shocks, fiscal policy, and monetay policy how to deive the aggegate demand cuve fom the - model seveal theoies about what caused the Geat Depession slide 0 slide 1 Equilibium in the - model olicy analysis with the - model The cuve epesents equilibium in the goods maket. C ( T) I( ) G M L(, ) C ( T) I( ) G The cuve epesents money maket equilibium. M L(, ) 1 The intesection detemines the unique combination of and that satisfies equilibium in both makets. 1 We can use the - model to analyze the effects of fiscal policy: G and/o T monetay policy: M 1 1 slide 2 slide 3 An incease in govenment puchases Cowding Out 1. cuve shifts ight 1 by 1 MC G causing output & 2 income to ise This aises money demand, causing the inteest ate to ise 1 3. which educes investment, so the final incease in 1 is smalle than G 1 MC slide 4 Why is expansionay fiscal policy less effective in the - famewok, than it was when we focused on alone? A fiscal expansion causes the inteest ate to ise which, in tun, cowds out investment, leading to a smalle final influence on. The stength of the dampening effect on fiscal policy depends on the slope of the cuve. If money demand is vey sensitive to income, the cuve will be steep (because a lage incease in will be needed in ode to equilibate the money maket) and a change in fiscal policy will have a small effect on output. slide 5 1

2 A (lump-sum) tax cut Monetay policy: An incease in M Consumes save (1 MC) of the tax cut, so the initial boost in spending is smalle fo T than fo an equal G 2. and the cuve shifts by MC 1. 1 MC T 2. so the effects on and ae smalle fo T than fo an equal G M > 0 shifts the cuve down (o to the ight) 2. causing the inteest ate to fall 3. which inceases investment, causing output & income to ise slide 6 slide 7 How esponsive is to monetay policy? This will depend on both the investment demand esponsiveness to the inteest ate, and the money demand esponsiveness to the inteest ate and income. If investment demand is vey esponsive to the inteest ate, then the cuve will be vey flat (since a given inteest ate change will coespond to a big investment change and theefoe a big planned expenditue change), and any shift in will have a lage effect on. How esponsive is to monetay policy? (cont.) One the money maket side, the esponse of income to a change in monetay policy will depend on the esponsiveness of money demand to both the inteest ate and income. If money demand is vey esponsive to the inteest ate, then a given incease in the money supply will equie only a small change in the inteest ate to bing the money maket back into equilibium. This small change in the inteest ate means that the cuve will shift down only a little, and the coesponding incease in output will be small. slide 8 slide 9 How esponsive is to monetay policy? (cont.) Inteaction between monetay & fiscal policy Similaly, if money demand is vey esponsive to income, then the money demand cuve shifts a lot with a change in income, leading to a lage inteest ate change, making the cuve vey steep. Theefoe, if money demand is vey esponsive to income, monetay policy will have a small effect on output. 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 inteaction may alte the impact of the oiginal policy change. slide 10 slide 11 2

3 The Fed s esponse to G > 0 Response 1: Hold M constant Suppose Congess inceases G. ossible Fed esponses: 1. hold M constant 2. hold constant t 3. hold constant In each case, the effects of the G ae diffeent: If Congess aises G, the cuve shifts ight. If Fed holds M constant, then cuve doesn t shift. Results: slide 12 slide 13 Response 2: Hold constant Response 3: Hold constant If Congess aises G, the cuve shifts ight. 1 If Congess aises G, the cuve shifts ight. 2 1 To keep constant, Fed inceases M to shift cuve ight. Results: To keep constant, Fed educes M to shift cuve left. Results: slide 14 slide 15 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 / G Estimated value of / T Shocks in the - model shocks: exogenous changes in the demand fo goods & sevices. Examples: stock maket boom o cash change in households wealth C change in business o consume confidence o expectations I and/o C slide 16 slide 17 3

4 Shocks in the - model 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. EXERCE: Analyze shocks with the - model Use the - model to analyze the effects of 1. a boom in the stock maket that makes consumes wealthie. 2. afte a wave of cedit cad faud, consumes using cash moe fequently in tansactions. Fo each shock, a. use the - diagam to show the effects of the shock on and. b. detemine what happens to C, I, and the unemployment ate. slide 18 slide 19 Effects of a Stock Maket boom Consumes use moe cash The cuve shifts to the ight, because consumes feel they can affod to spend moe given this exogenous incease in thei wealth. This causes and to ise. C ises fo two easons: the stock maket boom, and the incease in income. I falls, because is highe. u falls, because fims hie moe wokes to poduce the exta output that is demanded. The incease in money demand shifts the cuve to the left: We ae assuming that all othe exogenous vaiables, including M and, emain unchanged, so an incease in money demand causes an incease in the value of associated with each value of (this can be seen using the Liquidity efeence diagam). This tanslates to an upwad (i.e. leftwad) shift in the cuve. This shift causes to fall and to ise. The fall in income causes a fall in C. The incease in causes a fall in I. The fall in causes an incease in u. slide 20 slide 21 CASE STUD: The U.S. ecession of 2001 CASE STUD: The U.S. ecession of 2001 Duing 2001, 2.1 million people lost thei jobs, as unemployment ose fom 3.9% to 5.8%. GD gowth slowed to 0.8% (compaed to 3.9% aveage annual gowth duing ). Causes: 1) Stock maket decline C 100) Index (1942 = Standad & oo s 500 slide slide 23 4

5 CASE STUD: The U.S. ecession of 2001 Causes: 2) 9/11 inceased uncetainty fall in consume & business confidence esult: lowe spending, cuve shifted left Causes: 3) Copoate accounting scandals Enon, WoldCom, etc. educed stock pices, discouaged investment CASE STUD: The U.S. ecession of 2001 Fiscal policy esponse: shifted cuve ight tax cuts in 2001 and 2003 spending inceases ailine industy bailout NC econstuction Afghanistan wa slide 24 slide 25 CASE STUD: The U.S. ecession of 2001 Monetay policy esponse: shifted cuve ight Thee-month T-Bill Rate slide 26 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 cuve to achieve its taget. Othe shot-tem ates typically move with the fedeal funds ate. slide 27 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 shocks ae moe pevalent than shocks. If so, then tageting the inteest ate stabilizes income bette than tageting the money supply. - and aggegate demand So fa, we ve been using the - model to analyze the shot un, when the pice level is assumed fixed. Howeve, a change in would shift and theefoe affect. The aggegate demand cuve captues this elationship between and. slide 28 slide 29 5

6 Deiving the AD cuve Intuition fo slope of AD cuve: (M/) shifts left I ( 2 ) ( 1 ) AD Monetay policy and the AD cuve The Fed can incease aggegate demand: M shifts ight I at each value of (M 1 / 1 ) 2 2 (M 2 / 1 ) slide 30 slide 31 Fiscal policy and the AD cuve Expansionay fiscal policy ( G and/o T) inceases agg. demand: T C shifts ight at each value 1 of - and AD-AS in the shot un & long un Recall: The foce that moves the economy fom the shot un to the long un is the gadual adjustment of pices. In the shot-un un equilibium, if then ove time, the pice level will ise fall emain constant slide 32 slide 33 The SR and LR effects of an shock ( 1 ) A negative shock shifts and AD left, causing to fall. The SR and LR effects of an shock ( 1 ) In the new shot-un equilibium, 1 1 slide 34 slide 35 6

7 The SR and LR effects of an shock In the new shot-un equilibium, Ove time, gadually falls, which causes SRAS to move down. M/ to incease, which causes to move down. 1 ( 1 ) slide 36 The SR and LR effects of an shock ( 1 ) ( 2 ) Ove time, gadually falls, which causes SRAS to move down. 1 M/ to incease, 2 SRAS 2 which causes to move down. slide 37 The SR and LR effects of an shock ( 1 ) ( 2 ) This pocess continues until economy eaches a long-un equilibium with 1 2 SRAS 2 slide 38 The Geat Depession billions of dollas Unemployment (ight scale) 140 Real GN (left scale) pecent of la abo foce slide 39 THE SENDING HOTHES: Shocks to the cuve assets that the Depession was lagely due to an exogenous fall in the demand fo goods & sevices a leftwad shift of the cuve. evidence: output and inteest ates both fell, which is what a leftwad shift would cause. slide 40 THE SENDING HOTHES: Reasons fo the shift Stock maket cash exogenous C Oct-Dec 1929: S& 500 fell 17% Oct 1929-Dec 1933: S& 500 fell 71% Dop in investment coection afte ovebuilding in the 1920s widespead bank failues made it hade to obtain financing fo investment Contactionay fiscal policy oliticians aised tax ates and cut spending to combat inceasing deficits. slide 41 7

8 THE MONE HOTHES: A shock to the cuve assets that the Depession was lagely due to huge fall in the money supply. evidence: M1 fell 25% duing But, two poblems with this hypothesis: fell even moe, so M/ actually ose slightly duing nominal inteest ates fell, which is the opposite of what a leftwad shift would cause. THE MONE HOTHES AGAIN: The effects of falling pices assets that the seveity of the Depession was due to a huge deflation: fell 25% duing This deflation was pobably caused by the fall in M, so pehaps money played an impotant ole afte all. In what ways does a deflation affect the economy? slide 42 slide 43 THE MONE HOTHES AGAIN: The effects of falling pices THE MONE HOTHES AGAIN: The effects of falling pices The stabilizing effects of deflation: (M/) shifts ight igou effect: (M/) consumes wealth C shifts ight slide 44 The destabilizing effects of expected deflation: e fo each value of i I because I = I( ) planned expenditue & agg. demand income & output slide 45 THE MONE HOTHES AGAIN: The effects of falling pices Why anothe Depession is unlikely The destabilizing effects of unexpected deflation: debt-deflation theoy (if unexpected) tansfes puchasing powe fom boowes to lendes boowes spend less, lendes spend moe if boowes popensity to spend is lage than lendes, then aggegate spending falls, the cuve shifts left, and falls slide 46 olicymakes (o thei advisos) now know much moe about macoeconomics: The Fed knows bette than to let M fall so much, especially duing a contaction. Fiscal policymakes know bette than to aise taxes o cut spending duing a contaction. Fedeal deposit insuance makes widespead bank failues vey unlikely. Automatic stabilizes make fiscal policy expansionay duing an economic downtun. slide 47 8