11. Aggregate Demand II

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11. Aggregate Demand II

• Agenda
• How is the IS-LM model used for analyzing
  economic fluctuation and policies?
• How is the IS-LM model related to the AD-AS
  model?
• What is the causes of the Great Depression?

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Keynesian cross, Liquid preference, IS-LM and
AD-AS
Y C(Y-T) I(r) G
M/P L(rpe, Y)
IS curve for given G, T, pairs of (Y, r)
satisfying Y C(Y-T) I(r) G
LM curve for given M, P, pe, pairs of (Y, r)
satisfying M/P L(rpe, Y)
AD curve for given T, G, M, pe, pairs of (Y, P)
satisfying both Y C(Y-T) I(r) G and M/P
L(rpe, Y)
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Summary of the IS-LM model
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How fiscal policy shifts the IS curve and change
the short-run equilibrium
If government purchase increases by DG
? The IS curve shifts to the right by DG/(1-MPC)
? The equilibrium moves from A to B
Government purchases increases ? the output
increases (So consumption increases) ? the
demand for money increases ? but the money supply
is fixed ? the real interest rate increases ? the
investment decreases
B
A
Note that the increase in output is smaller in
the IS-LM model than it is in the Keynesian cross
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How monetary policy shifts the LM curve and
change the short-run equilibrium
If money supply increases,
? The LM curve shifts to the right (downward).
? The equilibrium moves from A to B
Money supply increases ? the real money balance
increases (so people start to deposit the money
or to buy bonds) ? the real interest
decreases ? the investment increases ? the output
increases (so the consumption increases)
A
B
This is called monetary transmission mechanism.
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The interaction between monetary and fiscal policy

• In general, the impact of a change in one policy
  depends on other policies.
• For example, if the government increases the
  taxes, the impact depends on the monetary policy
• The central bank will
• (a) hold the money supply constant
• (b) hold the interest rate constant
• (C) hold the output constant
• The different mixes of monetary and fiscal policy
  will achieve the different goals.

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The effect of a tax increase monetary policy (a)
(a) If the central bank holds the money supply
constant.
? The IS curve shifts to the left by
DTMPC/(1-MPC)
? But the LM curve stays the same.
The impact of a tax increase Output ?(-)
Interest rate ?(-) Consumption ?(-)
Investment ?()
A
B
The decrease in output is partially offset by the
increase in investment.
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The effect of a tax increase monetary policy (b)
(b) If the central bank holds real interest rate
constant.
? The IS curve shifts to the left by
DTMPC/(1-MPC)
? In order to hold the real interest rate
constant, the central bank contracts the money
supply (The LM curve shifts to the left)
The effect of a tax increase Output ?(-)
Interest rate no change (0) Consumption ?(-)
Investment no change (0)
B
A
The decrease in output is larger than (a) because
the investment does not increase. (the same
effect as the Keynesian cross model)
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The effect of a tax increase monetary policy (c)
(c) If the central bank holds output constant.
? The IS curve shifts to the left by
DTMPC/(1-MPC)
? In order to hold the output constant, the
central bank expands the money supply (The LM
curve shifts to the right)
The impact of a tax increase Output no change
(0) Interest rate ?(-) Consumption ?(-)
Investment ?()
A
The output does not change but the components
change. (The consumption decreases and the
investment increases)
B
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What is the central banks policy instrument, the
money supply or the interest rate?

• Central banks usually use/control the interest
  rate, not the money supply as its short-term
  policy instrument. But
• The central bank lowers the interest rate
• can be translated into
• The central bank buys bonds in open market
  operations so as to increase the money supply,
  shift the LM curve, and reduce the short-run
  equilibrium nominal interest rate to hit a new
  lower target.
• Why does the central bank prefer the interest
  rate?
• The shock to the LM curve are more prevalent than
  shocks to the IS curve
• The interest rates are easier to measure then the
  money supply.

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From the IS-LM to the AD curve (1)
The higher price level, the lower real money
balances (M/P) ? The LM curve shifts to the left,
and the lower output
The AD curve summarizes the relationship between
P and Y.
Y1
A change in output in the IS-LM model resulting
from a change in the price level represents a
movement along the AD curve
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From the IS-LM to the AD curve (2)
An expansionary fiscal (or monetary) policy
increases the output for any given price level.
The AD curve shifts to the right.
Y1
A change in output in the IS-LM model for a fixed
price level represents a shift in the AD curve
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The IS-LM model in the short run and long run
Assuming the central bank holds money supply
constant, if government purchases increases (G?)
In the short run, the IS curve shifts to the
right. (A?B)
The AD curve shifts to the right. B is the
short-run equilibrium.
In the long run, the price level increases
(P1?P2).
So the LM curve shifts to the left. (B?C)
C is the new equilibrium in the short-run and
long-run
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The short-run effects of an increase in
government purchases
In the short run, the economy moves from A to B.
The output (Y) ?() Y increases from YLR to
YSR The price level (P) No change (0) The price
is fixed at P1 The real interest rate (r) ?()
because the higher Y requires the higher r to
hold the L(rpe, Y) constant. The consumption
(C) ?() because the disposable income (Y-T)
increases. The investment (I) ?(-) because the
real interest increases.
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The long-run effects of an increase in government
purchases
In the long run, the economy moves from A to C.
The output (Y) No change (0) the LM curve shifts
to the left until YYLR (natural level). The
price level (P) ?() because P increases until
YYLR The real interest rate (r) ??() more
increase is required due to the decline in M/P.
(Alternatively, r must increase until SI, i.e.,
YYLR) The consumption (C) No change (0) Y comes
back to the original level, so Y-T does not
change. The investment (I) ??(-) because r rises
more.
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The effects of monetary expansion
LM1(PP2, MM2)
If the central bank raises money supply (M?)
In the short run, the LM curve shifts to the
right. (A?B)
The AD curve shifts to the right. B is the
short-run equilibrium.
In the long run, the price level increases (P1?P2)
until the LM curve comes back to the original
curve. (B?C)
C is the same equilibrium as A except the price
level.
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The short-run effects of monetary expansion
LM1(PP2, MM2)
In the short run, the economy moves from A to B.
The output (Y) ?() Y increases from YLR to
YSR The price level (P) No change (0) The price
is fixed at P1 The real interest rate (r) ?(-)
because the M/P increases (the LM curve shifts to
the right) The consumption (C) ?() because the
(Y-T) increases. The investment (I) ?()
because r decreases.
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The long-run effects of monetary expansion
LM1(PP2, MM2)
In the long run, the economy moves from A to C.
The output (Y) No change (0) the LM curve shifts
to the left until YYLR (natural level). The
price level (P) ?() because P increases until
YYLR The real interest rate (r) No change (0)
LM curve comes back The consumption (C) No change
(0) Y-T does not change. The investment (I) No
change (0) r does not chage
Monetary neutrality
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The shock in the IS-LM model

• Shocks (exogenous changes) to the IS curve
• Consumption
• - consumer confidence
• - wealth, expected future disposable income,
  interest rate (Ch 16)
• C(Y-T, W/P, (Y-T)future, r)
• Investment
• - investors animal spirits
• - depreciation, the relative price of capital
  goods and housing, taxation, financing
  constraints, technology and population (Ch 17)
• I(r, d, Pk/P, Ph/P, taxation, financial
  constraints, MPKcurrent and future)
• Shocks (exogenous changes) to the LM curve
• Money supply
• - money multiplier (money supply/monetary
  base) (Ch 18)
• Money demand
• - returns on risky assets, wealth, financial
  innovation
• L(r, pe, rrisky, W/P, financial innovation)

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A shock to the IS curve (Numerical example)
C2000.75(Y-T)?C1000.75(Y-T) (The society
becomes more thrifty.) I200-25r, L(r, Y) Y-5r,
G100, T100, M1000, P2
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The Great Depression (1930s)

• During 1929-1933, the output fell 30, the
  unemployment rose from 3.2 to 25.2., the
  nominal interest rate fell from 5.9 to 1.7, the
  money supply and the price level fell 25.
• Spending hypothesis because of the
  contractionary shift of the IS curve
• Consumption partially because of the stock
  market crash of 1929
• Housing investment overbuilding in 1920s,
  slowdown of immigration
• Capital investment banking crises and credit
  crunches
• Fiscal policy more concerns with balanced budget
  than now.
• Money hypothesis because of the contractionary
  shift of the LM curve
• Falling money supply decline in money multiplier
  due to bank crises
• Deflation the effect of falling prices
• The stabilizing effects of deflation increasing
  the output ()
• - The real money balances (M/P) increases ? the
  LM curves shifts downward
• - Pigou effect the real wealth (W/P) increase
  ? the consumption increases.
• The destabilizing effects of deflation
  decreasing the output (-)
• - Debt-deflation redistribution from debtors
  to creditors ? the MPC falls
• - The expected deflation increases the real
  interest rate.

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The effects of the expected deflation
If the expected inflation rate falls by p (pe ?
pe-p) Then, the money demand L(rpe, Y) ?
L(rpe-p, Y)
? The LM curve shifts upward by p
If the expected inflation rate falls ? the real
interest rate increases ? the investment
decreases ? the output decreases However, the
increase in the real interest rate is smaller
than p ? the nominal interest falls
B
Note that the vertical axis is the real interest
rate. If it is the nominal interest rate, the IS
curve shifts by p downward instead of the LM
curve
A
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Summary

• The IS-LM model and the AD curve say
• The intersection of the IS and LM curves shows
  the equilibrium points (Y, r) for a given price
  level.
• The expansionary fiscal policy (G?or T?) shifts
  the IS curve to the right, so the output and the
  interest rate increases (Y?and r?). Thus,
  consumption increases but the investment
  decreases (C?and I?).
• The monetary expansionary policy (M?) shifts the
  LM curve to the right, so the output increases
  but the interest rate decreases (Y?and r?). Thus,
  both consumption and investment increases (C?and
  I?).
• The AD curve summarizes the results from the
  IS-LM model by showing the output at any given
  price level.