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IS-LM and Aggregate Demand
Learning Objectives
• Learn how to use the IS and LM curves to
graphically derive the aggregate demand curve.
• Understand how changes in fiscal policy and
monetary policy shift the aggregate demand
curve.
• Understand the monetary policy transmission
mechanism.
• Understand the fiscal policy transmission
mechanism.
IS/LM: Equilibrium
i
LM
A
C
B
IS
0
Y*
Y
Equilibrium in the IS/LM model
occurs at the intersection of the
IS curve and the LM curve.
At every point on the IS curve,
the capital market is in
equilibrium.
At every point on the LM curve,
the money market is in
equilibrium.
Only at the intersection are both
markets simultaneously in
equilibrium.
Equilibrium may or may not
occur at full employment Y*.
Aggregate Demand
• Aggregate demand is a relationship between
aggregate output and the price level.
– As the price level rises, national output falls.
– As the price level falls, national output rises.
Aggregate Demand: Graphical
Derivation
• In the IS/LM model, the price level helps to
determine real money demand.
– Increases in the price level decrease real money
balances and increase money demand, shifting the
MD right and the LM curve to the left.
– Decreases in the price level, increase real money
balances and decrease money demand, shifting
MD left and the LM curve to the right.
• We use this relationship to derive aggregate
demand.
Aggregate Demand: Derivation
r
LM(P1)
LM(P2)
E1
E2
IS
0
P
P1
P2
Let the price level fall to P2. At the lower
price level, real money balances are higher.
The LM curve shifts right to LM2.
The new equilibrium occurs at the point E2.
The price level is P2 and output is Y2.
E1
0
When points E1 and E2 are plotted in the P-Y
space, they represent two points on an
aggregate demand curve.
E2
AD
0
Y
At point E1, equilibrium exists in the real goods
market and the money market. The
price level is P1 and output is Y1.
Y 1 Y2
Y
Aggregate Demand Shift
r
r2
r1
LM(P1)
Expansionary Monetary Policy
LM(P1)
E1
E2
An increase in the nominal money supply,
when there is no change in the price level,
increases real money balances and shifts
the LM curve to the right.
IS
0
P
P1
Y
E1
E2
The change in policy is not initiated by a
change in the price level so aggregate
demand shifts right.
AD1
0
As interest rates fall, investment spending
increases, causing Y to rise.
Y1 Y2
AD2
Y
Aggregate Demand Shift
r
r2
r1
E2
E1
IS1
0
P
P1
IS2
Y
E1
An increase in government spending or a
decrease in taxes, when there is no change
in the price level, shifts the IS curve to the
right.
The increase in aggregate spending causes
interest rates and output to rise.
E2
The change in government policy is
not initiated by a change in the price level
so aggregate demand shifts right.
AD1
0
Expansionary Fiscal Policy
LM
Y1 Y2
AD2
Y
The Short Run and the Long Run
LRAS
r
P
LM(P2)
LM(P1)
r1
S
P2
P1
r2
S
L
L
IS
0
Y
Y*
Y
0
Y*
AD
Y
Short Run and Long Run:
• The difference between the short-run
approach and the long-run approach is the
assumptions made about P and Y.
– In the short-run we assume that prices are
sticky; ie., they do not adjust quickly to changes
in the economy.
• This means that r and Y must adjust to bring the
model back to equilibrium.
Short Run and Long Run:
– Short-run assumptions are reflected in point
S.
• Prices do not adjust so Y can be less than full
employment Y, even while there is equilibrium
in both markets.
• The policy implication is that government
intervention is required to reach full
employment.
Short Run and Long Run:
• The difference between the short-run
approach and the long-run approach is the
assumptions made about P and Y.
– In the long-run we assume that prices are
flexible; ie., they adjust quickly to changes in
the economy.
• This means that P must adjust to bring the model
back to equilibrium.
Short Run and Long Run:
– Long-run assumptions are reflected in
point L.
• Prices change so the economy self-adjusts
back to full employment Y.
• The policy implication is that no government
intervention is required to reach full
employment.
Summary
• The IS/LM model provides a general theory of
aggregate demand.
• The IS curve represents the negative
relationship between interest rates and income
in the capital market.
• The LM curve represents the positive
relationship between interest rates and income
in the money market.
Summary
• Changes in fiscal policy shift the IS curve
and the aggregate demand curve.
– Expansionary fiscal policy shifts the IS and AD
curves to the right.
• Ceteris paribus, income and interest rates rise.
• Changes in the price level depend on the slope of the
aggregate supply curve.
Summary
• Changes in fiscal policy shift the IS curve
and the aggregate demand curve.
– Contractionary fiscal policy shifts the IS and
AD curves to the left.
• Ceteris paribus, income and interest rates fall.
• Changes in the price level depend on the slope of the
aggregate supply curve.
Summary
• Changes in monetary policy shift the LM
curve and the aggregate demand curve.
– Expansionary monetary policy shifts the LM
and AD curves to the right.
• Ceteris paribus, interest rates fall and Y rises.
• Changes in the price level depend on the slope of the
aggregate supply curve.
Summary
• Changes in monetary policy shift the LM
curve and the aggregate demand curve.
– Contractionary monetary policy shifts the LM
and the AD curves to the left.
• Ceteris paribus, interest rates rise and Y falls.
• Changes in the price level depend on the slope of the
aggregate supply curve.