March 22-31
The Keynesian Cross Y=C(Y-T)+I+G with I, T, and G fixed
Government-purchases multiplier Y/ G (if interest rate is fixed)
Tax multiplier Y/ T (if interest rate is fixed)
Marginal propensity to consume (MPC) 1 Multipliers: Y/ G = 1 MP C Y/ T = MP C 1 MP C (=1.9 in an estimate) (=-1.2)
Actual and planned expenditure
Inventory cycle
The IS-LM model Determination of income and interest rate Crowding-out takes effect partially
IS curve IS curve shows the possible combination of interest rate and income which equilibrates the market of goods and services It shows a condition for Investment - Savings balance (equilibrium of the loanable funds market)
Shifters of IS curve Government purchases Tax Factors which shift the investment function (e.g. animal spirits, consumer confidence, etc)
LM curve LM curve shows the possible combination of income and interest rate which equilibrates the market for real money balances It shows a condition for the Liquidity demand - Money supply balance
Theory of liquidity preference Demand for real money balances depends not only on the income but also on the interest rate In chapter 9, the money demand only depended on the income and coincided with the quantity equation Money demand can depend on the interest rate, because households and firms have an incentive to convert money to bonds when the interest goes up (demand for liquidity goes down)
Money market equilibrium (when income is fixed)
Deriving the LM curve
Shifters of the LM curve Money supply Factors which shift demand for real money balances Change in money demand for the transaction purposes (e.g. credit cards) Change in liquidity preference
Shift of LM curve by a change in money supply
Short-run equilibrium Intersection of the IS and LM curves Or equivalently, the solution (Y, r) of the system of equations: Y = C(Y-T) + I(r) + G (IS curve) M/P = L(r, Y) (LM curve) when G, T, M/P are fixed (note that these are policy variables -- the government can control them)
Policy analysis by IS-LM Three expansionary policies Fiscal Increase in government purchases Tax cut Monetary Increase in money supply
Government purchases
Tax cut The expansionary fiscal policies lead to a smaller increase in Y than the case of the Keynesian cross, because of the partial crowding-out
Money supply increase
Policy coordination For example, a shrink in income caused by a tax increase will be exacerbated by the Fed s policy to keep the interest rate constant
IS-LM as a theory of AD Aggregate demand curve traces the short-run equilibrium income (which is determined by the IS-LM) for different price levels
Shifters of AD curve Any factor which shifts IS or LM (other than the price level) shifts the AD curve E.g. A monetary expansion (rightward shift of the LM) shifts the AD to the right E.g.2 An expansionary fiscal policy (rightward shift of the IS) shifts the AD to the right
IS-LM in the short run and long run Gradual adjustments in price change the supply of real money balances (M/P), and shift the LM curve gradually until the output attains the long-run level
The Great Depression Triggered by the stock market crash in 1929, the U.S. economy plunged into a prolonged and severe depression From 1929 to the trough 1933, the unemployment rate increased from 3% to 25% and the real GDP decreased by 30% Consumption fell by 20%; investment fell to 1/8; nominal interest decreased from 6% to 1%; money supply fell by 1/4; price fell 20%
IS-LM analyses of the great depression The spending hypothesis: contraction of the IS stock market crash shifted the consumption function downward bank failures caused credit crunches and shifted the investment demand to the left The money hypothesis A contraction in money supply -- but in reality the real money balances did not fall as much
Effects of deflation and the great depression Deflation lowers the LM and increases output Pigou effect: increased real money balance raises the household wealth and increases consumption Debt-deflation theory: Deflation transfers wealth from debtors to creditors. Since the debtors have higher propensities to consume than the creditors, the transfer decreases the total expenditure Expected deflation raises the ex ante real interest rate. It shifts the IS to the left, since the investment demand depends on real interest whereas the money demand depends on nominal interest (r and i were the same when P was fixed)