Chapter 12/11. Aggregate Demand II: Applying the IS-LM Model Part 2 11/7/2017. The Great Depression. Real Side of Economy. Unemployment (right scale)

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1 billions of 1958 dollas pecent of labo foce 11/7/2017 Chapte 12/11 ggegate Demand II: pplying the IS- Model Pat 2 The Geat Depession Unemployment (ight scale) Real GNP (left scale) Real Side of Economy 1

2 Geat Depession: Obsevations Real side of economy: Output: falling Consumption: falling Investment: falling a lot Gov. puchases: fall (with a delay) Nominal Side of the Economy Geat Depession: Obsevations Nominal side: Nominal inteest ate: falling Money supply (nominal): falling Pice level: falling (deflation) 2

3 THE SPENDING HPOTHESIS: Shocks to the IS cuve ssets the Depession was lagely due to an exogenous fall in the demand fo goods & sevices a leftwad shift of the IS cuve. Evidence: output and inteest ates both fell, which is what a leftwad IS shift would cause. THE SPENDING HPOTHESIS: Reasons fo the IS shift Stock maket cash educed consumption Oct 1929 Dec 1929: S&P 500 fell 17% Oct 1929 Dec 1933: S&P 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 Politicians aised tax ates and cut spending to combat inceasing deficits. THE MONE HPOTHESIS: shock to the cuve ssets that the Depession was lagely due to huge fall in the money supply. Evidence: M1 fell 25% duing ut thee ae two poblems with this hypothesis: P fell even moe, so M/P actually ose slightly duing (M/P inceased fom 52.6 to 54.5) nominal inteest ates fell, which is the opposite of what a leftwad shift would cause. 3

4 THE MONE HPOTHESIS GIN: The effects of falling pices ssets that the seveity of the Depession was due to a huge deflation: - P fell 25% duing This deflation was pobably caused by the fall in M, so pehaps money played an impotant ole afte all. How does a deflation affect the economy? THE MONE HPOTHESIS GIN: The effects of falling The stabilizing effects of deflation: ip g h(m/p) g shifts ight g h Pigou effect: ip g h(m/p ) g consumes wealth h g hc g IS shifts ight g h THE MONE HPOTHESIS GIN: The effects of falling The destabilizing effects of unexpected deflation: debt-deflation theoy ip (if unexpected) g tansfes puchasing powe fom boowes to lendes g boowes spend less and lendes spend moe g if boowes popensity to spend is lage than lendes, then aggegate spending falls, the IS cuve shifts left, and falls 4

5 THE MONE HPOTHESIS GIN: The effects of falling pices Thee was a big deflation: P fell 25% sudden fall in expected inflation means the ex-ante eal inteest ate ises fo any given nominal ate (i ) ex ante eal inteest ate = i e This could have discouaged the investment expenditue and helped cause the depession. g planned expenditue falls & agg. demand falls g income & output i Since the deflation likely was caused by fall in M, monetay policy may have played a ole hee. New Stuff: IS- Model with e 0 IS-Cuve: = C( T) + I(i - e ) + G -Cuve: M/P = L( i, ) Expect inflation entes the model in the IS-cuve π e 0, i on the vetical axis Expected deflation shifts the IS-cuve to the left i IS 2 (π e < 0) IS 1 () 2 1 = i 1 i 2 πe 2 The IS-cuve is dawn fo a given expected inflation. t point,, on IS 1 and 1 = i 1 π e < 0 shifts IS to IS 2, at, 2 = i 2 - π e => 2 = i 2 - (-π e ). 1 5

6 π e 0, i on the vetical axis Expected inflation shifts the IS-cuve to the ight i IS 1 () IS 2 (π e > 0) i 2 = i 1 π e 2 1 The IS-cuve is dawn fo a given expected inflation. t point,, on IS 1 and 1 = i 1 π e > 0 shifts IS to IS 2, at, 2 = i 2 - π e 2 Money Demand, Money Supply, Liquidity Tap MS 1 MS 2 MS 4 MS C D Md M/P Liquidity Tap - t vey low inteest ates, investos ae indiffeent between bonds and money money demand becomes pefectly elastic. Incease in the money supply is held as cash. Deivation of the -Cuve With Liquidity Tap 1 MS1 Md ( 1) Md ( 2) 1 2 Md (3) 2 0 C M/P 0 C s income falls below 3, no effect on the inteest ate. The cuve is hoizontal. 6

7 Monetay Policy in a Liquidity Tap IS F The economy is at 0 which is below full employment potential. Monetay policy is ineffective in pushing the economy beyond 1. Fiscal Policy in a Liquidity Tap IS 1 IS 2 F 0 1 ut, fiscal policy seems to wok and you get the full multiplie effect as you move fom 0 to 1. Why do you get the full multiplie effect? Fiscal Policy in a Liquidity Tap IS 1 IS 2 IS 3 F 0 1 7

8 Unconventional Monetay Policy in a Liquidity Tap π e 0 i IS 1 (π e =2%) IS2 (π e =4%) 0 F The Fed inceases the money supply and inceases inflation and inflationay expectations. 1. IS- model C H P T E R S U M M R 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 cuve: money maket equilibium D cuve C H P T E R S U M M R shows elation between P and the IS- model s equilibium. negative slope because hp g i(m/p) g h g ii g i expansionay fiscal policy shifts IS cuve ight, aises income, and shifts D cuve ight. expansionay monetay policy shifts cuve ight, aises income, and shifts D cuve ight. IS o shocks shift the D cuve. 23 8