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AGGREGATE DEMAND AND AGGREGATE SUPPLY (Continued…)

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Macroeconomics ECO 403
VU
LESSON 28
AGGREGATE DEMAND AND AGGREGATE SUPPLY (Continued...)
The Big Picture
Keynesian
IS
Cross
curve
Explanation of
IS-LM
model
short-run
Theory of
fluctuations
LM curve
Liquidity
Preference
Aggregate.
demand
curve
Model of aggregate
demand and
aggregate supply
Aggregate.
supply
curve
Equilibrium in the IS-LM Model
The IS curve represents equilibrium in the goods market.
Y = C ( -T ) + I (r ) + G
Y
The LM curve represents money market equilibrium
M P = L (r ,Y )
LM
r
r1
IS
Y
Y1
The intersection determines the unique combination of Y and r that satisfies equilibrium in both
markets.
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Policy analysis with the IS-LM Model
Policymakers can affect macroeconomic variables with
·  fiscal policy: G and/or T
·  monetary policy: M
We can use the IS-LM model to analyze the effects of these policies.
An increase in government purchases
r
LM
r2
2.
r1
1.
IS2
IS1
Y
Y1
Y2
3.
1
ΔG, causing output & income to rise.
(1-MPC)
1. IS curve shifts right by
1
2. This raises money demand, causing the interest rate to rise
(1-MPC) ΔG.
3. ...which reduces investment, so the final increase in Y is smaller than
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A tax cut
r
LM
r2
2.
r1
1.
IS2
IS1
Y
Y1
Y2
2.
Because consumers save (1-MPC) of the tax cut, the initial boost in spending is smaller for ΔT
than for an equal ΔG... and the IS curve shifts by
1
ΔT
1.
(1-MPC)
2. ...so the effects on r and Y are smaller for a ΔT than for an equal ΔG.
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Monetary Policy: an increase in M
r
LM1
LM2
r1
r2
IS
Y
Y2
Y1
1. ΔM > 0 shifts the LM curve down (or to the right)
2. ...causing the interest rate to fall
3. ...this increases investment, causing output & income to rise.
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.
Central Bank's response to ΔG > 0
·  Suppose Government increases G.
·  Possible central bank responses:
1. Hold M constant
2. Hold r constant
3. Hold Y constant
·  In each case, the effects of the ΔG are different:
Response 1: hold M constant
If Government raises G, the IS curve shifts right. If central bank holds M constant, then LM
curve doesn't shift.
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r
LM1
r2
r1
IS2
IS1
Y
Y1
Y2
Results:
Δr = r2 - r1
ΔY = Y  2 - Y1
Response 2A: hold r constant
If Government raises G, the IS curve shifts right. To keep r constant, central bank increases M
r
LM1
LM2
r2
r1
IS2
IS1
Y
Y1
Y2
Y3
to shift LM curve right.
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ΔY = Y  3 - Y1
Δr = 0
Results:
Response2B: hold Y constant
If Government raises G, the IS curve shifts right. To keep Y constant, central Bank reduces M
to shift LM curve left.
r
LM2
LM1
r3
r2
r1
IS2
IS1
Y
Y1
Y2
ΔY = 0
Δr = r3 - r1
Results:
Shocks in the IS-LM Model
IS shocks: exogenous changes in the demand for goods & services.
Examples:
·
Stock market boom or crash
⇒ change in households' wealth
⇒ ΔC
·
Change in business or consumer
confidence or expectations
⇒ ΔI and/or ΔC
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LM shocks: exogenous changes in the demand for money.
Examples:
·
A wave of credit card fraud increases demand for money
·
More ATMs or the Internet reduce money demand
Analyzing 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.
What is the central bank's policy instrument?
·  What the newspaper says:
"The central bank lowered interest rates by one-half point today"
·  What actually happened:
The central bank conducted expansionary monetary policy to shift the LM curve to the
right until the interest rate fell 0.5 points.
·  The central bank targets the discount rate: it announces a target value, and uses
monetary policy to shift the LM curve as needed to attain its target rate.
Why does the central bank target interest rates instead of the money supply?
1)
They are easier to measure than the money supply
2)
The central bank might believe that LM shocks are more prevalent than IS shocks.
If so, then targeting the interest rate stabilizes income better than targeting the
money supply.
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.
·  The aggregate demand curve captures this relationship between P and Y
Deriving the AD curve
Intuition for slope of AD curve:
↑P
⇒ ↓(M/P)
⇒ LM shifts left
⇒ ↑r
⇒ ↓I
⇒ ↓Y
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LM (P2)
r
LM (P1)
r2
r1
IS
Y1
Y
Y2
P
P2
P1
AD
Y
Y2
Y1
Monetary policy and the AD curve
The central bank can increase aggregate demand:
↑M ⇒ LM shifts right
⇒ ↓r
⇒ ↑I
⇒ ↑Y at each value of P
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LM (M1/P1)
r
LM (M2/P1)
r1
r2
IS
Y2
Y
Y1
P
P1
AD2
AD1
Y
Y1
Y2
Fiscal policy and the AD curve
Expansionary fiscal policy (↑G and/or ↓T) increases aggregate demand:
↓T ⇒ ↑C
⇒ IS shifts right
⇒ ↑Y at each value of P
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r
LM
r2
r1
IS2
IS1
Y
Y2
Y1
P
P1
AD2
AD1
Y
Y2
Y1
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Table of Contents:
  1. INTRODUCTION:COURSE DESCRIPTION, TEN PRINCIPLES OF ECONOMICS
  2. PRINCIPLE OF MACROECONOMICS:People Face Tradeoffs
  3. IMPORTANCE OF MACROECONOMICS:Interest rates and rental payments
  4. THE DATA OF MACROECONOMICS:Rules for computing GDP
  5. THE DATA OF MACROECONOMICS (Continued…):Components of Expenditures
  6. THE DATA OF MACROECONOMICS (Continued…):How to construct the CPI
  7. NATIONAL INCOME: WHERE IT COMES FROM AND WHERE IT GOES
  8. NATIONAL INCOME: WHERE IT COMES FROM AND WHERE IT GOES (Continued…)
  9. NATIONAL INCOME: WHERE IT COMES FROM AND WHERE IT GOES (Continued…)
  10. NATIONAL INCOME: WHERE IT COMES FROM AND WHERE IT GOES (Continued…)
  11. MONEY AND INFLATION:The Quantity Equation, Inflation and interest rates
  12. MONEY AND INFLATION (Continued…):Money demand and the nominal interest rate
  13. MONEY AND INFLATION (Continued…):Costs of expected inflation:
  14. MONEY AND INFLATION (Continued…):The Classical Dichotomy
  15. OPEN ECONOMY:Three experiments, The nominal exchange rate
  16. OPEN ECONOMY (Continued…):The Determinants of the Nominal Exchange Rate
  17. OPEN ECONOMY (Continued…):A first model of the natural rate
  18. ISSUES IN UNEMPLOYMENT:Public Policy and Job Search
  19. ECONOMIC GROWTH:THE SOLOW MODEL, Saving and investment
  20. ECONOMIC GROWTH (Continued…):The Steady State
  21. ECONOMIC GROWTH (Continued…):The Golden Rule Capital Stock
  22. ECONOMIC GROWTH (Continued…):The Golden Rule, Policies to promote growth
  23. ECONOMIC GROWTH (Continued…):Possible problems with industrial policy
  24. AGGREGATE DEMAND AND AGGREGATE SUPPLY:When prices are sticky
  25. AGGREGATE DEMAND AND AGGREGATE SUPPLY (Continued…):
  26. AGGREGATE DEMAND AND AGGREGATE SUPPLY (Continued…):
  27. AGGREGATE DEMAND AND AGGREGATE SUPPLY (Continued…)
  28. AGGREGATE DEMAND AND AGGREGATE SUPPLY (Continued…)
  29. AGGREGATE DEMAND AND AGGREGATE SUPPLY (Continued…)
  30. AGGREGATE DEMAND IN THE OPEN ECONOMY:Lessons about fiscal policy
  31. AGGREGATE DEMAND IN THE OPEN ECONOMY(Continued…):Fixed exchange rates
  32. AGGREGATE DEMAND IN THE OPEN ECONOMY (Continued…):Why income might not rise
  33. AGGREGATE SUPPLY:The sticky-price model
  34. AGGREGATE SUPPLY (Continued…):Deriving the Phillips Curve from SRAS
  35. GOVERNMENT DEBT:Permanent Debt, Floating Debt, Unfunded Debts
  36. GOVERNMENT DEBT (Continued…):Starting with too little capital,
  37. CONSUMPTION:Secular Stagnation and Simon Kuznets
  38. CONSUMPTION (Continued…):Consumer Preferences, Constraints on Borrowings
  39. CONSUMPTION (Continued…):The Life-cycle Consumption Function
  40. INVESTMENT:The Rental Price of Capital, The Cost of Capital
  41. INVESTMENT (Continued…):The Determinants of Investment
  42. INVESTMENT (Continued…):Financing Constraints, Residential Investment
  43. INVESTMENT (Continued…):Inventories and the Real Interest Rate
  44. MONEY:Money Supply, Fractional Reserve Banking,
  45. MONEY (Continued…):Three Instruments of Money Supply, Money Demand