Lecture_8_chap09_10_11

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9. ISLM model
CHAPTER 9
Introduction to Economic Fluctuations
slide 0
In this lecture, you will learn…
 an introduction to business cycle and aggregate
demand
 the IS curve, and its relation to
 the Keynesian cross
 the loanable funds model
 the LM curve, and its relation to
 the theory of liquidity preference
 how the IS-LM model determines income and
the interest rate in the short run when P is fixed
CHAPTER 9
Introduction to Economic Fluctuations
slide 1
Short run
 In the following lectures, we will study the shortrun fluctuations of the economy (business
cycles)
 We focus on three models:
 ISLM model (lecture 9)
 Mudell-Fleming model (lecture 10)
 Model AS-AD
 AD (lectures 9 and 10)
 AS (lecture 11)
CHAPTER 9
Introduction to Economic Fluctuations
slide 2
Facts about the business cycle
 GDP growth averages 3–3.5 percent per year over
the long run with large fluctuations in the short run.
 Consumption and investment fluctuate with GDP,
but consumption tends to be less volatile and
investment more volatile than GDP.
 Unemployment rises during recessions and falls
during expansions.
 Okun’s Law: the negative relationship between
GDP and unemployment.
CHAPTER 9
Introduction to Economic Fluctuations
slide 3
Growth rates of real GDP, consumption
Percent 10
change
from 4 8
quarters
earlier 6
Real GDP
growth rate
Consumption
growth rate
Average 4
growth
rate 2
0
-2
-4
1975 1980
1985 Fluctuations
1990 1995
CHAPTER1970
9 Introduction
to Economic
2000
2005
slide 4
Growth rates of real GDP, consumption, investment
Percent 40
change
from 4 30
quarters
earlier 20
10
Investment
growth rate
Real GDP
growth rate
0
-10
Consumption
growth rate
-20
-30
1975 1980
1985 Fluctuations
1990 1995
CHAPTER1970
9 Introduction
to Economic
2000
2005
slide 5
Unemployment
Percent 12
of labor
force
10
8
6
4
2
0
1975 1980
1985 Fluctuations
1990 1995
CHAPTER1970
9 Introduction
to Economic
2000
2005
slide 6
Okun’s Law
Percentage 10
change in
real GDP 8
1951
Y
 3.5  2 u
Y
1966
1984
6
2003
4
1987
2
0
1975
2001
-2
1991 1982
-4
-3
CHAPTER 9
-2
-1
0
1
2
3
4
in unemploymentslide
rate7
Introduction to EconomicChange
Fluctuations
Time horizons in macroeconomics
 Long run:
Prices are flexible, respond to changes in supply
or demand.
 Short run:
Many prices are “sticky” at some predetermined
level.
The economy behaves much
differently when prices are sticky.
CHAPTER 9
Introduction to Economic Fluctuations
slide 8
Recap of classical macro theory
(Chaps. 3-8)
 Output is determined by the supply side:
 supplies of capital, labor
 technology.
 Changes in demand for goods & services
(C, I, G ) only affect prices, not quantities.
 Assumes complete price flexibility.
 Applies to the long run.
CHAPTER 9
Introduction to Economic Fluctuations
slide 9
When prices are sticky…
…output and employment also depend on
demand, which is affected by
 fiscal policy (G and T )
 monetary policy (M )
 other factors, like exogenous changes in
C or I.
CHAPTER 9
Introduction to Economic Fluctuations
slide 10
The model of
aggregate demand and supply
 the paradigm most mainstream economists
and policymakers use to think about economic
fluctuations and policies to stabilize the economy
 shows how the price level and aggregate output
are determined
 shows how the economy’s behavior is different
in the short run and long run
CHAPTER 9
Introduction to Economic Fluctuations
slide 11
IS-LM
 This chapter develops the IS-LM model,
the basis of the aggregate demand curve.
 We focus on the short run and assume the price
level is fixed.
 This lecture focuses on the closed-economy
case.
 Next lecture presents the open-economy case.
CHAPTER 9
Introduction to Economic Fluctuations
slide 12
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 9
Introduction to Economic Fluctuations
slide 13
Elements of the Keynesian Cross
consumption function:
C  C (Y T )
govt policy variables:
G  G , T T
for now, planned
investment is exogenous:
planned expenditure:
I I
E  C (Y  T )  I  G
equilibrium condition:
actual expenditure = planned expenditure
Y  E
CHAPTER 9
Introduction to Economic Fluctuations
slide 14
Graphing planned expenditure
E
planned
expenditure
E =C +I +G
MPC
1
income, output, Y
CHAPTER 9
Introduction to Economic Fluctuations
slide 15
Graphing the equilibrium condition
E
E =Y
planned
expenditure
45º
income, output, Y
CHAPTER 9
Introduction to Economic Fluctuations
slide 16
The equilibrium value of income
E
E =Y
planned
expenditure
E =C +I +G
income, output, Y
Equilibrium
income
CHAPTER 9
Introduction to Economic Fluctuations
slide 17
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 9
Y
E1 = Y1
Y
E2 = Y 2
Introduction to Economic Fluctuations
slide 18
Solving for Y
Y  C  I  G
equilibrium condition
Y  C  I  G
in changes

C
 G
 MPC  Y  G
Collect terms with Y
on the left side of the
equals sign:
(1  MPC)  Y  G
CHAPTER 9
because I exogenous
because C = MPC Y
Solve for Y :


1
Y  
  G
 1  MPC 
Introduction to Economic Fluctuations
slide 19
The government purchases multiplier
Definition: the increase in income resulting from a
$1 increase in G.
In this model, the govt
purchases multiplier equals
Y
1

G
1  MPC
Example: If MPC = 0.8, then
Y
1

 5
G
1  0.8
CHAPTER 9
An increase in G
causes income to
increase 5 times
as much!
Introduction to Economic Fluctuations
slide 20
Why the multiplier is greater than 1
 Initially, the increase in G causes an equal increase
in Y:
Y = G.
 But Y  C
 further Y
 further C
 further Y
 So the final impact on income is much bigger than
the initial G.
CHAPTER 9
Introduction to Economic Fluctuations
slide 21
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 9
Y
E2 = Y2
Y
E1 = Y1
Introduction to Economic Fluctuations
slide 22
Solving for Y
eq’m condition in
changes
Y  C  I  G
I and G exogenous
 C
 MPC   Y  T
Solving for Y :
Final result:
CHAPTER 9

(1  MPC)  Y   MPC  T
  MPC 
Y  
  T
 1  MPC 
Introduction to Economic Fluctuations
slide 23
The tax multiplier
def: the change in income resulting from
a $1 increase in T :
Y
T
 MPC

1  MPC
If MPC = 0.8, then the tax multiplier equals
Y
T
CHAPTER 9
 0.8
 0.8


 4
1  0.8
0.2
Introduction to Economic Fluctuations
slide 24
The tax multiplier
…is negative:
A tax increase reduces C,
which reduces income.
…is greater than one
(in absolute value):
A change in taxes has a
multiplier effect on income.
…is smaller than the govt spending multiplier:
Consumers save the fraction (1 – MPC) of a tax cut,
so the initial boost in spending from a tax cut is
smaller than from an equal increase in G.
CHAPTER 9
Introduction to Economic Fluctuations
slide 25
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 9
Introduction to Economic Fluctuations
slide 26
Deriving the IS curve
E =Y E =C +I (r )+G
2
E
r
E =C +I (r1 )+G
 I
 E
 Y
I
r
Y1
Y
Y2
r1
r2
IS
Y1
CHAPTER 9
Y2
Introduction to Economic Fluctuations
Y
slide 27
Why the IS curve is negatively
sloped
 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 9
Introduction to Economic Fluctuations
slide 28
The IS curve and the loanable funds
model
(a) The L.F. model
r
S2
(b) The IS curve
r
S1
r2
r2
r1
r1
I (r )
S, I
CHAPTER 9
IS
Y2
Introduction to Economic Fluctuations
Y1
Y
slide 29
Fiscal Policy and the IS curve
 We can use the IS-LM model to see
how fiscal policy (G and T ) affects
aggregate demand and output.
 Let’s start by using the Keynesian cross
to see how fiscal policy shifts the IS curve…
CHAPTER 9
Introduction to Economic Fluctuations
slide 30
Shifting the IS curve: G
At any value of r,
G  E  Y
E =Y E =C +I (r )+G
1
2
E
E =C +I (r1 )+G1
…so the IS curve
shifts to the right.
The horizontal
distance of the
IS shift equals
r
Y1
r1
Y
1
Y 
G
1 MPC
Y1
CHAPTER 9
Y
Y2
IS1
Y2
IS2
Y
Introduction to Economic Fluctuations
slide 31
The Theory of Liquidity Preference
 Due to John Maynard Keynes.
 A simple theory in which the interest rate
is determined by money supply and
money demand.
CHAPTER 9
Introduction to Economic Fluctuations
slide 32
Money supply
r
The supply of
real money
balances
is fixed:
M
interest
rate
M
P
s
P M P
s
M P
CHAPTER 9
Introduction to Economic Fluctuations
M/P
real money
balances
slide 33
Money demand
r
Demand for
real money
balances:
M
P
d
interest
rate
M
P
s
 L (r )
L (r )
M P
CHAPTER 9
Introduction to Economic Fluctuations
M/P
real money
balances
slide 34
Equilibrium
The interest
rate adjusts
to equate the
supply and
demand for
money:
r
interest
rate
M
P
r1
L (r )
M P  L (r )
M P
CHAPTER 9
s
Introduction to Economic Fluctuations
M/P
real money
balances
slide 35
How the Fed raises the interest rate
r
To increase r,
Fed reduces M
interest
rate
r2
r1
L (r )
M2
P
CHAPTER 9
M1
P
Introduction to Economic Fluctuations
M/P
real money
balances
slide 36
CASE STUDY:
Monetary Tightening & Interest Rates
 Late 1970s:  > 10%
 Oct 1979: Fed Chairman Paul Volcker
announces that monetary policy
would aim to reduce inflation
 Aug 1979-April 1980:
Fed reduces M/P 8.0%
 Jan 1983:  = 3.7%
How do you think this policy change
would affect nominal interest rates?
CHAPTER 9
Introduction to Economic Fluctuations
slide 37
Monetary Tightening & Rates, cont.
The effects of a monetary tightening
on nominal interest rates
model
short run
long run
Liquidity preference
Quantity theory,
Fisher effect
(Keynesian)
(Classical)
prices
sticky
flexible
prediction
i > 0
i < 0
actual
outcome
8/1979: i = 10.4%
8/1979: i = 10.4%
4/1980: i = 15.8%
1/1983: i = 8.2%
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 9
Introduction to Economic Fluctuations
slide 39
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 9
M/P
Y1
Introduction to Economic Fluctuations
Y2
Y
slide 40
Why the LM curve is upward sloping
 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 9
Introduction to Economic Fluctuations
slide 41
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 9
M1
P
M/P
Y1
Introduction to Economic Fluctuations
Y
slide 42
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 9
IS
Y1
Introduction to Economic Fluctuations
Y
slide 44
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 9
LM
IS2
1.
IS1
Y1 Y2
Y
3.
Introduction to Economic Fluctuations
slide 45
A tax cut
Consumers save
r
(1MPC) 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 9
IS2
IS1
Y1 Y2
Y
2.
Introduction to Economic Fluctuations
slide 46
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
3. …which increases
investment, causing
output & income to
rise.
CHAPTER 9
r
LM1
LM2
r1
r2
IS
Y1 Y2
Introduction to Economic Fluctuations
Y
slide 47
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 9
Introduction to Economic Fluctuations
slide 48
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 9
Introduction to Economic Fluctuations
slide 49
Response 1: Hold M constant
If Congress raises G,
the IS curve shifts right.
r
If Fed holds M constant,
then LM curve doesn’t
shift.
r2
r1
LM1
IS2
IS1
Results:
Y  Y 2  Y1
r  r2  r1
CHAPTER 9
Y1 Y2
Introduction to Economic Fluctuations
Y
slide 50
Response 2: Hold r constant
If Congress raises G,
the IS curve shifts right.
To keep r constant,
Fed increases M
to shift LM curve right.
r
LM1
r2
r1
IS2
IS1
Results:
Y  Y 3  Y1
LM2
Y1 Y2 Y3
Y
r  0
CHAPTER 9
Introduction to Economic Fluctuations
slide 51
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 9
Introduction to Economic Fluctuations
slide 52
Estimates of fiscal policy multipliers
from the DRI macroeconometric model
Assumption about
monetary policy
Estimated
value of
Y / G
Estimated
value of
Y / T
Fed holds money
supply constant
0.60
0.26
Fed holds nominal
interest rate constant
1.93
1.19
CHAPTER 9
Introduction to Economic Fluctuations
slide 53
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 9
Introduction to Economic Fluctuations
slide 54
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 9
Y1
Y1
Introduction to Economic Fluctuations
Y
slide 55
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 9
Y2
Y2
Introduction to Economic Fluctuations
Y
AD2
AD1
Y
slide 56
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 9
Y2
Introduction to Economic Fluctuations
AD2
AD1
Y
slide 57
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 9
then over time, the
price level will
Y Y
rise
Y Y
fall
Y Y
remain constant
Introduction to Economic Fluctuations
slide 58
The Big Picture
Keynesian
Cross
Theory of
Liquidity
Preference
IS
curve
LM
curve
IS-LM
model
Agg.
demand
curve
Agg.
supply
curve
CHAPTER 9
Explanation
of short-run
fluctuations
Model of
Agg.
Demand
and Agg.
Supply
Introduction to Economic Fluctuations
slide 59
Chapter Summary
1. Keynesian cross
 basic model of income determination
 takes fiscal policy & investment as exogenous
 fiscal policy has a multiplier effect 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 60
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 and Y that equate
demand for real money balances with supply
CHAPTER 10
Aggregate Demand I
slide 61
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 62
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 63
APPENDIX: The Great Depression
CHAPTER 9
Introduction to Economic Fluctuations
slide 64
The Great Depression
30
Unemployment
(right scale)
220
25
200
20
180
15
160
10
Real GNP
(left scale)
140
120
1929
CHAPTER 9
5
percent of labor force
billions of 1958 dollars
240
0
1931
1933
1935
1937
Introduction to Economic Fluctuations
1939
slide 65
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 9
Introduction to Economic Fluctuations
slide 66
THE SPENDING HYPOTHESIS:
Reasons for the IS shift
 Stock market crash  exogenous C
 Oct-Dec 1929: S&P 500 fell 17%
 Oct 1929-Dec 1933: S&P 500 fell 71%
 Drop in investment
 “correction” after overbuilding in the 1920s
 widespread bank failures made it harder to obtain
financing for investment
 Contractionary fiscal policy
 Politicians raised tax rates and cut spending to
combat increasing deficits.
CHAPTER 9
Introduction to Economic Fluctuations
slide 67
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:
 P fell even more, so M/P actually rose slightly
during 1929-31.
 nominal interest rates fell, which is the opposite
of what a leftward LM shift would cause.
CHAPTER 9
Introduction to Economic Fluctuations
slide 68
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 9
Introduction to Economic Fluctuations
slide 69
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 9
Introduction to Economic Fluctuations
slide 70
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 9
Introduction to Economic Fluctuations
slide 71
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 9
Introduction to Economic Fluctuations
slide 72