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Aggregate Demand II: Applying the IS-LM Model
Part 2
Chapter 12
Some argue: if the Fed chooses an interest
rate target and adjusts the money supply to
achieve it, then draw a horizontal LM curve.
IS
LM
Y
r1
Note: if Y = Yf, the interest rate consistent
with full employment is call the “natural” rate
or the “neutral” rate. In chapter 15 called ρ.
IS
Yf
ρ=r*
Where do you think we get natural rate r*?
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Shocks in the IS -LM model
IS shocks: exogenous changes in the demand for
goods & services.
Examples:
stock market boom or crash
g change in households’ wealth
g ΔC (ΔC0 in the consumption function)
change in business or consumer
confidence or expectations
g ΔI and/or ΔC (Δ C0 or ΔI0)
Shocks in the IS -LM model
LM shocks: exogenous changes in the
demand for money.
Examples:
A wave of credit card fraud increases
demand for money.
More ATMs or the Internet reduce money
demand.
NOW YOU TRY:
Analyze shocks with the IS-LM Model
Use the IS-LM model to analyze the effects of
1. a boom in the stock market that makes
consumers wealthier.
2. after a wave of credit card fraud, consumers using
cash more frequently in transactions.
For each shock,
a. use the IS-LM diagram to show the effects of the
shock on Y and r.
b. determine what happens to C, I, and the
unemployment rate.
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NOW YOU TRY
Analyze shocks with the IS-LM model
Use the IS-LM model to analyze the effects of
1. a housing market crash that reduces
consumers’ wealth (2008)
For this shock,
a. use the IS-LM diagram to determine the effects
on Y and r.
b. figure out what happens to C, I, and the
unemployment rate.
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Case Study: Housing market crash
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IS1
Y
r
LM1
r1
Y1
IS2
Y2
r2
IS shifts left, causing
r and Y to fall.
Why?
C falls due to lower wealth
(a falls) and lower income,
I rises because
r is lower
u rises because
Y is lower
(Okun’s law)
Case Study: The U.S. Recession of
2001
3.9% on 9/00
4.9% on 8/01
6.3% on 6/03
5.0% on 7/05
0.0
1.0
2.0
3.0
4.0
5.0
6.0
7.0
Unemployment
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The U.S. Recession of 2001
Growth of
GDP was
negative in
the 1st and 3rd
quarters of
2001
essentially
before 9/11 -2.0
0.0
2.0
4.0
6.0
8.0
10.0
GDP growth rate
The U.S. Recession of 2001
Why?
Demand shocks moved the IS curve left The “tech bubble” ended and
stocks fell 25% between 8/00 and 8/01
9/11 attacks led to a 12% fall in stock prices in one week and a huge rise in uncertainty
Scandals at Enron, WorldCom and other corporations led to stock price declines and a decline in trust and a rise in uncertainty
Lower household wealth reduced Co and higher uncertainty reduced Io
IS
Y
r
LM
r1
Y1
CASE STUDY:
The U.S. recession of 2001
Tech Bubble Ended => Stock market decline C
300
600
900
1200
1500
1995 1996 1997 1998 1999 2000 2001 2002 2003
Inde
x (
194
2 =
100
) Standard & Poor’s
500
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The U.S. Recession of 2001
Fiscal stimulus moved IS curve right (IS1 to IS2) Major tax cuts were enacted in
2001 and 2003
Government spending was boosted to rebuild NYC, and
to bail out the airline industry
Fed printed money and moved LM curve right (LM1 to LM2) Interest rate on 3-month
Treasury bills fell 6.4% in 11/00
3.3% in 8/01
0.9% in 7/03
IS1
Y
r
LM1
r1
Y1
IS2
LM2
Y3
All three tools—G, T and M—were
used
CASE STUDY:
The U.S. recession of 2001
Monetary policy response: shifted LM curve right
Three-month
T-Bill Rate
0
1
2
3
4
5
6
7
Policy “shocks” - defined
Monetary Policy:
Decrease in i − increase in M
− monetary
expansion
Increase in i − decrease in M
− monetary
contraction (monetary tightening)
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Policy “Shocks” - defined
Fiscal Policy:
Increase in (T–G) − fiscal contraction
−
also called fiscal consolidation
Decrease in (T–G) − fiscal expansion
What is the Fed’s policy instrument?
The news media commonly report the Fed’s policy
changes as interest rate changes, as if the Fed
has direct control over market interest rates.
In fact, the Fed targets the federal funds rate—the
interest rate banks charge one another on
overnight loans.
The Fed changes the money supply and shifts the
LM curve to achieve its target.
Other short-term rates typically move with the
federal funds rate.
What is the Fed’s policy instrument?
Why does the Fed target interest rates instead of
the money supply?
1) They are easier to measure than the money
supply.
2) The Fed might believe that LM shocks are
more prevalent than IS shocks. If so, then
targeting the interest rate stabilizes income
better than targeting the money supply.
(See problem 8 on p.364.)
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Some argue: If Fed chooses the interest rate
target and adjusts the money supply to
achieve it, draw a horizontal LM curve.
IS
LM
Y
r1
Case Study : Interest rate target, Horizontal LM curve
and an Increase in Spending at Full Employment
If IS2 represents a permanent increase in spending, Y1 – Yf is a positive output gap which exerts upward pressure on inflation. The Fed responds by increasing r from r1 to r2.
IS1
LM1
Yf
r1
IS2
Y1
Case Study : interest rate target, horizontal LM curve
and an increase in spending at full employment
The LM shifts up to LM2. How does the Fed increase r?
IS1
LM1
Yf
r1
IS2
Y1
LM2 r2
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Suppose the IS curve is not stable.
IS0
LM money supply target
Y
r1
IS1
IS2
LM’interest rate target
How Does the IS-LM Model Fit the Facts?
Adjustment in RGDP(output) takes time, need to look at
dynamics:
Consumers are likely to take time to adjust their consumption
following a change in disposable income due to a change in
taxes.
Firms are likely to take time to adjust investment spending
following a change in their sales.
Firms are likely to take time to adjust investment spending
following a change in the interest rate.
Firms are likely to take time to adjust production following a
change in their sales.
How Does the IS-LM Model Fit the Facts? From Blanchard
The Empirical
Effects of an
Increase in the
Federal Funds
Rate - tight
money.
In the short run, an increase in the federal funds rate leads to a decrease in output and to an increase in unemployment, but it has little effect on the price level.
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How Does the IS-LM Model Fit the Facts?
The Empirical
Effects of an
Increase in the
Federal Funds
Rate - tight
money.