10/13/2010 Context . Chapter 9 introduced the model of aggregate Chapter 10: demand and aggregate supply. Long run Aggregate Demand I . prices flexible . output determined by factors of production & technology . unemployment equals its natural rate . Short run . prices fixed . output determined by aggregate demand . unemployment negatively related to output CHAPTER 10 Aggregate Demand I 0 CHAPTER 10 Aggregate Demand I 1 Context The Keynesian Cross . This chapter develops the IS-LM model, . A simple closed economy model in which income the basis of the aggregate demand curve. is determined by expenditure. (due to J.M. Keynes) . We focus on the short run and assume the price . Notation: level is fixed (so, SRAS curve is horizontal) . I = planned investment . This chapter (and chapter 11) focus on the PE = C + I + G = planned expenditure closed-economy case. Y = real GDP = actual expenditure Chapter 12 presents the open-economy case. Difference between actual & planned expenditure = unplanned inventory investment CHAPTER 10 Aggregate Demand I 2 CHAPTER 10 Aggregate Demand I 3 Elements of the Keynesian Cross Graphing planned expenditure consumption function: CCYT() PE planned govt policy variables: GG, TT expenditure PE =C +I +G for now, planned investment is exogenous: II MPC 1 planned expenditure: PE C() Y T I G equilibrium condition: income, output, Y actual expenditure = planned expenditure Y PE CHAPTER 10 Aggregate Demand I 4 CHAPTER 10 Aggregate Demand I 5 1 10/13/2010 Graphing the equilibrium condition The equilibrium value of income PE PE planned PE =Y planned PE =Y expenditure expenditure PE =C +I +G 45º income, output, Y income, output, Y Equilibrium income CHAPTER 10 Aggregate Demand I 6 CHAPTER 10 Aggregate Demand I 7 An increase in government purchases Solving for Y PE Y CIG equilibrium condition At Y , 1 PE =C +I +G2 there is now an Y CIG in changes unplanned drop PE =C +I +G 1 because I exogenous in inventory… CG MPC YGbecause C = MPC Y G …so firms Collect terms with Y Solve for Y : increase output, on the left side of the and income Y equals sign: 1 rises toward a Y G Y 1MPC new equilibrium. PE1 = Y1 PE2 = Y2 (1 MPC)Y G CHAPTER 10 Aggregate Demand I 8 CHAPTER 10 Aggregate Demand I 9 The government purchases multiplier Why the multiplier is greater than 1 Definition: the increase in income resulting from a . Initially, the increase in G causes an equal increase $1 increase in G. in Y: Y = G. In this model, the govt Y 1 . But Y C purchases multiplier equals G 1MPC further Y further C Example: If MPC = 0.8, then further Y An increase in G Y 1 5 causes income to . So the final impact on income is much bigger than G 10.8 increase 5 times the initial G. as much! CHAPTER 10 Aggregate Demand I 10 CHAPTER 10 Aggregate Demand I 11 2 10/13/2010 An increase in taxes Solving for Y PE eq’m condition in Y CIG Initially, the tax changes increase reduces PE =C1 +I +G consumption, and C I and G exogenous PE =C2 +I +G therefore PE: MPC Y T C = MPC T At Y1, there is now an unplanned Solving for Y : (1 MPC)Y MPC T inventory buildup… …so firms reduce output, and income falls Y MPC Final result: Y T toward a new 1MPC PE = Y Y PE = Y equilibrium 2 2 1 1 CHAPTER 10 Aggregate Demand I 12 CHAPTER 10 Aggregate Demand I 13 The tax multiplier The tax multiplier …is negative: def: the change in income resulting from A tax increase reduces C, a $1 increase in T : which reduces income. Y MPC …is greater than one T 1MPC (in absolute value): A change in taxes has a If MPC = 0.8, then the tax multiplier equals multiplier effect on income. …is smaller than the govt spending multiplier: Y 0.8 0.8 4 Consumers save the fraction (1 – MPC) of a tax cut, T 10.8 0.2 so the initial boost in spending from a tax cut is smaller than from an equal increase in G. CHAPTER 10 Aggregate Demand I 14 CHAPTER 10 Aggregate Demand I 15 NOW YOU TRY: The IS curve Practice with the Keynesian Cross . Use a graph of the Keynesian cross def: a graph of all combinations of r and Y that to show the effects of an increase in planned result in goods market equilibrium investment on the equilibrium level of i.e. actual expenditure (output) income/output. = ppplanned expenditure The equation for the IS curve is: Y CY()() T I r G CHAPTER 10 Aggregate Demand I 17 3 10/13/2010 Deriving the IS curve Why the IS curve is negatively sloped PE =Y PE PE =C +I (r2 )+G . A fall in the interest rate motivates firms to increase investment spending, which drives up r I PE =C +I (r1 )+G total planned spending (PE). PE I . To restore equilibrium in the goods market, Y Y output (akaa.k.a. actual expenditure, Y) Y1 Y2 r must increase. r1 r2 IS Y Y1 Y2 CHAPTER 10 Aggregate Demand I 18 CHAPTER 10 Aggregate Demand I 19 The IS curve and the loanable funds model Fiscal Policy and the IS curve . We can use the IS-LM model to see (a) The L.F. model (b) The IS curve how fiscal policy (G and T) affects r r S2 S1 aggregate demand and output. Let’s start by using the Keynesian cross to see how fiscal policy shifts the IS curve… r2 r2 r r 1 I (r ) 1 IS S, I Y Y2 Y1 CHAPTER 10 Aggregate Demand I 20 CHAPTER 10 Aggregate Demand I 21 NOW YOU TRY: Shifting the IS curve: G Shifting the IS curve: T PE PE =Y At any value of r, PE =C +I (r1 )+G2 Use the diagram of the Keynesian cross or G PE Y PE =C +I (r )+G . 1 1 loanable funds model to show how an …so the IS curve shifts to the right. increase in taxes shifts the IS curve. Y Y Y The horizontal r 1 2 distance of the r IS shift equals 1 1 Y G Y IS 1MPC IS1 2 Y Y1 Y2 CHAPTER 10 Aggregate Demand I 22 4 10/13/2010 The Theory of Liquidity Preference Money supply . Due to John Maynard Keynes. r s The supply of interest MP . A simple theory in which the interest rate real money rate is determined by money supply and balances money demand. is fixed: s MP MP M/P MP real money balances CHAPTER 10 Aggregate Demand I 24 CHAPTER 10 Aggregate Demand I 25 Money demand Equilibrium r r s s Demand for interest MP The interest interest MP real money rate rate adjusts rate balances: to equate the d supply and MP Lr() ddfdemand for money: r1 L(r ) MP Lr() L(r ) M/P M/P MP MP real money real money balances balances CHAPTER 10 Aggregate Demand I 26 CHAPTER 10 Aggregate Demand I 27 How the Fed raises the interest rate CASE STUDY: Monetary Tightening & Interest Rates r . Late 1970s: > 10% interest To increase r, rate . Oct 1979: Fed Chairman Paul Volcker Fed reduces M announces that monetary policy r2 would aim to reduce inflation r . Aug 1979-April 1980: 1 Fed reduces M/P 8.0% L(r ) . Jan 1983: = 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 28 CHAPTER 10 Aggregate Demand I 29 5 10/13/2010 Monetary Tightening & Interest 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: d MP LrY(, ) Quantity theory, Liquidity preference model Fisher effect (Keynes ian ) 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 i > 0 i < 0 The equation for the LM curve is: actual 8/1979: i = 10.4% 8/1979: i = 10.4% MP LrY(, ) outcome 4/1980: i = 15.8% 1/1983: i = 8.2% CHAPTER 10 Aggregate Demand I 31 Deriving the LM curve Why the LM curve is upward sloping (a) The market for . An increase in income raises money demand. (b) The LM curve real money balances 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. r r 2 2 . The interest rate must rise to restore equilibrium in the money market. L (r,Y2 ) r1 r1 L (r,Y1 ) M/P Y M1 Y1 Y2 P CHAPTER 10 Aggregate Demand I 32 CHAPTER 10 Aggregate Demand I 33 How M shifts the LM curve NOW YOU TRY: Shifting the LM curve (a) The market for (b) The LM curve real money balances . Suppose a wave of credit card fraud causes r r consumers to use cash more frequently in LM2 transactions. LM 1 . Use the liquidity preference model r r2 2 to show how these events shift the LM curve. r1 r1 L (r,Y1 ) M/P Y M 2 M1 Y1 P P CHAPTER 10 Aggregate Demand I 34 6 10/13/2010 The short-run equilibrium The Big Picture The short-run equilibrium is r Keynesian IS the combination of r and Y Cross curve LM IS-LM that simultaneously satisfies Explanation Theory of model the equilibrium conditions in LM of short-run Liquidity curve fluctuations the ggyoods & money markets: Preference Agg.