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Transcript of CHAPTER TEN Aggregate Demand I macro - …abduls/econ5213/Pdf/ch10.pdfCHAPTER 10. Aggregate Demand...
macroeconomicsfifth edition
N. Gregory Mankiw
PowerPoint® Slides by Ron Cronovich
CHAPTER TEN
Aggregate Demand Im
acro
© 2002 Worth Publishers, all rights reserved
CHAPTER 10CHAPTER 10 Aggregate Demand IAggregate Demand I slide 1
In this chapter you will learnIn this chapter you will learnthe IS curve, and its relation to– the Keynesian Cross– the Loanable Funds model
the LM curve, and its relation to– the Theory of Liquidity Preference
how the IS-LM model determines income and the interest rate in the short run when P is fixed
CHAPTER 10CHAPTER 10 Aggregate Demand IAggregate Demand I slide 2
ContextContextChapter 9 introduced the model of aggregate demand and aggregate supply.
Long run– prices flexible– output determined by factors of production &
technology– unemployment equals its natural rate
Short run– prices fixed– output determined by aggregate demand– unemployment is negatively related to output
CHAPTER 10CHAPTER 10 Aggregate Demand IAggregate Demand I slide 3
ContextContextThis chapter develops the IS-LM model, the theory that yields the aggregate demand curve.
We focus on the short run and assume the price level is fixed.
CHAPTER 10CHAPTER 10 Aggregate Demand IAggregate Demand I slide 4
The Keynesian CrossThe Keynesian CrossA simple closed economy model in which income is determined by expenditure. (due to J.M. Keynes)
Notation: I = planned investmentE = C + I + G = planned expenditureY = real GDP = actual expenditure
Difference between actual & planned expenditure: unplanned inventory investment
CHAPTER 10CHAPTER 10 Aggregate Demand IAggregate Demand I slide 5
Elements of the Keynesian CrossElements of the Keynesian Crossconsumption function: ( )C C Y T= −
govt policy variables: ,G G T T= =
for now, investment is exogenous: I I=
planned expenditure: ( )E C Y T I G= − + +
Equilibrium condition:Actual expenditure Planned expenditure
Y E==
CHAPTER 10CHAPTER 10 Aggregate Demand IAggregate Demand I slide 6
Graphing planned expenditureGraphing planned expenditure
income, output, Y
E =C +I
MPC1
Eplanned
expenditure+G
CHAPTER 10CHAPTER 10 Aggregate Demand IAggregate Demand I slide 7
Graphing the equilibrium conditionGraphing the equilibrium condition
income, output, Y
E =Y
45º
Eplanned
expenditure
CHAPTER 10CHAPTER 10 Aggregate Demand IAggregate Demand I slide 8
The equilibrium value of incomeThe equilibrium value of income
income, output, Y
E =Y
E =C +I +G
Equilibrium income
Eplanned
expenditure
CHAPTER 10CHAPTER 10 Aggregate Demand IAggregate Demand I slide 9
An increase in government purchasesAn increase in government purchases
Y
E
E =YE =C +I +G1
E1 = Y1
E =C +I +G2
E2 = Y2∆Y
At Y1, there is now an unplanned drop in inventory…
∆G
…so firms increase output, and income rises toward a new equilibrium
CHAPTER 10CHAPTER 10 Aggregate Demand IAggregate Demand I slide 10
Solving for Solving for ∆∆YYY equilibrium conditionC I G= + +
Y C I G∆ = ∆ + ∆ + ∆ in changes
C G= ∆ + ∆ because I exogenous
MPC Y G= × ∆ + ∆ because ∆C = MPC ∆Y
(1 MPC) Y G− ×∆ = ∆
11 MPC
Y G ∆ = × ∆ −
Finally, solve for ∆Y :Collect terms with ∆Yon the left side of the equals sign:
CHAPTER 10CHAPTER 10 Aggregate Demand IAggregate Demand I slide 11
The government purchases multiplierThe government purchases multiplier
Example: MPC = 0.8
11 MPC
1 15
1 0 8 0 2. .
Y G
G G G
∆ = ∆−
= ∆ = ∆ = ∆−
The increase in G causes income to increase by 5 times as much!
CHAPTER 10CHAPTER 10 Aggregate Demand IAggregate Demand I slide 12
The government purchases multiplierThe government purchases multiplier
Definition: the increase in income resulting from a $1 increase in G.
In this model, the G multiplier equals1
1 MPCYG
∆=
∆ −
In the example with MPC = 0.8,
15
1 0.8YG
∆= =
∆ −
CHAPTER 10CHAPTER 10 Aggregate Demand IAggregate Demand I slide 13
Why the multiplier is greater than 1Why the multiplier is greater than 1Initially, the increase in G causes an equal increase in Y: ∆Y = ∆G.
But ↑Y ⇒ ↑ C
⇒ further ↑Y
⇒ further ↑C
⇒ further ↑Y
So the final impact on income is much bigger than the initial ∆G.
CHAPTER 10CHAPTER 10 Aggregate Demand IAggregate Demand I slide 14
An increase in taxesAn increase in taxes
Y
E
E =YE =C2 +I +G
E2 = Y2
E =C1 +I +G
E1 = Y1∆Y
At Y1, there is now an unplanned inventory buildup…
∆C = −MPC ∆T
Initially, the tax increase reduces consumption, and therefore E:
…so firms reduce output, and income falls toward a new equilibrium
CHAPTER 10CHAPTER 10 Aggregate Demand IAggregate Demand I slide 15
Solving for Solving for ∆∆YY
Y C I G∆ = ∆ + ∆ + ∆ eq’m condition in changes
I and G exogenousC= ∆
( )MPC Y T= × ∆ − ∆
(1 MPC) MPCY T− ×∆ = − × ∆Solving for ∆Y :
MPC1 MPC
Y T −∆ = × ∆ −
Final result:
CHAPTER 10CHAPTER 10 Aggregate Demand IAggregate Demand I slide 16
The Tax MultiplierThe Tax Multiplierdef: the change in income resulting from a $1 increase in T :
MPC1 MPC
YT
∆ −=
∆ −
If MPC = 0.8, then the tax multiplier equals
0 8 0 84
1 0 8 0 2. .. .
YT
∆ − −= = = −
∆ −
CHAPTER 10CHAPTER 10 Aggregate Demand IAggregate Demand I slide 17
The Tax MultiplierThe Tax Multiplier…is negative:A tax hike reduces consumer spending, which reduces income.
…is greater than one(in absolute value):
A change in taxes has a multiplier effect on income.
…is smaller than the govt spending multiplier:Consumers save the fraction (1-MPC) of a tax cut, so the initial boost in spending from a tax cut is smaller than from an equal increase in G.
CHAPTER 10CHAPTER 10 Aggregate Demand IAggregate Demand I slide 18
The Tax MultiplierThe Tax Multiplier…is negative:An increase in taxes reduces consumer spending, which reduces equilibrium income.
…is greater than one (in absolute value): A change in taxes has a multiplier effect on income.
…is smaller than the govt spending multiplier:Consumers save the fraction (1-MPC) of a tax cut, so the initial boost in spending from a tax cut is smaller than from an equal increase in G.
CHAPTER 10CHAPTER 10 Aggregate Demand IAggregate Demand I slide 19
Exercise:Exercise:
Use a graph of the Keynesian Cross to show the impact of an increase in investment on the equilibrium level of income/output.
CHAPTER 10CHAPTER 10 Aggregate Demand IAggregate Demand I slide 20
The The ISIS curvecurvedef: a graph of all combinations of r and Ythat result in goods market equilibrium,
i.e. actual expenditure (output) = planned expenditure
The equation for the IS curve is:
( ) ( )C Y T I r G= − + +Y
CHAPTER 10CHAPTER 10 Aggregate Demand IAggregate Demand I slide 21
Deriving the Deriving the ISIS curve
Y2Y1
Y2Y1 Y
E
r
Y
E =C +I (r1 )+G
E =C +I (r2 )+G
r1
r2
E =Y
IS
∆I
curve
↓r ⇒ ↑ I
⇒ ↑ E
⇒ ↑ Y
CHAPTER 10CHAPTER 10 Aggregate Demand IAggregate Demand I slide 22
Understanding the Understanding the ISIS curve’s slopecurve’s slope
The IS curve is negatively sloped.
Intuition:A fall in the interest rate motivates firms to increase investment spending, which drives up total planned spending (E ). To restore equilibrium in the goods market, output (a.k.a. actual expenditure, Y ) must increase.
CHAPTER 10CHAPTER 10 Aggregate Demand IAggregate Demand I slide 23
The IS The IS curve and the curve and the Loanable Loanable Funds modelFunds model
S, I
r
I (r )r1
r2
r
YY1
r1
r2
(a) The L.F. model
Y2
S1S2
IS
(b) The IS curve
CHAPTER 10CHAPTER 10 Aggregate Demand IAggregate Demand I slide 24
Fiscal Policy and the Fiscal Policy and the ISIS curvecurveWe can use the IS-LM model to see how fiscal policy (G and T ) can affect aggregate demand and output.
Let’s start by using the Keynesian Cross to see how fiscal policy shifts the IScurve…
CHAPTER 10CHAPTER 10 Aggregate Demand IAggregate Demand I slide 25
Shifting the Shifting the ISIS curve: curve: ∆∆G
Y2Y1
Y2Y1 Y
E
r
Y
E =C +I (r1 )+G1
E =C +I (r1 )+G2
r1
E =Y
IS1IS2
∆Y
G
At any value of r, ↑G ⇒ ↑ E ⇒ ↑ Y…so the IS curve shifts to the right.
The horizontal distance of the IS shift equals
11 MPC
Y G∆ = ∆−
CHAPTER 10CHAPTER 10 Aggregate Demand IAggregate Demand I slide 26
Exercise: Shifting the IS curveExercise: Shifting the IS curve
Use the diagram of the Keynesian Cross or Loanable Funds model to show how an increase in taxes shifts the IS curve.
CHAPTER 10CHAPTER 10 Aggregate Demand IAggregate Demand I slide 27
The Theory of Liquidity PreferenceThe Theory of Liquidity Preference
due to John Maynard Keynes.
A simple theory in which the interest rate is determined by money supply and money demand.
CHAPTER 10CHAPTER 10 Aggregate Demand IAggregate Demand I slide 28
Money SupplyMoney Supply
The supply of real money balances is fixed:
M/Preal money
balances
( )sM P
M P
rinterest
rate
( )sM P M P=
CHAPTER 10CHAPTER 10 Aggregate Demand IAggregate Demand I slide 29
Money DemandMoney Demand
Demand forreal money balances:
M/Preal money
balances
rinterest
rate( )sM P
M P
( ) ( )dM P L r=
L (r )
CHAPTER 10CHAPTER 10 Aggregate Demand IAggregate Demand I slide 30
EquilibriumEquilibrium
The interest rate adjusts to equate the supply and demand for money:
M/Preal money
balances
rinterest
rate( )sM P
M P
( )M P L r= L (r )
r1
CHAPTER 10CHAPTER 10 Aggregate Demand IAggregate Demand I slide 31
How the Fed raises the interest rateHow the Fed raises the interest rate
To increase r, Fed reduces M
M/Preal money
balances
rinterest
rate
1MP
L (r )
r1
r2
2MP
CHAPTER 10CHAPTER 10 Aggregate Demand IAggregate Demand I slide 32
CASE STUDY CASE STUDY Volcker’sVolcker’s Monetary TighteningMonetary Tightening
Late 1970s: π > 10%
Oct 1979: Fed Chairman Paul Volckerannounced that monetary policy would aim to reduce inflation.
Aug 1979-April 1980: Fed reduces M/P 8.0%
Jan 1983: π = 3.7%
How do you think this policy change would affect interest rates?
How do you think this policy change How do you think this policy change would affect interest rates? would affect interest rates?
CHAPTER 10CHAPTER 10 Aggregate Demand IAggregate Demand I slide 33
Volcker’sVolcker’s Monetary Tightening, Monetary Tightening, cont.cont.
∆i < 0∆i > 0
1/1983: i = 8.2%8/1979: i = 10.4%4/1980: i = 15.8%
flexiblesticky
Quantity Theory, Fisher Effect
(Classical)
Liquidity Preference(Keynesian)
prediction
actual outcome
The effects of a monetary tightening on nominal interest rates
prices
model
long runshort run
CHAPTER 10CHAPTER 10 Aggregate Demand IAggregate Demand I slide 34
The LM curveThe LM curve
Now let’s put Y back into the money demand function:
( )dM P L r Y= ( , )
The LM curve is a graph of all combinations of r and Y that equate the supply and demand for real money balances.
The equation for the LM curve is:
( , )M P L r Y=
CHAPTER 10CHAPTER 10 Aggregate Demand IAggregate Demand I slide 35
Deriving the LM curveDeriving the LM curve
M/P
r
1MP
L (r ,Y1 )
r1
r2
r
YY1
r1
L (r ,Y2 )
r2
Y2
LM
(a) The market for real money balances (b) The LM curve
CHAPTER 10CHAPTER 10 Aggregate Demand IAggregate Demand I slide 36
Understanding the Understanding the LMLM curve’s slopecurve’s slope
The LM curve is positively sloped.
Intuition:An increase in income raises money demand. Since the supply of real balances is fixed, there is now excess demand in the money market at the initial interest rate. The interest rate must rise to restore equilibrium in the money market.
CHAPTER 10CHAPTER 10 Aggregate Demand IAggregate Demand I slide 37
How How ∆∆MM shifts the LM curveshifts the LM curve
M/P
r
1MP
L (r ,Y1 )r1
r2
r
YY1
r1
r2
LM1
(a) The market for real money balances
2MP
LM2
(b) The LM curve
CHAPTER 10CHAPTER 10 Aggregate Demand IAggregate Demand I slide 38
Exercise: Shifting the LM curveExercise: Shifting the LM curve
Suppose a wave of credit card fraud causes consumers to use cash more frequently in transactions.
Use the Liquidity Preference model to show how these events shift the LM curve.
CHAPTER 10CHAPTER 10 Aggregate Demand IAggregate Demand I slide 39
The shortThe short--run equilibriumrun equilibrium
The short-run equilibrium is the combination of r and Ythat simultaneously satisfies the equilibrium conditions in the goods & money markets:
( ) ( )Y C Y T I r G= − + +
Y
r
( , )M P L r Y=
IS
LM
Equilibriuminterestrate
Equilibriumlevel ofincome
CHAPTER 10CHAPTER 10 Aggregate Demand IAggregate Demand I slide 40
The Big PictureThe Big Picture
KeynesianCross
IScurve
Theory of Liquidity Preference
LMcurve
IS-LMmodel Explanation
of short-run fluctuations
Agg. demand
curve Model of Agg.
Demand and Agg. Supply
Agg. supplycurve
CHAPTER 10CHAPTER 10 Aggregate Demand IAggregate Demand I slide 41
Chapter summaryChapter summary1. Keynesian Cross
basic model of income determinationtakes fiscal policy & investment as exogenousfiscal policy has a multiplied impact on income.
2. IS curvecomes from Keynesian Cross when planned investment depends negatively on interest rateshows all combinations of r and Y that equate planned expenditure with actual expenditure on goods & services
CHAPTER 10CHAPTER 10 Aggregate Demand IAggregate Demand I slide 42
Chapter summaryChapter summary3. Theory of Liquidity Preference
basic model of interest rate determinationtakes money supply & price level as exogenousan increase in the money supply lowers the interest rate
4. LM curvecomes from Liquidity Preference Theory when money demand depends positively on incomeshows all combinations of r andY that equate demand for real money balances with supply
CHAPTER 10CHAPTER 10 Aggregate Demand IAggregate Demand I slide 43
Chapter summaryChapter summary5. IS-LM model
Intersection of IS and LM curves shows the unique point (Y, r ) that satisfies equilibrium in both the goods and money markets.
CHAPTER 10CHAPTER 10 Aggregate Demand IAggregate Demand I slide 44
Preview of Chapter 11Preview of Chapter 11In Chapter 11, we will
use the IS-LM model to analyze the impact of policies and shockslearn how the aggregate demand curve comes from IS-LMuse the IS-LM and AD-AS models together to analyze the short-run and long-run effects of shockslearn about the Great Depression using our models
CHAPTER 10CHAPTER 10 Aggregate Demand IAggregate Demand I slide 45