Slide 0ContextEquilibrium in the IS-LM ModelPolicy analysis with the IS-LM ModelAn increase in government purchasesA tax cutMonetary Policy: an increase in MShocks in the IS-LM ModelSlide 9CASE STUDY The U.S. economic slowdown of 2001Slide 11Slide 12What is the Fed’s policy instrument?Slide 14Recession of 2008-9Slide 16Slide 17Slide 18Slide 19Recall: IS curveRecall: LM CurveIS-LM and Aggregate DemandDeriving the AD curveMonetary policy and the AD curveFiscal policy and the AD curvePolicy EffectivenessSlide 27IS-LM and AD-AS in the short run & long runQuiz #4Answers to Quiz #4The SR and LR effects of an IS shockSlide 32Slide 33Slide 34Slide 35EXERCISE: Analyze SR & LR effects of MShort run for rise in MLong run: for rise in MThe Great DepressionSlide 39Great Depression: ObservationsSlide 41Slide 43The Spending Hypothesis: Shocks to the IS CurveThe Spending Hypothesis: Reasons for the IS shiftThe Money Hypothesis: A Shock to the LM CurveA revision to the Money HypothesisWhy another Depression is unlikelyChapter summarySlide 50macroeconomics fifth editionN. Gregory MankiwPowerPoint® Slides by Ron CronovichCHAPTER ELEVENAggregate Demand IImacro © 2002 Worth Publishers, all rights reservedTopic 10:Aggregate Demand II(chapter 11) updated 11/17/09CHAPTER 11CHAPTER 11 Aggregate Demand II Aggregate Demand IIslide 2ContextContextChapter 9 introduced the model of aggregate demand and supply. Chapter 10 developed the IS-LM model, the basis of the aggregate demand curve.In Chapter 11, we will use the IS-LM model to–see how policies and shocks affect income and the interest rate in the short run when prices are fixed–derive the aggregate demand curve–explore various explanations for the Great DepressionCHAPTER 11CHAPTER 11 Aggregate Demand II Aggregate Demand IIslide 3The intersection determines the unique combination of Y and r that satisfies equilibrium in both markets.The LM curve represents money market equilibrium.Equilibrium in the Equilibrium in the ISIS--LMLM ModelModelThe IS curve represents equilibrium in the goods market.( ) ( )Y C Y T I r G= - + +( , )M P L r Y=ISY rLMr1Y1CHAPTER 11CHAPTER 11 Aggregate Demand II Aggregate Demand IIslide 4Policy analysis with the Policy analysis with the ISIS--LMLM Model ModelPolicymakers can affect macroeconomic variables with •fiscal policy: G and/or T•monetary policy: MWe can use the IS-LM model to analyze the effects of these policies.( ) ( )Y C Y T I r G= - + +( , )M P L r Y=ISY rLMr1Y1CHAPTER 11CHAPTER 11 Aggregate Demand II Aggregate Demand IIslide 5causing output & income to rise. IS1An increase in government purchasesAn increase in government purchases1. IS curve shifts right Y rLMr1Y11by 1 MPCGD-IS2Y2r21.2. This raises money demand, causing the interest rate to rise…2.3. …which reduces investment, so the final increase in Y1is smaller than 1 MPCGD-3.CHAPTER 11CHAPTER 11 Aggregate Demand II Aggregate Demand IIslide 6IS11.A tax cutA tax cutY rLMr1Y1IS2Y2r2Because consumers save (1MPC) of the tax cut, the initial boost in spending is smaller for T than for an equal G… and the IS curve shifts byMPC1 MPCT-D-1.2.2.…so the effects on r and Y are smaller for a T than for an equal G. 2.CHAPTER 11CHAPTER 11 Aggregate Demand II Aggregate Demand IIslide 72. …causing the interest rate to fall ISMonetary Policy: an increase in Monetary Policy: an increase in MM1. M > 0 shifts the LM curve down(or to the right)Y rLM1r1Y1Y2r2LM23. …which increases investment, causing output & income to rise.CHAPTER 11CHAPTER 11 Aggregate Demand II Aggregate Demand IIslide 8Shocks in the Shocks in the ISIS--LMLM Model ModelIS shocks: exogenous changes in the demand for goods & services. Examples: •stock market boom or crash change in households’ wealth C •change in business or consumer confidence or expectations  I and/or CCHAPTER 11CHAPTER 11 Aggregate Demand II Aggregate Demand IIslide 9Shocks in the Shocks in the ISIS--LMLM Model ModelLM 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 demandCHAPTER 11CHAPTER 11 Aggregate Demand II Aggregate Demand IIslide 10CASE STUDYCASE STUDY The U.S. economic slowdown of 2001The U.S. economic slowdown of 2001 ~What happened~1. Real GDP growth rate1994-2000: 3.9% (average annual)2001: 1.2%2. Unemployment rateDec 2000: 4.0%Dec 2001: 5.8%CHAPTER 11CHAPTER 11 Aggregate Demand II Aggregate Demand IIslide 11CASE STUDYCASE STUDY The U.S. economic slowdown of 2001The U.S. economic slowdown of 2001 ~Shocks that contributed to the slowdown~1. Falling stock prices From Aug 2000 to Aug 2001: -25%Week after 9/11: -12%2. The terrorist attacks on 9/11•increased uncertainty •fall in consumer & business confidenceBoth shocks reduced spending and shifted the IS curve left.CHAPTER 11CHAPTER 11 Aggregate Demand II Aggregate Demand IIslide 12CASE STUDYCASE STUDY The U.S. economic slowdown of 2001The U.S. economic slowdown of 2001 ~The policy response~1. Fiscal policy•large long-term tax cut, immediate $300 rebate checks•spending increases:aid to New York City & the airline industry,war on terrorism2. Monetary policy•Fed lowered its Fed Funds rate target 11 times during 2001, from 6.5% to 1.75%•Money growth increased, interest rates fellCHAPTER 11CHAPTER 11 Aggregate Demand II Aggregate Demand IIslide 13What is the Fed’s policy instrument?What is the Fed’s policy instrument?What the newspaper says:“the Fed lowered interest rates by one-half point today”What actually happened:The Fed conducted expansionary monetary policy to shift the LM curve to the right until the interest rate fell 0.5 points. The Fed The Fed targetstargets the Federal Funds rate: the Federal Funds rate: it announces a target value, it announces a target value, and uses monetary policy to shift the LM and uses monetary policy to shift the LM curve curve as needed to attain its target rate. as needed to attain its target rate. The Fed The Fed targetstargets the Federal Funds rate: the Federal Funds rate: it announces a target value, it announces a target value, and uses monetary policy to shift the LM and uses monetary policy to shift the LM curve curve as needed to attain its target rate. as needed to attain its target rate.CHAPTER 11CHAPTER 11 Aggregate Demand II Aggregate Demand IIslide 14What is the Fed’s policy