Lecture 7 Business Cycles 3 ISLM and ADAS

Lecture 7 Business Cycles (3) IS-LM and AD-AS

The Big Picture Keynesian Cross Theory of Liquidity Preference IS curve LM curve IS-LM model Agg. demand curve Agg. supply curve Explanation of short-run fluctuations Model of Agg. Demand Agg. Supply 1

The FE Line: Equilibrium in the Labor Market • Labor market showed how equilibrium in the labor market leads to employment at its full-employment level ( ) and output at its fullemployment level ( ) • If we plot output against the real interest rate, we get a vertical line, since labor market equilibrium is unaffected by changes in the real interest rate (Fig. 9. 1)

Figure 9. 1 The FE line

The FE Line • The full-employment line shifts right because of – a beneficial supply shock – an increase in labor supply – an increase in the capital stock • The full-employment line shifts left when the opposite happens to the three factors above

The IS curve def: a graph of all combinations of r and Y that result in goods market equilibrium, i. e. actual expenditure (output) = planned expenditure The equation for the IS curve is: (Investment depends on r) 5

Deriving the IS curve E =Y E =C +I (r )+G 2 E E =C +I (r 1 )+G r I E Y I r Y 1 Y Y 2 r 1 r 2 IS Y 1 Y 2 Y 6

Understanding the IS curve’s slope • The IS curve is negatively sloped. • Intuition: A fall in the interest rate motivates firms to increase investment spending, which drives up total planned spending (E ). To restore equilibrium in the goods market, output (actual expenditure, Y ) must increase. 7

Fiscal Policy and the IS curve • We can use the IS-LM model to see how fiscal policy (G and T ) can affect aggregate demand output. • Let’s start by using the Keynesian Cross to see how fiscal policy shifts the IS curve… 8

Shifting the IS curve: G At any value of r, G E Y E =C +I (r )+G 1 2 E E =C +I (r 1 )+G 1 …so the IS curve shifts to the right. The horizontal distance of the IS shift equals r Y 1 Y Y 2 r 1 Y Y 1 IS 1 Y 2 IS 2 Y 9

The IS curve and the Loanable Funds model (b) The IS curve (a) The L. F. model r S 2 r S 1 r 2 r 1 I (r ) S, I IS Y 2 Y 10

The Theory of Liquidity Preference • due to John Maynard Keynes. • A simple theory in which the interest rate is determined by money supply and money demand. 11

Equilibrium The interest rate adjusts to equate the supply and demand for money: r interest rate r 1 L (r ) M/P real money balances 12

How the Fed raises the interest rate r interest rate To increase r, Fed reduces M r 2 r 1 L (r ) M/P real money balances 13

The LM curve Now let’s put Y back into the money demand function: The LM curve is a graph of all combinations of r and Y that equate the supply and demand for real money balances. The equation for the LM curve is: 14

Deriving the LM curve (a) The market for r real money balances (b) The LM curve r LM r 2 r 1 r 2 L ( r , Y 2 ) r 1 L ( r , Y 1 ) M/P Y 1 Y 2 Y 15

Understanding the LM curve’s slope • The LM curve is positively sloped. • Intuition: An increase in income raises money demand. Since the supply of real balances is fixed, there is now excess demand in the money market at the initial interest rate. The interest rate must rise to restore equilibrium in the money market. 16

How M shifts the LM curve (a) The market for r real money balances (b) The LM curve r LM 2 LM 1 r 2 r 1 L ( r , Y 1 ) M/P Y 17

The short-run equilibrium is the combination of r and Y that simultaneously satisfies the equilibrium conditions in the goods & money markets: r LM IS Y Equilibrium interest rate Equilibrium level of income 18

Policy analysis • Fiscal Policy (IS curve) –Government purchases: G –Taxes: T • Monetary Policy (LM curve) –Money Supply: M 19

An increase in government purchases r 1. IS curve shifts right causing output & income to rise. 2. This raises money LM r 2 r 1 3. …which reduces investment, so the final increase in Y IS 2 1. demand, causing the interest rate to rise… IS 1 Y 2 Y 3. 20

A tax cut Because 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 by r LM r 2 2. r 1 1. IS 1 1. 2. …so the effects on r and Y are smaller for a T than for an equal G. IS 2 Y 1 Y 2. 21

Monetary Policy: an increase in M 1. M > 0 shifts the LM curve down (or to the right) 2. …causing the interest rate to fall 3. …which increases investment, causing output & income to rise. r LM 1 LM 2 r 1 r 2 IS Y 1 Y 22

Shocks in the IS-LM Model IS 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 C 23

Shocks in the IS-LM Model LM 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 demand 24

The U. S. economic slowdown of 2001 ~What happened~ 1. Real GDP growth rate 1994 -2000: 2001: 3. 9% (average annual) 1. 2% 2. Unemployment rate Dec 2000: Dec 2001: 4. 0% 5. 8% 25

The 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 confidence Both shocks reduced spending and shifted the IS curve left. 26

The 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 terrorism 2. Monetary policy • Fed lowered its Fed Funds rate target 11 times during 2001, from 6. 5% to 1. 75% • Money growth increased, interest rates fell 27

What is the Fed’s policy instrument? • The news media commonly report the Fed’s policy changes as interest rate changes, as if the Fed has direct control over market interest rates. • In fact, the Fed targets the federal funds rate – the interest rate banks charge one another on overnight loans. • The Fed changes the money supply and shifts the LM curve to achieve its target. • Other short-term rates typically move with the federal funds rate. 28

The Great Depression Unemployment (right scale) Real GNP (left scale) slide 29

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 slide 30

The Spending Hypothesis: Reasons for the IS shift 1. Stock market crash exogenous C § Oct-Dec 1929: S&P 500 fell 17% § Oct 1929 -Dec 1933: S&P 500 fell 71% 2. Drop in investment § “correction” after overbuilding in the 1920 s § widespread bank failures made it harder to obtain financing for investment 3. Contractionary fiscal policy § in the face of falling tax revenues and increasing deficits, politicians raised tax rates and cut spending slide 31

The Money Hypothesis: A Shock to the LM Curve • asserts that the Depression was largely due to huge fall in the money supply • evidence: M 1 fell 25% during 1929 -33. But, two problems with this hypothesis: 1. P fell even more, so M/P actually rose slightly during 1929 -31. 2. nominal interest rates fell, which is the opposite of what would result from a leftward LM shift. slide 32

The Money Hypothesis Again: 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. • In what ways does a deflation affect the economy? slide 33

The Money Hypothesis Again: 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 slide 34

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 borrowers spend less, lenders spend more if borrowers’ propensity to spend is larger than lenders, then aggregate spending falls, the IS curve shifts left, and Y falls slide 35

The Money Hypothesis Again: The Effects of Falling Prices The destabilizing effects of expected deflation: e slide 36 r for each value of i I because I = I (r ) planned expenditure & agg. demand income & output

Why another Depression is unlikely • Policymakers (or their advisors) now know much more about macroeconomics: § The Fed knows better than to let M fall so much, especially during a contraction. § Fiscal policymakers know better than to raise taxes or cut spending during a contraction. • Federal deposit insurance makes widespread bank failures very unlikely. • Automatic stabilizers make fiscal policy expansionary during an economic downturn. slide 37

Aggregate Production Function • The aggregate production function is written as the equation: Y = F(L, K, T ) 38

Long-Run Aggregate Supply • The macroeconomic long run is a time frame that is sufficiently long for all adjustments to be made so that real GDP equals potential GDP and there is full employment. • The long-run aggregate supply curve (LAS) is the relationship between the quantity of real GDP supplied and the price level when real GDP equals potential GDP. 39

Long-run Aggregate Supply This figure shows an LAS curve with potential GDP of $10 trillion. The LAS curve is vertical because potential GDP is independent of the price level. Along the LAS curve all prices and wage rates vary by the same percentage so that relative prices and the real wage rate remain constant. 40

Short-Run Aggregate Supply • The macroeconomic short run is a period during which real GDP has fallen below or risen above potential GDP. • At the same time, the unemployment rate has risen above or fallen below the natural unemployment rate. • The short-run aggregate supply curve (SAS) is the relationship between the quantity of real GDP supplied and the price level in the short-run when the money wage rate, the prices of other resources, and potential GDP remain constant. 41

Short-run Aggregate Supply • The figure shows a short-run aggregate supply curve. • Along the SAS curve, rise in the price level with no change in the money wage rate and other input prices increases the quantity of real GDP supplied—the SAS curve is upward sloping. 42

Short-run Aggregate Supply • The SAS curve is upward sloping because: • A rise in the price level with no change in costs induces firms to bear a higher marginal cost and increase production. • A fall in the price level with no change in costs induces firms to decrease production to lower marginal cost. 43

Short-run Aggregate Supply – Along the SAS curve, real GDP might be above potential GDP… – … or below potential GDP. 44

Changes in LAS • When potential GDP increases, both the LAS and SAS curves shift rightward. • Potential GDP changes, for three reasons – Change in the full-employment quantity of labor. – Change in the quantity of capital (physical or human). – Advance in technology. 45

Changes in LAS • The figure shows how these factors shift the LAS curve and have the same effect on the SAS curve. 46

Changes in SAS • The figure shows the effect of a change in the money wage rate on aggregate supply. • A rise in the money wage rate decreases short-run aggregate supply and shifts the SAS curve leftward. • But it has no effect on long-run aggregate supply. 47

Aggregate Demand • The quantity of real GDP demanded, Y, is the total amount of final goods and services produced that people, businesses, governments, and foreigners plan to buy. Y = C + I + G + X – M. 48

Aggregate Demand Curve 49

Changes in Aggregate Demand • The main influences on aggregate demand other than the price level are § Expectations § Fiscal and monetary policy § The world economy. 50

Changes in Aggregate Demand • The figure illustrates changes in aggregate demand. • When aggregate demand increases, the AD curve shifts rightward… • … and when aggregate demand decreases, the AD curve shifts leftward. 51

Macroeconomic Equilibrium • Short-Run Macroeconomic Equilibrium – Short-run macroeconomic equilibrium occurs when AD=SAS 52

Macroeconomic Equilibrium • Long-Run Macroeconomic Equilibrium – Long-run macroeconomic equilibrium occurs when real GDP equals potential GDP—when the economy is on its LAS curve. AD=SAS=LAS 53

Macroeconomic Equilibrium The figure illustrates longrun equilibrium. Long-run equilibrium occurs where the AD and LAS curves intersect and results when the money wage has adjusted to put the SAS curve through the long-run equilibrium point. 54

Economic Growth and Inflation 55

Fluctuations in Aggregate Demand 56

Fluctuations in Aggregate Demand – Firms increase production and rise prices—a movement along the SAS curve. 57

Fluctuations in Aggregate Demand – The money wage rate begins to rise and shortrun aggregate supply begins to decrease. – The SAS curve shifts leftward. – The price level rises and real GDP decreases until it has returned to potential GDP. 58

Fluctuations in Aggregate Supply • The figure shows the effects of a decrease in aggregate supply. • Starting at long-run equilibrium, a rise in the price of oil decreases short-run aggregate supply and the SAS curve shifts leftward. 59

Fluctuations in Aggregate Supply • Real GDP decreases and the price level rises. • The combination of recession combined with inflation is called stagflation. 60

U. S. Economic Growth, Inflation, and Cycles – The figure interprets the changes in real GDP and the price level each year from 1963 to 2003 in terms of shifting AD, SAS, and LAS curves. 61

U. S. Economic Growth, Inflation, and Cycles – The figure shows the business cycle, – … long-term economic growth, … – …. and inflation 62

U. S. Economic Growth, Inflation, and Cycles – From 1963 to 2003: – Real GDP and potential GDP grew from $2. 8 trillion to $10. 3 trillion. – The price level rose from 22 to 105. – Business cycle expansions alternated with recessions. 63

Deriving the AD curve r Intuition for slope of AD curve: P (M/P ) LM(P 2) LM(P 1) r 2 r 1 IS LM shifts left r P I P 2 Y P 1 Y 2 Y 1 Y AD Y 2 Y 1 Y 64

Monetary policy and the AD curve The Fed can increase aggregate demand: M LM shifts right r LM(M 1/P 1) LM(M 2/P 1) r 1 r 2 IS r I P Y at each value of P P 1 Y 1 Y 2 Y AD 2 AD 1 Y 65

Fiscal policy and the AD curve Expansionary fiscal policy ( G and/or T ) increases agg. demand: r LM r 2 r 1 IS 2 T C IS shifts right Y at each value of P IS 1 P Y 1 Y 2 Y P 1 Y 2 AD 1 Y 66

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 rise fall remain constant 67

The SR and LR effects of an IS shock r A negative IS shock shifts IS and AD left, causing Y to fall. LRAS LM(P ) 1 IS 2 IS 1 Y P P 1 LRAS SRAS 1 AD 2 Y 68

The SR and LR effects of an IS shock r LRAS LM(P ) 1 In the new short-run equilibrium, IS 2 IS 1 Y P P 1 LRAS SRAS 1 AD 2 Y 69

The SR and LR effects of an IS shock r LRAS LM(P ) 1 In the new short-run equilibrium, IS 2 Over time, P gradually falls, which causes • • SRAS to move down M/P to increase, which causes LM to move down IS 1 Y P P 1 LRAS SRAS 1 AD 2 Y 70

The SR and LR effects of an IS shock r LRAS LM(P ) 1 LM(P 2) IS 2 Over time, P gradually falls, which causes • • SRAS to move down M/P to increase, which causes LM to move down IS 1 Y P LRAS P 1 SRAS 1 P 2 SRAS 2 AD 1 AD 2 Y 71

The SR and LR effects of an IS shock r LRAS LM(P ) 1 LM(P 2) This process continues until economy reaches a long-run equilibrium with IS 2 IS 1 Y P LRAS P 1 SRAS 1 P 2 SRAS 2 AD 1 AD 2 Y 72

Aggregate Expenditure and Aggregate Demand • The aggregate expenditure curve is the relationship between aggregate planned expenditure and real GDP, with all other influences on aggregate planned expenditure remaining the same. • The aggregate demand curve is the relationship between the quantity of real GDP demanded and the price level, with all other influences on aggregate demand remaining the same. • They are actually the same thing, but expressed in different ways 73

Aggregate Expenditure and the Price Level – When the price level changes, a wealth effect and substitution effect change aggregate planned expenditure and change the quantity of real GDP demanded. – The figure on the next slide illustrates the effects of a change in the price level on the AE curve, equilibrium expenditure, and the quantity of real GDP demanded. 74

AE and AD A fall in price level from 110 to 85 shifts the AE curve from AE 0 upward to AE 2 and increases equilibrium real GDP from $10 trillion to $11 trillion. The same fall in the price level that raises equilibrium expenditure brings a movement along the AD curve to point C. 75

AE and AD • Points A, B, and C on the AD curve correspond to the equilibrium expenditure points A, B, and C at the intersection of the AE curve and the 45° line. 76

AE and AD • This figure illustrates the effects of an increase in autonomous expenditure. • An increase in autonomous expenditure shifts the aggregate expenditure curve upward and shifts the aggregate demand curve rightward by the multiplied increase in equilibrium expenditure. 77

AE and AD • Equilibrium Real GDP and the Price Level – This figure shows the effect of an increase in investment in the short run when the prices level changes and the economy moves along its SAS curve. 78

AE and AD – The increase in investment shifts the AE curve upward… … and shifts the AD curve rightward. With no change in the price level real GDP would increase to $12 trillion at point B. 79

AE and AD • The AD curve shifts rightward by the amount of the multiplier effect but equilibrium real GDP increases by less than this amount because the price level rises. 80

AE and AD • Real GDP increases from $10 trillion from $11. 3 trillion, instead of to $12 trillion as it does with a fixed price level. 81

AE and AD • This figure illustrates the long-run effects of an increase in autonomous expenditure at full employment. 82

AE and AD • If the increase in autonomous expenditure takes real GDP above potential GDP. • The money wage rate rises, the SAS curve shifts leftward, and real GDP decreases until it is back at potential real GDP. • The long-run multiplier is zero. 83

Ripple Effects of Monetary Policy – If the Fed increases the interest rate, three events follow: § Investment and consumption expenditures decrease. § The dollar rises and next exports decrease. § A multiplier process unfolds. 84

The Fed Eases to Avoid Recession – This figure illustrates the attempt to avoid recession. 85

The Fed Eases to Avoid Recession An increase in the money supply in part (a) lowers the interest rate. 86

The Fed Eases to Avoid Recession – The fall in the interest rate increases investment in part (b). 87

The Fed Eases to Avoid Recession The increase in investment shifts the AD curve rightward with a multiplier effect in part (c). 88

The Fed Eases to Avoid Recession – Real GDP increases and the price level rises. 89

Advantage and Limitation of Monetary Stabilization Policy • The size of the multiplier effect of monetary policy depends on the sensitivity of expenditure plans to the interest rate. • Advantage: No policy or law making lag 90

Long-Run Effects of Monetary Policy • In the long run, an increase in the quantity of money leaves real GDP unchanged but raises the price level. 91

The Classical Dichotomy Real variables are measured in physical units: quantities and relative prices, e. g. § quantity of output produced § real wage: output earned per hour of work § real interest rate: output earned in the future by lending one unit of output today Nominal variables: measured in money units, e. g. § nominal wage: dollars per hour of work § nominal interest rate: dollars earned in future by lending one dollar today § the price level: the amount of dollars needed to buy a representative basket of goods slide 92

The Classical Dichotomy • Classical Dichotomy : theoretical separation of real and nominal variables in the classical model, which implies nominal variables do not affect real variables. • Neutrality of Money : Changes in the money supply do not affect real variables. In the real world, money is approximately neutral in the long run. slide 93