Download Mankiw 5/e Chapter 11: Aggregate Demand II

macro
Topic
10: ELEVEN
CHAPTER
Aggregate
AggregateDemand
DemandIIII
(chapter 11) updated 11/17/09
macroeconomics
fifth edition
N. Gregory Mankiw
PowerPoint® Slides
by Ron Cronovich
© 2002 Worth Publishers, all rights reserved
Context
 Chapter 9 introduced the model of aggregate
demand and supply.
 Chapter 10 developed the IS-LM model, the
basis of the aggregate demand curve.
 In Chapter 11, we will use the IS-LM model to
– see how policies and shocks affect income
and the interest rate in the short run when
prices are fixed
– derive the aggregate demand curve
– explore various explanations for the
Great Depression
CHAPTER 11
Aggregate Demand II
slide 1
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 2
Policy analysis with the IS-LM Model
Y  C (Y  T )  I (r )  G
r
LM
M P  L (r ,Y )
Policymakers can affect
macroeconomic variables
r1
with
• fiscal policy: G and/or T
• monetary policy: M
We can use the IS-LM
model to analyze the
effects of these policies.
CHAPTER 11
Aggregate Demand II
IS
Y1
Y
slide 3
An increase in government purchases
r
1. IS curve shifts right
1
by
G
1  MPC
causing output &
income to rise.
2. This raises money
2.
LM
r2
r1
3. …which reduces investment,
so the final increase in Y
1
is smaller than
G
1  MPC
CHAPTER 11
Aggregate Demand II
IS2
1.
demand, causing the
interest rate to rise…
IS1
Y1 Y2
Y
3.
slide 4
A tax cut
Because consumers save
(1MPC) of the tax cut,
the initial boost in
spending is smaller for T
than for an equal G…
and the IS curve
shifts by
MPC
1.
T
1  MPC
r
r2
2.
r1
2. …so the effects on r and Y
are smaller for a T than
for an equal G.
CHAPTER 11
LM
Aggregate Demand II
1.
IS2
IS1
Y1 Y2
Y
2.
slide 5
Monetary Policy: an increase in M
1. M > 0 shifts
the LM curve down
(or to the right)
2. …causing the
interest rate to fall
r
LM2
r1
r2
3. …which increases
investment, causing
output & income to
rise.
CHAPTER 11
LM1
Aggregate Demand II
IS
Y1 Y2
Y
slide 6
Shocks in the IS-LM Model
IS shocks: exogenous changes in the
demand for goods & services.
Examples:
• stock market boom or crash
 change in households’ wealth
 C
• change in business or consumer
confidence or expectations
 I and/or C
CHAPTER 11
Aggregate Demand II
slide 7
Shocks in the IS-LM Model
LM shocks: exogenous changes in the
demand for money.
Examples:
• a wave of credit card fraud increases
demand for money
• more ATMs or the Internet reduce money
demand
CHAPTER 11
Aggregate Demand II
slide 8
CASE STUDY
The U.S. economic slowdown of 2001
~What happened~
1. Real GDP growth rate
1994-2000: 3.9% (average annual)
2001: 1.2%
2. Unemployment rate
Dec 2000: 4.0%
Dec 2001: 5.8%
CHAPTER 11
Aggregate Demand II
slide 9
CASE STUDY
The U.S. economic slowdown of 2001
~Shocks that contributed to the slowdown~
1. Falling stock prices
From Aug 2000 to Aug 2001: -25%
Week after 9/11: -12%
2. The terrorist attacks on 9/11
• increased uncertainty
• fall in consumer & business confidence
Both shocks reduced spending and
shifted the IS curve left.
CHAPTER 11
Aggregate Demand II
slide 10
CASE STUDY
The U.S. economic slowdown of 2001
~The policy response~
1. Fiscal policy
• large long-term tax cut,
immediate $300 rebate checks
• spending increases:
aid to New York City & the airline industry,
war on terrorism
2. Monetary policy
• Fed lowered its Fed Funds rate target
11 times during 2001, from 6.5% to 1.75%
• Money growth increased, interest rates fell
CHAPTER 11
Aggregate Demand II
slide 11
What is the Fed’s policy instrument?
What the newspaper says:
“the Fed lowered interest rates by one-half point today”
What actually happened:
The Fed conducted expansionary monetary policy to
shift the LM curve to the right until the interest rate fell
0.5 points.
The Fed targets the Federal Funds rate:
it announces a target value,
and uses monetary policy to shift the LM curve
as needed to attain its target rate.
CHAPTER 11
Aggregate Demand II
slide 12
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.
CHAPTER 11
Aggregate Demand II
slide 13
Recession of 2008-9
Questions:
1) How severe is the recession? Is it still
going on?
2) Can we tell what caused it: IS or LM
curve shift?
3) Can we see evidence of the government’s
response, in fiscal and monetary policy?
CHAPTER 11
Aggregate Demand II
slide 14
Recession of 2008-9
Quarterly GDP Growth Rates:
6
4
2
0
-2
-4
-6
-8
CHAPTER 11
Aggregate Demand II
slide 15
Recession of 2008-9
Unemployment rate:
CHAPTER 11
Aggregate Demand II
slide 16
0
CHAPTER 11
Aggregate Demand II
Oct-09
Jul-09
Apr-09
Jan-09
Oct-08
Jul-08
Apr-08
Jan-08
Oct-07
Jul-07
Apr-07
Jan-07
Oct-06
Jul-06
Apr-06
Jan-06
Oct-05
Jul-05
Apr-05
Jan-05
Oct-04
Jul-04
Apr-04
Jan-04
Recession of 2008-9
Federal funds interest rate
6
5
4
3
2
1
slide 17
Recession of 2008-9
Government saving (2004 to 2008)
0
-200
-400
-600
-800
-1000
-1200
CHAPTER 11
Aggregate Demand II
slide 18
Recall: IS curve
Def: equilibrium points in
the Goods market:
Story: fall in r raises I,
which raises E and Y.
r
LM
r2
r1
Shifted right by:
Fiscal policy: raise G or cut T;
Shocks: exogenous rise in C
or I (rise in Consumer or
Business confidence).
IS2
IS1
Y1 Y2
Y
Shift in IS leads to: a rise in Y, which raises money
demand and bids up r (move along LM).
CHAPTER 11
Aggregate Demand II
slide 19
Recall: LM Curve
Def: equilibrium points
in the money market.
Story: rise in Y raises money
demand, which bids up r.
r
r
LM1
LM2
1
r2
Shifted right by:
Monetary policy: rise in M;
Shocks: fall in exogenous
money demand.
IS
Y1 Y2
Y
Shift in LM leads to fall in r, raises I, hence raises E and Y
(movement along IS curve).
CHAPTER 11
Aggregate Demand II
slide 20
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 21
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 22
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 23
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 24
Policy Effectiveness
Fiscal policy is effective (Y will rise much) when:
LM flatter
As the rise in G raises Y,
IS1 IS2
LM
r
2
1
2’
the increase in money demand
LM’ does not raise r much:
so investment is not crowded
out as much.
Y1 Y2 Y2’
CHAPTER 11
Aggregate Demand II
slide 25
Policy Effectiveness
Monetary policy is effective (Y will rise much) when:
IS flatter
r
IS
LM1
1
LM2
2’
2
IS’
As a rise in M lowers the
interest rate (r),
investment rises more in
response to the fall in r,
so output rises more.
Y1 Y2 Y2’
CHAPTER 11
Aggregate Demand II
slide 26
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 27
Quiz #4
Suppose a fall in G leads to a
leftward shift in the IS curve.
r
LRAS LM(P )
1
What is the short run effect
on the following variables
(rise, fall, no change)?
IS2
1) Y
Y
2) r
P
3) C
SRAS1
Please also write your name
and section day/time
Y
CHAPTER 11
Aggregate Demand II
Y
LRAS
P1
4) I
IS1
AD1
AD2
Y
slide 28
Answers to Quiz #4
Suppose a fall in G leads to a
leftward shift in the IS curve.
r
LRAS LM(P )
1
What is the short run effect
on the following variables
(rise, fall, no change)?
IS2
1) Y falls
2) r falls
3) C(Y-T) falls
4) I(r ) rises
Y
P
LRAS
P1
SRAS1
Y
CHAPTER 11
Aggregate Demand II
Y
AD2
Y
slide 29
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 30
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 31
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 32
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 33
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 34
EXERCISE:
Analyze SR & LR effects of M
a. Drawing the IS-LM and AD-
r
AS diagrams as shown here,
LRAS LM(M /P )
1
1
b. show the short run effect of
a Fed increases in M. Label
points and show curve shifts
with arrows.
c. Show what happens in the
transition from the short run P
to the long run. Label points.
P1
d. How do the new long-run
equilibrium values compare
to their initial values?
IS
Y
LRAS
SRAS1
AD1
Y
CHAPTER 11
Aggregate Demand II
Y
Y
slide 35
Short run for rise in M
r
Short run:
Rise in M raises real money r
0
supply in money market r1
LRAS LM(M /P )
1
1
0
1
IS
and shifts LM curve right.
Also shifts AD curve right.
Equilibrium moves from
point 0 to point 1.
Output rises to Y1.
Note that interest rate
P
P1
Y Y1
0
1
SRAS1
AD1AD2
Y Y1
Aggregate Demand II
Y
LRAS
falls from r0 to r1.
CHAPTER 11
LM(M2/P1)
Y
slide 36
Long run: for rise in M
Price rises in proportion to M,
from P1 to P2,
So real money supply
r
r0
r1
LRAS LM(M /P )
2
2
0,2
1
IS
returns to original level:
M2/P2 = M1/P1.
So LM curve returns to
original position.
Equilibrium moves from
point 1 to point 2.
P
P2
P1
Y Y1
CHAPTER 11
Aggregate Demand II
Y
LRAS
2
0
1
Output and interest rate
return to original levels.
LM(M2/P1)
SRAS2
SRAS1
AD1AD2
Y Y1
Y
slide 37
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 38
CHAPTER 11
Aggregate Demand II
slide 39
Great Depression: Observations
 Real side of economy:
–
–
–
–
Output:
Consumption:
Investment:
Gov. purchases:
CHAPTER 11
falling
falling
falling much
fall (with a delay)
Aggregate Demand II
slide 40
CHAPTER 11
Aggregate Demand II
slide 41
Great Depression: Observations
 Nominal side:
– Nominal interest rate:
falling
– Money supply (nominal):
falling
– Price level:
falling (deflation)
CHAPTER 11
Aggregate Demand II
slide 42
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 43
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 44
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.
But, two problems with this hypothesis:
1. P fell even more, so M/P actually rose
slightly during 1929-31.
2. nominal interest rates fell, which is the
opposite of what would result from a
leftward LM shift.
CHAPTER 11
Aggregate Demand II
slide 45
A revision to the Money Hypothesis
 There was a big deflation: P fell 25% 1929-33.
 A sudden fall in expected inflation means the exante real interest rate rises for any given nominal
rate (i)
ex ante real interest rate = i – e
 This could have discouraged the investment
expenditure and helped cause the depression.
 Since the deflation likely was caused by fall in M,
monetary policy may have played a role here.
CHAPTER 11
Aggregate Demand II
slide 46
Why another Depression is unlikely
 Policymakers (or their advisors) now know
much more about macroeconomics:
 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.
CHAPTER 11
Aggregate Demand II
slide 47
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
CHAPTER 11
Aggregate Demand II
slide 48
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
CHAPTER 11
Aggregate Demand II
slide 49