MACROECONOMICS. Applying the IS -LM Model MANKIW. Context. In this chapter, you will learn N. GREGORY. Equilibrium in the IS -LM model

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1 C H A T E R 11 Aggegate Demand II: Applying the - Model Context Chapte 9 intoduced the model of aggegate demand and supply. Chapte 10 developed the - model, the basis of the aggegate demand cuve. MACROECONOMICS N. GREGOR MANKIW 2007 Woth ublishes, all ights eseved SIXTH EDITION oweoint Slides by Ron Conovich CHATER 11 Aggegate Demand II slide 1 In this chapte, you will lean Equilibium in the - model 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 The cuve epesents equilibium in the goods maket. = C( "T + I(+ G The cuve epesents money maket equilibium. M = L(, The intesection detemines the unique combination of and that satisfies equilibium in both makets. 1 1 CHATER 11 Aggegate Demand II slide 2 CHATER 11 Aggegate Demand II slide 3 olicy analysis with the - model = C( "T + I(+ G M = L(, We can use the - model to analyze the effects of fiscal policy: G and/o T monetay policy: M 1 CHATER 11 Aggegate Demand II slide 4 1 An incease in govenment puchases 1. cuve shifts ight 1 by 1" MC! G causing output & income to ise. 2. This aises money demand, causing the inteest ate to ise CHATER 11 Aggegate Demand II slide which educes investment, so the final incease in is smalle than 1! G 1 " MC

2 A 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 ΔT than fo an equal ΔG and the cuve shifts by 2. 1.! MC " 1! MC T so the effects on and ae smalle fo ΔT than fo an equal ΔG ΔM > 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 CHATER 11 Aggegate Demand II slide 6 CHATER 11 Aggegate Demand II slide 7 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. CHATER 11 Aggegate Demand II slide 8 The Fed 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: CHATER 11 Aggegate Demand II slide 9 Response 1: Hold M constant Response 2: Hold constant If Congess aises G, the cuve shifts ight. 1 If Congess aises G, the cuve shifts ight. 1 If Fed holds M constant, then cuve doesn t shift. 2 1 To keep constant, Fed inceases M to shift cuve ight Results:! = 2 " 1! = 2 " Results:! = 3 " 1! = CHATER 11 Aggegate Demand II slide 10 CHATER 11 Aggegate Demand II slide 11 2

3 Response 3: Hold constant If Congess aises G, the cuve shifts ight. To keep constant, Fed educes M to shift cuve left. Results:! = 0! = 3 " 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 Δ / ΔG Estimated value of Δ / ΔT CHATER 11 Aggegate Demand II slide 12 CHATER 11 Aggegate Demand II slide 13 Shocks in the - model shocks: exogenous changes in the demand fo goods & sevices. Examples: stock maket boom o cash change in households wealth ΔC change in business o consume confidence o expectations ΔI and/o ΔC 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. CHATER 11 Aggegate Demand II slide 14 CHATER 11 Aggegate Demand II slide 15 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. CHATER 11 Aggegate Demand II slide 16 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 CHATER 11 Aggegate Demand II slide 17 3

4 CASE STUD: The U.S. ecession of 2001 Causes: 1 Stock maket decline C Index (1942 = Standad & oo s CHATER 11 Aggegate Demand II slide 18 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 CHATER 11 Aggegate Demand II slide 19 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 CHATER 11 Aggegate Demand II slide 20 CASE STUD: The U.S. ecession of 2001 Monetay policy esponse: shifted cuve ight 7 Thee-month 6 T-Bill Rate /03/ /03/ /03/ /05/ /06/ /06/ /06/ /08/ /09/ /09/ /09/ /11/ /01/ /02/2000 CHATER 11 Aggegate Demand II slide 21 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. CHATER 11 Aggegate Demand II slide 22 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. CHATER 11 Aggegate Demand II slide 23 4

5 - 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 (intoduced in Chap. 9 captues this elationship between and. CHATER 11 Aggegate Demand II slide 24 Deiving the AD cuve Intuition fo slope of AD cuve: (M/ shifts left I CHATER 11 Aggegate Demand II slide 25 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 (M 2 / 1 CHATER 11 Aggegate Demand II slide 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 2 1 CHATER 11 Aggegate Demand II slide and AD-AS in the shot un & long un Recall fom Chapte 9: 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 CHATER 11 Aggegate Demand II slide 28 The SR and LR effects of an shock A negative shock shifts and AD left, causing to fall. 1 CHATER 11 Aggegate Demand II slide 29 ( 1 5

6 The SR and LR effects of an shock In the new shot-un equilibium, < 1 CHATER 11 Aggegate Demand II slide 30 ( 1 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 CHATER 11 Aggegate Demand II slide 31 ( 1 The SR and LR effects of an shock Ove time, gadually falls, which causes SRAS to move down. M/ to incease, which causes to move down. 1 2 CHATER 11 Aggegate Demand II slide 32 ( 1 ( 2 SRAS 2 The SR and LR effects of an shock This pocess continues until economy eaches a long-un equilibium with = 1 2 ( 1 ( 2 SRAS 2 CHATER 11 Aggegate Demand II slide 33 EXERCE: Analyze SR & LR effects of ΔM Daw the - and AD-AS diagams as shown hee. Suppose Fed inceases M. Show the shot-un effects on you gaphs. Show what happens in the tansition fom the shot un to the long un. How do the new long-un equilibium values of the 1 endogenous vaiables compae to thei initial values? CHATER 11 Aggegate Demand II slide 34 (M 1 / 1 Chapte Summay 1. - model a theoy of aggegate demand exogenous: M, G, T, exogenous in shot un, in long un endogenous:, endogenous in shot un, in long un cuve: goods maket equilibium cuve: money maket equilibium CHATER 11 Aggegate Demand II slide 35 6

7 Chapte Summay The Geat Depession 2. AD cuve shows elation between and the - model s equilibium. negative slope because (M/ I expansionay fiscal policy shifts cuve ight, aises income, and shifts AD cuve ight. expansionay monetay policy shifts cuve ight, aises income, and shifts AD cuve ight. o shocks shift the AD cuve. billions of 1958 dollas Unemployment (ight scale 140 Real GN (left scale pecent of labo foce CHATER 11 Aggegate Demand II slide 36 CHATER 11 Aggegate Demand II slide 37 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. CHATER 11 Aggegate Demand II slide 38 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. CHATER 11 Aggegate Demand II slide 39 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? CHATER 11 Aggegate Demand II slide 40 CHATER 11 Aggegate Demand II slide 41 7

8 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 CHATER 11 Aggegate Demand II slide 42 THE MONE HOTHES AGAIN: The effects of falling pices The destabilizing effects of expected deflation: π e fo each value of i I because I = I ( planned expenditue & agg. demand income & output CHATER 11 Aggegate Demand II slide 43 THE MONE HOTHES AGAIN: The effects of falling pices 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 CHATER 11 Aggegate Demand II slide 44 Why anothe Depession is unlikely 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. CHATER 11 Aggegate Demand II slide 45 8