AGGREGATE DEMAND II

oppositemincedΔιαχείριση

28 Οκτ 2013 (πριν από 3 χρόνια και 9 μήνες)

105 εμφανίσεις

AGGREGATE DEMAND II

IS
-
LM MODEL


Eva Hrom
á
dkov
á
, 22.3 2010

Macroeconomics ECO 110/1, AAU

Lecture
7

Overview of Lecture
7

IS
-
LM model of AD curve:


Model for AD curve => analysis of stabilization
policies


IS curve


goods market


Fiscal policy


expenditures and taxes


LM curve


money market


Monetary policy


money supply


Equilibrium


interest rates

2

IS
-
LM model

Context

3


We have already introduced the model of aggregate
demand (QTM) and aggregate supply.


Long run


prices
flexible


output determined by

factors of production &
technology


unemployment equals its
natural rate


Short run


prices
fixed


output determined by
aggregate demand


unemployment is
negatively

related to output





IS
-
LM model

Context II

4


Today we will develop
IS
-
LM model
, the theory that
explains the aggregate demand curve


First, we focus on the
short run
and assume hat price level
is fixed


Then, we allow price to be
flexible
, and derive AD curve


Finally, we analyze the effect of
fiscal and monetary
policy
on the most important macroeconomic aggregates


output and unemployment





IS curve

Keynesian cross

5


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


IS curve

Elements of the Keynesian cross

6

Consumption function:


C = MPC*(Y
-
T)


Govt. policy variables:


G, T


Investment:



I = I(r)


Planned expenditure:


E = C(Y
-
T) + I(r) + G


Equilibrium:



Y = E


IS curve

Graphing planned expenditure




7

income, output,

Y



E


planned


expenditure

E

=
C
+
I
+
G


Slope
is MPC

IS curve

Graphing the equilibrium condition

8



income, output,

Y



E


planned


expenditure

E

=
Y


45
º

IS curve

Equilibrium value of income

9

E>Y: depleting inventories => produce more

E<Y: accumulating inventories=> produce less

income, output,

Y



E


planned


expenditure

E

=
Y


E>Y

E<Y

IS curve

Fiscal policy

10


Fiscal stimulus:


Increase in government expenditures


Cut taxes


Increase transfer payments


Fiscal restraint:


Decrease in government expenditures


Increased taxes


Decreased transfer payments


IS curve

Increase in government purchases

11

Y


E

E

=
C
+
I
+
G
1

E
1

=
Y
1

E

=
C
+
I
+
G
2

E
2

=
Y
2


Y


G

Looks like

Y>

G


IS curve

Why is change in Y > change in G?

12


Def: Government purchases multiplier:



Initially, the increase in
G

causes an equal increase in
Y
:


Y

=

G
.


But

Y





C (Y
-
T)





further


Y






further


C





further


Y


So the government purchases multiplier will be greater
than one.


IS curve

Change in G
-

Sum up changes in expenditure

13

IS curve

Increase in taxes


14

Y


E

E

=
C
2

+
I
+
G

E
2

=
Y
2

E

=
C
1

+
I
+
G

E
1

=
Y
1


Y

At
Y
1
, there is now
an unplanned

inventory buildup…

…so firms
reduce output,
and income falls
toward a new
equilibrium


C
=

MPC

T

IS curve

Change in T
-

Sum up changes in expenditure

15

equilibrium condition
in changes

I
and
G

exogenous

Solving for

Y

:

Final result:

IS curve

Tax multiplier

Question: how is this different from the government spending
multiplier considered previously?


The tax multiplier:

…is
negative:


An increase in taxes reduces consumer spending, which reduces
equilibrium income.

…is
smaller than the
govt

spending multiplier:


(in absolute value) 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
.


16

IS curve

How to derive the IS curve I

17

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

The
IS


curve is
negatively sloped.


Intuition:

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.



Y
2

Y
1

Y
2

Y
1

IS curve

How to derive the IS curve II


r





I

Y


E

r

Y


E
=
C
+
I

(
r
1

)+
G


E
=
C
+
I

(
r
2

)+
G


r
1

r
2

E
=
Y

IS


I





E





Y

Y
2

Y
1

Y
2

Y
1

IS curve

Fiscal policy and IS curve


ex. of increase in G

At given value of
r
,

G




E




Y

Y


E

r

Y


E
=
C
+
I

(
r
1

)+
G
1


E
=
C
+
I

(
r
1

)+
G
2


r
1

E
=
Y

IS
1

The horizontal
distance of the

IS shift equals


IS
2

…so the IS curve
shifts

to the right.


Y

LM curve

How to build the LM curve

20

The theory of liquidity preference:


Developed by John Maynard Keynes.


A simple theory in which the interest rate

is determined by money supply and

money demand.


LM curve

Money supply

M/P


real money
balances

r


interest


rate

The supply of real
money balances is
fixed
.

LM curve

Money demand

22

M/P


real money
balances

r


interest


rate

L

(
r,Y

)


The demand for
real money
balances is
negatively
dependent on
interest rate.

LM curve

Equilibrium

23



M/P


real money
balances

r


interest


rate

L

(
r,Y

)


r
1

The interest rate
adjusts

to equate the
supply and
demand for
money

LM curve

Monetary policy

24

LM curve

Monetary policy


How can CB affect the interest rate?

25

M/P


real money
balances

r


interest


rate

L

(
r ,Y
)


r
1

r
2

To reduce r, central bank
reduces M.

In reality, this is hardly he
case.

More used technique =
change of
discount rate
.

LM curve

How to derive LM curve?

26

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:


The
LM


curve is
positively sloped
.

Intuition: 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.



LM curve

How to derive LM curve II

M/P


r

L

(
r

,

Y
1

)


r
1

r
2

r

Y

Y
1

r
1

r
2

LM
1

(a)

The market for

real money balances

(b)

The LM curve

LM
2

IS
-
LM model

Equilibrium

The short
-
run equilibrium is the
combination of
r

and
Y

that
simultaneously satisfies the
equilibrium conditions in the
goods & money markets:

Y


r

IS

LM

Equilibrium

interest

rate

Equilibrium

level of

income

slide
29




causing output &
income to rise.

IS
1

IS
-
LM model

Fiscal policy:

An

increase in government purchases

1.

IS


curve shifts right

Y


r

LM

r
1

Y
1

IS
2

Y
2

r
2

1.

2.

This raises money
demand, causing the
interest rate to rise…

2.

3.

…which reduces investment, so the
final increase in
Y

3.

slide
30

IS
1

1.

IS
-
LM model

Fiscal policy: A tax cut

Y


r

LM

r
1

Y
1

IS
2

Y
2

r
2

Because consumers save
(1

MPC) of the tax cut,
the initial boost in
spending is smaller for

T

than for an equal

G


and the
IS

curve

shifts by

1.

2.

2.

…so the effects on
r

and
Y

are smaller for a

T

than
for an equal

G
.

2.

slide
31

2.

…causing the
interest rate to fall

IS

IS
-
LM model

Monetary
Policy: an increase in
M

1.

M

> 0 shifts

the
LM


curve down

(or to the right)

Y


r

LM
1

r
1

Y
1

Y
2

r
2

LM
2

3.

…which increases
investment, causing
output & income to
rise.

IS
-
LM model

Shocks I

32

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 banking reduce money
demand


IS
-
LM model

Shocks II

33

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


Aggregate demand

How to get from IS
-
LM to AD

34


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 the
LM


curve and therefore affect
Y
.


The
aggregate demand curve


(
introduced in chap. 9
)

captures this

relationship between
P

and
Y

Y
1

Y
2

Aggregate demand

How to get from IS
-
LM to AD II

Y


r

Y


P

IS

LM
(
P
1
)

LM
(
P
2
)

AD

P
1

P
2

Y
2

Y
1

r
2

r
1

Intuition for slope

of
AD


curve:


P





(
M
/
P

)




LM


shifts left





r





I





Y


Aggregate demand

Effect of monetary policy

Y


P

IS

LM
(
M
2
/
P
1
)

LM
(
M
1
/
P
1
)

AD
1

P
1

Y
1

Y
1

Y
2

Y
2

r
1

r
2

The Fed can increase
aggregate demand:


M



LM


shifts right

AD
2

Y


r





r





I





Y

at each



value of
P

Y
2

Y
2

r
2

Y
1

Y
1

r
1

Aggregate demand

Effect of fiscal policy

Y


r

Y


P

IS
1

LM

AD
1

P
1

Expansionary fiscal policy
(

G

and/or

T
)
increases agg. demand:


T




C




IS shifts right





Y

at each



value of
P

AD
2

IS
2

slide
38

Aggregate demand

When is fiscal policy more effective?

Fiscal policy is effective

(
Y

will rise much) when:

LM flatter

As the rise in
G

raises Y,

the increase in money demand
does not raise
r

much
:

so investment is not crowded
out as much.

LM’

Y
2


2’

Y
2

IS
2

2

LM

Y
1

IS
1

r

1

slide
39

Aggregate demand

When is monetary policy more effective?

Monetary policy is effective

(
Y

will rise much) when:

IS flatter

As a rise in
M

lowers the
interest rate (
r
),

investment rises more

in
response to the fall in
r
,

so output rises more
.

Y
2

LM
2

2

Y
1

LM
1

r

1

Y
2


2’

IS

IS’

slide
40

IS
-
LM and AD
-
AS model

combination of short & long run

rise

fall

remain constant

In the short
-
run
equilibrium, if

then over time,
the price level will

IS
-
LM and AD
-
AS model

short & long run effect of IS shock I

A negative
IS


shock
shifts
IS


and
AD


left,
causing
Y

to fall.

Y


r

Y


P

LRAS

LRAS

IS
1

SRAS
1

P
1

LM
(
P
1
)

IS
2

AD
2

AD
1

IS
-
LM and AD
-
AS model

short & long run effect of IS shock II

Y


r

Y


P

LRAS

LRAS

IS
1

SRAS
1

P
1

LM
(
P
1
)

IS
2

AD
2

AD
1

In the new short
-
run
equilibrium,

IS
-
LM and AD
-
AS model

short & long run effect of IS shock II

Y


r

Y


P

LRAS

LRAS

IS
1

SRAS
1

P
1

LM
(
P
1
)

IS
2

AD
2

AD
1

In the new short
-
run
equilibrium,

Over time,

P

gradually falls,
which causes


SRAS

to move down


M
/
P

to increase,
which causes
LM


to move down

AD
2

IS
-
LM and AD
-
AS model

short & long run effect of IS shock III

Y


r

Y


P

LRAS

LRAS

IS
1

SRAS
1

P
1

LM
(
P
1
)

IS
2

AD
1

Over time,

P

gradually falls,
which causes


SRAS

to move down


M
/
P

to increase,
which causes
LM


to move down

SRAS
2

P
2

LM
(
P
2
)

AD
2

SRAS
2

P
2

LM
(
P
2
)

IS
-
LM and AD
-
AS model

short & long run effect of IS shock IV

Y


r

Y


P

LRAS

LRAS

IS
1

SRAS
1

P
1

LM
(
P
1
)

IS
2

AD
1

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

The Great
Depression

CASE STUDY

Unemployment
(right scale)

Real GNP

(left scale)

slide
47

slide
48

The Great Depression

CASE STUDY


Real side of economy
:


Output:


falling


Consumption:

falling


Investment:


falling much


Gov. purchases:

fall (with a delay)



slide
49

slide
50

The Great Depression

CASE STUDY


Nominal side
:


Nominal interest rate:

falling


Money supply (nominal):

falling


Price level:



falling (deflation)


slide
51

The Great Depression

CASE STUDY

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

slide
52

The Spending Hypothesis:

Reasons
for the IS shift

1.
Stock
market crash


exogenous

C



Oct
-
Dec 1929: S&P 500 fell 17%


Oct 1929
-
Dec 1933: S&P 500 fell 71%

2.
Drop in investment


“correction” after overbuilding in the 1920s


widespread bank failures made it harder to obtain
financing for investment

3.
Contractionary

fiscal policy


in the face of falling tax revenues and increasing
deficits, politicians raised tax rates and cut spending

slide
53

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:

1.

P

fell even more, so
M
/
P


actually rose slightly
during 1929
-
31.

2.
nominal interest rates fell, which is the opposite
of what would result from a leftward
LM


shift.

slide
54

The Money Hypothesis:

Revision


There was a big deflation:
P

fell 25% 1929
-
33.


A sudden fall in expected inflation means the ex
-
ante real
interest rate rises for any given nominal rate (
i
)



ex ante


real interest rate =
i




e



This could have discouraged the investment expenditure and
helped cause the depression.


Since the deflation likely was caused by fall in M, monetary
policy may have played a role here.