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Econ 101: Intermediate Macroeconomic Theory Larry Hu Lecture 12: Application of IS-LM Model and Great Depression CHAPTER 11 Aggregate Demand II slide 0 Equilibrium in the IS-LM Model The IS curve represents equilibrium in the goods market. Y C (Y T ) I (r ) G r LM The LM curve represents r1 money market equilibrium. IS M P L (r ,Y ) Y1 The intersection determines the unique combination of Y and r that satisfies equilibrium in both markets. CHAPTER 11 Aggregate Demand II Y slide 1 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. CHAPTER 11 Aggregate Demand II slide 2 The Fed’s 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 G are different: CHAPTER 11 Aggregate Demand II slide 3 Response 1: hold M constant If Congress raises G, the IS curve shifts right If Fed holds M constant, then LM curve doesn’t shift. r LM1 r2 r1 IS2 IS1 Results: Y Y 2 Y1 Y1 Y2 Y r r2 r1 CHAPTER 11 Aggregate Demand II slide 4 Response 2: hold r constant If Congress raises G, the IS curve shifts right r To keep r constant, Fed increases M to shift LM curve right. r2 r1 LM1 IS2 IS1 Results: Y Y 3 Y1 LM2 Y1 Y2 Y3 Y r 0 CHAPTER 11 Aggregate Demand II slide 5 Response 3: hold Y constant If Congress raises G, the IS curve shifts right To keep Y constant, Fed reduces M to shift LM curve left. LM2 LM1 r r3 r2 r1 IS2 IS1 Results: Y 0 Y1 Y2 Y r r3 r1 CHAPTER 11 Aggregate Demand II slide 6 What is the Fed’s policy instrument? Why does the Fed target interest rates instead of the money supply? 1) They are easier to measure than the money supply 2) The Fed might believe that LM shocks are more prevalent than IS shocks. If so, then targeting the interest rate stabilizes income better than targeting the money supply. (See Problem 7 on p.306) CHAPTER 11 Aggregate Demand II slide 7 CHAPTER 11 Aggregate Demand II slide 8 CHAPTER 11 Aggregate Demand II slide 9 CHAPTER 11 Aggregate Demand II slide 10 IS-LM and Aggregate Demand So far, we’ve been using the IS-LM model to analyze the short run, when the price level is assumed fixed. However, a change in P would shift the LM curve and therefore affect Y. The aggregate demand curve (introduced in chap. 9 ) captures this relationship between P and Y CHAPTER 11 Aggregate Demand II slide 11 Deriving the AD curve Intuition for slope of AD curve: P (M/P ) LM shifts left r I Y r LM(P2) LM(P1) r2 r1 IS P Y2 Y P2 P1 AD Y2 CHAPTER 11 Y1 Aggregate Demand II Y1 Y slide 12 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 IS r I P Y at each value of P P1 Y1 Y1 CHAPTER 11 Aggregate Demand II Y2 Y2 Y AD2 AD1 Y slide 13 Fiscal policy and the AD curve Expansionary fiscal policy (G and/or T ) increases agg. demand: r LM r2 r1 IS2 T C IS1 IS shifts right P Y1 Y2 Y Y at each value P1 of P Y1 CHAPTER 11 Aggregate Demand II Y2 AD2 AD1 Y slide 14 IS-LM and AD-AS in the short run & long run Recall from Chapter 9: The force that moves the economy from the short run to the long run is the gradual adjustment of prices. In the short-run equilibrium, if then over time, the price level will Y Y rise Y Y fall Y Y remain constant CHAPTER 11 Aggregate Demand II slide 15 The SR and LR effects of an IS shock r A negative IS shock shifts IS and AD left, causing Y to fall. LRAS LM(P ) 1 IS2 Y P SRAS1 Y Aggregate Demand II Y LRAS P1 CHAPTER 11 IS1 AD1 AD2 Y slide 16 The SR and LR effects of an IS shock r LRAS LM(P ) 1 In the new short-run equilibrium, Y Y IS2 Y P SRAS1 Y Aggregate Demand II Y LRAS P1 CHAPTER 11 IS1 AD1 AD2 Y slide 17 The SR and LR effects of an IS shock r LRAS LM(P ) 1 In the new short-run equilibrium, Y Y IS2 Over time, P gradually falls, which causes • SRAS to move down • M/P to increase, which causes LM to move down CHAPTER 11 Y P Y LRAS P1 Aggregate Demand II IS1 SRAS1 Y AD1 AD2 Y slide 18 The SR and LR effects of an IS shock r LRAS LM(P ) 1 LM(P2) IS2 Over time, P gradually falls, which causes • SRAS to move down • M/P to increase, which causes LM to move down CHAPTER 11 Y P IS1 Y LRAS P1 SRAS1 P2 SRAS2 Aggregate Demand II Y AD1 AD2 Y slide 19 The SR and LR effects of an IS shock r LRAS LM(P ) 1 LM(P2) This process continues until economy reaches a long-run equilibrium with Y Y IS2 Y P Y LRAS P1 SRAS1 P2 SRAS2 Y CHAPTER 11 IS1 Aggregate Demand II AD1 AD2 Y slide 20 The Great Depression 220 billions of 1958 dollars 30 Unemployment (right scale) 25 200 20 180 15 160 10 Real GNP (left scale) 140 120 1929 percent of labor force 240 5 0 1931 CHAPTER 11 1933 1935 Aggregate Demand II 1937 1939 slide 21 The Spending Hypothesis: Shocks to the IS Curve asserts that the Depression was largely due to an 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 CHAPTER 11 Aggregate Demand II slide 22 The Spending Hypothesis: Reasons for the IS shift 1. Stock market crash exogenous C Oct-Dec 1929: S&P 500 fell 17% Oct 1929-Dec 1933: S&P 500 fell 71% 2. Drop in investment “correction” after overbuilding in the 1920s widespread bank failures made it harder to obtain financing for investment 3. Contractionary fiscal policy in the face of falling tax revenues and increasing deficits, politicians raised tax rates and cut spending CHAPTER 11 Aggregate Demand II slide 23 The Money Hypothesis: A Shock to the LM Curve asserts that the Depression was largely due to huge fall in the money supply evidence: M1 fell 25% during 1929-33. CHAPTER 11 Aggregate Demand II slide 24 The Money Hypothesis Again: The Effects of Falling Prices asserts that the severity of the Depression was due to a huge deflation: P fell 25% during 1929-33. This deflation was probably caused by the fall in M, so perhaps money played an important role after all. In what ways does a deflation affect the economy? CHAPTER 11 Aggregate Demand II slide 25 The Money Hypothesis Again: The Effects of Falling Prices The stabilizing effects of deflation: P (M/P ) LM shifts right Y Pigou effect: P (M/P ) consumers’ wealth C IS shifts right Y CHAPTER 11 Aggregate Demand II slide 26 The Money Hypothesis Again: The Effects of Falling Prices 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 than lenders, then aggregate spending falls, the IS curve shifts left, and Y falls CHAPTER 11 Aggregate Demand II slide 27 The Money Hypothesis Again: The Effects of Falling Prices The destabilizing effects of expected deflation: e r for each value of i I because I = I (r ) planned expenditure & agg. demand income & output CHAPTER 11 Aggregate Demand II slide 28 Liquidity Trap IS-LM: monetary policy increase investment by reducing interest rate r When interest rate is low, it may not work, just like today IS LM Y CHAPTER 11 Aggregate Demand II slide 29 Liquidity Trap IS The policy maker can create inflation expectationi = r + r Nominal interest rate never below zero If inflation is zero, real interest rate never falls below zero LM1 IS LM2 Y If inflation if 3%, real interest rate can be 3% CHAPTER 11 Aggregate Demand II slide 30