1. slide 0 CHAPTER 9 Introduction to Economic Fluctuations 9. ISLM model

2. slide 1 CHAPTER 9 Introduction to Economic Fluctuations In this lecture, you will learn…  an introduction to business cycle and aggregate demand  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

3. slide 2 CHAPTER 9 Introduction to Economic Fluctuations Short run  In the following lectures, we will study the short- run fluctuations of the economy (business cycles)  We focus on three models:  ISLM model (lecture 9)  Mudell-Fleming model (lecture 10)  Model AS-AD  AD (lectures 9 and 10)  AS (lecture 11)

4. slide 3 CHAPTER 9 Introduction to Economic Fluctuations Facts about the business cycle  GDP growth averages 3–3.5 percent per year over the long run with large fluctuations in the short run.  Consumption and investment fluctuate with GDP, but consumption tends to be less volatile and investment more volatile than GDP.  Unemployment rises during recessions and falls during expansions.  Okun’s Law: the negative relationship between GDP and unemployment.

5. slide 4 CHAPTER 9 Introduction to Economic Fluctuations Growth rates of real GDP, consumption -4 -2 0 2 4 6 8 10 19701975198019851990199520002005 Real GDP growth rate Average growth rate Consumption growth rate Percent change from 4 quarters earlier

6. slide 5 CHAPTER 9 Introduction to Economic Fluctuations Growth rates of real GDP, consumption, investment -30 -20 -10 0 10 20 30 40 19701975198019851990199520002005 Percent change from 4 quarters earlier Investment growth rate Real GDP growth rate Consumption growth rate

7. slide 6 CHAPTER 9 Introduction to Economic Fluctuations Unemployment 0 2 4 6 8 10 12 19701975198019851990199520002005 Percent of labor force

8. slide 7 CHAPTER 9 Introduction to Economic Fluctuations Okun’s Law Percentage change in real GDP Change in unemployment rate -4 -2 0 2 4 6 8 10 -3-201234 1975 1982 1991 2001 1984 1951 1966 2003 1987

9. slide 8 CHAPTER 9 Introduction to Economic Fluctuations Time horizons in macroeconomics  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.

10. slide 9 CHAPTER 9 Introduction to Economic Fluctuations Recap of classical macro theory (Chaps. 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.  Assumes complete price flexibility.  Applies to the long run.

11. slide 10 CHAPTER 9 Introduction to Economic Fluctuations When prices are sticky… …output and employment also depend on demand, which is affected by  fiscal policy ( G and T )  monetary policy ( M )  other factors, like exogenous changes in C or I.

12. slide 11 CHAPTER 9 Introduction to Economic Fluctuations The model of aggregate demand and supply  the paradigm most mainstream economists and 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

13. slide 12 CHAPTER 9 Introduction to Economic Fluctuations IS-LM  This chapter develops the IS-LM model, the basis of the aggregate demand curve.  We focus on the short run and assume the price level is fixed.  This lecture focuses on the closed-economy case.  Next lecture presents the open-economy case.

14. slide 13 CHAPTER 9 Introduction to Economic Fluctuations 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

15. slide 14 CHAPTER 9 Introduction to Economic Fluctuations Elements of the Keynesian Cross consumption function: for now, planned investment is exogenous: planned expenditure: equilibrium condition: govt policy variables: actual expenditure = planned expenditure

16. slide 15 CHAPTER 9 Introduction to Economic Fluctuations Graphing planned expenditure income, output, Y E planned expenditure E =C +I +G MPC 1

17. slide 16 CHAPTER 9 Introduction to Economic Fluctuations Graphing the equilibrium condition income, output, Y E planned expenditure E =Y 45 º

18. slide 17 CHAPTER 9 Introduction to Economic Fluctuations The equilibrium value of income income, output, Y E planned expenditure E =Y E =C +I +G Equilibrium income

19. slide 18 CHAPTER 9 Introduction to Economic Fluctuations 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 YY At Y 1, there is now an unplanned drop in inventory… …so firms increase output, and income rises toward a new equilibrium. GG

20. slide 19 CHAPTER 9 Introduction to Economic Fluctuations 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: Solve for  Y :

21. slide 20 CHAPTER 9 Introduction to Economic Fluctuations 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 5 times as much!

22. slide 21 CHAPTER 9 Introduction to Economic Fluctuations 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.

23. slide 22 CHAPTER 9 Introduction to Economic Fluctuations 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 YY 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:

24. slide 23 CHAPTER 9 Introduction to Economic Fluctuations Solving for  Y eq’m condition in changes I and G exogenous Solving for  Y : Final result:

25. slide 24 CHAPTER 9 Introduction to Economic Fluctuations The tax multiplier def: the change in income resulting from a $1 increase in T : If MPC = 0.8, then the tax multiplier equals

26. slide 25 CHAPTER 9 Introduction to Economic Fluctuations The tax multiplier …is negative: A tax increase reduces C, 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.

27. slide 26 CHAPTER 9 Introduction to Economic Fluctuations 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:

28. slide 27 CHAPTER 9 Introduction to Economic Fluctuations 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 II  E E  Y Y

29. slide 28 CHAPTER 9 Introduction to Economic Fluctuations 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.

30. slide 29 CHAPTER 9 Introduction to Economic Fluctuations 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

31. slide 30 CHAPTER 9 Introduction to Economic Fluctuations Fiscal Policy and the IS curve  We can use the IS-LM model to see how fiscal policy (G and T ) affects aggregate demand and output.  Let’s start by using the Keynesian cross to see how fiscal policy shifts the IS curve…

32. slide 31 CHAPTER 9 Introduction to Economic Fluctuations 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. YY

33. slide 32 CHAPTER 9 Introduction to Economic Fluctuations 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.

34. slide 33 CHAPTER 9 Introduction to Economic Fluctuations Money supply The supply of real money balances is fixed: M/P real money balances r interest rate

35. slide 34 CHAPTER 9 Introduction to Economic Fluctuations Money demand Demand for real money balances: M/P real money balances r interest rate L (r )L (r )

36. slide 35 CHAPTER 9 Introduction to Economic Fluctuations 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

37. slide 36 CHAPTER 9 Introduction to Economic Fluctuations 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

38. slide 37 CHAPTER 9 Introduction to Economic Fluctuations CASE STUDY: Monetary Tightening & Interest Rates  Late 1970s:  > 10%  Oct 1979: Fed Chairman Paul Volcker announces 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 nominal interest rates?

39. Monetary Tightening & Rates, cont.  i < 0  i > 0 8/1979: i = 10.4% 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

40. slide 39 CHAPTER 9 Introduction to Economic Fluctuations 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:

41. slide 40 CHAPTER 9 Introduction to Economic Fluctuations 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

42. slide 41 CHAPTER 9 Introduction to Economic Fluctuations 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.

43. slide 42 CHAPTER 9 Introduction to Economic Fluctuations 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

44. slide 43 CHAPTER 9 Introduction to Economic Fluctuations 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

45. slide 44 CHAPTER 9 Introduction to Economic Fluctuations Policy analysis with the IS -LM model We can use the IS-LM model to analyze the effects of fiscal policy: G and/or T monetary policy: M IS Y r LM r1r1 Y1Y1

46. slide 45 CHAPTER 9 Introduction to Economic Fluctuations 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.

47. slide 46 CHAPTER 9 Introduction to Economic Fluctuations IS 1 1. A tax cut Y r LM r1r1 Y1Y1 IS 2 Y2Y2 r2r2 Consumers save (1  MPC) of the tax cut, so 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  T than for an equal  G. 2.

48. slide 47 CHAPTER 9 Introduction to Economic Fluctuations 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.

49. slide 48 CHAPTER 9 Introduction to Economic Fluctuations 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.

50. slide 49 CHAPTER 9 Introduction to Economic Fluctuations 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:

51. slide 50 CHAPTER 9 Introduction to Economic Fluctuations 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:

52. slide 51 CHAPTER 9 Introduction to Economic Fluctuations 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:

53. slide 52 CHAPTER 9 Introduction to Economic Fluctuations 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 If Congress raises G, the IS curve shifts right.

54. slide 53 CHAPTER 9 Introduction to Economic Fluctuations 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

55. slide 54 CHAPTER 9 Introduction to Economic Fluctuations 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 LM and therefore affect Y.  The aggregate demand curve (introduced in Chap. 9) captures this relationship between P and Y.

56. slide 55 CHAPTER 9 Introduction to Economic Fluctuations 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

57. slide 56 CHAPTER 9 Introduction to Economic Fluctuations 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

58. slide 57 CHAPTER 9 Introduction to Economic Fluctuations 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

59. slide 58 CHAPTER 9 Introduction to Economic Fluctuations 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

60. slide 59 CHAPTER 9 Introduction to Economic Fluctuations 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

61. 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 CHAPTER 10 Aggregate Demand I slide 60

62. 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 and Y that equate demand for real money balances with supply CHAPTER 10 Aggregate Demand I slide 61

63. 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. CHAPTER 10 Aggregate Demand I slide 62

64. 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. CHAPTER 11 Aggregate Demand II slide 63

65. slide 64 CHAPTER 9 Introduction to Economic Fluctuations APPENDIX: The Great Depression

66. slide 65 CHAPTER 9 Introduction to Economic Fluctuations The Great Depression Unemployment (right scale) Real GNP (left scale) 120 140 160 180 200 220 240 192919311933193519371939 billions of 1958 dollars 0 5 10 15 20 25 30 percent of labor force

67. slide 66 CHAPTER 9 Introduction to Economic Fluctuations 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.

68. slide 67 CHAPTER 9 Introduction to Economic Fluctuations 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  Politicians raised tax rates and cut spending to combat increasing deficits.

69. slide 68 CHAPTER 9 Introduction to Economic Fluctuations 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:  P fell even more, so M/P actually rose slightly during 1929-31.  nominal interest rates fell, which is the opposite of what a leftward LM shift would cause.

70. slide 69 CHAPTER 9 Introduction to Economic Fluctuations 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?

71. slide 70 CHAPTER 9 Introduction to Economic Fluctuations 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 )P  (M/P )  consumers’ wealth   C C  IS shifts right  Y Y

72. slide 71 CHAPTER 9 Introduction to Economic Fluctuations 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 

73. slide 72 CHAPTER 9 Introduction to Economic Fluctuations 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