Download Macroeconomics

Financial Markets and
Aggregate Demand
Chapter 8
0
Outline

Investment and the Interest Rate

Net Exports and the Interest Rate

The Demand for and Supply of Money

The IS Curve and the LM Curve

Policy Analysis with IS-LM

The Aggregate-Demand Curve

Determination of Output and
Unemployment in the Short Run
1
8.1. Investment and the Interest Rate
Investment depends negatively on interest
rates. Why?
 Most investments are financed through
borrowing or with funds from selling
financial securities. If interest rates are high,
then there are high borrowing costs or high
losses in income
Investment function:
I = e - dR
e, d = constants
d = how much investment falls when the interest
rate increases by 1%

2
3
Investment and the Interest Rate
By making investment endogenous, we have
introduced a new endogenous variable: the
interest rate, R
We focus here on the average interest rate
(which represents the behavior of all the
different types of rates: long-term, short-term
securities, etc.)
Note: distinguish between real and nominal
interest rates:
Real interest rate (R) = Nominal interest rate (i) –
Inflation real interest rate: R
Here we use the real interest rate: R
4
8.2. Net Exports and the Interest Rate

Net exports depend negatively on the
interest rate. Why?
If U.S. interest rates are higher than rates in
other countries, dollars become more
attractive, which drive up the price of
dollars; U.S. goods become more expensive
and foreign goods cheaper, thus net exports
fall
X = g – mY -- nR
n – measures the decrease in net exports when
the interest rate rises by 1%
5
8.3. The Demand for and Supply of Money

Money is:

Currency issued by the Federal Reserve
(coins, dollar bills) together with checking
account balances held by public in banks

It does not include larger amount of wealth,
such as mutual funds, bonds, corporate
stock, etc.
6
The Demand for Money
1.
People want to hold less money when the
interest rate is high and more money
when the interest rate is low.
2.
People want to hold more money when
income is higher and less money when
income is lower.
3.
People want to hold more money when
price level is higher and less money when
price level is lower.
7
The Demand for Money
Money demand function
M = (kY – hR)P
M – demand for money
R – interest rate
P – price level
k, h – coefficients
k – how much money demand increases when
income increases
h – how much money demand declines when
interest rate raises
8
The Supply of Money

Money Supply level – determined by the
Federal Reserve System

For now, we assume that the Fed picks a
certain level, M

In the short-run model, when prices are
predetermined, income and interest rates
adjust to keep the demand for money equal
to its fixed supply
9
8.4. The IS Curve and the LM Curve
Five relations in the IS – LM framework
Y=C+I+G+X
C = a + b(1-t)Y
I = e – dR
X = g – mY - nR
M = (kY – hR)P
Endogenous variables: Y, C, I, X, and R
Exogenous variables: G and M
Predetermined variable: P
10
a) The IS Curve

The IS curve shows all combinations of R and Y
that satisfy the income identity, the consumption
function, the investment function, and the netexport function.

It is the set of points for which spending balance
occurs.

When the curve slopes downward -- higher
interest rate reduces investment and net exports
and thereby reduces GDP through the multiplier
process

Shifts: an increase in government spending
increases GDP through the multiplier and shifts the
IS curve to the right
11
FIGURE 8.2
THE IS CURVE
INTEREST RATE (R) (%)
INTEREST RATE (R) (%)
10 –
10 –
1
Government spending increases by ΔG
9 –
2 IS Curve shifts right by
8 –
1
ΔG
1- b (1-t) + m
7 –
6 –
IS curve
5 –
5 –
4 –
3 –
2 –
Old
IS
1 –
5,800
5,900
6,000
6,100
6,200
GDP (Y)
5,800
5,900
6,000
6,100
New
IS
6,200 GDP (Y)
12
FIGURE 8.3 GRAPH DERIVATION OF THE IS CURVE
45º line
SPENDING
6,100 –
Old spending line
New spending line
6,000 –
5,900 –
5,800 –
5,800
5,900
6,000
6,100
6,200 GDP (Y)
INTEREST RATE
New
interest
rate
Old
interest
rate
8–
7–
6.2 ––
5–
4–
3–
2–
1–
5,800
New Level
of GDP
5,900
Old Level
of GDP
6,000
IS Curve
6,100
6,200 GDP (Y)
13
The LM Curve

The LM curve shows all combinations of R and
Y that satisfy the money demand relationship
for a fixed level of the money supply and a
predetermined value of the price level.

When the curve slopes upward: if the
interest rate increases, money demand
decreases; therefore, to have equilibrium in the
money market there should be an increase in
income. So, an interest-rate increase is
associated with a rise in income.
14
The LM Curve

Note: Real money = money supply M divided
by price level P
M/P = kY – hR


The demand for real money depends
positively on real GDP and negatively on the
interest rate
Shifts: an increases in money supply shifts the
LM curve to the right
15
FIGURE 8.4
THE LM CURVE
INTEREST RATE (R) (%)
INTEREST RATE (R) (%)
10 –
LM
curve
9 –
10 –
9 –
8 –
8 –
7 –
7 –
6 –
6 –
5 –
5 –
4 –
4 –
3 –
3 –
2 –
2 –
1 –
1 –
5,800
5,900
6,000
6,100
Money supply increases by ΔM
6,200
GDP (Y)
Old
LM
New
LM
LM curve shifts
to right by 1/k ΔM
5,800
5,900
6,000
6,100
6,200 GDP (Y)
16
FIGURE 8.5
GRAPHICAL DERIVATION OF THE LM CURVE
INTEREST RATE (R) (%)
INTEREST RATE (R) (%)
10 –
10 –
Money supply
9 –
R = 8.17
8 –
New
9
interest
rate
LM
Curve
–
8 –
7 –
7 –
6 –
5 –
Old
6
interest
rate
–
New 4
money
3
demand
–
5 –
4 –
3 –
2 –
–
2 –
Old money
demand
1 –
850
900
1 –
950
GDP (Y)
5,800
5,900
6,000
Old
GDP
6,100
6,200 GDP (Y)
New
GDP
17
Algebraic Derivation of the IS and LM Curves
IS curve: R  a  e  g  1  b(1  t )  m Y  1 G
d n
k
1
M
LM curve: R  Y 
h
h P

d n
d n
To satisfy all five relationships of the model, the
values of R and Y must be on both the IS curve
and the LM curve; that is, at their intersection
(next figure)
18
FIGURE 8.6
THE INTERSECTION OF THE IS CURVE
INTEREST RATE (R) (%)
AND THE LM CURVE
10 –
LM
5 –
IS
5,800
5,900
6,000
6,100
6,200
GDP (Y)
19
8.5.Policy Analysis with IS-LM
Monetary Policy: changes in the money supply
What happens in the economy when the Fed
increases the money supply?
 Immediately after the increase, more money is
in the economy than people demand. This
makes the interest rate fall, so the demand for
money increases.
 The lower interest rate stimulates investment
and net exports.
 This raises GDP through the multiplier process;
GDP rises and the interest rate falls
 LM curve shifts to the right (increase in real
money)
20
Policy Analysis with IS-LM
Fiscal Policy: the use of tax rates and government
spending to influence the economy

Ex. Congress passes a bill that increases government
spending or decrease in taxes

An increase in government spending increases the
interest rate (through the increase in the demand for
money) and increases income (through the multiplier)

Increasing the interest rate reduces investment and net
exports, thereby offsetting some of the increase in
income – crowding out
21
Policy Analysis with IS-LM
These are short-run results with the price
level predetermined. When the time frame is
lengthened in the next chapter, so that the
price level can adjust, these results will have
to be modified.
22
FIGURE 8.7 EFFECTS OF MONETARY AND FISCAL
POLICIES
INTEREST RATE (R) (%)
INTEREST RATE (R) (%)
10 –
10 –
9 –
9 –
8 –
Old LM 8 –
LM curve shifts right
7 –
6 –
5 –
LM
7 –
New LM
6 –
Interest
rate falls
5 –
4 –
4 –
3 –
3 –
2 –
IS curve shifts right
IS
GDP rises
1 –
Interest
rate rises
New IS
GDP
rises
2 –
Old IS
1 –
5,800
5,900
6,000 6,100
Old level
of GDP
New level
of GDP
Increase in Money Supply
6,200
GDP (Y)
5,800
5,900
6,000
Old level
of GDP
6,100
6,200 GDP (Y)
New level
of GDP
Increase in Government spending
23
8.6 The Aggregate Demand Curve
The AD curve shows combinations of price
levels and output where the IS and LM curves
intersect, or where spending balance occurs and
money demand equals money supply.
Note: Even though they look similar, the ideas behind
the aggregate demand curve are much different
from those that underlie the typical demand curve
of microeconomics.
The financial system — the demand for and supply
of money lies behind the aggregate demand
curve.
24
The Aggregate Demand Curve
The AD curve slopes downward; therefore, a
decrease in prices increases real money, shifting the
LM curve to the right, lowering interest rates,
increasing investment and increasing output.
25
FIGURE 8.8
THE AGGREGATE DEMAND CURVE
PRICE LEVEL (P)
PRICE LEVEL (P)
1.2 –
AD curve shifts right if
(1) money (M) increases, or
(2) government spending (G)
increases
1.2 –
1.1 –
Aggregate
demand
curve (AD)
1.0 –
1.1 –
1.0 –
New
AD
.9 –
.9 –
.8 –
.8 –
5,700
5,900
6,100
6,300 6,500
GDP (Y) 5,700
Old AD
5,900
6,100
6,300 6,500
GDP (Y)
26
FIGURE 8.9 DERIVATION OF THE AD CURVE
INTEREST RATE (R) (%)
New LM
8–
7–
6–
5–
4–
3–
2–
1–
5,800
Old LM
IS
5,900
6,000
6,100
PRICE LEVEL (P)
1.15 –
6,200 GDP (Y)
1.10 –
New price
level
Old price
level
1.05 –
1.00 –
AD
.95 –
.90 –
5,800
5,900
New level
of GDP
6,000
Old level
of GDP
6,100
6,200 GDP (Y)
27
The Aggregate Demand Curve
Changes in the money supply and in government
spending both shift the aggregate demand curve.
Monetary Policy
 An increase in M at a given price level results in an
increase in aggregate demand
 Rationale? More money means that a lower interest
rate equates money demand with money supply. A
lower interest rate stimulates more investment and
net exports, which in turn require a higher level of
GDP for spending balance
 The aggregate demand curve shifts to the right
when the money supply increases

28
The Aggregate Demand Curve
Fiscal policy
 An increase in government spending shifts the
aggregate demand curve to the right.
 At a given price level, more government spending
means more aggregate demand.
29
8.7. Determination of Output in the Short Run

Recall: Prices are sticky; they take some time
to adjust in response to demand conditions.

The level of output at a predetermined price
level is determined by the point on the
aggregate demand curve corresponding to
the price level.

In the short run, output can be above or
below its potential level.
30
FIGURE 8.10 DETERMINATION OF OUTPUT WITH A
PREDETERMINED PRICE
PRICE LEVEL (P)
PRICE LEVEL (P)
Predetermined-price line
P0
Predetermined-price line
P0
Aggregate
demand
curve (AD)
5,800
Y0
6,200
GDP (Y)
New AD
Old AD
5,800
Y0
Y1
6,200 GDP (Y)
31
FIGURE 8.10 DETERMINATION OF OUTPUT WITH A
PREDETERMINED PRICE
PRICE LEVEL (P)
PRICE LEVEL (P)
Y*
Y*
Predetermined-price line
P0
Predetermined-price line
P0
Aggregate
demand curve
Aggregate
demand curve
5,800
Y0 6,000
Output
below
potential
6,200
GDP (Y)
5,800
6,000
Y0
Output
above
potential
6,200
GDP (Y)
32
8.7. Determination of
Unemployment in the Short Run


If GDP declines, most workers who are laid off
become unemployed (and it becomes harder for
people who are looking for work to find jobs).
Because of the importance of hours reductions
and the common pattern of retaining workers
during temporary declines in demand (called
labor hoarding), a 3 percent decline in GDP is
associated with only a 1 percentage point
increase in unemployment (Okun’s Law).
33
FIGURE 8.12 DETERMINATION OF EMPLOYMENT
PRICE
1
The AD curve
shifts inward
2
AD
Y declines
from Y* to Y’
Y’
AD’
Y*
% GDP GAP
GDP
GDP gap
% GDP GAP
Okun’s law
3
0
(Y – Y*)/Y*
declines from
0 to a negative
amount
-3.6%
5,784
6,000
GDP
4
Okun’s law shows
how much unemployment rises
U*
6%
U’
7.2%
UNEMPLOYMENT RATE
34
Numerical Example

Consider the following economy :
Y=C+I+G+X
C = 100 + 0.9Yd
I = 200 – 500R
X = 100 – 0.12Y – 500R
M = (0.8Y -2000R)P
G = $200, t = 0.2, M = $800, P = 1
Yd = Y - 0.2Y
 Note: All quantities are in billions of dollars
35
Numerical Example
What is the IS curve?
 Substitute C, I and X in the income identity:
Y = 100 + 0.9(Y-0.2Y) + 200 – 500R + 200 + 100 0.12Y – 500R
Y = 600 + 0.6Y -1000R
0.4Y = 600 – 1000R
IS curve: Y = 1500 – 2500R
36
Numerical Example
What is the LM curve?
 Derive from the equation for money demand:
M = (0.8Y -2000R)P
800 = 0.8Y - 2000R,
0.8Y = 800 + 2000R
So LM curve: Y = 1000 + 2500R
37
Numerical Example
What are the values of income and interest rate if
spending balance occurs and the demand for
money equals the supply for money?
 Y (from IS curve) = Y (from LM curve)
1500 – 2500R = 1000 + 2500R
500 = 500R
R = 0.10 (10%)
Substitute R into IS or LM: Y = 1250
38
Numerical Example
What are the values of consumption, investment
and net exports?
C = 1000
I = 150
X = 100
39
Numerical Example
Derive the aggregate demand curve:
1) To derive the effects of increases in government
spending or real money on income, start with the
equation for the LM curve, do not substitute a
specific value for real money, and solve for output.
M/P = 0.8Y-2000R
Y = 1.25 (M/P) + 2500R
40
Numerical Example
Derive the aggregate demand curve:
2) Now use the income identity, substitute the
consumption, investment and net export
equations, but not a specific value for government
spending, and solve for 2500 times the interest
rate:
Y = 100 + 0.9(Y-0.2Y) + 200 – 500R + G + 100 0.12Y – 500R
Y = 400 + 0.6Y – 1000R + G
1000R = 400 – 0.4Y + G
2500R = 1000 – Y +2.5G
41
Numerical Example
Derive the aggregate demand curve:
3) Then substitute the spending balance equation into
the LM curve, and solve for Y
Y = 1.25 (M/P) + 1000 – Y +2.5G
2Y = 1.25 (M/P) + 1000 + 2.5G
AD curve: Y = 0.625(M/P) + 500 +1.25G
42
Numerical Example
How much does an increase in
government spending or real money of
$100 bill increase GDP?
AD curve: Y = 0.625(M/P) + 500 +1.25G
An increase in government spending of 100
raises real GDP by 125. An increase in the
money supply of 100, with the price level
constant, raises real GDP by 62.5.
43