CHAPTER ELEVEN Aggregate Demand II

Now that we’ve assembled the IS-LM model of aggregate demand, let’s apply it to three issues: 1) Causes of fluctuations in national income 2) How IS-LM fits into the model of aggregate supply and aggregate demand 3) The Great Depression

1. Explaining Fluctuations with the IS-LM Model The intersection of the IS curve and the LM curve determines the level of national income. When one of these curves shifts, the short-run equilibrium of the economy changes, and national income fluctuates. Let’s examine how changes in policy and shocks to the economy can cause these curves to shift. IS-LM

Short-run Equilibrium How Fiscal Policy Shifts the IS Curve and Changes the Short-run Equilibrium

+G Consider an increase in government purchases. This will raise the level of income by G/(1- MPC) LM r Y IS A IS´ B The IS curve shifts to the right by G/(1- MPC) which raises income and the interest rate.

Short-run Equilibrium How Monetary Policy Shifts the LM Curve and Changes the Short-run Equilibrium

+M Consider an increase in the money supply. IS r LM LM A B Y The LM curve shifts downward and lowers the interest rate which raises income.

The IS-LM model shows that monetary policy influences income by changing the interest rate. Here we see how a monetary expansion induces greater spending on goods and services--a process called the monetary transmission mechanism. The IS-LM model shows that an increase in the money supply lowers the interest rate, which stimulates investment and thereby expands the demand for goods and services.

The Central Bank holds money supply constant The interaction between monetary and fiscal policy - How the economy responds to a tax increase depends on how the monetary authority responds LM The Central Bank holds money supply constant Interest rate, r IS1 IS2 Income, output, Y

The central bank holds interest rate constant, by reducing the money supply - LM curve shifts upward Interest rate, r LM2 LM1 IS1 IS2 Income, output, Y

The central bank holds income constant, by raising the money supply - the LM curve shifts downward Interest rate, r LM1 LM2 IS1 IS2 Income, output, Y

2. IS-LM as a Theory of Aggregate Demand

From IS-LM to AD You probably noticed from the IS and LM diagrams that r and Y were on the two axes. Now we’re going to bring a third variable, the price level (P) into the analysis. We can accomplish this by linking both two-dimensional graphs. LM(P2) B P2 IS To derive AD, start at point A in the top graph. Now increase the price level from P1 to P2. r LM(P1) An increase in P lowers the value of real money balances, and Y, shifting LM leftward to point B. A Notice that r increased. Since r increased, we know that investment will decrease as it just got more costly to take on various investment projects. This sets off a multiplier process since -DI causes a –DY. The - DY triggers -DC as we move up the IS curve. Y P A P1 AD The +DP triggers a sequence of events that end with a -DY, the inverse relationship that defines the downward slope of AD. Y

A change in income in the IS-LM model resulting from a change in the price level represents a movement along the AD curve. A change in income in the IS-LM model for a fixed price level represents a shift in the AD curve.

The IS-LM model in the Short Run and the Long Run The model of aggregate demand and aggregate supply The IS-LM model LRAS LRAS Price level, P Interest rate, r LM(P1) K SRAS1 K P1 LM(P2) P2 SRAS2 C C IS AD Income, output, Y Income, output, Y

3. The Great Depression - An extended case study to show how economists use the IS-LM model to analyze economic fluctuations 1. The Spending Hypothesis - Shocks to the IS curve - the cause of the decline may have been a contractionary shift of the IS curve fall in spending of goods and service - the decline in income in the 1930s coincided with falling interest rates Explanations for the decline in spending: the stock market crash of 1929 a large drop in investment in housing (residential boom of the 1920s was excessive, the reduction in immigration in the 1930s)

After Depression: bank failures the fiscal policy of the 1930s (more concern with balancing the budget that with using fiscal policy to keep production and employment at their natural rates )

2. The Money Hypothesis: a Shock to the LM curve - It attempts to explain the effects of the historical fall of the money supply of 25% from 1929 to 1933 (a contractionary shift in the LM curve) - It places primary blame on the Federal Reserve for allowing the money supply to fall by such a large amount (Milton Friedman and Anna Schwartz) 2 problems of this hypothesis: the behavior of real money balances (they should fall). From 1929 to 1931 real money balances increased slightly, since the fall in the money supply was accompanied by an even greater fall in the price level. The behavior of interest rates (we should have observed higher interest rates because of the contractionary shift in the LM curve). Nominal interest rates fell continuously from 1929 to 1933.

3. The Money Hypothesis: the Effects of Falling Prices (Deflation) - The price level fell 25% during 1929 to 1933 - Some economists say that deflation worsened the Great Depression. They argue that the deflation may have turned what in 1931 was a typical economic downturn into an unprecedented period of high unemployment and depressed income. Because the falling money supply was possibly responsible for the falling price level, it could very well have been responsible for the severity of the depression. Let’s see how changes in the price level affect income in the IS-LM model.

The Stabilizing Effects of Deflation IS-LM model: falling prices raise income, through an increase in real money balances Pigou effect: another channel through which falling prices raise income - real money balances are part of households’ wealth - as prices fall and real money balances rise, consumers should feel wealthier and spend more. This would generate higher incomes and would cause an expansionary shift in the IS curve That is why some economists thought in the 1930s that deflation would help stabilize the economy.

The Destabilizing Effects of Deflation Falling prices could help depress income rather than raise it. 2 theories to explain this: 1. The debt deflation theory - the effects of unexpected falls in the price level - unanticipated changes in the price level redistribute wealth between debtors and creditors - this redistribution of wealth affects spending on goods and services (debtors reduce their spending by more than creditors raise theirs) spending reduces, a contractionary shift in the IS curve and lower national income

πe - expected inflation 2. The effects of expected fall in prices (expected deflation) - include a new variable in the IS-LM model - distinguish between the nominal and real interest rates Y=C(Y-T)+I(i-πe)+G IS M/P=L(i,Y) LM i - nominal interest rate πe - expected inflation

The Central Bank holds money supply constant Expected Deflation in the IS-LM model An expected deflation raises the real interest rate for any given nominal interest rate, and this depresses investment spending. The reduction in investment shifts the IS curve downward. LM The Central Bank holds money supply constant Interest rate, i IS1 IS2 Income, output, Y

What Happened During the Great Depression?

Key Concepts of Ch. 11 Monetary transmission mechanism Pigou Effect Debt-deflation theory