AD continued (Ch.11) An increase in G. Policy analysis with the IS-LM. Model

Transcription

1 AD continued (Ch.11 Use the IS-LM model to see how policies and shocks affect income and the inteest ate in the shot un when pices ae fixed deive the aggegate demand cuve exploe vaious explanations fo the Geat Depession AD II slide 0 olicy analysis with the IS-LM Model = C ( T + I( + G M = L(, LM olicymakes can affect macoeconomic vaiables with G and/o T M 1 1 IS AD II slide 1 An incease in G 1. IS cuve shifts ight 1 by 1 MC ΔG LM 2. This aises M D which educes I, final incease in smalle 3. AD II slide 2 1

2 A tax cut Initial boost in C smalle fo ΔT than fo an equal ΔG LM IS cuve shifts by MC 1. Δ 1 MC T so the effects on and ae smalle AD II slide 3 Monetay olicy: an incease in M 1. ΔM > 0 shifts the LM cuve down 2. falls 1 2 LM 1 LM 2 3. Output ises 1 2 IS AD II slide 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 inteaction may alte the impact of the oiginal policy change. AD II slide 5 2

3 The Fed s s esponse to ΔG > 0 Suppose Congess inceases G. ossible Fed esponses: 1. hold M constant 2. hold constant 3. hold constant In each case, the effects of the ΔG ae diffeent: AD II slide 6 G Response 1: hold M constant Fed keeps M constant LM 1 2 Results: Δ = 2 1 Δ = AD II slide 7 G Response 2: hold constant Fed inceases M LM 1 LM Results: Δ = 3 1 Δ = AD II slide 8 3

4 G Response 3: hold constant LM 2 Fed educes M LM Results: Δ = 0 Δ = IS2 AD II slide 9 Shocks in the IS-LM Model IS shocks: exogenous changes in demand fo goods Examples: stock maket boom o cash change in households wealth ΔC change in confidence o expectations ΔI and/o ΔC AD II slide 10 Shocks in the IS-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 AD II slide 11 4

5 What is the Fed s s policy instument? The Fed tagets the Fedeal Funds ate: it announces a taget value + uses monetay policy to shift LM to attain taget ate. Why does the Fed taget inteest ates? 1 easie to measue 2 Fed might believe that LM shocks ae moe pevalent than IS shocks. If so, tageting stabilizes bette than tageting the M. (See oblem 7 on p.306 AD II slide 12 IS-LM and Aggegate Demand So fa, we ve been using the IS-LM model to analyze the shot un, when the pice level is assumed fixed. Howeve, a change in would shift the LM cuve and theefoe affect. The aggegate demand cuve (intoduced in chap. 9 captues this elationship between and AD II slide 13 Deiving the AD cuve Intuition fo slope of AD cuve: (M/ LM shifts left I LM( 2 LM( 1 IS AD AD II slide 14 5

6 Monetay policy and the AD cuve The Fed can incease aggegate demand: 1 LM(M 1 / 1 LM(M 2 / 1 M LM shifts ight I IS at each value of 1 AD AD 1 AD II slide 15 Fiscal policy and the AD cuve Expansionay fiscal policy ( G and/o T inceases agg. demand: 2 1 LM T C IS shifts ight at each value of AD 2 AD 1 AD II slide 16 SR and LR effects of a negative IS shock A negative IS shock shifts IS and AD left, causing to fall. LRAS LM( 1 1 LRAS SRAS 1 AD 1 AD 2 AD II slide 17 6

7 The SR and LR effects of an IS shock Ove time, falls (since below eq m level This pocess continues until economy eaches a long-un equilibium with equal to bal 1 2 LRAS LM( 1 LM( 2 LRAS SRAS 2 AD 1 AD 2 AD II slide 18 SRAS 1 The Geat Depession Unemployment (ight scale billions of 1958 dollas Real GN (left scale pecent of labo foce AD II slide 19 The Spending Hypothesis: Shocks to the IS Cuve LEFTWARD SHIFT of the IS cuve Why? 1. Stock maket cash exogenous C ( : S& 500 fell 71% 2. Dop in investment (bank failues made it hade to obtain financing fo investment 3. Contactionay fiscal policy: politicians aised tax ates and cut spending EVIDENCE: output and inteest ates both fell, which is what a leftwad IS shift would cause AD II slide 20 7

8 The Money Hypothesis: A Shock to the LM Cuve the Depession was lagely due to huge fall in the money supply evidence: M1 fell 25% duing But, two poblems with this hypothesis: 1. fell even moe, M/ actually ose slightly duing nominal inteest ates fell, which is the opposite of what would esult fom a leftwad LM shift. AD II slide 21 The Money Hypothesis Again: The Effects of Falling ices 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. Can deflation be bad? AD II slide 22 The Money Hypothesis Again: The Effects of Falling ices THE GOOD SIDE OF DEFLATION igou effect: (M/ C IS shifts ight THE BAD SIDE debt-deflation theoy: unexpected deflation (if unexpected tansfes puchasing powe fom boowes to lendes if boowes MC > lendes MC aggegate spending falls IS left falls Expected deflation: π e I income & output AD II slide 23 8

9 1. IS-LM model Chapte summay a theoy of aggegate demand IS cuve: goods maket equilibium LM cuve: money maket equilibium 2. AD cuve shows elation between and the IS-LM model s equilibium. negative slope because (M/ I expansionay fiscal policy shifts IS cuve ight, aises income, and shifts AD cuve ight expansionay monetay policy shifts LM cuve ight, aises income, and shifts AD cuve ight IS o LM shocks shift the AD cuve AD II slide 24 9