Motivation The Great Depression caused a rethinking of the Classical Theory of the macroeconomy. It could not explain: Drop in output by 30% from 1929.
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1 MotivationThe Great Depression caused a rethinking of the Classical Theory of the macroeconomy. It could not explain:Drop in output by 30% from 1929 to 1933Rise in unemployment to 25%In 1936, J.M. Keynes developed a theory to explain this phenomenon.We will learn a version of this theory, called the ‘IS-LM’ model.
2 ContextChapter 9 introduced the model of aggregate demand and aggregate supply.Long runprices flexibleoutput determined by factors of production & technologyunemployment equals its natural rateShort runprices fixedoutput determined by aggregate demandunemployment is negatively related to output
3 ContextThis 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.
4 The Keynesian CrossA simple closed economy model in which income is determined by expenditure. (due to J.M. Keynes)Notation:I = planned investmentE = C + I + G = planned expenditureY = real GDP = actual expenditureDifference between actual & planned expenditure: unplanned inventory investment
5 Elements of the Keynesian Cross consumption function:govt policy variables:for now, 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:
6 Graphing planned expenditure E =C +I +GSlope is MPCWhy 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
7 Graphing the equilibrium condition plannedexpenditureE =Y45ºincome, output, Y
8 The equilibrium value of income plannedexpenditureE =YE =C +I +GThe equilibrium point is the value of income where the curves cross.Equilibrium incomeincome, output, Y
9 The equilibrium value of income plannedexpenditureE =YE =C +I +GE<YE>Yincome, output, YE>Y: depleting inventories: must produce more.E<Y: accumulating inventories: must produce less.
10 An increase in government purchases YEE =YAt Y1, there is now an unplanned drop in inventory…E =C +I +G2E =C +I +G1GLooks like Y>G…so firms increase output, and income rises toward a new equilibriumExplain 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 = Y1YE2 = Y2
11 Why the multiplier is greater than 1 Def: Government purchases multiplier:Initially, the increase in G causes an equal increase in Y: Y = G.But Y C further Y further CSo the government purchases multiplier will be greater than one.Students are better able to understand this if given a more concrete example. 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 Chevy Trailblazers. Then, General Motors sees its revenues increase by $80 million, all of which becomes income to somebody - either GM’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).
12 An increase in government purchases YEE =YC even moreC moreCY even moreY moreGY onceExplain 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).
14 Solving for Y equilibrium condition in changes because I exogenous because C = MPC YCollect terms with Y on the left side of the equals sign:Finally, solve for Y :
15 Algebra example Suppose consumption function: C= a+b(Y-T) where a and b are some numbers (MPC=b)Use Goods market equilibrium condition:
16 Algebra example Solve for Y: So if b=MPC=0.75, multiplier = 1/( ) = 4.
17 An increase in taxes E C = MPC T Y Y E =C1 +I +G E =C2 +I +G E =YYEInitially, the tax increase reduces consumption, and therefore E:E =C1 +I +GE =C2 +I +GAt Y1, there is now an unplanned inventory buildup…C = MPC T…so firms reduce output, and income falls toward a new equilibriumSuppose taxes are increased by T. Because I and G are exogenous, they do not change. However, C depends on (YT). 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 TC 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.E2 = Y2YE1 = Y1
18 Tax multiplierDefine tax multiplier: how much does output fall for a unit rise in taxes:Can read the tax multiplier from the algebraic solution above:If b=0.75, tax multiplier = -0.75/( ) = -3.
19 Solving for Y eq’m condition in changes I and G exogenous Final result:
20 The Tax MultiplierQuestion: how is this different from the government spending multiplier considered previously?The tax multiplier:…is negative: An increase in taxes reduces consumer spending, which reduces equilibrium income.…is smaller than the govt spending multiplier: (in absolute value) 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.
21 A question to consider: Using the Keynesian Cross, what would be the effect of an increase in investment on the equilibrium level of income/output.Note :This in-class exercise not only gives students practice with the model, it also helps them understand the next topic: the IS curve.Effect is just like rise in G previously.
22 Building the IS curvedef: a graph of all combinations of r and Y that result in goods market equilibrium,i.e. actual expenditure (output) = planned expenditureThe equation for the IS curve is:
23 Deriving the IS curve r I E Y E =C +I (r2 )+G
24 Understanding the IS curve’s slope The IS curve is negatively sloped.Intuition: 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.
25 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…
26 Shifting the IS curve: G E =YYEE =C +I (r1 )+G2At any value of r, G E YE =C +I (r1 )+G1…so the IS curve shifts to the right.The horizontal distance of the IS shift equalsY1Y2rYr1YIS2IS1Y1Y2
27 Algebra example for IS curve Suppose the expenditure side of the economy is characterized by:C = (Y-T)I = 100 – 100rG = 20, T=20Use the goods market equilibrium conditionY = C + I + GY = (Y-20) – 100r0.25Y = 200 – 100rIS: Y = 800 – 400r or write asIS: r = Y
29 Slope of IS curveSuppose that investment expenditure is “more responsive” to the interest rate:I = 100 – 100r200rUse the goods market equilibrium conditionY = C + I + GY = (Y-20) – 200r0.25Y = 200 – 200rIS: Y = 800 – 800r or write asIS: r = Y (slope is lower)So this makes the IS curve flatter: A fall in r raises I more, which raises Y more.
30 Building the LM 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.
31 Money Supply The supply of real money balances is fixed: r M/P interestrateWe are assuming a fixed supply of real money balances becauseP is fixed by assumption (short-run), and M is an exogenous policy variable.M/Preal money balances
32 Money Demand Demand for real money balances: L (r ) r M/P interest rateL (r )As we learned in chapter 4, the nominal interest rate is the opportunity cost of holding money (instead of bonds).Here, we are assuming the price level is fixed, so = 0 and r = i.M/Preal money balances
33 EquilibriumThe interest rate adjusts to equate the supply and demand for money:rinterestrater1L (r )M/Preal money balances
34 How the Fed raises the interest rate To increase r, Fed reduces Mr2r1L (r )M/Preal money balances
35 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?
36 Volcker’s Monetary Tightening, cont. predictionactual outcomeThe effects of a monetary tightening on nominal interest ratespricesmodellong runshort runLiquidity Preference(Keynesian)Quantity Theory, Fisher Effect(Classical)stickyflexibleSince 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.)i > 0i < 08/1979: i = 10.4%4/1980: i = 15.8%1/1983: i = 8.2%
37 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:
38 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 curveL (r , Y1 )M/PrrYLMY1Y2r2r2r1r1
39 Understanding the LM curve’s slope The LM curve is positively sloped.Intuition: 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.
40 Deriving LM curve with algebra Suppose a money demand:Where e describes the responsiveness of money demand to changes in income.And f describes responsiveness to interest rate.Suppose money supply:Use money market equilibrium condition:
41 Graph the LM curve r LM Slope = e/f Y (1/f)(M/P) A steep LM curve (e/f large) means that a rise in output implies a big rise in interest rate to maintain equilibrium.Causes of this:Money demand is not very responsive to interest rate (f is small)Money demand is very responsive to output (e large)
42 How M shifts the LM curve (a) The market for real money balances(b) The LM curveL (r , Y1 )M/PrrYLM2Y1LM1r2r2r1r1We 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.)
43 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:YrLMISEquilibriuminterestrateEquilibriumlevel ofincome
44 The Big Picture Keynesian Cross IS curve IS-LM model Explanation of short-run fluctuationsTheory of Liquidity PreferenceLM curveAgg. demand curveModel of Agg. Demand and Agg. SupplyAgg. supply curve
45 Chapter summary Keynesian Cross basic model of income determination takes fiscal policy & investment as exogenousfiscal policy has a multiplied impact on income.IS curvecomes from Keynesian Cross when planned investment depends negatively on interest rateshows all combinations of r and Y that equate planned expenditure with actual expenditure on goods & services
46 Chapter summary Theory of Liquidity Preference basic model of interest rate determinationtakes money supply & price level as exogenousan increase in the money supply lowers the interest rateLM curvecomes from Liquidity Preference Theory when money demand depends positively on incomeshows all combinations of r andY that equate demand for real money balances with supply
47 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.
48 Preview of Chapter 11 In Chapter 11, we will use the IS-LM model to analyze the impact of policies and shockslearn how the aggregate demand curve comes from IS-LMuse the IS-LM and AD-AS models together to analyze the short-run and long-run effects of shockslearn about the Great Depression using our models