Context & Objectives

National Income & Business Cycles

ƒ Chapter 11 (10) developed the IS-LM model, the basis of the aggregate demand curve.

ƒ In Chapter 12 (11), we will use the IS-LM model to

Ohio Wesleyan University

• see how policies and shocks affect income and

Goran Skosples

the interest rate in the short run when prices are fixed • derive the aggregate demand curve

9. IS-LM and Aggregate Demand

ƒ We will analyze the short- and long-run effects of monetary and fiscal policies 0

Equilibrium in the IS -LM Model The IS curve represents equilibrium in the goods market.

r

The LM curve represents money market equilibrium.

1

Policy analysis with the IS -LM Model r

LM

We can use the IS-LM model to analyze the effects of IS

LM

r1 IS

• fiscal policy:

Y

• monetary policy:

Y1

Y

The intersection determines the unique combination of __ and __ that satisfies equilibrium in both markets. 2

3

An increase in government purchases 1. IS curve shifts ____

r

Monetary Policy: an increase in M 1. 'M > 0 shifts the LM curve _____

LM

causing output & income to rise. 2. …causing the interest rate to ____

2. This _____ money demand, causing the interest rate to ____…

IS1

3. …which _______ investment, so the final increase in Y

Result:

G Ÿ

r

&

Y

r

r1

IS

3. …which _________ investment, causing output & income to ______.

Y

4

Interaction between monetary & fiscal policy

LM1

Result: n M Ÿ

Y

Y1

r

and

Y

5

The Fed’s response to 'G > 0 ƒ Suppose Congress increases G.

ƒ Model:

ƒ Possible Fed responses:

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

1. hold M constant

ƒ Real world:

2. hold r constant

Monetary policymakers may adjust M in response to changes in fiscal policy, or vice versa.

3. hold Y constant

ƒ In each case, the effects of the 'G are different…

ƒ Such interaction may alter the impact of the original policy change. 6

7

Response 2: Hold r constant

Response 1: Hold M constant If Congress raises G, the IS curve shifts ____. If Fed holds M constant, then LM curve _______ _____.

r

LM1

r1

Results:

IS1 Y1

If Congress raises G, the IS curve shifts right.

r

To keep r constant, Fed __________ M to shift LM curve ____.

r2 r1

LM1

IS2 IS1

Results:

Y

Y1 Y2

Y

8

Response 3: Hold Y constant

9

Estimates of fiscal policy multipliers from the DRI macroeconometric model

If Congress raises G, the IS curve shifts right. To keep Y constant, Fed ________ M to shift LM curve ___.

r

LM1

r2 r1 IS2 IS1

Results:

Y2

Y

10

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

11

Estimates of fiscal policy multipliers

Estimates of fiscal policy multipliers

12

13

Exercise: Analyze shocks with the IS-LM model

Shocks in the IS -LM Model IS shocks: exogenous changes in the demand for goods & services. • stock market boom or crash Î change in households’ wealth Î • change in business or consumer confidence or expectations (“animal spirits”) Î LM shocks: exogenous changes in the demand for money. • a wave of credit card fraud __ demand for money • more ATMs or the Internet __ money demand 14

ƒ Use the IS-LM model to analyze the effects of • A boom in the stock market makes consumers wealthier. • After a wave of credit card fraud, consumers use cash more frequently in transactions.

ƒ For each shock, • use the IS-LM diagram to show the effects of the shock on Y and r . • determine what happens to C, I, and the unemployment rate. 15

Exercise: After a wave of credit card fraud, consumers use cash more frequently in transactions

Exercise: A boom in the stock market makes consumers wealthier r

Which curve shifts and why?

LM

___, because of Effects on:

LM

___, because of ______

r1

r Y C I U/L

r

Which curve shifts and why?

r1

Effects on:

r Y C I U/L

IS Y1

Y

16

CASE STUDY:

IS Y2

Y

Y1

17

CASE STUDY:

The U.S. recession of 2001

The U.S. recession of 2001

ƒ During 2001, • 2.1 million people lost their jobs,

ƒ Causes: 1) Stock market decline Ÿ

C

as unemployment rose from 3.9% to 5.8%. Index (1942 = 100)

• GDP growth slowed to 0.8% (compared to 3.9% average annual growth during 1994-2000).

1500 1200

Standard & Poor’s 500

900 600 300 1995

18

1996

1997

1998

1999

2000

2001

2002

2003 19

CASE STUDY:

CASE STUDY:

The U.S. recession of 2001

The U.S. recession of 2001

ƒ Causes: 2) 9/11 • increased uncertainty • fall in consumer & business confidence • result: lower spending, IS curve shifted left

ƒ Fiscal policy response: shifted IS curve ______ • tax cuts in 2001 and 2003 • spending increases - airline industry bailout - NYC reconstruction - Afghanistan war

ƒ Causes: 3) Corporate accounting scandals • Enron, WorldCom, etc. • reduced stock prices, discouraged investment

20

21

CASE STUDY:

The U.S. recession of 2001

What is the Fed’s policy instrument? ƒ The news media commonly report the Fed’s policy

ƒ Monetary policy response: shifted LM curve _____

changes as interest rate changes, as if the Fed has direct control over market interest rates.

7 6 5

Three-month T-Bill Rate

ƒ In fact, the Fed targets the ____________ rate –

4

the interest rate banks charge one another on overnight loans.

3 2

ƒ The Fed changes the money supply and shifts the

1 0

_____ curve to achieve its target.

ƒ Other short-term rates typically move with the federal funds rate. 22

23

IS-LM and Aggregate Demand

Deriving the AD curve

ƒ So far, we’ve been using the IS-LM model to analyze the short run, when the price level is assumed fixed.

ƒ However, a change in P would shift the LM

Intuition for slope of AD curve:

r

nP Ÿ

r1

(M/P )

LM(P1)

IS

Ÿ LM shifts ___

curve and therefore affect Y. Why?

ƒ The aggregate demand curve captures this relationship between P and Y

ƒ Definition: Aggregate demand indicates the

Ÿ

r

Ÿ

I

Ÿ

Y

Y

Y1

P

P1 AD

quantity demanded at a given price level

Y

Y1 24

25

Fiscal policy and the AD curve

Monetary policy and the AD curve The Fed can increase aggregate demand:

r

LM(M1/P1)

r1

nM Ÿ LM shifts ____ Ÿ

r

Ÿ I Ÿ Y at each value of P

Expansionary fiscal policy (nG and/or pT ) increases AD:

IS

P

Y1

pT Ÿ

Y

Ÿ

Y1

LM

r1 IS1

C

Ÿ ___ shifts _____

P1

r

Y at each value

P

Y1

Y

Y1

AD1 Y

P1

of P

AD1 Y 26

27

Aggregate Supply in the Long Run

The long-run aggregate supply curve

Recall from chapter 3: In the long-run, output is determined by factor supplies and technology

P

The LRAS curve is vertical at the fullemployment level of output.

is the full-employment or natural level of output, the level of output at which the economy’s resources are _____ employed.

“Full employment” means that unemployment equals its _______ rate.

Y

does not depend on the price level, so the long run aggregate supply (LRAS) curve is _______: 28

Aggregate Supply in the Short Run

29

The short run aggregate supply curve

ƒ In the real world, many prices are _____ in the The SRAS curve is horizontal:

short run.

ƒ If we assume that all prices are stuck at a

P

The price level is fixed at a predetermined level, and firms sell as much as buyers demand.

predetermined level in the short run… …and that firms are willing to sell as much as their customers are willing to buy at that price level. ...then, the short-run aggregate supply (SRAS) curve is _________:

Y

30

31

Fiscal policy: Increase in G

IS-LM and AD-AS in the short run & long run

r

ƒ 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

LM0 (M0/P0) r0

IS1

then over time, the price level will

Y0

P

LRAS

Po

32

Effects of a fiscal policy over time Y

Y

SRAS0

Y0

AD0 Y

nG Ÿ IS shifts _____ Ÿ Y & r Ÿ AD shifts ____ now, Y1 Y0 Ÿ P P n Ÿ LM ______ _____________ Ÿ SRAS shifts ___ until the new equilibrium is reached: Y0 & P1

33

Fiscal policy in the long run

r

ƒ Point: FP has real effects in the SR and in the LR in this model.

ƒ In this example “crowding out” occurs. The t0

time

P

time

t0

FP has real effects in the SR and in the LR in this model t0

time

SR:

Y,

LR: Y

r, P ,

r, P

34

increase in government expenditure (G) stimulates Y in the SR. In the LR, however, Y is fixed. Thus, the increase in the real interest rate (r ) causes private investment to decrease to offset the increase in G. Private investment is “crowded out” by government spending and Y remains fixed at Y0 = F(K,L). 35

Monetary policy: Increase in M

Exercise: Analyze SR & LR effects of ' 'M M r

a. Suppose Fed increases M. Show the SR effects on your graphs.

r0

b. Show what happens in the transition from

IS1

the SR to the LR.

c. How do the new LR equilibrium values of

Y

Y0

P

Use the graphs provided on the next slide.

Po

SRAS1

AD0 Y0

36

r

time

P

time

t0

SR: t0

37

1. IS-LM model • a theory of aggregate demand • exogenous: M, G, T,

MP is effective in the SR but ineffective in the LR in this model time

Y

until the new equilibrium is reached: Y0 and P1

Summary

Effects of a monetary policy over time

t0

P n Ÿ LM ______ ______________ Ÿ ____ shifts ___

LRAS

the endogenous variables compare to their initial values?

Y

nM Ÿ __ shifts _____ Ÿ Y & r Ÿ __ shifts _____ now, Y1 Y0 Ÿ P

LM0 (M0/P0)

Y,

LR: Y

• • •

P exogenous in short run, Y in long run endogenous: r, Y endogenous in short run, P in long run IS curve: goods market equilibrium LM curve: money market equilibrium

r, P ,r

,P 38

39

Summary

Summary

2. AD curve • shows relation between P and the IS-LM • • • •

3. Short- and long-run effects of FP and MP • Fiscal policy has real effects in the SR and in

model’s equilibrium Y. negative slope because nP Ÿ p(M/P ) Ÿ nr Ÿ pI Ÿ pY 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 40

•

the LR in this model (real interest rate increases in the LRÆ government spending crowds out private investment) Monetary policy is effective in the SR but ineffective in the LR in this model

41