Download Document

Chapter 12: IS-LM and Aggregate Demand
Instructor’s Manual
Chapter 12: IS-LM and Aggregate Demand
Problem 1
Higher expected inflation leads to higher nominal interest rates (See Figure 11.2 in Chapter 11).
Higher expected inflation shifts the IS curve to the right towards higher interest rates at a
constant level of income. This increase in the IS curve also shifts the AD curve to the right.
Problem 2
If the LM curve is vertical, a change in the IS curve (induced by changes in fiscal policy) will not
change the equilibrium output in the IS-LM model. Consequently, the AD curve will be flatter
than it is when the LM curve is upward sloping.
A vertical LM curve says that money demand does not respond to the interest rate, exactly as
in the Classical Quantity Theory of Money.
Problem 3
As the term suggests, the AD curve reflects the entire economy's demand for GDP. The demand
side of the economy is modeled using the IS-LM diagram. Suppose prices decrease in this
economy for some reason. Agents will find that their real balances are now higher than before,
and higher than what they need for their daily transactions. Consequently, at any given level of Y,
the nominal interest rate has to fall to induce people to willingly hold these extra money
balances. Thus, the LM curve will shift to the right. A drop in the nominal interest rate will spur
investment spending (a downward movement along the IS curve) and equilibrium GDP demand
will be higher. In other words, a lower price level increases the demand for the economy's goods
and services. Therefore, the AD curve is downward sloping.
The effect of an increase in the money supply on the IS-LM diagram is the same as the effect
of a price decrease just discussed. But now, although prices have not changed, an increase in the
money supply increases equilibrium GDP demand. Thus, an increase in the money supply will
shift the AD curve to the right.
Problem 4
In the quantity theory, equilibrium in the money market was the sole determinant of the AD
curve. As a result, only changes in the money supply and the propensity to hold money, k, could
shift the AD curve. In the Keynesian model, AD is determined by equilibrium in both the money
market and the capital market simultaneously. As a result, variables that change equilibrium in
the capital market can also affect AD, such as taxes, government spending, government transfers,
animal spirits, and expected inflation.
123
Chapter 12: IS-LM and Aggregate Demand
Instructor’s Manual
Problem 5
Factors affecting the slope of the AD curve are the interest and output elasticities of the saving
function, the investment function and the money demand function.
To see how the AD curve is affected when investment becomes more sensitive to the interest
rate, let us start out with the investment curve:
i
i1
i2
I2
I1
I1(i1)=I2(i2) I1(i2)
I
I2(i2)
Figure 1
When investment is more sensitive to the interest rate, the investment demand curve is flatter; a
given fall (rise) in the interest rate causes a more pronounced rise (fall) in investment along the I 2
curve than along the I1 curve. See Figure 1 above.
Let us put this in an investment-saving (capital market) diagram. Figure 2 shows that the fall
in the interest rate, when Y increases from Y1 to Y2, is larger for the I2 curve than for the I1 curve.
Hence, the IS curve is flatter for I2 than for I1.
i
S(r-e, Y1)
S(r-e, Y2)
I2(r-e)
I1(r-e)
S, I
I1
I2
I3
Figure 2
124
Chapter 12: IS-LM and Aggregate Demand
Instructor’s Manual
To trace the effects on the AD curve, we will use Figure 3 below to analyze the effects of a
fall in the price level.
i
LM(P1)
LM(P2)
A
i1
B
i2*
i1*
IS2
C
IS1
Y
Y2* Y32*
Y1*
Figure 3
IS1 corresponds to the investment curve I1 in Figure 2, and IS2 corresponds to the flatter
investment curve I2. Suppose the price level falls from P1 to P2, shifting the LM curve to the
right.
With the drop in the price level, the increase in equilibrium GDP in the IS-LM model is
larger when the IS curve is IS2 than when it is IS1. For IS1 the equilibrium moves from A to C,
for IS2 it moves from A to B. Hence, when prices decrease, GDP falls by more (along the
aggregate demand curve) the more sensitive investment is to changes in the interest rate. This is
depicted in Figure 4 below, where the new aggregate demand curve is flatter. Thus a flatter
investment schedule translates to a flatter aggregate demand curve.
P
E
P1
P2
AD2
AD1
Y1 *
Y2*
Y
Y 3*
Figure 4
125
Chapter 12: IS-LM and Aggregate Demand
Instructor’s Manual
Problem 6
Animal spirits refer to changes in expectations that may or may not be based on fundamental
changes in the economy. Animal spirits are important in the Keynesian theory because they were
thought by Keynes to be the key to explaining the volatility of investment demand. If a wave of
pessimism sweeps the economy, investment demand falls which shifts the IS curve to the left,
reducing interest rates and income. As a result, the AD curve also shifts to the left, reducing the
price level as well.
Problem 7
If changes in aggregate demand are the source of business cycles, then positive increases in
aggregate demand increase both the price level and income, meaning that prices should be
procyclical. This is completely consistent with the experience of the Great Depression (see
Figure 12.5 Panel B of the text) in which prices were procyclical. This seems to indicate that the
Great Depression was caused by a decrease in AD, not by a decrease in AS as classical and Real
Business Cycle theorists propose.
Problem 8
Looking at Figure 12.5 Panel E in the text, we see that there was a negative relationship between
prices and output during the 1990s, meaning prices were countercyclical. This would be
consistent with the fact that changes in aggregate supply were driving changes in output, as is
illustrated in Panel C of Figure 12.5.
Problem 9
This would be consistent with an increase in the LM curve, which would decrease interest rates
and increase output. The probable cause of this increase in the LM curve was an increase in the
money supply.
Problem 10
The classical model attempted to explain the Great Depression as being caused by a large
decrease in the aggregate supply curve. Because there is little government policy can do in the
short run to increase aggregate supply, classical economists took a laissez faire attitude towards
the Depression; meaning that they thought the best policy was to let the economy self-adjust back
to equilibrium. However, this classical view is inconsistent with many facts that we know about
the Great Depression, such as the facts that prices were procyclical and real wages were
countercyclical during the Great Depression. In addition, there is no probable explanation for
why AS fell during the depression.
126
Chapter 12: IS-LM and Aggregate Demand
Instructor’s Manual
The Keynesian model explained the Great Depression as being caused by a large
decrease in AD created by pessimistic animal spirits which reduced investment and shifted the IS
curve to the left. This explanation is consistent with the facts that prices and interest rates fell
during the Great Depression while real wages rose. The obvious solution to the Great
Depression then given this explanation was to use government policy to increase the IS curve and
stimulate AD. Keynes thought that the most quick and predictable way to do this was to increase
government spending.
Problem 11
Keynesian aggregate demand management refers to the use of fiscal policy (government
spending and taxation) and monetary policy to adjust AD in order to smooth any fluctuations in
output and reduce or eliminate business cycles. For example, if agents begin to become more
pessimistic and reduce their levels of spending and investment, the government can respond by
either increasing the money supply, increasing government spending, or cutting taxes in order to
prevent AD and output from falling.
Problem 12
The Keynesian argument for government intervention is that the government has the power to
control AD and as a result influence output. Enlightened policy makers should use this power to
stabilize the economy and eliminate recessions for the good of the public. The arguments against
using stabilization policy are of a practical nature and assert that while stabilization policy is
attractive in theory, in practice it might not work so well. First, policy makers do not have
perfect information and may respond incorrectly to any changes in the economy, actually making
conditions worse. Second, expectations are not constant and may change in response to change
in policy, making the end result of these policies unpredictable. Third, there are lags in policy,
meaning that a change in policy now will not have real effects on the economy until a later point
in time, at which point this policy may not be needed anymore.
Problem 13
If a central bank is worried about stabilizing output then it should increase the money supply and
aggregate demand in response to a recession caused by a negative supply shock. However, the
big drawback of such a policy is that it drives up the price level, which is already at a high level
because of the negative supply shock. Thus, the end result of such a policy is a sizeable increase
in the inflation rate.
Problem 14
We see in this example that as output is falling, the price level is falling and nominal interest
rates are falling. This would be consistent with a recession that is caused by decreases in the IS
curve and the AD curve. The best policy solution to remedy this recession would be to increase
the IS curve and AD by either increasing government spending or cutting taxes.
127
Chapter 12: IS-LM and Aggregate Demand
Instructor’s Manual
Problem 15
a.
Setting Y – C – G = I, the IS curve can be calculated and is equal to Y = 800 – 125i.
Setting MS/P = Md/P, the LM curve can be calculated and is equal to Y = 200 + 100i. An
increase in output in the money market increases money demand and interest rates, so the
LM curve is upward sloping. An increase in income increases savings which reduces
interest rates in the capital market, so the IS curve is downward sloping.
b.
Setting IS = LM, the equilibrium levels are Y = 467 and i = 2.67.
c.
Now the LM curve is equal to Y = 250 + 100i. The equilibrium levels of output and
interest rate are now Y = 495 and i = 2.44. Notice that the interest rate fell and output
rose as a result of this increase in the money supply, just as you would expect.
Problem 16
a.
Setting Y – C – G = I, the IS curve can be calculated and is equal to Y = 3,200 – 80i.
Setting MS/P = Md/P, the LM curve can be calculated and is equal to Y = 2000 + 40i. An
increase in output in the money market increases money demand and interest rates, so the
LM curve is upward sloping. An increase in income increases savings which reduces
interest rates in the capital market, so the IS curve is downward sloping.
b.
Setting IS = LM, the equilibrium levels are Y = 2,400 and i = 10.
c.
If G rises to 400, then the new IS curve is Y = 3,600 – 80i. The equilibrium values of
output and the interest rate are now Y = 2,533 and i = 13.33.
If T falls to 300, then the new IS curve is Y =3,500 – 80i. The equilibrium
values of output and the interest rate are now Y = 2,500 and i = 12.5.
The intuition here is as follows. A $100 increase in government spending
reduces savings by more than a $100 tax cut because a fraction of the tax cut is saved.
As a result, the shift to the right in the IS curve is larger when government spending is
increased and the changes in output and the interest rate are larger.
Problem 17
A class discussion is helpful here.
128