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Context for Studying Chapter 11 Chapter 9 introduced the model of aggregate demand and supply. Chapter 10 developed the IS-LM model, the basis of the aggregate demand curve. CHAPTER 11 Aggregate Demand II slide 0 In Chapter 11, you will learn… how to use the IS-LM model to analyze the effects of shocks, fiscal policy, and monetary policy how to derive the aggregate demand curve from the IS-LM model several theories about what caused 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. r LM Y C (Y T ) I (r ) G The LM curve represents money market equilibrium. r1 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 IS Y slide 2 Policy analysis with the IS -LM model Y C (Y T ) I (r ) G r LM M P L (r ,Y ) We can use the IS-LM model to analyze the effects of r1 • fiscal policy: G and/or T • monetary policy: M CHAPTER 11 Aggregate Demand II IS Y1 Y slide 3 An increase in government purchases 1. IS curve shifts right 1 by G 1 MPC causing output & income to rise. 2. This raises money demand, causing the interest rate to rise… r 2. r2 r1 3. …which reduces investment, so the final increase in Y 1 is smaller than G 1 MPC CHAPTER 11 LM Aggregate Demand II IS2 1. IS1 Y1 Y2 Y 3. slide 4 A tax cut 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 the IS curve shifts by 1. LM 1. MPC T 1 MPC 2. …so the effects on r and Y are smaller for T than for an equal G. CHAPTER 11 Aggregate Demand II 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 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 7 The B of C’s response to G > 0 Suppose Parliament increases G. Possible B of C 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 8 Response 1: Hold M constant If govt raises G, the IS curve shifts right. r If B of C holds M constant, then LM curve doesn’t shift. r2 r1 LM1 IS2 IS1 Results: Y Y 2 Y1 r r2 r1 CHAPTER 11 Aggregate Demand II Y1 Y2 Y slide 9 Response 2: Hold r constant If Congress raises G, the IS curve shifts right. r To keep r constant, B of C 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 10 Response 3: Hold Y constant If govt raises G, the IS curve shifts right. To keep Y constant, B of C 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 11 Estimates of fiscal policy multipliers from the DRI macroeconometric model Assumption about monetary policy Estimated value of Y / G Estimated value of Y / T B of C holds money supply constant 0.60 0.26 B of C holds nominal interest rate constant 1.93 1.19 CHAPTER 11 Aggregate Demand II slide 12 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 13 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 14 EXERCISE: 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 more frequently in transactions. 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 slide 15 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 LM 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 16 Deriving the AD curve r Intuition for slope of AD curve: P (M/P ) LM shifts left r I Y LM(P2) LM(P1) r2 r1 IS P Y2 Y P2 P1 AD Y2 CHAPTER 11 Y1 Aggregate Demand II Y1 Y slide 17 Monetary policy and the AD curve The B of C 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 18 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 19 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 CHAPTER 11 then over time, the price level will Y Y rise Y Y fall Y Y remain constant Aggregate Demand II slide 20 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 21 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 22 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, Y P P1 SRAS1 Y Aggregate Demand II Y LRAS which causes LM to move down. CHAPTER 11 IS1 AD1 AD2 Y slide 23 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, Y P Y LRAS P1 SRAS1 P2 SRAS2 which causes LM to move down. Y CHAPTER 11 IS1 Aggregate Demand II AD1 AD2 Y slide 24 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 25