# The Big Picture Keynesian Cross IS curve IS-LM model

## Presentation on theme: "The Big Picture Keynesian Cross IS curve IS-LM model"— Presentation transcript:

This chapter sets up the IS-LM model, which chapter 11 then uses extensively to analyze the effects of policies and economic shocks. This chapter also introduces students to the Keynesian Cross and Liquidity Preference models, which underlie the IS curve and LM curve, respectively. If you would like to spend less time on this chapter, you might consider omitting the Keynesian Cross, instead using the loanable funds model from Chapter 3 to derive the IS curve. Advantage: students are already familiar with the loanable funds model, so skipping the KC means one less model to learn. Additionally, the KC model is not used anywhere else in this textbook. Once it’s used to derive IS, it disappears for good. However, there are some good reasons for NOT omitting the KC model: 1) Many principles textbooks (though not Mankiw’s) cover the KC model; students who learned the KC model in their principles class may benefit from seeing it here, as a bridge to new material (the IS curve). 2) The KC model is of some historical importance. One could argue that anybody graduating from college with a degree in economics should be familiar with the KC model.

The Big Picture Keynesian Cross IS curve IS-LM model
Explanation of short-run fluctuations Theory of Liquidity Preference LM curve Agg. demand curve Model of Agg. Demand and Agg. Supply Agg. supply curve

In this chapter you will learn
the IS curve, and its relation to the Keynesian Cross the Loanable Funds model the LM curve, and its relation to the Theory of Liquidity Preference how the IS-LM model determines income and the interest rate in the short run when P is fixed I’ve included this slide but “hidden” it (so, it will not appear in your presentation unless you intentionally “unhide” it). I believe the following two slides do a far better job of introducing this chapter.

Context Chapter 9 introduced the model of aggregate demand and aggregate supply. Long run prices flexible output determined by factors of production & technology unemployment equals its natural rate Short run prices fixed output determined by aggregate demand unemployment is negatively related to output

Context This chapter develops the IS-LM model, the theory that yields the aggregate demand curve. We focus on the short run and assume the price level is fixed. This chapter (and chapter 11) focus on the closed-economy case. Chapter 12 presents the open-economy case.

The Keynesian Cross A simple closed economy model in which income is determined by expenditure. (due to J.M. Keynes) Notation: I = planned investment E = C + I + G = planned expenditure Y = real GDP = actual expenditure Difference between actual & planned expenditure: unplanned inventory investment

Elements of the Keynesian Cross
consumption function: govt policy variables: for now, planned investment is exogenous: planned expenditure: Stress that much of this model is very familiar to students: same consumption function as in previous chapters, same treatment of fiscal policy variables. Note: In equilibrium, there’s no unplanned inventory investment. Firms are selling everything they had intended wanted to sell. Equilibrium condition:

Graphing planned expenditure
E =C +I +G MPC 1 Why slope of E line equals the MPC: With I and G exogenous, the only component of (C+I+G) that changes when income changes is consumption. A one-unit increase in income causes consumption---and therefore E---to increase by the MPC. Recall from Chapter 3: the marginal propensity to consume, MPC, equals the increase in consumption resulting from a one-unit increase in disposable income. Since T is exogenous here, a one-unit increase in Y causes a one-unit increase in disposable income. income, output, Y

Graphing the equilibrium condition
planned expenditure E =Y 45º income, output, Y

The equilibrium value of income
planned expenditure E =Y E =C +I +G The equilibrium point is the value of income where the curves cross. Be sure your students understand why the equilibrium income appears on the horizontal and vertical axes. Answer: In equilibrium, E (which is measured on the vertical) = Y (which is measured on the horizontal). Equilibrium income income, output, Y

An increase in government purchases
Y E E =Y At Y1, there is now an unplanned drop in inventory… E =C +I +G2 E =C +I +G1 G …so firms increase output, and income rises toward a new equilibrium Explain why the vertical distance of the shift in the E curve equals G: At any value of Y, an increase in G by the amount G causes an increase in E by the same amount. At Y1, there is now an unplanned depletion of inventories, because people are buying more than firms are producing (E > Y). E1 = Y1 Y E2 = Y2

Solving for Y equilibrium condition in changes because I exogenous
because C = MPC Y Collect terms with Y on the left side of the equals sign: Finally, solve for Y :

The government purchases multiplier
Definition: the increase in income resulting from a \$1 increase in G. In this model, the govt purchases multiplier equals Example: If MPC = 0.8, then The textbook defines the multiplier as the increase in income resulting from a \$1 increase in G. However, G is a real variable (as is Y ). So, if you wish to be more precise, then you might consider defining the multiplier as “the increase in income resulting from a one-unit increase in G.” An increase in G causes income to increase by 5 times as much!

Why the multiplier is greater than 1
Initially, the increase in G causes an equal increase in Y: Y = G. But Y  C  further Y  further C So the final impact on income is much bigger than the initial G. Students are better able to understand this if given a more concrete example, which you can explain as you make the elements on this slide appear on the screen. For instance, Suppose the government spends an additional \$100 million on defense. Then, the revenues of defense firms increase by \$100 million, all of which becomes income to somebody: some of it is paid to the workers and engineers and managers, the rest is profit paid as dividends to shareholders. Hence, income rises \$100 million (Y = \$100 million = G ). The people whose income just rose by \$100 million are also consumers, and they will spend the fraction MPC of this extra income. Suppose MPC = 0.8, so C rises by \$80 million. To be concrete, suppose they buy \$80 million worth of Ford Explorers. Then, Ford sees its revenues increase by \$80 million, all of which becomes income to somebody - either Ford’s workers, or its shareholders (Y = \$80 million). And what do these folks do with this extra income? They spend the fraction MPC (0.8) of it, causing C = \$64 million (8/10 of \$80 million). Suppose they spend all \$64 million on Hershey’s chocolate bars, the ones with the bits of mint cookie inside. Then, Hershey Foods Corporation experiences a revenue increase of \$64 million, which becomes income to somebody or other. (Y = \$64 million). So far, the total impact on income is \$100 million + \$80 million + \$64 million, which is much bigger than the government’s initial increase in spending. But this process continues, and the final impact on Y is \$500 million (because the multiplier is 5).

An increase in taxes E C = MPC T Y Y E =C1 +I +G E =C2 +I +G
E =Y Y E Initially, the tax increase reduces consumption, and therefore E: E =C1 +I +G E =C2 +I +G At Y1, there is now an unplanned inventory buildup… C = MPC T …so firms reduce output, and income falls toward a new equilibrium Experiment: An increase in taxes (note: the book does a decrease in taxes) Suppose taxes are increased by T. Because I and G are exogenous, they do not change. However, C depends on (YT). So, at the initial value of Y, a tax increase of T causes disposable income to fall by T, which causes consumption to fall by MPC  T. Because consumption falls, the change in C is negative: C =  MPC  T C is part of planned expenditure. The fall in C causes the E line to shift down by the size of the initial drop in C. At the initial value of output, there is now unplanned inventory investment: Sales have fallen below output, so the unsold output adds to inventory. In this situation, firms will reduce production, causing total output, income, and expenditure to fall. The new equilibrium is at Y2, where planned expenditure once again equals actual expenditure/output, and unplanned inventory investment is again equal to zero. E2 = Y2 Y E1 = Y1

Solving for Y eq’m condition in changes I and G exogenous
Final result:

The Tax Multiplier def: the change in income resulting from a \$1 increase in T : If MPC = 0.8, then the tax multiplier equals

The Tax Multiplier …is negative: A tax hike reduces consumer spending, which reduces income. …is greater than one (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.

Exercise: Use a graph of the Keynesian Cross to show the impact of an increase in planned investment on the equilibrium level of income/output. This in-class exercise not only gives students practice with the model, it also helps them understand the next topic: the derivation of the IS curve.

The IS curve def: a graph of all combinations of r and Y that result in goods market equilibrium, i.e. actual expenditure (output) = planned expenditure The equation for the IS curve is:

Deriving the IS curve r  I  E  Y E =C +I (r2 )+G

Why the IS curve is negatively sloped
A fall in the interest rate motivates firms to increase investment spending, which drives up total planned spending (E ). To restore equilibrium in the goods market, output (a.k.a. actual expenditure, Y ) must increase.

The IS curve and the Loanable Funds model
(a) The L.F. model (b) The IS curve I (r ) S, I r r Y S2 S1 Y2 Y1 r2 r2 r1 The IS curve can also be derived from the (hopefully now familiar) loanable funds model from chapter 3. A decrease in income from Y1 to Y2 causes a fall in national saving. (Recall, S = Y-C-G) The fall in saving causes a reduction in the supply of loanable funds. The interest rate must rise to restore equilibrium to the loanable funds market. Now we can see where the IS curve gets its name: When the loanable funds market is in equilibrium, investment = saving. The IS curve shows all combinations of r and Y such that investment (I) equals saving (S). Hence, “IS curve.” r1 IS

Fiscal Policy and the IS curve
We can use the IS-LM model to see how fiscal policy (G and T ) can affect aggregate demand and output. Let’s start by using the Keynesian Cross to see how fiscal policy shifts the IS curve…

Shifting the IS curve: G
E =Y Y E E =C +I (r1 )+G2 At any value of r, G  E  Y E =C +I (r1 )+G1 …so the IS curve shifts to the right. The horizontal distance of the IS shift equals Y1 Y2 r Y r1 This slide has two purposes. First, to show which way the IS curve shifts when G changes. Second, to actually measure the distance of the shift. We can measure either the horizontal or vertical distance of the shift. The horizontal distance of the IS curve shift is the change in Y required to restore goods market equilibrium AT THE INITIAL INTEREST RATE when G is raised. Since the interest rate is unchanged at r1, investment will also be unchanged. This is why, in the upper panel, we write “I(r1)” in the E equation for both expenditure curves – to remind us that investment and the interest rate are not changing. Y IS2 IS1 Y1 Y2

Exercise: Shifting the IS curve
Use the diagram of the Keynesian Cross or Loanable Funds model to show how an increase in taxes shifts the IS curve.

The Theory of Liquidity Preference
due to John Maynard Keynes. A simple theory in which the interest rate is determined by money supply and money demand.

Money Supply The supply of real money balances is fixed: r M/P
interest rate We are assuming a fixed supply of real money balances because P is fixed by assumption (short-run), and M is an exogenous policy variable. M/P real money balances

Money Demand Demand for real money balances: L (r ) r M/P interest
rate L (r ) As we learned in chapter 4, the nominal interest rate is the opportunity cost of holding money (instead of bonds), so money demand depends negatively on the nominal interest rate. Here, we are assuming the price level is fixed, so  = 0 and r = i. M/P real money balances

Equilibrium The interest rate adjusts to equate the supply and demand for money: r interest rate r1 L (r ) M/P real money balances

How the Fed raises the interest rate
To increase r, Fed reduces M r2 r1 L (r ) M/P real money balances

CASE STUDY Volcker’s Monetary Tightening
Late 1970s:  > 10% Oct 1979: Fed Chairman Paul Volcker announced that monetary policy would aim to reduce inflation. Aug 1979-April 1980: Fed reduces M/P 8.0% Jan 1983:  = 3.7% This and the next slide summarize the case study on pp The data source is given on the next slide. At this point, students have now learned different theories about the effects of monetary policy on interest rates. This case study shows them that both theories are relevant, using a real-world example to remind students that the classical theory of chapter 4 applies in the long-run while the liquidity preference theory applies in the short run. How do you think this policy change would affect interest rates?

Volcker’s Monetary Tightening, cont.
prediction actual outcome The effects of a monetary tightening on nominal interest rates prices model long run short run Liquidity Preference (Keynesian) Quantity Theory, Fisher Effect (Classical) sticky flexible Since prices are sticky in the short run, the Liquidity Preference Theory predicts that both the nominal and real interest rates will rise in the short run. And in fact, both did. (However, the inflation rate was not zero, and in fact it increased, so the real interest rate didn’t rise as much as the nominal interest rate did during the period shown.) In the long run, the Quantity Theory of Money says that the monetary tightening should reduce inflation. The Fisher Effect says that the fall in  should cause an equal fall in i. By January of 1983 (which is “the long run” from the viewpoint of 1979), inflation and nominal interest rates had fallen. (However, they did not fall by equal amounts. This doesn’t contradict the Fisher Effect, though, as other economic changes caused movements in the real interest rate.) About the data: i = 3-month rate on Commercial Paper (which seemed to be the closest match to the interest rate described in the case study: “on short-term commercial loans”, top of p.274). % change in M/P from previous slide: I computed M1/CPI (the measure used in the case study), then computed the percentage change in M1/CPI over the 8-month period beginning with the month in which Volcker became the Fed chairman, August 1979. Source: FRED database, Federal Reserve Bank of St. Louis. i > 0 i < 0 8/1979: i = 10.4% 4/1980: i = 15.8% 1/1983: i = 8.2%

The LM curve Now let’s put Y back into the money demand function:
The LM curve is a graph of all combinations of r and Y that equate the supply and demand for real money balances. The equation for the LM curve is:

Deriving the LM curve L (r , Y2 ) L (r , Y1 ) r r LM Y1 Y2 r2 r2 r1 r1
(a) The market for real money balances (b) The LM curve L (r , Y1 ) M/P r r Y LM Y1 Y2 r2 r2 r1 r1

Why the LM curve is upward-sloping
An increase in income raises money demand. Since the supply of real balances is fixed, there is now excess demand in the money market at the initial interest rate. The interest rate must rise to restore equilibrium in the money market.

How M shifts the LM curve
(a) The market for real money balances (b) The LM curve L (r , Y1 ) M/P r r Y LM2 Y1 LM1 r2 r2 r1 If you’re as anal as I am, you might consider helping your students understand the analytical difference between looking at a shift as a horizontal shift and looking at it as a vertical shift. We can think of the LM curve shift as a vertical shift: When the Fed reduces M, the vertical distance of the shift tells us what happens to the equilibrium interest rate associated with a given value of income. Or, we can think of the LM curve shifting horizontally: When the Fed reduces M, the horizontal distance of the shift tells us what would have to happen to income to restore money market equilibrium at the initial interest rate. (The graphical analysis would be a little different than what’s depicted on this slide.) r1

Exercise: Shifting the LM curve
Suppose a wave of credit card fraud causes consumers to use cash more frequently in transactions. Use the Liquidity Preference model to show how these events shift the LM curve. Answer: This causes an increase in money demand. In the Liquidity Preference diagram, the money demand curve shifts up. Hence, at the the initial value of income, the interest rate must rise to restore equilibrium in the money market. As a result, the LM curve shifts up: each value of income (such as the initial income) is associated with a higher interest rate than before.

The short-run equilibrium
The short-run equilibrium is the combination of r and Y that simultaneously satisfies the equilibrium conditions in the goods & money markets: Y r LM IS Equilibrium interest rate Equilibrium level of income

The Big Picture Keynesian Cross IS curve IS-LM model
Explanation of short-run fluctuations Theory of Liquidity Preference LM curve Agg. demand curve Model of Agg. Demand and Agg. Supply Agg. supply curve

Chapter summary Keynesian Cross basic model of income determination
takes fiscal policy & investment as exogenous fiscal policy has a multiplier effect on income. IS curve comes from Keynesian Cross when planned investment depends negatively on interest rate shows all combinations of r and Y that equate planned expenditure with actual expenditure on goods & services

Chapter summary Theory of Liquidity Preference
basic model of interest rate determination takes money supply & price level as exogenous an increase in the money supply lowers the interest rate LM curve comes from Liquidity Preference Theory when money demand depends positively on income shows all combinations of r andY that equate demand for real money balances with supply

Chapter summary IS-LM model
Intersection of IS and LM curves shows the unique point (Y, r ) that satisfies equilibrium in both the goods and money markets.

Preview of Chapter 11 In Chapter 11, we will
use the IS-LM model to analyze the impact of policies and shocks learn how the aggregate demand curve comes from IS-LM use the IS-LM and AD-AS models together to analyze the short-run and long-run effects of shocks use our models to learn about the Great Depression

This is a very substantial chapter, and among the most challenging in the text. I encourage you to go over this chapter a little more slowly than average, or at least recommend to your students that they study it extra carefully. I have included a number of in-class exercises to give students immediate reinforcement of concepts as they are covered, and also to break up the lecture. If you need to get through the material more quickly, you can omit some or all of these exercises (perhaps assigning them as homeworks, instead). A graph unfolds on slides If you create handouts of this file for your students (or create a PDF version for them to download from the web), you might consider omitting slides 28 and 30 to save paper, as they contain intermediate animations.

Context Chapter 9 introduced the model of aggregate demand and supply.
Chapter 10 developed the IS-LM model, the basis of the aggregate demand curve. In Chapter 11, we will use the IS-LM model to see how policies and shocks affect income and the interest rate in the short run when prices are fixed derive the aggregate demand curve explore various explanations for the Great Depression

Equilibrium in the IS-LM Model
The IS curve represents equilibrium in the goods market. Y r LM IS r1 The LM curve represents money market equilibrium. Y1 The intersection determines the unique combination of Y and r that satisfies equilibrium in both markets.

Policy analysis with the IS-LM Model
r LM IS Policymakers can affect macroeconomic variables with fiscal policy: G and/or T monetary policy: M We can use the IS-LM model to analyze the effects of these policies. r1 Y1

An increase in government purchases
1. IS curve shifts right Y r LM causing output & income to rise. IS2 IS1 r2 Y2 2. r1 Y1 2. This raises money demand, causing the interest rate to rise… 1. Chapter 10 showed that an increase in G causes the IS curve to shift to the right by (G)/(1-MPC). 3. …which reduces investment, so the final increase in Y 3.

A tax cut Because consumers save (1MPC) of the tax cut, the initial boost in spending is smaller for T than for an equal G… and the IS curve shifts by Y r LM IS2 IS1 r2 2. Y2 r1 Y1 1. 1. Chapter 10 used the Keynesian Cross to show that a decrease in T causes the IS curve to shift to the right by (-MPCT)/(1-MPC). If your students ask why the IS curve shifts to the right when there’s a negative sign in the expression for the shift, remind them that T < 0 for a tax cut, so the expression actually is positive. The term showing the distance of the shift in the IS curve is almost the same as in the case of a government spending increase, where the numerator of the fraction equals (1) for government spending rather than (-MPC) for the tax cut. Here’s the intuition: Every dollar of a government spending increase adds to aggregate spending. However, for tax cuts, the fraction (1-MPC) of the tax cut leaks into saving, so aggregate spending only rises by MPC times the tax cut. …so the effects on r and Y are smaller for a T than for an equal G. 2. 2.

Monetary Policy: an increase in M
1. M > 0 shifts the LM curve down (or to the right) LM1 LM2 IS r1 Y1 2. …causing the interest rate to fall r2 Y2 3. …which increases investment, causing output & income to rise. Chapter 10 showed that an increase in M shifts the LM curve to the right. Here is a richer explanation for the LM shift: The increase in M causes the interest rate to fall. [People like to keep optimal proportions of money and bonds in their portfolios; if money is increased, then people try to re-attain their optimal proportions by “exchanging” some of the money for bonds: they use some of the extra money to buy bonds. This increase in the demand for bonds drives up the price of bonds -- and causes interest rates to fall (since interest rates are inversely related to bond prices). The fall in the interest rate induces an increase in investment demand, which causes output and income to increase. The increase in income causes money demand to increase, which increases the interest rate (though doesn’t increase it all the way back to its initial value; instead, this effect simply reduces the total decrease in the interest rate).

Interaction between monetary & fiscal policy
Model: monetary & fiscal policy variables (M, G and T ) are exogenous Real world: Monetary policymakers may adjust M in response to changes in fiscal policy, or vice versa. Such interaction may alter the impact of the original policy change.

The Fed’s response to G > 0
Suppose Congress increases G. Possible Fed responses: 1. hold M constant 2. hold r constant 3. hold Y constant In each case, the effects of the G are different:

Response 1: hold M constant
If Congress raises G, the IS curve shifts right Y r LM1 IS2 IS1 If Fed holds M constant, then LM curve doesn’t shift. Results: r2 Y2 r1 Y1

Response 2: hold r constant
If Congress raises G, the IS curve shifts right Y r LM1 IS2 LM2 IS1 To keep r constant, Fed increases M to shift LM curve right. r2 Y2 r1 Y1 Y3 Results:

Response 3: hold Y constant
LM2 If Congress raises G, the IS curve shifts right Y r LM1 Y1 IS2 r3 IS1 To keep Y constant, Fed reduces M to shift LM curve left. r2 Y2 r1 Results:

Estimates of fiscal policy multipliers
from the DRI macroeconometric model Estimated value of Y / G Estimated value of Y / T Assumption about monetary policy Fed holds money supply constant 0.60 0.26 The preceding slides show that the impact of fiscal policy on GDP depends on the Fed’s response (or lack thereof). This slide shows estimates of the fiscal policy multipliers under different assumptions about monetary policy; these estimates are consistent with the theoretical results on the preceding slides. First, the slide shows estimates of the government spending multiplier for the two different monetary policy scenarios. Then, the slide reveals the tax multiplier estimates. (If you wish, you can turn off the animation so that everything appearing on the slide appears at one time. Just click on the “Slide Show” pull-down menu, then on “Custom animation…”, then uncheck all of the boxes next to the elements of the screen that you do not wish to be animated. Regarding the estimates: First, note that the estimates of the fiscal policy multipliers are smaller (in absolute value) when the money supply is held constant than when the interest rate is held constant. This is consistent with the results from the IS-LM model presented in the preceding few slides. Second, notice that the tax multiplier is smaller than the government spending multiplier in each of the monetary policy scenarios. This should make sense from material presented earlier in this chapter: the government spending multiplier (for a constant money supply) is 1/(1-MPC), while the tax multiplier is only (-MPC)/(1-MPC). Fed holds nominal interest rate constant 1.93 1.19

Shocks in the IS-LM Model
IS shocks: exogenous changes in the demand for goods & services. Examples: stock market boom or crash  change in households’ wealth  C change in business or consumer confidence or expectations  I and/or C

Shocks in the IS-LM Model
LM shocks: exogenous changes in the demand for money. Examples: a wave of credit card fraud increases demand for money more ATMs or the Internet reduce money demand

EXERCISE: Analyze shocks with the IS-LM model
Use the IS-LM model to analyze the effects of A boom in the stock market makes consumers wealthier. After a wave of credit card fraud, consumers use cash more frequently in transactions. For each shock, use the IS-LM diagram to show the effects of the shock on Y and r . determine what happens to C, I, and the unemployment rate. Earlier slides showed how to use the IS-LM model to analyze fiscal and monetary policy. Now is a good time for students to get some hands-on practice with the model. Also, note that part (b) helps students learn that shocks and policies can potentially affect all of the model’s endogenous variables, not just the ones that are measured on the axes. After working this exercise, your students will better understand the following case study on the 2001 U.S. economic slowdown that immediately follows. Suggestion: Instead of having students work on these exercises individually, get them into pairs. One student of each pair works on the first shock, the other student works on the second shock. Give them 5 minutes to work individually on the analysis of the shock. Then, allow 10 minutes (5 for each student) for students to present their results to their partners. This activity gives students immediate application and reinforcement of the concepts, so students learn them better and will then better understand and appreciate the remainder of your lecture on Chapter 11. Answers: 1a. The IS curve shifts to the right, because consumers feel they can afford to spend more given this exogenous increase in their wealth. This causes Y and r to rise. 1b. C rises for two reasons: the stock market boom, and the increase in income. I falls, because r is higher. u falls, because firms hire more workers to produce the extra output that is demanded. 2a. (This is a continuation of the in-class exercise at the end of the PowerPoint presentation of Chapter 10.) The increase in money demand shifts the LM curve to the left: We are assuming that all other exogenous variables, including M and P, remain unchanged, so an increase in money demand causes an increase in the value of r associated with each value of Y (this can be seen easily using the Liquidity Preference diagram). This translates to an upward (i.e. leftward) shift in the LM curve. This shift causes Y to fall and r to rise. 2b. The fall in income causes a fall in C. The increase in r causes a fall in I. The fall in Y causes an increase in u.

CASE STUDY The U.S. economic slowdown of 2001
~What happened~ 1. Real GDP growth rate : 3.9% (average annual) 2001: 0.8% for the year, March 2001 determined to be the end of the longest expansion on record. 2. Unemployment rate Dec 2000: 3.9% Dec 2001: 5.8% The number of unemployed people rose by 2.1 million during 2001!

CASE STUDY The U.S. economic slowdown of 2001
~Shocks that contributed to the slowdown~ 1. Falling stock prices From Aug 2000 to Aug 2001: -25% Week after 9/11: -12% 2. The terrorist attacks on 9/11 increased uncertainty fall in consumer & business confidence Both shocks reduced spending and shifted the IS curve left.

CASE STUDY The U.S. economic slowdown of 2001
~The policy response~ 1. Fiscal policy large long-term tax cut, immediate \$300 rebate checks spending increases: aid to New York City & the airline industry, war on terrorism 2. Monetary policy Fed lowered its Fed Funds rate target 11 times during 2001, from 6.5% to 1.75% Money growth increased, interest rates fell

CASE STUDY The U.S. economic slowdown of 2001
~The recovery~ The recession officially ended in November 2001. Real GDP recovered, growing 2.3% in 2002 and 4.4% in 2003. The unemployment rate lagged: 5.8% in 2002, 6.0% in 2003. The Fed cut interest rates in 11/02 and 6/03. Unemployment finally appears to be responding: 5.6% for the first half of 2004.

What is the Fed’s policy instrument?
What the newspaper says: “the Fed lowered interest rates by one-half point today” What actually happened: The Fed conducted expansionary monetary policy to shift the LM curve to the right until the interest rate fell 0.5 points. The Fed targets the Federal Funds rate: it announces a target value, and uses monetary policy to shift the LM curve as needed to attain its target rate. In case your students aren’t familiar with the Fed Funds rate, you might briefly explain that it’s the rate banks charge each other on overnight loans. Since most short-term interest rates move closely together, the changes in the Fed Funds rate caused by monetary policy end up causing similar changes in most other short-term rates. Long term rates may well also move in the same direction, but they are also affected by other factors beyond the scope of this chapter. Chapter 18 discusses monetary policy in detail.

What is the Fed’s policy instrument?
Why does the Fed target interest rates instead of the money supply? 1) They are easier to measure than the money supply 2) The Fed might believe that LM shocks are more prevalent than IS shocks. If so, then targeting the interest rate stabilizes income better than targeting the money supply. (See Problem 7 on p.306)

IS-LM and Aggregate Demand
So far, we’ve been using the IS-LM model to analyze the short run, when the price level is assumed fixed. However, a change in P would shift the LM curve and therefore affect Y. The aggregate demand curve (introduced in chap. 9 ) captures this relationship between P and Y

Deriving the AD curve  Y Intuition for slope of AD curve:
LM(P2) Intuition for slope of AD curve: P  (M/P )  LM shifts left  r  I  Y IS LM(P1) r2 r1 Y2 Y1 Y P P2 It might be useful to explain to students the reason why we draw P1 before drawing the LM curve: The position of the LM curve depends on the value of M/P. M is an exogenous policy variable. So, if P is low (like P1 in the lower panel of the diagram), then M/P is relatively high, so the LM curve is over toward the right in the upper diagram. If P is high, like P2, then M/P is relatively low, so the LM curve is more toward the left. Because the value of P affects the position of the LM curve, we label the LM curves in the upper panel as LM(P1) and LM(P2). P1 AD Y2 Y1

Monetary policy and the AD curve
LM(M1/P1) The Fed can increase aggregate demand: M  LM shifts right IS LM(M2/P1) r1 Y1 r2 Y2  r  I  Y at each value of P Y P AD2 AD1 It’s worth taking a moment to explain why we are holding P fixed at P1: To find out whether the AD curve shifts to the left or right, we need to find out what happens to the value of Y associated with any given value of P. This is not to say that the equilibrium value of P will remain fixed after the policy change (though, in fact, we are assuming P is fixed in the short run). We just want to see what happens to the AD curve. Once we know how the AD curve shifts, we can then add the AS curves (short- or long-run) to find out what, if anything, happens to P (in the short- or long-run). P1

Fiscal policy and the AD curve
Expansionary fiscal policy (G and/or T ) increases agg. demand: T  C  IS shifts right  Y at each value of P LM IS2 Y2 r2 IS1 Y1 r1 Y P AD2 AD1 P1

IS-LM and AD-AS in the short run & long run
Recall from Chapter 9: The force that moves the economy from the short run to the long run is the gradual adjustment of prices. In the short-run equilibrium, if then over time, the price level will rise The next few slides put our IS-LM-AD in the context of the bigger picture - the AD-AS model in the short-run and long-run, which was introduced in Chapter 9. fall remain constant

The SR and LR effects of an IS shock
Y r LRAS LM(P1) IS1 IS2 AD2 A negative IS shock shifts IS and AD left, causing Y to fall. AD1 Y P LRAS SRAS1 P1 Abbreviation: SR = short run, LR = long run

The SR and LR effects of an IS shock
Y r LRAS LM(P1) In the new short-run equilibrium, IS2 IS1 Y P LRAS AD2 SRAS1 P1 AD1

The SR and LR effects of an IS shock
Y r LRAS LM(P1) In the new short-run equilibrium, IS2 IS1 Over time, P gradually falls, which causes SRAS to move down M/P to increase, which causes LM to move down Y P LRAS AD2 SRAS1 P1 AD1

The SR and LR effects of an IS shock
Y r LRAS LM(P1) SRAS2 P2 LM(P2) IS2 IS1 Over time, P gradually falls, which causes SRAS to move down M/P to increase, which causes LM to move down Y P LRAS AD2 SRAS1 P1 AD1

The SR and LR effects of an IS shock
Y r LRAS LM(P1) SRAS2 P2 LM(P2) IS2 This process continues until economy reaches a long-run equilibrium with IS1 Y P LRAS AD2 SRAS1 A good thing to do: Go back through this experiment again, and see if your students can figure out what is happening to the other endogenous variables (C, I, u) in the short run and long run. P1 AD1

EXERCISE: Analyze SR & LR effects of M
Draw the IS-LM and AD-AS diagrams as shown here. Suppose Fed increases M. Show the short-run effects on your graphs. Show what happens in the transition from the short run to the long run. How do the new long-run equilibrium values of the endogenous variables compare to their initial values? Y r LRAS LM(M1/P1) IS Y P AD1 LRAS This exercise has two objectives: 1. To give students immediate reinforcement of the preceding concepts. 2. To show them that money is neutral in the long run, just like in chapter 4. You might have your students try other exercises using this framework: * the short-run and long-run effects of expansionary fiscal policy. Have them compare the long-run results in this framework with the results they obtained when doing the same experiment in Chapter 3 (the loanable funds model). * Immediately after a negative shock pushes output below its natural rate, show how monetary or fiscal policy can be used to restore full-employment immediately (i.e., without waiting for prices to adjust). SRAS1 P1

Unemployment (right scale)
The Great Depression Unemployment (right scale) Real GNP (left scale) This chart presents data from Table 11-2 on p.296 of the text. For data sources, see notes accompanying that table. Note the very strong negative correlation between output and unemployment.

The Spending Hypothesis: Shocks to the IS Curve
asserts that the Depression was largely due to an exogenous fall in the demand for goods & services -- a leftward shift of the IS curve evidence: output and interest rates both fell, which is what a leftward IS shift would cause

The Spending Hypothesis: Reasons for the IS shift
Stock market crash  exogenous C Oct-Dec 1929: S&P 500 fell 17% Oct 1929-Dec 1933: S&P 500 fell 71% Drop in investment “correction” after overbuilding in the 1920s widespread bank failures made it harder to obtain financing for investment Contractionary fiscal policy in the face of falling tax revenues and increasing deficits, politicians raised tax rates and cut spending In item 2, I’m using the term “correction” in the stock market sense.

The Money Hypothesis: A Shock to the LM Curve
asserts that the Depression was largely due to huge fall in the money supply evidence: M1 fell 25% during But, two problems with this hypothesis: P fell even more, so M/P actually rose slightly during nominal interest rates fell, which is the opposite of what would result from a leftward LM shift.

The Money Hypothesis Again: The Effects of Falling Prices
asserts that the severity of the Depression was due to a huge deflation: P fell 25% during This deflation was probably caused by the fall in M, so perhaps money played an important role after all. In what ways does a deflation affect the economy?

The Money Hypothesis Again: The Effects of Falling Prices
The stabilizing effects of deflation: P  (M/P )  LM shifts right  Y Pigou effect: P  (M/P )  consumers’ wealth   C  IS shifts right  Y

The Money Hypothesis Again: The Effects of Falling Prices
The destabilizing effects of unexpected deflation: debt-deflation theory P (if unexpected)  transfers purchasing power from borrowers to lenders  borrowers spend less, lenders spend more  if borrowers’ propensity to spend is larger than lenders, then aggregate spending falls, the IS curve shifts left, and Y falls

The Money Hypothesis Again: The Effects of Falling Prices
The destabilizing effects of expected deflation: e  r  for each value of i  I  because I = I (r )  planned expenditure & agg. demand   income & output  The textbook (from the bottom of p.299 through p.300) uses an “extended” IS-LM model, which includes both the nominal interest rate (measured on the vertical axis) and the real interest rate (which equals the nominal rate less expected inflation). Because money demand depends on the nominal rate, which is measured on the vertical axis, the change in expected inflation doesn’t shift the LM curve. However, investment depends on the real interest rate, so the fall in expected inflation shifts the IS curve: each value of i is now associated with a higher value of r, which reduces investment and shifts the IS curve to the left. Results: income falls, i falls, and r rises --- which is exactly what happened from 1929 to 1931 (see table 11-2 on pp.296-7). This slide gives the basic intuition, which students often can grasp more quickly and easily than the graphical analysis. After you cover this material in your lecture, it will be easier for your students to grasp the analysis on pp

Why another Depression is unlikely
Policymakers (or their advisors) now know much more about macroeconomics: The Fed knows better than to let M fall so much, especially during a contraction. Fiscal policymakers know better than to raise taxes or cut spending during a contraction. Federal deposit insurance makes widespread bank failures very unlikely. Automatic stabilizers make fiscal policy expansionary during an economic downturn. Examples of automatic stabilizers: the income tax: people pay less taxes automatically if their income falls unemployment insurance: prevents income - and hence spending - from falling as much during a downturn This is discussed in Chapter 14.

Chapter summary a theory of aggregate demand
1. IS-LM model a theory of aggregate demand exogenous: M, G, T, P exogenous in short run, Y in long run endogenous: r, Y endogenous in short run, P in long run IS curve: goods market equilibrium LM curve: money market equilibrium

Chapter summary 2. AD curve shows relation between P and the IS-LM model’s equilibrium Y. negative slope because P  (M/P )  r  I  Y expansionary fiscal policy shifts IS curve right, raises income, and shifts AD curve right expansionary monetary policy shifts LM curve right, raises income, and shifts AD curve right IS or LM shocks shift the AD curve

Aggregate Demand in the Open Economy
CHAPTER TWELVE Aggregate Demand in the Open Economy Chapter 12 covers a lot of material. First, it develops the Mundell-Fleming open-economy IS-LM model for a small open economy with perfect capital mobility. The model is used to analyze the effects of fiscal & monetary policy under floating and flexible exchange rates. Trade policy is also considered. Then, the chapter explores interest rate differentials, or risk premia that arise due to country risk or expected changes in exchange rates. The Mundell-Fleming model is used to analyze the effects of a change in the risk premium. The Mexican Peso Crisis is an important real-world example of this. The chapter summarizes the debate over fixed vs. floating exchange rates. Following that discussion, the Mundell-Fleming model is used to derive the aggregate demand curve for a small open economy. And finally, the chapter discusses how the results it derives would be different in a large open economy. To reinforce this material, I urge you to do some in-class exercises (I’ve suggested several in the lecture notes accompanying some of the slides in this presentation) *and* to assign a homework consisting of several of the “Questions for Review” and “Problems and Applications” starting on p.339 of the text.

Learning objectives The Mundell-Fleming model: IS-LM for the small open economy Causes and effects of interest rate differentials Arguments for fixed vs. floating exchange rates The aggregate demand curve for the small open economy

The Mundell-Fleming Model
Key assumption: Small open economy with perfect capital mobility. r = r* Goods market equilibrium---the IS* curve: In this and the following sections (in which we analyze policies with the M-F model), we assume the price level is fixed---just as we did when we first used the closed economy IS-LM model to do policy analysis in chapter 11. As we learned in chapter 5, NX depends on the real exchange rate. However, with price levels fixed, the real & nominal exchange rates move together. So, for simplicity, we write NX as a function of the nominal exchange rate here. (At the end of this chapter, when we use M-F to derive the aggregate demand curve, we go back to writing NX as a function of the real exchange rate, because the nominal & real exchange rates may behave differently when the price level is changing.) Chapter 5 introduced the notation r* for the world interest rate, and explained why r = r* in a small open economy with perfect capital mobility. Perfect capital mobility means that there are no restrictions on the international flow of financial capital: the country’s residents can borrow or lend as much as they wish in the world financial markets; and because the country is small, the amount its residents borrow or lend in the world financial market has no impact on the world interest rate. Chapter 5 also explained why net exports depend negatively on the exchange rate. where e = nominal exchange rate = foreign currency per unit of domestic currency

The IS* curve: Goods Market Eq’m
The IS* curve is drawn for a given value of r*. Intuition for the slope: Y e IS* Again, “eq’m” is an abbreviation for “equilibrium.” The text (p.315) shows how the Keynesian Cross can be used to derive the IS* curve. Suggestion: Before continuing, ask your students to figure out what happens to this IS* curve if taxes are reduced. Answer: The IS* curve shifts rightward (i.e., upward). Explanation: Start at any point on the initial IS* curve. At this point, initially, Y = C + I + G + NX. Now cut taxes. At the initial value of Y, disposable income is higher, causing consumption to be higher. Other things equal, the goods market is out of whack: C + I + G + NX > Y. An increase in Y (of just the right amount) would restore equilibrium. Hence, each value of e is associated with a larger value of Y. OR, a decrease in NX of just the right amount would restore equilibrium at the initial value of Y. But the decrease in NX requires an increase in e. Hence, each value of Y is associated with a higher value of e. Rationale: Doing this exercise now will break up your lecture, and will prepare students for the fiscal policy experiment that is coming up in just a few slides.

The LM* curve: Money Market Eq’m
is drawn for a given value of r* is vertical because: given r*, there is only one value of Y that equates money demand with supply, regardless of e. Y e LM* The text (p.316) shows how the LM curve in (Y,r) space, together with the fixed r*, determines the value of Y at which the LM* curve here is vertical. Suggestion: Before continuing, ask your students to figure out what happens to this LM* curve if the money supply is increased. Answer: LM* shifts to the right. Explanation: The equation for the LM* curve is: M/P = L(r*, Y) P is fixed, r* is exogenous, the central bank sets M, then Y must adjust to equate money demand (L) with money supply (M/P). Now, if M is raised, then money demand must rise to restore equilibrium (remember: P is fixed). A fall in r would cause money demand to rise, but in a small open economy, r = r* is exogenous. Hence, the only way to restore equilibrium is for Y to rise. Rationale: Doing this exercise now will break up your lecture, and will prepare students for the monetary policy experiment that is coming up in just a few slides.

Equilibrium in the Mundell-Fleming model
Y e LM* IS* equilibrium exchange rate equilibrium level of income

Floating & fixed exchange rates
In a system of floating exchange rates, e is allowed to fluctuate in response to changing economic conditions. In contrast, under fixed exchange rates, the central bank trades domestic for foreign currency at a predetermined price. We now consider fiscal, monetary, and trade policy: first in a floating exchange rate system, then in a fixed exchange rate system.

Fiscal policy under floating exchange rates
At any given value of e, a fiscal expansion increases Y, shifting IS* to the right. e2 e1 Intuition for the shift in IS*: At a given value of e (and hence NX), an increase in G causes an increase in the value of Y that equates planned expenditure with actual expenditure. Intuition for the results: As we learned in earlier chapters, a fiscal expansion puts upward pressure on the country’s interest rate. In a small open economy with perfect capital mobility, as soon as the domestic interest rate rises even the tiniest bit about the world rate, tons of foreign (financial) capital will flow in to take advantage of the rate difference. But in order for foreigners to buy these U.S. bonds, they must first acquire U.S. dollars. Hence, the capital inflows cause an increase in foreign demand for dollars in the foreign exchange market, causing the dollar to appreciate. This appreciation makes exports more expensive to foreigners, and imports cheaper to people at home, and thus causes NX to fall. The fall in NX offsets the effect of the fiscal expansion. How do we know that Y = 0? Because maintaining equilibrium in the money market requires that Y be unchanged: the fiscal expansion does not affect either the real money supply (M/P) or the world interest rate (because this economy is “small”). Hence, any change in income would throw the money market out of whack. So, the exchange rate has to rise until NX has fallen enough to perfectly offset the expansionary impact of the fiscal policy on output. Results: e > 0, Y = 0 Y1

In a small open economy with perfect capital mobility, fiscal policy cannot affect real GDP. “Crowding out” closed economy: Fiscal policy crowds out investment by causing the interest rate to rise. small open economy: Fiscal policy crowds out net exports by causing the exchange rate to appreciate.

Mon. policy under floating exchange rates
An increase in M shifts LM* right because Y must rise to restore eq’m in the money market. e1 Suggestion: Treat this experiment as an in-class exercise. Display the graph with the initial equilibrium. Then give students 2-3 minutes to use the model to determine the effects of an increase in M on e and Y. Intuition for the rightward LM* shift: At the initial (r*,Y), an increase in M throws the money market out of whack. To restore equilibrium, either Y must rise or the interest rate must fall, or some combination of the two. In a small open economy, though, the interest rate cannot fall. So Y must rise to restore equilibrium in the money market. Intuition for the results: Initially, the increase in the money supply puts downward pressure on the interest rate. (In a closed economy, the interest rate would fall.) Because the economy is small and open, when the interest rate tries to fall below r*, savers send their loanable funds to the world financial market. This capital outflow causes the exchange rate to fall, which causes NX --- and hence Y --- to increase. e2 Results: e < 0, Y > 0 Y2

Monetary policy affects output by affecting one (or more) of the components of aggregate demand: closed economy: M  r  I  Y small open economy: M  e  NX  Y Expansionary mon. policy does not raise world aggregate demand, it shifts demand from foreign to domestic products. Thus, the increases in income and employment at home come at the expense of losses abroad. Suggestion: Before revealing the text on this slide, ask students to take out a piece of paper and answer this question: “Contrast the way in which monetary policy affects output in the closed economy with the small open economy.” Or something to that effect.

Trade policy under floating exchange rates
At any given value of e, a tariff or quota reduces imports, increases NX, and shifts IS* to the right. e2 Intuition for results: At the initial exchange rate, the tariff or quota shifts domestic residents’ demand from foreign to domestic goods. The reduction in their demand for foreign goods causes a corresponding reduction in the supply of the country’s currency in the foreign exchange market. This causes the exchange rate to rise. The appreciation reduces NX, offsetting the import restriction’s initial expansion of NX. How do we know that the effect of the appreciation on NX exactly cancels out the effect of the import restriction on NX? There is only one value of Y that allows the money market to clear; since Y, C, I, and G are all unchanged, NX = Y-(C+I+G) must also be unchanged. Or looking at it differently: As we learned in chapter 5, the accounting identities say that NX = S - I. The import restriction does not affect S or I, so it cannot affect the equilibrium value of NX. Results: e > 0, Y = 0

Import restrictions cannot reduce a trade deficit. Even though NX is unchanged, there is less trade: the trade restriction reduces imports the exchange rate appreciation reduces exports Less trade means fewer ‘gains from trade.’ Import restrictions on specific products save jobs in the domestic industries that produce those products, but destroy jobs in export-producing sectors. Hence, import restrictions fail to increase total employment. Worse yet, import restrictions create “sectoral shifts,” which cause frictional unemployment. Import restrictions cause a sectoral shift, a shift in demand from export-producing sectors to import-competing sectors. As we learned in chapter 6, sectoral shifts contribute to the natural rate of unemployment, because displaced workers in declining sectors take time to be matched with appropriate jobs in other sectors.

Fixed exchange rates Under a system of fixed exchange rates, the country’s central bank stands ready to buy or sell the domestic currency for foreign currency at a predetermined rate. In the context of the Mundell-Fleming model, the central bank shifts the LM* curve as required to keep e at its preannounced rate. This system fixes the nominal exchange rate. In the long run, when prices are flexible, the real exchange rate can move even if the nominal rate is fixed.

Fiscal policy under fixed exchange rates
Under floating rates, a fiscal expansion would raise e. Under floating rates, fiscal policy ineffective at changing output. Under fixed rates, fiscal policy is very effective at changing output. Y e To keep e from rising, the central bank must sell domestic currency, which increases M and shifts LM* right. e1 Results: e = 0, Y > 0 Y1 Y2

Mon. policy under fixed exchange rates
An increase in M would shift LM* right and reduce e. Under floating rates, monetary policy is very effective at changing output. Under fixed rates, monetary policy cannot be used to affect output. Y e Y1 e1 To prevent the fall in e, the central bank must buy domestic currency, which reduces M and shifts LM* back left. The monetary expansion puts downward pressure on the exchange rate. To prevent it from falling, the central bank starts buying domestic currency in greater quantities to “prop up” the value of the currency in foreign exchange markets. This buying removes domestic currency from circulation, causing the money supply to fall, which shifts the LM* curve back. Another way of looking at it: To keep the exchange rate fixed, the central bank must use monetary policy to shift LM* as required so that the intersection of LM* and IS* always occurs at the desired exchange rate. Unless the IS* curve shifts right (an experiment we are not considering now), the central bank simply cannot increase the money supply. Results: e = 0, Y = 0

Trade policy under fixed exchange rates
Under floating rates, import restrictions do not affect Y or NX. Under fixed rates, import restrictions increase Y and NX. But, these gains come at the expense of other countries, as the policy merely shifts demand from foreign to domestic goods. A restriction on imports puts upward pressure on e. Y e Y1 e1 To keep e from rising, the central bank must sell domestic currency, which increases M and shifts LM* right. Suggestion: Assign this experiment as an in-class exercise. Give students 3 minutes to work on it before displaying the answer on the screen. Results: e = 0, Y > 0 Y2

M-F: summary of policy effects
type of exchange rate regime: floating fixed impact on: Policy Y e NX fiscal expansion mon. expansion import restriction Table 12-1 on p (“M-F” = “Mundell-Fleming”) This table makes it easy to see that the effects of policies depend very much on whether exchange rates are fixed or flexible.

Interest-rate differentials
Two reasons why r may differ from r* country risk: The risk that the country’s borrowers will default on their loan repayments because of political or economic turmoil. Lenders require a higher interest rate to compensate them for this risk. expected exchange rate changes: If a country’s exchange rate is expected to fall, then its borrowers must pay a higher interest rate to compensate lenders for the expected currency depreciation.

Differentials in the M-F model
where  is a risk premium. Substitute the expression for r into the IS* and LM* equations: The first equation says that a country’s interest rate equals the world interest rate plus a risk premium (whose size depends on investors’ perceptions of the political & economic risk of holding that country’s assets and on the expected rate of depreciation or appreciation of the country’s currency. We can now use the M-F model to analyze the effects of a change in the risk premium. The next few slides present this analysis, then discuss an important real-world example (the Mexican peso crisis).

The effects of an increase in 
IS* shifts left, because    r  I Y e Y1 e1 LM* shifts right, because    r  (M/P )d, so Y must rise to restore money market eq’m. Intuition: If prospective lenders expect the country’s currency to depreciation, or if they perceive that the country’s assets are especially risky, then they will demand that borrowers in that country pay them a higher interest rate (over and above r*). The higher interest rate reduces investment and shifts the IS* curve to the left. But it also lowers money demand, so income must rise to restore money market equilibrium. Why does the exchange rate fall? The increase in the risk premium causes foreign investors to sell some of their holdings of domestic assets and pull their ‘loanable funds’ out of the country. The capital outflow causes an increase in the supply of domestic currency in the foreign exchange market, which causes the fall in the exchange rate. Or, in simpler terms, an increase in country risk or an expected depreciation makes holding the country’s currency less desirable. e2 Results: e < 0, Y > 0 Y2

The effects of an increase in 
The fall in e is intuitive: An increase in country risk or an expected depreciation makes holding the country’s currency less attractive. Note: an expected depreciation is a self-fulfilling prophecy. The increase in Y occurs because the boost in NX (from the depreciation) is even greater than the fall in I (from the rise in r ).

Why income might not rise
The central bank may try to prevent the depreciation by reducing the money supply The depreciation might boost the price of imports enough to increase the price level (which would reduce the real money supply) Consumers might respond to the increased risk by holding more money. Each of the above would shift LM* leftward. The result that income rises when the risk premium rises seems counter-intuitive and inaccurate. This slide explains why the increase in the risk premium may cause other things to occur that prevent income from rising, and may even cause income to fall.

CASE STUDY: The Mexican Peso Crisis
Mexico’s central bank had maintained a fixed exchange rate with the U.S. dollar at about 29 cents per peso.

CASE STUDY: The Mexican Peso Crisis
In the week before Christmas 1994, the central bank abandoned the fixed exchange rate, allowing the peso’s value to “float.” Then, in just one week, the peso lost nearly 40% of its value, and fell further during the following months.

The Peso Crisis didn’t just hurt Mexico
U.S. goods more expensive to Mexicans U.S. firms lost revenue Hundreds of bankruptcies along U.S.-Mex border Mexican assets worth less in dollars Affected retirement savings of millions of U.S. citizens The purpose of this slide is to motivate the topic. Even though this occurred in another country some years ago, it was very important for the U.S. The parents of many of your students probably held Mexican assets (indirectly through mutual funds in their 401k accounts and pension funds, which viewed Mexico very favorably prior to the crisis) and took losses when the crisis occurred.

Understanding the crisis
In the early 1990s, Mexico was an attractive place for foreign investment. During 1994, political developments caused an increase in Mexico’s risk premium ( ): peasant uprising in Chiapas assassination of leading presidential candidate Another factor: The Federal Reserve raised U.S. interest rates several times during 1994 to prevent U.S. inflation. (So, r* > 0) When the last line displays, it might be helpful to note that, from Mexico’s viewpoint, the U.S. interest rate is r*.

Understanding the crisis
These events put downward pressure on the peso. Mexico’s central bank had repeatedly promised foreign investors that it would not allow the peso’s value to fall, so it bought pesos and sold dollars to “prop up” the peso exchange rate. Doing this requires that Mexico’s central bank have adequate reserves of dollars. Did it? We have already seen why an increase in a country’s risk premium causes its exchange rate to fall. One could also use the M-F model to show that an increase in r* also causes the exchange rate to fall. The intuition is as follows: An increase in foreign interest rates causes capital outflows: investors shift some of their funds out of the country to take advantage of higher returns abroad. This capital outflow causes the exchange rate to fall as it implies an increase in the supply of the country’s currency in the foreign exchange market.

Dollar reserves of Mexico’s central bank
December 1993 ……………… \$28 billion August 17, 1994 ……………… \$17 billion December 1, 1994 …………… \$ 9 billion December 15, 1994 ………… \$ 7 billion Defending the peso in the face of large capital outflows was draining the reserves of Mexico’s central bank. (August 17, 1994 was the date of the presidential election.) Ask your students if they can figure out why Mexico’s central bank didn’t tell anybody it was running out of reserves. The answer: If people had known that the reserves were dwindling, then they would also have known that the central bank would soon have to devalue or abandon the fixed exchange rate altogether. They would have expected the peso to fall, which would have caused a further increase in Mexico’s risk premium, which would have put even more downward pressure on Mexico’s exchange rate and made it even harder for the central bank to “defend the peso.” Source (not only for the data on this slide, but some of the other information in this case study): Washington Post National Weekly Edition, pp8‑9, Feb 20‑ , various issues of The Economist in Jan & Feb '95. During 1994, Mexico’s central bank hid the fact that its reserves were being depleted.

 the disaster  Dec. 20: Mexico devalues the peso by 13%
(fixes e at 25 cents instead of 29 cents) Investors are shocked ! ! ! …and realize the central bank must be running out of reserves… , Investors dump their Mexican assets and pull their capital out of Mexico. Dec. 22: central bank’s reserves nearly gone. It abandons the fixed rate and lets e float. In a week, e falls another 30%.

The rescue package 1995: U.S. & IMF set up \$50b line of credit to provide loan guarantees to Mexico’s govt. This helped restore confidence in Mexico, reduced the risk premium. After a hard recession in 1995, Mexico began a strong recovery from the crisis. The case study on pp gives more detail on the peso crisis.

The S.E. Asian Crisis exchange rate % change from 7/97 to 1/98
stock market % change from 7/97 to 1/98 nominal GDP % change Indonesia -59.4% -32.6% -16.2% Japan -12.0% -18.2% -4.3% Malaysia -36.4% -43.8% -6.8% Singapore -15.6% -36.0% -0.1% S. Korea -47.5% -21.9% -7.3% Taiwan -14.6% -19.7% n.a. Thailand -48.3% -25.6% -1.2% ( ) U.S. 2.7% 2.3% The case study on the Asian crisis (pp of the text) is omitted from this PowerPoint presentation. If you wish to do this case study in your class, I have included some data here which may be helpful. The slide currently is “hidden” - it won’t display when you present this file in slide-show mode. But you can “unhide” it if you wish to include it in your lecture.

Floating vs. Fixed Exchange Rates
Argument for floating rates: allows monetary policy to be used to pursue other goals (stable growth, low inflation) Arguments for fixed rates: avoids uncertainty and volatility, making international transactions easier disciplines monetary policy to prevent excessive money growth & hyperinflation

So far in M-F model, P has been fixed. Next: to derive the AD curve, consider the impact of a change in P in the M-F model. We now write the M-F equations as: Net exports really depend on the real exchange rate, not the nominal exchange rate. Earlier in the chapter, we wrote NX as a function of the nominal rate, because the price level was assumed fixed, so the nominal & real rates always moved together. But now, with the price level changing also, we need to write NX as a function of the real exchange rate. (Earlier in this chapter, P was fixed, so we could write NX as a function of e instead of .)

Deriving the AD curve  Y Why AD curve has negative slope: P
LM*(P2) LM*(P1) Why AD curve has negative slope: IS* 2 1 P  (M/P )  LM shifts left Y2 Y1 Y P   P2 Like figure on p.336, except here we are showing what happens to Y when P increases (not falls). The derivation of the open economy AD curve is very similar to that of the closed economy AD curve (see chapter 11).  NX P1  Y AD Y2 Y1

From the short run to the long run
Y P IS* AD LRAS LM*(P2) P2 SRAS2 LM*(P1) then there is downward pressure on prices. 1 2 Over time, P will move down, causing (M/P )   NX  Y  P1 SRAS1 Figure on p.337. Suggestion: Have your students draw the two panels of the diagram on this screen, with the economy in an initial equilibrium with output equal to its natural rate. Then, have them use their diagrams to analyze the short-run and long-run effects of a negative IS* shock.

Large: between small and closed
Many countries - including the U.S. - are neither closed nor small open economies. A large open economy is in between the polar cases of closed & small open. Consider a monetary expansion: Like in a closed economy, M > 0  r  I (though not as much) Like in a small open economy, M > 0    NX (though not as much) For more details, see the Appendix to chapter 12 (not included in this PowerPoint presentation).

Chapter summary the IS-LM model for a small open economy.
1. Mundell-Fleming model the IS-LM model for a small open economy. takes P as given can show how policies and shocks affect income and the exchange rate 2. Fiscal policy affects income under fixed exchange rates, but not under floating exchange rates.

Chapter summary affects income under floating exchange rates.
3. Monetary policy affects income under floating exchange rates. Under fixed exchange rates, monetary policy is not available to affect output. 4. Interest rate differentials exist if investors require a risk premium to hold a country’s assets. An increase in this risk premium raises domestic interest rates and causes the country’s exchange rate to depreciate.

Chapter summary 5. Fixed vs. floating exchange rates Under floating rates, monetary policy is available for can purposes other than maintaining exchange rate stability. Fixed exchange rates reduce some of the uncertainty in international transactions.

This chapter has two main objectives

Chapter objectives difference between short run & long run
introduction to aggregate demand aggregate supply in the short run & long run see how model of aggregate supply and demand can be used to analyze short-run and long-run effects of “shocks”

Real GDP Growth in the U.S., 1960-2004
Average growth rate = 3.4% NOTE: The growth rate here is calculated as the percentage change in real GDP over the previous quarter, multiplied by four to express as an annual rate. If you instead want to show your students a graph of the growth rate calculated as the percentage change in real GDP over 4 quarters earlier, then “hide” this slide and “unhide” the next one. I prefer this slide, because the recession of 2001 is easier to see here. However, quarterly growth rates are more volatile than annual ones, so you may prefer the less scattered look of the graph on the following slide to this one. Point out the recessions, where GDP growth is negative for two or more quarters. 1974:2 through 1975:2 1980:2 through 1980:4 1982:1 through 1982:4 1991:1 through 1991:3 Source: Department of Commerce, Bureau of Economic Analysis: Growth rate of real GDP (chained 1996 dollars) Note: Recession dates may not precisely match official NBER recession dates, but data here do match that used in the text.

Real GDP Growth in the U.S., 1960-2004
Average growth rate = 3.4% Point out the recessions, where GDP growth is negative for two or more quarters. 1974:2 through 1975:2 1980:2 through 1980:4 1982:1 through 1982:4 1991:1 through 1991:3 Source: Department of Commerce, Bureau of Economic Analysis: Growth rate of real GDP (chained 1996 dollars) Note: Recession dates may not precisely match official NBER recession dates, but data here do match that used in the text.

The economy behaves much differently when prices are sticky.
Time horizons Long run: Prices are flexible, respond to changes in supply or demand Short run: many prices are “sticky” at some predetermined level The material on this slide was introduced in Chapter 1. Since it’s been a while since your students read that chapter, it’s probably worth repeating at this point, especially since the behavior of prices is so critical for understanding short-run fluctuations. It might also be worth reminding them that they (and most adults) are already aware of the concept of sticky prices. If they have a favorite beverage at Starbucks, ask if they can remember when its price was last increased. If they work, ask how long they go between wage changes. Sticky prices are a fact of everyday life, even if most adults have not heard the term “sticky prices” or studied the implications of sticky prices for short-run economic fluctuations. The economy behaves much differently when prices are sticky.

In Classical Macroeconomic Theory,
(what we studied in chapters 3-8) Output is determined by the supply side: supplies of capital, labor technology Changes in demand for goods & services (C, I, G ) only affect prices, not quantities. Complete price flexibility is a crucial assumption, so classical theory applies in the long run. Classical macroeconomic theory is what we learned in chapters This slide recaps an important lesson from classical theory, which stands in sharp contrast to what we’re about to cover now.

When prices are sticky …output and employment also depend on demand for goods & services, which is affected by fiscal policy (G and T ) monetary policy (M ) other factors, like exogenous changes in C or I. Chapters 9-11 focus on the closed economy case. In an open economy, the list of things that affect aggregate demand is a bit larger. (See chapter 12.)

The model of aggregate demand and supply
the paradigm that most mainstream economists & policymakers use to think about economic fluctuations and policies to stabilize the economy shows how the price level and aggregate output are determined shows how the economy’s behavior is different in the short run and long run

Aggregate demand The aggregate demand curve shows the relationship between the price level and the quantity of output demanded. For this chapter’s intro to the AD/AS model, we use a simple theory of aggregate demand based on the Quantity Theory of Money. Chapters develop the theory of aggregate demand in more detail.

The Quantity Equation as Agg. Demand
From Chapter 4, recall the quantity equation M V = P Y For given values of M and V, these equations imply an inverse relationship between P and Y:

An increase in the price level causes a fall in real money balances (M/P ), causing a decrease in the demand for goods & services. AD Y P The textbook explains different ways of thinking about the AD curve’s slope. Here’s one that uses the idea of the simple money demand function introduced in chapter 4 (M/P = kY, where k = 1/V): An increase in the price level causes a fall in real money balances, and therefore a fall in the demand for goods & services (because the demand for output is proportional to real money balances according to the simple money demand function that is implied by the quantity theory of money). Here’s an explanation of the AD curve slope that doesn’t refer to the simple money demand function: A fall in P reduces real money balances. In order to buy the same amount of stuff, velocity would have to increase. But, by definition, velocity is constant along the AD curve. For simplicity, suppose V = 1. With lower real money balances (or, equivalently, the same nominal balances but higher goods prices), people demand a smaller quantity of goods and services.

Shifting the AD curve AD2 AD1 Y P An increase in the money supply shifts the AD curve to the right. For future reference (a bunch of slides later in this chapter), it will be useful to see how a change in M shifts the AD curve. The tops of p.244 and 245 give some simple intuition for the shift. Here’s the idea: With velocity fixed, the quantity equation implies that PY is determined by M. An increase in M causes an increase in PY, which means higher Y for each value of P, or higher P for each value of Y. Or: for a given value of P, an increase in M implies higher real money balances. In the simple money demand function associated with the Quantity Theory, the demand for real balances is proportional to the demand for output, so output must rise at each P in order for real money demand to rise and equal the new, higher supply of real balances M/P. Or, if you like, just have your students take on faith that an increase in the money supply shifts the AD curve to the right for now, telling them that they will learn how this works in Chapters 10 and 11.

Aggregate Supply in the Long Run
Recall from chapter 3: In the long run, output is determined by factor supplies and technology is the full-employment or natural level of output, the level of output at which the economy’s resources are fully employed. Some textbooks also use the term “potential GDP” to mean the full-employment level of output. “Full employment” means that unemployment equals its natural rate.

Aggregate Supply in the Long Run
Recall from chapter 3: In the long run, output is determined by factor supplies and technology Full-employment output does not depend on the price level, so the long run aggregate supply (LRAS) curve is vertical:

The long-run aggregate supply curve
LRAS The LRAS curve is vertical at the full-employment level of output. Sometimes it takes students a little while to understand why the LRAS curve is vertical, when the supply curves they learned in their micro principles class were mostly upward-sloping. Here’s an explanation that they might find helpful: “P” on the vertical axis is the economy’s overall price level – the average price of EVERYTHING. A 10% increase in the price level means that, on average, EVERYTHING costs 10% more. Thus, a firm can get 10% more revenue for each unit it sells. But the firm also pays an average of 10% more in wages, prices of intermediate goods, advertising, and so on. Thus, the firm has no incentive to increase output. Another thought: We learn from microeconomics that a firm’s supply depends on the RELATIVE price of its output. If all prices increase by 10%, then each firm’s relative price is the same as before, hence no incentive to alter output.

Long-run effects of an increase in M
AD2 AD1 Y P LRAS An increase in M shifts the AD curve to the right. In the long run, this increases the price level… P2 P1 [The textbook does a fall in AD (Figure 9-5 on p.246); these slides do an increase.] Notice that the results in this graph are exactly as we learned in chapters 3-8: a change in the money supply affects the price level, but not the quantity of output. Here, we are seeing these results on a graph with different variables on the axes (P and Y), but it’s the same model. …but leaves output the same.

Aggregate Supply in the Short Run
In the real world, many prices are sticky in the short run. For now (and throughout Chapters 9-12), we assume that all prices are stuck at a predetermined level in the short run… …and that firms are willing to sell as much at that price level as their customers are willing to buy. Therefore, the short-run aggregate supply (SRAS) curve is horizontal: The assumption that all prices are fixed in the short run is extreme. Chapter 13 derives the SRAS curve under more realistic assumptions, and Chapter 19 (section 19-2) explores price stickiness in more detail. ke Yet, the extreme assumption here is worth making. The short-run response of output & employment to policies and shocks is the same (qualitatively) whether the SRAS curve is upward-sloping or horizontal. But the horizontal SRAS curve makes the analysis much simpler: a shift in AD leaves P unchanged in the short run. This greatly simplifies analysis in the IS-LM-AD model (chapters 10 and 11). (With an upward-sloping SRAS curve, a shock to the IS and AD curves would change prices in the short run in addition to changing output. The change in prices would change the real money supply, which would shift the LM curve.)

The short run aggregate supply curve
The SRAS curve is horizontal: The price level is fixed at a predetermined level, and firms sell as much as buyers demand. SRAS

Short-run effects of an increase in M
AD2 AD1 Y P In the short run when prices are sticky,… …an increase in aggregate demand… SRAS Y2 [The textbook (Figure 9-7 on p.248) does a decrease in AD, these slides do an increase.] What about the unemployment rate? Remember from chapter 2: Okun’s law says that unemployment and output are negatively related. In the graph here, in order for firms to increase output, they require more workers. Employment rises, and the unemployment rate falls. …causes output to rise. Y1

From the short run to the long run
Over time, prices gradually become “unstuck.” When they do, will they rise or fall? In the short-run equilibrium, if then over time, the price level will rise fall You might want to discuss the intuition for the price adjustment in each case. First, suppose aggregate demand is higher than the full-employment level of output in the economy’s initial short-run equilibrium. Then, there is upward pressure on prices: In order for firms to produce this above-average level of output, they must pay their workers overtime and make their capital work at a high intensity, which causes more maintenance, repairs, and depreciation. For all these reasons, firms would like to raise their prices. In the short run, they cannot. But over time, prices gradually become “unstuck,” and firms can increase prices in response to these cost pressures. Instead, suppose that output is below its natural rate. Then, there is downward pressure on prices: Firms can’t sell as much output as they’d like at their current prices, so they would like to reduce prices. With lower than normal output, firms won’t need as many workers as normal, so they cut back on labor, and the unemployment rate rises above the “natural rate of unemployment.” The high unemployment rate puts downward pressure on wages. Wages and prices are “stuck” in the short run, but over time, they fall in response to these pressures. Finally: if output equals its normal (or “natural”) level, then there is no pressure for prices to rise or fall. Over time, as prices become “unstuck,” they will simply remain constant. remain constant This adjustment of prices is what moves the economy to its long-run equilibrium.

The SR & LR effects of M > 0
AD2 A = initial equilibrium AD1 Y P LRAS B = new short-run eq’m after Fed increases M C P2 SRAS B A Y2 This slide puts together the pieces that have been developed over the previous slides: the short-run and long-run effects, as well as the adjustment of prices over time that causes the economy to move from the short-run equilibrium at point B to the long-run equilibrium at C. The economy starts at point A; output and unemployment are at their “natural” rates. The Fed increases the money supply, shifting AD to the right. In the short run, prices are sticky, so output rises. The new short-run equilibrium is at point B in the graph. In order for firms to increase output, they hire more workers, so unemployment falls below the natural rate of unemployment, putting upward pressure on wages. The high level of demand for goods & services at point B puts upward pressure on prices. Over time, as prices become “unstuck,” they begin to rise in response to these pressures. The price level rises and the economy moves up its (new) AD curve, from point B toward point C. This process stops when the economy gets to point C: output again equals the “natural rate of output,” and unemployment again equals the natural rate of unemployment, so there is no further pressure on prices to change. C = long-run equilibrium

How shocking!!! shocks: exogenous changes in aggregate supply or demand Shocks temporarily push the economy away from full-employment. An example of a demand shock: exogenous decrease in velocity If the money supply is held constant, then a decrease in V means people will be using their money in fewer transactions, causing a decrease in demand for goods and services: [The example in the textbook is an exogenous INCREASE in velocity.] The exogenous decrease in velocity corresponds to an exogenous increase in demand for real money balances (relative to income & transactions). This might occur in response to a wave of credit card fraud, which presumably would make nervous consumers more inclined to use cash in their transactions. If there’s an exogenous increase in real money demand (i.e., an increase NOT caused by an increase in Y), then M/P must increase as well; if the Fed holds M constant, then P must fall. Thus, the increase in real money demand causes a decrease in the value of P associated with each Y, and the AD curve shifts down. The velocity shock is the only AD shock we can analyze at this point, because (for this chapter only) we have derived the AD curve from the Quantity Theory of Money. However, if you have not derived the AD curve from the Quantity Theory, as discussed in the notes accompanying the title slide of this chapter, then you could pick any number of AD shocks: a stock market crash causes consumers to cut back on spending; a fall in business confidence causes a decrease in investment; a recession in a country with which we trade causes causes an exogenous decrease in their demand for our exports.

The effects of a negative demand shock
AD1 The shock shifts AD left, causing output and employment to fall in the short run Y P AD2 LRAS SRAS B A Y2 Over time, prices fall and the economy moves down its demand curve toward full-employment. C P2 Note the economy’s “self-correction” mechanism: When in a recession, the economy --- left to its own devices --- “fixes” itself: the gradual adjustment of prices helps the economy recover from the shock and return to full employment. Of course, before the economy has finished self-correcting, a period of low output and high unemployment is endured.

Supply shocks A supply shock alters production costs, affects the prices that firms charge. (also called price shocks) Examples of adverse supply shocks: Bad weather reduces crop yields, pushing up food prices. Workers unionize, negotiate wage increases. New environmental regulations require firms to reduce emissions. Firms charge higher prices to help cover the costs of compliance. (Favorable supply shocks lower costs and prices.)

CASE STUDY: The 1970s oil shocks
Early 1970s: OPEC coordinates a reduction in the supply of oil. Oil prices rose 11% in % in % in 1975 Such sharp oil price increases are supply shocks because they significantly impact production costs and prices. Oil is required to heat the factories in which goods are produced, and to fuel the trucks that transport the goods from the factories to the warehouses to Walmart stores. A sharp increase in the price of oil, therefore, has a substantial effect on production costs.

CASE STUDY: The 1970s oil shocks
AD The oil price shock shifts SRAS up, causing output and employment to fall. Y P LRAS SRAS2 B In absence of further price shocks, prices will fall over time and economy moves back toward full employment. Y2 SRAS1 A A And, as output falls from Ybar to Y2 in the graph, we would expect to see unemployment increase above the natural rate of unemployment. (Recall from chapter 2: Okun’s law says that output and unemployment are inversely related.) Note the phrase “in absence of further price shocks.” As we will see shortly, just as the economy was recovering from the first big oil shock, a second one came along.

CASE STUDY: The 1970s oil shocks
Predicted effects of the oil price shock: inflation  output  unemployment  …and then a gradual recovery. This slide first summarizes the model’s predictions from the preceding slide, and then presents data (from the text, p.253) that supports the model’s predictions.

CASE STUDY: The 1970s oil shocks
Late 1970s: As economy was recovering, oil prices shot up again, causing another huge supply shock!!! Data source: See p.254 of the textbook. This second shock was associated with the revolution in Iran. The Shah, who maintained cordial relations with the West, was deposed. The new leader, Ayatollah Khomeini, was considerably less friendly toward the West. (He even forbade his citizens from listening to Western music.)

CASE STUDY: The 1980s oil shocks
1980s: A favorable supply shock-- a significant fall in oil prices. As the model would predict, inflation and unemployment fell: A few slides back, we did the analysis of an adverse supply shock. It might be worth noting that the predicted effects of a favorable supply shock are just the opposite: in the short run, the price level (or inflation rate) falls, output rises, and unemployment falls. Looking at the graph: at first glance, it may seem that the fall in oil prices doesn’t occur until But remind students to look at the left-hand scale, on which 0 is in the middle, not at the bottom. Oil prices fell about 10% in 1982, and generally fell during most years between 1982 and 1986.

Stabilization policy def: policy actions aimed at reducing the severity of short-run economic fluctuations. Example: Using monetary policy to combat the effects of adverse supply shocks: Chapter 14 is devoted to stabilization policy.

Stabilizing output with monetary policy
AD1 Y P LRAS The adverse supply shock moves the economy to point B. SRAS2 B Y2 SRAS1 A

Stabilizing output with monetary policy
AD2 AD1 But the Fed accommodates the shock by raising agg. demand. Y P LRAS SRAS2 B C Y2 A results: P is permanently higher, but Y remains at its full-employment level. Note: If the Fed correctly anticipates the sign and magnitude of the shock, then the Fed can respond as the shock occurs rather than after, and the economy never would go to point B - it would go immediately to point C.

Chapter summary 1. Long run: prices are flexible, output and employment are always at their natural rates, and the classical theory applies. Short run: prices are sticky, shocks can push output and employment away from their natural rates. 2. Aggregate demand and supply: a framework to analyze economic fluctuations

Chapter summary 3. The aggregate demand curve slopes downward.
4. The long-run aggregate supply curve is vertical, because output depends on technology and factor supplies, but not prices. 5. The short-run aggregate supply curve is horizontal, because prices are sticky at predetermined levels.

Chapter summary 6. Shocks to aggregate demand and supply cause fluctuations in GDP and employment in the short run. 7. The Fed can attempt to stabilize the economy with monetary policy.