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7/31/2019 Chap11(Agg Demand II)
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macroeconomicsfifth edition
N. Gregory Mankiw
PowerPoint Slides
by Ron Cronovich
CHAPTER ELEVEN
Aggregate Demand II
macro
2004 Worth Publishers, all rights reserved
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m
CHAPTER 11 Aggregate Demand II slide 1
Context
Chapter 9 introduced the model of aggregatedemand and supply.
Chapter 10 developed the IS-LM model, thebasis of the aggregate demand curve.
In Chapter 11, we will use the IS-LM model to
see how policies and shocks affect incomeand the interest rate in the short run when
prices are fixed derive the aggregate demand curve
explore various explanations for theGreat Depression
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CHAPTER 11 Aggregate Demand II slide 2
The intersection determines
the unique combination ofY and r
that satisfies equilibrium in both markets.
The LMcurve represents
money market equilibrium.
Equilibrium in the IS-LMModel
The IScurve representsequilibrium in the goods
market.
( ) ( )Y C Y T I r G
( , )M P L r Y IS
Y
rLM
r1
Y1
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CHAPTER 11 Aggregate Demand II slide 3
Policy analysis with the IS-LMModel
Policymakers can affect
macroeconomic variableswith
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
rLM
r1
Y1
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CHAPTER 11 Aggregate Demand II slide 4
causing output &
income to rise.
IS1
An increase in government purchases
1. IScurve shifts right
Y
rLM
r1
Y1
1by
1 MPCG
IS2
Y2
r2
1.2. This raises money
demand, causing theinterest rate to rise
2.
3. which reduces investment,so the final increase in Y
1is smaller than
1 MPCG
3.
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CHAPTER 11 Aggregate Demand II slide 5
IS1
1.
A tax cut
Y
rLM
r1
Y1
IS2
Y2
r2
Because consumers save
(1MPC) of the tax cut,
the initial boost in
spending is smaller for T
than for an equal G
and the IScurve
shifts by
MPC
1 MPCT
1.
2.
2.so the effects on r and Y
are smaller for a T than
for an equal G.
2.
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CHAPTER 11 Aggregate Demand II slide 6
2. causing theinterest rate to fall
IS
Monetary Policy: an increase in M
1. M> 0 shiftsthe LMcurve down(or to the right)
Y
r LM1
r1
Y1 Y2
r2
LM2
3. which increases
investment, causingoutput & income torise.
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CHAPTER 11 Aggregate Demand II slide 7
Interaction betweenmonetary & 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 ofthe original policy change.
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CHAPTER 11 Aggregate Demand II slide 8
The Feds 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 Gare different:
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CHAPTER 11 Aggregate Demand II slide 9
If Congress raises G,the IS curve shifts
right
IS1
Response 1: hold M constant
Y
rLM1
r1
Y1
IS2
Y2
r2If Fed holds M
constant, then LM
curve doesnt shift.
Results:
2 1Y Y Y
2 1r r r
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CHAPTER 11 Aggregate Demand II slide 10
If Congress raises G,the IS curve shifts
right
IS1
Response 2: hold r constant
Y
rLM1
r1
Y1
IS2
Y2
r2To keep r constant,
Fed increases M to
shift LM curve right.
3 1Y Y Y
0r
LM2
Y3
Results:
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CHAPTER 11 Aggregate Demand II slide 11
If Congress raises G,the IS curve shifts
right
IS1
Response 3: hold Y constant
Y
rLM1
r1
IS2
Y2
r2To keep Y constant,
Fed reduces M to
shift LM curve left.
0Y
3 1r r r
LM2
Results:
Y1
r3
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CHAPTER 11 Aggregate Demand II slide 12
Estimates of fiscal policy multipliers
from the DRI macroeconometric model
Assumption aboutmonetary policy
Estimatedvalue ofY/ G
Fed holds nominalinterest rate constant
Fed holds moneysupply constant
1.93
0.60
Estimatedvalue ofY/ T
1.19
0.26
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CHAPTER 11 Aggregate Demand II slide 13
Shocks in the IS-LMModel
ISshocks: exogenous changes in thedemand for goods & services.
Examples:
stock market boom or crashchange in households wealth C
change in business or consumer
confidence or expectations I and/or C
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CHAPTER 11 Aggregate Demand II slide 15
EXERCISE:Analyze shocks with the IS-LM model
Use the IS-LMmodel to analyze the effects of1. A boom in the stock market makes
consumers wealthier.
2. After a wave of credit card fraud, consumers
use cash more frequently in transactions.
For each shock,
a. use the IS-LMdiagram to show the effects
of the shock on Y and r.b. determine what happens to C, I, and the
unemployment rate.
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CHAPTER 11 Aggregate Demand II slide 16
CASE STUDY
The U.S. economic slowdown of 2001~What happened~
1. Real GDP growth rate
1994-2000: 3.9% (average annual)
2001: 0.8% for the year,
March 2001 determined to be the end ofthe longest expansion on record.
2. Unemployment rate
Dec 2000: 3.9%
Dec 2001: 5.8%
The number of unemployed peoplerose by 2.1 million during 2001!
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CHAPTER 11 Aggregate Demand II slide 17
CASE STUDY
The U.S. economic slowdown of 2001
~Shocks that contributed to the slowdown~1. Falling stock prices
From Aug 2000 to Aug 2001: -25%Week after 9/11: -12%
2. The terrorist attacks on 9/11
increased uncertainty
fall in consumer & business confidence
Both shocks reduced spending andshifted the IS curve left.
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CHAPTER 11 Aggregate Demand II slide 18
CASE STUDY
The U.S. economic slowdown of 2001
~The policy response~1. Fiscal policy large long-term tax cut,
immediate $300 rebate checks
spending increases:aid to New York City & the airline industry,war on terrorism
2. Monetary policy
Fed lowered its Fed Funds rate target11 times during 2001, from 6.5% to 1.75%
Money growth increased, interest rates fell
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CHAPTER 11 Aggregate Demand II slide 19
CASE STUDY
The U.S. economic slowdown of 2001~The recovery~
The recession officially ended in November2001.
Real GDP recovered, growing2.3% in 2002 and 4.4% in 2003.
The unemployment rate lagged:5.8% in 2002, 6.0% in 2003.
The Fed cut interest rates in 11/02 and 6/03.
Unemployment finally appears to beresponding: 5.6% for the first half of 2004.
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CHAPTER 11 Aggregate Demand II slide 20
What is the Feds policy instrument?
What the newspaper says:the Fed lowered interest rates by one-half point today
What actually happened:The Fed conducted expansionary monetary policy to
shift the LM curve to the right until the interest rate fell0.5 points.
The Fedtargetsthe Federal Funds rate:
it announces a target value,and uses monetary policy to shift the LM curve
as needed to attain its target rate.
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CHAPTER 11 Aggregate Demand II slide 21
What is the Feds policy instrument?
Why does the Fed target interest ratesinstead of the money supply?
1) They are easier to measure than themoney supply
2) The Fed might believe that LMshocks aremore prevalent than ISshocks. If so, thentargeting the interest rate stabilizes incomebetter than targeting the money supply.(See Problem 7 on p.306)
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CHAPTER 11 Aggregate Demand II slide 22
IS-LM and Aggregate Demand
So far, weve been using the IS-LMmodelto analyze the short run, when the pricelevel is assumed fixed.
However, a change inP
would shift theLMcurve and therefore affect Y.
The aggregate demand curve(introduced in chap. 9) captures thisrelationship between P and Y
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CHAPTER 11 Aggregate Demand II slide 23
Y1Y2
Deriving the ADcurve
Y
r
Y
P
IS
LM(P1)
LM(P2)
AD
P1
P2
Y2 Y1
r2
r1
Intuition for slope
ofADcurve:
P (M/P)
LM shifts left
r
I
Y
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CHAPTER 11 Aggregate Demand II slide 24
Monetary policy and the ADcurve
Y
P
IS
LM(M2/P1)
LM(M1/P
1)
AD1
P1
Y1
Y1
Y2
Y2
r1
r2
The Fed can increaseaggregate demand:
M LM shifts right
AD2
Y
r
r
I
Y at each
value ofP
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CHAPTER 11 Aggregate Demand II slide 25
Y2
Y2
r2
Y1
Y1
r1
Fiscal policy and the ADcurve
Y
r
Y
P
IS1
LM
AD1
P1
Expansionary fiscal policy(G and/or T)
increases agg. demand:
T
C
IS shifts right
Y at each
value
ofP AD2
IS2
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CHAPTER 11 Aggregate Demand II slide 26
IS-LMand AD-ASin the short run & long run
Recall from Chapter 9: The force that movesthe economy from the short run to the long run
is the gradual adjustment of prices.
Y Y
Y Y
Y Y
rise
fall
remain constant
In the short-runequilibrium, if
then over time,the price level will
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CHAPTER 11 Aggregate Demand II slide 27
The SR and LR effects of an ISshock
A negative ISshock
shifts ISandAD left,causing Y to fall.
Y
r
Y
P LRAS
Y
LRAS
Y
IS1
SRAS1P1
LM(P1)
IS2
AD2AD1
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CHAPTER 11 Aggregate Demand II slide 28
The SR and LR effects of an ISshock
Y
r
Y
P LRAS
Y
LRAS
Y
IS1
SRAS1P1
LM(P1)
IS2
AD2AD1
In the new short-runequilibrium, Y Y
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CHAPTER 11 Aggregate Demand II slide 29
The SR and LR effects of an ISshock
Y
r
Y
P LRAS
Y
LRAS
Y
IS1
SRAS1P1
LM(P1)
IS2
AD2AD1
In the new short-runequilibrium, Y Y
Over time,P gradually falls,which causes
SRAS to move down
M/P to increase,which causes LMto move down
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CHAPTER 11 Aggregate Demand II slide 30
AD2
The SR and LR effects of an ISshock
Y
r
Y
P LRAS
Y
LRAS
Y
IS1
SRAS1P1
LM(P1)
IS2
AD1
Over time,P gradually falls,which causes
SRAS to move down
M/P to increase,which causes LMto move down
SRAS2P2
LM(P2)
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CHAPTER 11 Aggregate Demand II slide 31
AD2
SRAS2P2
LM(P2)
The SR and LR effects of an ISshock
Y
r
Y
P LRAS
Y
LRAS
Y
IS1
SRAS1P1
LM(P1
)
IS2
AD1
This process continuesuntil economy reachesa long-run equilibrium
with Y Y
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CHAPTER 11 Aggregate Demand II slide 32
EXERCISE:Analyze SR & LR effects of M
a. Draw the IS-LMandAD-AS
diagrams as shown here.
b. Suppose Fed increases M.Show the short-run effectson your graphs.
c. Show what happens in thetransition from the shortrun to the long run.
d. How do the new long-run
equilibrium values of theendogenous variablescompare to their initialvalues?
Y
r
Y
P LRAS
Y
LRAS
Y
IS
SRAS1P1
LM(M1
/P1
)
AD1
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CHAPTER 11 Aggregate Demand II slide 33
The Great Depression
120
140
160
180
200
220
240
1929 1931 1933 1935 1937 1939
billionso
f1958
dollars
0
5
10
15
20
25
30
percentofla
borforce
Unemployment(right scale)
Real GNP
(left scale)
Th S di H th i
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CHAPTER 11 Aggregate Demand II slide 34
The Spending Hypothesis:Shocks to the IS Curve
asserts that the Depression was largely dueto 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 ISshift would cause
Th S di H th i
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CHAPTER 11 Aggregate Demand II slide 35
The Spending Hypothesis:Reasons for the IS shift
1. Stock market crash exogenous C
Oct-Dec 1929: S&P 500 fell 17%
Oct 1929-Dec 1933: S&P 500 fell 71%
2. Drop in investment
correction after overbuilding in the 1920s widespread bank failures made it harder to
obtain financing for investment
3. Contractionary fiscal policy in the face of falling tax revenues and
increasing deficits, politicians raised tax ratesand cut spending
Th M H th i
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CHAPTER 11 Aggregate Demand II slide 36
The Money Hypothesis:A Shock to the LM Curve
asserts that the Depression was largely due
to huge fall in the money supply
evidence:
M1 fell 25% during 1929-33.
But, two problems with this hypothesis:
1. P fell even more, so M/Pactually rose
slightly during 1929-31.
2. nominal interest rates fell, which is theopposite of what would result from a
leftward LMshift.
Th M H th i A i
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CHAPTER 11 Aggregate Demand II slide 37
The Money Hypothesis Again:The Effects of Falling Prices
asserts that the severity of the Depressionwas due to a huge deflation:
P fell 25% during 1929-33.
This deflation was probably caused bythe fall in M, so perhaps money played
an important role after all.
In what ways does a deflation affect theeconomy?
Th M H th i A i
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CHAPTER 11 Aggregate Demand II slide 38
The Money Hypothesis Again:The Effects of Falling Prices
The stabilizing effects of deflation: P(M/P) LM shifts right Y
Pigou effect:
P (M/P)
consumers wealth
C
IS shifts right
Y
Th M H th i Ag i
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CHAPTER 11 Aggregate Demand II slide 39
The Money Hypothesis Again:The Effects of Falling Prices
The destabilizing effects of unexpected deflation:
debt-deflation theory
P(if unexpected)
transfers purchasing power from borrowers
to lenders
borrowers spend less,
lenders spend more
if borrowers propensity to spend is largerthan lenders, then aggregate spending falls,
the IScurve shifts left, and Y falls
The Money Hypothesis Again
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CHAPTER 11 Aggregate Demand II slide 40
The Money Hypothesis Again:The Effects of Falling Prices
The destabilizing effects of expected deflation:e
r for each value ofi
I
becauseI
=I
(r)
planned expenditure & agg. demand
income & output
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CHAPTER 11 Aggregate Demand II slide 41
Why another Depression is unlikely
Policymakers (or their advisors) now knowmuch more about macroeconomics:
The Fed knows better than to let M fallso much, especially during a contraction.
Fiscal policymakers know better than to raisetaxes or cut spending during a contraction.
Federal deposit insurance makes widespread
bank failures very unlikely.Automatic stabilizers make fiscal policy
expansionary during an economic downturn.
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CHAPTER 11 Aggregate Demand II slide 42
Chapter summary
1. IS-LMmodel
a theory of aggregate demand
exogenous: M, G, T,
P exogenous in short run, Y in long run
endogenous: r,
Y endogenous in short run, P in long run
IScurve: goods market equilibrium
LM curve: money market equilibrium
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Chapter summary
2.AD curve
shows relation between Pand the IS-LM
models equilibrium Y.
negative slope because
P (M/P) rIY
expansionary fiscal policy shifts IScurve right,
raises income, and shiftsADcurve right
expansionary monetary policy shifts LMcurveright, raises income, and shiftsADcurve right
ISor LMshocks shift theADcurve