《宏观经济学》课程教学资源（英文版）Lecture 4-11 Aggregate Demand II

Aggregate Demand ll Science is a parasite: the greater the patient population the better the ad ance in physiology and pathology; and out of pathology arises therapy The year 1932 was the trough of the great depression, and from its rotten soil was belatedly begot a new subject that today we call macroeconomics In Chapter 10 we assembled the pieces of the IS-LM model. We saw that the IS curve represents the equilibrium in the market for goods and services, that the LM curve represents the equilibrium in the market for real money balances, and that the IS and LM curves together

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Worth: Mankiw Economics 5e CHAPTER ELEVEN Aggregate Demand ll Science is a parasite: the greater the patient population the better the ad ance in physiology and pathology; and out of pathology arises therapy The year 1932 was the trough of the great depression, and from its rotten soil was belatedly begot a new subject that today we call macroeconomics In Chapter 10 we assembled the pieces of the IS-LM model. We saw that the IS curve represents the equilibrium in the market for goods and services, that the LM curve represents the equilibrium in the market for real money balances, and that the IS and LM curves together determine the interest rate and national in- come in the short run when the price level is fixed. Now we turn our attention to applying the IS-LM model to analyze three issues First, we examine the potential causes of fluctuations in national income. We use the IS-LM model to see how changes in the exogenous variables (govern- ment purchases, taxes, and the money supply) infuence the endogenous variables (the interest rate and national income). We also examine how various shocks to he goods markets(the IS curve)and the money market(the LM curve)affect he interest rate and national income in the short run Second, we discuss how the IS-LM model fits into the model of aggregate supply and aggregate demand we introduced in Chapter 9. In particular, we ex- amine how the IS-LM model provides a theory of the slope and position of the aggregate demand curve. Here we relax the assumption that the price level is fixed, and we show that the IS-LM model implies a negative relationship be- tween the price level and national income. The model can also tell us what events shift the aggregate demand curve and in what direction. Third, we examine the Great Depression of the 1930s. As this chapter's open ing quotation indicates, this episode gave birth to short-run macroeconomic the- ory, for it led Keynes and his many followers to think that aggregate demand was the key to understanding fluctuations in national income. With the benefit of hindsight, we can use the IS-LM model to discuss the various explanations of 281 User JoEkA: Job EFFo1427: 6264_chl1: Pg 281: 25874#/eps at 10045 wed,Feb13,200210:264

User JOEWA:Job EFF01427:6264_ch11:Pg 281:25874#/eps at 100% *25874* Wed, Feb 13, 2002 10:26 AM In Chapter 10 we assembled the pieces of the IS–LM model.We saw that the IS curve represents the equilibrium in the market for goods and services, that the LM curve represents the equilibrium in the market for real money balances, and that the IS and LM curves together determine the interest rate and national income in the short run when the price level is fixed. Now we turn our attention to applying the IS–LM model to analyze three issues. First, we examine the potential causes of fluctuations in national income.We use the IS–LM model to see how changes in the exogenous variables (government purchases, taxes, and the money supply) influence the endogenous variables (the interest rate and national income).We also examine how various shocks to the goods markets (the IS curve) and the money market (the LM curve) affect the interest rate and national income in the short run. Second, we discuss how the IS–LM model fits into the model of aggregate supply and aggregate demand we introduced in Chapter 9. In particular, we examine how the IS–LM model provides a theory of the slope and position of the aggregate demand curve. Here we relax the assumption that the price level is fixed, and we show that the IS–LM model implies a negative relationship between the price level and national income. The model can also tell us what events shift the aggregate demand curve and in what direction. Third, we examine the Great Depression of the 1930s.As this chapter’s opening quotation indicates, this episode gave birth to short-run macroeconomic theory, for it led Keynes and his many followers to think that aggregate demand was the key to understanding fluctuations in national income. With the benefit of hindsight, we can use the IS–LM model to discuss the various explanations of this traumatic economic downturn. | 281 Aggregate Demand II 11 CHAPTER Science is a parasite: the greater the patient population the better the advance in physiology and pathology; and out of pathology arises therapy. The year 1932 was the trough of the great depression, and from its rotten soil was belatedly begot a new subject that today we call macroeconomics. — Paul Samuelson ELEVEN

User JOEWA:Job EFF01427:6264_ch11:Pg 282:27329#/eps at 100% *27329* Wed, Feb 13, 2002 10:26 AM 11-1 Explaining Fluctuations With the IS–LM Model The intersection of the IS curve and the LM curve determines the level of national income.When one of these curves shifts, the short-run equilibrium of the economy changes, and national income fluctuates. In this section we examine how changes in policy and shocks to the economy can cause these curves to shift. How Fiscal Policy Shifts the IS Curve and Changes the Short-Run Equilibrium We begin by examining how changes in fiscal policy (government purchases and taxes) alter the economy’s short-run equilibrium. Recall that changes in fiscal policy influence planned expenditure and thereby shift the IS curve.The IS–LM model shows how these shifts in the IS curve affect income and the interest rate. Changes in Government Purchases Consider an increase in government purchases of DG.The government-purchases multiplier in the Keynesian cross tells us that, at any given interest rate, this change in fiscal policy raises the level of income by DG/(1 − MPC).Therefore,as Figure 11-1 shows,the IS curve shifts to the right by this amount.The equilibrium of the economy moves from point A to point B. The increase in government purchases raises both income and the interest rate. To understand fully what’s happening in Figure 11-1,it helps to keep in mind the building blocks for the IS–LM model from the preceding chapter—the Keynesian cross and the theory of liquidity preference.Here is the story.When the government 282 | PART IV Business Cycle Theory: The Economy in the Short Run figure 11-1 Interest rate, r Y Income, output, Y 1 Y2 r 1 r 2 IS1 B A IS2 LM 2. . . . which raises income . . . 3. . . . and the interest rate. 1. The IS curve shifts to the right by G/(1 MPC), . .. An Increase in Government Purchases in the IS–LM Model An increase in government purchases shifts the IS curve to the right. The equilibrium moves from point A to point B. Income rises from Y1 to Y2, and the interest rate rises from r1 to r2.

Worth: Mankiw Economics 5e CHAPTER 11 Aggregate Demand ll 283 increases its purchases of goods and services, the economy's planned expenditure rises. The increase in planned expenditure stimulates the production of goods and services which causes total income y to rise. These effects should be familiar from he Keynesian cross. Now consider the money market, as described by the theory of liquidity pref erence. Because the economy's demand for money depends on income, the rise in total income increases the quantity of money demanded at every interest rate. The supply of money has not changed, however, so higher money demand causes the equilibrium interest rate r to rise. The higher interest rate arising in the money market, in turn, has ramifications back in the goods market. When the interest rate rises, firms cut back on their in- vestment plans. This fall in investment partially offsets the expansionary effect of the increase in government purchases. Thus, the increase in income in response to a fiscal expansion is smaller in the IS-LM model than it is in the Keynesian cross(where investment is assumed to be fixed). You can see this in Figure 11-1 The horizontal shift in the IS curve equals the rise in equilibrium income in the Keynesian cross. This amount is larger than the increase in equilibrium income here in the IS-LM model. The difference is explained by the crowding out of in- vestment caused by a higher interest rate Changes in Taxes In the IS-LM model, changes in taxes affect the economy much the same as changes in government purchases do, except that taxes affect expenditure through consumption. Consider, for instance, a decrease in taxes of AT. The tax cut encourages consumers to spend more and, therefore, increases planned expenditure. The tax multiplier in the Keynesian cross tells us that, at any given interest rate, this change in policy raises the level of income by ATX MPC/(1-MPC) Therefore, as Figure 11-2 illustrates, the IS curve shifts to the figure 11-2 Interest rate, r A Decrease in Taxes in the /S-LM Model a decrease in LM from point A to pointB c c axes shifts the Is curve to the right. The equilibrium mov Income rises from Y, to y2 and the interest rate rises from Lo 3.. and 1. The /S curve the interest User JOENA: Job EFF01427: 6264_ch11: Pg 283: 27330 #/eps at 100s Wed,Feb13,200210:26M

User JOEWA:Job EFF01427:6264_ch11:Pg 283:27330#/eps at 100% *27330* Wed, Feb 13, 2002 10:26 AM increases its purchases of goods and services, the economy’s planned expenditure rises.The increase in planned expenditure stimulates the production of goods and services, which causes total income Y to rise.These effects should be familiar from the Keynesian cross. Now consider the money market, as described by the theory of liquidity preference. Because the economy’s demand for money depends on income, the rise in total income increases the quantity of money demanded at every interest rate. The supply of money has not changed, however, so higher money demand causes the equilibrium interest rate r to rise. The higher interest rate arising in the money market, in turn, has ramifications back in the goods market.When the interest rate rises, firms cut back on their investment plans.This fall in investment partially offsets the expansionary effect of the increase in government purchases.Thus, the increase in income in response to a fiscal expansion is smaller in the IS–LM model than it is in the Keynesian cross (where investment is assumed to be fixed).You can see this in Figure 11-1. The horizontal shift in the IS curve equals the rise in equilibrium income in the Keynesian cross.This amount is larger than the increase in equilibrium income here in the IS–LM model.The difference is explained by the crowding out of investment caused by a higher interest rate. Changes in Taxes In the IS–LM model, changes in taxes affect the economy much the same as changes in government purchases do, except that taxes affect expenditure through consumption. Consider, for instance, a decrease in taxes of DT.The tax cut encourages consumers to spend more and, therefore, increases planned expenditure.The tax multiplier in the Keynesian cross tells us that, at any given interest rate, this change in policy raises the level of income by DT × MPC/(1 − MPC).Therefore, as Figure 11-2 illustrates, the IS curve shifts to the CHAPTER 11 Aggregate Demand II | 283 figure 11-2 Interest rate, r Y Income, output, Y 1 Y2 r 1 r 2 IS1 B A LM 2. . . . which raises income . . . IS2 3. . . . and the interest rate. 1. The IS curve shifts to the right by T MPC , ... 1 MPC A Decrease in Taxes in the IS–LM Model A decrease in taxes shifts the IS curve to the right. The equilibrium moves from point A to point B. Income rises from Y1 to Y2, and the interest rate rises from r1 to r2.

Worth: Mankiw Economics 5e 284 PART IV Business Cycle Theory: The Economy in the Short Run right by this amount. The equilibrium of the economy moves from point a to point B. The tax cut raises both income and the interest rate. Once again, because he higher interest rate depresses investment, the increase in income is smaller in the IS-LM model than it is in the Keynesian cross How Monetary Policy Shifts the LM Curve and Changes the Short-Run Equilibrium We now examine the effects of monetary policy. Recall that a change in the money supply alters the interest rate that equilibrates the money market for any given level of income and, thereby, shifts the LM curve. The IS-LM model shows how a shift in the lm curve affects income and the interest rate Consider an increase in the money supply. An increase in M leads to an in crease in real money balances M/P, because the price level P is fixed in the short run. The theory of liquidity preference shows that for any given level of income, an increase in real money balances leads to a lower interest rate. Therefore, the LM curve shifts downward, as in Figure 11-3.The equilibrium moves from point a to point B. The increase in the money supply lowers the interest rate and raises the level of income Once again, to tell the story that explains the economy's adjustment from point A to point B, we rely on the building blocks of the IS-LM modeh-the Keynesian cross and the theory of liquidity preference. This time, we begin with the money market, where the monetary-policy action occurs When the Federal Reserve increases the supply of money, people have more money than the want to hold at the prevailing interest rate. As a result, they start depositing this extra money in banks or use it to buy bonds. The interest rate r then falls until people are willing to hold all the extra money that the Fed has created; this brings the money market to a new equilibrium. The lower interest rate, in turn, fi Interest rater An Increase in the Money Supply in the IS-LM Model An increase in the money supply shifts the LM curve downward. The equilib moves from point A to point B Income rises from Y, to Y2 1. An increase in the and the interest rate falls from supply shifts lowers the Interest rate User JoENA: Job EFFo1427:6264_chl1: Pg 284: 27331#/eps at 100s wed,Feb13,200210:264

User JOEWA:Job EFF01427:6264_ch11:Pg 284:27331#/eps at 100% *27331* Wed, Feb 13, 2002 10:26 AM right by this amount.The equilibrium of the economy moves from point A to point B.The tax cut raises both income and the interest rate. Once again, because the higher interest rate depresses investment, the increase in income is smaller in the IS–LM model than it is in the Keynesian cross. How Monetary Policy Shifts the LM Curve and Changes the Short-Run Equilibrium We now examine the effects of monetary policy. Recall that a change in the money supply alters the interest rate that equilibrates the money market for any given level of income and, thereby, shifts the LM curve.The IS–LM model shows how a shift in the LM curve affects income and the interest rate. Consider an increase in the money supply. An increase in M leads to an increase in real money balances M/P, because the price level P is fixed in the short run.The theory of liquidity preference shows that for any given level of income, an increase in real money balances leads to a lower interest rate.Therefore, the LM curve shifts downward, as in Figure 11-3.The equilibrium moves from point A to point B.The increase in the money supply lowers the interest rate and raises the level of income. Once again, to tell the story that explains the economy’s adjustment from point A to point B, we rely on the building blocks of the IS–LM model—the Keynesian cross and the theory of liquidity preference.This time, we begin with the money market, where the monetary-policy action occurs.When the Federal Reserve increases the supply of money, people have more money than they want to hold at the prevailing interest rate.As a result, they start depositing this extra money in banks or use it to buy bonds.The interest rate r then falls until people are willing to hold all the extra money that the Fed has created; this brings the money market to a new equilibrium.The lower interest rate, in turn, 284 | PART IV Business Cycle Theory: The Economy in the Short Run figure 11-3 Interest rate, r Y Income, output, Y 1 Y2 r 2 r 1 IS B A LM1 LM2 3. . . . and lowers the interest rate. 2. . . . which raises income . . . 1. An increase in the money supply shifts the LM curve downward, ... An Increase in the Money Supply in the IS–LM Model An increase in the money supply shifts the LM curve downward. The equilibrium moves from point A to point B. Income rises from Y1 to Y2, and the interest rate falls from r1 to r2

Worth: Mankiw Economics 5e CHAPTER 11 Aggregate Demand Il 285 has ramifications for the goods market. A lower interest rate stimulates planned investment, which increases planned expenditure, production, and income y Thus, the IS-LM model shows that monetary policy influences income by changing the interest rate. This conclusion sheds light on our analysis of mone- tary policy in Chapter 9. In that chapter we showed that in the short run, when prices are sticky, an expansion in the money supply raises income. But we did not discuss how a monetary expansion induces greater spending on goods and ser vices--a process called the monetary transmission mechanism. The IS-LM model shows that an increase in the money supply lowers the interest rate, which stimulates investment and thereby expands the demand for goods and services The Interaction Between Monetary and Fiscal Policy When analyzing any change in monetary or fiscal policy, it is important to keep in mind that the policymakers who control these policy tools are aware of what the policymakers are doing. A change in one policy, therefore, may infu- ence the other, and this interdependence may alter the impact of a policy change For example, suppose Congress were to raise taxes. What effect should this pol ve on the economy? According to the IS-LM model, the answer on how the Fed responds to the tax increase Figure 11-4 shows three of the many possible outcomes In panel (a), the Fed holds the money supply constant. The tax increase shifts the Is curve to the left Income falls(because higher taxes reduce consumer spending), and the interest rate falls(because lower income reduces the demand for money). The fall inin- come indicates that the tax hike causes a recession In panel(b), the Fed wants to hold the interest rate constant. In this case, when he tax increase shifts the IS curve to the left, the Fed must decrease the money supply to keep the interest rate at its original level. This fall in the money supply shifts the LM curve upward. The interest rate does not fall, but income falls by a larger amount than if the Fed had held the money supply constant. Whereas in panel(a)the lower interest rate stimulated investment and partially offset the contractionary effect of the tax hike, in panel(b) the Fed deepens the recession by keeping the interest rate high In panel(c), the Fed wants to prevent the tax increase from lowering income It must, therefore, raise the money supply and shift the LM curve downward enough to offset the shift in the Is curve. In this case. the tax increase does not cause a recession, but it does cause a large fall in the interest rate. Although the level of income is not changed, the combination of a tax increase and a monetary expansion does change the allocation of the economy's resources. The higher Income is not affected because these two effects exactly balane ates investment From this example we can see that the impact of a change in fiscal policy de- pends on the policy the Fed pursues--that is, on whether it holds the money sup- ply, the interest rate, or the level of income constant. More generally, whenever alyzing a change in one policy, we must make an assumption about its effect on the other policy. The most appropriate assumption depends on the case at hand and the many political considerations that lie behind economic policymaking User JoENA: Job EFFo1427:6264_chl1: Pg 285: 27332#/eps at 100s wed,Feb13,200210:264

User JOEWA:Job EFF01427:6264_ch11:Pg 285:27332#/eps at 100% *27332* Wed, Feb 13, 2002 10:26 AM has ramifications for the goods market.A lower interest rate stimulates planned investment, which increases planned expenditure, production, and income Y. Thus, the IS–LM model shows that monetary policy influences income by changing the interest rate.This conclusion sheds light on our analysis of monetary policy in Chapter 9. In that chapter we showed that in the short run, when prices are sticky, an expansion in the money supply raises income. But we did not discuss how a monetary expansion induces greater spending on goods and services—a process called the monetary transmission mechanism.The IS–LM model shows that an increase in the money supply lowers the interest rate, which stimulates investment and thereby expands the demand for goods and services. The Interaction Between Monetary and Fiscal Policy When analyzing any change in monetary or fiscal policy, it is important to keep in mind that the policymakers who control these policy tools are aware of what the other policymakers are doing. A change in one policy, therefore, may influence the other, and this interdependence may alter the impact of a policy change. For example, suppose Congress were to raise taxes.What effect should this policy have on the economy? According to the IS–LM model, the answer depends on how the Fed responds to the tax increase. Figure 11-4 shows three of the many possible outcomes. In panel (a), the Fed holds the money supply constant. The tax increase shifts the IS curve to the left. Income falls (because higher taxes reduce consumer spending), and the interest rate falls (because lower income reduces the demand for money). The fall in income indicates that the tax hike causes a recession. In panel (b), the Fed wants to hold the interest rate constant. In this case, when the tax increase shifts the IS curve to the left, the Fed must decrease the money supply to keep the interest rate at its original level.This fall in the money supply shifts the LM curve upward.The interest rate does not fall, but income falls by a larger amount than if the Fed had held the money supply constant.Whereas in panel (a) the lower interest rate stimulated investment and partially offset the contractionary effect of the tax hike, in panel (b) the Fed deepens the recession by keeping the interest rate high. In panel (c), the Fed wants to prevent the tax increase from lowering income. It must, therefore, raise the money supply and shift the LM curve downward enough to offset the shift in the IS curve. In this case, the tax increase does not cause a recession, but it does cause a large fall in the interest rate. Although the level of income is not changed, the combination of a tax increase and a monetary expansion does change the allocation of the economy’s resources. The higher taxes depress consumption, while the lower interest rate stimulates investment. Income is not affected because these two effects exactly balance. From this example we can see that the impact of a change in fiscal policy depends on the policy the Fed pursues—that is, on whether it holds the money supply, the interest rate, or the level of income constant. More generally, whenever analyzing a change in one policy, we must make an assumption about its effect on the other policy.The most appropriate assumption depends on the case at hand and the many political considerations that lie behind economic policymaking. CHAPTER 11 Aggregate Demand II | 285

Worth: Mankiw Economics 5e CHAPTER 11 Aggregate Demand ll 287 Policy Analysis With Macroeconometric Models The IS-LM model shows how monetary and fiscal policy infuence the equilib- rium level of income. The predictions of the model, however, are qualitative, not quantitative. The IS-LM model shows that increases in government purchas raise GDP and that increases in taxes lower GDP. But when economists analyze specific policy proposals, they need to know not only the direction of the effect but also the size. For example, if Congress increases taxes by $100 billion and if monetary policy is not altered, how much will GDP fall? To answer this question, economists need to go beyond the graphical representation of the IS-LM model. Macroeconometric models of the economy provide one way to evaluate policy proposals. A macroeconometric model is a model that describes the economy quanti tatively, rather than only qualitatively. Many of these models are essentially more complicated and more realistic versions of our IS-LM model. The economists ho build macroeconometric models use historical data to estimate parameters such as the marginal propensity to consume, the sensitivity of investment to the interest rate, and the sensitivity of money demand to the interest rate. Once a model is built, economists can simulate the effects of alternative policies with the help of a computer. Table 11-1 shows the fiscal-policy multipliers implied by one widely used macroeconometric model, the Data Resources Incorporated(DRI)model, named for the economic forecasting firm that developed it. The multipliers are given for two assumptions about how the Fed might respond to changes in fiscal polio One assumption about monetary policy is that the Fed keeps the nominal in- terest rate constant. That is, when fiscal policy shifts the IS curve to the right or to the left, the Fed adjusts the money supply to shift the LM curve in the same direction. Because there is no crowding out of investment due to a changing in- terest rate, the fiscal-policy multipliers are similar to those from the Keynesian cross.The DRI model indicates that, in this case, the government-purchases mul- tiplier is 1.93, and the tax multiplier is -1.19. That is, a $100 billion increase in government purchases raises GDP by $193 billion, and a $100 billion increase in taxes lowers GDP by $119 billi table 11-1 The Fiscal-Policy Multipliers in the DRI Model VALUE OF MULTIPLIERS Assumption About Monetary P △Y△G 1.93 Money supply held constant 0.60 -0.26 fiscal-pol ultipliers for a sustained change in government hases or in personal income taxes. These multipliers are for the fourth quarter after the Otto Eckstein, The DRI Model of the U.S. Economy(New York: McGraw-Hill, 1983), 169 User JOENA: Job EFF01427: 6264_ch11: Pg 287: 27334 #/eps at 100s wed,Feb13,200210:27M

User JOEWA:Job EFF01427:6264_ch11:Pg 287:27334#/eps at 100% *27334* Wed, Feb 13, 2002 10:27 AM CHAPTER 11 Aggregate Demand II | 287 CASE STUDY Policy Analysis With Macroeconometric Models The IS–LM model shows how monetary and fiscal policy influence the equilibrium level of income.The predictions of the model, however, are qualitative, not quantitative. The IS–LM model shows that increases in government purchases raise GDP and that increases in taxes lower GDP. But when economists analyze specific policy proposals, they need to know not only the direction of the effect but also the size. For example, if Congress increases taxes by $100 billion and if monetary policy is not altered, how much will GDP fall? To answer this question, economists need to go beyond the graphical representation of the IS–LM model. Macroeconometric models of the economy provide one way to evaluate policy proposals. A macroeconometric model is a model that describes the economy quantitatively, rather than only qualitatively. Many of these models are essentially more complicated and more realistic versions of our IS–LM model. The economists who build macroeconometric models use historical data to estimate parameters such as the marginal propensity to consume, the sensitivity of investment to the interest rate, and the sensitivity of money demand to the interest rate. Once a model is built, economists can simulate the effects of alternative policies with the help of a computer. Table 11-1 shows the fiscal-policy multipliers implied by one widely used macroeconometric model, the Data Resources Incorporated (DRI) model, named for the economic forecasting firm that developed it.The multipliers are given for two assumptions about how the Fed might respond to changes in fiscal policy. One assumption about monetary policy is that the Fed keeps the nominal interest rate constant.That is, when fiscal policy shifts the IS curve to the right or to the left, the Fed adjusts the money supply to shift the LM curve in the same direction. Because there is no crowding out of investment due to a changing interest rate, the fiscal-policy multipliers are similar to those from the Keynesian cross.The DRI model indicates that, in this case, the government-purchases multiplier is 1.93, and the tax multiplier is −1.19.That is, a $100 billion increase in government purchases raises GDP by $193 billion, and a $100 billion increase in taxes lowers GDP by $119 billion. VALUE OF MULTIPLIERS Assumption About Monetary Policy DY/ DG DY/ DT Nominal interest rate held constant 1.93 −1.19 Money supply held constant 0.60 −0.26 Note: This table gives the fiscal-policy multipliers for a sustained change in government purchases or in personal income taxes. These multipliers are for the fourth quarter after the policy change is made. Source: Otto Eckstein, The DRI Model of the U.S. Economy (New York: McGraw-Hill, 1983), 169. The Fiscal-Policy Multipliers in the DRI Model table 11-1

Worth: Mankiw Economics 5e 288 PART IV Business Cycle Theory: The Economy in the Short Run The second assumption about monetary policy is that the Fed keeps the money supply constant so that the LM curve does not shift. In this case, the inter- est rate rises, and investment is crowded out, so the multipliers are much smaller. The government-purchases multiplier is only 0.60, and the tax multiplier is only -0. 26. That is, a $100 billion increase in government purchases raises gDp by $60 billion, and a $100 billion increase in taxes lowers gDP by $26 billion. Table 11-1 shows that the fiscal-policy multipliers are very different under the two assumptions about monetary policy. The impact of any change in fiscal pol icy depends crucially on how the Fed responds to that change. Shocks in the /s-LM Model Because the is-lm model shows how national income is determined in the short run. we can use the model to examine how various economic disturbances affect income. So far we have seen how changes in fiscal policy shift the IS curve and how changes in monetary policy shift the LM curve. Similarly, we can group other disturbances into two categories: shocks to the IS curve and shocks to the LM curve Shocks to the IS curve are exogenous changes in the demand for goods and services. Some economists, including Keynes, have emphasized that such changes in demand can arise fron Im Investors a nimal spirits-exogenous and perhaps self- fulfilling waves of optimism and pessimism. For example, suppose that firms be come pessimistic about the future of the economy and that this pessimism causes hem to build fewer new factories This reduction in the demand for investment goods causes a contractionary shift in the investment function: at every interest rate, firms want to invest less. The fall in investment reduces planned expenditure and shifts the IS curve to the left, reducing income and employment. This fall r equilibrium income in part validates the firms'initial pessimism. Shocks to the IS curve may also arise from changes in the demand for consumer goods. Suppose, for instance, that the election of a popular president increases con- sumer confidence in the economy. This induces consumers to save less for the fu ture and consume more today. We can interpret this change as an upward shift in the consumption function. This shift in the consumption function increases planned expenditure and shifts the IS curve to the right, and this raises income Calvin and Hobbes by Bill Watterson · User JoENA: Job EFFo1427: 6264_chl1: Pg 288: 27335#/eps at 100sm I wea,Feb13,200210:27AM

User JOEWA:Job EFF01427:6264_ch11:Pg 288:27335#/eps at 100% *27335* Wed, Feb 13, 2002 10:27 AM Shocks in the IS–LM Model Because the IS–LM model shows how national income is determined in the short run, we can use the model to examine how various economic disturbances affect income. So far we have seen how changes in fiscal policy shift the IS curve and how changes in monetary policy shift the LM curve. Similarly, we can group other disturbances into two categories: shocks to the IS curve and shocks to the LM curve. Shocks to the IS curve are exogenous changes in the demand for goods and services. Some economists, including Keynes, have emphasized that such changes in demand can arise from investors’ animal spirits—exogenous and perhaps selffulfilling waves of optimism and pessimism. For example, suppose that firms become pessimistic about the future of the economy and that this pessimism causes them to build fewer new factories.This reduction in the demand for investment goods causes a contractionary shift in the investment function: at every interest rate, firms want to invest less.The fall in investment reduces planned expenditure and shifts the IS curve to the left, reducing income and employment.This fall in equilibrium income in part validates the firms’ initial pessimism. Shocks to the IS curve may also arise from changes in the demand for consumer goods. Suppose, for instance, that the election of a popular president increases consumer confidence in the economy.This induces consumers to save less for the future and consume more today.We can interpret this change as an upward shift in the consumption function. This shift in the consumption function increases planned expenditure and shifts the IS curve to the right, and this raises income. 288 | PART IV Business Cycle Theory: The Economy in the Short Run The second assumption about monetary policy is that the Fed keeps the money supply constant so that the LM curve does not shift. In this case, the interest rate rises, and investment is crowded out, so the multipliers are much smaller. The government-purchases multiplier is only 0.60, and the tax multiplier is only −0.26.That is, a $100 billion increase in government purchases raises GDP by $60 billion, and a $100 billion increase in taxes lowers GDP by $26 billion. Table 11-1 shows that the fiscal-policy multipliers are very different under the two assumptions about monetary policy.The impact of any change in fiscal policy depends crucially on how the Fed responds to that change. Calvin and Hobbes © 1992 Watterson. Dist. by Universal Press Syndicate

Worth: Mankiw Economics 5e CHAPTER 11 Aggregate Demand ll 289 Shocks to the LM curve arise from exogenous changes in the demand for money. For example, suppose that new restrictions on credit-card availabilit increase the amount of money people choose to hold. According to the theory of liquidity preference, when money demand rises, the interest rate necessary to equilibrate the money market is higher(for any given level of income and money supply). Hence, an increase in money demand shifts the LM curve up ward, which tends to raise the interest rate and depress Income In summary, several kinds of events can cause economic fuctuations by shift ing the iS curve or the Lm curve. Remember, however, that such fluctuations are not inevitable. Policymakers can try to use the tools of monetary and fiscal polie to offset exogenous shocks If policymakers are sufficiently quick and skillful(ad- mittedly, a big if), shocks to the IS or LM curves need not lead to fluctuations in Income or employment. CASE STUDY The U.s. slowdown of 2001 In 2001, the U.S. economy experienced a pronounced slowdown in economic activity. The unemployment rate rose from 3.9 percent in October 2000 to 4.9 percent in August 2001, and then to 5.8 percent in December 2001. In many ways, the slowdown looked like a typical recession driven by a fall in aggregate demand Two notable shocks can help explain this event. The first was a decline in the stock market. During the 1990s, the stock market experienced a boom of his- toric proportions, as investors became optimistic about the prospects of the new information technology. Some economists viewed the optimism as excessive at the time, and in hindsight this proved to be the case. When the optimism faded, average stock prices fell by about 25 percent from August 2000 to August 2001 The fall in the market reduced household wealth and thus consumer spending In addition, the declining perceptions of the profitability of the new technologies led to a fall in investment spending. In the language of the IS-LM model, the IS curve shifted to the left The second shock was the terrorist attacks on New York and Washington on September 11, 2001. In the week after the attacks, the stock market fell another 12 percent, its biggest weekly loss since the Great Depression of the 1930s Moreover, the attacks increased uncertainty about what the future would hold Uncertainty can reduce spending because households and firms postpone some of their plans until the uncertainty is resolved. Thus, the terrorist attacks shifted the Is curve further to the left Fiscal and monetary policymakers were quick to respond to these events. ongress passed a tax cut in 2001, including an immediate tax rebate. One goal of the tax cut was to stimulate consumer spending. After the terrorist attacks, Congress increased government spending by appropriating funds to rebuild New York and to bail out the ailing airline industry. Both of these fiscal measures shifted the Is curve to the right User JOENA: Job EFF01427: 6264_ch11: Pg 289: 27336#/eps at 100s wed,Feb13,200210:27M

User JOEWA:Job EFF01427:6264_ch11:Pg 289:27336#/eps at 100% *27336* Wed, Feb 13, 2002 10:27 AM Shocks to the LM curve arise from exogenous changes in the demand for money. For example, suppose that new restrictions on credit-card availability increase the amount of money people choose to hold.According to the theory of liquidity preference, when money demand rises, the interest rate necessary to equilibrate the money market is higher (for any given level of income and money supply). Hence, an increase in money demand shifts the LM curve upward, which tends to raise the interest rate and depress income. In summary, several kinds of events can cause economic fluctuations by shifting the IS curve or the LM curve. Remember, however, that such fluctuations are not inevitable. Policymakers can try to use the tools of monetary and fiscal policy to offset exogenous shocks. If policymakers are sufficiently quick and skillful (admittedly, a big if ), shocks to the IS or LM curves need not lead to fluctuations in income or employment. CHAPTER 11 Aggregate Demand II | 289 CASE STUDY The U.S. Slowdown of 2001 In 2001, the U.S. economy experienced a pronounced slowdown in economic activity.The unemployment rate rose from 3.9 percent in October 2000 to 4.9 percent in August 2001, and then to 5.8 percent in December 2001. In many ways, the slowdown looked like a typical recession driven by a fall in aggregate demand. Two notable shocks can help explain this event.The first was a decline in the stock market. During the 1990s, the stock market experienced a boom of historic proportions, as investors became optimistic about the prospects of the new information technology. Some economists viewed the optimism as excessive at the time, and in hindsight this proved to be the case.When the optimism faded, average stock prices fell by about 25 percent from August 2000 to August 2001. The fall in the market reduced household wealth and thus consumer spending. In addition, the declining perceptions of the profitability of the new technologies led to a fall in investment spending. In the language of the IS–LM model, the IS curve shifted to the left. The second shock was the terrorist attacks on New York and Washington on September 11, 2001. In the week after the attacks, the stock market fell another 12 percent, its biggest weekly loss since the Great Depression of the 1930s. Moreover, the attacks increased uncertainty about what the future would hold. Uncertainty can reduce spending because households and firms postpone some of their plans until the uncertainty is resolved.Thus, the terrorist attacks shifted the IS curve further to the left. Fiscal and monetary policymakers were quick to respond to these events. Congress passed a tax cut in 2001, including an immediate tax rebate. One goal of the tax cut was to stimulate consumer spending. After the terrorist attacks, Congress increased government spending by appropriating funds to rebuild New York and to bail out the ailing airline industry. Both of these fiscal measures shifted the IS curve to the right

Worth: Mankiw Economics 5e 290 PART IV Business Cycle Theory: The Economy in the Short Run At the same time, the Fed pursued expansionary monetary policy, shifting the LM curve to the right. Money growth accelerated, and interest rates fell. The in- terest rate on three-month Treasury bills fell from 6.4 percent in November of 2000 to 3.3 percent in August 2001, and then to 2. 1 percent in September 2001 in the immediate aftermath of the terrorist attacks The magnitude of the slowdown of 2001 was not yet determined as this book was going to press. The big question was whether the policy measures under taken were sufficient to offset the shocks that the economy had suffered. By the time you are reading this, you may know the answer. What Is the Fed's Policy Instrument-The Money Supply or the interest rate? Our analysis of monetary policy has been based on the assumption that the Fed infuences the economy by controlling the money supply. By contrast, when th media report on changes in Fed policy, they often simply say that the Fed has raised or lowered interest rates. Which is right? Even though these two views may seem different, both are correct, and it is important to understand why In recent years, the Fed has used the federal funds rate-the interest rate that banks charge one another for overnight loans as its short-term policy instrument. When the Federal Open Market Committee meets every six weeks to set monetary policy, it votes on a target for this interest rate that will apply until the next meeting. After the meeting is over, the Feds bond traders in New York are told to conduct the open-market operations necessary to hit that target. These open-market operations change the money supply and shift the LM curve so that the equilibrium interest rate(determined by the intersection of the IS and LM curves)equals the target in- terest rate that the Federal Open Market Committee has chosen. As a result of this operating procedure, Fed policy is often discussed in terms of changing interest rates. Keep in mind, however, that behind these changes in interest rates are the necessary changes in the money supply. A newspaper might report, for instance, that "the Fed has lowered interest rates. "To be more precise, we can translate this statement as meaning " the Federal Open Market Commit- tee has instructed the Fed bond traders to buy bonds in open-market operations so as to increase the money supply, shift the LM curve, and reduce the equilib- rium interest rate to hit a new lower target. Why has the Fed chosen to use an interest rate, rather than the money supply, as its short-term policy instrument? One possible answer is that shocks to the LM curve are more prevalent than shocks to the IS curve. When the Fed targets nterest rates, it automatically offsets LM shocks by altering the money supply, but the policy exacerbates IS shocks If LM shocks are the more prevalent type, chen a policy of targeting the interest rate leads to greater economic stability than a policy of targeting the money supply(problem 7 at the end of this chapter asks you to analyze this issue more fully Another possible reason for using the interest rate as the short-term po strument is that interest rates are easier to measure than the money supply. As we User JOENA: Job EFF01427: 6264_ch11: Pg 290: 27337#/eps at 100s wea,Feb13,200210:27AM

User JOEWA:Job EFF01427:6264_ch11:Pg 290:27337#/eps at 100% *27337* Wed, Feb 13, 2002 10:27 AM What Is the Fed’s Policy Instrument—The Money Supply or the Interest Rate? Our analysis of monetary policy has been based on the assumption that the Fed influences the economy by controlling the money supply. By contrast, when the media report on changes in Fed policy, they often simply say that the Fed has raised or lowered interest rates. Which is right? Even though these two views may seem different, both are correct, and it is important to understand why. In recent years, the Fed has used the federal funds rate—the interest rate that banks charge one another for overnight loans—as its short-term policy instrument.When the Federal Open Market Committee meets every six weeks to set monetary policy, it votes on a target for this interest rate that will apply until the next meeting.After the meeting is over, the Fed’s bond traders in New York are told to conduct the open-market operations necessary to hit that target.These open-market operations change the money supply and shift the LM curve so that the equilibrium interest rate (determined by the intersection of the IS and LM curves) equals the target interest rate that the Federal Open Market Committee has chosen. As a result of this operating procedure, Fed policy is often discussed in terms of changing interest rates. Keep in mind, however, that behind these changes in interest rates are the necessary changes in the money supply.A newspaper might report, for instance, that “the Fed has lowered interest rates.” To be more precise, we can translate this statement as meaning “the Federal Open Market Committee has instructed the Fed bond traders to buy bonds in open-market operations so as to increase the money supply, shift the LM curve, and reduce the equilibrium interest rate to hit a new lower target.” Why has the Fed chosen to use an interest rate, rather than the money supply, as its short-term policy instrument? One possible answer is that shocks to the LM curve are more prevalent than shocks to the IS curve.When the Fed targets interest rates, it automatically offsets LM shocks by altering the money supply, but the policy exacerbates IS shocks. If LM shocks are the more prevalent type, then a policy of targeting the interest rate leads to greater economic stability than a policy of targeting the money supply. (Problem 7 at the end of this chapter asks you to analyze this issue more fully.) Another possible reason for using the interest rate as the short-term policy instrument is that interest rates are easier to measure than the money supply.As we 290 | PART IV Business Cycle Theory: The Economy in the Short Run At the same time, the Fed pursued expansionary monetary policy, shifting the LM curve to the right. Money growth accelerated, and interest rates fell.The interest rate on three-month Treasury bills fell from 6.4 percent in November of 2000 to 3.3 percent in August 2001, and then to 2.1 percent in September 2001 in the immediate aftermath of the terrorist attacks. The magnitude of the slowdown of 2001 was not yet determined as this book was going to press. The big question was whether the policy measures undertaken were sufficient to offset the shocks that the economy had suffered. By the time you are reading this, you may know the answer

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