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10/14/2013 Equilibrium in the IS -LM model r The IS curve represents equilibrium in the goods market. Chapter 11: Aggregate Demand II, Applying the IS-LM Model LM Y C (Y T ) I (r ) G r1 The LM curve represents Th t money market equilibrium. IS M P L (r ,Y ) Y Y1 The intersection determines the unique combination of Y and r that satisfies equilibrium in both markets. CHAPTER 11 Aggregate Demand II 0 We can use the IS-LM model to analyze the effects of LM r1 IS • fiscal policy: G and/or T • monetary policy: M CHAPTER 11 1. IS curve shifts right 1 G by 1 MPC causing output & income to rise. 2 Thi 2. This raises i money demand, causing the interest rate to rise… r M P L (r ,Y ) Y Y1 Aggregate Demand II 2 CHAPTER 11 Aggregate Demand II LM 2. CHAPTER 11 r2 r1 IS2 1. IS1 Y1 Y2 Y 3. Aggregate Demand II 1. M > 0 shifts the LM curve down (or to the right) LM 1. MPC T 1 MPC and Y are smaller for T than for an equal G. r 3 Monetary policy: An increase in M Consumers save r (1MPC) of the tax cut, so the initial boost in spending is smaller for T r2 than for an equal G… 2. r1 and d th the IS curve shifts hift by b 2. …so the effects on r 1 3. …which reduces investment, so the final increase in Y 1 is smaller than G 1 MPC A tax cut 1. Aggregate Demand II An increase in government purchases Policy analysis with the IS -LM model Y C (Y T ) I (r ) G CHAPTER 11 Y1 Y2 IS2 IS1 2. …causing the interest rate to fall 3. …which increases investment, causing output & income to rise. Y 2. 4 CHAPTER 11 Aggregate Demand II r LM1 LM2 r1 r2 IS Y1 Y2 Y 5 1 10/14/2013 Interaction between monetary & fiscal policy Model: The Fed’s response to G > 0 Suppose Congress increases G. Possible Fed responses: Monetary & fiscal policy variables (M, G, and T ) are exogenous. 1. hold M constant Real world: 2. hold r constant Monetary policymakers may adjust M in response to changes in fiscal policy, or vice versa. 3. hold Y constant In each case, the effects of the G are different… Such interaction may alter the impact of the original policy change. CHAPTER 11 Aggregate Demand II 6 r If Fed holds M constant, then LM curve doesn’t shift. r2 r1 IS2 IS1 Y Y 2 Y1 Y1 Y2 r r2 r1 CHAPTER 11 If Congress raises G, the IS curve shifts right. LM1 Results: To keep r constant, Fed increases M to shift LM curve right. Y 8 Aggregate Demand II LM2 r2 r1 IS2 IS1 Y1 Y2 Y3 Y CHAPTER 11 Aggregate Demand II 9 Estimates of fiscal policy multipliers from the DRI macroeconometric model LM2 LM1 r r3 r2 r1 IS2 IS1 Y1 Y2 Y r r3 r1 CHAPTER 11 LM1 r 0 Results: Y 0 r Y Y 3 Y1 Response 3: Hold Y constant To keep Y constant, Fed reduces M to shift LM curve left. 7 Results: Aggregate Demand II If Congress raises G, the IS curve shifts right. Aggregate Demand II Response 2: Hold r constant Response 1: Hold M constant If Congress raises G, the IS curve shifts right. CHAPTER 11 10 Assumption about monetary policy Estimated value of Y/ G Estimated value of Y/ T Fed holds money supply constant 0.60 0.26 Fed holds nominal interest rate constant 1.93 1.19 CHAPTER 11 Aggregate Demand II 11 2 10/14/2013 Shocks in the IS -LM model Shocks in the IS -LM model IS shocks: exogenous changes in the demand for goods & services. LM shocks: exogenous changes in the demand for money. Examples: stock market boom or crash change in households’ wealth C change in business or consumer confidence or expectations I and/or C Examples: a wave of credit card fraud increases demand for money. more ATMs or the Internet reduce money demand. CHAPTER 11 Aggregate Demand II 12 CHAPTER 11 Aggregate Demand II 13 CASE STUDY: 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 h more ffrequently tl iin ttransactions. ti 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 3.9% 9% average annual growth during 1994-2000). 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. CHAPTER 11 Aggregate Demand II CASE STUDY: The U.S. recession of 2001 The U.S. recession of 2001 Causes: 1) Stock market decline C Causes: 2) 9/11 increased uncertainty fall in consumer & business confidence result: lower spending, IS curve shifted left Index (1942 = 100) CASE STUDY: 1500 Standard & Poor’s 500 1200 15 Causes: 3) Corporate accounting scandals Enron, WorldCom, etc. reduced stock prices, discouraged investment 900 600 300 1995 CHAPTER 11 1996 1997 1998 Aggregate Demand II 1999 2000 2001 2002 2003 16 CHAPTER 11 Aggregate Demand II 17 3 10/14/2013 CASE STUDY: CASE STUDY: The U.S. recession of 2001 Fiscal policy response: shifted IS curve right The U.S. recession of 2001 Monetary policy response: shifted LM curve right tax cuts in 2001 and 2003 spending increases 7 Three-month T-Bill Rate 6 5 airline industry bailout NYC reconstruction Afghanistan war 4 3 2 1 0 CHAPTER 11 Aggregate Demand II 18 What is the Fed’s policy instrument? CHAPTER 11 Aggregate Demand II 19 What is the Fed’s policy instrument? The news media commonly report the Fed’s policy Why does the Fed target interest rates instead of the money supply? changes as interest rate changes, as if the Fed has direct control over market interest rates. 1) They are easier to measure than the money supply. In fact, the Fed targets the federal funds rate – th iinterest the t t rate t banks b k charge h one another th on overnight loans. 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. The Fed changes the money supply and shifts the LM curve to achieve its target. (See end-of-chapter Problem 7 on p.337.) Other short-term rates typically move with the federal funds rate. CHAPTER 11 Aggregate Demand II 20 IS-LM and aggregate demand 21 r Intuition for slope of AD curve: analyze the short run, when the price level is assumed fixed. P (M/P ) However, a change in P would shift LM and LM shifts left therefore affect Y. r The aggregate demand curve I (introduced in Chap. 9) captures this relationship between P and Y. Aggregate Demand II Aggregate Demand II Deriving the AD curve So far, we’ve been using the IS-LM model to CHAPTER 11 CHAPTER 11 Y 22 CHAPTER 11 Aggregate Demand II LM(P2) LM(P1) r2 r1 IS P Y2 Y1 Y2 Y1 Y P2 P1 AD Y 23 4 10/14/2013 Monetary policy and the AD curve The Fed can increase aggregate demand: M LM shifts right r LM(M1/P1) LM(M2/P1) r1 r2 I P Y at each value of P P1 Y1 Y1 Y Y2 Y2 Expansionary fiscal policy (G and/or T ) increases agg. demand: r LM r2 r1 IS2 T C IS r CHAPTER 11 Fiscal policy and the AD curve IS shifts right P Y at each value of P P1 AD2 AD1 Y Aggregate Demand II Y1 Y1 24 IS-LM and AD-AS CHAPTER 11 IS1 Y2 Y2 Y AD2 AD1 Y Aggregate Demand II 25 The SR and LR effects of an IS shock in the short run & long run r Recall from Chapter 9: The force that moves the economy from the short run to the long run is the gradual adjustment of prices. A negative IS shock shifts IS and AD left, causing Y to fall. LRAS LM(P ) 1 IS2 In the short short-run run equilibrium, if CHAPTER 11 then over time, time the price level will P Y Y rise P1 Y Y fall Y Y remain constant The SR and LR effects of an IS shock Y P CHAPTER 11 LRAS LM(P ) 1 In the new short-run equilibrium, Y Y IS1 IS2 Y Over time, P gradually falls, causing • SRAS to move down • M/P to increase, SRAS1 Y 27 r LRAS P1 AD1 AD2 Y Aggregate Demand II LRAS LM(P ) 1 IS2 Aggregate Demand II SRAS1 The SR and LR effects of an IS shock In the new short-run equilibrium, Y Y CHAPTER 11 LRAS Y 26 r Y Y Aggregate Demand II IS1 Y P P1 SRAS1 Y 28 CHAPTER 11 Aggregate Demand II Y LRAS which causes LM to move down AD1 AD2 Y IS1 AD1 AD2 Y 29 5 10/14/2013 The SR and LR effects of an IS shock r LRAS LM(P ) 1 LRAS LM(P ) 1 LM(P2) IS2 Over time, P gradually falls, causing • SRAS to move down • M/P to increase, P LRAS P1 SRAS1 P2 SRAS2 P2 SRAS2 AD1 AD2 Y LRAS LM(M /P ) 1 1 b. Suppose Fed increases M. IS Show the short-run effects on your graphs. equilibrium values of the endogenous variables compare to their initial values? Y Y P LRAS P1 Aggregate Demand II 31 SRAS1 30 Unemployment (right scale) 220 25 200 20 180 15 160 10 Real GNP (left scale) 140 120 1929 AD1 Y 240 billions of 19 958 dollars diagrams as shown here. c. Show what happens in the CHAPTER 11 The Great Depression Analyze SR & LR effects of M r AD1 AD2 Y Y 30 NOW YOU TRY: d. How do the new long-run LRAS SRAS1 Y transition from the short run to the long run. P IS1 Y Y Y Y Aggregate Demand II a. Draw the IS-LM and AD-AS IS2 P1 which causes LM to move down CHAPTER 11 This process continues until economy reaches a long-run long run equilibrium with IS1 Y Y LM(P2) 5 percent of la abor force r The SR and LR effects of an IS shock 0 1931 1933 1935 1937 1939 Y THE SPENDING HYPOTHESIS: THE SPENDING HYPOTHESIS: asserts that the Depression was largely due to Stock market crash exogenous C Shocks to the IS curve Reasons for the IS shift Oct-Dec 1929: S&P 500 fell 17% Oct 1929-Dec 1933: S&P 500 fell 71% an exogenous fall in the demand for goods & services – a leftward shift of the IS curve. evidence: Drop in investment “correction” after overbuilding in the 1920s widespread bank failures made it harder to obtain output and interest rates both fell, which is what a leftward IS shift would cause. financing for investment Contractionary fiscal policy Politicians raised tax rates and cut spending to combat increasing deficits. CHAPTER 11 Aggregate Demand II 34 CHAPTER 11 Aggregate Demand II 35 6 10/14/2013 THE MONEY HYPOTHESIS: THE MONEY HYPOTHESIS AGAIN: A shock to the LM curve The effects of falling prices asserts that the Depression was largely due to asserts that the severity of the Depression was huge fall in the money supply. due to a huge deflation: P fell 25% during 1929-33. evidence: M1 fell 25% during 1929-33. This deflation was probably caused by the fall in But, two problems with this hypothesis: P fell even more, so M/P actually rose slightly M, so perhaps money played an important role after all. during 1929-31. In what ways does a deflation affect the nominal interest rates fell, which is the opposite economy? of what a leftward LM shift would cause. CHAPTER 11 Aggregate Demand II 36 CHAPTER 11 Aggregate Demand II THE MONEY HYPOTHESIS AGAIN: THE MONEY HYPOTHESIS AGAIN: The effects of falling prices The effects of falling prices The stabilizing effects of deflation: The destabilizing effects of expected deflation: P (M/P ) LM shifts right Y E Pigou effect: P (M/P ) consumers’ wealth C 37 r for each value of i I because I = I (r ) planned expenditure & agg. demand income & output IS shifts right Y CHAPTER 11 Aggregate Demand II 38 THE MONEY HYPOTHESIS AGAIN: 39 Policymakers (or their advisors) now know The destabilizing effects of unexpected deflation: much more about macroeconomics: debt-deflation theory P (if unexpected) transfers purchasing power from borrowers to l d lenders borrowers spend less, lenders spend more if borrowers’ propensity to spend is larger than lenders’, then aggregate spending falls, the IS curve shifts left, and Y falls Aggregate Demand II Aggregate Demand II Why another Depression is unlikely The effects of falling prices CHAPTER 11 CHAPTER 11 The Fed knows better than to let M fall so much, especially during a contraction. Fiscal policymakers know better than to raise taxes 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. 40 CHAPTER 11 Aggregate Demand II 41 7 10/14/2013 Interest rates and house prices The 2008-09 Financial Crisis & Recession 2009: Real GDP fell, u-rate approached 10% 9 Important factors in the crisis: early 2000s Federal Reserve interest rate policy sub-prime mortgage crisis bursting of house price bubble, 8 Aggregate Demand II interest ra ate (%) 6 130 4 110 90 2 70 1 0 2000 42 2001 2002 2003 50 2005 2004 House price change and new foreclosures, 2006:Q3 – 2009Q1 14% 20% US house price index 12% 1.4 Nevada 18% New foreclosures Illinois Florida 1.2 8% 1.0 6% 0.8 4% 0.6 2% 0% 0.4 16% New forec closures, % of all mo ortgages 10% New foreclosurre starts (% of total morttgages) 14% California Georgia 12% Colorado Arizona 10% Rhode Island New Jersey 8% Texas S. Dakota Hawaii 4% Oregon Alaska -2% 2% 0.2 -4% -6% 1999 0% -40% 0.0 2001 2003 2005 2007 -30% -20% -10% Wyoming N. Dakota 0% 10% Major U.S. stock indexes (% change from 52 weeks earlier) DJIA 140% 70 60 20% Cumulative change in house price index 2009 U.S. bank failures by year, 2000-2009 Ohio Michigan 6% 120% S&P 500 100% NASDAQ 80% 50 60% 40 40% 20% 30 0% -20% 20 -40% 10 -60% 7/20/2009 3/5/2008 11/11/2008 6/28/2007 10/20/2006 6/5/2005 2/11/2006 9/27/2004 1/20/2004 5/14/2003 9/5/2002 12/28/2001 * as of July 24, 2009. 4/21/2001 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009* 8/13/2000 -80% 0 12/6/1999 Percent change in h house prices (from 4 quarters s earlier) 150 5 3 Change in U.S. house price index and rate of new foreclosures, 1999-2009 Number of b bank failures 170 7 rising foreclosure rates falling stock prices failing financial institutions declining consumer confidence, drop in spending on consumer durables and investment goods CHAPTER 11 Federal Funds rate 30-year mortgage rate 190 Case-Shiller 20-city composite house price index House price index x, 2000=100 CASE STUDY 8 10/14/2013 Consumer sentiment and growth in consumer durables and investment spending Real GDP growth and Unemployment 10 10% Real GDP growth rate (left scale) 100 5% 90 0% 80 -5% -10% 70 -15% Durables -20% Investment 60 UM Consumer Sentiment Index -25% 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 50 8 6% 7 6 4% 5 2% 4 3 0% 2 -2% 1 -4% 1995 0 1997 Chapter Summary 1. IS-LM model 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 IS curve: goods market equilibrium LM curve: money market equilibrium 9 Unemployment rate (right scale) % of labor force 10% 8% % change from 4 q quaters earlier 110 15% Consumer Sentiment In ndex, 1966=100 % change from four qu uarters earlier 20% 1999 2001 2003 2005 2007 2009 Chapter Summary 2. AD curve shows relation between P and the IS-LM model’s equilibrium Y. negative slope because P (M/P ) r I Y expansionary fiscal policy shifts IS curve right, raises income, and shifts AD curve right. expansionary monetary policy shifts LM curve right, raises income, and shifts AD curve right. IS or LM shocks shift the AD curve. 9