Context Chapter 9 introduced the model of aggregate demand and supply Chapter 10 developed the Is-LM model, the basis of the aggregate demand curve In Chapter 11, we will use the Is-LM model to see how policies and shocks affect income and the interest rate in the short run when prices are fixed derive the aggregate demand curve explore various explanations for the Great Depression CHAPTER 11 Aggregate Demand Il slide o
CHAPTER 11 Aggregate Demand II slide 0 Context ▪ Chapter 9 introduced the model of aggregate demand and supply. ▪ Chapter 10 developed the IS-LM model, the basis of the aggregate demand curve. ▪ In Chapter 11, we will use the IS-LM model to – see how policies and shocks affect income and the interest rate in the short run when prices are fixed – derive the aggregate demand curve – explore various explanations for the Great Depression
Equilibrium in the IS-LM Model The Is curve represents equilibrium in the goods LM market y=C(y-7)+C()+G The LM curve represents i money market equilibrium M/P=L(Y) The intersection determines the unique combination of y and r that satisfies equilibrium in both markets CHAPTER 11 Aggregate Demand Il slide 1
CHAPTER 11 Aggregate Demand II slide 1 The intersection determines the unique combination of Y and r that satisfies equilibrium in both markets. The LM curve represents money market equilibrium. Equilibrium in the IS-LM Model The IS curve represents equilibrium in the goods market. Y C Y T I r G = − + + ( ) ( ) M P L r Y = ( , ) IS Y r LM r1 Y1
Policy analysis with the Is-LM Model Y=c(r-T)+I(r)+G MP=L(Y) LM Policymakers can affect macroeconomic variables With fiscal policy: G and or T monetary policy: M We can use the is-LM model to analyze the effects of these policies CHAPTER 11 Aggregate Demand Il slide 2
CHAPTER 11 Aggregate Demand II slide 2 Policy analysis with the IS-LM Model Policymakers can affect macroeconomic variables with • fiscal policy: G and/or T • monetary policy: M We can use the IS-LM model to analyze the effects of these policies. Y C Y T I r G = − + + ( ) ( ) M P L r Y = ( , ) IS Y r LM r1 Y1
An increase in government purchases 1. IS curve shifts right △G LM y 1-MPC causing output income to rise 2. This raises money demand causing the interest rate to rise 3... which reduces investment so the final increase in y 3 is smaller than △G 1-MPC CHAPTER 11 Aggregate Demand Il slide 3
CHAPTER 11 Aggregate Demand II slide 3 causing output & income to rise. IS1 An increase in government purchases 1. IS curve shifts right Y r LM r1 Y1 1 by 1 MPC G − IS2 Y2 r2 1. 2. This raises money demand, causing the interest rate to rise… 2. 3. …which reduces investment, so the final increase in Y 1 is smaller than 1 MPC G − 3
A tax cut Because consumers save (1-MPC)of the tax cut LM the initial boost in spending is smaller forAT than for an equal△G and the is curve shifts by -MPC IS2 △7 1-MPC 2.)… so the effects on r and y are smaller for a△ T than for an equa△G CHAPTER 11 Aggregate Demand Il slide 4
CHAPTER 11 Aggregate Demand II slide 4 IS1 1. A tax cut Y r LM r1 Y1 IS2 Y2 r2 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 MPC 1 MPC T − − 1. 2. …so the effects on 2. r and Y are smaller for a T than for an equal G. 2
Monetary Policy: an increase in M 1.△M>0 shifts the ly curve down (or to the right) 2 2. .causing the 1 interest rate to fall 3.∴ Which increases investment, causing output income to rise CHAPTER 11 Aggregate Demand Il slide 5
CHAPTER 11 Aggregate Demand II slide 5 2. …causing the interest rate to fall IS Monetary Policy: an increase in M 1. M > 0 shifts the LM curve down (or to the right) Y r LM1 r1 Y1 Y2 r2 LM2 3. …which increases investment, causing output & income to rise
Interaction between monetary fiscal policy Model: monetary fiscal policy variables ( M, G and T)are exogenous Real world 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 CHAPTER 11 Aggregate Demand Il slide 6
CHAPTER 11 Aggregate Demand II slide 6 Interaction between monetary & fiscal policy ▪ Model: monetary & fiscal policy variables (M, G and T ) are exogenous ▪ Real world: 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 AG>o Suppose Congress increases G. Possible fed responses 1. hold M constant 2. hold r constant 3. hold y constant In each case, the effects of the a are different CHAPTER 11 Aggregate Demand Il slide 7
CHAPTER 11 Aggregate Demand II slide 7 The Fed’s response to G > 0 ▪ Suppose Congress increases G. ▪ Possible Fed responses: 1. hold M constant 2. hold r constant 3. hold Y constant ▪ In each case, the effects of the G are different:
Response 1: hold M constant If Congress raises G, the is curve shifts LM ight If Fed holds mi constant then lm curve doesn't shift Results △y=y-y YY2 △r=12- CHAPTER 11 Aggregate Demand Il slide 8
CHAPTER 11 Aggregate Demand II slide 8 If Congress raises G, the IS curve shifts right IS1 Response 1: hold M constant Y r LM1 r1 Y1 IS2 Y2 r2 If Fed holds M constant, then LM curve doesn’t shift. Results: = − Y Y Y 2 1 2 1 = − r r r
Response 2: hold r constant If Congress raises G the s curve shifts LMi right Lm2 To keep r constant Fed increases to shift LM curve right. Results △y=y3-Y YY2Y3 △r=0 CHAPTER 11 Aggregate Demand Il slide 9
CHAPTER 11 Aggregate Demand II slide 9 If Congress raises G, the IS curve shifts right IS1 Response 2: hold r constant Y r LM1 r1 Y1 IS2 Y2 To keep r constant, r2 Fed increases M to shift LM curve right. = − Y Y Y 3 1 = r 0 LM2 Y3 Results:
