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macroeconomics fifth edition N. Gregory Mankiw PowerPoint ® Slides by Ron Cronovich CHAPTER TEN Aggregate Demand I macro © 2004 Worth Publishers, all rights reserved

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CHAPTER 10 Aggregate Demand I slide 1 The Big Picture Keynesian Cross Theory of Liquidity Preference IS curve LM curve IS-LM model Agg. demand curve Agg. supply curve Model of Agg. Demand and Agg. Supply Explanation of short-run fluctuations

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CHAPTER 10 Aggregate Demand I slide 2 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

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CHAPTER 10 Aggregate Demand I slide 3 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

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CHAPTER 10 Aggregate Demand I slide 4 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.

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CHAPTER 10 Aggregate Demand I slide 5 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

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CHAPTER 10 Aggregate Demand I slide 6 Elements of the Keynesian Cross consumption function: for now, planned investment is exogenous: planned expenditure: Equilibrium condition: govt policy variables:

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CHAPTER 10 Aggregate Demand I slide 7 Graphing planned expenditure income, output, Y E planned expenditure E =C +I +G MPC 1

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CHAPTER 10 Aggregate Demand I slide 8 Graphing the equilibrium condition income, output, Y E planned expenditure E =Y 45 º

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CHAPTER 10 Aggregate Demand I slide 9 The equilibrium value of income income, output, Y E planned expenditure E =Y E =C +I +G Equilibrium income

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CHAPTER 10 Aggregate Demand I slide 10 An increase in government purchases Y E E =Y E =C +I +G 1 E 1 = Y 1 E =C +I +G 2 E 2 = Y 2 YY At Y 1, there is now an unplanned drop in inventory… …so firms increase output, and income rises toward a new equilibrium GG

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CHAPTER 10 Aggregate Demand I slide 11 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 :

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CHAPTER 10 Aggregate Demand I slide 12 The government purchases multiplier Example: If MPC = 0.8, then Definition: the increase in income resulting from a $1 increase in G. In this model, the govt purchases multiplier equals An increase in G causes income to increase by 5 times as much!

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CHAPTER 10 Aggregate Demand I slide 13 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 further Y So the final impact on income is much bigger than the initial G.

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CHAPTER 10 Aggregate Demand I slide 14 An increase in taxes Y E E =Y E =C 2 +I +G E 2 = Y 2 E =C 1 +I +G E 1 = Y 1 YY At Y 1, there is now an unplanned inventory buildup… …so firms reduce output, and income falls toward a new equilibrium C = MPC T Initially, the tax increase reduces consumption, and therefore E:

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CHAPTER 10 Aggregate Demand I slide 15 Solving for Y eq’m condition in changes I and G exogenous Solving for Y : Final result:

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CHAPTER 10 Aggregate Demand I slide 16 The Tax Multiplier def: the change in income resulting from a $1 increase in T : If MPC = 0.8, then the tax multiplier equals

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CHAPTER 10 Aggregate Demand I slide 17 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.

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CHAPTER 10 Aggregate Demand I slide 18 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.

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CHAPTER 10 Aggregate Demand I slide 19 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:

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CHAPTER 10 Aggregate Demand I slide 20 Y2Y2 Y1Y1 Y2Y2 Y1Y1 Deriving the IS curve r I Y E r Y E =C +I (r 1 )+G E =C +I (r 2 )+G r1r1 r2r2 E =Y IS II E E Y Y

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CHAPTER 10 Aggregate Demand I slide 21 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.

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CHAPTER 10 Aggregate Demand I slide 22 The IS curve and the Loanable Funds model S, I r I (r )I (r ) r1r1 r2r2 r Y Y1Y1 r1r1 r2r2 (a) The L.F. model (b) The IS curve Y2Y2 S1S1 S2S2 IS

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CHAPTER 10 Aggregate Demand I slide 23 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…

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CHAPTER 10 Aggregate Demand I slide 24 Y2Y2 Y1Y1 Y2Y2 Y1Y1 Shifting the IS curve: G At any value of r, G E Y Y E r Y E =C +I (r 1 )+G 1 E =C +I (r 1 )+G 2 r1r1 E =Y IS 1 The horizontal distance of the IS shift equals IS 2 …so the IS curve shifts to the right. YY

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CHAPTER 10 Aggregate Demand I slide 25 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.

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CHAPTER 10 Aggregate Demand I slide 26 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.

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CHAPTER 10 Aggregate Demand I slide 27 Money Supply The supply of real money balances is fixed: M/P real money balances r interest rate

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CHAPTER 10 Aggregate Demand I slide 28 Money Demand Demand for real money balances: M/P real money balances r interest rate L (r )L (r )

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CHAPTER 10 Aggregate Demand I slide 29 Equilibrium The interest rate adjusts to equate the supply and demand for money: M/P real money balances r interest rate L (r )L (r ) r1r1

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CHAPTER 10 Aggregate Demand I slide 30 How the Fed raises the interest rate To increase r, Fed reduces M M/P real money balances r interest rate L (r )L (r ) r1r1 r2r2

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CHAPTER 10 Aggregate Demand I slide 31 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% How do you think this policy change would affect interest rates?

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CHAPTER 10 Aggregate Demand I slide 32 Volcker’s Monetary Tightening, cont. i < 0 i > 0 1/1983: i = 8.2% 8/1979: i = 10.4% 4/1980: i = 15.8% flexiblesticky Quantity Theory, Fisher Effect (Classical) Liquidity Preference (Keynesian) prediction actual outcome The effects of a monetary tightening on nominal interest rates prices model long runshort run

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CHAPTER 10 Aggregate Demand I slide 33 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:

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CHAPTER 10 Aggregate Demand I slide 34 Deriving the LM curve M/P r L (r, Y1 )L (r, Y1 ) r1r1 r2r2 r Y Y1Y1 r1r1 L (r, Y2 )L (r, Y2 ) r2r2 Y2Y2 LM (a) The market for real money balances (b) The LM curve

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CHAPTER 10 Aggregate Demand I slide 35 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.

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CHAPTER 10 Aggregate Demand I slide 36 How M shifts the LM curve M/P r L (r, Y1 )L (r, Y1 ) r1r1 r2r2 r Y Y1Y1 r1r1 r2r2 LM 1 (a) The market for real money balances (b) The LM curve LM 2

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CHAPTER 10 Aggregate Demand I slide 37 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.

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CHAPTER 10 Aggregate Demand I slide 38 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 IS LM Equilibrium interest rate Equilibrium level of income

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CHAPTER 10 Aggregate Demand I slide 39 The Big Picture Keynesian Cross Theory of Liquidity Preference IS curve LM curve IS-LM model Agg. demand curve Agg. supply curve Model of Agg. Demand and Agg. Supply Explanation of short-run fluctuations

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CHAPTER 10 Aggregate Demand I slide 40 Chapter summary 1. Keynesian Cross basic model of income determination takes fiscal policy & investment as exogenous fiscal policy has a multiplier effect on income. 2. 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

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CHAPTER 10 Aggregate Demand I slide 41 Chapter summary 3. 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 4. 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

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CHAPTER 10 Aggregate Demand I slide 42 Chapter summary 5. 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.

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CHAPTER 10 Aggregate Demand I slide 43 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

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CHAPTER 10 Aggregate Demand I slide 44

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macroeconomics fifth edition N. Gregory Mankiw PowerPoint ® Slides by Ron Cronovich CHAPTER TEN Aggregate Demand I macro © 2004 Worth Publishers, all rights reserved

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CHAPTER 10 Aggregate Demand I slide 46 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

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CHAPTER 10 Aggregate Demand I slide 47 The intersection determines the unique combination of Y and r that satisfies equilibrium in both markets. The LM curve represents money market equilibrium. Equilibrium in the IS-LM Model The IS curve represents equilibrium in the goods market. IS Y r LM r1r1 Y1Y1

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CHAPTER 10 Aggregate Demand I slide 48 Policy analysis with the IS-LM Model 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. IS Y r LM r1r1 Y1Y1

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CHAPTER 10 Aggregate Demand I slide 49 causing output & income to rise. IS 1 An increase in government purchases 1. IS curve shifts right Y r LM r1r1 Y1Y1 IS 2 Y2Y2 r2r2 1. 2. This raises money demand, causing the interest rate to rise… 2. 3. …which reduces investment, so the final increase in Y 3.

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CHAPTER 10 Aggregate Demand I slide 50 IS 1 1. A tax cut Y r LM r1r1 Y1Y1 IS 2 Y2Y2 r2r2 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 1. 2. …so the effects on r and Y are smaller for a T than for an equal G. 2.

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CHAPTER 10 Aggregate Demand I slide 51 2.…causing the interest rate to fall IS Monetary Policy: an increase in M 1. M > 0 shifts the LM curve down (or to the right) Y r LM 1 r1r1 Y1Y1 Y2Y2 r2r2 LM 2 3.…which increases investment, causing output & income to rise.

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CHAPTER 10 Aggregate Demand I slide 52 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.

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CHAPTER 10 Aggregate Demand I slide 53 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:

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CHAPTER 10 Aggregate Demand I slide 54 If Congress raises G, the IS curve shifts right IS 1 Response 1: hold M constant Y r LM 1 r1r1 Y1Y1 IS 2 Y2Y2 r2r2 If Fed holds M constant, then LM curve doesn’t shift. Results:

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CHAPTER 10 Aggregate Demand I slide 55 If Congress raises G, the IS curve shifts right IS 1 Response 2: hold r constant Y r LM 1 r1r1 Y1Y1 IS 2 Y2Y2 r2r2 To keep r constant, Fed increases M to shift LM curve right. LM 2 Y3Y3 Results:

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CHAPTER 10 Aggregate Demand I slide 56 If Congress raises G, the IS curve shifts right IS 1 Response 3: hold Y constant Y r LM 1 r1r1 IS 2 Y2Y2 r2r2 To keep Y constant, Fed reduces M to shift LM curve left. LM 2 Results: Y1Y1 r3r3

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CHAPTER 10 Aggregate Demand I slide 57 Estimates of fiscal policy multipliers from the DRI macroeconometric model Assumption about monetary policy Estimated value of Y / G Fed holds nominal interest rate constant Fed holds money supply constant 1.93 0.60 Estimated value of Y / T 1.19 0.26

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CHAPTER 10 Aggregate Demand I slide 58 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

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CHAPTER 10 Aggregate Demand I slide 59 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

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CHAPTER 10 Aggregate Demand I slide 60 EXERCISE: Analyze shocks with the IS-LM model Use the IS-LM model to analyze the effects of 1. A boom in the stock market makes consumers wealthier. 2. After a wave of credit card fraud, consumers use cash more frequently in transactions. For each shock, a. use the IS-LM diagram to show the effects of the shock on Y and r. b. determine what happens to C, I, and the unemployment rate.

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CHAPTER 10 Aggregate Demand I slide 61 CASE STUDY The U.S. economic slowdown of 2001 ~What happened~ 1. Real GDP growth rate 1994-2000: 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!

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CHAPTER 10 Aggregate Demand I slide 62 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.

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CHAPTER 10 Aggregate Demand I slide 63 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

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CHAPTER 10 Aggregate Demand I slide 64 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.

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CHAPTER 10 Aggregate Demand I slide 65 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.

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CHAPTER 10 Aggregate Demand I slide 66 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)

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CHAPTER 10 Aggregate Demand I slide 67 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

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CHAPTER 10 Aggregate Demand I slide 68 Y1Y1 Y2Y2 Deriving the AD curve Y r Y P IS LM(P 1 ) LM(P 2 ) AD P1P1 P2P2 Y2Y2 Y1Y1 r2r2 r1r1 Intuition for slope of AD curve: P (M/P ) LM shifts left r r I I Y Y

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CHAPTER 10 Aggregate Demand I slide 69 Monetary policy and the AD curve Y P IS LM(M 2 /P 1 ) LM(M 1 /P 1 ) AD 1 P1P1 Y1Y1 Y1Y1 Y2Y2 Y2Y2 r1r1 r2r2 The Fed can increase aggregate demand: M LM shifts right AD 2 Y r r r I I Y at each value of P

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CHAPTER 10 Aggregate Demand I slide 70 Y2Y2 Y2Y2 r2r2 Y1Y1 Y1Y1 r1r1 Fiscal policy and the AD curve Y r Y P IS 1 LM AD 1 P1P1 Expansionary fiscal policy ( G and/or T ) increases agg. demand: T C IS shifts right Y at each value of P AD 2 IS 2

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CHAPTER 10 Aggregate Demand I slide 71 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. rise fall remain constant In the short-run equilibrium, if then over time, the price level will

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CHAPTER 10 Aggregate Demand I slide 72 The SR and LR effects of an IS shock A negative IS shock shifts IS and AD left, causing Y to fall. Y r Y P LRAS IS 1 SRAS 1 P1P1 LM(P 1 ) IS 2 AD 2 AD 1

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CHAPTER 10 Aggregate Demand I slide 73 The SR and LR effects of an IS shock Y r Y P LRAS IS 1 SRAS 1 P1P1 LM(P 1 ) IS 2 AD 2 AD 1 In the new short-run equilibrium,

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CHAPTER 10 Aggregate Demand I slide 74 The SR and LR effects of an IS shock Y r Y P LRAS IS 1 SRAS 1 P1P1 LM(P 1 ) IS 2 AD 2 AD 1 In the new short-run equilibrium, Over time, P gradually falls, which causes SRAS to move down M/P to increase, which causes LM to move down

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CHAPTER 10 Aggregate Demand I slide 75 AD 2 The SR and LR effects of an IS shock Y r Y P LRAS IS 1 SRAS 1 P1P1 LM(P 1 ) IS 2 AD 1 Over time, P gradually falls, which causes SRAS to move down M/P to increase, which causes LM to move down SRAS 2 P2P2 LM(P 2 )

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CHAPTER 10 Aggregate Demand I slide 76 AD 2 SRAS 2 P2P2 LM(P 2 ) The SR and LR effects of an IS shock Y r Y P LRAS IS 1 SRAS 1 P1P1 LM(P 1 ) IS 2 AD 1 This process continues until economy reaches a long-run equilibrium with

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CHAPTER 10 Aggregate Demand I slide 77 EXERCISE: Analyze SR & LR effects of M a. Draw the IS-LM and AD-AS diagrams as shown here. b. Suppose Fed increases M. Show the short-run effects on your graphs. c. Show what happens in the transition from the short run to the long run. d. How do the new long-run equilibrium values of the endogenous variables compare to their initial values? Y r Y P LRAS IS SRAS 1 P1P1 LM( M 1 /P 1 ) AD 1

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CHAPTER 10 Aggregate Demand I slide 78 The Great Depression Unemployment (right scale) Real GNP (left scale)

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CHAPTER 10 Aggregate Demand I slide 79 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

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CHAPTER 10 Aggregate Demand I slide 80 The Spending Hypothesis: Reasons for the IS shift 1. Stock market crash exogenous C Oct-Dec 1929: S&P 500 fell 17% Oct 1929-Dec 1933: S&P 500 fell 71% 2. Drop in investment “correction” after overbuilding in the 1920s widespread bank failures made it harder to obtain financing for investment 3. Contractionary fiscal policy in the face of falling tax revenues and increasing deficits, politicians raised tax rates and cut spending

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CHAPTER 10 Aggregate Demand I slide 81 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 1929-33. But, two problems with this hypothesis: 1. P fell even more, so M/P actually rose slightly during 1929-31. 2. nominal interest rates fell, which is the opposite of what would result from a leftward LM shift.

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CHAPTER 10 Aggregate Demand I slide 82 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 1929-33. 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?

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CHAPTER 10 Aggregate Demand I slide 83 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 C IS shifts right Y Y

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CHAPTER 10 Aggregate Demand I slide 84 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

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CHAPTER 10 Aggregate Demand I slide 85 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

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CHAPTER 10 Aggregate Demand I slide 86 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.

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CHAPTER 10 Aggregate Demand I slide 87 Chapter summary 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

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CHAPTER 10 Aggregate Demand I slide 88 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

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CHAPTER 10 Aggregate Demand I slide 89

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macroeconomics fifth edition N. Gregory Mankiw PowerPoint ® Slides by Ron Cronovich CHAPTER TEN Aggregate Demand I macro © 2004 Worth Publishers, all rights reserved CHAPTER TWELVE Aggregate Demand in the Open Economy

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CHAPTER 10 Aggregate Demand I slide 91 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

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CHAPTER 10 Aggregate Demand I slide 92 The Mundell-Fleming Model Key assumption: Small open economy with perfect capital mobility. r = r* Goods market equilibrium---the IS* curve: where e = nominal exchange rate = foreign currency per unit of domestic currency

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CHAPTER 10 Aggregate Demand I slide 93 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*

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CHAPTER 10 Aggregate Demand I slide 94 The LM* curve: Money Market Eq’m The LM* curve 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*

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CHAPTER 10 Aggregate Demand I slide 95 Equilibrium in the Mundell-Fleming model Y e LM* IS* equilibrium exchange rate equilibrium level of income

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CHAPTER 10 Aggregate Demand I slide 96 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.

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CHAPTER 10 Aggregate Demand I slide 97 Fiscal policy under floating exchange rates Y e Y1Y1 e1e1 e2e2 At any given value of e, a fiscal expansion increases Y, shifting IS* to the right. Results: e > 0, Y = 0

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CHAPTER 10 Aggregate Demand I slide 98 Lessons about fiscal policy 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.

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CHAPTER 10 Aggregate Demand I slide 99 Mon. policy under floating exchange rates Y e e1e1 Y1Y1 Y2Y2 e2e2 An increase in M shifts LM* right because Y must rise to restore eq’m in the money market. Results: e 0

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CHAPTER 10 Aggregate Demand I slide 100 Lessons about monetary policy 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.

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CHAPTER 10 Aggregate Demand I slide 101 Trade policy under floating exchange rates Y e e1e1 Y1Y1 e2e2 At any given value of e, a tariff or quota reduces imports, increases NX, and shifts IS* to the right. Results: e > 0, Y = 0

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CHAPTER 10 Aggregate Demand I slide 102 Lessons about trade policy 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.

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CHAPTER 10 Aggregate Demand I slide 103 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.

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CHAPTER 10 Aggregate Demand I slide 104 Fiscal policy under fixed exchange rates Y e Y1Y1 e1e1 Under floating rates, a fiscal expansion would raise e. Results: e = 0, Y > 0 Y2Y2 To keep e from rising, the central bank must sell domestic currency, which increases M and shifts LM* right. Under floating rates, fiscal policy ineffective at changing output. Under fixed rates, fiscal policy is very effective at changing output.

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CHAPTER 10 Aggregate Demand I slide 105 Mon. policy under fixed exchange rates An increase in M would shift LM* right and reduce e. Y e Y1Y1 e1e1 To prevent the fall in e, the central bank must buy domestic currency, which reduces M and shifts LM* back left. Results: e = 0, Y = 0 Under floating rates, monetary policy is very effective at changing output. Under fixed rates, monetary policy cannot be used to affect output.

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CHAPTER 10 Aggregate Demand I slide 106 Trade policy under fixed exchange rates Y e Y1Y1 e1e1 A restriction on imports puts upward pressure on e. Results: e = 0, Y > 0 Y2Y2 To keep e from rising, the central bank must sell domestic currency, which increases M and shifts LM* right. 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.

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CHAPTER 10 Aggregate Demand I slide 107 M-F: summary of policy effects type of exchange rate regime: floatingfixed impact on: PolicyYeNXYe fiscal expansion0 00 mon. expansion 000 import restriction0 0 0

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CHAPTER 10 Aggregate Demand I slide 108 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.

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CHAPTER 10 Aggregate Demand I slide 109 Differentials in the M-F model where is a risk premium. Substitute the expression for r into the IS* and LM* equations:

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CHAPTER 10 Aggregate Demand I slide 110 The effects of an increase in IS* shifts left, because r I Y e Y1Y1 e1e1 LM* shifts right, because r (M/P ) d, so Y must rise to restore money market eq’m. Results: e 0 e2e2 Y2Y2

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CHAPTER 10 Aggregate Demand I slide 111 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 ). The effects of an increase in

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CHAPTER 10 Aggregate Demand I slide 112 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.

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CHAPTER 10 Aggregate Demand I slide 113 CASE STUDY: The Mexican Peso Crisis

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CHAPTER 10 Aggregate Demand I slide 114 CASE STUDY: The Mexican Peso Crisis

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CHAPTER 10 Aggregate Demand I slide 115 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

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CHAPTER 10 Aggregate Demand I slide 116 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)

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CHAPTER 10 Aggregate Demand I slide 117 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?

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CHAPTER 10 Aggregate Demand I slide 118 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 December 1993 ………………$28 billion August 17, 1994 ………………$17 billion December 1, 1994 ……………$ 9 billion December 15, 1994 …………$ 7 billion During 1994, Mexico’s central bank hid the fact that its reserves were being depleted.

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CHAPTER 10 Aggregate Demand I slide 119 the disaster the disaster Dec. 20: Mexico devalues the peso by 13% (fixes e at 25 cents instead of 29 cents) shocked 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%.

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CHAPTER 10 Aggregate Demand I slide 120 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.

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CHAPTER 10 Aggregate Demand I slide 121 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 1997-98 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% (1996-97) U.S.n.a.2.7%2.3%

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CHAPTER 10 Aggregate Demand I slide 122 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

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CHAPTER 10 Aggregate Demand I slide 123 Mundell-Fleming and the AD curve 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: (Earlier in this chapter, P was fixed, so we could write NX as a function of e instead of .)

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CHAPTER 10 Aggregate Demand I slide 124 Y1Y1 Y2Y2 Deriving the AD curve Y Y P IS* LM*(P 1 ) LM*(P 2 ) AD P1P1 P2P2 Y2Y2 Y1Y1 22 11 Why AD curve has negative slope: PP LM shifts left NX Y Y (M/P) (M/P)

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CHAPTER 10 Aggregate Demand I slide 125 From the short run to the long run LM*(P 1 ) 11 22 then there is downward pressure on prices. Over time, P will move down, causing (M/P )(M/P ) NX Y Y P1P1 SRAS 1 Y Y P IS* AD LRAS LM*(P 2 ) P2P2 SRAS 2

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CHAPTER 10 Aggregate Demand I slide 126 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)

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CHAPTER 10 Aggregate Demand I slide 127 Chapter summary 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.

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CHAPTER 10 Aggregate Demand I slide 128 Chapter summary 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.

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CHAPTER 10 Aggregate Demand I slide 129 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.

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CHAPTER 10 Aggregate Demand I slide 130

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macroeconomics fifth edition N. Gregory Mankiw PowerPoint ® Slides by Ron Cronovich CHAPTER TEN Aggregate Demand I macro © 2004 Worth Publishers, all rights reserved

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CHAPTER 10 Aggregate Demand I slide 132 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”

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CHAPTER 10 Aggregate Demand I slide 133 Real GDP Growth in the U.S., 1960-2004 Average growth rate = 3.4%

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CHAPTER 10 Aggregate Demand I slide 134 Real GDP Growth in the U.S., 1960-2004 Average growth rate = 3.4%

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CHAPTER 10 Aggregate Demand I slide 135 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 economy behaves much differently when prices are sticky.

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CHAPTER 10 Aggregate Demand I slide 136 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.

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CHAPTER 10 Aggregate Demand I slide 137 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.

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CHAPTER 10 Aggregate Demand I slide 138 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

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CHAPTER 10 Aggregate Demand I slide 139 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 10-12 develop the theory of aggregate demand in more detail.

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CHAPTER 10 Aggregate Demand I slide 140 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:

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CHAPTER 10 Aggregate Demand I slide 141 The downward-sloping AD curve An increase in the price level causes a fall in real money balances (M/P ), causing a decrease in the demand for goods & services. Y P AD

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CHAPTER 10 Aggregate Demand I slide 142 Shifting the AD curve An increase in the money supply shifts the AD curve to the right. Y P AD 1 AD 2

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CHAPTER 10 Aggregate Demand I slide 143 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. “Full employment” means that unemployment equals its natural rate.

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CHAPTER 10 Aggregate Demand I slide 144 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:

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CHAPTER 10 Aggregate Demand I slide 145 The long-run aggregate supply curve Y P LRAS The LRAS curve is vertical at the full-employment level of output.

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CHAPTER 10 Aggregate Demand I slide 146 Long-run effects of an increase in M Y P AD 1 AD 2 LRAS An increase in M shifts the AD curve to the right. P1P1 P2P2 In the long run, this increases the price level… …but leaves output the same.

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CHAPTER 10 Aggregate Demand I slide 147 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:

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CHAPTER 10 Aggregate Demand I slide 148 The short run aggregate supply curve Y P SRAS The SRAS curve is horizontal: The price level is fixed at a predetermined level, and firms sell as much as buyers demand.

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CHAPTER 10 Aggregate Demand I slide 149 Short-run effects of an increase in M Y P AD 1 AD 2 …an increase in aggregate demand… In the short run when prices are sticky,… …causes output to rise. SRAS Y2Y2 Y1Y1

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CHAPTER 10 Aggregate Demand I slide 150 From the short run to the long run Over time, prices gradually become “unstuck.” When they do, will they rise or fall? rise fall remain constant In the short-run equilibrium, if then over time, the price level will This adjustment of prices is what moves the economy to its long-run equilibrium.

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CHAPTER 10 Aggregate Demand I slide 151 The SR & LR effects of M > 0 Y P AD 1 AD 2 LRAS SRAS P2P2 Y2Y2 A = initial equilibrium A B C B = new short- run eq’m after Fed increases M C = long-run equilibrium

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CHAPTER 10 Aggregate Demand I slide 152 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:

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CHAPTER 10 Aggregate Demand I slide 153 LRAS AD 2 SRAS The effects of a negative demand shock Y P AD 1 P2P2 Y2Y2 The shock shifts AD left, causing output and employment to fall in the short run A B C Over time, prices fall and the economy moves down its demand curve toward full- employment.

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CHAPTER 10 Aggregate Demand I slide 154 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.)

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CHAPTER 10 Aggregate Demand I slide 155 CASE STUDY: The 1970s oil shocks Early 1970s: OPEC coordinates a reduction in the supply of oil. Oil prices rose 11% in 1973 68% in 1974 16% in 1975 Such sharp oil price increases are supply shocks because they significantly impact production costs and prices.

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CHAPTER 10 Aggregate Demand I slide 156 SRAS 1 Y P AD LRAS Y2Y2 The oil price shock shifts SRAS up, causing output and employment to fall. A B In absence of further price shocks, prices will fall over time and economy moves back toward full employment. SRAS 2 CASE STUDY: The 1970s oil shocks A

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CHAPTER 10 Aggregate Demand I slide 157 CASE STUDY: The 1970s oil shocks Predicted effects of the oil price shock: inflation output unemployment …and then a gradual recovery.

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CHAPTER 10 Aggregate Demand I slide 158 CASE STUDY: The 1970s oil shocks Late 1970s: As economy was recovering, oil prices shot up again, causing another huge supply shock!!!

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CHAPTER 10 Aggregate Demand I slide 159 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:

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CHAPTER 10 Aggregate Demand I slide 160 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:

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CHAPTER 10 Aggregate Demand I slide 161 Stabilizing output with monetary policy SRAS 1 Y P AD 1 B SRAS 2 A Y2Y2 LRAS The adverse supply shock moves the economy to point B.

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CHAPTER 10 Aggregate Demand I slide 162 Stabilizing output with monetary policy Y P AD 1 B SRAS 2 A C Y2Y2 LRAS AD 2 But the Fed accommodates the shock by raising agg. demand. results: P is permanently higher, but Y remains at its full- employment level.

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CHAPTER 10 Aggregate Demand I slide 163 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

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CHAPTER 10 Aggregate Demand I slide 164 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.

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CHAPTER 10 Aggregate Demand I slide 165 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.

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CHAPTER 10 Aggregate Demand I slide 166

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