Class Slides for EC 204 Spring 2006 To Accompany Chapter 11

The Short-Run Equilibrium Y = C(Y-T) + I(r) + G(IS) M/P = L(r, Y)(LM)

Using the Macroeconometric Models for Policy Analysis Large-scale Macroeconometric Models are essentially more complex versions of ISLM Use historical data to estimate parameters Then use model to simulate effects of alternative policies or combinations of policies Key concept is the multipliers implied by these models

Shocks to the ISLM Model Shocks to IS curve Shocks to the LM curve Policymakers can use monetary and fiscal policy tools to offset exogenous shocks The U.S. recession of 2001 Fiscal and monetary policy responded and probably limited the extent and duration of the downturn

What is the Fed’s Short-term Policy Instrument? Fed targets the federal funds rate Achieves this by open-market operations that change the money supply Why target an interest rate rather than a the money supply? Prevalence of shocks to LM curve Easier to measure interest rate than money supply

IS-LM Model in the Short Run and in the Long Run Two Equations with Three Endogenous Variables: Y = C(Y-T) + I(r) + G(IS) M/P = L(r, Y)(LM) To complete the model, we need an equation to set either the price level or output.

Keynesian Approach is to assume fixed prices: P = P 1 Classical Approach is to assume that output reaches the natural rate: Which assumption is most appropriate depends on the time horizon: Short Run compared to Long Run

Deriving the Aggregate Demand Curve in the ISLM Model

What Caused The Great Depression? The Spending Hypothesis: Shocks to the IS Curve The Money Hypothesis: Shocks to the LM Curve The Money Hypothesis Round II: The Effects of Falling Prices

The Spending Hypothesis Wealth Effect on Consumer Spending Overbuilding of Housing During the 1920s Bank Failures Disrupt Financing of Business Investment Bad Fiscal Policy: Revenue Act of 1932 and Desire to Balance the Budget

The Money Hypothesis I Money Supply Fell SharplyYET Real Money Balances Increased Nominal Interest Rates Fell So Can We Blame the Federal Reserve?

The Money Hypothesis II Prices Declined Sharply: Stabilizing Effects via Rise in Real Money Balances and Pigou Effect on Real Wealth Destabilizing Effect via Unexpected Deflation-- Redistribution of Wealth from Debtors to Creditors Destabilizing Effect via Expected Deflation and a Rise in the Real Interest Rate

Liquidity Traps Nominal interest rate can not fall below zero Monetary policy becomes ineffective because it can no longer lower interest rates and stimulate investment Aggregate demand, output and employment become “trapped” at low levels Some believe this occurred in the 1930s and in Japan during the 1990s

Monetary Policy Might Still be Effective Monetary expansion might raise inflation expectations, lowering the real interest rate below zero and thus raising investment Monetary expansion might lead to depreciation of the currency, stimulating exports And we still have fiscal policy as a tool

Inflation Targeting Danger of liquidity traps is one reason why advocates of inflation targeting suggest a rate greater than zero A positive rate of inflation (say 1-2 percent) gives monetary policy more room to maneuver