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- 1. Chapter Ten 1 A PowerPoint™Tutorial to Accompany macroeconomics, 5th ed. N. Gregory Mankiw ® Aggregate Demand
- 2. Chapter Ten 2 The Great Depression caused many economists to question the validity of classical economic theory (from Chapters 3-6). They believed they needed a new model to explain such a pervasive economic downturn and to suggest that government policies might ease some of the economic hardship that society was experiencing. In 1936, John Maynard Keynes wrote The General Theory of Employment, Interest and Money. In it, he proposed a new way to analyze the economy, which he presented as an alternative to the classical theory. Keynes proposed that low aggregate demand is responsible for the low income and high unemployment that characterize economic downturns. He criticized the notion that aggregate supply alone determines national income. The Great Depression caused many economists to question the validity of classical economic theory (from Chapters 3-6). They believed they needed a new model to explain such a pervasive economic downturn and to suggest that government policies might ease some of the economic hardship that society was experiencing. In 1936, John Maynard Keynes wrote The General Theory of Employment, Interest and Money. In it, he proposed a new way to analyze the economy, which he presented as an alternative to the classical theory. Keynes proposed that low aggregate demand is responsible for the low income and high unemployment that characterize economic downturns. He criticized the notion that aggregate supply alone determines national income.
- 3. Chapter Ten 3
- 4. Chapter Ten 4 ‘Keynesian’ means different things to different people. It’s useful to think of the basic textbook Keynesian model as an elaboration and extension of the ‘classical theory’. Its variable velocity of money and ‘sticky’ prices reflects Keynes’ belief that the Classical model’s shortcomings arose from its overly-strict assumptions of constant velocity and highly flexible wages and prices. The model of aggregate demand (AD) can be split into two parts: IS model of the ‘goods market’ and the LM model of the ‘money market’.
- 5. Chapter Ten 5 Price Level, P Income, Output, Y SRAS AD Y*Y*' AD' AD'' Y*'' In the short run, when the price level is fixed, shifts in the aggregate demand curve lead to changes in national income, Y. The model of aggregate demand developed in this chapter called the IS-LM is the leading interpretation of Keynes’ work. The IS-LM model takes the price level as given and shows what causes income to change. It shows what causes AD to shift. The Keynesian model can be viewed as showing what causes the aggregate demand curve to shift.
- 6. Chapter Ten 6 The IS curve (which stands for investment saving) plots the relationship between the interest rate and the level of income that arises in the market for goods and services. The LM curve (which stands for liquidity and money) plots the relationship between the interest rate and the level of income that arises in the money market.
- 7. Chapter Ten 7 In the General Theory of Money, Interest and Employment (1936), Keynes proposed that an economy’s total income was, in the short run, determined largely by the desire to spend by households, firms and the government. The more people want to spend, the more goods and services firms can sell. The more firms can sell, the more output they will choose to produce and the more workers they will choose to hire. Thus, the problem during recessions and depressions, according to Keynes, was inadequate spending. The Keynesian cross is an attempt to model this insight. In the General Theory of Money, Interest and Employment (1936), Keynes proposed that an economy’s total income was, in the short run, determined largely by the desire to spend by households, firms and the government. The more people want to spend, the more goods and services firms can sell. The more firms can sell, the more output they will choose to produce and the more workers they will choose to hire. Thus, the problem during recessions and depressions, according to Keynes, was inadequate spending. The Keynesian cross is an attempt to model this insight. Because the interest rate influences both investment and money demand, it is the variable that links the two parts of the IS-LM model. The model shows how interactions between these markets determine the position and slope of the aggregate demand curve, and therefore, the level of national income in the short run. Because the interest rate influences both investment and money demand, it is the variable that links the two parts of the IS-LM model. The model shows how interactions between these markets determine the position and slope of the aggregate demand curve, and therefore, the level of national income in the short run.
- 8. Chapter Ten 8 The Keynesian cross shows how income Y is determined for given levels of planned investment I and fiscal policy G and T. We can use this model to show how income changes when one of the exogenous variables change. Actual expenditure is the amount households, firms and the government spend on goods and services (GDP). Planned expenditure is the amount households, firms and the government would like to spend on goods and services. The economy is in equilibrium when: Actual Expenditure = Planned Expenditure or Y=E Expenditure, E Income, Output, Y Actual Expenditure, Y=E Planned Expenditure, E = C + I + G Y YY*
- 9. Chapter Ten 9 Expenditure, E Income, Output, Y Actual Expenditure, Y=E Planned Expenditure, E = C + I + G Y2 Y1Y* The 45-degree line (Y=E) plots the points where this condition holds. With the addition of the planned-expenditure function, this diagram becomes the Keynesian Cross. How does the economy get to this equilibrium? Inventories play an important role in the adjustment process. Whenever the economy is not in equilibrium, firms experience unplanned changes in inventories, and this induces them to change production levels. Changes in production in turn influence total income and expenditure, moving the economy toward equilibrium.
- 10. Chapter Ten 10 Consider how changes in government purchases affect the economy. Because government purchases are one component of expenditure, higher government purchases result in higher planned expenditure, for any given level of income.Expenditure, E Income, Output, Y Actual Expenditure, Y=E Planned Expenditure, E = C + I + G Y1Y* ∆G An increase in government purchases of ∆G raises planned expenditure by that amount for any given level of income. The equilibrium moves from A to B and income rises. Note that the increase in income Y exceeds the increase in government purchases ∆G. Thus, fiscal policy has a multiplied effect on income. A B
- 11. Chapter Ten 11 If government spending were to increase by $1, then you might expect equilibrium output (Y) to also rise by $1. But it doesn’t! The multiplier shows that the change in demand for output (Y) will be larger than the initial change in spending. Here’s why: When there is an increase in government spending (∆G), income rises by ∆G as well. The increase in income will raise consumption by MPC × ∆G, where MPC is the marginal propensity to consume. The increase in consumption raises expenditure and income again. The second increase in income of MPC × ∆G again raises consumption, this time by MPC × (MPC × ∆G), which again raises income and so on. So, the multiplier process helps explain fluctuations in the demand for output. For example, if something in the economy decreases investment spending, then people whose incomes have decreased will spend less, thereby driving equilibrium demand down even further.
- 12. Chapter Ten 12 The government-purchases multiplier is: ∆Y/∆G = 1 + MPC + MPC2 + MPC3 + … ∆Y/∆G = 1 / 1 - MPC The government-purchases multiplier is: ∆Y/∆G = 1 + MPC + MPC2 + MPC3 + … ∆Y/∆G = 1 / 1 - MPC The tax multiplier is: ∆Y/∆T = - MPC / (1 - MPC) The tax multiplier is: ∆Y/∆T = - MPC / (1 - MPC)
- 13. Chapter Ten 13 Let’s now add the relationship between the interest rate and investment to our model, writing the level of planned investment as: I = I (r). On the next slide, the investment function is graphed downward- sloping showing the inverse relationship between investment and the interest rate. To determine how income changes when the interest rate changes, we combine the investment function with the Keynesian-cross diagram. The IS curve summarizes this relationship between the interest rate and the level of income. In essence, the IS curve combines the interaction between I and Y demonstrated by the Keynesian cross. Because an increase in the interest rate causes planned investment to fall, which in turn causes income to fall, the IS curve slopes downward.
- 14. Chapter Ten 14 E Income, Output, Y Y=E Planned Expenditure, E = C + I + G r Income, Output, Y r Investment, I I(r) IS An increase in the interest rate (in graph a), lowers planned investment, which shifts planned expenditure downward (in graph b) and lowers income (in graph c). (a) (b) (c)
- 15. Chapter Ten 15 In summary, the IS curve shows the combinations of the interest rate and the level of income that are consistent with equilibrium in the market for goods and services. The IS curve is drawn for a given fiscal policy. Changes in fiscal policy that raise the demand for goods and services shift the IS curve to the right. Changes in fiscal policy that reduce the demand for goods and services shift the IS curve to the left. In summary, the IS curve shows the combinations of the interest rate and the level of income that are consistent with equilibrium in the market for goods and services. The IS curve is drawn for a given fiscal policy. Changes in fiscal policy that raise the demand for goods and services shift the IS curve to the right. Changes in fiscal policy that reduce the demand for goods and services shift the IS curve to the left.
- 16. Chapter Ten 16 r M/PM/P Supply Now that we’ve derived the IS part of AD, it’s now time to complete the model of AD by adding a money market equilibrium schedule, the LM curve. To develop this theory, we begin with the supply of real money balances (M/P); both of these variables are taken to be exogenously given. This yields a vertical supply curve. Now, consider the demand for real money balances, L. The theory of liquidity preference suggests that a higher interest rate lowers the quantity of real balances demanded, because r is the opportunity cost of holding money. Demand, L (r) The supply and demand for real money balances determine the interest rate. At the equilibrium interest rate, the quantity of money balances demanded equals the quantity supplied.
- 17. Chapter Ten 17 Money DemandMoney Demand equalsequals Real Money BalancesReal Money Balances L(r) = M/PL(r) = M/P
- 18. Chapter Ten 18 (M/P)d = L (r,Y)(M/P)d = L (r,Y) The quantity of real money balances demanded is negatively related to the interest rate (because r is the opportunity cost of holding money) and positively related to income (because of transactions demand).
- 19. Chapter Ten 19 r M/PM/P Supply Demand, L (r,Y) Since the price level is fixed, a reduction in the money supply reduces the supply of real balances. Notice the equilibrium interest rate rose. A Reduction in the Money Supply: -∆M/P Supply'
- 20. Chapter Ten 20 r M/PM/P Supply L (r,Y)' L (r,Y) r1 r2 r Y LM An increase in income raises money demand, which increases the interest rate; this is called an increase in transactions demand for money. The LM curve summarizes these changes in the money market equilibrium.
- 21. Chapter Ten 21 r M/P L (r,Y) r Y LM M/P Supply A contraction in the money supply raises the interest rate that equilibrates the money market. Why? Because a higher interest rate is needed to convince people to hold a smaller quantity of real balances. As a result of the decrease in the money supply, the LM shifts upward. r1 r1 M´/P Supply' LM' r2 r2
- 22. Chapter Ten 22 r Y LM(P0)IS r0 Y0 The intersection of the IS curve/equation, Y= C (Y-T) + I(r) + G and the LM curve/equation M/P = L(r, Y) determines the level of aggregate demand. The intersection of the IS and LM curves represents simultaneous equilibrium in the market for goods and services and in the market for real money balances for given values of government spending, taxes, the money supply, and the price level. The intersection of the IS curve/equation, Y= C (Y-T) + I(r) + G and the LM curve/equation M/P = L(r, Y) determines the level of aggregate demand. The intersection of the IS and LM curves represents simultaneous equilibrium in the market for goods and services and in the market for real money balances for given values of government spending, taxes, the money supply, and the price level.
- 23. Chapter Eleven 23 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 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
- 24. Chapter Eleven 24 IS-LM 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.
- 25. Chapter Eleven 25
- 26. Chapter Eleven 26 LMr Y IS A +∆G Consider an increase in government purchases. This will raise the level of income by ∆G/(1- MPC) IS´ B The IS curve shifts to the right by ∆G/(1- MPC) which raises income and the interest rate.
- 27. Chapter Eleven 27
- 28. Chapter Eleven 28 ISr Y LM A LM′ B +∆M Consider an increase in the money supply. The LM curve shifts downward and lowers the interest rate which raises income. Why? Because when the Fed increases the supply of money, people have more money than they want to hold at the prevailing interest rate. As a result, they start depositing this extra money in banks or use it to buy bonds. The interest rate r then falls until people are willing to hold all the extra money that the Fed has created; this brings the money market to a new equilibrium. The lower interest rate, in turn has ramifications for the goods market. A lower interest rate stimulates planned investment, which increases planned expenditure, production, and income Y.
- 29. Chapter Eleven 29 The IS-LM model shows that monetary policy influences income by changing the interest rate. This conclusion sheds light on our analysis of monetary policy in Chapter 9. In that chapter we showed that in the short run, when prices are sticky, an expansion in the money supply raises income. But, we didn’t discuss 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.
- 30. Chapter Eleven 30
- 31. Chapter Eleven 31 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. rr PP YY YY ISIS LM(PLM(P11)) AA AA ADAD To derive AD, start at point A in the top graph. Now increase the price level from P1 to P2. An increase in P lowers the value of real money balances, and Y, shifting LM leftward to point B. The +∆P triggers a sequence of events that end with a -∆Y, the inverse relationship that defines the downward slope of AD. 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 -∆I causes a –∆Y. The - ∆Y triggers -∆C as we move up the IS curve. LM(PLM(P22)) BB BBP2 P1
- 32. Chapter Eleven 32 +∆G This translates into a rightward shift of the IS and AD curves. LM (P2) Suppose there is a +∆G. In the short-run, we move along SRAS from point A to point B. But as the output market clears, in the long-run, the price level will increase from P0 to P2. This +∆P decreases the value of real money balances, which translates into a leftward shift of the LM curve. Finally, this leaves us at point C in both diagrams. r P Y Y IS LM(P0) AD P0 AD´ IS´ SRAS A A B B P2 C C LRAS Y = C (Y-T) + I(r) + G M/ P = L (r, Y)
- 33. Chapter Eleven 33 Now it’s time to determine the effects on the variables in the economy. For the variables Y, P, and r, you can read the effects right off the diagrams. Remember that SR is the movement from A to B. Remember that SR is the movement from A to B. +, because Y moved from Y* to Y´ 0, because prices are sticky in the SR. +, because a +∆Y leads to a rise in r as IS slides along the LM curve. +, because a +∆Y increases the level of consumption (↑C=C(↑Y-T)). – , since r increased, the level of investment decreased. YY PP rr CC II r P Y Y IS LM(P0) AD P0 AD´ IS´ SRAS A A B B P2 C C LRAS *Y Y´ LM(P2)
- 34. Chapter Eleven 34 +, in order to eliminate the excess demand at P0. 0, because rising P shifts LM to left, returning Y to Y* as required by long-run LRAS. +, reflecting the leftward shift in LM due to +∆P 0, since both Y and T are back to their initial levels (C=C(Y-T)) – – , since r has risen even more due to the +∆P. YY PP rr CC II For the variables Y, P and r, you can read the effects right off the diagrams. Remember that LR is the movement from A to C.Remember that LR is the movement from A to C. r P Y Y IS LM(P0) AD P0 AD´ IS´ SRAS A A B B P2 C C LRAS *Y Y´ LM(P2)
- 35. Chapter Eleven 35 LM′ B AD´ B Notice that M was increased, thus increasing the value of the real money supply which translates into a rightward shift of the LM and AD curves. Suppose there is a +∆M. Look at the appropriate equation that captures the M term: In the short-run, we move along SRAS from point A to point B. But as the output market clears, in the long-run, the price level will increase from P0 to P2. This +∆P decreases the value of the real money supply which translates into a leftward shift of the LM curve. Finally, this leaves us at point C in both diagrams. C AD ISr P Y Y LM(P0) P0 SRAS A A LRAS = C P2 M/ P = L (r, Y) M/ P = L (r, Y)
- 36. Chapter Eleven 36 Now it’s time to determine the effects on the variables in the economy. For the variables Y, P, and r, you can read the effects right off the diagrams. Remember that SR is the movement from A to B. +, because Y moved from Y* to Y´ 0, because prices are sticky in the SR. –, because a +∆Y leads to a decrease in r as LM slides along the IS curve. +, because a +∆Y increases the level of consumption (↑C=C(↑Y-T)). + , since r increased, the level of investment decreased. YY PP rr CC II LM′ B AD´ B C AD ISr P Y Y LM(P0) P0 SRAS A A LRAS = C P2 (P2) Y´Y*
- 37. Chapter Eleven 37 +, in order to eliminate the excess demand at P0. 0, because rising P shifts LM to left, returning Y to Y* as required by LRAS. 0, reflecting the leftward shift in LM due to +∆P, restoring r to its original level. 0, since both Y and T are back to their initial levels (C=C(Y-T)). 0, since Y or r has not changed. YY PP rr CC I For the variables Y, P and r, you can read the effects right off the diagrams. Remember that LR is the movement from A to C. Notice that the only LR impact of an increase in the money supply was an increase in the price level. LM′ B AD´ B C = C P2 AD ISr P Y Y LM(P0) P0 SRAS A A LRAS Y´Y*
- 38. Chapter Eleven 38
- 39. Chapter Eleven 39 LM(P0) 1) +1) +∆∆CC causes the IS curve to shiftcauses the IS curve to shift right to IS‘.right to IS‘. LRAS 2) This leads to a rightward shift in AD2) This leads to a rightward shift in AD to AD’.to AD’. Short Run:Short Run: Move from A to B.Move from A to B. Long Run:Long Run: Market clears at PMarket clears at P00 to Pto P22 from B to C.from B to C. 3) +3) +∆∆P causes LM(PP causes LM(P00) to shift leftward) to shift leftward to LM(Pto LM(P22) due to the lowering of the) due to the lowering of the real value of the money supply.real value of the money supply. rr YY PP YY IS AD IS' P0 AD' LRAS LM(P2) Α • • Α •Β •Β P2 • •C C Y = C (Y-T) + I(r) + G IS-LM M/ P = L (r, Y)
- 40. Chapter Eleven 40 Short Run: Y + P 0 r + C + I - Long Run: 0 + ++ + -- SRAS r Y P Y IS AD IS' P 0 AD' LRAS LM(P2) Α• •Α •Β •Β P 2 • •C C LM(P0)
- 41. Chapter Eleven 41 The spending hypothesis suggests that perhaps the cause of the decline may have been a contractionary shift of the IS curve. The money hypothesis attempts to explain the effects of the historical fall of the money supply of 25% from 1929 to 1933 during which time unemployment rose from 3.2% to 25.2.%. 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.
- 42. Chapter Eleven 42 LM Y IS A IS´ B An expected deflation (a negative value of πe ) 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. The level of income and the nominal interest rate (i) fall, but the real interest rate (r) rises. i2 r1 = i1 r2 interest rate, i
- 43. Chapter Ten 43 IS-LM Model IS Curve LM Curve Keynesian cross Government-purchases multiplier Tax multiplier Theory of liquidity preference Monetary transmission mechanism Pigou Effect Debt-deflation theory IS-LM Model IS Curve LM Curve Keynesian cross Government-purchases multiplier Tax multiplier Theory of liquidity preference Monetary transmission mechanism Pigou Effect Debt-deflation theory

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