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macroeconomics fifth edition
N. Gregory Mankiw
PowerPoint® Slides by Ron Cronovich
CHAPTER TEN
Aggregate Demand Im
acro
© 2002 Worth Publishers, all rights reserved
Topic 9:
Aggregate Demand I(chapter 10)
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CHAPTER 10CHAPTER 10 Aggregate Demand I Aggregate Demand I slide 2
MotivationMotivation
The Great Depression caused a rethinking of the Classical Theory of the macroeconomy. It could not explain:– Drop in output by 30% from 1929 to
1933– Rise in unemployment to 25%
In 1936, J.M. Keynes developed a theory to explain this phenomenon.
We will learn a version of this theory, called the ‘IS-LM’ model.
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CHAPTER 10CHAPTER 10 Aggregate Demand I Aggregate Demand I slide 3
ContextContext
Chapter 9 introduced the model of aggregate demand and aggregate supply.
Long run– prices flexible– output determined by factors of production
& technology– unemployment equals its natural rate
Short run– prices fixed– output determined by aggregate demand– unemployment is negatively related to
output
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CHAPTER 10CHAPTER 10 Aggregate Demand I Aggregate Demand I slide 4
ContextContext
This chapter develops the IS-LM model, the theory that yields the aggregate demand curve.
We focus on the short run and assume the price level is fixed.
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CHAPTER 10CHAPTER 10 Aggregate Demand I Aggregate Demand I slide 5
The Keynesian CrossThe Keynesian Cross
A simple closed economy model in which income is determined by expenditure. (due to J.M. Keynes)
Notation: I = _______________E = C + I + G = ______________Y = real GDP = ____________
Difference between actual & planned expenditure: _________________
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CHAPTER 10CHAPTER 10 Aggregate Demand I Aggregate Demand I slide 6
Elements of the Keynesian CrossElements of the Keynesian Cross
( )C C Y T
I I
,G G T T
Actual expenditure Planned expenditure
_____________
consumption function:
for now, investment is exogenous:
planned expenditure:Equilibrium condition:
govt policy variables:
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CHAPTER 10CHAPTER 10 Aggregate Demand I Aggregate Demand I slide 7
Graphing planned expenditureGraphing planned expenditure
income, output, Y
E
planned
expenditure
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CHAPTER 10CHAPTER 10 Aggregate Demand I Aggregate Demand I slide 8
Graphing the equilibrium conditionGraphing the equilibrium condition
income, output, Y
E
planned
expenditure
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CHAPTER 10CHAPTER 10 Aggregate Demand I Aggregate Demand I slide 9
The equilibrium value of incomeThe equilibrium value of income
income, output, Y
E
planned
expenditure
E =Y
E =C +I +G
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CHAPTER 10CHAPTER 10 Aggregate Demand I Aggregate Demand I slide 10
The equilibrium value of incomeThe equilibrium value of income
income, output, Y
E
planned
expenditure
E =Y
E =C +I +G
E>Y: ___________ inventories: must produce more.
E<Y: ___________ inventories: must produce less.
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CHAPTER 10CHAPTER 10 Aggregate Demand I Aggregate Demand I slide 11
An increase in government purchasesAn increase in government purchases
Y
E
E =Y
E =C +I +G1
E1 = Y1
…so firms increase output, and income rises toward a new equilibrium
G Looks like
Y>G
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CHAPTER 10CHAPTER 10 Aggregate Demand I Aggregate Demand I slide 12
Why the multiplier is greater than 1Why the multiplier is greater than 1 Def: Government purchases multiplier:
Initially, the increase in G causes an equal increase in Y: Y = G.
But Y C
further Y
further C
further Y So the government purchases multiplier will
be _________________.
YG
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CHAPTER 10CHAPTER 10 Aggregate Demand I Aggregate Demand I slide 13
An increase in government purchasesAn increase in government purchases
Y
E
E =Y
GY once
Y more
Y even more
C more
C
C even more
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CHAPTER 10CHAPTER 10 Aggregate Demand I Aggregate Demand I slide 14
Sum up changes in expenditureSum up changes in expenditure
Y G MPC G MPC MPC G
MPC MPC MPC G ...
1 2 3G MPC G MPC G MPC G ...
So the multiplier is:
YG
This is a standard geometric series from algebra:
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CHAPTER 10CHAPTER 10 Aggregate Demand I Aggregate Demand I slide 15
Solving for Solving for YY
Y C I G
Y C I G
MPC Y G
C G
(1 MPC) Y G
equilibrium conditionin changes
because I exogenousbecause C = MPC Y
Collect terms with Y on the left side of the equals sign:
Finally, solve for Y :
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CHAPTER 10CHAPTER 10 Aggregate Demand I Aggregate Demand I slide 16
Algebra exampleAlgebra example
Suppose consumption function: C= a+b(Y-T)
where a and b are some numbers (MPC=b)
and other variables exogenous:
I I T T G G, ,
Use Goods market equilibrium condition:
Y C I G
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CHAPTER 10CHAPTER 10 Aggregate Demand I Aggregate Demand I slide 17
Algebra exampleAlgebra example
Y C I G
Y a b Y T I G( )
Solve for Y: Y bY a bT I G
1 b Y a bT I G( )
1 1
1 1 1 1a b
Y G I Tb b b b
So if b=MPC=0.75, multiplier =
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CHAPTER 10CHAPTER 10 Aggregate Demand I Aggregate Demand I slide 18
An increase in taxesAn increase in taxes
Y
E
E =Y
E =C1 +I +G
E1 = Y1
…so firms reduce output, and income falls toward a new equilibrium
C = ______
Initially, the tax increase reduces consumption, and therefore E:
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CHAPTER 10CHAPTER 10 Aggregate Demand I Aggregate Demand I slide 19
Tax multiplierTax multiplier
Define tax multiplier:
Can read the tax multiplier from the algebraic solution above:
1 1
1 1 1 1a b
Y G I Tb b b b
So: where is the MPC.1
bY T b
b
If b=0.75, tax multiplier =
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CHAPTER 10CHAPTER 10 Aggregate Demand I Aggregate Demand I slide 20
Solving for Solving for YY
Y C I G
MPC Y T
C
(1 MPC) MPCY T
eq’m condition in changes
I and G exogenous
Solving for Y :
Final result:
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CHAPTER 10CHAPTER 10 Aggregate Demand I Aggregate Demand I slide 21
The Tax MultiplierThe Tax Multiplier
Question: how is this different from the government spending multiplier considered previously?
The tax multiplier:
…is __________: An increase in taxes reduces consumer spending, which reduces equilibrium income.
…is __________________________: (in absolute value) Consumers save the fraction (1-MPC) of a tax cut, so the initial boost in spending from a tax cut is smaller than from an equal increase in G.
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CHAPTER 10CHAPTER 10 Aggregate Demand I Aggregate Demand I slide 22
A question to consider:A question to consider:
Using the Keynesian Cross, what would be the effect of an increase in investment on the equilibrium level of income/output.
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CHAPTER 10CHAPTER 10 Aggregate Demand I Aggregate Demand I slide 23
Building the Building the ISIS curve curve
def: ____________________________________________________________________________,
i.e. actual expenditure (output) = planned expenditure
The equation for the IS curve is:
( ) ( )Y C Y T I r G
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CHAPTER 10CHAPTER 10 Aggregate Demand I Aggregate Demand I slide 24
Y2Y1
Y2Y1
Deriving the Deriving the ISIS curve curve
r
Y
E
r
Y
E =C +I (r1 )+G
E =C +I (r2 )+G
r1
r2
E =Y
IS
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CHAPTER 10CHAPTER 10 Aggregate Demand I Aggregate Demand I slide 25
Understanding the Understanding the ISIS curve’s slope curve’s slope
The IS curve is negatively sloped.
Intuition:A fall in the interest rate motivates firms to increase investment spending, which drives up total planned spending (E ).
To restore equilibrium in the goods market, output (a.k.a. actual expenditure, Y ) must increase.
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CHAPTER 10CHAPTER 10 Aggregate Demand I Aggregate Demand I slide 26
Fiscal Policy and the Fiscal Policy and the ISIS curve curve
We can use the IS-LM model to see how fiscal policy (G and T ) can affect aggregate demand and output.
Let’s start by using the Keynesian Cross to see how fiscal policy shifts the IS curve…
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CHAPTER 10CHAPTER 10 Aggregate Demand I Aggregate Demand I slide 27
Y2Y1
Y2Y1
Shifting the Shifting the ISIS curve: curve: GG
At any value of
r, G E Y
Y
E
r
Y
E =C +I (r1 )+G1
E =C +I (r1 )+G2
r1
E =Y
IS1
The horizontal distance of the
IS shift equals IS2
…so the IS curve shifts to the right.
Y ___________
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CHAPTER 10CHAPTER 10 Aggregate Demand I Aggregate Demand I slide 28
Algebra example for IS curveAlgebra example for IS curve
Suppose the expenditure side of the economy is characterized by:
C =95 + 0.75(Y-T)I = 100 – 100rG = 20, T=20
Use the goods market equilibrium conditionY = C + I + GY = 215 + 0.75 (Y-20) – 100r
IS: or write asIS:
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CHAPTER 10CHAPTER 10 Aggregate Demand I Aggregate Demand I slide 29
Graph the IS curveGraph the IS curve
IS
Slope = __
r
Y
IS: r = 2 - 0.0025Y
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CHAPTER 10CHAPTER 10 Aggregate Demand I Aggregate Demand I slide 30
Slope of IS curveSlope of IS curve
Suppose that investment expenditure is “more responsive” to the interest rate:
I = 100 – 100r
Use the goods market equilibrium conditionY = C + I + GY = 215 + 0.75 (Y-20) – 200r0.25Y = 200 – 200rIS: Y = 800 – 800r or write asIS: r = 1 - 0.00125Y (slope is lower)So this makes the IS curve ________: A fall in
r raises I ____, which raises Y _____.
200r
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CHAPTER 10CHAPTER 10 Aggregate Demand I Aggregate Demand I slide 31
Building the LM Curve:Building the LM Curve:The Theory of Liquidity PreferenceThe 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.
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CHAPTER 10CHAPTER 10 Aggregate Demand I Aggregate Demand I slide 32
Money SupplyMoney Supply
The supply of real money balances is fixed:
sM P M P
M/P real money
balances
rinterest
rate sM P
M P
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CHAPTER 10CHAPTER 10 Aggregate Demand I Aggregate Demand I slide 33
Money DemandMoney Demand
Demand forreal money balances:
M/P real money
balances
rinterest
rate
M P
( )d
M P L r
L (r )
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CHAPTER 10CHAPTER 10 Aggregate Demand I Aggregate Demand I slide 34
EquilibriumEquilibrium
The interest rate adjusts to equate the supply and demand for money:
M/P real money
balances
rinterest
rate sM P
M P
( )M P L r L (r )
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CHAPTER 10CHAPTER 10 Aggregate Demand I Aggregate Demand I slide 35
How the Fed raises the interest rateHow the Fed raises the interest rate
To increase r, Fed reduces M
M/P real money
balances
rinterest
rate
1M
P
L (r )
r1
r2
2M
P
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CHAPTER 10CHAPTER 10 Aggregate Demand I Aggregate Demand I slide 36
CASE STUDY CASE STUDY
Volcker’s Monetary TighteningVolcker’s Monetary Tightening Late 1970s: > 10%
Oct 1979: Fed Chairman Paul Volcker announced that monetary policy would aim to reduce inflation.
Aug 1979-April 1980: Fed reduces M/P 8.0%
Jan 1983: = 3.7%
How do you think this policy change How do you think this policy change would affect interest rates? would affect interest rates?
How do you think this policy change How do you think this policy change would affect interest rates? would affect interest rates?
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CHAPTER 10CHAPTER 10 Aggregate Demand I Aggregate Demand I slide 37
Volcker’s Monetary Tightening, Volcker’s Monetary Tightening, cont.cont.
i < 0i > 0
1/1983: i = 8.2%8/1979: i = 10.4%4/1980: i = 15.8%
flexiblesticky
Quantity Theory, Fisher Effect
(Classical)
Liquidity Preference(Keynesian)
prediction
actual outcome
The effects of a monetary tightening on nominal interest rates
prices
model
long runshort run
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CHAPTER 10CHAPTER 10 Aggregate Demand I Aggregate Demand I slide 38
The LM curveThe 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:
dM P L r Y ( , )
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CHAPTER 10CHAPTER 10 Aggregate Demand I Aggregate Demand I slide 39
Deriving the LM curveDeriving the LM curve
M/P
r
1M
P
L (r ,
Y1 )
r1
r
YY1
r1
LM
(a) The market for real money balances
(b) The LM curve
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CHAPTER 10CHAPTER 10 Aggregate Demand I Aggregate Demand I slide 40
Understanding the Understanding the LMLM curve’s slope curve’s slope
The LM curve is positively sloped.
Intuition: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.
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CHAPTER 10CHAPTER 10 Aggregate Demand I Aggregate Demand I slide 41
Deriving LM curve with algebraDeriving LM curve with algebra
Suppose a money demand:• Where e describes the responsiveness of
money demand to changes in income.• And f describes responsiveness to
interest rate.
Suppose money supply:
Use money market equilibrium condition:
d
M P eY fr/
s
M P M P/ /
s d
M P M P/ /
So: M P/
or write as:
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CHAPTER 10CHAPTER 10 Aggregate Demand I Aggregate Demand I slide 42
Graph the LM curveGraph the LM curve
LMr
Y
1e Mr Y
ff P
A steep LM curve (_________) means that a rise in output implies a ______________ to maintain equilibrium.
Causes of this:Money demand is _______________ to interest rate (f is small)
Money demand __________________ to output (e large)
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CHAPTER 10CHAPTER 10 Aggregate Demand I Aggregate Demand I slide 43
How How MM shifts the LM curve shifts the LM curve
M/P
r
1M
P
L (r , Y1 ) r1
r2
r
YY1
r1
r2
LM1
(a) The market for real money balances
(b) The LM curve
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CHAPTER 10CHAPTER 10 Aggregate Demand I Aggregate Demand I slide 44
The short-run equilibriumThe 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:
( ) ( )Y C Y T I r G
Y
r
( , )M P L r YEquilibriuminterestrate
Equilibriumlevel ofincome
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CHAPTER 10CHAPTER 10 Aggregate Demand I Aggregate Demand I slide 45
The Big PictureThe Big Picture
KeynesianCross
Theory of Liquidity Preference
IScurve
LM curve
IS-LMmodel
Agg. demand
curve
Agg. supplycurve
Model of Agg.
Demand and Agg. Supply
Explanation of short-run fluctuations
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CHAPTER 10CHAPTER 10 Aggregate Demand I Aggregate Demand I slide 46
Chapter summaryChapter summary
1.Keynesian Cross basic model of income determination takes fiscal policy & investment as exogenous fiscal policy has a multiplied impact on
income.
2. IS curve comes from Keynesian Cross when planned
investment depends negatively on interest rate
shows all combinations of r and Y that equate planned expenditure with actual expenditure on goods & services
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CHAPTER 10CHAPTER 10 Aggregate Demand I Aggregate Demand I slide 47
Chapter summaryChapter summary
3.Theory of Liquidity Preference basic model of interest rate determination takes money supply & price level as exogenous an increase in the money supply lowers the
interest rate
4. LM curve comes from Liquidity Preference Theory when
money demand depends positively on income shows all combinations of r andY that equate
demand for real money balances with supply
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CHAPTER 10CHAPTER 10 Aggregate Demand I Aggregate Demand I slide 48
Chapter summaryChapter summary
5. IS-LM model Intersection of IS and LM curves shows
the unique point (Y, r ) that satisfies equilibrium in both the goods and money markets.