Chapter 12/11 Part 1. Aggregate Demand II: Applying the IS-LM Model 10/28/2017. Equilibrium in the IS -LM model IN THIS CHAPTER WE: M P L( r, Y )

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1 Chapte 12/11 at 1 Aggegate Demand II: Applying the -LM Model IN TH CHATER WE: use the -LM model to analyze the effects of shocks, fiscal policy, monetay policy affect income and the inteest ate in the shot un when pices ae fixed deive the aggegate demand cuve fom the - LM model exploe seveal explanations fo the Geat Depession 1 Equilibium in the -LM model The cuve epesents equilibium in the goods maket. = C( T) + I () + G = C T + I i e + G The LM cuve epesents money maket equilibium. M L(, ) = i The intesection detemines the unique combination of and that satisfies equilibium in both makets. 1 1 LM 1

2 olicy analysis with the -LM model C ( T ) I ( ) G M L(, ) LM We can use the -LM model to analyze the effects of 1 fiscal policy: G and/o T monetay policy: M 1 An incease in govenment puchases 1. cuve shifts ight by 1 1 mpc o 1 1 mpc+mpc x t x ΔG LM causing output & income to 2 ise This aises money 1 demand, causing the 1. inteest ate to ise 3. which educes investment, so 1 2 the final incease in is smalle 3. 1 than 1 mpc+mpc x t I ll show the dynamics on the boad A tax cut Consumes save (1 MC) of the tax cut, so the initial boost in spending is smalle fo ΔT than fo an equal ΔG and 1. the cuve shifts by b o b x ΔT 1 mpc 1 mpc+mpc x t 2. so the effects on and ae smalle fo ΔT than fo an equal ΔG LM I ll show the dynamics on the boad 2

3 Monetay policy: An incease in M 1. ΔM > 0 shifts the LM cuve down (o to the ight) 2. causing the inteest ate to fall 1 2 LM 1 LM 2 3. which inceases investment, causing output & income to ise. 1 2 I ll show the dynamics on the boad Slopes Matte! If investment is inelastic, not esponsive to changes in, -cuve is elatively steep monetay policy is less effective. But, have less cowding out, which makes fiscal policy to be moe effective. NOW OU TR: Shifting the LM cuve Suppose a wave of cedit cad faud causes consumes to use cash moe fequently in tansactions. Use the liquidity pefeence model to show how these events shift the LM cuve. 3

4 Inteaction between monetay & fiscal policy 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 inteactions may alte the impact of the oiginal policy change. The Fed s esponse to ΔG > 0 Suppose Congess inceases G (deficit inceases). ossible Fed esponses: 1. hold M constant 2. hold constant 3. hold constant In each case, the effect of the ΔG is diffeent Response 1: Hold M constant If Congess aises G, the cuve shifts ight. If Fed holds M constant, then LM cuve doesn t shift. Results: LM 1 4

5 Response 2: Hold constant If Congess aises G, the cuve shifts ight. To keep constant, Fed inceases M to shift LM cuve ight. Results: LM 1 LM 2 Response 3: Hold constant If Congess aises G, the cuve shifts ight. To keep constant, Fed educes M to shift LM cuve left. Results: LM 2 LM 1 2 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

6 Shocks in the -LM model shocks: exogenous changes in the demand fo goods & sevices. Examples: stock maket boom o cash g change in households wealth g ΔC (Δa) change in business o consume confidence o expectations g ΔI and/o ΔC (Δa o Δd) Shocks in the -LM model LM 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. NOW OU TR Analyze shocks with the -LM model Use the -LM model to analyze the effects of 1. a housing maket cash that educes consumes wealth (2008) Fo this shock, a. use the -LM diagam to detemine the effects on and. b. figue out what happens to C, I, and the unemployment ate. 17 6

7 Index (1942 = 100) 10/28/2017 Housing maket cash shifts left, causing and to fall. C falls due to lowe wealth and lowe income, I ises because is lowe u ises because is lowe (Okun s law) LM 1 18 CASE STUD: The U.S. ecession of 2001 Duing 2001: 2.1 million jobs lost, unemployment ose fom 3.9% to 5.8%. GD gowth slowed to 0.8% (compaed to 3.9% aveage annual gowth duing ). CASE STUD: The U.S. ecession of 2001 Causes: 1) Stock maket decline g ic 1,500 1,200 Standad & oo s

8 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 CASE STUD: The U.S. ecession of 2001 Monetay policy esponse: shifted LM cuve ight Thee-month T-Bill ate 8

9 shocks - defined Monetay olicy: Decease in i incease in M monetay expansion Incease in i decease in M monetay contaction monetay tightening Shocks - defined Fiscal olicy: Incease in T G fiscal contaction also called fiscal consolidation Decease in T G fiscal expansion 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 LM cuve to achieve its taget. Othe shot-tem ates typically move with the fedeal funds ate. 9

10 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 LM shocks ae moe pevalent than shocks. If so, then tageting the inteest ate stabilizes income bette than tageting the money supply. (See poblem 8 on p.364.) Some ague: If Fed chooses the inteest ate and adjusts the money supply to achieve it, daw a hoizontal LM cuve. LM How Does the -LM Model Fit the Facts? Adjustment in RGD(output) takes time, need to eintoduce dynamics: Consumes ae likely to take time to adjust thei consumption following a change in disposable income. Fims ae likely to take time to adjust investment spending following a change in thei sales. Fims ae likely to take time to adjust investment spending following a change in the inteest ate. Fims ae likely to take time to adjust poduction following a change in thei sales. 10

11 How Does the -LM Model Fit the Facts? Fom Blanchad The Empiical Effects of an Incease in the Fedeal Funds Rate In the shot un, an incease in the fedeal funds ate leads to a decease in output and to an incease in unemployment, but it has little effect on the pice level. How Does the -LM Model Fit the Facts? The Empiical Effects of an Incease in the Fedeal Funds Rate -LM and Aggegate Demand So fa, we ve been using the -LM model to analyze the shot un, when the pice level is assumed fixed. Howeve, a change in would shift LM and theefoe affect. The aggegate demand cuve (intoduced in Chap. 10) captues this elationship between and. 11

12 Deiving the AD cuve Intuition fo slope of AD cuve: h g i(m/ ) g LM shifts left g h g ii g i LM( 2 ) LM( 1 ) AD Monetay policy and the AD cuve The Fed can incease aggegate demand: 1 LM(M 1 / 1 ) LM(M 2 / 1 ) hm g LM shifts ight g i g hi g h at each value of Fiscal policy and the AD cuve Expansionay fiscal policy (hg and/o it ) inceases agg. demand: 2 1 LM it g hc g shifts ight 1 2 g h at each value of

13 -LM and AD-AS in the shot un & long un The foce that moves the economy fom the shot un to the long un is the gadual adjustment of pices. In the shot-un equilibium, if then ove time, the pice level will ise fall emain constant The SR and LR effects of an shock A negative shock shifts and AD left, causing to fall. 1 LM( 1 ) A B B A SRAS 1 The SR and LR effects of an shock LM( 1 ) In the new shot-un equilibium, 1 SRAS 1 13

14 The SR and LR effects of an shock LM( 1 ) In the new shot-un equilibium, Ove time, gadually falls, causing: SRAS to move down M/ to incease, which causes LM to move down 1 SRAS 1 The SR and LR effects of an shock LM( 1 ) LM( 2 ) Ove time, gadually falls, causing: SRAS to move down M/ to incease, which causes LM to move down 1 2 SRAS 1 SRAS 2 The SR and LR effects of an shock LM( 1 ) LM( 2 ) This pocess continues until economy eaches a long-un equilibium with 1 SRAS 1 2 SRAS 2 14

15 SR & LR effects of ΔM a. Daw the -LM and AD-AS diagams as shown hee. LM(M 1 / 1 ) b. Suppose Fed inceases M. Show the shot-un effects on you gaphs. c. Show what happens in the tansition fom the shot un to the long un. d. How do the new long-un equilibium values of the endogenous vaiables compae to thei initial values? 1 SRAS 1 42 Shot-un effects of ΔM LM and AD shift ight. falls, ises above 1 2 LM(M 1 / 1 ) LM(M 2 / 1 ) 2 1 SRAS 2 43 Tansition fom shot un to long un Ove time, ises SRAS moves upwad M/ falls LM moves leftwad New long-un eq m highe all eal vaiables back at thei initial values Money is neutal in the long un. LM(M 12 / 13 ) LM(M 2 / 1 ) 3 = SRAS SRAS 44 15