cover R1,C4 slide ‹#› CHAPTER 9 Introduction to Economic Fluctuations CHAPTER 9 Introduction to Economic Fluctuations § § § 9. ISLM model § > cover R1,C4 slide ‹#› CHAPTER 9 Introduction to Economic Fluctuations CHAPTER 9 Introduction to Economic Fluctuations In this lecture, you will learn… §an introduction to business cycle and aggregate demand §the IS curve, and its relation to §the Keynesian cross §the loanable funds model §the LM curve, and its relation to §the theory of liquidity preference §how the IS-LM model determines income and the interest rate in the short run when P is fixed > cover R1,C4 slide ‹#› CHAPTER 9 Introduction to Economic Fluctuations CHAPTER 9 Introduction to Economic Fluctuations Short run §In the following lectures, we will study the short-run fluctuations of the economy (business cycles) §We focus on three models: §ISLM model (lecture 9) §Mudell-Fleming model (lecture 10) §Model AS-AD §AD (lectures 9 and 10) §AS (lecture 11) > cover R1,C4 slide ‹#› CHAPTER 9 Introduction to Economic Fluctuations CHAPTER 9 Introduction to Economic Fluctuations Facts about the business cycle §GDP growth averages 3–3.5 percent per year over the long run with large fluctuations in the short run. §Consumption and investment fluctuate with GDP, but consumption tends to be less volatile and investment more volatile than GDP. §Unemployment rises during recessions and falls during expansions. §Okun’s Law: the negative relationship between GDP and unemployment. > The four slides that follow provide data on each of these points. If you wish, you can “hide” (omit) this slide from your presentation, and instead give students the information verbally as you display the following slides. cover R1,C4 slide ‹#› CHAPTER 9 Introduction to Economic Fluctuations CHAPTER 9 Introduction to Economic Fluctuations Growth rates of real GDP, consumption -4 -2 0 2 4 6 8 10 1970 1975 1980 1985 1990 1995 2000 2005 Real GDP growth rate Average growth rate Consumption growth rate Percent change from 4 quarters earlier Over the long run, real GDP grows about 3 percent per year. Over the short run, though, there are substantial fluctuations in GDP, as this graph clearly shows. The pink shaded vertical bars denote recessions. This graph also shows the growth rate of consumption (from Figure 9-2(a) on p.255). I have graphed both variables on the same graph to make it easier for students to see that, in most years, consumption is less volatile than income. (An exception occurs in the late 1990s, when consumption growth exceeded income growth – probably due to the stock market boom.) As Chapter 16 covers in more detail, consumers prefer smooth consumption, so they use saving as a buffer against income shocks. Source of data: See Figure 9-1, p.254 cover R1,C4 slide ‹#› CHAPTER 9 Introduction to Economic Fluctuations CHAPTER 9 Introduction to Economic Fluctuations Growth rates of real GDP, consumption, investment -30 -20 -10 0 10 20 30 40 1970 1975 1980 1985 1990 1995 2000 2005 Percent change from 4 quarters earlier Investment growth rate Real GDP growth rate Consumption growth rate This graph reproduces GDP and consumption growth using a larger scale. The scale accommodates the investment growth rate data. The point: investment is much more volatile than consumption or GDP in the short run. Source: See Figure 9-2, p.255 cover R1,C4 slide ‹#› CHAPTER 9 Introduction to Economic Fluctuations CHAPTER 9 Introduction to Economic Fluctuations Unemployment 0 2 4 6 8 10 12 1970 1975 1980 1985 1990 1995 2000 2005 Percent of labor force The unemployment rate rises during recessions and falls during expansions. The unemployment rate sometimes lags changes in GDP growth. For example, after the 1991 recession ended, unemployment continued to rise for about a year before falling. After the 2001 recession ended, unemployment did not begin to fall for a couple quarters. Source: See Figure 9-3, p.256. cover R1,C4 slide ‹#› CHAPTER 9 Introduction to Economic Fluctuations CHAPTER 9 Introduction to Economic Fluctuations Okun’s Law Percentage change in real GDP Change in unemployment rate -4 -2 0 2 4 6 8 10 -3 -2 -1 0 1 2 3 4 1975 1982 1991 2001 1984 1951 1966 2003 1987 The green boxed equation in the upper right is the Okun’s Law equation shown on the bottom of p.256. In this equation, “u” denotes the unemployment rate. cover R1,C4 slide ‹#› CHAPTER 9 Introduction to Economic Fluctuations CHAPTER 9 Introduction to Economic Fluctuations Time horizons in macroeconomics §Long run: Prices are flexible, respond to changes in supply or demand. §Short run: Many prices are “sticky” at some predetermined level. The economy behaves much differently when prices are sticky. The material on this slide was introduced in Chapter 1. Since it’s been a while since your students read that chapter, it’s probably worth repeating at this point, especially since the behavior of prices is so critical for understanding short-run fluctuations. It might also be worth reminding them that they (and most adults) are already aware of the concept of sticky prices. If they have a favorite beverage at Starbucks, ask if they can remember when its price was last increased. If they work, ask how long they go between wage changes. Sticky prices are a fact of everyday life, even if most adults have not heard the term “sticky prices” or studied the implications of sticky prices for short-run economic fluctuations. cover R1,C4 slide ‹#› CHAPTER 9 Introduction to Economic Fluctuations CHAPTER 9 Introduction to Economic Fluctuations Recap of classical macro theory (Chaps. 3-8) §Output is determined by the supply side: §supplies of capital, labor §technology. §Changes in demand for goods & services (C, I, G ) only affect prices, not quantities. §Assumes complete price flexibility. §Applies to the long run. Classical macroeconomic theory is what we learned in chapters 3-8. This slide recaps an important lesson from classical theory, which stands in sharp contrast to what we are about to cover now. cover R1,C4 slide ‹#› CHAPTER 9 Introduction to Economic Fluctuations CHAPTER 9 Introduction to Economic Fluctuations When prices are sticky… §…output and employment also depend on demand, which is affected by §fiscal policy (G and T ) §monetary policy (M ) §other factors, like exogenous changes in C or I. > Chapters 9-11 focus on the closed economy case. In an open economy, the list of things that affect aggregate demand is a bit larger. (See chapter 12.) cover R1,C4 slide ‹#› CHAPTER 9 Introduction to Economic Fluctuations CHAPTER 9 Introduction to Economic Fluctuations The model of aggregate demand and supply §the paradigm most mainstream economists and policymakers use to think about economic fluctuations and policies to stabilize the economy §shows how the price level and aggregate output are determined §shows how the economy’s behavior is different in the short run and long run > cover R1,C4 slide ‹#› CHAPTER 9 Introduction to Economic Fluctuations CHAPTER 9 Introduction to Economic Fluctuations IS-LM §This chapter develops the IS-LM model, the basis of the aggregate demand curve. §We focus on the short run and assume the price level is fixed. §This lecture focuses on the closed-economy case. §Next lecture presents the open-economy case. > cover R1,C4 slide ‹#› CHAPTER 9 Introduction to Economic Fluctuations CHAPTER 9 Introduction to Economic Fluctuations The Keynesian Cross §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 > cover R1,C4 slide ‹#› CHAPTER 9 Introduction to Economic Fluctuations CHAPTER 9 Introduction to Economic Fluctuations Elements of the Keynesian Cross consumption function: for now, planned investment is exogenous: planned expenditure: equilibrium condition: govt policy variables: actual expenditure = planned expenditure Stress that much of this model is very familiar to students: same consumption function as in previous chapters, same treatment of fiscal policy variables. Note: In equilibrium, there is no unplanned inventory investment. Firms are selling everything they had intended to sell. cover R1,C4 slide ‹#› CHAPTER 9 Introduction to Economic Fluctuations CHAPTER 9 Introduction to Economic Fluctuations Graphing planned expenditure income, output, Y E planned expenditure E =C +I +G MPC 1 Why slope of E line equals the MPC: With I and G exogenous, the only component of (C+I+G) that changes when income changes is consumption. A one-unit increase in income causes consumption---and therefore E---to increase by the MPC. Recall from Chapter 3: the marginal propensity to consume, MPC, equals the increase in consumption resulting from a one-unit increase in disposable income. Since T is exogenous here, a one-unit increase in Y causes a one-unit increase in disposable income. cover R1,C4 slide ‹#› CHAPTER 9 Introduction to Economic Fluctuations CHAPTER 9 Introduction to Economic Fluctuations Graphing the equilibrium condition income, output, Y E planned expenditure E =Y 45º cover R1,C4 slide ‹#› CHAPTER 9 Introduction to Economic Fluctuations CHAPTER 9 Introduction to Economic Fluctuations The equilibrium value of income income, output, Y E planned expenditure E =Y E =C +I +G Equilibrium income The equilibrium point is the value of income where the curves cross. Be sure your students understand why the equilibrium income appears on the horizontal and vertical axes. Answer: In equilibrium, E (which is measured on the vertical) equals Y (which is measured on the horizontal). cover R1,C4 slide ‹#› CHAPTER 9 Introduction to Economic Fluctuations CHAPTER 9 Introduction to Economic Fluctuations An increase in government purchases Y E E =C +I +G1 E1 = Y1 E =C +I +G2 E2 = Y2 DY At Y1, there is now an unplanned drop in inventory… …so firms increase output, and income rises toward a new equilibrium. DG Explain why the vertical distance of the shift in the E curve equals G: At any value of Y, an increase in G by the amount G causes an increase in E by the same amount. At Y[1], there is now an unplanned depletion of inventories, because people are buying more than firms are producing (E > Y). cover R1,C4 slide ‹#› CHAPTER 9 Introduction to Economic Fluctuations CHAPTER 9 Introduction to Economic Fluctuations Solving for DY equilibrium condition in changes because I exogenous because DC = MPC DY Collect terms with DY on the left side of the equals sign: Solve for DY : cover R1,C4 slide ‹#› CHAPTER 9 Introduction to Economic Fluctuations CHAPTER 9 Introduction to Economic Fluctuations The government purchases multiplier Example: If MPC = 0.8, then §Definition: the increase in income resulting from a $1 increase in G. §In this model, the govt purchases multiplier equals An increase in G causes income to increase 5 times as much! The textbook defines the multiplier as the increase in income resulting from a $1 increase in G. However, G is a real variable (as is Y ). So, if you wish to be more precise, then you might consider defining the multiplier as “the increase in income resulting from a one-unit increase in G.” cover R1,C4 slide ‹#› CHAPTER 9 Introduction to Economic Fluctuations CHAPTER 9 Introduction to Economic Fluctuations Why the multiplier is greater than 1 §Initially, the increase in G causes an equal increase in Y: DY = DG. §But Y Þ C § Þ further Y § Þ further C § Þ further Y §So the final impact on income is much bigger than the initial DG. > Students are better able to understand this if given a more concrete example, which you can explain as you display the elements on this slide. For instance, Suppose the government spends an additional $100 million on defense. Then, the revenues of defense firms increase by $100 million, all of which becomes income to somebody: some of it is paid to the workers and engineers and managers, the rest is profit paid as dividends to shareholders. Hence, income rises $100 million (Y = $100 million = G ). The people whose income just rose by $100 million are also consumers, and they will spend the fraction MPC of this extra income. Suppose MPC = 0.8, so C rises by $80 million. To be concrete, suppose they buy $80 million worth of Ford Explorers. Then, Ford sees its revenues increase by $80 million, all of which becomes income to somebody - either Ford’s workers, or its shareholders (Y = $80 million). And what do these folks do with this extra income? They spend the fraction MPC (0.8) of it, causing C = $64 million (8/10 of $80 million). Suppose they spend all $64 million on Hershey’s chocolate bars, the ones with the bits of mint cookie inside. Then, Hershey Foods Corporation experiences a revenue increase of $64 million, which becomes income to somebody or other. (Y = $64 million). So far, the total impact on income is $100 million + $80 million + $64 million, which is much bigger than the government’s initial increase in spending. But this process continues, and the final impact on Y is $500 million (because the multiplier is 5). cover R1,C4 slide ‹#› CHAPTER 9 Introduction to Economic Fluctuations CHAPTER 9 Introduction to Economic Fluctuations An increase in taxes Y E E =C2 +I +G E2 = Y2 E =C1 +I +G E1 = Y1 DY At Y1, there is now an unplanned inventory buildup… …so firms reduce output, and income falls toward a new equilibrium DC = -MPC DT Initially, the tax increase reduces consumption, and therefore E: Experiment: An increase in taxes (note: the book does a decrease in taxes) Suppose taxes are increased by T. Because I and G are exogenous, they do not change. However, C depends on (YT). So, at the initial value of Y, a tax increase of T causes disposable income to fall by T, which causes consumption to fall by MPC  T. Because consumption falls, the change in C is negative: C =  MPC  T C is part of planned expenditure. The fall in C causes the E line to shift down by the size of the initial drop in C. At the initial value of output, there is now unplanned inventory investment: Sales have fallen below output, so the unsold output adds to inventory. In this situation, firms will reduce production, causing total output, income, and expenditure to fall. The new equilibrium is at Y[2], where planned expenditure once again equals actual expenditure/output, and unplanned inventory investment is again equal to zero. cover R1,C4 slide ‹#› CHAPTER 9 Introduction to Economic Fluctuations CHAPTER 9 Introduction to Economic Fluctuations Solving for DY eq’m condition in changes I and G exogenous Solving for DY : Final result: cover R1,C4 slide ‹#› CHAPTER 9 Introduction to Economic Fluctuations CHAPTER 9 Introduction to Economic Fluctuations The tax multiplier §def: the change in income resulting from a $1 increase in T : If MPC = 0.8, then the tax multiplier equals cover R1,C4 slide ‹#› CHAPTER 9 Introduction to Economic Fluctuations CHAPTER 9 Introduction to Economic Fluctuations The tax multiplier tax forms(60) §…is negative: A tax increase reduces C, which reduces income. §…is greater than one (in absolute value): A change in taxes has a multiplier effect on income. §…is smaller than the govt spending multiplier: 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. > cover R1,C4 slide ‹#› CHAPTER 9 Introduction to Economic Fluctuations CHAPTER 9 Introduction to Economic Fluctuations The IS curve §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: cover R1,C4 slide ‹#› CHAPTER 9 Introduction to Economic Fluctuations CHAPTER 9 Introduction to Economic Fluctuations Y2 Y1 Y2 Y1 Deriving the IS curve §¯r Þ I Y E r Y E =C +I (r1 )+G E =C +I (r2 )+G r1 r2 E =Y IS DI Þ E Þ Y cover R1,C4 slide ‹#› CHAPTER 9 Introduction to Economic Fluctuations CHAPTER 9 Introduction to Economic Fluctuations Why the IS curve is negatively sloped §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. > This slide simply states the intuition behind the graphs on the preceding slide. Suggestion: Omit this slide from your presentation, and just give the students this information verbally as you present the preceding slide. cover R1,C4 slide ‹#› CHAPTER 9 Introduction to Economic Fluctuations CHAPTER 9 Introduction to Economic Fluctuations The IS curve and the loanable funds model S, I r I (r ) r1 r2 r Y Y1 r1 r2 (a) The L.F. model (b) The IS curve Y2 S1 S2 IS The IS curve can also be derived from the (hopefully now familiar) loanable funds model from chapter 3. A decrease in income from Y[1] to Y[2] causes a fall in national saving. (Recall, S = Y-C-G) The fall in saving causes a reduction in the supply of loanable funds. The interest rate must rise to restore equilibrium to the loanable funds market. Now we can see where the IS curve gets its name: When the loanable funds market is in equilibrium, investment = saving. The IS curve shows all combinations of r and Y such that investment (I) equals saving (S). Hence, “IS curve.” cover R1,C4 slide ‹#› CHAPTER 9 Introduction to Economic Fluctuations CHAPTER 9 Introduction to Economic Fluctuations Fiscal Policy and the IS curve §We can use the IS-LM model to see how fiscal policy (G and T ) affects aggregate demand and output. §Let’s start by using the Keynesian cross to see how fiscal policy shifts the IS curve… > cover R1,C4 slide ‹#› CHAPTER 9 Introduction to Economic Fluctuations CHAPTER 9 Introduction to Economic Fluctuations Y2 Y1 Y2 Y1 Shifting the IS curve: DG §At any value of r, G Þ E Þ Y Y E r Y E =C +I (r1 )+G1 E =C +I (r1 )+G2 r1 E =Y IS1 The horizontal distance of the IS shift equals IS2 …so the IS curve shifts to the right. DY This slide has two purposes. First, to show which way the IS curve shifts when G changes. Second, to actually measure the distance of the shift. We can measure either the horizontal or vertical distance of the shift. The horizontal distance of the IS curve shift is the change in Y required to restore goods market equilibrium AT THE INITIAL INTEREST RATE when G is raised. Since the interest rate is unchanged at r[1], investment will also be unchanged. This is why, in the upper panel, we write “I(r[1])” in the E equation for both expenditure curves – to remind us that investment and the interest rate are not changing. cover R1,C4 slide ‹#› CHAPTER 9 Introduction to Economic Fluctuations CHAPTER 9 Introduction to Economic Fluctuations The Theory of Liquidity Preference §Due to John Maynard Keynes. §A simple theory in which the interest rate is determined by money supply and money demand. § > cover R1,C4 slide ‹#› CHAPTER 9 Introduction to Economic Fluctuations CHAPTER 9 Introduction to Economic Fluctuations Money supply §The supply of real money balances is fixed: M/P real money balances r interest rate We are assuming a fixed supply of real money balances because P is fixed by assumption (short-run), and M is an exogenous policy variable. cover R1,C4 slide ‹#› CHAPTER 9 Introduction to Economic Fluctuations CHAPTER 9 Introduction to Economic Fluctuations Money demand §Demand for real money balances: M/P real money balances r interest rate L (r ) As we learned in chapter 4, the nominal interest rate is the opportunity cost of holding money (instead of bonds), so money demand depends negatively on the nominal interest rate. Here, we are assuming the price level is fixed, so  = 0 and r = i. cover R1,C4 slide ‹#› CHAPTER 9 Introduction to Economic Fluctuations CHAPTER 9 Introduction to Economic Fluctuations Equilibrium §The interest rate adjusts to equate the supply and demand for money: M/P real money balances r interest rate L (r ) r1 cover R1,C4 slide ‹#› CHAPTER 9 Introduction to Economic Fluctuations CHAPTER 9 Introduction to Economic Fluctuations How the Fed raises the interest rate §To increase r, Fed reduces M M/P real money balances r interest rate L (r ) r1 r2 cover R1,C4 slide ‹#› CHAPTER 9 Introduction to Economic Fluctuations CHAPTER 9 Introduction to Economic Fluctuations CASE STUDY: Monetary Tightening & Interest Rates §Late 1970s: p > 10% §Oct 1979: Fed Chairman Paul Volcker announces that monetary policy would aim to reduce inflation §Aug 1979-April 1980: Fed reduces M/P 8.0% §Jan 1983: p = 3.7% How do you think this policy change would affect nominal interest rates? This and the next slide summarize the case study on p.295. The data source is given on the next slide. At this point, students have now learned two theories about the effects of monetary policy on interest rates. This case study shows them that both theories are relevant, using a real-world example to remind students that the classical theory of chapter 4 applies in the long-run while the liquidity preference theory applies in the short run. cover R1,C4 Monetary Tightening & Rates, cont. Di < 0 Di > 0 8/1979: i = 10.4% 1/1983: i = 8.2% 8/1979: i = 10.4% 4/1980: i = 15.8% flexible sticky Quantity theory, Fisher effect (Classical) Liquidity preference (Keynesian) prediction actual outcome The effects of a monetary tightening on nominal interest rates prices model long run short run Since prices are sticky in the short run, the Liquidity Preference Theory predicts that both the nominal and real interest rates will rise in the short run. And in fact, both did. (However, the inflation rate was not zero, and in fact it increased, so the real interest rate didn’t rise as much as the nominal interest rate did during the period shown.) In the long run, the Quantity Theory of Money says that the monetary tightening should reduce inflation. The Fisher Effect says that the fall in  should cause an equal fall in i. By January of 1983 (which is “the long run” from the viewpoint of 1979), inflation and nominal interest rates had fallen. (However, they did not fall by equal amounts. This doesn’t contradict the Fisher Effect, though, as other economic changes caused movements in the real interest rate.) About the data: i = 3-month rate on Commercial Paper % change in M/P from previous slide: I computed M1/CPI (the measure used in the case study), then computed the percentage change in M1/CPI over the 8-month period beginning with the month in which Volcker became the Fed chairman, August 1979. Source: FRED database, Federal Reserve Bank of St. Louis. cover R1,C4 slide ‹#› CHAPTER 9 Introduction to Economic Fluctuations CHAPTER 9 Introduction to Economic Fluctuations The LM curve §Now let’s put Y back into the money demand function: 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: cover R1,C4 slide ‹#› CHAPTER 9 Introduction to Economic Fluctuations CHAPTER 9 Introduction to Economic Fluctuations Deriving the LM curve M/P r L (r , Y1 ) r1 r2 r Y Y1 r1 L (r , Y2 ) r2 Y2 LM (a) The market for real money balances (b) The LM curve cover R1,C4 slide ‹#› CHAPTER 9 Introduction to Economic Fluctuations CHAPTER 9 Introduction to Economic Fluctuations Why the LM curve is upward sloping §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. > This slide simply states the intuition behind the graphs on the preceding slide. Suggestion: Omit this slide from your presentation, and just give the students this information verbally as you present the preceding slide. cover R1,C4 slide ‹#› CHAPTER 9 Introduction to Economic Fluctuations CHAPTER 9 Introduction to Economic Fluctuations How DM shifts the LM curve M/P r L (r , Y1 ) r1 r2 r Y Y1 r1 r2 LM1 (a) The market for real money balances (b) The LM curve LM2 If you’re as anal as I am, you might consider helping your students understand the analytical difference between looking at a shift as a horizontal shift and looking at it as a vertical shift. We can think of the LM curve shift as a vertical shift: When the Fed reduces M, the vertical distance of the shift tells us what happens to the equilibrium interest rate associated with a given value of income. Or, we can think of the LM curve shifting horizontally: When the Fed reduces M, the horizontal distance of the shift tells us what would have to happen to income to restore money market equilibrium at the initial interest rate. (The graphical analysis would be a little different than what’s depicted on this slide.) cover R1,C4 slide ‹#› CHAPTER 9 Introduction to Economic Fluctuations CHAPTER 9 Introduction to Economic Fluctuations 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. IS Y r LM r1 Y1 Review/recap of the very end of Chapter 10. cover R1,C4 slide ‹#› CHAPTER 9 Introduction to Economic Fluctuations CHAPTER 9 Introduction to Economic Fluctuations Policy analysis with the IS -LM model §We can use the IS-LM model to analyze the effects of •fiscal policy: G and/or T •monetary policy: M IS Y r LM r1 Y1 cover R1,C4 slide ‹#› CHAPTER 9 Introduction to Economic Fluctuations CHAPTER 9 Introduction to Economic Fluctuations causing output & income to rise. IS1 An increase in government purchases §1. IS curve shifts right Y r LM r1 Y1 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 3. Chapter 10 showed that an increase in G causes the IS curve to shift to the right by (G)/(1-MPC). cover R1,C4 slide ‹#› CHAPTER 9 Introduction to Economic Fluctuations CHAPTER 9 Introduction to Economic Fluctuations IS1 1. A tax cut Y r LM r1 Y1 IS2 Y2 r2 Consumers save (1-MPC) of the tax cut, so the initial boost in spending is smaller for DT than for an equal DG… and the IS curve shifts by 1. 2. 2. …so the effects on r and Y are smaller for DT than for an equal DG. 2. Chapter 10 used the Keynesian Cross to show that a decrease in T causes the IS curve to shift to the right by (-MPCT)/(1-MPC). If your students ask why the IS curve shifts to the right when there’s a negative sign in the expression for the shift, remind them that T < 0 for a tax cut, so the expression actually is positive. The term showing the distance of the shift in the IS curve is almost the same as in the case of a government spending increase, where the numerator of the fraction equals (1) for government spending rather than (-MPC) for the tax cut. Here’s the intuition: Every dollar of a government spending increase adds to aggregate spending. However, for tax cuts, the fraction (1-MPC) of the tax cut leaks into saving, so aggregate spending only rises by MPC times the tax cut. cover R1,C4 slide ‹#› CHAPTER 9 Introduction to Economic Fluctuations CHAPTER 9 Introduction to Economic Fluctuations 2. …causing the interest rate to fall IS Monetary policy: An increase in M §1. DM > 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. Chapter 10 showed that an increase in M shifts the LM curve to the right. Here is a richer explanation for the LM shift: The increase in M causes the interest rate to fall. [People like to keep optimal proportions of money and bonds in their portfolios; if money is increased, then people try to re-attain their optimal proportions by “exchanging” some of the money for bonds: they use some of the extra money to buy bonds. This increase in the demand for bonds drives up the price of bonds -- and causes interest rates to fall (since interest rates are inversely related to bond prices). The fall in the interest rate induces an increase in investment demand, which causes output and income to increase. The increase in income causes money demand to increase, which increases the interest rate (though doesn’t increase it all the way back to its initial value; instead, this effect simply reduces the total decrease in the interest rate). cover R1,C4 slide ‹#› CHAPTER 9 Introduction to Economic Fluctuations CHAPTER 9 Introduction to Economic Fluctuations 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. > cover R1,C4 slide ‹#› CHAPTER 9 Introduction to Economic Fluctuations CHAPTER 9 Introduction to Economic Fluctuations The Fed’s response to DG > 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 DG are different: > cover R1,C4 slide ‹#› CHAPTER 9 Introduction to Economic Fluctuations CHAPTER 9 Introduction to Economic Fluctuations 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: cover R1,C4 slide ‹#› CHAPTER 9 Introduction to Economic Fluctuations CHAPTER 9 Introduction to Economic Fluctuations If Congress raises G, the IS curve shifts right. IS1 Response 2: Hold r constant Y r LM1 r1 Y1 IS2 Y2 r2 To keep r constant, Fed increases M to shift LM curve right. LM2 Y3 Results: cover R1,C4 slide ‹#› CHAPTER 9 Introduction to Economic Fluctuations CHAPTER 9 Introduction to Economic Fluctuations IS1 Response 3: Hold Y constant Y r LM1 r1 IS2 Y2 r2 To keep Y constant, Fed reduces M to shift LM curve left. LM2 Results: Y1 r3 If Congress raises G, the IS curve shifts right. cover R1,C4 slide ‹#› CHAPTER 9 Introduction to Economic Fluctuations CHAPTER 9 Introduction to Economic Fluctuations Estimates of fiscal policy multipliers §from the DRI macroeconometric model Assumption about monetary policy Estimated value of DY / DG Fed holds nominal interest rate constant Fed holds money supply constant 1.93 0.60 Estimated value of DY / DT -1.19 -0.26 The preceding slides show that the impact of fiscal policy on GDP depends on the Fed’s response (or lack thereof). This slide shows estimates of the fiscal policy multipliers under different assumptions about monetary policy; these estimates are consistent with the theoretical results on the preceding slides. First, the slide shows estimates of the government spending multiplier for the two different monetary policy scenarios. Then, the slide reveals the tax multiplier estimates. (If you wish, you can turn off the animation so that everything appearing on the slide appears at one time. Just click on the “Slide Show” pull-down menu, then on “Custom animation…”, then uncheck all of the boxes next to the elements of the screen that you do not wish to be animated. Regarding the estimates: First, note that the estimates of the fiscal policy multipliers are smaller (in absolute value) when the money supply is held constant than when the interest rate is held constant. This is consistent with the results from the IS-LM model presented in the preceding few slides. Second, notice that the tax multiplier is smaller than the government spending multiplier in each of the monetary policy scenarios. This should make sense from material presented earlier in this chapter: the government spending multiplier (for a constant money supply) is 1/(1-MPC), while the tax multiplier is only (-MPC)/(1-MPC). cover R1,C4 slide ‹#› CHAPTER 9 Introduction to Economic Fluctuations CHAPTER 9 Introduction to Economic Fluctuations 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 P would shift LM and therefore affect Y. §The aggregate demand curve (introduced in Chap. 9) captures this relationship between P and Y. cover R1,C4 slide ‹#› CHAPTER 9 Introduction to Economic Fluctuations CHAPTER 9 Introduction to Economic Fluctuations Y1 Y2 Deriving the AD curve Y r Y P IS LM(P1) LM(P2) AD P1 P2 Y2 Y1 r2 r1 Intuition for slope of AD curve: P Þ ¯(M/P ) Þ LM shifts left Þ r Þ ¯I Þ ¯Y It might be useful to explain to students the reason why we draw P[1] before drawing the LM curve: The position of the LM curve depends on the value of M/P. M is an exogenous policy variable. So, if P is low (like P[1] in the lower panel of the diagram), then M/P is relatively high, so the LM curve is over toward the right in the upper diagram. If P is high, like P[2], then M/P is relatively low, so the LM curve is more toward the left. Because the value of P affects the position of the LM curve, we label the LM curves in the upper panel as LM(P[1]) and LM(P[2]). cover R1,C4 slide ‹#› CHAPTER 9 Introduction to Economic Fluctuations CHAPTER 9 Introduction to Economic Fluctuations Monetary policy and the AD curve Y P IS LM(M2/P1) LM(M1/P1) AD1 P1 Y1 Y1 Y2 Y2 r1 r2 The Fed can increase aggregate demand: M Þ LM shifts right AD2 Y r Þ ¯r Þ I Þ Y at each value of P It’s worth taking a moment to explain why we are holding P fixed at P[1]: To find out whether the AD curve shifts to the left or right, we need to find out what happens to the value of Y associated with any given value of P. This is not to say that the equilibrium value of P will remain fixed after the policy change (though, in fact, we are assuming P is fixed in the short run). We just want to see what happens to the AD curve. Once we know how the AD curve shifts, we can then add the AS curves (short- or long-run) to find out what, if anything, happens to P (in the short- or long-run). cover R1,C4 slide ‹#› CHAPTER 9 Introduction to Economic Fluctuations CHAPTER 9 Introduction to Economic Fluctuations Y2 Y2 r2 Y1 Y1 r1 Fiscal policy and the AD curve Y r Y P IS1 LM AD1 P1 Expansionary fiscal policy (G and/or ¯T ) increases agg. demand: ¯T Þ C Þ IS shifts right Þ Y at each value of P AD2 IS2 cover R1,C4 slide ‹#› CHAPTER 9 Introduction to Economic Fluctuations CHAPTER 9 Introduction to Economic Fluctuations 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. rise fall remain constant In the short-run equilibrium, if then over time, the price level will The next few slides put our IS-LM-AD in the context of the bigger picture - the AD-AS model in the short-run and long-run, which was introduced in Chapter 9. cover R1,C4 slide ‹#› CHAPTER 9 Introduction to Economic Fluctuations CHAPTER 9 Introduction to Economic Fluctuations The Big Picture Keynesian Cross Theory of Liquidity Preference IS curve LM curve IS-LM model Agg. demand curve Agg. supply curve Model of Agg. Demand and Agg. Supply Explanation of short-run fluctuations Figure 10-15, p.300. This schematic diagram shows how the different pieces of the theory of short-run fluctuations fit together. Chapter Summary 1.Keynesian cross §basic model of income determination §takes fiscal policy & investment as exogenous §fiscal policy has a multiplier effect on income. 2. IS curve §comes from Keynesian cross when planned investment depends negatively on interest rate §shows all combinations of r and Y that equate planned expenditure with actual expenditure on goods & services CHAPTER 10 Aggregate Demand I slide 60 cover R3,C1 > Chapter Summary 3.Theory of Liquidity Preference §basic model of interest rate determination §takes money supply & price level as exogenous §an increase in the money supply lowers the interest rate 4. LM curve §comes from liquidity preference theory when money demand depends positively on income §shows all combinations of r and Y that equate demand for real money balances with supply CHAPTER 10 Aggregate Demand I slide 61 cover R3,C1 > Chapter Summary 5. IS-LM model §Intersection of IS and LM curves shows the unique point (Y, r ) that satisfies equilibrium in both the goods and money markets. § CHAPTER 10 Aggregate Demand I slide 62 cover R3,C1 > Chapter Summary § 2. AD curve §shows relation between P and the IS-LM model’s equilibrium Y. §negative slope because P Þ ¯(M/P ) Þ r Þ ¯I Þ ¯Y §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. CHAPTER 11 Aggregate Demand II slide 63 cover R3,C1 > cover R1,C4 slide ‹#› CHAPTER 9 Introduction to Economic Fluctuations CHAPTER 9 Introduction to Economic Fluctuations § §APPENDIX: The Great Depression § > cover R1,C4 slide ‹#› CHAPTER 9 Introduction to Economic Fluctuations CHAPTER 9 Introduction to Economic Fluctuations The Great Depression Unemployment (right scale) Real GNP (left scale) 120 140 160 180 200 220 240 1929 1931 1933 1935 1937 1939 0 5 10 15 20 25 30 This chart presents data from Table 11-2 on pp.318-9 of the text. For data sources, see notes accompanying that table. Things to note: 1. The magnitude of the fall in output and increase in unemployment. In 1933, the unemployment rate is over 25%!! 2. There’s a very strong negative correlation between output and unemployment. cover R1,C4 slide ‹#› CHAPTER 9 Introduction to Economic Fluctuations CHAPTER 9 Introduction to Economic Fluctuations 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. > cover R1,C4 slide ‹#› CHAPTER 9 Introduction to Economic Fluctuations CHAPTER 9 Introduction to Economic Fluctuations THE SPENDING HYPOTHESIS: Reasons for the IS shift §Stock market crash Þ exogenous ¯C §Oct-Dec 1929: S&P 500 fell 17% §Oct 1929-Dec 1933: S&P 500 fell 71% §Drop in investment §“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. > In item 2, I’m using the term “correction” in the stock market sense. cover R1,C4 slide ‹#› CHAPTER 9 Introduction to Economic Fluctuations CHAPTER 9 Introduction to Economic Fluctuations 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: §P fell even more, so M/P actually rose slightly during 1929-31. §nominal interest rates fell, which is the opposite of what a leftward LM shift would cause. > cover R1,C4 slide ‹#› CHAPTER 9 Introduction to Economic Fluctuations CHAPTER 9 Introduction to Economic Fluctuations THE MONEY HYPOTHESIS AGAIN: The effects of falling prices §asserts that the severity of the Depression was due to a huge deflation: P fell 25% during 1929-33. §This deflation was probably caused by the fall in M, so perhaps money played an important role after all. §In what ways does a deflation affect the economy? > cover R1,C4 slide ‹#› CHAPTER 9 Introduction to Economic Fluctuations CHAPTER 9 Introduction to Economic Fluctuations THE MONEY HYPOTHESIS AGAIN: The effects of falling prices §The stabilizing effects of deflation: §¯P Þ (M/P ) Þ LM shifts right Þ Y §Pigou effect: § ¯P Þ (M/P ) § Þ consumers’ wealth § Þ C § Þ IS shifts right § Þ Y > cover R1,C4 slide ‹#› CHAPTER 9 Introduction to Economic Fluctuations CHAPTER 9 Introduction to Economic Fluctuations THE MONEY HYPOTHESIS AGAIN: The effects of falling prices §The destabilizing effects of expected deflation: § ¯p e §Þ r for each value of i §Þ I ¯ because I = I (r ) §Þ planned expenditure & agg. demand ¯ §Þ income & output ¯ § > The textbook (starting p.322) uses an “extended” IS-LM model, which includes both the nominal interest rate (measured on the vertical axis) and the real interest rate (which equals the nominal rate less expected inflation). Because money demand depends on the nominal rate, which is measured on the vertical axis, the change in expected inflation doesn’t shift the LM curve. However, investment depends on the real interest rate, so the fall in expected inflation shifts the IS curve: each value of i is now associated with a higher value of r, which reduces investment and shifts the IS curve to the left. Results: income falls, i falls, and r rises --- which is exactly what happened from 1929 to 1931 (see table 11-2 on pp.318-9). This slide gives the basic intuition, which students often can grasp more quickly and easily than the graphical analysis. After you cover this material in your lecture, it will be easier for your students to grasp the analysis on pp.322-23. cover R1,C4 slide ‹#› CHAPTER 9 Introduction to Economic Fluctuations CHAPTER 9 Introduction to Economic Fluctuations THE MONEY HYPOTHESIS AGAIN: The effects of falling prices §The destabilizing effects of unexpected deflation: debt-deflation theory §¯P (if unexpected) §Þ transfers purchasing power from borrowers to lenders §Þ borrowers spend less, lenders spend more §Þ if borrowers’ propensity to spend is larger than lenders’, then aggregate spending falls, the IS curve shifts left, and Y falls >