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10/14/2013

Equilibrium in the IS-LM model

The IS curve represents r Chapter 11: equilibrium in the LM . II, Y  CY()() T I r  G r Applying the IS-LM Model The LM curve represents 1 market equilibrium. MP LrY(, ) IS Y The intersection determines Y1 the unique combination of Y and r that satisfies equilibrium in both markets.

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Policy analysis with the IS-LM model An increase in government purchases

1. IS curve shifts right Y CY()() T I r G r r 1 LM by G LM MP LrY(, ) 1MPC causing output & r We can use the IS-LM 2 income to rise. 2. model to analyze the r r 1 2Thii2. This raises money 1 effects of demand, causing the 1. IS2 • : G and/or T IS rate to rise… IS1 • : M Y Y Y 3. …which reduces , Y Y 1 so the final increase in Y 1 2 1 3. is smaller than G 1MPC

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A tax cut Monetary policy: An increase in M

Consumers save r r 1. M > 0 shifts LM (1MPC) of the tax cut, LM 1 so the initial boost in the LM curve down LM spending is smaller for T (or to the right) 2 than for an equal G… r2 2. r1 r 2. …causing the andthd the IS curve shifts by b 1 to fall r2 MPC 1. IS 1. T 2 1MPC IS1 3. …which increases IS Y investment, causing Y Y1 Y2 Y Y 2. …so the effects on r 1 2 2. output & income to and Y are smaller for T rise. than for an equal G.

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Interaction between The Fed’s response to G > 0 monetary & fiscal policy . Model: . Suppose Congress increases G. Monetary & fiscal policy variables . Possible Fed responses: (M, G, and T) are exogenous. 1. hold M constant . Real world: 2. hold r constant Monetary policymakers may adjust M 3. hold Y constant in response to changes in fiscal policy, . In each case, the effects of the G or vice versa. are different… . Such interaction may alter the impact of the original policy change.

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Response 1: Hold M constant Response 2: Hold r constant

If Congress raises G, r If Congress raises G, r the IS curve shifts right. LM1 the IS curve shifts right. LM1 LM2 If Fed holds M constant, To keep r constant, r r then LM curve doesn’t 2 2 r Fed increases M r shift. 1 to shift LM curve right. 1

IS2 IS2 Results: Results: IS1 IS1 Y YY21  Y Y Y1 Y2 Y YY31 Y1 Y2 Y3 rr r 21  r  0

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Response 3: Hold Y constant Estimates of fiscal policy multipliers from the DRI macroeconometric model If Congress raises G, r LM2 LM the IS curve shifts right. 1 Estimated Estimated Assumption about of value of To keep Y constant, r3 r monetary policy Y/G Y/T Fed reduces M 2 r1 to shift LM curve left. Fed holds money IS2 0.60 0.26 Results: supply constant IS1 Y Fed holds nominal Y 0 Y Y 1.93 1.19 1 2 interest rate constant rr31  r

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Shocks in the IS-LM model Shocks in the IS-LM model

IS shocks: exogenous changes in the LM shocks: exogenous changes in the demand for goods & services. demand for money. Examples: Examples: . stock market boom or crash . a wave of credit card fraud increases  change in ’ wealth demand for money.  C . more ATMs or the Internet reduce money . change in business or consumer demand. confidence or expectations  I and/or C

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NOW YOU TRY: CASE STUDY: Analyze shocks with the IS-LM Model The U.S. of 2001 . During 2001, Use the IS-LM model to analyze the effects of . 2.1 million jobs lost, 1. a boom in the stock market that makes rose from 3.9% to 5.8%. consumers wealthier. 2. after a wave of credit card fraud, consumers using . GDP growth slowed to 0.8% cash more frequentl y in transacti ons. (compared to 3. 9% average annual growth during 1994-2000). For each shock, a. use the IS-LM diagram 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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CASE STUDY: CASE STUDY: The U.S. recession of 2001 The U.S. recession of 2001 Causes: 2) 9/11 Causes: 1) Stock market decline C . increased uncertainty fall in consumer & business confidence 1500 . Standard & Poor’s . result: lower spending, IS curve shifted left

100) 500 1200 Causes: 3) Corporate accounting scandals

900 . Enron, WorldCom, etc. . reduced stock , discouraged investment 600 (1942 = (1942 Index

300 1995 1996 1997 1998 1999 2000 2001 2002 2003 CHAPTER 11 Aggregate Demand II 16 CHAPTER 11 Aggregate Demand II 17

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CASE STUDY: CASE STUDY: The U.S. recession of 2001 The U.S. recession of 2001 . Fiscal policy response: shifted IS curve right . Monetary policy response: shifted LM curve right . tax cuts in 2001 and 2003 7 6 Three-month . spending increases T-Bill Rate 5 . airline industry bailout 4 . NYC reconstruction 3 . Afghanistan war 2 1 0

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What is the Fed’s policy instrument? What is the Fed’s policy instrument?

. The news media commonly report the Fed’s policy Why does the Fed target interest rates instead of changes as interest rate changes, as if the Fed the ? has direct control over market interest rates. 1) They are easier to measure than the money . In fact, the Fed targets the federal funds rate – supply. the in teres t rat e b ank s ch arge one ano ther on 2) The Fed might believe that LM shocks are overnight loans. more prevalent than IS shocks. If so, then . The Fed changes the money supply and shifts the targeting the interest rate stabilizes income LM curve to achieve its target. better than targeting the money supply. (See end-of-chapter Problem 7 on p.337.) . Other short-term rates typically move with the federal funds rate.

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IS-LM and aggregate demand Deriving the AD curve

LM(P ) . So far, we’ve been using the IS-LM model to r 2 Intuition for slope LM(P ) analyze the short run, when the level is r 1 of AD curve: 2 assumed fixed. r1 P (M/P) . However, a change in P would shift LM and IS  LM shifts left Y Y Y therefore affect Y. P 2 1 r . The aggregate demand curve P2 I (introduced in Chap. 9) captures this P1 Y relationship between P and Y. AD

Y2 Y1 Y

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Monetary policy and the AD curve Fiscal policy and the AD curve

r LM(M1/P1) r LM The Fed can increase Expansionary fiscal LM(M2/P1) aggregate demand: r1 policy (G and/or T) r2 r2 increases agg. demand: r IS M  LM shifts right 1 2 IS T C IS  r 1 Y Y Y Y Y Y P 1 2  IS shifts right P 1 2 I Y at each Y at each P1 value of P P1 value of P AD2 AD2 AD1 AD1

Y1 Y2 Y Y1 Y2 Y

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IS-LM and AD-AS The SR and LR effects of an IS shock in the short run & long run r LRAS LM(P1) Recall from Chapter 9: The force that moves the A negative IS shock economy from the short run to the long run shifts IS and AD left, is the gradual adjustment of prices. causing Y to fall. IS1 IS2 In the short-run then over time , the Y Y equilibrium, if will P LRAS rise SRAS Y  Y P1 1 Y  Y fall AD1 Y  Y remain constant AD2 Y Y CHAPTER 11 Aggregate Demand II 26 CHAPTER 11 Aggregate Demand II 27

The SR and LR effects of an IS shock The SR and LR effects of an IS shock

r LRAS r LRAS LM(P1) LM(P1)

In the new short-run In the new short-run equilibrium, Y  Y equilibrium, Y  Y IS1 IS1 IS2 IS2 Y Y Y Over time, P gradually Y P LRAS falls, causing P LRAS SRAS SRAS P1 1 • SRAS to move down P1 1 • M/P to increase,

AD1 which causes LM AD1 AD2 to move down AD2 Y Y Y Y CHAPTER 11 Aggregate Demand II 28 CHAPTER 11 Aggregate Demand II 29

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The SR and LR effects of an IS shock The SR and LR effects of an IS shock

r LRAS r LRAS LM(P1) LM(P1)

LM(P2) LM(P2)

This process continues IS1 IS1 IS2 until economy reaches a IS2 Y long-run equilibrium with Y Over time, P gradually Y Y Y Y falls, causing P LRAS  P LRAS SRAS SRAS • SRAS to move down P1 1 P1 1 SRAS SRAS • M/P to increase, P2 2 P2 2

which causes LM AD1 AD1 to move down AD2 AD2 Y Y Y Y CHAPTER 11 Aggregate Demand II 30 CHAPTER 11 Aggregate Demand II 31

NOW YOU TRY: Analyze SR & LR effects of M The

a. Draw the IS-LM and AD-AS r LRAS LM(M /P ) 240 30 1 1 Unemployment diagrams as shown here. 220 (right scale) 25 b. Suppose Fed increases M. Show the short-run effects IS 200 20 bor force bor

on your graphs. 58 dollars a 9 180 15 c. Show what happens in the Y Y transition from the short run P LRAS 160 10 to the long run.

Real GNP of percent l d. How do the new long-run billions of 1 140 5 P SRAS1 equilibrium values of the 1 (left scale) endogenous variables 120 0 AD compare to their initial 1 1929 1931 1933 1935 1937 1939 values? Y Y

THE SPENDING HYPOTHESIS: THE SPENDING HYPOTHESIS: Shocks to the IS curve Reasons for the IS shift . asserts that the Depression was largely due to . Stock market crash  exogenous C an exogenous fall in the demand for goods & . Oct-Dec 1929: S&P 500 fell 17% services – a leftward shift of the IS curve. . Oct 1929-Dec 1933: S&P 500 fell 71% . evidence: . Drop in investment output and interest rates both fell, which is what . “correction” after overbuilding in the 1920s a leftward IS shift would cause. . 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.

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THE MONEY HYPOTHESIS: THE MONEY HYPOTHESIS AGAIN: A shock to the LM curve The effects of falling prices . asserts that the Depression was largely due to . asserts that the severity of the Depression was huge fall in the money supply. due to a huge : . evidence: P fell 25% during 1929-33. M1 fell 25% during 1929-33. . This deflation was probably caused by the fall in . But, two problems with this hypothesis: M, so perhaps money played an important role . P fell even more, so M/P actually rose slightly after all. during 1929-31. . In what ways does a deflation affect the . nominal interest rates fell, which is the opposite economy? of what a leftward LM shift would cause.

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THE MONEY HYPOTHESIS AGAIN: THE MONEY HYPOTHESIS AGAIN: The effects of falling prices The effects of falling prices

. The stabilizing effects of deflation: . The destabilizing effects of expected deflation: . P (M/P)  LM shifts right Y E r for each value of i . Pigou effect:    I  because I = I(r ) P  (M/P)  planned expenditure & agg. demand   consumers’ wealth   income & output  C  IS shifts right Y

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THE MONEY HYPOTHESIS AGAIN: The effects of falling prices Why another Depression is unlikely

. The destabilizing effects of unexpected deflation: . Policymakers (or their advisors) now know debt-deflation theory much more about : P (if unexpected) . The Fed knows better than to let M fall  transfers purchasing power from borrowers to so much, especially during a contraction. ldlenders . Fiscal policymakers know better than to raise taxes or cut spending during a contraction.  borrowers spend less, lenders spend more . Federal deposit insurance makes widespread  if borrowers’ propensity to spend is larger than bank failures very unlikely. lenders’, then aggregate spending falls, . Automatic stabilizers make fiscal policy the IS curve shifts left, and Y falls expansionary during an economic downturn.

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CASE STUDY Interest rates and house prices

The 2008-09 & Recession Federal Funds rate 9 2009: Real GDP fell, u-rate approached 10% 30-year mortgage rate . Case-Shiller 20-city composite house price index190 8

. Important factors in the crisis: 170 7 . early 2000s Federal Reserve interest rate policy 6 150 sub-prime mortgage crisis

. (%) te , 2000=100 a 5 x . bursting of house price bubble, 130 rising foreclosure rates 4 110 interest r . falling stock prices 3 . failing financial institutions 90 2 House price inde . declining , drop in spending 70 on consumer durables and investment goods 1 0 50 CHAPTER 11 Aggregate Demand II 42 2000 2001 2002 2003 2004 2005

Change in U.S. house price index House price change and new foreclosures, and rate of new foreclosures, 1999-2009 2006:Q3 – 2009Q1

14% 20% US house price index 1.4 12% 18% Nevada New foreclosures Florida Illinois 10% 1.2 16% Michigan Ohio 8% 14% 1.0 California Georgia rtgages

gages) 12% earlier) ouse prices losures, e starts t 6% o s r c h Colorado 0.8 10% Arizona 4% Rhode Island 8% Texas 2% 0.6 New Jersey New fore % of all m all of % 6% 0% Hawaii S. Dakota (% of total mor total of (% 0.4 New foreclosu (from 4 quarter 4% Oregon -2% Wyoming Percent change in 2% Alaska 0.2 N. Dakota -4% 0% -40% -30% -20% -10% 0% 10% 20% -6% 0.0 1999 2001 2003 2005 2007 2009 Cumulative change in house price index

U.S. bank failures by year, 2000-2009 Major U.S. stock indexes (% change from 52 weeks earlier) DJIA 70 140% 120% S&P 500

60 100% NASDAQ

80% 50 60%

40 40% ank failures b b 20% 30 0% 20 -20%

Number of -40% 10 -60%

0 -80% 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009* 9/5/2002 6/5/2005 3/5/2008 2/11/2006 12/6/1999 8/13/2000 4/21/2001 5/14/2003 1/20/2004 9/27/2004 7/20/2009 * as of July 24, 2009. 6/28/2007 11/11/2008 12/28/2001 10/20/2006

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Consumer sentiment and growth in consumer Real GDP growth and Unemployment durables and investment spending 10% 10 20% Real GDP growth rate (left scale) 9 110 8% 15% Unemployment rate (right scale) 8 10% 100 6% 7 5% 6 arters earlier dex, 1966=100

90 force uaters earlier 4% u n 0% q 5

-5% 80 2% 4

-10% labor of % 70 0% 3

-15% Durables 2 60 change% from 4 Investment -2%

% change % from four q -20% 1 UM Consumer Sentiment Index Consumer Sentiment I -25% 50 -4% 0 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 1995 1997 1999 2001 2003 2005 2007 2009

Chapter Summary Chapter Summary

1. IS-LM model 2. AD curve . a theory of aggregate demand . shows relation between P and the IS-LM model’s . exogenous: M, G, T, equilibrium Y. P exogenous in short run, Y in long run . negative slope because . endogenous: r, P  (M/P )  r  I  Y Y endogenous in short run, P in long run . expansionary fiscal policy shifts IS curve right, raises income, and shifts AD curve right. . IS curve: goods market equilibrium . expansionary monetary policy shifts LM curve . LM curve: equilibrium right, raises income, and shifts AD curve right. . IS or LM shocks shift the AD curve.

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