National Income & Business Cycles 0 Ohio Wesleyan University Goran Skosples 9. IS-LM and Aggregate Demand

1 Context & Objectives  Chapter 11 (10) developed the IS-LM model, the basis of the aggregate demand curve.  In Chapter 12 (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  We will analyze the short- and long-run effects of monetary and fiscal policies

2 The intersection determines the unique combination of __ and __ 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

3 Policy analysis with the IS -LM Model IS Y r LM r1r1 Y1Y1 We can use the IS-LM model to analyze the effects of fiscal policy: monetary policy:

4 causing output & income to rise. IS 1 An increase in government purchases 1. IS curve shifts ____ Y r LM 2. This _____ money demand, causing the interest rate to ____… 3. …which _______ investment, so the final increase in Y Result: G  r & Y

5 2.…causing the interest rate to ____ IS Monetary Policy: an increase in M 1.  M > 0 shifts the LM curve _____ Y r LM 1 r1r1 Y1Y1 3.…which _________ investment, causing output & income to ______. Result:  M  r and Y

6 Interaction between monetary & fiscal policy  Model: Monetary & fiscal policy variables (M, G, and T ) are ______________.  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.

7 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…

8 If Congress raises G, the IS curve shifts ____. IS 1 Response 1: Hold M constant Y r LM 1 r1r1 Y1Y1 If Fed holds M constant, then LM curve _______ _____. Results:

9 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 __________ M to shift LM curve ____. Results:

10 IS 1 Response 3: Hold Y constant Y r LM 1 r1r1 IS 2 Y2Y2 r2r2 To keep Y constant, Fed ________ M to shift LM curve ___. Results: If Congress raises G, the IS curve shifts right.

11 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 Estimated value of  Y /  T  1.19  0.26

12 Estimates of fiscal policy multipliers

13 Estimates of fiscal policy multipliers

14 Shocks in the IS -LM Model IS shocks: exogenous changes in the demand for goods & services. stock market boom or crash  change in households’ wealth  change in business or consumer confidence or expectations (“animal spirits”)  LM shocks: exogenous changes in the demand for money. a wave of credit card fraud __ demand for money more ATMs or the Internet __ money demand

15 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.

16 IS Exercise: A boom in the stock market makes consumers wealthier Y r LM r1r1 Y1Y1 Which curve shifts and why? ___, because of Effects on: r Y C I U/L

17 IS Exercise: After a wave of credit card fraud, consumers use cash more frequently in transactions Y r LM r1r1 Y1Y1 Which curve shifts and why? ___, because of ______ Effects on: Y2Y2 r Y C I U/L

18 CASE STUDY: The U.S. recession of 2001  During 2001, 2.1 million people lost their jobs, as unemployment rose from 3.9% to 5.8%. GDP growth slowed to 0.8% (compared to 3.9% average annual growth during ).

19 CASE STUDY: The U.S. recession of 2001  Causes: 1) Stock market decline  C Index (1942 = 100) Standard & Poor’s 500

20 CASE STUDY: The U.S. recession of 2001  Causes: 2) 9/11 increased uncertainty fall in consumer & business confidence result: lower spending, IS curve shifted left  Causes: 3) Corporate accounting scandals Enron, WorldCom, etc. reduced stock prices, discouraged investment

21 CASE STUDY: The U.S. recession of 2001  Fiscal policy response: shifted IS curve ______ tax cuts in 2001 and 2003 spending increases - airline industry bailout - NYC reconstruction - Afghanistan war

22 CASE STUDY: The U.S. recession of 2001  Monetary policy response: shifted LM curve _____ Three-month T-Bill Rate /01/200004/02/ /03/200010/03/ /03/200104/05/200107/06/200110/06/200101/06/200204/08/200207/09/ /09/ /09/200304/11/2003

23 What is the Fed’s policy instrument?  The news media commonly report the Fed’s policy changes as interest rate changes, as if the Fed has direct control over market interest rates.  In fact, the Fed targets the ____________ rate – the interest rate banks charge one another on overnight loans.  The Fed changes the money supply and shifts the _____ curve to achieve its target.  Other short-term rates typically move with the federal funds rate.

24 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. Why?  The aggregate demand curve captures this relationship between P and Y  Definition: Aggregate demand indicates the quantity demanded at a given price level

25 Y1Y1 Deriving the AD curve Y r Y P IS LM(P 1 ) AD P1P1 Y1Y1 r1r1 Intuition for slope of AD curve:  P  (M/P )  LM shifts ___  r  I  Y

26 Monetary policy and the AD curve Y P ISLM(M 1 /P 1 ) AD 1 P1P1 Y1Y1 Y1Y1 r1r1 The Fed can increase aggregate demand:  M  LM shifts ____ Y r  r  I  Y at each value of P

27 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 AD:  T  C  ___ shifts _____  Y at each value of P

28 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 _____ employed. “Full employment” means that unemployment equals its _______ rate. does not depend on the price level, so the long run aggregate supply (LRAS) curve is _______:

29 The long-run aggregate supply curve Y P The LRAS curve is vertical at the full- employment level of output.

30 Aggregate Supply in the Short Run  In the real world, many prices are _____ in the short run.  If we assume that all prices are stuck at a predetermined level in the short run… …and that firms are willing to sell as much as their customers are willing to buy at that price level....then, the short-run aggregate supply (SRAS) curve is _________:

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

32 IS-LM and AD-AS in the short run & long run  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

33 Fiscal policy: Increase in G Y r Y P IS 1 SRAS 0 PoPo LM 0 (M 0 /P 0 ) AD 0 Y0Y0 r0r0  G  IS shifts _____  Y & r  AD shifts ____ now, Y 1 Y 0  P P  LM ______ _____________  SRAS shifts ___ until the new equilibrium is reached: Y 0 & P 1 LRAS Y0Y0 

34 Effects of a fiscal policy over time t0t0 time Y t0t0 r t0t0 P FP has real effects in the SR and in the LR in this model SR: Y, r, P LR: Y, r, P

35 Fiscal policy in the long run  Point: FP has real effects in the SR and in the LR in this model.  In this example “crowding out” occurs. The increase in government expenditure (G) stimulates Y in the SR. In the LR, however, Y is fixed. Thus, the increase in the real interest rate (r ) causes private investment to decrease to offset the increase in G. Private investment is “crowded out” by government spending and Y remains fixed at Y 0 = F(K,L).

36 Exercise: Analyze SR & LR effects of  M a. Suppose Fed increases M. Show the SR effects on your graphs. b. Show what happens in the transition from the SR to the LR. c. How do the new LR equilibrium values of the endogenous variables compare to their initial values? Use the graphs provided on the next slide.

37 Monetary policy: Increase in M Y r Y P IS 1 SRAS 1 PoPo LM 0 (M 0 /P 0 ) AD 0 Y0Y0 r0r0  M  __ shifts _____  Y & r  __ shifts _____ now, Y 1 Y 0  P P   LM ______ ______________  ____ shifts ___ until the new equilibrium is reached: Y 0 and P 1 LRAS Y0Y0

38 Effects of a monetary policy over time t0t0 time Y t0t0 r t0t0 P MP is effective in the SR but ineffective in the LR in this model SR: Y, r, P LR: Y, r, P

39 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

40 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

41 Summary 3. Short- and long-run effects of FP and MP Fiscal policy has real effects in the SR and in the LR in this model (real interest rate increases in the LR  government spending crowds out private investment) Monetary policy is effective in the SR but ineffective in the LR in this model