Chapter 11: Aggregate Demand II, Applying the IS-LM Model Th LM t

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1 Equilibium in the - model The cuve epesents equilibium in the goods maket. Chapte :, Applying the - Model Th t C ( T) I( ) G The cuve epesents money maket equilibium. M L(, ) The intesection detemines the unique combination of and that satisfies equilibium in both makets. olicy analysis with the - model An incease in govenment puchases C ( T) I( ) G M L(, ) We can use the - model to analyze the effects of fiscal policy: G and/o T monetay policy: M. cuve shifts ight by MC G causing output & income to ise... This aises money demand, causing the inteest ate to ise. which educes investment, so the final incease in is smalle than MC G.. A tax cut Monetay policy: An incease in M Consumes save ( MC) of the tax cut, so the initial boost in spending is smalle fo T than fo an equal G and dthe cuve shifts by MC. MC T. so the effects on and ae smalle fo T than fo an equal G..... M > shifts the cuve down (o to the ight). causing the inteest ate to fall. which inceases investment, causing output & income to ise.

2 Inteaction between monetay & fiscal policy Model: Monetay & fiscal policy vaiables (M, G, and T) ae exogenous. Real wold: Monetay policymakes may adjust M in esponse to changes in fiscal policy, o vice vesa. Such inteaction may alte the impact of the oiginal policy change. The Fed s esponse to G > Suppose Congess inceases G. ossible Fed esponses:. hold M constant. hold constant. hold constant In each case, the effects of the G ae diffeent Response : Hold M constant Response : Hold constant If Congess aises G, the cuve shifts ight. If Congess aises G, the cuve shifts ight. If Fed holds M constant, then cuve doesn t shift. To keep constant, Fed inceases M to shift cuve ight. Results: Results: 8 9 Response : Hold constant If Congess aises G, the cuve shifts ight. To keep constant, Fed educes M to shift cuve left. Results: Estimates of fiscal policy multiplies fom the DRI macoeconometic model Assumption about monetay policy Fed holds money supply constant Fed holds nominal inteest ate constant Estimated value of / G..9 Estimated value of / T..9

3 Shocks in the - model shocks: exogenous changes in the demand fo goods & sevices. Examples: stock maket boom o cash change in households wealth C change in business o consume confidence o expectations I and/o C Shocks in the - model shocks: exogenous changes in the demand fo money. Examples: a wave of cedit cad faud inceases demand fo money. moe ATMs o the Intenet educe money demand. NOW OU TR: Analyze shocks with the - Model Use the - model to analyze the effects of. a boom in the stock maket that makes consumes wealthie.. afte a wave of cedit cad faud, consumes using cash moe fequently in tansactions. ti Fo each shock, a. use the - diagam to show the effects of the shock on and. b. detemine what happens to C, I, and the unemployment ate. CASE STUD: The U.S. ecession of Duing,. million jobs lost, unemployment ose fom.9% to.8%. GD gowth slowed to.8% (compaed to.9% aveage annual gowth duing 99-). CASE STUD: The U.S. ecession of Causes: ) Stock maket decline C ) Index (9 = 9 Standad & oo s CASE STUD: The U.S. ecession of Causes: ) 9/ inceased uncetainty fall in consume & business confidence esult: lowe spending, cuve shifted left Causes: ) Copoate accounting scandals Enon, WoldCom, etc. educed stock pices, discouaged investment

4 CASE STUD: The U.S. ecession of Fiscal policy esponse: shifted cuve ight tax cuts in and spending inceases ailine industy bailout NC econstuction Afghanistan wa CASE STUD: The U.S. ecession of Monetay policy esponse: shifted cuve ight Thee-month T-Bill Rate 8 9 What is the Fed s policy instument? What is the Fed s policy instument? The news media commonly epot the Fed s policy changes as inteest ate changes, as if the Fed has diect contol ove maket inteest ates. In fact, the Fed tagets the fedeal funds ate the inteest t ate banks chage one anothe on ovenight loans. The Fed changes the money supply and shifts the cuve to achieve its taget. Othe shot-tem ates typically move with the fedeal funds ate. Why does the Fed taget inteest ates instead of the money supply? ) They ae easie to measue than the money supply. ) The Fed might believe that shocks ae moe pevalent than shocks. If so, then tageting the inteest ate stabilizes income bette than tageting the money supply. (See end-of-chapte oblem on p..) - and aggegate demand Deiving the AD cuve So fa, we ve been using the - model to analyze the shot un, when the pice level is assumed fixed. Howeve, a change in would shift and theefoe affect. The aggegate demand cuve (intoduced in Chap. 9) captues this elationship between and. Intuition fo slope of AD cuve: (M/) shifts left I ( ) ( ) AD

5 Monetay policy and the AD cuve Fiscal policy and the AD cuve The Fed can incease aggegate demand: M shifts ight I at each value of (M / ) (M / ) Expansionay fiscal policy ( G and/o T) inceases agg. demand: T C shifts ight at each value of AD AD - and AD-AS in the shot un & long un Recall fom Chapte 9: The foce that moves the economy fom the shot un to the long un is the gadual adjustment of pices. The SR and LR effects of an shock A negative shock shifts and AD left, causing to fall. ( ) In the shot-un un equilibium, if then ove time, the pice level will ise fall emain constant SRAS AD The SR and LR effects of an shock The SR and LR effects of an shock ( ) ( ) In the new shot-un equilibium, In the new shot-un equilibium, SRAS AD 8 Ove time, gadually falls, causing SRAS to move down M/ to incease, which causes to move down SRAS AD 9

6 The SR and LR effects of an shock The SR and LR effects of an shock ( ) ( ) ( ) ( ) Ove time, gadually falls, causing SRAS to move down M/ to incease, which causes to move down SRAS SRAS AD This pocess continues until economy eaches a long-un equilibium with SRAS SRAS AD NOW OU TR: Analyze SR & LR effects of M a. Daw the - and AD-AS diagams as shown hee. b. Suppose Fed inceases M. Show the shot-un effects on you gaphs. c. Show what happens in the tansition fom the shot un to the long un. d. How do the new long-un equilibium values of the endogenous vaiables compae to thei initial values? (M / ) SRAS AD The Geat Depession billions of 9 98 dollas 8 Unemployment (ight scale) Real GN (left scale) pecent of la abo foce THE SENDING HOTHES: Shocks to the cuve THE SENDING HOTHES: Reasons fo the shift assets that the Depession was lagely due to an exogenous fall in the demand fo goods & sevices a leftwad shift of the cuve. Stock maket cash exogenous C Oct-Dec 99: S& fell % Oct 99-Dec 9: S& fell % evidence: output and inteest ates both fell, which is what a leftwad shift would cause. Dop in investment coection afte ovebuilding in the 9s widespead bank failues made it hade to obtain financing fo investment Contactionay fiscal policy oliticians aised tax ates and cut spending to combat inceasing deficits.

7 THE MONE HOTHES: A shock to the cuve assets that the Depession was lagely due to huge fall in the money supply. evidence: M fell % duing 99-. But, two poblems with this hypothesis: fell even moe, so M/ actually ose slightly duing 99-. nominal inteest ates fell, which is the opposite of what a leftwad shift would cause. THE MONE HOTHES AGAIN: The effects of falling pices assets that the seveity of the Depession was due to a huge deflation: fell % duing 99-. This deflation was pobably caused by the fall in M, so pehaps money played an impotant ole afte all. In what ways does a deflation affect the economy? THE MONE HOTHES AGAIN: The effects of falling pices The stabilizing effects of deflation: (M/) shifts ight igou effect: (M/) consumes wealth C shifts ight THE MONE HOTHES AGAIN: The effects of falling pices The destabilizing effects of expected deflation: E fo each value of i I because I = I( ) planned expenditue & agg. demand income & output 8 9 THE MONE HOTHES AGAIN: The effects of falling pices The destabilizing effects of unexpected deflation: debt-deflation theoy (if unexpected) tansfes puchasing powe fom boowes to lendes boowes spend less, lendes spend moe if boowes popensity to spend is lage than lendes, then aggegate spending falls, the cuve shifts left, and falls Why anothe Depession is unlikely olicymakes (o thei advisos) now know much moe about macoeconomics: The Fed knows bette than to let M fall so much, especially duing a contaction. Fiscal policymakes know bette than to aise taxes o cut spending duing a contaction. Fedeal deposit insuance makes widespead bank failues vey unlikely. Automatic stabilizes make fiscal policy expansionay duing an economic downtun.

8 CASE STUD The 8-9 Financial Cisis & Recession 9: Real GD fell, u-ate appoached % Impotant factos in the cisis: ealy s Fedeal Reseve inteest ate policy sub-pime motgage cisis busting of house pice bubble, ising foeclosue ates falling stock pices failing financial institutions declining consume confidence, dop in spending on consume duables and investment goods ate (%) inteest a Inteest ates and house pices 9 8 Fedeal Funds ate -yea motgage ate Case-Shille -city composite house pice index 9 9 x, = House pice index Change in U.S. house pice index and ate of new foeclosues, house pices s ealie) ecent change in h (fom quates % % % 8% % % % % -% -% US house pice index New foeclosues -% e stats tgages) New foeclosu (% of total mot House pice change and new foeclosues, :Q 9Q closues, otgages New foec % of all mo % 8% Nevada Floida Illinois % Michigan Ohio % Califonia Geogia % % Aizona Coloado 8% Rhode Island New Jesey Texas % Hawaii S. Dakota % Oegon Wyoming % Alaska N. Dakota % -% -% -% -% % % % Cumulative change in house pice index U.S. bank failues by yea, -9 Numbe of bank failues Majo U.S. stock indexes (% change fom weeks ealie) % % % 8% % % % % -% -% -% DJIA S& NASDAQ 8 9* * as of July, 9. -8% //999 8// // /8/ 9// // // 9// // // // /8/ //8 //8 //9 8

9 uates ealie % change fom fou qu Consume sentiment and gowth in consume duables and investment spending % % % % % -% -% -% Duables -% Investment UM Consume Sentiment Index -% ndex, 9= Consume Sentiment In quates ealie % change fom q Real GD gowth and Unemployment % Real GD gowth ate (left scale) 8% Unemployment ate (ight scale) % % % % -% -% foce % of labo. - model Chapte Summay a theoy of aggegate demand exogenous: M, G, T, exogenous in shot un, in long un endogenous:, endogenous in shot un, in long un cuve: goods maket equilibium cuve: money maket equilibium. AD cuve Chapte Summay shows elation between and the - model s equilibium. negative slope because (M/ ) I (M/ ) I expansionay fiscal policy shifts cuve ight, aises income, and shifts AD cuve ight. expansionay monetay policy shifts cuve ight, aises income, and shifts AD cuve ight. o shocks shift the AD cuve. 9