Chapter 11 Aggregate Demand IIEquilibrium in the IS -LM modelShocks in the IS -LM modelShocks in the IS -LM modelAn increase in government purchasesA tax cutMonetary policy: An increase in MInteraction between monetary & fiscal policyThe Fed’s response to G > 0The Slopes of the IS and LM CurvesCASE STUDY: The U.S. recession of 2001CASE STUDY: The U.S. recession of 2001CASE STUDY: The U.S. recession of 2001CASE STUDY: The U.S. recession of 2001CASE STUDY: The U.S. recession of 2001IS-LM and aggregate demandDeriving the AD curveMonetary policy and the AD curveFiscal policy and the AD curveIS-LM and AD-AS in the short run & long runThe SR and LR effects of an IS shockThe SR and LR effects of an IS shockThe SR and LR effects of an IS shockThe SR and LR effects of an IS shockThe SR and LR effects of an IS shockNOW YOU TRY: Analyze SR & LR effects of MChapter 11 Aggregate Demand II In this chapter, we learn • how to use the IS-LM model to analyze the effects of shocks, fiscal policy, and monetary policy • how to derive the aggregate demand curve from the IS-LM modelThe 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 IS -LM model The IS curve represents equilibrium in the goods market. ( ) ()Y CY T I r G= −+ +(, )MP LrY=IS Y r LM r1 Y1Shocks in the IS -LM model IS shocks: exogenous changes in the demand for goods & services. Examples: – Increase in government spending or tax cut – stock market boom or crash ⇒ change in households’ wealth ⇒ ∆C – change in business or consumer confidence or expectations ⇒ ∆I and/or ∆CShocks in the IS -LM model LM shocks: exogenous changes in the supply of or demand for money. Examples: – Changes in money supply – a wave of credit card fraud increases demand for money. – more ATMs or the Internet reduce money demand.causing output & income to rise. IS1 An increase in government purchases 1. IS curve shifts right Y r LM r1 Y1 1by 1 MPCG∆−IS2 Y2 r2 1. 2. This raises money demand, causing the interest rate to rise… 2. 3. …which reduces investment, so the final increase in Y 1is smaller than 1 MPCG∆−3.IS1 1. A tax cut Y r LM r1 Y1 IS2 Y2 r2 Consumers save (1−MPC) of the tax cut, so the initial boost in spending is smaller for ∆T than for an equal ∆G… and the IS curve shifts by MPC1 MPCT−∆−1. 2. 2. …so the effects on r and Y are smaller for ∆T than for an equal ∆G. 2.2. …causing the interest rate to fall IS Monetary policy: An increase in M 1. ∆M > 0 shifts the LM curve down (or to the right) Y r LM1 r1 Y1 Y2 r2 LM2 3. …which increases investment, causing output & income to rise.Interaction between monetary & fiscal policy • Model: Monetary & fiscal policy variables (M, G, and T ) are exogenous. • Real world: Monetary policymakers may adjust M in response to changes in fiscal policy, or vice versa. • Such interaction may alter the impact of the original policy change.The Fed’s response to ∆G > 0 • Suppose Congress increases G. • Possible Fed responses: 1. hold M constant 2. hold r constant 3. hold Y constant • In each case, the effects of the ∆G are different…The Slopes of the IS and LM Curves • Determining factors for the slope of the IS curve: – The elasticity of investment with regard to r – The slope of the planned expenditure line • Determining factors for the slope of the LM curve: – The elasticity of money demand with regard to r – The elasticity of money demand with regard to Y – The slope of money supply curve • Examples of extreme casesCASE STUDY: The U.S. recession of 2001 • During 2001, – 2.1 million jobs lost, unemployment rose from 3.9% to 5.8%. – GDP growth slowed to 0.8% (compared to 3.9% average annual growth during 1994-2000).CASE STUDY: The U.S. recession of 2001 Causes: 1) Stock market decline ⇒ ↓C 300 600 900 1200 1500 1995 1996 1997 1998 1999 2000 2001 2002 2003 Index (1942 = 100) Standard & Poor’s 500CASE STUDY: The U.S. recession of 2001 Causes: 2) 9/11 – increased uncertainty – fall in consumer & business confidence – result: lower spending, IS curve shifted left Causes: 3) Corporate accounting scandals – Enron, WorldCom, etc. – reduced stock prices, discouraged investmentCASE STUDY: The U.S. recession of 2001 • Fiscal policy response: shifted IS curve right – tax cuts in 2001 and 2003 – spending increases • airline industry bailout • NYC reconstruction • Afghanistan warCASE STUDY: The U.S. recession of 2001 • Monetary policy response: shifted LM curve right Three-month T-Bill Rate 0 1 2 3 4 5 6 7IS-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 (introduced in Chap. 9) captures this relationship between P and Y.Y1 Y2 Deriving the AD curve Y r Y P IS LM(P1) LM(P2) AD P1 P2 Y2 Y1 r2 r1 Intuition for slope of AD curve: ↑P ⇒ ↓(M/P ) ⇒ LM shifts left ⇒ ↑r ⇒ ↓I ⇒ ↓YMonetary policy and the AD curve Y P IS LM(M2/P1) LM(M1/P1) AD1 P1 Y1 Y1 Y2 Y2 r1 r2 The Fed can increase aggregate demand: ↑M ⇒ LM shifts right AD2 Y r ⇒ ↓r ⇒ ↑I ⇒ ↑Y at each value of PY2 Y2 r2 Y1 Y1 r1 Fiscal policy and the AD curve Y r Y P IS1 LM AD1 P1 Expansionary fiscal policy (↑G and/or ↓T ) increases agg. demand: ↓T ⇒ ↑C ⇒ IS shifts right ⇒ ↑Y at each value of P AD2 IS2IS-LM and AD-AS in the short run & long run Recall from Chapter 9: The force that moves the economy from the short run to the long run is the gradual adjustment of prices. YY>YY<YY=rise fall remain constant In the short-run equilibrium, if then over time, the price level willThe SR and LR effects of an IS shock A negative IS shock shifts IS and AD left, causing Y to fall. Y r Y P LRAS YLRAS YIS1 SRAS1 P1 LM(P1) IS2 AD2 AD1The SR and LR effects of an IS shock Y r Y P LRAS YLRAS YIS1 SRAS1 P1 LM(P1) IS2 AD2 AD1 In the new short-run equilibrium, YY<The SR and LR effects of an IS shock Y r Y P LRAS YLRAS YIS1 SRAS1 P1 LM(P1) IS2 AD2 AD1 In the new short-run equilibrium, YY<Over time, P gradually falls, causing • SRAS to move