Chapte 10. Aggegate Demand I Context Chapte 9 intoduced the model of aggegate demand and aggegate supply. Long un pices flexible output detemined by factos of poduction & technology unemployment equals its natual ate Shot un pices fixed output detemined by aggegate demand unemployment is negatively elated to output slide 0 slide 1 Context The Big Pictue This chapte develops the IS-LM model, the theoy that yields the aggegate demand cuve. We focus on the shot un and assume the pice level is fixed. IS LM model can be intepeted as A theoy of GDP detemination given the P is fixed O, a theoy of AD (as a pat of AD-AS model) Keynesian Coss Theoy of Liquidity Pefeence IS cuve LM cuve IS-LM model Agg. demand cuve Agg. supply cuve Model of Agg. Demand and Agg. Supply xplanation of shot-un fluctuations slide 2 slide 3 1
The Keynesian Coss lements of the Keynesian Coss A simple closed economy model in which income is detemined by expenditue. (due to J.M. Keynes) consumption function: govt policy vaiables: C = C( T ) G = G, T = T Notation: I = planned investment = C + I + G = planned expenditue = eal GDP = actual expenditue Diffeence between actual & planned expenditue: unplanned inventoy investment slide 5 fo now, planned investment is exogenous: planned expenditue: quilibium condition: Actual expenditue = = I = I = C( T ) + I + G Planned expenditue slide 6 Gaphing planned expenditue Gaphing the equilibium condition planned expenditue =C +I +G planned expenditue = 1 MPC 45º income, output, income, output, slide 7 slide 8 2
The equilibium value of income planned expenditue = =C +I +G quilibium income income, output, slide 9 slide 10 An incease in govenment puchases Why the multiplie is geate than 1 At 1, thee is now an unplanned dop in inventoy = =C +I +G 2 =C +I +G 1 Initially, the incease in G causes an equal incease in : Δ = ΔG. But C futhe ΔG futhe C so fims incease output, and income ises towad a new equilibium 1 = 1 Δ 2 = 2 futhe So the final impact on income is much bigge than the initial ΔG. slide 11 slide 12 3
Solving fo Δ Intepetations of Multiplie = C + I + G Δ = Δ C + Δ I + ΔG = Δ C + ΔG = MPC Δ + ΔG Collect tems with Δ on the left side of the equals sign: (1 MPC) Δ = ΔG equilibium condition in changes because I exogenous because ΔC = MPC Δ Finally, solve fo Δ : 1 Δ = ΔG 1 MPC We have the powe to use fiscal policy to affect the economy damatically in the SR (G) Fluctuations in spending have magnified effects on GDP (C, I) xogenous shock to planned I o C Fluctuations in GDP and animal spiit slide 13 slide 14 The govenment puchases multiplie Definition: the incease in income esulting fom a $1 incease in G. In this model, the govt puchases multiplie equals Δ 1 = ΔG 1 MPC xample: If MPC = 0.8, then Δ 1 = = 5 ΔG 1 0.8 An incease in G causes income to incease by 5 times as much! slide 15 Initially, the tax incease educes consumption, and theefoe : ΔC = MPC ΔT so fims educe output, and income falls towad a new equilibium An incease in taxes 2 = 2 Δ = =C 1 +I +G =C 2 +I +G At 1, thee is now an unplanned inventoy buildup 1 = 1 slide 16 4
Solving fo Δ The Tax Multiplie Δ = Δ C + Δ I + ΔG = ΔC = MPC ( Δ ΔT ) eq m condition in changes I and G exogenous def: the change in income esulting fom a $1 incease in T : Δ MPC = ΔT 1 MPC Solving fo Δ : Final esult: (1 MPC) Δ = MPC ΔT MPC Δ = ΔT 1 MPC If MPC = 0.8, then the tax multiplie equals Δ 08. 08. = = = 4 ΔT 1 0. 8 0. 2 slide 17 slide 18 The Tax Multiplie is negative: tax hike educes consume spending, which educes income. is geate than one (in absolute value, if MPC>0.5) A change in taxes has a multiplie effect on income. is smalle than the govt spending multiplie: Consumes save the faction (1-MPC) of a tax cut, so the initial boost in spending fom a tax cut is smalle than fom an equal incease in G. Case Study Cutting Taxes to Stimulate the conomy Kennedy in 64: cuts in pesonal and copoate income taxes GW Bush: poposed tax cuts in 2000 slide 19 slide 20 5
The IS cuve Deiving the IS cuve def: a gaph of all combinations of and that esult in goods maket equilibium, i.e. actual expenditue (output) = planned expenditue The equation fo the IS cuve is: I ΔI 1 = =C +I ( 2 )+G =C +I ( 1 )+G 2 = C ( T) + I( ) + G 1 2 1 2 IS slide 21 slide 22 Why the IS cuve is negatively sloped A fall in the inteest ate motivates fims to incease investment spending, which dives up total planned spending ( ). To estoe equilibium in the goods maket, output (a.k.a. actual expenditue, ) must incease. The IS cuve and the Loanable Funds model (a) The L.F. model (b) The IS cuve S 2 S 1 2 2 1 I ( ) S, I 1 2 1 IS slide 23 slide 24 6
Fiscal Policy and the IS cuve We can use the IS-LM model to see how fiscal policy (G and T ) can affect aggegate demand and output. Let s stat by using the Keynesian Coss to see how fiscal policy shifts the IS cuve Keynesian Coss o Loanable Funds Maket d => d O d => d slide 25 slide 26 Shifting the IS cuve: ΔG xecise: Shifting the IS cuve At any value of, G so the IS cuve shifts to the ight. = =C +I ( 1 )+G 2 =C +I ( 1 )+G 1 Use the diagam of the Keynesian Coss o Loanable Funds model to show how an incease in taxes shifts the IS cuve. The hoizontal distance of the IS shift equals 1 Δ = ΔG 1 MPC 1 1 2 Δ IS 1 1 2 IS 2 slide 27 slide 28 7
The Theoy of Liquidity Pefeence Money Supply due to John Maynad Keynes. A simple theoy in which the inteest ate is detemined by money supply and money demand. The supply of eal money balances is fixed: ( M P ) s = M P inteest ate ( M P ) s M P M/P eal money balances slide 29 slide 30 Money Demand quilibium Demand fo eal money balances: d ( M P ) = L( ) inteest ate ( M P ) s L ( ) The inteest ate adjusts to equate the supply and demand fo money: inteest ate 1 ( M P ) s M P = L( ) L ( ) M P M/P eal money balances M P M/P eal money balances slide 31 slide 32 8
How the Fed aises the inteest ate To incease, Fed educes M inteest ate 2 1 M 2 P M 1 P L ( ) M/P eal money balances CAS STUD Volcke s Monetay Tightening Late 1970s: π > 10% Oct 1979: Fed Chaiman Paul Volcke announced that monetay policy would aim to educe inflation. Aug 1979-Apil 1980: Fed educes M/P 8.0% Jan 1983: π = 3.7% How do do you think this policy change would affect inteest ates? slide 33 slide 34 Volcke s Monetay Tightening, cont. model pices pediction actual outcome The effects of a monetay tightening on nominal inteest ates shot un Liquidity Pefeence (Keynesian) sticky Δi > 0 8/1979: i = 10.4% 4/1980: i = 15.8% long un Quantity Theoy, Fishe ffect (Classical) flexible Δi < 0 1/1983: i = 8.2% slide 35 The LM cuve Now let s put back into the money demand function: = L(, ) ( M P ) d The LM cuve is a gaph of all combinations of and that equate the supply and demand fo eal money balances. The equation fo the LM cuve is: M P = L(, ) slide 36 9
Deiving the LM cuve Why the LM cuve is upwad-sloping An incease in income aises money demand. Since the supply of eal balances is fixed, thee is now excess demand in the money maket at the initial inteest ate. The inteest ate must ise to estoe equilibium in the money maket. slide 37 slide 38 xecise: 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. slide 39 slide 40 10
The shot-un un equilibium The Big Pictue The shot-un equilibium is the combination of and that simultaneously satisfies the equilibium conditions in the goods & money makets: LM Keynesian Coss Theoy of Liquidity Pefeence IS cuve LM cuve IS-LM model xplanation of shot-un fluctuations = C ( T) + I( ) + G M P = L(, ) quilibium inteest ate IS quilibium level of income Agg. demand cuve Agg. supply cuve Model of Agg. Demand and Agg. Supply slide 41 slide 42 Key Featues of IS LM model IS LM is a moe detailed look at what lies behind AD It decomposes AD into two mkts (money and goods) It allows us to look at the two mkts sepaately To examine the detemination of inteest ates To distinguish clealy between fiscal and monetay policy 1) Position of LM cuve depends on M/P 2) xpansionay monetay policy 3) Inceases in P 4) xogenous shocks to Md 5) Position of IS cuve 6) xpansionay fiscal policy slide 43 slide 44 11
6) xpansionay fiscal policy 7) xogenous spending shock 8) Slopes of IS and LM depend on 9) xpansionay fiscal policy 10) xpansionay monetay policy 11) Adjustment of the economy to LR equil. slide 45 slide 50 12