Financial Markets and Aggregate Demand Chapter 8

Outline Investment and the Interest Rate Net Exports and the Interest Rate The Demand for and Supply of Money The IS Curve and the LM Curve Policy Analysis with IS-LM The Aggregate-Demand Curve Determination of Output and Unemployment in the Short Run

8.1. Investment and the Interest Rate Investment depends negatively on interest rates. Why? Most investments are financed through borrowing or with funds from selling financial securities. If interest rates are high, then there are high borrowing costs or high losses in income Investment function: I = e - dR e, d = constants d = how much investment falls when the interest rate increases by 1%

Fig. 8.1

Investment and the Interest Rate By making investment endogenous, we have introduced a new endogenous variable: the interest rate, R We focus here on the average interest rate (which represents the behavior of all the different types of rates: long-term, short-term securities, etc.) Note: distinguish between real and nominal interest rates: Real interest rate (R) = Nominal interest rate (i) – Inflation real interest rate: R Here we use the real interest rate: R

8.2. Net Exports and the Interest Rate Net exports depend negatively on the interest rate. Why? If U.S. interest rates are higher than rates in other countries, dollars become more attractive, which drive up the price of dollars; U.S. goods become more expensive and foreign goods cheaper, thus net exports fall X = g – mY -- nR n – measures the decrease in net exports when the interest rate rises by 1%

8.3. The Demand for and Supply of Money Money is: Currency issued by the Federal Reserve (coins, dollar bills) together with checking account balances held by public in banks It does not include larger amount of wealth, such as mutual funds, bonds, corporate stock, etc.

The Demand for Money People want to hold less money when the interest rate is high and more money when the interest rate is low. People want to hold more money when income is higher and less money when income is lower. People want to hold more money when price level is higher and less money when price level is lower.

The Demand for Money M – demand for money R – interest rate Money demand function M = (kY – hR)P M – demand for money R – interest rate P – price level k, h – coefficients k – how much money demand increases when income increases h – how much money demand declines when interest rate raises

The Supply of Money Money Supply level – determined by the Federal Reserve System For now, we assume that the Fed picks a certain level, M In the short-run model, when prices are predetermined, income and interest rates adjust to keep the demand for money equal to its fixed supply

8.4. The IS Curve and the LM Curve Five relations in the IS – LM framework Y = C + I + G + X C = a + b(1-t)Y I = e – dR X = g – mY - nR M = (kY – hR)P Endogenous variables: Y, C, I, X, and R Exogenous variables: G and M Predetermined variable: P

a) The IS Curve The IS curve shows all combinations of R and Y that satisfy the income identity, the consumption function, the investment function, and the net- export function. It is the set of points for which spending balance occurs. When the curve slopes downward -- higher interest rate reduces investment and net exports and thereby reduces GDP through the multiplier process Shifts: an increase in government spending increases GDP through the multiplier and shifts the IS curve to the right

FIGURE 8.2 THE IS CURVE 10 – 9 – 8 – 7 – 6 – 5 – 4 – 3 – 2 – 1 – 10 – INTEREST RATE (R) (%) INTEREST RATE (R) (%) 1 Government spending increases by ΔG 10 – 9 – 8 – 7 – 6 – 5 – 4 – 3 – 2 – 1 – 10 – 5 – 2 IS Curve shifts right by 1 ΔG 1- b (1-t) + m IS curve New IS Old IS 5,800 5,900 6,000 6,100 6,200 5,800 5,900 6,000 6,100 6,200 GDP (Y) GDP (Y)

FIGURE 8.3 GRAPH DERIVATION OF THE IS CURVE 45º line SPENDING 6,100 – 6,000 – 5,900 – 5,800 – Old spending line New spending line 5,800 5,900 6,000 6,100 6,200 GDP (Y) INTEREST RATE 8 – New interest rate 7 – 6.2 – – 5 – Old interest rate 4 – 3 – New Level of GDP Old Level of GDP IS Curve 2 – 1 – 5,800 5,900 6,000 6,100 6,200 GDP (Y)

The LM Curve The LM curve shows all combinations of R and Y that satisfy the money demand relationship for a fixed level of the money supply and a predetermined value of the price level. When the curve slopes upward: if the interest rate increases, money demand decreases; therefore, to have equilibrium in the money market there should be an increase in income. So, an interest-rate increase is associated with a rise in income.

The LM Curve Note: Real money = money supply M divided by price level P M/P = kY – hR The demand for real money depends positively on real GDP and negatively on the interest rate Shifts: an increases in money supply shifts the LM curve to the right

FIGURE 8.4 THE LM CURVE 10 – 9 – 8 – 7 – 6 – 5 – 4 – 3 – 2 – 1 – 10 – INTEREST RATE (R) (%) INTEREST RATE (R) (%) 10 – 9 – 8 – 7 – 6 – 5 – 4 – 3 – 2 – 1 – 10 – 9 – 8 – 7 – 6 – 5 – 4 – 3 – 2 – 1 – Money supply increases by ΔM LM curve Old LM New LM LM curve shifts to right by 1/k ΔM 5,800 5,900 6,000 6,100 6,200 5,800 5,900 6,000 6,100 6,200 GDP (Y) GDP (Y)

FIGURE 8.5 GRAPHICAL DERIVATION OF THE LM CURVE INTEREST RATE (R) (%) INTEREST RATE (R) (%) 10 – 9 – 8 – 7 – 6 – 5 – 4 – 3 – 2 – 1 – 10 – 9 – 8 – 7 – 6 – 5 – 4 – 3 – 2 – 1 – Money supply New interest rate LM Curve R = 8.17 Old interest rate New money demand Old money demand 850 900 950 5,800 5,900 6,000 6,100 6,200 GDP (Y) GDP (Y) Old GDP New GDP

Algebraic Derivation of the IS and LM Curves IS curve: LM curve: To satisfy all five relationships of the model, the values of R and Y must be on both the IS curve and the LM curve; that is, at their intersection (next figure)

FIGURE 8.6 THE INTERSECTION OF THE IS CURVE AND THE LM CURVE INTEREST RATE (R) (%) 10 – 5 – LM IS 5,800 5,900 6,000 6,100 6,200 GDP (Y)

8.5.Policy Analysis with IS-LM Monetary Policy: changes in the money supply What happens in the economy when the Fed increases the money supply? Immediately after the increase, more money is in the economy than people demand. This makes the interest rate fall, so the demand for money increases. The lower interest rate stimulates investment and net exports. This raises GDP through the multiplier process; GDP rises and the interest rate falls LM curve shifts to the right (increase in real money)

Policy Analysis with IS-LM Fiscal Policy: the use of tax rates and government spending to influence the economy Ex. Congress passes a bill that increases government spending or decrease in taxes An increase in government spending increases the interest rate (through the increase in the demand for money) and increases income (through the multiplier) Increasing the interest rate reduces investment and net exports, thereby offsetting some of the increase in income – crowding out

Policy Analysis with IS-LM These are short-run results with the price level predetermined. When the time frame is lengthened in the next chapter, so that the price level can adjust, these results will have to be modified.

FIGURE 8.7 EFFECTS OF MONETARY AND FISCAL POLICIES INTEREST RATE (R) (%) INTEREST RATE (R) (%) 10 – 9 – 8 – 7 – 6 – 5 – 4 – 3 – 2 – 1 – 10 – 9 – 8 – 7 – 6 – 5 – 4 – 3 – 2 – 1 – IS curve shifts right LM Old LM LM curve shifts right New LM Interest rate rises Interest rate falls New IS GDP rises IS Old IS GDP rises 5,800 5,900 6,000 6,100 6,200 5,800 5,900 6,000 6,100 6,200 GDP (Y) GDP (Y) Old level of GDP New level of GDP Old level of GDP New level of GDP Increase in Money Supply Increase in Government spending

8.6 The Aggregate Demand Curve The AD curve shows combinations of price levels and output where the IS and LM curves intersect, or where spending balance occurs and money demand equals money supply. Note: Even though they look similar, the ideas behind the aggregate demand curve are much different from those that underlie the typical demand curve of microeconomics. The financial system — the demand for and supply of money lies behind the aggregate demand curve.

The Aggregate Demand Curve The AD curve slopes downward; therefore, a decrease in prices increases real money, shifting the LM curve to the right, lowering interest rates, increasing investment and increasing output.

FIGURE 8.8 THE AGGREGATE DEMAND CURVE PRICE LEVEL (P) PRICE LEVEL (P) AD curve shifts right if (1) money (M) increases, or (2) government spending (G) increases 1.2 – 1.1 – 1.0 – .9 – .8 – 1.2 – 1.1 – 1.0 – .9 – .8 – Aggregate demand curve (AD) New AD Old AD 5,700 5,900 6,100 6,300 6,500 GDP (Y) GDP (Y) 5,700 5,900 6,100 6,300 6,500

FIGURE 8.9 DERIVATION OF THE AD CURVE INTEREST RATE (R) (%) New LM 8 – Old LM 7 – 6 – 5 – 4 – 3 – IS 2 – 1 – 5,800 5,900 6,000 6,100 6,200 GDP (Y) PRICE LEVEL (P) 1.15 – 1.10 – 1.05 – 1.00 – .95 – .90 – New price level Old price level AD 5,800 5,900 6,000 6,100 6,200 GDP (Y) New level of GDP Old level of GDP

The Aggregate Demand Curve Changes in the money supply and in government spending both shift the aggregate demand curve. Monetary Policy An increase in M at a given price level results in an increase in aggregate demand Rationale? More money means that a lower interest rate equates money demand with money supply. A lower interest rate stimulates more investment and net exports, which in turn require a higher level of GDP for spending balance The aggregate demand curve shifts to the right when the money supply increases

The Aggregate Demand Curve Fiscal policy An increase in government spending shifts the aggregate demand curve to the right. At a given price level, more government spending means more aggregate demand.

8.7. Determination of Output in the Short Run Recall: Prices are sticky; they take some time to adjust in response to demand conditions. The level of output at a predetermined price level is determined by the point on the aggregate demand curve corresponding to the price level. In the short run, output can be above or below its potential level.

FIGURE 8.10 DETERMINATION OF OUTPUT WITH A PREDETERMINED PRICE PRICE LEVEL (P) PRICE LEVEL (P) Predetermined-price line Predetermined-price line P0 P0 Aggregate demand curve (AD) New AD Old AD 5,800 6,200 Y0 Y0 Y1 GDP (Y) 5,800 6,200 GDP (Y)

FIGURE 8.10 DETERMINATION OF OUTPUT WITH A PREDETERMINED PRICE PRICE LEVEL (P) PRICE LEVEL (P) Y* Y* Predetermined-price line Predetermined-price line P0 P0 Aggregate demand curve Aggregate demand curve 5,800 6,000 6,200 5,800 6,000 6,200 Y0 Y0 GDP (Y) GDP (Y) Output below potential Output above potential

8.7. Determination of Unemployment in the Short Run If GDP declines, most workers who are laid off become unemployed (and it becomes harder for people who are looking for work to find jobs). Because of the importance of hours reductions and the common pattern of retaining workers during temporary declines in demand (called labor hoarding), a 3 percent decline in GDP is associated with only a 1 percentage point increase in unemployment (Okun’s Law).

FIGURE 8.12 DETERMINATION OF EMPLOYMENT PRICE 1 The AD curve shifts inward 2 Y declines from Y* to Y’ AD AD’ Y’ Y* GDP % GDP GAP GDP gap % GDP GAP Okun’s law 3 (Y – Y*)/Y* declines from 0 to a negative amount 4 Okun’s law shows how much unem-ployment rises -3.6% 5,784 6,000 U* U’ GDP 6% 7.2% UNEMPLOYMENT RATE

Numerical Example Consider the following economy : Y = C + I + G + X C = 100 + 0.9Yd I = 200 – 500R X = 100 – 0.12Y – 500R M = (0.8Y -2000R)P G = $200, t = 0.2, M = $800, P = 1 Yd = Y - 0.2Y Note: All quantities are in billions of dollars

Numerical Example What is the IS curve? Substitute C, I and X in the income identity: Y = 100 + 0.9(Y-0.2Y) + 200 – 500R + 200 + 100 -0.12Y – 500R Y = 600 + 0.6Y -1000R 0.4Y = 600 – 1000R IS curve: Y = 1500 – 2500R

Numerical Example What is the LM curve? Derive from the equation for money demand: M = (0.8Y -2000R)P 800 = 0.8Y - 2000R, 0.8Y = 800 + 2000R So LM curve: Y = 1000 + 2500R

Numerical Example What are the values of income and interest rate if spending balance occurs and the demand for money equals the supply for money? Y (from IS curve) = Y (from LM curve) 1500 – 2500R = 1000 + 2500R 500 = 500R R = 0.10 (10%) Substitute R into IS or LM: Y = 1250

Numerical Example What are the values of consumption, investment and net exports? C = 1000 I = 150 X = 100

Numerical Example Derive the aggregate demand curve: 1) To derive the effects of increases in government spending or real money on income, start with the equation for the LM curve, do not substitute a specific value for real money, and solve for output. M/P = 0.8Y-2000R Y = 1.25 (M/P) + 2500R

Numerical Example Derive the aggregate demand curve: 2) Now use the income identity, substitute the consumption, investment and net export equations, but not a specific value for government spending, and solve for 2500 times the interest rate: Y = 100 + 0.9(Y-0.2Y) + 200 – 500R + G + 100 -0.12Y – 500R Y = 400 + 0.6Y – 1000R + G 1000R = 400 – 0.4Y + G 2500R = 1000 – Y +2.5G

Numerical Example Derive the aggregate demand curve: 3) Then substitute the spending balance equation into the LM curve, and solve for Y Y = 1.25 (M/P) + 1000 – Y +2.5G 2Y = 1.25 (M/P) + 1000 + 2.5G AD curve: Y = 0.625(M/P) + 500 +1.25G

Numerical Example How much does an increase in government spending or real money of $100 bill increase GDP? AD curve: Y = 0.625(M/P) + 500 +1.25G An increase in government spending of 100 raises real GDP by 125. An increase in the money supply of 100, with the price level constant, raises real GDP by 62.5.