In this chapter, you will learn… C H A P T E R 10 . the IS curve, and its relation to Aggregate Demand I: . the Keynesian cross . the LM curve, and its relation to Building the IS -LM Model . the theory of liquidity preference . how the IS-LM model determines income and the interest rate in the short run when P is fixed MACROECONOMICS SIXTH EDITION N. GREGORY MANKIW PowerPoint® Slides by Ron Cronovich © 2007 Worth Publishers, all rights reserved CHAPTER 10 Aggregate Demand I slide 1 Context Context . Chapter 9 introduced the model of aggregate demand and aggregate supply. This chapter develops the IS-LM model, the basis of the aggregate demand curve. Long run . prices flexible . We focus on the short run and assume the price . output determined by factors of production & level is fixed (so, SRAS curve is horizontal). technology . This chapter (and chapter 11) focus on the . unemployment equals its natural rate closed-economy case. Short run . Chapter 12 presents the open-economy case. prices fixed . output determined by aggregate demand . unemployment negatively related to output CHAPTER 10 Aggregate Demand I slide 2 CHAPTER 10 Aggregate Demand I slide 3 The Keynesian Cross Elements of the Keynesian Cross consumption function: . A simple closed economy model in which income C = C (Y !T ) is determined by expenditure. govt policy variables: G = G , T =T (due to J.M. Keynes) for now, planned . Notation: investment is exogenous: I = I I = planned investment E = C + I + G = planned expenditure planned expenditure: E = C (Y !T ) + I + G Y = real GDP = actual expenditure equilibrium condition: . Difference between actual & planned expenditure actual expenditure = planned expenditure = unplanned inventory investment Y = E CHAPTER 10 Aggregate Demand I slide 4 CHAPTER 10 Aggregate Demand I slide 5 1 Graphing planned expenditure Graphing the equilibrium condition E E E =Y planned E =C +I +G planned expenditure expenditure MPC 1 45º income, output, Y income, output, Y CHAPTER 10 Aggregate Demand I slide 6 CHAPTER 10 Aggregate Demand I slide 7 The equilibrium value of income An increase in government purchases E Y E = E =Y At Y , E 1 E =C +I +G2 there is now an planned E =C +I +G unplanned drop E =C +I +G1 in inventory… expenditure ΔG …so firms increase output, income, output, Y and income Y rises toward a ΔY Equilibrium new equilibrium. E1 = Y1 E2 = Y2 income CHAPTER 10 Aggregate Demand I slide 8 CHAPTER 10 Aggregate Demand I slide 9 Solving for ΔY The government purchases multiplier Y = C + I + G equilibrium condition Definition: the increase in income resulting from a $1 increase in G. !Y = !C + !I + !G in changes In this model, the govt !Y 1 = !C + !G because I exogenous = purchases multiplier equals !G 1 " MPC = MPC ! "Y + "G because ΔC = MPC ΔY Example: If MPC = 0.8, then Collect terms with ΔY Solve for ΔY : An increase in G on the left side of the !Y 1 = = 5 causes income to equals sign: ! 1 " !G 1 " 0.8 #Y = % & $ #G increase 5 times 1 ' MPC (1 ! MPC)"#Y = #G ( ) as much! CHAPTER 10 Aggregate Demand I slide 10 CHAPTER 10 Aggregate Demand I slide 11 2 Why the multiplier is greater than 1 An increase in taxes E Y Initially, the increase in G causes an equal increase Initially, the tax = . E E =C +I +G in Y: ΔY = ΔG. increase reduces 1 consumption, and E =C2 +I +G . But ↑Y ⇒ ↑C therefore E: ⇒ further ↑Y ΔC = −MPC ΔT At Y1, there is now ⇒ further ↑C an unplanned inventory buildup… …so firms ⇒ further ↑Y reduce output, . So the final impact on income is much bigger than and income Y falls toward a ΔY the initial ΔG. E2 = Y2 E = Y new equilibrium 1 1 CHAPTER 10 Aggregate Demand I slide 12 CHAPTER 10 Aggregate Demand I slide 13 Solving for ΔY The tax multiplier eq’m condition in Y C I G ! = ! + ! + ! changes def: the change in income resulting from a $1 increase in T : = !C I and G exogenous !Y "MPC = = MPC ! ("Y # "T ) !T 1 " MPC Solving for ΔY : (1 ! MPC)"#Y = !MPC " #T If MPC = 0.8, then the tax multiplier equals !Y "0.8 "0.8 4 Final result: ! # MPC " = = = " $Y = & ' % $T !T 1 " 0.8 0.2 (1 # MPC ) CHAPTER 10 Aggregate Demand I slide 14 CHAPTER 10 Aggregate Demand I slide 15 The tax multiplier Exercise: …is negative: A tax increase reduces C, . Use a graph of the Keynesian cross which reduces income. to show the effects of an increase in planned investment on the equilibrium level of …is greater than one income/output. (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. CHAPTER 10 Aggregate Demand I slide 16 CHAPTER 10 Aggregate Demand I slide 17 3 The IS curve Deriving the IS curve E E =Y E =C +I (r2 )+G def: a graph of all combinations of r and Y that ↓r ⇒ ↑I E =C +I (r1 )+G result in goods market equilibrium i.e. actual expenditure (output) ⇒ ↑E ΔI = planned expenditure ⇒ ↑Y Y1 Y2 Y The equation for the IS curve is: r r1 Y C(Y T ) I(r) G = " + + r2 IS Y Y1 Y2 CHAPTER 10 Aggregate Demand I slide 18 CHAPTER 10 Aggregate Demand I slide 19 ! Fiscal Policy and the IS curve Shifting the IS curve: ΔG E =Y E E =C +I (r )+G At any value of r, ↑ 1 2 . We can use the IS-LM model to see G ⇒ ↑E ⇒ ↑Y E =C +I (r1 )+G1 how fiscal policy (G and T ) affects aggregate demand and output. …so the IS curve shifts to the right. Let’s start by using the Keynesian cross The horizontal Y1 Y2 Y to see how fiscal policy shifts the IS curve… r distance of the r IS shift equals 1 1 ΔY !Y = !G IS 1"MPC IS1 2 Y Y1 Y2 CHAPTER 10 Aggregate Demand I slide 22 CHAPTER 10 Aggregate Demand I slide 23 The Theory of Liquidity Preference Money supply r s . Due to John Maynard Keynes. The supply of interest (M P ) rate . A simple theory in which the interest rate real money is determined by money supply and balances is fixed: money demand. M s M ( P) = P M/P M P real money balances ! CHAPTER 10 Aggregate Demand I slide 25 CHAPTER 10 Aggregate Demand I slide 26 4 Money demand Equilibrium r r s s Demand for interest (M P ) The interest interest (M P ) real money rate rate adjusts rate balances: to equate the supply and demand for r M d money: 1 ( P) = L(r) L (r ) M P = L(r ) L (r ) M/P M/P M P M P real money real money balances balances ! CHAPTER 10 Aggregate Demand I slide 27 CHAPTER 10 Aggregate Demand I slide 28 CASE STUDY: How the Fed raises the interest rate Monetary Tightening & Interest Rates r . Late 1970s: > 10% interest π To increase r, rate . Oct 1979: Fed Chairman Paul Volcker Fed reduces M announces that monetary policy r2 would aim to reduce inflation r1 . Aug 1979-April 1980: Fed reduces M/P 8.0% L (r ) . Jan 1983: π = 3.7% M/P M M 2 1 real money How do you think this policy change P P balances would affect nominal interest rates? CHAPTER 10 Aggregate Demand I slide 29 CHAPTER 10 Aggregate Demand I slide 30 Monetary Tightening & Rates, cont. The LM curve The effects of a monetary tightening on nominal interest rates Now let’s put Y back into the money demand short run long run function: (M )d = L(r,Y ) Quantity theory, P Liquidity preference model Fisher effect (Keynesian) The LM curve is a graph of all combinations of (Classical) r and Y that equate the supply and demand for prices sticky flexible real money balances. prediction Δi > 0 Δi < 0 Th!e equation for the LM curve is: M 8/1979: i = 10.4% 8/1979: i = 10.4% L(r,Y ) actual P = outcome 4/1980: i = 15.8% 1/1983: i = 8.2% CHAPTER 10 Aggregate Demand I slide 32 ! 5 Deriving the LM curve Why the LM curve is upward sloping (a) The market for real money balances (b) The LM curve . An increase in income raises money demand. r r . Since the supply of real balances is fixed, there LM is now excess demand in the money market at the initial interest rate. r2 r2 . The interest rate must rise to restore equilibrium L (r , Y ) r 2 1 r1 in the money market. L (r , Y1 ) M/P Y M1 Y1 Y2 P CHAPTER 10 Aggregate Demand I slide 33 CHAPTER 10 Aggregate Demand I slide 34 How ΔM shifts the LM curve Exercise: Shifting the LM curve (a) The market for real money balances (b) The LM curve . Suppose a wave of credit card fraud causes r r LM2 consumers to use cash more frequently in transactions. LM1 . Use the liquidity preference model r r 2 2 to show how these events shift the LM curve. r 1 r1 L (r , Y1 ) M/P Y M 2 M1 Y1 P P CHAPTER 10 Aggregate Demand I slide 35 CHAPTER 10 Aggregate Demand I slide 36 The short-run equilibrium The Big Picture The short-run equilibrium is r Keynesian IS the combination of r and Y LM Cross curve that simultaneously satisfies IS-LM model Explanation the equilibrium conditions in Theory of LM of short-run Liquidity curve fluctuations the goods & money markets: Preference Agg.