Chapter 10 Aggregate Demand I: Building the IS -LM Model (continued) slide 0
Exercise: Shifting the IS curve Use the diagram of the Keynesian cross to show how an increase in taxes shifts the IS curve. slide 1
The Theory of Liquidity Preference Due to John Maynard Keynes. A simple theory in which the interest rate is determined by money supply and money demand. Note: Because we are in the short-run, the price level is fixed, so = 0 and r = i. slide 2
Money supply The supply of real money balances is fixed: s M P M P r interest rate M P s M P M/P real money balances slide 3
Money demand Demand for real money balances: d M P L( r ) r interest rate M P s L (r ) M P M/P real money balances slide 4
Equilibrium The interest rate adjusts to equate the supply and demand for money: M P r interest rate r 1 M P L( r ) L (r ) s M P M/P real money balances slide 5
How do we reach equilibrium? r 1 r e r r 2 M P s M P L (r ) M/P real money balances At r 1 > r e : Ms > Md: More people are trying to lower their money holdings and convert them into bonds and interest bearing deposits: seeing the high demand for savings deposits banks offer lower interest rates: r At r 2 < r e : Ms < Md: More people are trying to raise their money holdings: withdraw savings deposits. In order to make savings deposits more attractive banks offer higher interest rate: r slide 6
How the Fed raises the interest rate To increase r, Fed reduces M r interest rate r 2 r 1 M 2 P M 1 P L (r ) M/P real money balances slide 7
Notes (1) Only monetary policy can change M. Fiscal policy has no impact on the money supply. An expansionary MP will M, r, I, Y in SR How about the impact of MP in LR? Recall: MV = PY: M e M e slide 8
Notes (2) In SR: M will i SR and r SR because i = r + e, e = 0, i = r In LR: M will e and i LR as e, (i LR = r LR + e ) r LR remains constant, i LR increases. slide 9
CASE STUDY: Monetary Tightening & Interest Rates Late 1990s: > 50% 2002: CBRT Chairman Serdengecti announces that monetary policy would aim to reduce inflation (implicit inflation targeting) CBRT reduces M/P Jan 2003: = 25% How do you think this policy change would affect nominal interest rates? slide 10
The LM curve Now let s put Y back into the money demand function: The LM curve is a graph of all combinations of r and Y that equate the supply and demand for real money balances. The equation for the LM curve is: d M P L( r, Y ) M P L( r, Y ) slide 11
Deriving the LM curve r (a) The market for real money balances r (b) The LM curve LM r 2 r 2 L (r, Y 2 ) r 1 r 1 L (r, Y 1 ) M 1 P M/P Y 1 Y 2 Y slide 12
Why the LM curve is upward sloping An increase in income raises money demand. Since the supply of real balances is fixed, there is now excess demand in the money market at the initial interest rate. The interest rate must rise to restore equilibrium in the money market. slide 13
How M shifts the LM curve r (a) The market for real money balances r (b) The LM curve LM 2 r 2 r 2 LM 1 r 1 L (r, Y 1 ) r 1 M 2 P M 1 P M/P Y 1 Y slide 14
Exercise: Shifting the LM curve Suppose a wave of credit card fraud causes consumers to use cash more frequently in transactions. Use the liquidity preference model to show how these events shift the LM curve. slide 15
The short-run equilibrium The short-run equilibrium is the combination of r and Y that simultaneously satisfies the equilibrium conditions in the goods & money markets: r LM Y C ( Y T ) I ( r ) G M P L( r, Y ) Equilibrium interest rate IS Equilibrium level of income Y slide 16
The Big Picture Keynesian Cross Theory of Liquidity Preference IS curve LM curve IS-LM model Explanation of short-run fluctuations Agg. demand curve Agg. supply curve Model of Agg. Demand and Agg. Supply slide 17
Quiz #4 this Thursday (December 6, 2012 from Chapter 10 slide 18
End of Chapter Problem 1 Use the Keynesian cross to predict the impact of: An increase in G An increase in T An equal increase in G and T slide 19
End of Chapter Problem 2 Suppose C=200+0.75 (Y-T) I=100, G=100, T=100 Graph planned expenditure What is Y? If G increases to 125, what is new Y? What should G be to achieve Y=1600? slide 20
b) Y=200+0.75(Y-100)+100+100 Y=325+0.75Y Y=1300 c) DeltaG=G2-G1=125-100=25 DeltaY/DeltaG=1/(1-0.75)=4 DeltaY=100 Y2=1300+100=1400 slide 21
c) Y=1600 DeltaY=1600-1300=300 DeltaY/DeltaG=4 DeltaG=75 G2=100+75=175 slide 22
End of Chapter Problem 4 C=Cbar+c(Y-T) a) What happens to equilibrium income if Cbar declines (people become more thrifty)? b) What happens to equilibrium savings? c) Why is this result called the paradox of thrift? d) Did we get this result in Chapter 3? slide 23
a) Y declines b) Y=Cbar+c(Y-T)+I+G Delta(Y)=Delta(Cbar)+c(DeltaY) Delta(Y)(1-c)=Delta(Cbar) Delta(Y)/Delta(Cbar)=[1/1-c]>1 Y declines more than C S=(Y-C-G) declines as well slide 24
c) It is called the paradox of thrift because when people consume less, they end up saving less d) We did not get this result in Chapter 3 because the income was constant in the long run. Hence, a decline in consumption lead to an increase in savings. slide 25
End of Chapter Problem 5 Suppose (M/P)d=1000-100r Ms=1000, P=2 a) Graph the money market b) What is equilibrium r? c) If Ms=1200, what is new r? d) If r=7, what is Ms? slide 26
b) 1000-100r=1000/2 r=5 c) 1000-100r=1200/2 r=4 d) 1000-100.7=Ms/2 Ms=600 slide 27