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

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Chapter 11:

Aggregate Demand II,

Applying the IS-LM Model

0

CHAPTER 11 Aggregate Demand II

Applying the IS-LM Model

Th LM t

Equilibrium in the

IS

-

LM

model

The IScurve represents equilibrium in the goods market. ( ) ( ) Y C Y T I r G r LM r1 1

The intersection determines the unique combination of Yand r that satisfies equilibrium in both markets. The LMcurve represents

money market equilibrium.

( , )

M P L r Y IS

Y r1

Y1

Policy analysis with the

IS

-

LM

model

We can use the IS-LM

model to analyze the

( ) ( ) Y C Y T I r G ( , ) M P L r Y r LM r1 2

model to analyze the effects of

•fiscal policy: Gand/or T •monetary policy: M

IS Y r1

Y1

causing output & income to rise.

An increase in government purchases

1. IS curve shifts right _r

LM r1 1 by 1 MPC G r2 2 Thi i 2. 3

IS1 Y r1 Y1 IS2 Y2 1. 2. This raises money

demand, causing the interest rate to rise… 3. …which reduces investment,

so the final increase in Y 1 is smaller than 1 MPC G 3.

A tax cut

r LM r1 r2 Consumers save (1MPC) of the tax cut, so the initial boost in spending is smaller for T than for an equal G…

d th IS hift b 2. IS1 1. Y r1 Y1 IS2 Y2

and the IScurve shifts by

MPC 1 MPC T  _  1. 2. …so the effects on r

and Yare smaller for T than for an equal G. 2.

2. …causing the

Monetary policy: An increase in

M

1. M> 0 shifts

the LMcurve down (or to the right)

r _LM

1

r1

LM2

interest rate to fall

IS Y Y1 Y2 r2 3. …which increases investment, causing output & income to rise.

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Interaction between

monetary & fiscal policy



Model:

Monetary & fiscal policy variables (M, G,and T) are exogenous.



Real world:

6

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.

The Fed’s response to



G

> 0



Suppose Congress increases G.



Possible Fed responses:

1. hold M constant 2. holdr constant

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2. hold r constant 3. hold Y constant



In each case, the effects of the G

are different…

If Congress raises G, the IScurve shifts right.

Response 1: Hold

M

constant

r

LM1

r1

r2 If Fed holds Mconstant, then LMcurve doesn’t

8

IS1 Y r1 Y1 IS₂ Y2 shift. Results: 2 1

Y







2 1

r

 



If Congress raises G, the IScurve shifts right.

Response 2: Hold

r

constant

r LM1 r1 r2 To keep rconstant, Fed increases M LM2 9

IS1 Y r1 Y1 IS₂ Y2

to shift LMcurve right.

3 1

Y







0

r

 

Y3 Results:

Response 3: Hold

Y

constant

r LM1 r1 r2 To keep Yconstant, Fed reduces M LM2 r3 If Congress raises G, the IScurve shifts right.

10

IS1

Y r1

IS2 Y2

to shift LMcurve left.

0

Y





3 1

r

 



Results: Y1

Estimates of fiscal policy multipliers

from the DRI macroeconometric model

Assumption about monetary policy Estimated value of Y /G Estimated value of Y /T 11

Fed holds nominal interest rate constant

Fed holds money supply constant

1.93 0.60

1.19

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Shocks in the

IS

-

LM

model

IS shocks: exogenous changes in the demand for goods & services. Examples:



stock market boom or crash

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stock market boom or crash

change in households’ wealth

 C



change in business or consumer confidence or expectations

 I and/or C

Shocks in the

IS

-

LM

model

LM shocks: exogenous changes in the demand for money.

Examples:



a wave of credit card fraud increases

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a wave of credit card fraud increases demand for money.



more ATMs or the Internet reduce money demand.

NOW YOU TRY:

Analyze shocks with the

IS-LM

Model

Use the IS-LMmodel 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

h f tl i t ti

cash more frequently in transactions. For each shock,

a. use the IS-LMdiagram to show the effects of the shock on Yand r.

b.determine what happens to C, I, and the

unemployment rate.

CASE STUDY:

The U.S. recession of 2001



During 2001,



2.1 million jobs lost,

unemployment rose from 3.9% to 5.8%.



GDP growth slowed to 0.8%

(compared to 3 9% average annual growth

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(compared to 3.9% average annual growth during 1994-2000).

CASE STUDY:

Causes: 1) Stock market decline  C

1200 1500

100)

Standard & Poor’s 500 300 600 900 1200 1995 1996 1997 1998 1999 2000 2001 2002 2003 Index ( 1942 = CASE STUDY:

The U.S. recession of 2001

Causes: 2) 9/11



increased uncertainty



fall in consumer & business confidence



result: lower spending, IScurve shifted left Causes: 3) Corporate accounting scandals



Enron, WorldCom, etc.

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CASE STUDY:



Fiscal policy response: shifted IScurve right



tax cuts in 2001 and 2003



spending increases airline industry bailout

NYC reconstruction

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NYC reconstruction Afghanistan war

CASE STUDY:



Monetary policy response: shifted LMcurve right Three-month T-Bill Rate Three-month T-Bill Rate 4 5 6 7 19

0 1 2 3

What is the Fed’s policy instrument?



The news media commonly report the Fed’s policy changes as interest rate changes, as if the Fed has direct control over market interest rates.



In fact, the Fed targetsthe federal funds rate–

th i t t t b k h th

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the interest rate banks charge one another on overnight loans.



The Fed changes the money supply and shifts the LM curve to achieve its target.



Other short-term rates typically move with the federal funds rate.

What is the Fed’s policy instrument?

Why does the Fed target interest rates instead of the money supply?

1) They are easier to measure than the money supply.

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2) The Fed might believe that LMshocks are more prevalent than ISshocks. If so, then targeting the interest rate stabilizes income better than targeting the money supply. (See end-of-chapter Problem 7 on p.337.)

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 Pwould shift LM and

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therefore affect Y.



The aggregate demand curve (introduced in Chap. 9) captures this relationship between Pand Y.

Deriving the

AD

curve

r IS LM(P1) LM(P2) r2 r1 Intuition for slope

of ADcurve: P  (M/P)

LMshifts left

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Y₁ Y2 Y Y P AD P1 P2 Y2 Y1 LMshifts left  r  I  Y

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Monetary policy and the

AD

curve

IS LM(M2/P1) LM(M1/P1) r1 r2

The Fed can increase aggregate demand: M LMshifts right

r

 r

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Y P AD1 P1 Y1 Y₁ Y2 Y2 AD2 Y  r  I  Y at each value of P r2 r1

Fiscal policy and the

AD

curve

r

IS1 LM

Expansionary fiscal policy (G and/or T) increases agg. demand: T  C

IS2

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Y2 Y2 Y1 Y₁ Y Y P AD1 P1 ISshifts right  Y at each value of P AD2

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 then over time the

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Y



Y



Y



Y

rise fall remain constant In the short-run equilibrium, if

then over time, the price level will

The SR and LR effects of an IS shock

A negative ISshock shifts ISand ADleft, causing Y to fall.

A negative ISshock shifts ISand ADleft, causing Y to fall. Y r LRAS IS1 LM(P1) IS2 27

Y Y P LRAS Y Y SRAS1 P1 AD2 AD1

The SR and LR effects of an ISshock

Y

r LRAS

IS1 LM(P1)

IS2

In the new short-run equilibrium, In the new short-run equilibrium, Y Y Y Y P LRAS Y Y SRAS1 P1 AD2 AD1

The SR and LR effects of an IS shock

Y

r LRAS

IS1 LM(P1)

IS2

In the new short-run equilibrium, In the new short-run equilibrium, Y Y Y Y P LRAS Y Y SRAS1 P1 AD2 AD1 Over time, Pgradually

falls, causing

•SRAS to move down •M/P to increase,

which causes LM

to move down Over time, Pgradually falls, causing

which causes LM

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The SR and LR effects of an ISshock Y r LRAS IS1 LM(P1) IS2 LM(P2) 30

AD2 Y Y P LRAS Y Y SRAS1 P1 AD1 SRAS2 P2

Over time, Pgradually falls, causing

which causes LM

to move down Over time, Pgradually falls, causing

which causes LM

to move down

LM(P2)

The SR and LR effects of an IS shock

Y

r LRAS

IS1

LM(P1)

IS2

This process continues until economy reaches a long-run equilibrium with This process continues until economy reaches a long-run equilibrium with

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AD₂ SRAS2 P2 Y Y P LRAS Y Y SRAS1 P1 AD1 long run equilibrium with

long run equilibrium with

Y Y

NOW YOU TRY:

Analyze SR & LR effects of

M

a.Draw the IS-LMand AD-AS

diagrams as shown here.

b.Suppose Fed increases M.

Show the short-run effects on your graphs.

r LRAS

IS LM(M1/P1)

c.Show what happens in the transition from the short run to the long run.

d.How do the new long-run equilibrium values of the endogenous variables compare to their initial values? Y Y P LRAS Y Y SRAS₁ P1 AD1

The Great Depression

Unemployment (right scale) 200 220 240 9 58 dollar s 20 25 30 a bor for c e Real GNP (left scale) 120 140 160 180 1929 1931 1933 1935 1937 1939 billions of 1 9 0 5 10 15 per cent of la

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:

34

output and interest rates both fell, which is what a leftward ISshift would cause.

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

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“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.

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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.

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

But, two problems with this hypothesis:



Pfell even more, so M/Pactually rose slightly

during 1929-31.



nominal interest rates fell, which is the opposite of what a leftward LMshift would cause.

THE MONEY HYPOTHESIS AGAIN:

The effects of falling prices



asserts that the severity of the Depression was due to a huge deflation:

Pfell 25% during 1929-33.



This deflation was probably caused by the fall in

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M, so perhaps money played an important role after all.



In what ways does a deflation affect the economy?

The effects of falling prices



The stabilizing effects of deflation:



P (M/P) LM shifts right  Y



Pigou effect:

 

38

P  (M/P)

consumers’ wealth   C

ISshifts right  Y



The destabilizing effects of expected deflation: E



r for each value of i

I becauseI=I(r)

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I because I I(r)

planned expenditure & agg. demand 

income & output 

THE MONEY HYPOTHESIS AGAIN:



The destabilizing effects of unexpected deflation: debt-deflation theory

P(if unexpected)

transfers purchasing power from borrowers to l d

lenders

borrowers spend less, lenders spend more

if borrowers’ propensity to spend is larger than lenders’, then aggregate spending falls, the IScurve shifts left, and Y falls

Why another Depression is unlikely



Policymakers (or their advisors) now know much more about macroeconomics:



The Fed knows better than to let Mfall so much, especially during a contraction.



Fiscal policymakers know better than to raise



Fiscal policymakers know better than to raise

taxes or cut spending during a contraction.



Federal deposit insurance makes widespread

bank failures very unlikely.



Automatic stabilizers make fiscal policy expansionary during an economic downturn.

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CASE STUDY

The 2008-09 Financial Crisis & Recession



2009: Real GDP fell, u-rate approached 10%



Important factors in the crisis:



early 2000s Federal Reserve interest rate policy



sub-prime mortgage crisis

42



bursting of house price bubble, rising foreclosure rates



falling stock prices



failing financial institutions



declining consumer confidence, drop in spending on consumer durables and investment goods

Interest rates and house prices

150 170 190 6 7 8 9 x , 2000= 100 a te (% )

Federal Funds rate 30-year mortgage rate

Case-Shiller 20-city composite house price index

50 70 90 110 130 0 1 2 3 4 5 2000 2001 2002 2003 2004 2005 House pri ce i n de x in te rest r a

Change in U.S. house price index and rate of new foreclosures, 1999-2009

1.0 1.2 1.4 6% 8% 10% 12% 14% re st art s tgages) h ouse pri ces s earl ie r)

US house price index New foreclosures 0.0 0.2 0.4 0.6 0.8 -6% -4% -2% 0% 2% 4% 1999 2001 2003 2005 2007 2009 New f o recl osu r (% o f to ta l mo rt Percent change in h (f rom 4 quart er s

House price change and new foreclosures,

2006:Q3 – 2009Q1 12% 14% 16% 18% 20% c lo sures, o rtgages Nevada Georgia California Florida Illinois Michigan Ohio 0% 2% 4% 6% 8% 10% -40% -30% -20% -10% 0% 10% 20% New f o re c % o f a ll m o

Cumulative change in house price index

Colorado Texas Alaska Wyoming Arizona S. Dakota Rhode Island N. Dakota Oregon New Jersey Hawaii

U.S. bank failures by year, 2000-2009

40 50 60 70 b ank f a il u res 0 10 20 30 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 Num b er of b * as of July 24, 2009. *

Major U.S. stock indexes

(% change from 52 weeks earlier)

40% 60% 80% 100% 120% 140% DJIA S&P 500 NASDAQ -80% -60% -40% -20% 0% 20% 12/ 6/ 1999 8/ 13/ 2000 4/ 21/ 2001 12/ 28/ 2001 9/ 5 /2002 5/ 14/ 2003 1/ 20/ 2004 9/ 27/ 2004 6/ 5 /2005 2/ 1 1 /2006 10/ 20/ 2006 6/ 28/ 2007 3/ 5 /2008 1 1 /1 1/ 20 08 7/ 20/ 2009

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Consumer sentiment and growth in consumer durables and investment spending

90 100 110 5% 10% 15% 20% n dex, 1966=100 u art e rs earl ie r 50 60 70 80 -25% -20% -15% -10% -5% 0% 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 Consumer Sent im ent I n % change fr om fo ur q u Durables Investment

UM Consumer Sentiment Index

Real GDP growth and Unemployment

6 7 8 9 10 4% 6% 8% 10% fo rc e q uat e rs earl ie r

Real GDP growth rate (left scale) Unemployment rate (right scale)

0 1 2 3 4 5 -4% -2% 0% 2% 1995 1997 1999 2001 2003 2005 2007 2009 % of l a bor % change f rom 4 q

Chapter Summary

1. IS-LMmodel

a theory of aggregate demand

exogenous: M, G, T,

P exogenous in short run, Y in long run

endogenous: r,

Y endogenous in short run, P in long run

IScurve: goods market equilibrium

LMcurve: money market equilibrium

Chapter Summary

2. ADcurve

shows relation between Pand the IS-LMmodel’s equilibrium Y.

negative slope because

P (M/P) r I Y

P  (M/P )  r  I  Y

expansionary fiscal policy shifts IScurve right, raises income, and shifts ADcurve right.

expansionary monetary policy shifts LMcurve right, raises income, and shifts ADcurve right.