1macroeconomicsfifth editionN. Gregory MankiwPowerPoint®Slides by Ron CronovichCHAPTER ELEVENAggregate Demand IImacro © 2002 Worth Publishers, all rights reservedTopic 10:Aggregate Demand II(chapter 11) updated 11/15/06CHAPTER 11CHAPTER 11Aggregate Demand IIAggregate Demand IIslide 1The intersection determines the unique combination of Yand rthat satisfies equilibrium in both markets.The LMcurve represents money market equilibrium.Equilibrium in the Equilibrium in the ISIS--LMLMModelModelThe IScurve represents equilibrium in the goods market.()()YCY T I r G=−+ +(,)MP LrY=ISYrLMr1Y1CHAPTER 11CHAPTER 11Aggregate Demand IIAggregate Demand IIslide 2Policy analysis with the Policy analysis with the ISIS--LMLMModelModelPolicymakers can affect macroeconomic variables with • fiscal policy: Gand/or T• monetary policy: MWe can use the IS-LMmodel to analyze the effects of these policies.()()YCY T I r G=−++(, )MP LrY=ISYrLMr1Y12CHAPTER 11CHAPTER 11Aggregate Demand IIAggregate Demand IIslide 3causing output & income to rise. IS1An increase in government purchasesAn increase in government purchases1.IScurve shifts right Yrr1Y1by ___________2. This raises money demand, causing the interest rate to rise…3. …which reduces investment, so the final increase in Y∆−1is ________ than 1MPCGCHAPTER 11CHAPTER 11Aggregate Demand IIAggregate Demand IIslide 4IS11.A tax cutA tax cutYrLMr1Y1IS2Y2r2Because consumers save (1−MPC) of the tax cut, the initial boost in spending is smaller for ∆Tthan for an equal ∆G…and the IScurve shifts by__________1.2.2.…so the effects on rand Yare____________________________________. 2.CHAPTER 11CHAPTER 11Aggregate Demand IIAggregate Demand IIslide 52. …causing the interest rate to fall Monetary Policy: an increase in Monetary Policy: an increase in MM1. ∆M> 0 shifts the LMcurve down(or to the right)YrLM1r1Y13. …which increases investment, causing output & income to rise.3CHAPTER 11CHAPTER 11Aggregate Demand IIAggregate Demand IIslide 6Shocks in the Shocks in the ISIS--LMLMModelModelISshocks: exogenous changes in the _________________________. Examples: • stock market boom or crash⇒ change in households’ wealth⇒ ∆C• change in business or consumer confidence or expectations ⇒ ∆Iand/or ∆CCHAPTER 11CHAPTER 11Aggregate Demand IIAggregate Demand IIslide 7Shocks in the Shocks in the ISIS--LMLMModelModelLMshocks: exogenous changes in the _______________________. Examples:• a wave of credit card fraud increases demand for money• more ATMs or the Internet reduce money demandCHAPTER 11CHAPTER 11Aggregate Demand IIAggregate Demand IIslide 8CASE STUDYCASE STUDYThe 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%4CHAPTER 11CHAPTER 11Aggregate Demand IIAggregate Demand IIslide 9CASE STUDYCASE STUDYThe U.S. economic slowdown of 2001The U.S. economic slowdown of 2001~Shocks that contributed to the slowdown~1. ______________ From Aug 2000 to Aug 2001: -25%Week after 9/11: -12%2. The terrorist attacks on 9/11• increased uncertainty • ____________________Both shocks reduced spending and _____________________. CHAPTER 11CHAPTER 11Aggregate Demand IIAggregate Demand IIslide 10CASE STUDYCASE STUDYThe U.S. economic slowdown of 2001The U.S. economic slowdown of 2001~The policy response~1. Fiscal policy• large long-term ___________, immediate $300 rebate checks• _______________:aid to New York City & the airline industry,war on terrorism2. _______________• Fed lowered its Fed Funds rate target 11 times during 2001, from 6.5% to 1.75%• Money growth increased, interest rates fellCHAPTER 11CHAPTER 11Aggregate Demand IIAggregate Demand IIslide 11What is the FedWhat is the Fed’’s policy instrument?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 targetstargetsthe 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 curve and uses monetary policy to shift the LM curve as needed to attain its target rate. as needed to attain its target rate.5CHAPTER 11CHAPTER 11Aggregate Demand IIAggregate Demand IIslide 12What is the FedWhat is the Fed’’s policy instrument?s policy instrument?Why does the Fed target interest rates instead of the money supply?1) They are easier to measure than the money supply2) The Fed might believe that LMshocks are more prevalent than ISshocks. If so, then targeting the interest rate stabilizes income better than targeting the money supply. CHAPTER 11CHAPTER 11Aggregate Demand IIAggregate Demand IIslide 13ISIS--LM and Aggregate DemandLM and Aggregate Demand! So far, we’ve been using the IS-LMmodel to analyze the short run, when the price level is assumed fixed. ! However, a change in Pwould shift the LMcurve and therefore affect Y. ! The ______________________(introduced in chap. 9 ) captures this relationship between Pand YCHAPTER 11CHAPTER 11Aggregate Demand IIAggregate Demand IIslide 14Y1Deriving the Deriving the ADADcurvecurveYrYPISLM(P1)ADP1Y1r1Intuition for slope of ADcurve:↑P⇒ ↓(M/P)⇒LMshifts left⇒ ↑⇒ ↓⇒ ↓6CHAPTER 11CHAPTER 11Aggregate Demand IIAggregate Demand IIslide 15Monetary policy and the Monetary policy and the ADADcurvecurveYPISLM(M1/P1)AD1P1Y1Y1r1The Fed can increase aggregate demand:↑M⇒LMshifts rightYr⇒ ↓⇒ ↑⇒ ↑CHAPTER 11CHAPTER 11Aggregate Demand IIAggregate Demand IIslide 16Y1Y1r1Fiscal policy and the Fiscal policy and the ADADcurvecurveYrYPIS1LMAD1P1Expansionary fiscal policy (↑Gand/or ↓T ) increases agg. demand:↓T⇒ ↑⇒⇒ ↑Yat each value of PCHAPTER 11CHAPTER 11Aggregate Demand IIAggregate Demand IIslide 17Policy EffectivenessPolicy EffectivenessFiscal policy is effective (Ywill rise much) when:____________As the rise in Graises Y,the increase in money demand _____________so investment is not crowed out as much.LM’Y2’2’Y2IS22LMY1IS1r17CHAPTER 11CHAPTER 11Aggregate Demand IIAggregate Demand IIslide 18Policy EffectivenessPolicy EffectivenessMonetary policy is effective (Ywill rise much) when:__________As a rise in Mlowers the interest rate (r),_________________in