mankiw7e-chap11 no notes

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MACROECONOMICS

2010 Worth Publishers, all rights reserved

SEV

ENT

H

EDI

TION

PowerPointSlides by Ron Cronovich

N. Gregory Mankiw

C H A P T E R

Aggregate Demand II:Applying the IS-LMModel

11


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In this chapter, you will learn:

how to use the IS-LMmodel to analyze theeffects of shocks, fiscal policy, and monetary

policy

how to derive the aggregate demand curvefrom the IS-LMmodel

several theories about what caused the

Great Depression


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3CHAPTER 11 Aggregate Demand II

The intersection determines

the unique combination of Y and r

that satisfies equilibrium in both markets.

The LMcurve represents

money market equilibrium.

Equilibrium in the IS-LMmodel

The IScurve representsequilibrium in the goods

market.

( ) ( )Y C Y T I r G

( , )M P L r Y IS

Y

rLM

r1

Y1


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Policy analysis with the IS-LM model

We can use the IS-LM

model to analyze the

effects of

fiscal policy: G and/or T

monetary policy: M

( ) ( )Y C Y T I r G

( , )M P L r Y

IS

Y

rLM

r1

Y1


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causing output &

income to rise.

IS1

An increase in government purchases

1. IS curve shifts right

Y

rLM

r1

Y1

1by

1 MPCG

IS2

Y2

r2

1.

2. This raises money

demand, causing the

interest rate to rise

2.

3. which reduces investment,so the final increase in Y

1is smaller than

1 MPCG

3.


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IS1

1.

A tax cut

Y

rLM

r1

Y1

IS2

Y2

r2

Consumers save(1MPC) of the tax cut,

so the initial boost in

spending is smaller for Tthan for an equal Gand the IScurve shifts by

MPC

1 MPCT

1.

2.

2.so the effects on r

and Y are smaller for Tthan for an equal G.

2.


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2. causing theinterest rate to fall

IS

Monetary policy: An increase in M

1. M> 0 shiftsthe LM curve down

(or to the right)

Y

r LM1

r1

Y1 Y2

r2

LM2

3. which increases

investment, causingoutput & income to

rise.


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Interaction between

monetary & fiscal policy

Model:

Monetary & fiscal policy variables

(M, G, and T) are exogenous.

Real world:Monetary policymakers may adjust M

in response to changes in fiscal policy,

or vice versa. Such interaction may alter the impact of the

original policy change.


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The Feds response to G> 0 Suppose Congress increases G.

Possible Fed responses:

1. hold M constant

2. hold r constant

3. hold Y constant

In each case, the effects of the Gare different


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If Congress raises G,the IS curve shifts right.

IS1

Response 1: Hold M constant

Y

rLM1

r1

Y1

IS2

Y2

r2If Fed holds Mconstant,

then LMcurve doesntshift.

Results:

2 1Y Y Y

2 1r r r


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IS1

Response 2: Hold r constant

Y

rLM1

r1

Y1

IS2

Y2

r2To keep r constant,

Fed increases Mto shift LM curve right.

3 1Y Y Y

0r

LM2

Y3

Results:


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IS1

Response 3: Hold Y constant

Y

rLM1

r1

IS2

Y2

r2To keep Y constant,

Fed reduces Mto shift LM curve left.

0Y

3 1r r r

LM2

Results:

Y1

r3



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Estimates of fiscal policy multipliersfrom the DRI macroeconometric model

Assumption about

monetary policy

Estimated

value of

Y/G

Fed holds nominalinterest rate constant

Fed holds money

supply constant

1.93

0.60

Estimated

value of

Y/T

1.19

0.26


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Shocks in the IS-LM model

IS shocks: exogenous changes in thedemand for goods & services.

Examples:

stock market boom or crashchange in households wealthC

change in business or consumerconfidence or expectationsI and/or C


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Shocks in the IS-LM model

LM shocks: exogenous changes in thedemand for money.

Examples:

a wave of credit card fraud increasesdemand for money.

more ATMs or the Internet reduce money

demand.


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NOW YOU TRY:

Analyze shocks with the IS-LMModel

Use the IS-LMmodel to analyze the effects of

1. a boom in the stock market that makesconsumers wealthier.

2. after a wave of credit card fraud, consumers usingcash more frequently in transactions.

For each shock,

a. use the IS-LMdiagram to show the effects of theshock on Y and r.

b.determine what happens to C, I, and theunemployment rate.


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CASE STUDY:

The U.S. recession of 2001

During 2001, 2.1 million jobs lost,

unemployment rose from 3.9% to 5.8%.

GDP growth slowed to 0.8%(compared to 3.9% average annual growthduring 1994-2000).


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CASE STUDY:


Causes: 1) Stock market decline C

300

600

900

1200

1500

1995 1996 1997 1998 1999 2000 2001 2002 2003

Inde

x

(1942

=1

0

0)

Standard & Poors

500


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CASE STUDY:


Fiscal policy response: shifted IS curve right tax cuts in 2001 and 2003

spending increases

airline industry bailout

NYC reconstruction

Afghanistan war


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CASE STUDY:


Monetary policy response: shifted LM

curve right

Three-monthT-Bill Rate

0

1

2

34

5

6

7


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What is the Feds policy instrument?

The news media commonly report the Feds policychanges as interest rate changes, as if the Fed

has direct control over market interest rates.

In fact, the Fed targets the federal funds ratethe interest rate banks charge one another on

overnight loans.

The Fed changes the money supply and shifts the

LMcurve to achieve its target.

Other short-term rates typically move with the

federal funds rate.


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What is the Feds policy instrument?

Why does the Fed target interest rates instead ofthe money supply?

1) They are easier to measure than the money

supply.2) The Fed might believe that LMshocks are

more prevalent than ISshocks. If so, thentargeting the interest rate stabilizes income

better than targeting the money supply.(See end-of-chapter Problem 7 on p.337.)


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IS-LM and aggregate demand

So far, weve been using the IS-LM model toanalyze the short run, when the price level is

assumed fixed.

However, a change in P would shift LMandtherefore affect Y.

The aggregate demand curve

(introduced in Chap. 9) captures thisrelationship between P and Y.


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Y1Y2

Deriving theAD curve

Y

r

Y

P

IS

LM(P1)

LM(P2)

AD

P1

P2

Y2 Y1

r2

r1

Intuition for slope

of AD curve:

P (M/P)

LM shifts left

r

I

Y


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Y2

Y2

r2

Y1

Y1

r1

Fiscal policy and theAD curve

Y

r

Y

P

IS1

LM

AD1

P1

Expansionary fiscalpolicy (G and/or T)

increases agg. demand:

T

C

IS shifts right

Y at each

value of PAD2

IS2


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IS-LM andAD-ASin the short run & long run

Recall from Chapter 9: The force that moves theeconomy from the short run to the long run

is the gradual adjustment of prices.

Y Y

Y Y

Y Y

rise

fall

remain constant

In the short-runequilibrium, if

then over time, theprice level will


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The SR and LR effects of an IS shock

A negative ISshockshifts ISand ADleft,

causing Y to fall.

Y

r

Y

P LRAS

Y

LRAS

Y

IS1

SRAS1P1

LM(P1

)

IS2

AD2AD1


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Y

r

Y

P LRAS

Y

LRAS

Y

IS1

SRAS1P1

LM(P1

)

IS2

AD2AD1

In the new short-run

equilibrium, Y Y


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Y

r

Y

P LRAS

Y

LRAS

Y

IS1

SRAS1P1

LM(P1

)

IS2

AD2AD1

In the new short-run

equilibrium, Y Y

Over time, Pgradually

falls, causing

SRAS to move down

M/P to increase,which causes LM

to move down


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AD2


Y

r

Y

P LRAS

Y

LRAS

Y

IS1

SRAS1P1

LM(P1

)

IS2

AD1

SRAS2P2

LM(P2)

Over time, Pgradually

falls, causing

SRAS to move down

M/P to increase,which causes LM

to move down


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AD2

SRAS2P2

LM(P2)


Y

r

Y

P LRAS

Y

LRAS

Y

IS1

SRAS1P1

LM(P1

)

IS2

AD1

This process continues

until economy reaches a

long-run equilibrium with

Y Y


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NOW YOU TRY:

Analyze SR & LR effects ofMa. Draw the IS-LMand AD-AS

diagrams as shown here.

b. Suppose Fed increases M.

Show the short-run effects

on your graphs.c. Show what happens in the

transition from the short run

to the long run.

d. How do the new long-runequilibrium values of the

endogenous variables

compare to their initial

values?

Y

r

Y

P LRAS

Y

LRAS

Y

IS

SRAS1P1

LM(M1/P1)

AD1


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The Great Depression

Unemployment(right scale)

Real GNP(left scale)

120

140

160

180

200

220

240

1929 1931 1933 1935 1937 1939

b

illions

of195

8d

ollars

0

5

10

15

20

25

30

p

ercentoflab

orforce

THE SPENDING HYPOTHESIS


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THE SPENDING HYPOTHESIS:

Shocks to the IS curve

asserts that the Depression was largely due toan exogenous fall in the demand for goods &

services a leftward shift of the IS curve.

evidence:output and interest rates both fell, which is what

a leftward IS shift would cause.

THE SPENDING HYPOTHESIS


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THE SPENDING HYPOTHESIS:

Reasons for the IS shift

Stock market crash exogenous C Oct-Dec 1929: S&P 500 fell 17%

Oct 1929-Dec 1933: S&P 500 fell 71%

Drop in investment correction after overbuilding in the 1920s

widespread bank failures made it harder to obtainfinancing for investment

Contractionary fiscal policy

Politicians raised tax rates and cut spending tocombat increasing deficits.

THE MONEY HYPOTHESIS


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THE MONEY HYPOTHESIS:

A shock to the LM curve

asserts that the Depression was largely due tohuge fall in the money supply.

evidence:M1 fell 25% during 1929-33.

But, two problems with this hypothesis:

P fell even more, so M/P actually rose slightlyduring 1929-31.

nominal interest rates fell, which is the oppositeof what a leftward LM shift would cause.

THE MONEY HYPOTHESIS AGAIN


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THE MONEY HYPOTHESIS AGAIN:

The effects of falling prices

asserts that the severity of the Depression wasdue to a huge deflation:

P fell 25% during 1929-33.

This deflation was probably caused by the fall inM, so perhaps money played an important role

after all.

In what ways does a deflation affect theeconomy?



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The stabilizing effects of deflation:

P(M/P) LMshifts right Y

Pigou effect:

P (M/P)

consumers wealth

C

IS shifts right

Y



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The destabilizing effects of expected deflation:

E

r for each value of i

I because I= I(r)

planned expenditure & agg. demand income & output



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The destabilizing effects of unexpected deflation:debt-deflation theory

P(if unexpected)

transfers purchasing power from borrowers to

lenders

borrowers spend less,

lenders spend more

if borrowers propensity to spend is larger thanlenders, then aggregate spending falls,

the IS curve shifts left, and Y falls


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Why another Depression is unlikely

Policymakers (or their advisors) now knowmuch more about macroeconomics:

The Fed knows better than to let M fallso much, especially during a contraction.

Fiscal policymakers know better than to raisetaxes or cut spending during a contraction.

Federal deposit insurance makes widespread

bank failures very unlikely. Automatic stabilizers make fiscal policy

expansionary during an economic downturn.


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CASE STUDY

The 2008-09 Financial Crisis & Recession

2009: Real GDP fell, u-rate approached 10%

Important factors in the crisis:

early 2000s Federal Reserve interest rate policy

sub-prime mortgage crisis

bursting of house price bubble,rising foreclosure rates

falling stock prices

failing financial institutions

declining consumer confidence, drop in spendingon consumer durables and investment goods

I t t t d h i


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Interest rates and house prices

50

70

90

110

130

150

170

190

0

1

2

3

4

5

6

7

8

9

2000 2001 2002 2003 2004 2005

Hous

epriceindex,2000=100

interestrate

(%)

Federal Funds rate

30-year mortgage rate

Case-Shiller 20-city composite house price index

Change in U S house price index


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Change in U.S. house price index

and rate of new foreclosures, 1999-2009

0.0

0.2

0.4

0.6

0.8

1.0

1.2

1.4

-6%

-4%

-2%

0%

2%

4%

6%

8%

10%

12%

14%

1999 2001 2003 2005 2007 2009

Ne

wforeclosure

starts

(%

oftotalmortg

ages)

Percen

tchangeinhouseprices

(from4quarterse

arlier)

US house price indexNew foreclosures

H i h d f l


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House price change and new foreclosures,2006:Q3 2009Q1

0%

2%

4%

6%

8%

10%

12%

14%

16%

18%

20%

-40% -30% -20% -10% 0% 10% 20%

Newforeclo

sures,

%o

fallmor

tgages

Cumulative change in house price index

Nevada

Georgia

Colorado

Texas

AlaskaWyoming

Arizona

California

Florida

S. Dakota

Illinois

Michigan

Rhode Island

N. Dakota

Oregon

Ohio

New Jersey

Hawaii


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U.S. bank failures by year, 2000-2009

0

10

20

30

40

50

60

70

2000 2001 2002 2003 2004 2005 2006 2007 2008 2009

Numberofba

nkfailures

* as of July 24, 2009.

*

Major U S stock indexes


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Major U.S. stock indexes(% change from 52 weeks earlier)

-80%

-60%

-40%

-20%

0%

20%

40%

60%

80%

100%

120%

140%

12/6/1999

8/13/2000

4/21/2001

1

2/28/2001

9/5/2002

5/14/2003

1/20/2004

9/27/2004

6/5/2005

2/11/2006

1

0/20/2006

6/28/2007

3/5/2008

1

1/11/2008

7/20/2009

DJIA

S&P 500

NASDAQ

Consumer sentiment and growth in consumer


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Consumer sentiment and growth in consumer

durables and investment spending

50

60

70

80

90

100

110

-25%

-20%

-15%

-10%

-5%

0%

5%

10%

15%

20%

1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009

ConsumerSentimentInd

ex,1966=100

%c

hangefromfourqua

rtersearlier

Durables

Investment

UM Consumer Sentiment Index

R l GDP th d U l t


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Real GDP growth and Unemployment

0

1

2

3

4

5

6

7

8

9

10

-4%

-2%

0%

2%

4%

6%

8%

10%

1995 1997 1999 2001 2003 2005 2007 2009

%o

flaborfo

rce

%c

hangefrom4qu

atersearlier

Real GDP growth rate (left scale)

Unemployment rate (right scale)


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Chapter Summary

1. IS-LMmodel a theory of aggregate demand

exogenous: M, G, T,

P exogenous in short run, Y in long run

endogenous: r,

Y endogenous in short run, P in long run

IScurve: goods market equilibrium

LM curve: money market equilibrium


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Chapter Summary

2. ADcurve shows relation between Pand the IS-LMmodels

equilibrium Y.

negative slope because

P (M/P) rIY

expansionary fiscal policy shifts IScurve right,raises income, and shifts ADcurve right.

expansionary monetary policy shifts LMcurveright, raises income, and shifts ADcurve right.

ISor LMshocks shift the ADcurve.

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