2. 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 LM and therefore affect Y.
The aggregate demand curve captures this
relationship between P and Y.
3. Deriving the AD curve
Intuition for slope
of AD curve:
P (M/P)
LM shifts left
r
I
Y
4. Monetary policy and the AD curve
The Fed can increase
aggregate demand:
M LM shifts right
r
I
Y at each
value of P
5. Fiscal policy and the AD curve
Expansionary fiscal
policy (G and/or T)
increases agg. demand:
T C
IS shifts right
Y at each
value of P
6. IS-LM and AD-AS
in the short run & long run
The force that moves the economy from the short run
to the long run is the gradual adjustment of prices.
In the short-run
equilibrium, if
then over time, the
price level will
Y Y
rise
Y Y
fall
Y Y
remain constant
14. THE SPENDING HYPOTHESIS:
Shocks to the IS curve
•asserts that the Depression was largely due to an exogenous fall in the
demand for goods & services – a leftward shift of the IS curve.
•evidence:
output and interest rates both fell, which is what a leftward IS shift would
cause.
15. THE SPENDING HYPOTHESIS:
Reasons for the IS shift
Stock market crash exogenous C
◦ Oct-Dec 1929: S&P 500 fell 17%
◦ Oct 1929-Dec 1933: S&P 500 fell 71%
Drop in investment
◦ “correction” after overbuilding in the 1920s
◦ widespread bank failures made it harder to obtain financing for investment
Contractionary fiscal policy
◦ Politicians raised tax rates and cut spending to combat increasing deficits.
16. THE MONEY HYPOTHESIS:
A shock to the LM curve
• asserts that the Depression was largely due to huge fall in the money
supply.
• evidence:
M1 fell 25% during 1929-33.
• But two problems with this hypothesis:
◦ P fell even more, so M/P actually rose slightly during 1929-31.
◦ Interest rates fell, which is the opposite of what a leftward LM shift
would cause.
17. THE MONEY HYPOTHESIS:
The effects of falling prices
•asserts that the severity of the Depression was due to a huge deflation:
P fell 25% during 1929-33.
•This deflation was probably caused by the fall in M, so perhaps money
played an important role after all.
• Why was it not considered a problem?
18. THE MONEY HYPOTHESIS:
The effects of falling prices
The stabilizing effects of deflation:
P (M/P ) LM shifts right Y
Pigou effect:
P (M/P )
consumers’ wealth
C
IS shifts right
Y
19. THE MONEY HYPOTHESIS AGAIN:
The effects of falling prices
The destabilizing effects of unexpected deflation:
debt-deflation theory
P (if unexpected)
transfers purchasing power from borrowers to lenders
if borrowers’ propensity to spend is larger than lenders’, then
aggregate spending falls,
the IS curve shifts left, and Y falls
20. THE MONEY HYPOTHESIS AGAIN:
The effects of falling prices
•The destabilizing effects of expected deflation:
• When firms expect deflation, reluctant to borrow and invest
•They will have to repay the loan in more valuable money.
• I IS shifts left Y
21. Short run Aggregate Supply
We assumed the price level P was “stuck” in the short run.
◦ This implies a horizontal SRAS curve.
We relax that assumption by making SRAS upward sloping
22. Three Theories of SRAS
In each,
◦ some type of market imperfection
◦ result:
Output deviates from its natural rate
when the actual price level deviates
from the price level people expected.
23. What the 3 Theories Have in Common:
In all 3 theories, Y deviates from YN when
P deviates from PE.
24. 1. The sticky-price Theory
Reasons for sticky prices:
◦ long-term contracts between firms and customers
◦ menu costs
◦ firms not wishing to annoy customers with frequent
price changes
Assumption:
◦ Firms set their own prices
(e.g., as in monopolistic competition).
25. 1. The sticky-price Theory
An individual firm’s desired price is:
p P a Y Y
( )
where a > 0.
Suppose two types of firms:
• firms with flexible prices, set prices as above
• firms with sticky prices, must set their price
before they know how P and Y will turn out:
p EP a EY EY
( )
26. 1. The sticky-price Theory
p EP a EY EY
( )
Assume sticky price firms expect that output will equal its
natural rate. Then,
p EP
To derive the aggregate supply curve,
first find an expression for the overall price level.
s = fraction of firms with sticky prices.
Then, we can write the overall price level as…
27. 1. The sticky-price Theory
1
[ ] ( )[ ( )]
P s EP s P a Y Y
price set by sticky
price firms
price set by flexible
price firms
Subtract (1s)P from both sides:
1
[ ] ( )[ ( )]
sP s EP s a Y Y
Divide both sides by s:
1
( )
( )
s a
P EP Y Y
s
28. 1. The sticky-price Theory
1
( )
( )
s a
P EP Y Y
s
Finally, derive AS equation by solving for Y:
( ),
Y Y P EP
0
1
s
s a
where
( )
29. 2. The Sticky-Wage Theory
• Imperfection:
Nominal wages are sticky in the short run,
they adjust sluggishly.
◦ Due to labor contracts, social norms
• Firms and workers set the nominal wage in advance based on PE,
the price level they expect to prevail.
30. 2. The Sticky-Wage Theory
• If P > PE, labor cost (real wage) is lower.
Production is more profitable, so firms increase output and
employment.
• Hence, higher P causes higher Y, so the SRAS curve slopes upward.
31. 3. The Misperceptions Theory
•Imperfection:
Firms may confuse changes in P with changes
in the relative price of the products they sell.
•If P rises above PE, a firm sees its price rise before realizing all prices
are rising. The firm may believe its relative price is rising,
and may increase output and employment.
•So, an increase in P can cause an increase in Y, making the SRAS
curve upward-sloping.
32. What the 3 Theories Have in Common
In all 3 theories, Y deviates from YN when
P deviates from PE.
34. SRAS and LRAS
The imperfections in these theories are temporary. Over time,
◦ sticky wages and prices become flexible
◦ misperceptions are corrected
In the LR,
◦ PE = P
◦ AS curve is vertical
36. Why the SRAS Curve Might Shift
Everything that shifts LRAS
shifts SRAS, too.
Also, PE shifts SRAS:
If PE rises,
workers & firms set higher
wages.
At each P,
production is less
profitable, Y falls, SRAS
shifts left.
37. The Long-Run Equilibrium
In the long-run
equilibrium,
PE = P,
Y = YN ,
and unemployment is
at its natural rate.
38. The Effects of a Shift in AD
Event: Stock market crash
1. Affects C, AD curve
2. C falls, so AD shifts left
3. SR eq’m at B.
P and Y lower,
unemp higher
4. Over time, PE falls,
SRAS shifts right,
until LR eq’m at C.
Y and unemp back
at initial levels.
39. The Effects of a Shift in SRAS
Event: Oil prices rise
1. Increases costs,
shifts SRAS
(assume LRAS constant)
2. SRAS shifts left
3. SR eq’m at point B.
P higher, Y lower,
unemp higher. From A to B,
stagflation, a period of
falling output and rising
prices.
40. Accommodating an Adverse Shift in SRAS
If policymakers do nothing,
4. Low employment
causes wages to fall, SRAS
shifts right,
until LR eq’m at A.
Or, policymakers could
use fiscal or monetary
policy to increase AD
and accommodate the
AS shift:
Y back to YN, but
P permanently higher.
42. Fiscal Policy and Aggregate Supply
•Most economists believe the short-run effects of fiscal policy mainly
work through agg demand.
•But fiscal policy might also affect agg supply.
•A cut in the tax rate gives workers incentive to work more, so it
might increase the quantity of g&s supplied and shift AS to the right.
•People who believe this effect is large are called “Supply-siders.”
43. Fiscal Policy and Aggregate Supply
Govt purchases might affect agg supply. Example:
◦ Govt increases spending on roads.
◦ Better roads may increase business productivity, which increases
the quantity of g&s supplied, shifts AS to the right.
This effect is probably more relevant in the long run: it takes time to
build the new roads and put them into use.
44. The Case for Active Stabilization Policy
Keynes: “Animal spirits” cause waves of pessimism and optimism among
households and firms, leading to shifts in aggregate demand and
fluctuations in output and employment.
Also, other factors cause fluctuations, e.g.,
◦ booms and recessions abroad
◦ stock market booms and crashes
If policymakers do nothing, these fluctuations are destabilizing to
businesses, workers, consumers.
45. The Case for Active Stabilization Policy
Proponents of active stabilization policy believe the govt should use policy
to reduce these fluctuations:
◦ When GDP falls below its natural rate, use expansionary monetary or
fiscal policy to prevent or reduce a recession.
◦ When GDP rises above its natural rate, use contractionary policy to
prevent or reduce an inflationary boom.
46. The Case Against Active Stabilization
Policy
Monetary policy affects economy with a long lag:
◦ Firms make investment plans in advance, so I takes time to respond to
changes in r.
◦ Most economists believe it takes at least 6 months for monetary policy
to affect output and employment.
Fiscal policy also works with a long lag:
◦ Changes in G and T require discussions in cabinet/parliament.
◦ The legislative process can take months or years.
47. The Case Against Active Stabilization
Policy
•Due to these long lags, critics of active policy argue that such policies may
destabilize the economy rather than help it.
• By the time the policies affect agg demand, the economy’s condition may
have changed.
•These critics contend that policymakers should focus on long-run goals
like economic growth and low inflation.
49. Automatic Stabilizers: Examples
The tax system
◦ In recession, taxes fall automatically, which stimulates agg demand.
Govt spending
◦ In recession, more people apply for public assistance (welfare,
unemployment insurance).
◦ Govt spending on these programs automatically rises, which stimulates
agg demand.
