10/14/2013 Equilibrium in the IS-LM model The IS curve represents r Chapter 11: equilibrium in the goods LM market. Aggregate Demand II, Y CY()() T I r G r Applying the IS-LM Model The LM curve represents 1 money market equilibrium. MP LrY(, ) IS Y The intersection determines Y1 the unique combination of Y and r that satisfies equilibrium in both markets. CHAPTER 11 Aggregate Demand II 0 CHAPTER 11 Aggregate Demand II 1 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 • fiscal policy: G and/or T IS interest rate to rise… IS1 • monetary policy: M Y Y Y 3. …which reduces investment, Y Y 1 so the final increase in Y 1 2 1 3. is smaller than G 1MPC CHAPTER 11 Aggregate Demand II 2 CHAPTER 11 Aggregate Demand II 3 A tax cut Monetary policy: An increase in M Consumers save r r 1. M > 0 shifts LM (1MPC) 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 interest rate 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. CHAPTER 11 Aggregate Demand II 4 CHAPTER 11 Aggregate Demand II 5 1 10/14/2013 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. CHAPTER 11 Aggregate Demand II 6 CHAPTER 11 Aggregate Demand II 7 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 CHAPTER 11 Aggregate Demand II 8 CHAPTER 11 Aggregate Demand II 9 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 value 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 CHAPTER 11 Aggregate Demand II 10 CHAPTER 11 Aggregate Demand II 11 2 10/14/2013 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 households’ 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 CHAPTER 11 Aggregate Demand II 12 CHAPTER 11 Aggregate Demand II 13 NOW YOU TRY: CASE STUDY: Analyze shocks with the IS-LM Model The U.S. recession 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 unemployment 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 frequen tly in transac tions. (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. CHAPTER 11 Aggregate Demand II 15 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 prices, discouraged investment 600 Index (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 3 10/14/2013 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 CHAPTER 11 Aggregate Demand II 18 CHAPTER 11 Aggregate Demand II 19 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 money supply? 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 ra te ban ks c harge 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. CHAPTER 11 Aggregate Demand II 20 CHAPTER 11 Aggregate Demand II 21 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 price 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 CHAPTER 11 Aggregate Demand II 22 CHAPTER 11 Aggregate Demand II 23 4 10/14/2013 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 CHAPTER 11 Aggregate Demand II 24 CHAPTER 11 Aggregate Demand II 25 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 price level 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 5 10/14/2013 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 Great Depression a.