Download Chapter 1: Introduction

Chapter 11
1
Final Candidate
Chapter 11: The Money Stock, Aggregate
Demand, and Aggregate Supply
J. Bradford DeLong
http://econ161.berkeley.edu/
[email protected]
8,869 words
Questions
What is "money-market equilibrium"?
What is the "LM Curve"?
What determines the equilibrium level of real GDP when the central bank's policy is
to keep the money stock constant?
What is the IS-LM framework?
What is an IS shock?
What is an LM shock?
Are business cycles in unemployment different from business cycles in output?
Chapter 11
2
Final Candidate
What is the relationship between shifts in the equilibrium on the IS-LM diagram and
changes in the real exchange rate and the balance of trade?
What is the aggregate supply curve?
What is the aggregate demand curve?
The IS curve built up in chapter 10 is enough to enable one to begin thinking about
business cycles as long as the central bank uses open market operations to set the real
interest rate. But the central bank does not always peg interest rates--in fact, there is not
always a central bank to peg interest rates. Alternative monetary arrangements fix not the
interest rate but the quantity of liquid readily-spendable money. And even when central
banks do peg interest rates, they usually peg not real but nominal interest rates. And in
order to think through the relationship between nominal and real interest rates, you need
to understand the determinants of inflation.
Thus this chapter is needed to build more tools. It builds up an “LM” curve to serve as a
sibling to the IS curve. The LM curve tells us how interest rates are determined when the
stock of liquid money is fixed. And it sketches out our model of aggregate supply: what
determines the rate of inflation, and what causes the rate of inflation to change when
prices are sticky.
Chapter 11
3
Final Candidate
11.1 The Money Stock and the Money Market: The LM
Curve
The IS curve of the previous chapter gave us enough tools to calculate the sticky-price
equilibrium level of real GDP if we knew the real interest rate. If the central bank
followed a policy of pegging the real interest rate, then calculating real GDP was simple.
But what if the central bank does not follow a policy of pegging the interest rate at some
target value? Or what if there is no central bank--as was the case in the U.S. back before
World War I? Or what if the central bank wishes to stand back, maintain a constant
supply of liquid monetary assets, and let interest rates be determined by market forces?
In all of these case the level of interest rates and of real GDP are jointly determined. The
economy must satisfy the IS equation that describes the IS curve and corresponds to
balanced inventories. The economy must also be on a "liquidity-money" LM curve that
represents equilibrium in the money market. It must be the case both that real GDP is
equal to total income which is equal to aggregate demand--that is what the IS curve
represents--and that money supply be equal to money demand--that is what the LM curve
represents.
11.1.1 Money Market Equilibrium
Recall from chapter 8 three facts about businesses’ and households’ demand for nominal
money--the quantity of liquid readily-spendable assets. First, money demand is
proportional to total nominal income P x Y. Second, money demand has a time trend (the
result of slow ongoing changes in banking-sector and transactions-processing
Chapter 11
4
Final Candidate
technology). Third, money demand is inversely related to the nominal interest rate--the
sum of the real interest rate and the current inflation rate.
Money demand is inversely related to the nominal interest rate because the nominal
interest rate is the opportunity cost of holding money. Money balances earn little or no
interest. Over time they lose their power to purchase real, useful goods and services at the
rate of inflation π. If you shifted them into some other part of your portfolio, they would
earn the real interest rate r. Thus the anticipated opportunity cost of holding money is the
nominal interest rate i = r + πe: the sum of the real interest rate r and the expected
inflation rate πe.
To keep our model a little bit simpler let us ignore the technologically-driven time trend
in velocity, and write the demand for money as the function:
Md
Y

e
P
V0  Vi  (r   )
Notice two things about this equation. First, it is real money demand--demand for real
money balances, for the nominal money stock divided by the price level, for an amount
of purchasing power held in readily-spendable form rather than an amount of pictures of
George Washington—that is proportional to the level of real GDP. People seek to hold a
particular amount of real purchasing power over goods and services in the readilyspendable form of money: the higher the price level, the more pieces of paper with
pictures of George Washington on it are necessary to add up to that amount of real
purchasing power. Second, the plus sign in front of the Vi parameter makes velocity an
increasing function of the nominal interest rate, and money demand a decreasing function
of the real interest rate.
Chapter 11
5
Final Candidate
Figure 11.1: Money Demand and Money Supply
Nominal
Interest
Rate
=r+š
Equilibrium
Nominal
Interest Rate
Y
Money Demand: (V - V i(r+š))
0
Real Quantity of Money
Money
Supply
=Ms
Legend: When the stock of liquid monetary assets is fixed, the equilibrium shortterm nominal interest rate is that at which households' and businesses' demand for
liquid money is equal to the (fixed) money stock.
In our sticky-price model the price level P is predetermined, and cannot move instantly
(as it could and did in the flexible-price model of chapter 8) to balance money supply Ms
and money demand Md. For each possible fixed level of the money supply, equilibrium in
the money market:
Ms = Md
Chapter 11
6
Final Candidate
determines the nominal interest rate is:
Y  P
i  (r   ) 
e
Ms
Vi
 V0
The nominal interest rate i=r+πe has to be that level at which the curves cross: where the
nominal interest rate is such that the quantity of money that households and businesses
wish to hold is just equal to the available money supply. This must be true whether the
money supply is automatically determined by the particular monetary system adopted, or
is explicitly controlled by the central bank.
Suppose that money supply is less than money demand: people and businesses find that
they want to hold more liquid money balances than exist in the economy. Businesses and
households then go to the banks and try to borrow from the banks to boost their cash
holdings. Banks respond by raising the interest rates they charge for loans. As the
nominal interest rate rises, the quantity of money demand falls. And when the quantity of
money demanded is equal to the money supply there is no more upward pressure on the
nominal interest rate.
Suppose that money supply is greater than money demand. Then businesses and
households find that they have more liquid money balances than they want. They take
these liquid money balances and deposit them at the bank. With more deposits reserves
banks seek to increase the amount of loans they make, and cut interest rates. As the
nominal interest rate falls, the quantity of money demanded rises. And when the quantity
of money demanded has risen enough to be equal to the money supply, there is no more
downward pressure on the nominal interest rate.
Chapter 11
7
Final Candidate
11.1.2 The LM Curve
How does the equilibrium nominal interest rate varies as real GDP Y varies? The higher
is total income, the higher is the demand for money. When income is high spending is
high too, and households and businesses wish to hold more real money balances. If real
GDP rises and the money supply does not, the nominal interest rate must rise too to make
households and businesses economize on their liquid cash holdings and so keep money
demand equal to money supply.
For each possible level of total income Y there is a different money demand curve to be
drawn on a diagram plotting the interest rate against the quantity of money demanded. As
long as the money supply is fixed, each of these money demand curves produces a
different equilibrium nominal interest rate.
Chapter 11
8
Final Candidate
Figure 11.2: Money Demand Varies as Total Income Y Varies
Nominal
Interest
Rate
=r+š
Interest rate for
high level of Y
Interest rate for
moderate level
of Y
Money Demand for a high level of Y
Interest rate for
low level of Y
Money Demand for a moderate level of Y
Money Demand for a low level of Y
Real Quantity of Money
Money
Supply
=Ms
Legend: The higher the level of total income, the higher is the quantity of money
demanded for any given interest rate, and (for a fixed money stock) the higher
will
be the equilibrium interest rate.
Draw another diagram with the nominal interest rate i=r+π on the vertical axis and the
level of total income Y on the horizontal axis. For each possible value of Y on the x-axis,
plot the point whose y-axis value is equilibrium nominal interest rate. You have just
plotted the LM curve. The LM curve is drawn for a given level of the real money stock
Ms/P. It slopes upward. The higher is total income Y, the stronger is demand for money,
and the higher a nominal interest rate is needed to keep households' and businesses'
desired money holdings at the level of the money supply.
Chapter 11
9
Final Candidate
Figure 11.3: From Money Demand to the LM Curve
Money Supply and Money Demand
Nominal
Interest
Rate
=r+š
LM Curve
Nominal
Interest
Rate
=r+š
Interest rate for
high level of Y
Interest rate for
moderate level
of Y
Interest rate for
low level of Y
Real Quantity of Money
Total Income Y
Money
Supply
=Ms
Low
Level
of
Y
Moderate
Level
of
Y
High
Level
of
Y
Legend: The LM Curve tells us what the nominal interest rate will be for each
possible value of total income Y.
The equation for the LM curve is simply the money demand function rewritten to put the
level of real GDP Y by itself on the left-hand side:
Y  V0  Vi  (r   )
e
M 
 P 
Monetary policy changes that increase the nominal money supply Ms shift the LM curve
out to the right. Monetary policy changes that decrease the nominal money supply Ms
shift the LM curve in and to the left. A decline in the price level boosts the real money
Chapter 11
10
Final Candidate
supply (Ms/P) and shifts the LM curve out to the right. A rise in the price level decreases
the real money supply (Ms/P) and shifts the LM curve in to the left.
11.1.3 The IS-LM Framework
As long as we know what inflation rate people expect, the fact that the nominal interest
rate is equal to the real interest rate plus the inflation rate means that we can plot the IS
and LM curves on the same set of axes.
Figure 11.4: The IS-LM Equilibrium
Real
Interest
Rate
r
LM Curve
Equilibrium
Interest
Rate
IS Curve
Real GDP Y
Equilibrium
Real GDP
Chapter 11
11
Final Candidate
Legend: What is the economy's equilibrium? The economy's equilibrium is that
point at which the IS and LM Curves cross. Along the IS Curve, total production
is
equal to aggregate demand. Along the LM Curve, the quantity of money
demanded
by households and businesses is equal to the money stock. Where the curves cross
both the "goods market" and the "money market" are in balance.
If we can do so, then the equilibrium level of real GDP and of the interest rate is at the
point where the IS curve and the LM curve cross. At that level of real GDP and total
income Y and the real interest rate r, the economy is in equilibrium in both the “goods
market” and the money market. Aggregate demand is equal to total production so
inventories are stable (that's what the IS curve indicates), and money demand is equal to
money supply (that's what the LM curve indicates).
Box 11.1--Example: IS-LM Equilibrium
Suppose that the economy's marginal propensity to spend [MPS] is 0.5, that the
initial level of baseline autonomous spending A0 is $5000 billion, and that a 1
percentage point increase in the real interest rate reduces the sum of investment
and net exports by $100 billion. Then the economy's initial IS curve is:
Y
A0
I  X  r
$5000 $100
 r
r

 r  $10000  $200  r
1  MPS 1  MPS
1  0.5 1  0.5
If its initial LM curve is represented by the equation:
Chapter 11
12
Final Candidate
Y  $1000  $1000  (r  )
and if the inflation rate π is constant at 3% per year, then the initial equilibrium of
the economy is at the one point which is on both the IS and the LM curves.
Where is that point? Find it by substituting the LM-curve expression for
equilibrium real GDP into the IS curve:
Y  $10000  $200  r  $1000  $1000  (r  3)
$6000  ($200  $1000)  r
r  5%
r equals 5% per year. And if r equals 5% per year, then equilibrium real GDP Y
equals $9000 billion.
Chapter 11
13
Final Candidate
Figure: IS-LM Equilibrium Example
Real
Interest
Rate
r
LM Curve: Y=$1000+$1000 x (r+š)
[inflation rate š=3%]
Equilibrium
Interest
Rate:
5%
IS Curve: Y=$10000-$200 x r
Real GDP Y
Equilibrium
Real GDP:
$9000
11.1.3.1 IS Shocks
Any change in economic policy or the economic environment that increases autonomous
spending--like an increase in government purchases, for example--shifts the IS curve out
and to the right. It moves the economy up and to the right along the LM curve. And the
new equilibrium will have both a higher level of real interest rates and a higher
equilibrium level of real GDP.
Chapter 11
14
Final Candidate
Figure 11.5: Effect of a Positive IS Shock
Real
Interest
Rate
r
An increase in autonomous spending
(like an increase in government purchases)
shifts the IS curve to the right...
LM Curve
...It raises the
equilibrium
interest rate...
Old IS Curve
Real GDP Y
...And it raises the
equilibrium level of
real GDP.
Legend: An expansionary shift in the IS curve raises both real GDP Y and the real
interest rate r.
How the consequences of an expansionary shift in the IS curve will be divided between
increases in interest rates and increases in equilibrium real GDP depends on the slope of
the LM curve. If the LM curve is nearly horizontal (or if the central bank is targeting the
money stock--in which case the "LM" curve is horizontal) there will be little or no
increase in interest rates. The increase in equilibrium real GDP will effectively be the
same as the outward shift in the IS curve. If the LM curve is very steeply sloped, then
Chapter 11
15
Final Candidate
there will be a big effect on interest rates, and little effect on real GDP. If demand for
money is extremely interest inelastic, it takes a big change in interest rates to cause a
small change in households' and businesses' desired holdings of money.
Any decrease in autonomous spending results in lower levels of interest rates and a lower
level of equilibrium real GDP. Such a contractionary IS shock is any event like a
reduction in government purchases or a sudden shift of beliefs on the part of foreign
exchange speculators in the direction of thinking that the home currency is more
valuable. It will move the economy down and to the left along the LM curve.
Box 11.2--Example: An IS Shock
Suppose that, as in the previous example, the economy's marginal propensity to
spend [MPS] is 0.5, that the initial level of baseline autonomous spending A0 is
$5000 billion, and that a 1 percentage point increase in the real interest rate
reduces the sum of investment and net exports by $100 billion. Then the
economy's initial IS curve is the same:
Y
A0
I  X  r
$5000 $100
 r
r

 r  $10000  $200  r
1  MPS 1  MPS
1  0.5 1  0.5
And suppose that the economy's initial LM curve is represented by the equation:
Y  $1000  $1000  (r  )
and the inflation rate π is constant at 3% per year. Thus the initial equilibrium of
the economy is--as in the previous example--where equilibrium annual real GDP
is $9000 billion and the real interest rate is 5%.
Chapter 11
16
Final Candidate
Now suppose that there is a positive real shock to the economy: there is no
immediate increase in potential GDP, yet new technological breakthroughs lead
businesses to become more optimistic and generate an increase in baseline
investment I0 (and thus in baseline autonomous spending A0) of $150 billion.
What happens to the economy's equilibrium level of output and interest rates?
The new IS curve is:
Y
A0  I0 I r  X  r
$5000  $150 $100

r 

 r  $10300 $200  r
1  MPS 1  MPS
1  0.5
1 0.5
Thus the IS curve shifts out and to the right by $300 billion--the magnitude of the
shift in baseline autonomous spending divided by one minus the marginal
propensity to spend.
The LM curve remains unchanged at:
Y  $1000  $1000  (r  )
So, with inflation constant at 3% per year, the new equilibrium can be found by
setting the values of Y produced by the IS and LM curve to be equal to each
other:
Y  $10300  $200  r  $1000  $1000  (r  3)
$6300  ($200  $1000)  r
r  5.25%
With the real interest rate r equal to 5.25% per year, annual equilibrium real GDP
Y equals $9250 billion. A $300 billion outward shift in the IS curve has led to an
Chapter 11
17
Final Candidate
0.25% increase in the real interest rate and a $250 billion increase in real GDP.
The higher interest rate has "crowded out" one-sixth of the shift in autonomous
spending.
Figure: IS Curve Expansion Example
Real
Interest
Rate
r
A $150 billion increase in
baseline investment generates,
with an MPS of 0.5, a $300
billion outward shift in the IS curve...
LM Curve: Y=$1000+$1000 x (r+š)
[inflation rate š=3%]
...which raises the
equilibrium real
interest rate by
0.25%...
Old IS Curve: Y=$10000-$200 x r
Real GDP Y
...and raises equilibrium
real GDP by $250.
11.1.3.2 LM Shocks
An increase in the money stock will shift the LM curve out and to the right. The higher
level of the money supply means that a given level of real GDP will be associated with a
lower nominal interest rate when the money market is in equilibrium. The nominal
interest rate is the "price" of holding money balances in your portfolio. With a greater
supply of money-like assets in the economy their price will fall.
Chapter 11
18
Final Candidate
Such an outward LM shift will shift the equilibrium position of the economy down and to
the right along the IS curve. The new equilibrium position will have a higher level of
equilibrium real GDP, and a lower interest rate. Conversely, a decrease in the money
supply or any other contractionary LM shock that shifts the LM curve in and to the left
will shift the economy up and to the left along the IS curve, resulting in higher
equilibrium interest rates and a lower equilibrium value of real GDP.
Note the difference between how the money market works in this sticky-price model and
in the flexible-price model of section III. In the flexible-price model, the real interest rate
balanced the supply and demand for loanable funds flowing through financial markets.
The nominal interest rate was the sum of the real interest rate and the expected inflation
rate. Changes in the money stock had no effect on the real or the nominal interest rate.
Instead, the price level adjusted upward or downward to keep the quantity of money
demanded equal to the money supply.
Here in the sticky-price model the price level is... sticky. It cannot adjust instantly upward
or downward. So imbalances in money demand and money supply cause not immediate
changes in the price level but immediate changes in the nominal interest rate.
Chapter 11
19
Final Candidate
Figure 11.6: An Expansionary LM Shock
Real
Interest
Rate
r
An increase in the money stock
shifts the LM curve to the right...
...It lowers the
equilibrium
interest rate...
Old IS Curve
LM Curve
Real GDP Y
...And it raises the
equilibrium level of
real GDP.
Legend: An expansionary shift in the LM curve raises real GDP Y and lowers the
equilibrium interest rate r.
Box 11.3--Example: An LM Shock
Suppose that, as in the previous example, the economy's marginal propensity to
spend [MPS] is 0.5, that the initial level of baseline autonomous spending A0 is
$5000 billion, and that a 1 percentage point increase in the real interest rate
Chapter 11
20
Final Candidate
reduces the sum of investment and net exports by $100 billion. Then the
economy's initial IS curve is the same:
Y
A0
I  X  r
$5000 $100
 r
r

 r  $10000  $200  r
1  MPS 1  MPS
1  0.5 1  0.5
And suppose that the economy's initial LM curve is represented by the equation:
Y  $1000  $1000  (r  )
and the inflation rate π is constant at 3% per year. Thus the initial equilibrium of
the economy is--as in the previous example--where equilibrium annual real GDP
is $9000 billion and the real interest rate is 5%.
Now suppose that the central bank conducts expansionary open market
operations: it buys bonds for cash and so increases the supply of money in the
economy to shift the LM curve out to:
Y  $2200  $1000  (r  )
So, with inflation constant at 3% per year, the new equilibrium can be found by
setting the values of Y produced by the IS and LM curve to be equal to each
other:
Y  $10000  $200  r  $2200  $1000  (r  3)
$4800  ($200  $1000)  r
r  4%
With the real interest rate r equal to 4% per year, annual equilibrium real GDP Y
equals $9200 billion--a $200 billion increase in annual equilibrium real GDP.
Chapter 11
21
Final Candidate
Figure: LM Expansion Example:
Real
Interest
Rate
r
Old LM Curve: Y=$1000+$1000 x (r+š)
[inflation rate š=3%]
...which lowers the
equilibrium real
interest rate by
1%...
Expansionary open market
operations shift the LM
curve out by $1200
IS Curve: Y=$10000-$200 x r
Real GDP Y
...and raises equilibrium
real GDP by $200.
11.1.3.3 Interest Rate Targets
The IS-LM diagram thus determines the short-run equilibrium of the economy--real GDP
and interest rates--when the money stock is fixed. It provides a flexible and useful
framework for analyzing the expenditure-driven determination of output, money market
equilibrium, and interest rates. Even the case in which the central bank is targeting the
interest rate can be viewed in the IS-LM framework. An interest rate target can be seen as
simply a flat, horizontal LM curve at the target level of the interest rate.
Chapter 11
22
Final Candidate
Figure 11.7: IS-LM Framework with an Interest Rate Target
Real
Interest
Rate
r
Central bank targeting the
interest rate = horizontal LM curve
IS curve
Real GDP Y
Legend: When the central bank targets and fixes the interest rate, we can think of
the LM curve as being a horizontal line.
11.1.4 Moving Along the LM Curve
The course of the U.S. economy in the early 1980s provides a good example of a
movement along the LM curve in the IS-LM framework. The Federal Reserve sought in
the early 1980s to keep the rate of growth of the money supply on a stable path in order
to build confidence that inflation was and would remain low.
Chapter 11
23
Final Candidate
Figure 11.8: Moving Along the LM Curve
Legend: At the end of the 1970s the Federal Reserve announced that it was
changing its operating procedures to place more emphasis on meeting targets for
the
growth rate of the money stock. This shift in emphasis lasted through the mid1980s. Between the early and the mid-1980s, as the Federal Reserve tried to meet
its target for the money stock, the rightward shift in the IS Curve driven
by the Reagan budget deficits pushed the U.S. economy up and to the right along
the LM Curve.
Chapter 11
24
Final Candidate
Consequently the large outward shift in the IS curve produced by the Reagan
administration fiscal policy expansion of the 1980s moved the economy up and to the
right along the LM curve, raising equilibrium real GDP and also raising real interest
rates.
11.1.5 Causes of Economic Fluctuations
The IS-LM framework allows us to classify many different kinds of changes in the
economic environment and in economic policy into four different groups. It is surprising
howmany different kinds of disturbances to the economy affect the level of aggregate
demand and can be fitted into the IS-LM framework.
Any change in the nominal money stock, in the price level, or in the trend velocity of
money will shift the LM curve's location. Any change in the interest sensitivity of money
demand--in how easy households and businesses find it to economize on their holdings of
real money balances--will change the slope of the LM curve.
Moreover, the fact that the IS-LM diagram is drawn with the real interest rate--the longterm, risky, real interest rate--on the vertical axis has important consequences for how to
construct the LM curve. The LM relationship is a relationship between the short-run
nominal interest rate and the level of real GDP for a given, fixed level of the real money
supply:
Chapter 11
25
Final Candidate
M 
Y  V0  Vi  (i)   
 P 
As long as the spread between the short-term, safe, nominal interest rate i in the LM
equation and the long-term, risky, real interest rate r in the IS equation is constant and
unchanging, there are no complications in drawing the LM curve onto the same diagram
as the IS curve.
But what if the rate of expected inflation πe, or the risk premium, or the term premium
between short and long-term interest rates changes? Then the position of the LM shifts
either upward (if expected inflation falls, or if the risk premium rises, or if the term
premium rises) or downward (if expected inflation rises, or if the risk premium falls, or if
the term premium falls).
Thus changes in today’s financial market expectations of future Federal Reserve policy,
of future inflation, or simply changes in the tolerance for risk of bond traders on Wall
Street affect the position of the LM curve. Not only disturbances to the money market,
but broader shifts in financial markets that alter the relationship between the nominal
interest rates on short-term safe bonds and the real interest rate paid by corporations
undertaking long-term risky investments affect the IS-LM equilibrium.
Chapter 11
26
Final Candidate
Figure 11.9: A Rise in Expected Inflation Moves the LM Curve Downward
Real
Interest
Rate
r
A rise in expected inflation means that
the same nominal interest rate is now
associated with a lower real interest rate.
So a fall in expected inflation generates
a downward shift in the LM curve...
...which lowers
the equilibrium
real interest rate...
IS Curve
LM Curve
Real GDP Y
...And raises the
equilibrium level of
real GDP.
Legend: The fact that the interest rate relevant to the IS curve is a real and the
interest rate relevant to the LM curve is a nominal rate is a source of
complications:
a change in expected inflation lowers the real interest rate that corresponds to any
given nominal interest rate, and so shifts the LM curve down on the IS-LM
diagram.
But changes in the IS curve are probably more frequent than changes in the LM curve,
for more types of shifts in the economic environment and economic policy affect planned
expenditure than affect the supply and demand for money. Any change in the effect of a
shift in interest rates on investment spending will change the slope of the IS curve.
Chapter 11
27
Final Candidate
Moreover, so will any change in either the sensitivity of exports to the exchange rate, or
any change in the sensitivity of the level of the exchange rate to the level of domestic
interest rates.
The slope of the IS curve will also be changed by anything that affects the marginal
propensity to spend--the MPS. Moreover, shifts in the MPS will change not just the slope
but also the position of the IS curve, because changes in the MPS change the multiplier
and thus change how much equilibrium real GDP is generated by a given amount of
baseline autonomous spending. Any shift in the marginal propensity to consume Cy will
change the MPS. Thus if households decide that income changes are more likely to be
permanent (raising the marginal propensity to consume) or more likely to be transitory
(lowering the marginal propensity to consume), they will raise or lower the MPS.
Changes in tax rates have a direct effect on the MPS. And so do changes in the propensity
to import. Thus, for example, the imposition or removal of a tariff on imports to
discourage them will affect the marginal propensity to spend, and thus will affect both the
location and the slope of the IS curve.
Last but surely not least, any of a large number of potential changes in the economic
environment and in economic policy can shift the level of autonomous spending, and thus
shift the IS curve in either an expansionary or contractionary direction. Anything that
affects the baseline level of consumption C0 affects autonomous spending--whether it is a
change in demography that changes desired savings behavior, a change in optimism
about future levels of income, or any other cause of a shift in consumer behavior.
Anything that affects the baseline level of investment I0 affects autonomous spending-whether it is a wave of innovation that increases expected future profits and desired
Chapter 11
28
Final Candidate
investment, a wave of irrational overoptimism or overpessimism, a change in tax policy
that affects not the level of revenue collected but the incentives to invest, or any other
cause. Changes in government purchases affect autonomous spending.
In sum, pretty much anything can affect the equilibrium level of aggregate demand. And
pretty much everything does affect it at one time or another. One of the principal merits
of the IS-LM apparatus is that it gives you a framework to use in sorting and classifying
the determinants of the equilibrium level of total output.
11.2 The Exchange Rate
11.2.1 Domestic Conditions, the Real Exchange Rate, and the
Balance of Trade
11.2.1.1 The IS-LM Framework and the Exchange Rate
In our model the real exchange rate  is equal to speculators' opinion of its baseline
fundamental value (call it 0), minus a factor r times the difference between the real
interest rate at home (r) and the interest rate abroad (rf):
   0   r r  r f 
Thus it is easy to read off the effects of changes in domestic conditions on the value of
the real exchange rate. As long as the domestic real interest rate does not change,
domestic conditions have no impact on the exchange rate. If the exchange rate shifts it is
for other, external reasons.
Chapter 11
29
Final Candidate
Figure 11.10: IS-LM and the Exchange Rate
Real
Interest
Rate
r
Real
Interest
Rate
r
An outward, expansionary s hift in the LM curve
...which lowers
the equilibrium
real interest rate...
IS Curve
LM Curve
Real Exchange Rate 
Real GDP Y
...will raise the real
exc hange rate...
...and raises the
equilibrium level of
real GDP...
Exports
...and boos t
exports.
Real Exchange Rate 
Legend: Outward shifts in the IS and inward shifts in the LM curve will both
lower
the value of foreign currency and reduce net exports.
However, changes in the IS curve and the LM curve that do change domestic real interest
rates will change the real exchange rate by an amount equal to r times the shift in the
domestic interest rate. Outward, expansionary shifts in the IS curve and inward,
contractionary shifts in the LM curve both lower the value of the exchange rate. Inward,
contractionary shifts in the IS curve and outward, expansionary shifts in the LM curve
will raise the value of the exchange rate..
Chapter 11
30
Final Candidate
Thus the effects of changes in domestic conditions on the real exchange rate are
straightforward. The change in the exchange rate is proportional to the change in the real
interest rate:
  r  r
What determines the size of the proportionality factor r? What determines the interest
sensitivity of the exchange rate? It is a function of foreign exchange speculators'
willingness to bear risk and their assessment of how long interest rate differentials
between home and abroad will last. If speculators think that differences in interest rates
will last for a long time, the interest sensitivity will be large. If speculators fear bearing
risk, the interest sensitivity will be small.
11.2.1.2 The IS-LM Framework and the Balance of Trade
The effects of changes in domestic conditions on the balance of net exports are a little
more complicated. Changes in r affect the exchange rate, which affects gross exports.
Changes in total income Y affect imports.
Chapter 11
31
Final Candidate
Figure 11.11: Effect of Change in Domestic Conditions on the Exchange Rate
Change in
Domestic
Conditions
Change in
Exchange Rate
Change in
Equilibrium Values
of Y, r
Change in
Imports
Change in
Gross Exports
Change in
Net Exports
The effect on net exports is the difference between these two:
NX  GX  IM   r  r  IMy  Y 
Chapter 11
32
Final Candidate
The higher is the interest rate, the lower are net exports. The higher is the level of real
GDP, the lower are net exports. As the economy moves up or to the right (or both) on the
IS-LM diagram, net exports fall.
Box 11.4--Example: An LM Shock and Its Effect on the Balance of Trade
Suppose that the economy's marginal propensity to spend [MPS] is 0.5, that the
marginal propensity to import IMy is .15, that the initial level of baseline
autonomous spending A0 is $5000 billion, and that a 1 percentage point increase
in the real interest rate reduces investment spending by $80 billion, and reduces
the value of the exchange rate by 10 percent. Suppose further that each one
percent increase in the exchange rate increases net exports by $2 billion. Then the
economy's initial IS curve is:
Y
A0
I  X  r
$5000 $80 10  $2
 r
r

 r  $10000  $200  r
1  MPS 1  MPS
1  0.5
1  0.5
If the economy's initial LM curve is represented by the equation:
Y  $1000  $1000  (r  )
and if the inflation rate π is constant at 3% per year, then the initial equilibrium of
the economy is with equilibrium annual real GDP is $9000 billion and the real
interest rate is 5%.
Now suppose the central bank conducts expansionary open market operations to
shift the LM curve out to:
Y  $2200  $1000  (r  )
Chapter 11
33
Final Candidate
The new equilibrium can be found by setting the values of Y produced by the IS
and LM curve to be equal to each other:
r  4%
Y  $9200
A $200 billion increase in annual equilibrium real GDP, and a 1 percentage point
decline in the real interest rate.
Figure: LM Expansion
Real
Interest
Rate
r
Old LM Curve: Y=$1000+$1000 x (r+š)
[inflation rate š=3%]
...which lowers the
equilibrium real
interest rate by
1%...
Expansionary open market
operations shift the LM
curve out by $1200
IS Curve: Y=$10000-$200 x r
Real GDP Y
...and raises equilibrium
real GDP by $200.
The decrease in the real interest rate increases the real exchange rate by:
r  r  10  (1)  10
and the rise in the real exchange rate increases gross exports by:
X    $2 10  $20
Chapter 11
34
Final Candidate
The $200 billion increase in real national income increases imports by:
IMy  Y  0.15  $200  $30
Thus the LM shock changes annual net exports by the difference between the two:
NX  GX  Y  $20  $30  $10
It shrinks net exports by $10 billion a year.
11.2.2 International Shocks and the Domestic Economy
Three different types of internationally-caused shocks affect the IS-LM equilibrium of
the domestic economy. The first are increases or decreases in foreign demand for
domestic exports--the result, usually, of increased or decreased total incomes abroad. The
second are changes in foreign real interest rates, and the third are changes in foreign
exchange speculators' opinions about the fundamental value of the exchange rate.
An increase in foreign demand for home-country exports has effects on the domestic
economy like any other expansionary IS shock: the increase in export demand is an
increase in baseline autonomous spending A0, and shifts the IS curve outward by an
amount A0/(1-MPS). This outward IS shift raises the equilibrium level of real GDP and,
to the extent that the LM curve is upward sloping, raises the real interest rate as well. The
increase in the real interest rate would make exports more expensive to foreigners, and
put some countervailing downward pressure on exports. The increase in the equilibrium
level of real GDP would raise demand for imports.
Chapter 11
35
Final Candidate
Figure 11.12: Effect of an Increase in Foreign Demand for Exports
Real
Interest
Rate
r
An expansion of foreign demand
for exports shifts the IS curve
outward...
LM Curve
...it raises the
equilibrium real
interest rate to
the extent that the
LM curve slopes
upward...
Higher real
interest rates
reduce the
exchange
rate
and put
some downward
countervailing
pressure on
exports
Old IS Curve
Real GDP Y
...and it raises equilibrium
real GDP
which
raises
imports
In the simple case in which the central bank is targeting the real interest rate--if the LM
curve is horizontal--then the change in equilibrium real GDP generated by a rise Yf in
foreign total income is:
Y 
X f  Y f
1  MPS
f

X f  Y


Y 

1 Cy (1 t)  IM y 
And the change in net exports is:
Chapter 11
36
Final Candidate
NX  GX  IM
NX  X f  Y  IMy 
f
X f  Y
f
1  MPS

IMy


NX  X f  Y f  1
 1  Cy (1  t)  IMy 
NX  X f  Y
f

1  Cy (1  t)
 1 C (1 t)  IM
y


y 
An increase in interest rates overseas rf has an immediate impact raising the value of the
exchange rate, and so encouraging exports. The increase in exports shifts the IS curve to
the right, leading to a higher level of equilibrium real GDP and--to the extent that the LM
curve is upward-sloping--to higher real interest rates as well. The consequences of such a
shift are similar to those of an increase in foreign incomes, save for the direction in which
the exchange rate moves. An increase in interest rates overseas raises the value of the
exchange rate. An increase in foreign levels of total income is likely to lower the value of
the exchange rate.
The third type of international shocks that can affect the IS-LM equilibrium is a sudden
change in speculators' expectations 0 of the long-run fundamental exchange rate.
Consider an upward shock to 0. It would have effects identical to an increase in interest
rates overseas: the exchange rate would rise, the IS curve would shift outward,
equilibrium real GDP would increase, and--to the extent that the LM curve is upward
sloping--the domestic real interest rate would increase as well.
Chapter 11
37
Final Candidate
Box 11.5--Example: A Shock to International Investors' Expectations
Suppose that the economy's LM curve is represented by the equation:
Y  $1000  $1000  (r  )
and that the inflation rate π is constant at 3% per year. Suppose further that the
economy's marginal propensity to spend [MPS] is 0.5, that the marginal
propensity to import IMy is .15, that the initial level of baseline autonomous
spending A0 is $5000 billion, that a 1 percentage point increase in the real interest
rate reduces investment spending by $40 billion and reduces the value of the
exchange rate by 10 percent, and that each one percent increase in the exchange
rate increases net exports by $6 billion. Then the economy's initial IS curve is:
Y
A0
I  X  r
$5000 $80 10  $2
 r
r

 r  $10000  $200  r
1  MPS 1  MPS
1  0.5
1  0.5
And the initial equilibrium has annual real GDP of $9000 billion and a real
interest rate of 5%.
Consider a sudden upward shock of ten percent, as foreign exchange speculators'
lose confidence in the value of the domestic currency, to their opinions 0 of the
long-run fundamental value of the real exchange rate. Such a shock shifts the IS
curve to the right--raising the level of real GDP on the IS curve for a given, fixed
level of the real interest rate by an amount:
X   0
1 MPS
The shifted IS curve is then:
Chapter 11
38
Final Candidate
A0  A0 Ir  X  r
A  X    0 Ir  X  r

r  0

r
1 MPS 1 MPS
1  MPS
1  MPS
$5000  $6  10 $80  12  $2
Y

 r  $10120  $200  r
1  0.5
1  0.5
Y
The new equilibrium can be found by setting the values of Y produced by the IS
and LM curve to be equal to each other:
$1000  $1000  (r  )  Y  $10120  $200  r
$6120  $1200  r
r  5.1%
Y  $9100
Equilibrium annual real GDP increases by $100 billion as the raised exchange rate
boosts exports, and the domestic real interest rate rises by 0.1%.
The increase in the domestic real interest rate means that the final change in the
real exchange rate:
    0   r  r
   10  10  0.1  9
is less than the 10 percent magnitude of the initial shock: higher domestic real
interest rates have offset some of the effect of the change in foreign exchange
speculators' opinions. The increase in the domestic real interest rate also means
that some domestic investment has been "crowded out" by the interest rate effects
of the export boom:
I  Ir  r  $40  0.1  $4
The total effect on gross exports from the net change in the exchange rate is:
Chapter 11
39
Final Candidate
GX  X    $6  9  $54
Since the total change in imports is:
IM  IMy  Y  0.15  $100  $15
The total change in net exports from the shift in expectations is +$39 billion.
11.3 The Aggregate Demand Relationship
11.3.1 The Price Level and Aggregate Demand
What happens to the level of real GDP as the price level rises? If the nominal money
supply is fixed, then an increase in the price level reduces real money balances. As a
result, it shifts the LM curve back and to the left. The equilibrium real interest rate rises,
and the equilibrium level of real GDP falls.
Chapter 11
40
Final Candidate
Figure 11.13: A Rise in the Price Level Shifts the LM Curve Left (If the Nominal
Money Supply Is Fixed)
Interest
Rate
As the price level rises...
...the LM curve shifts
leftward...
IS Curve
Real GDP
...and real GDP falls.
Legend: For a fixed level of the nominal money stock, an increase in the price
level
is a contractionary shift in the economy. The higher the price level, the lower the
real money stock. The lower the real money stock, the further to the left is the LM
curve. The further to the left is the LM curve, the lower is real GDP.
Suppose that we draw another diagram, this time with the price level on the vertical axis
and the level of real GDP on the horizontal axis, on which we plot what the equilibrium
Chapter 11
41
Final Candidate
level of real GDP is for each possible value of the price level. For each value of the price
level, we calculate what the LM curve is and use the IS-LM diagram to calculate the
equilibrium level of real GDP. We find that—still assuming that the nominal money
supply is fixed—we have a downward-sloping relationship between the price level and
real GDP. The lower the price level, the higher is the equilibrium level of real GDP
because a lower price level means higher real money balances, lower interest rates, and
higher aggregate demand.
Chapter 11
42
Final Candidate
Figure 11.14: From the IS-LM Diagram to the Aggregate Demand Curve
IS-LM Diagram
Interest
Rate
As the price level rises...
...the LM curve shifts
leftward...
IS Curve
Real GDP
...and real GDP falls.
Aggregate Demand
Price
Level
As the price
level rises...
Aggregate Demand Curve
Real GDP
...real GDP falls.
Chapter 11
43
Final Candidate
Legend: For a fixed value of the nominal money stock, each possible value for the
price level produces a different LM curve. Plot the equilibrium value of real GDP
for that LM curve on the horizontal axis and the price level on the vertical axis.
The
result is the aggregate demand curve.
A normal demand curve slopes downward and shows that the lower is the price the
higher is demand. By analogy, economists call this curve—according to which a lower
price level means higher aggregate demand—the aggregate demand curve.
Note that anything that shifts the equilibrium on the IS-LM diagram shifts the location of
the aggregate demand curve. An increase in the money stock or an increase in the trend
of velocity shifts the LM curve to the right. A decrease in the money stock or a fall in the
trend of velocity shifts the LM curve to the left. Anything that shifts the IS curve to the
right shifts the aggregate demand curve to the right as well. Anything that shifts the IS
curve to the left shifts the aggregate demand curve to the left as well.
11.3.2 Monetary Policy and Aggregate Demand
If the central bank is setting the real interest rate—rather than setting the money stock
and then sitting by passively watching the economy—the analysis of aggregate demand is
somewhat different. Modern central banks pay relatively little attention to the absolute
value of the price level. Instead, they pay a lot of attention to the inflation rate. The
higher the inflation rate, the higher the central bank will set the real interest rate.
Chapter 11
44
Final Candidate
A simple and straightforward way to model this is through what economists call a
central-bank Taylor rule (after Stanford economist and likely Bush CEA Chair John
Taylor). The central bank has a target value for what it would like inflation to be (call it
π’). The central bank has an estimate of what the normal real interest rate should be (call
it r*). Whenever inflation is higher than its target value, the central bank raises the real
interest rate above r*. Whenever inflation is lower than its target value, the central bank
will lower the interest rate below r*:
r  r * '' (  ' )
By how much will it raise interest rates if inflation rises? By a parameter ”, the Greek
letter “phi” with two apostrophes attached to it.
A higher level of the real interest rate means a lower level of real GDP. Thus the higher
the inflation rate, the lower is real GDP, as we can see by combining the Taylor rule
equation above with the IS-curve equation:
Y
to get:
A0
I  X  r
 r
r
1  MPE 1 MPE
"Ir  X  r 
A0
I  X  r
Y  
 r
 r *
 (  ' )
1  MPE 1 MPE

1  MPE
Once again it is useful to simplify—to suppress the details to look at the big picture. So
define a new parameter ’, the Greek letter “phi” with one apostrophe attached to it, to
be:
' 
"Ir  X  r 
1  MPE
Chapter 11
45
Final Candidate
And define Y0 to be the level of real GDP when the real interest rate is at its long-run
normal value r*:
Y0 
A0
I  X  r
 r
r*
1 MPE 1  MPE
Then our combination of the Taylor rule equation and the IS curve equation becomes the
simple-looking monetary policy reaction function:
Y  Y0   ' (  ' )
which looks very much like the aggregate demand curve of the previous section. Like
that curve, this one is built up from the IS curve and forces that raise interest rates when
prices increase. The higher is the inflation rate, the lower is real GDP.
There are, however, important differences. The aggregate demand curve of the previous
section was a relationship between the price level and real GDP. This monetary policy
reaction function is a relationship between the inflation rate and real GDP. The aggregate
demand curve assumed that the Federal Reserve sat by like a potted plant while things
happened to the economy. The monetary policy reaction function assumes that the
Federal Reserve is engaged in the economy, trying to manage it to keep inflation close to
the inflation target. Last, the monetary policy reaction function is a good model of the
way central banks actually behave.
Chapter 11
46
Final Candidate
Figure 11.15: The Monetary Policy Reaction Function
IS Diagram
Interest
Rate
As the price level rises...
...leads an
inflationfighting central
bank to raise
interest rates...
IS Curve
Real GDP
Monetary Policy Reaction Function
Inflation
Rate
A higher inflation
rate...
Aggregate Demand Curve
Real GDP
...real GDP falls.
Chapter 11
47
Final Candidate
Legend: The actions of an inflation-fighting central bank lead to the same kind of
downward-sloping relationship between prices and output as in the previous
section. But in this case it is a higher inflation rate, not a higher price level, that
associated with lower real GDP.
11.4 Aggregate Supply
11.4.1 Output and the Price Level
Inflation is an increase in the general, overall price level. An increase in the price of any
one particular good--even a large increase in the price of any one particular good--is not
inflation. Inflation is an increase in the price of just about everything: the prices of all (or
nearly all) goods (and incomes) have to rise, and they have to rise together by
approximately the same proportional amount for it to be inflation.
Whenever real GDP is greater than potential output, inflation is likely to be higher than
people had previously anticipated. Thus it is likely to speed up. This year's inflation is
likely to be higher than last year's. If total product continues to be higher than potential
output then inflation is likely to continue to accelerate upward. Conversely, whenever the
level of real GDP is below potential output, then inflation is likely to be lower than
people had previously anticipated. The inflation rate is likely to fall toward zero--and
perhaps prices will begin to fall in deflation.
Economists explain these correlations between real GDP (relative to the level of potential
output) and the rate of inflation (relative to its previously-expected value) by invoking the
Chapter 11
48
Final Candidate
idea of a short-run aggregate supply relationship: a relationship between the price level
(or its rate of change the inflation rate) and real GDP that holds in the time span for
which the IS-LM framework is relevant. One way to write such a short-run aggregate
supply function is as the form:
 P  P e 
Y Y*
   
 P e 
Y*
The proportional deviation of real GDP Y from potential output Y* is equal to a
parameter  (the Greek letter “theta”), the slope of the short-run aggregate supply
function, times the proportional deviation of the price level P from its previouslyanticipated level Pe.
Since the inflation rate π is simply the proportional rate of change of the price level, we
can replace the price level and the expected price level with the actual inflation rate π and
the previously-expected inflation rate πe to get:
Y Y*
e
      
Y*
Chapter 11
49
Final Candidate
Figure 11.16: Output Relative to Potential and the Inflation Rate
Inflation
Rate
Expected
Inflation
Output Relative to Potential
Potential
Output
Legend: When production is higher than potential output, prices will be higher
than
businesses, consumers, and workers had anticipated--and inflation will be higher
than expected inflation.
Whichever form of the aggregate supply equation we look at, we can combine it with the
aggregate demand equation and thus see not just what the level of real GDP will be, but
also what the price level and inflation rate will be. A higher inflation rate calls forth a
higher level of use of resources and thus a higher quantity of aggregate supply. A higher
Chapter 11
50
Final Candidate
inflation rate also cuts down on aggregate demand. Where the two are equal—where the
two curves cross--tells us both the current level of real GDP and the current inflation rate.
Figure 11.17: Aggregate Supply and Aggregate Demand
Inflation Rate
Aggregate
Demand
Aggregate
Supply
Expected
Inflation
Actual Inflation
Potential
Output
Output Relative to
Potential
Real GDP
Legend: Where aggregate supply equals aggregate demand determines not just
real
GDP but also the price level and the inflation rate.
Chapter 11
51
Final Candidate
11.4.2 Where Does the Short-Run Aggregate Supply
Relationship Come From?
There are a large number of reasons why high levels of real GDP (relative to potential
output) and low levels of unemployment (relative to the natural rate) should be associated
with higher inflation and a higher price level (relative to previously expected values).
When demand for products is stronger than anticipated, firms raise prices above what
they had previously planned. When aggregate demand is higher than potential output,
demand is stronger in nearly every single industry. Nearly all firms raise prices and hire
more workers. Employment expands beyond its average proportion of the adult
population and the unemployment rate falls below the "natural" rate of unemployment-the rate at which the rate of inflation is stable. High demand gives workers extra
bargaining power, and they use it to bargain for higher wage levels than they had
previously planned. Unions threaten to strike, knowing that firms will have a hard time
finding replacements. Individuals quit, knowing they can find better jobs elsewhere. Such
a high-pressure economy generates wages that rise faster than previously anticipated, and
they are passed along by firms in higher prices and accelerating inflation. Thus high
aggregate demand generates higher inflation.
When aggregate demand is higher than potential output, individual sectors and industries
in the economy quickly reach the limits of capacity: Bottlenecks emerge. Confronted
with a bottleneck--a vital item, part, or process where production cannot be increased
quickly--potential purchasers bid up the price of the bottlenecked item: Since a car is
useless without brakes, it is worth it for car manufacturers to pay any price for brake
assemblies if they are in short supply. Such high prices signal to the market that the
bottleneck industry should expand, and triggers investment that in the end boosts
Chapter 11
52
Final Candidate
productive capacity. But developing bottlenecks lead to prices that increase faster than
expected--thus to accelerating inflation.
To some degree the puzzle is not why are high levels of real GDP (and low levels of
unemployment) associated with higher prices and inflation, but why is the association as
weak as it is. Back in chapter 8, after all, changes in the total volume of nominal spending
showed up all as changes in prices and none as changes in real GDP. That too is a subject
for the next chapter--on aggregate supply.
11.5 Chapter Summary
11.5.1 Main Points
The money market is in equilibrium when the level of total incomes and of the shortterm nominal interest rate is just right to make households and businesses want to
hold all the real money balances that exist in the economy.
When the central bank's policy keeps the money stock fixed--or when there is no
central bank--the LM curve consists of those combinations of interest rates and real
GDP levels at which money demand equals money supply.
Chapter 11
53
Final Candidate
When the central bank's policy keeps the money stock fixed--or when there is no
central bank--then the point at which the IS and LM curves cross determines the
equilibrium level of real GDP and the interest rate.
The IS-LM framework consists of two equilibrium conditions: the IS curve shows
those combinations of interest rates and real GDP levels at which aggregate demand
is equal to total production; the LM curve shows those combinations of interest rates
and real GDP levels at which money demand is equal to money supply. Both
equilibrium conditions must be satisfied.
An IS shock is any shock to the level of aggregate demand: it shifts the IS curve.
An LM shock is a shock to money demand or money supply: it shifts the position of
the LM curve.
The aggregate supply curve captures the relationship between aggregate demand and
the price level. The higher is real GDP, the higher is the price level likely to be.
The aggregate demand relationship arises because changes in the price level and
inflation rates cause shifts in the determinants of aggregate demand--either directly as
changes in the price level change the money stock, or indirectly as changes in the
inflation rate change the interest rate target of the central bank.
Chapter 11
54
Final Candidate
11.5.2 Important Concepts
Money demand
Real money balances
Money stock
Money supply
Money market equilibrium
LM curve
IS-LM diagram
IS shock
LM shock
Expected rate of inflation
Aggregate supply
Aggregate demand
11.5.3 Analytical Exercises
1. What are the qualitative effects, in the IS-LM model, of…
…an increase in firms' optimism about future profits?
…a sudden improvement in banking technology that makes checks clear two days
faster?
…a wave of credit card fraud that leads people to use cash for purchases more
often?
…a banking crisis that diminishes banks' willingness to accept deposits?
…a sudden military spending program?
Chapter 11
55
Final Candidate
2. What are the qualitative effects of an increase in real GDP on the rate of inflation?
3. Explain why the LM curve slopes upward. What changes in the economic environment
can you think of that would increase its slope?
4. Suppose that the expected rate of inflation suddenly jumped. What would happen--with
no other changes in the economic environment--to the IS-LM equilibrium? Would
equilibrium real GDP go up or down? Would the equilibrium real interest rate go up or
down?
5. Suppose that the term premium--the gap between short-term and long-term interest
rates--suddenly went up. What would happen--with no other changes in the economic
environment--to the IS-LM equilibrium? Would equilibrium real GDP go up or down?
Would the equilibrium real interest rate in the IS curve go up or down?
11.5.4 Policy-Relevant Exercises [to be updated every year…]
1. In 1999 the unemployment rate averaged 4.3 percent, and the rate of growth of
potential output was 3.0 percent per year. Assuming that the rate of growth of potential
output remains unchanged and that Okun's law holds, how much higher would you
expect real GDP to be in 2002 than in 1999 if in year 2000 the unemployment rate
averages 6 percent?
Chapter 11
56
Final Candidate
2. In 1999 the unemployment rate averaged 4.3 percent. Back in 1995 it averaged 5.6
percent. Real GDP in 1999 stood some 15.8 percent above real GDP in 1995. Assuming
that the natural rate of unemployment remained unchanged between 1995 and 1999,
how much of this growth in real GDP over those four years was due to increases in
potential output? How much was due to "cyclical" factors--fluctuations in
unemployment?
3. Between 1980 and 1986 U.S. net exports shifted from +$10 billion (in 1992 dollars) to
-$164 billion. The unemployment rates in 1980 and 1986 were almost identical. Almost
all observers agreed that this shift in the trade deficit was driven by shifts in U.S.
domestic condition. Do you think that between 1980 and 1986…
…the LM curve shifted right and the IS curve shifted right?
…the LM curve shifted right and the IS curve shifted left?
…the LM curve shifted left and the IS curve shifted right?
…the LM curve shifted left and the IS curve shifted left?
4. Suppose that the Federal Reserve is wondering whether it should follow a policy of
stabilizing the money stock or one of stabilizing the real interest rate. Suppose that all
shocks to the economy are shocks to autonomous spending: which policy leads to smaller
shifts in real GDP in response to shocks? Suppose that all of the shocks to the economy
are shocks to the parameters of money demand--to the parameters L0 and Li in the money
demand equation:
Y
M 

 P  V0  Vi  (r  )
d
and in the LM equation:
Chapter 11
57
Y  V0  Vi  (r  ) 
Final Candidate
M 
 P 
which policy is now best in terms of leading to smaller shifts in real GDP? Suppose that
the only shocks to the economy are changes in assessments of expected inflation π. Now
what is your answer?
5. Suppose that money demand is interest insensitive. That is, suppose that the money
demand function is:
M  Y

 P  V
d
with no dependence on the interest rate at all. What, then, is the LM curve for this
economy? What effect does an increase in government purchases have on the level of real
interest rates and the equilibrium level of annual real GDP?
6. Consider the following data from the 1990s:
Year
1990
1991
1992
1993
1994
1995
1996
1997
1998
1999
Inflation Rate
4.4%
3.9%
2.8%
2.6%
2.4%
2.3%
1.9%
1.9%
1.3%
1.8%
Unemployment Rate
5.6%
6.8%
7.5%
6.9%
6.1%
5.6%
5.4%
4.9%
4.5%
4.3%
Real Interest Rate
3.1%
1.5%
0.6%
0.4%
1.9%
3.2%
3.1%
3.2%
3.5%
3.6%
Which particular Taylor rule reaction function for the real interest rate do you think that
the Federal Reserve has been following over the decade of the 1990s? Does it look like
Chapter 11
58
Final Candidate
the Federal Reserve changed its mind about what its monetary policy should be at some
point over the course of the decade?