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macro Topic 10: TEN CHAPTER Aggregate Aggregate Demand Demand II (chapter 10, Mankiw) Eva Hromadkova PowerPoint® Slides by Ron Cronovich © 2002 Worth Publishers, all rights reserved Motivation The Great Depression caused a rethinking of the Classical Theory of the macroeconomy. It could not explain: – Drop in output by 30% from 1929 to 1933 – Rise in unemployment to 25% In 1936, J.M. Keynes developed a theory to explain this phenomenon. – Focus on the role of aggregate demand We will learn a version of this theory, called the ‘IS-LM’ model. CHAPTER 10 Aggregate Demand I slide 1 Context We have already introduced the model of aggregate demand and aggregate supply. Long run – prices flexible – output determined by factors of production & technology – unemployment equals its natural rate Short run – prices fixed – output determined by aggregate demand – unemployment is negatively related to output CHAPTER 10 Aggregate Demand I slide 2 Context This chapter develops the IS-LM model, the theory that yields the aggregate demand curve. We focus on the short run and assume the price level is fixed. CHAPTER 10 Aggregate Demand I slide 3 The Keynesian Cross A simple closed economy model in which income is determined by expenditure. (due to J.M. Keynes) Notation: I = planned investment E = C + I + G = planned expenditure Y = real GDP = actual expenditure Difference between actual & planned expenditure: unplanned inventory investment CHAPTER 10 Aggregate Demand I slide 4 Elements of the Keynesian Cross consumption function: C C (Y T ) govt policy variables: G G , T T for now, investment is exogenous: planned expenditure: I I E C (Y T ) I G Equilibrium condition: Actual expenditure Planned expenditure Y E CHAPTER 10 Aggregate Demand I slide 5 Graphing planned expenditure E planned expenditure E =C +I +G Slope is MPC income, output, Y CHAPTER 10 Aggregate Demand I slide 6 Graphing the equilibrium condition E E =Y planned expenditure 45º income, output, Y CHAPTER 10 Aggregate Demand I slide 7 The equilibrium value of income E E =Y planned expenditure E =C +I +G income, output, Y Equilibrium income CHAPTER 10 Aggregate Demand I slide 8 The equilibrium value of income E planned expenditure E =Y E<Y E =C +I +G E>Y income, output, Y E>Y: depleting inventories: must produce more. E<Y: accumulating inventories: must produce less. CHAPTER 10 Aggregate Demand I slide 9 An increase in government purchases E At Y1, there is now an unplanned drop in inventory… E =C +I +G2 E =C +I +G1 G …so firms increase output, and income rises toward a new equilibrium CHAPTER 10 Looks like Y>G Y E1 = Y1 Y Aggregate Demand I E2 = Y 2 slide 10 Why is change in Y > change in G? Def: Government purchases multiplier: Y G Initially, the increase in G causes an equal increase in Y: Y = G. But Y C (Y-T) further Y further C further Y So the government purchases multiplier will be greater than one. CHAPTER 10 Aggregate Demand I slide 11 An increase in government purchases E C even more C more C G Y even more Y more Y once Y CHAPTER 10 Aggregate Demand I slide 12 Sum up changes in expenditure Y G MPC G MPC MPC G MPC MPC MPC G ... G MPC 1 G MPC 2 G MPC 3 G ... This is a standard geometric series from algebra: 1 G 1 MPC So the multiplier is: Y 1 1 for 0 < MPC < 1 G 1 MPC CHAPTER 10 Aggregate Demand I slide 13 An increase in taxes E Initially, the tax increase reduces consumption, and therefore E: E =C1 +I +G E =C2 +I +G At Y1, there is now an unplanned inventory buildup… C = MPC T …so firms reduce output, and income falls toward a new equilibrium CHAPTER 10 Y E2 = Y2 Y Aggregate Demand I E1 = Y1 slide 14 Solving for Y eq’m condition in changes Y C I G C I and G exogenous MPC Y T Solving for Y : Final result: CHAPTER 10 (1 MPC) Y MPC T MPC Y T 1 MPC Aggregate Demand I slide 15 The Tax Multiplier Question: how is this different from the government spending multiplier considered previously? The tax multiplier: …is negative: An increase in taxes reduces consumer spending, which reduces equilibrium income. …is smaller than the govt spending multiplier: (in absolute value) Consumers save the fraction (1MPC) of a tax cut, so the initial boost in spending from a tax cut is smaller than from an equal increase in G. CHAPTER 10 Aggregate Demand I slide 16 Building the IS curve def: a graph of all combinations of r and Y that result in goods market equilibrium, i.e. actual expenditure (output) = planned expenditure The equation for the IS curve is: Y C (Y T ) I (r ) G CHAPTER 10 Aggregate Demand I slide 17 Deriving the IS curve E =Y E =C +I (r )+G 2 E E =C +I (r1 )+G r I E Y I r Y1 Y Y2 r1 r2 IS Y1 CHAPTER 10 Y2 Aggregate Demand I Y slide 18 Understanding the IS curve’s slope The IS curve is negatively sloped. Intuition: A fall in the interest rate motivates firms to increase investment spending, which drives up total planned spending (E ). To restore equilibrium in the goods market, output (a.k.a. actual expenditure, Y ) must increase. CHAPTER 10 Aggregate Demand I slide 19 Fiscal Policy and the IS curve We can use the IS-LM model to see how fiscal policy (G and T ) can affect aggregate demand and output. Let’s start by using the Keynesian Cross to see how fiscal policy shifts the IS curve… CHAPTER 10 Aggregate Demand I slide 20 Shifting the IS curve: G At given value of r, G E Y …so the IS curve shifts to the right. The horizontal distance of the IS shift equals E =Y E =C +I (r )+G 1 2 E E =C +I (r1 )+G1 r Y1 r1 1 Y G 1 MPC Y Y1 CHAPTER 10 Y Y2 IS1 Y2 Aggregate Demand I IS2 Y slide 21 Algebra example for IS curve Suppose the expenditure side of the economy is characterized by: C =95 + 0.75(Y-T) I = 100 – 100r G = 20, T=20 Use the goods market equilibrium condition Y=C+I+G Y = 215 + 0.75 (Y-20) – 100r 0.25Y = 200 – 100r IS: Y = 800 – 400r or write as IS: r = 2 - 0.0025Y CHAPTER 10 Aggregate Demand I slide 22 Graph the IS curve r 2 Slope = -0.0025 IS Y IS: r = 2 - 0.0025Y CHAPTER 10 Aggregate Demand I slide 23 Slope of IS curve Suppose that investment expenditure is “more responsive” to the interest rate: I = 100 – 100r 200r Use the goods market equilibrium condition Y=C+I+G Y = 215 + 0.75 (Y-20) – 200r 0.25Y = 200 – 200r IS: Y = 800 – 800r or write as IS: r = 1 - 0.00125Y (slope is lower) So this makes the IS curve flatter: A fall in r raises I more, which raises Y more. CHAPTER 10 Aggregate Demand I slide 24 Building the LM Curve: The Theory of Liquidity Preference Developed by John Maynard Keynes. A simple theory in which the interest rate is determined by money supply and money demand. CHAPTER 10 Aggregate Demand I slide 25 Money Supply The supply of real money balances is fixed: M r interest rate M P s P M P s M P CHAPTER 10 Aggregate Demand I M/P real money balances slide 26 Money Demand r Demand for real money balances: M P d interest rate M P s L (r ) L (r ) M P CHAPTER 10 Aggregate Demand I M/P real money balances slide 27 Equilibrium The interest rate adjusts to equate the supply and demand for money: M P L (r ) r interest rate M P r1 L (r ) M P CHAPTER 10 s Aggregate Demand I M/P real money balances slide 28 How can CB affect the interest rate r interest rate To increase r, CB reduces M r2 r1 L (r ) M2 P CHAPTER 10 Aggregate Demand I M1 P M/P real money balances slide 29 The LM curve Now let’s put Y back into the money demand function: d M P L (r ,Y ) The LM curve is a graph of all combinations of r and Y that equate the supply and demand for real money balances. The equation for the LM curve is: M P L (r ,Y ) CHAPTER 10 Aggregate Demand I slide 30 Deriving the LM curve (a) The market for r real money balances (b) The LM curve r LM r2 r2 L (r , Y2 ) r1 r1 L (r , Y1 ) M1 P CHAPTER 10 M/P Aggregate Demand I Y1 Y2 Y slide 31 Understanding the LM curve’s slope The LM curve is positively sloped. Intuition: An increase in income raises money demand. Since the supply of real balances is fixed, there is now excess demand in the money market at the initial interest rate. The interest rate must rise to restore equilibrium in the money market. CHAPTER 10 Aggregate Demand I slide 32 How M shifts the LM curve (a) The market for r real money balances (b) The LM curve r LM2 LM1 r2 r2 r1 r1 L ( r , Y1 ) M2 P CHAPTER 10 M1 P M/P Aggregate Demand I Y1 Y slide 33 The short-run equilibrium The short-run equilibrium is the combination of r and Y that simultaneously satisfies the equilibrium conditions in the goods & money markets: r Y C (Y T ) I (r ) G LM IS Y M P L (r ,Y ) Equilibrium interest rate CHAPTER 10 Aggregate Demand I Equilibrium level of income slide 34 The Big Picture (preview) Keynesian Cross Theory of Liquidity Preference IS curve LM curve IS-LM model Agg. demand curve Agg. supply curve CHAPTER 10 Aggregate Demand I Explanation of short-run fluctuations Model of Agg. Demand and Agg. Supply slide 35 Chapter summary 1. Keynesian Cross basic model of income determination takes fiscal policy & investment as exogenous fiscal policy has a multiplied impact on income. 2. IS curve comes from Keynesian Cross when planned investment depends negatively on interest rate shows all combinations of r and Y that equate planned expenditure with actual expenditure on goods & services CHAPTER 10 Aggregate Demand I slide 36 Chapter summary 3. Theory of Liquidity Preference basic model of interest rate determination takes money supply & price level as exogenous an increase in the money supply lowers the interest rate 4. LM curve comes from Liquidity Preference Theory when money demand depends positively on income shows all combinations of r andY that equate demand for real money balances with supply CHAPTER 10 Aggregate Demand I slide 37 Chapter summary 5. IS-LM model Intersection of IS and LM curves shows the unique point (Y, r ) that satisfies equilibrium in both the goods and money markets. CHAPTER 10 Aggregate Demand I slide 38