Macroeconomics fifth edition N. Gregory Mankiw PowerPoint ® Slides by Ron Cronovich CHAPTER TEN Aggregate Demand I macro © 2004 Worth Publishers, all rights

macroeconomics fifth edition

N. Gregory Mankiw

PowerPoint® Slides by Ron Cronovich

CHAPTER TEN

Aggregate Demand Im

acro

© 2004 Worth Publishers, all rights reserved

CHAPTER 10CHAPTER 10 Aggregate Demand I Aggregate Demand I slide 2

The Big PictureThe Big Picture

KeynesianCross

Theory of Liquidity Preference

IScurve

LM curve

IS-LMmodel

Agg. demand

curve

Agg. supplycurve

Model of Agg.

Demand and Agg. Supply

Explanation of short-run fluctuations


ContextContext

Chapter 9 introduced the model of aggregate demand and aggregate supply.

Long run– prices flexible– output determined by factors of production

& technology– unemployment equals its natural rate

Short run– prices fixed– output determined by aggregate demand– unemployment is negatively related to

output


ContextContext

This chapter develops the IS-LM model, the theory that yields the aggregate demand curve.

We focus on the short run and assume the price level is fixed.

This chapter (and chapter 11) focus on the closed-economy case. Chapter 12 presents the open-economy case.


The Keynesian CrossThe Keynesian Cross

A simple closed economy model in which income is determined by expenditure. (due to J.M. Keynes)

Notation: I = planned investmentE = C + I + G = planned expenditureY = real GDP = actual expenditure

Difference between actual & planned expenditure: unplanned inventory investment


Elements of the Keynesian CrossElements of the Keynesian Cross

( )C C Y T

I I

,G G T T

( )E C Y T I G

Actual expenditure Planned expenditure

Y E

consumption function:

for now, plannedinvestment is exogenous:

planned expenditure:Equilibrium condition:

govt policy variables:


Graphing planned expenditureGraphing planned expenditure

income, output, Y

E

planned

expenditure

E =C +I +G

MPC1


Graphing the equilibrium conditionGraphing the equilibrium condition

income, output, Y

E

planned

expenditure

E =Y

45º


The equilibrium value of incomeThe equilibrium value of income

income, output, Y

E

planned

expenditure

E =Y

E =C +I +G

Equilibrium income


An increase in government purchasesAn increase in government purchases

Y

E

E =Y

E =C +I +G1

E1 = Y1

E =C +I +G2

E2 = Y2Y

At Y1,

there is now an unplanned drop in inventory…

…so firms increase output, and income rises toward a new equilibrium

G


Solving for Solving for YY

Y C I G

Y C I G

MPC Y G

C G

(1 MPC) Y G

11 MPC

Y G

equilibrium conditionin changes

because I exogenousbecause C = MPC Y

Collect terms with Y on the left side of the equals sign:

Finally, solve for Y :


The government purchases multiplierThe government purchases multiplier

Example: If MPC = 0.8, then

Definition: the increase in income resulting from a $1 increase in G.

In this model, the govt purchases multiplier equals 1

1 MPCYG

15

1 0.8YG

An increase in G causes income to

increase by 5 times as much!


Why the multiplier is greater than 1Why the multiplier is greater than 1

Initially, the increase in G causes an equal increase in Y: Y = G.

But Y C

further Y

further C

further Y

So the final impact on income is much bigger than the initial G.


An increase in taxesAn increase in taxes

Y

E

E =Y

E =C2 +I +G

E2 = Y2

E =C1 +I +G

E1 = Y1Y

At Y1, there is now

an unplanned inventory buildup……so firms

reduce output, and income falls toward a new equilibrium

C = MPC T

Initially, the tax increase reduces consumption, and therefore E:


Solving for Solving for YY

Y C I G

MPC Y T

C

(1 MPC) MPCY T

eq’m condition in changes

I and G exogenous

Solving for Y :

MPC1 MPC

Y T

Final result:


The Tax MultiplierThe Tax Multiplier

def: the change in income resulting from a $1 increase in T :

MPC1 MPC

YT

0 8 0 84

1 0 8 0 2. .. .

YT

If MPC = 0.8, then the tax multiplier equals


The Tax MultiplierThe Tax Multiplier…is negative: A tax hike reduces consumer spending, which reduces income.

…is greater than one (in absolute value): A change in taxes has a multiplier effect on income.

…is smaller than the govt spending multiplier: Consumers save the fraction (1-MPC) of a tax cut,

so the initial boost in spending from a tax cut is smaller than from an equal increase in G.


Exercise:Exercise:

Use a graph of the Keynesian Cross to show the impact of an increase in planned investment on the equilibrium level of income/output.


The The ISIS curve 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:

( ) ( )Y C Y T I r G


Y2Y1

Y2Y1

Deriving the Deriving the ISIS curve curve

r I

Y

E

r

Y

E =C +I (r1 )+G

E =C +I (r2 )+G

r1

r2

E =Y

IS

I E

Y


Why the Why the ISIS curve is negatively sloped curve is negatively sloped

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 (a.k.a. actual expenditure, Y ) must increase.


The IS curve and the Loanable Funds modelThe IS curve and the Loanable Funds model

S, I

r

I (r ) r1

r2

r

YY1

r1

r2

(a) The L.F. model (b) The IS curve

Y2

S1S2

IS


Fiscal Policy and the Fiscal Policy and the ISIS curve curve

We can use the IS-LM model to see how fiscal policy (G and T ) can affect aggregate demand and output.

Let’s start by using the Keynesian Cross to see how fiscal policy shifts the IS curve…


Y2Y1

Y2Y1

Shifting the Shifting the ISIS curve: curve: GG

At any value of

r, G E Y

Y

E

r

Y

E =C +I (r1 )+G1

E =C +I (r1 )+G2

r1

E =Y

IS1

The horizontal distance of the

IS shift equals IS2

…so the IS curve shifts to the right.

11 MPC

Y G

Y


Exercise: Shifting the IS curveExercise: Shifting the IS curve

Use the diagram of the Keynesian Cross or Loanable Funds model to show how an increase in taxes shifts the IS curve.


The Theory of Liquidity PreferenceThe 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.


Money SupplyMoney Supply

The supply of real money balances is fixed:

sM P M P

M/P real money

balances

rinterest

rate sM P

M P


Money DemandMoney Demand

Demand forreal money balances:

M/P real money

balances

rinterest

rate sM P

M P

( )d

M P L r

L (r )


EquilibriumEquilibrium

The interest rate adjusts to equate the supply and demand for money:

M/P real money

balances

rinterest

rate sM P

M P

( )M P L r L (r )

r1


How the Fed raises the interest rateHow the Fed raises the interest rate

To increase r, Fed reduces M

M/P real money

balances

rinterest

rate

1M

P

L (r )

r1

r2

2M

P


CASE STUDY CASE STUDY

Volcker’s Monetary TighteningVolcker’s Monetary Tightening Late 1970s: > 10%

Oct 1979: Fed Chairman Paul Volcker announced that monetary policy would aim to reduce inflation.

Aug 1979-April 1980: Fed reduces M/P 8.0%

Jan 1983: = 3.7%

How do you think this policy change How do you think this policy change would affect interest rates? would affect interest rates?

How do you think this policy change How do you think this policy change would affect interest rates? would affect interest rates?


Volcker’s Monetary Tightening, Volcker’s Monetary Tightening, cont.cont.

i < 0i > 0

1/1983: i = 8.2%8/1979: i = 10.4%4/1980: i = 15.8%

flexiblesticky

Quantity Theory, Fisher Effect

(Classical)

Liquidity Preference(Keynesian)

prediction

actual outcome

The effects of a monetary tightening on nominal interest rates

prices

model

long runshort run


The LM curveThe LM curve

Now let’s put Y back into the money demand function:

( , )M P L r Y

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:

dM P L r Y ( , )


Deriving the LM curveDeriving the LM curve

M/P

r

1M

P

L (r ,

Y1 )

r1

r2

r

YY1

r1

L (r ,

Y2 )

r2

Y2

LM

(a) The market for real money balances

(b) The LM curve


Why the Why the LMLM curve is upward-sloping curve is upward-sloping

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.


How How MM shifts the LM curve shifts the LM curve

M/P

r

1M

P

L (r , Y1 ) r1

r2

r

YY1

r1

r2

LM1

(a) The market for real money balances

(b) The LM curve

2M

P

LM2


Exercise: Shifting the LM curveExercise: Shifting the LM curve

Suppose a wave of credit card fraud causes consumers to use cash more frequently in transactions.

Use the Liquidity Preference model to show how these events shift the LM curve.


The short-run equilibriumThe short-run equilibrium

The short-run equilibrium is the combination of r and Y that simultaneously satisfies the equilibrium conditions in the goods & money markets:

( ) ( )Y C Y T I r G

Y

r

( , )M P L r Y

IS

LM

Equilibriuminterestrate

Equilibriumlevel ofincome


The Big PictureThe Big Picture

KeynesianCross

Theory of Liquidity Preference

IScurve

LM curve

IS-LMmodel

Agg. demand

curve

Agg. supplycurve

Model of Agg.

Demand and Agg. Supply

Explanation of short-run fluctuations


Chapter summaryChapter summary

1.Keynesian Cross basic model of income determination takes fiscal policy & investment as exogenous fiscal policy has a multiplier effect on income.

2. IS curve comes from Keynesian Cross when planned

investment depends negatively on interest rate

shows all combinations of r and Y that equate planned expenditure with actual expenditure on goods & services



3.Theory of Liquidity Preference basic model of interest rate determination takes money supply & price level as exogenous an increase in the money supply lowers the

interest rate

4. LM curve comes from Liquidity Preference Theory when

money demand depends positively on income shows all combinations of r andY that equate

demand for real money balances with supply



5. IS-LM model Intersection of IS and LM curves shows

the unique point (Y, r ) that satisfies equilibrium in both the goods and money markets.


Preview of Chapter 11Preview of Chapter 11

In Chapter 11, we will use the IS-LM model to analyze the

impact of policies and shocks learn how the aggregate demand

curve comes from IS-LM use the IS-LM and AD-AS models

together to analyze the short-run and long-run effects of shocks

use our models to learn about the Great Depression



N. Gregory Mankiw


CHAPTER TEN

Aggregate Demand Im

acro



ContextContext

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 Depression


The 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 ModelModel

The IS curve represents equilibrium in the goods market.

( ) ( )Y C Y T I r G

( , )M P L r Y ISY

rLM

r1

Y1


Policy analysis with the Policy analysis with the ISIS--LMLM Model Model

Policymakers can affect macroeconomic variables with • fiscal policy: G and/or

T• monetary policy: M

We 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

rLM

r1

Y1


causing output & income to rise.

IS1

An increase in government purchasesAn increase in government purchases

1. IS curve shifts right

Y

rLM

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 cutA tax cut

Y

rLM

r1

Y1

IS2

Y2

r2

Because consumers save (1MPC) of the tax cut, the initial boost in spending is smaller for T than for an equal G…

and the IS curve shifts by

MPC1 MPC

T

1.

2.

2.…so the effects on r and Y are smaller for a T than for an equal G.

2.


2. …causing the interest rate to fall

IS

Monetary Policy: an increase in Monetary Policy: an increase in MM

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 Interaction between monetary & fiscal policymonetary & 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 The Fed’s response to GG > 0 > 0

Suppose Congress increases G.

Possible Fed responses:1. hold M constant2. hold r constant3. hold Y constant

In each case, the effects of the G are different:


If Congress raises G, the IS curve shifts right

IS1

Response 1: hold Response 1: hold MM constant constant

Y

rLM1

r1

Y1

IS2

Y2

r2If Fed holds M constant, then LM curve doesn’t shift.

Results:2 1Y Y Y

2 1r r r



IS1

Response 2: hold Response 2: hold rr constant constant

Y

rLM1

r1

Y1

IS2

Y2

r2To keep r constant, Fed increases M to shift LM curve right.

3 1Y Y Y

0r

LM2

Y3

Results:



IS1

Response 3: hold Response 3: hold YY constant constant

Y

rLM1

r1

IS2

Y2

r2To keep Y constant, Fed reduces M to shift LM curve left.

0Y

3 1r r r

LM2

Results:

Y1

r3


Estimates of fiscal policy multipliersEstimates of fiscal policy multipliers

from the DRI macroeconometric model

Assumption about monetary policy

Estimated value of

Y / G

Fed holds nominal interest rate constant

Fed holds money supply constant

1.93

0.60

Estimated value of

Y / T

1.19

0.26


Shocks in the Shocks in the ISIS--LMLM Model 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


Shocks in the Shocks in the ISIS--LMLM Model 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


EXERCISE:EXERCISE: Analyze shocks with the IS-LM modelAnalyze shocks with the IS-LM modelUse the IS-LM model to analyze the effects of

1. A boom in the stock market makes consumers wealthier.

2. After a wave of credit card fraud, consumers use cash more frequently in transactions.

For each shock, a. use the IS-LM diagram to show the effects

of the shock on Y and r .b. determine what happens to C, I, and the

unemployment rate.


CASE STUDYCASE STUDY The U.S. economic slowdown of 2001The U.S. economic slowdown of 2001

~What happened~1. Real GDP growth rate

1994-2000: 3.9% (average annual)2001: 0.8% for the year,

March 2001 determined to be the end of the longest expansion on record.

2. Unemployment rateDec 2000: 3.9%

Dec 2001: 5.8%The number of unemployed people rose by 2.1 million during 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.



~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



~The recovery~

The recession officially ended in November 2001.

Real GDP recovered, growing 2.3% in 2002 and 4.4% in 2003.

The unemployment rate lagged: 5.8% in 2002, 6.0% in 2003.

The Fed cut interest rates in 11/02 and 6/03.

Unemployment finally appears to be responding: 5.6% for the first half of 2004.


What 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.


What is the Fed’s policy instrument?What is the Fed’s policy instrument?

Why does the Fed target interest rates instead of the money supply?

1)They are easier to measure than the money supply

2)The Fed might believe that LM shocks are more prevalent than IS shocks. If so, then targeting the interest rate stabilizes income better than targeting the money supply. (See Problem 7 on p.306)


IS-LM and Aggregate DemandIS-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 the LM curve and therefore affect Y.

The aggregate demand curve (introduced in chap. 9 ) captures this relationship between P and Y


Y1Y2

Deriving the Deriving the ADAD curve 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

Y


Monetary policy and the Monetary policy and the ADAD curve 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 P


Y2

Y2

r2

Y1

Y1

r1

Fiscal policy and the Fiscal policy and the ADAD curve 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

IS2


IS-LMIS-LM and and AD-AS AD-AS in the short run & long runin 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.

Y Y

Y Y

Y Y

rise

fall

remain constant

In the short-run equilibrium, if

then over time, the price level

will


The SR and LR effects of an The SR and LR effects of an ISIS shock shock

A negative IS shock shifts IS and AD left, causing Y to fall. Y

r

Y

P LRAS

Y

LRAS

Y

IS1

SRAS1P1

LM(P1)

IS2

AD2

AD1



Y

r

Y

P LRAS

Y

LRAS

Y

IS1

SRAS1P1

LM(P1)

IS2

AD2

AD1

In the new short-run equilibrium, Y Y



Y

r

Y

P LRAS

Y

LRAS

Y

IS1

SRAS1P1

LM(P1)

IS2

AD2

AD1

In the new short-run equilibrium, Y Y

Over time, P gradually falls, which causes• SRAS to move

down• M/P to increase,

which causes LM to move down


AD2


Y

r

Y

P LRAS

Y

LRAS

Y

IS1

SRAS1P1

LM(P1)

IS2

AD1

Over time, P gradually falls, which causes• SRAS to move

down• M/P to increase,

which causes LM to move down

SRAS2P2

LM(P2)


AD2

SRAS2P2

LM(P2)


Y

r

Y

P LRAS

Y

LRAS

Y

IS1

SRAS1P1

LM(P1)

IS2

AD1

This process continues until economy reaches a long-run equilibrium with Y Y


EXERCISE:EXERCISE: Analyze SR & LR effects of Analyze SR & LR effects of MM

a.Draw the IS-LM and AD-AS diagrams as shown here.

b.Suppose Fed increases M. Show the short-run effects on your graphs.

c. Show what happens in the transition from the short run to the long run.

d.How do the new long-run equilibrium values of the endogenous variables compare to their initial values?

Y

r

Y

P LRAS

Y

LRAS

Y

IS

SRAS1P1

LM(M1/P1)

AD1


The Great DepressionThe Great Depression

120

140

160

180

200

220

240

1929 1931 1933 1935 1937 1939

bill

ion

s o

f 19

58

do

llars

0

5

10

15

20

25

30

pe

rce

nt o

f la

bo

r fo

rce

120

140

160

180

200

220

240

1929 1931 1933 1935 1937 1939

bill

ion

s o

f 19

58

do

llars

0

5

10

15

20

25

30

pe

rce

nt o

f la

bo

r fo

rce

Unemployment (right scale)

Real GNP(left scale)


The Spending Hypothesis: The Spending Hypothesis: Shocks to the IS CurveShocks 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


The Spending Hypothesis: The Spending Hypothesis: Reasons for the IS shiftReasons 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

1920s 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


The Money Hypothesis: The Money Hypothesis: A Shock to the LM CurveA 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: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.


The Money Hypothesis Again: The Money Hypothesis Again: The Effects of Falling PricesThe 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?



The stabilizing effects of deflation:

P (M/P ) LM shifts right Y

Pigou effect:

P (M/P )

consumers’ wealth

C

IS shifts right

Y



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



The destabilizing effects of expected deflation:

e

r for each value of i I because I = I (r ) planned expenditure & agg.

demand income & output


Why another Depression is unlikelyWhy 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.



1. IS-LM model

a theory of aggregate demand

exogenous: M, G, T, P exogenous in short run, Y in long run

endogenous: r, Y endogenous in short run, P in long run

IS curve: goods market equilibrium

LM curve: money market equilibrium



2. AD curve

shows relation between P and the IS-LM

model’s equilibrium Y.

negative slope because P (M/P ) r I Y

expansionary fiscal policy shifts IS curve right, raises income, and shifts AD curve right

expansionary monetary policy shifts LM

curve right, raises income, and shifts AD

curve right IS or LM shocks shift the AD curve



N. Gregory Mankiw


CHAPTER TEN

Aggregate Demand Im

acro


CHAPTER TWELVE

Aggregate Demand in the Open Economy


Learning objectivesLearning objectives

The Mundell-Fleming model: IS-LM for the small open economy

Causes and effects of interest rate differentials

Arguments for fixed vs. floating exchange rates

The aggregate demand curve for the small open economy


The Mundell-Fleming ModelThe Mundell-Fleming Model

Key assumption: Small open economy with perfect capital mobility.

r = r*

Goods market equilibrium---the IS* curve:

( ) ( ) ( )*Y C Y T I r G NX e

where e = nominal exchange rate

= foreign currency per unit of domestic currency


The The IS*IS* curve: Goods Market Eq’m curve: Goods Market Eq’m

The IS* curve is drawn for a given value of r*.

Intuition for the slope:

Y

e

IS*

( ) ( ) ( )*Y C Y T I r G NX e

e NX Y


The The LM*LM* curve: Money Market Eq’m curve: Money Market Eq’m

The LM* curve is drawn for a given

value of r* is vertical because:

given r*, there is only one value of Y that equates money demand with supply,

regardless of e.

Y

e LM*

( , )*M P L r Y


Equilibrium in the Mundell-Fleming modelEquilibrium in the Mundell-Fleming model

Y

e LM*

( , )*M P L r Y

IS*

( ) ( ) ( )*Y C Y T I r G NX e

equilibriumexchange

rate

equilibriumlevel ofincome


Floating & fixed exchange ratesFloating & fixed exchange rates

In a system of floating exchange rates, e is allowed to fluctuate in response to changing economic conditions.

In contrast, under fixed exchange rates, the central bank trades domestic for foreign currency at a predetermined price.

We now consider fiscal, monetary, and trade policy: first in a floating exchange rate system, then in a fixed exchange rate system.


Fiscal policy under floating exchange ratesFiscal policy under floating exchange rates

Y

e

( , )*M P L r Y

( ) ( ) ( )*Y C Y T I r G NX e

Y1

e1

1*LM

1*IS

2*IS

e2 At any given value of e, a fiscal expansion increases Y, shifting IS* to the right.

Results:

e > 0, Y = 0


Lessons about fiscal policyLessons about fiscal policy

In a small open economy with perfect capital mobility, fiscal policy cannot affect real GDP.

“Crowding out”• closed economy:

Fiscal policy crowds out investment by causing the interest rate to rise.

• small open economy: Fiscal policy crowds out net exports by causing the exchange rate to appreciate.


Mon. policy under floating exchange ratesMon. policy under floating exchange rates

Y

e

( , )*M P L r Y

( ) ( ) ( )*Y C Y T I r G NX e

e1

Y1

1*LM

1*IS

Y2

2*LM

e2

An increase in M shifts LM* right because Y must rise to restore eq’m in the money market.

Results:

e < 0, Y > 0


Lessons about monetary policyLessons about monetary policy

Monetary policy affects output by affecting one (or more) of the components of aggregate demand: closed economy: M r I Ysmall open economy: M e NX Y

Expansionary mon. policy does not raise world aggregate demand, it shifts demand from foreign to domestic products. Thus, the increases in income and employment

at home come at the expense of losses abroad.


Trade policy under floating exchange ratesTrade policy under floating exchange rates

( , )*M P L r Y

( ) ( ) ( )*Y C Y T I r G NX e

Y

e

e1

Y1

1*LM

1*IS

2*IS

e2 At any given value of e, a tariff or quota reduces imports, increases NX, and shifts IS* to the right.

Results:

e > 0, Y = 0


Lessons about trade policyLessons about trade policy

Import restrictions cannot reduce a trade deficit. Even though NX is unchanged, there is less trade:

– the trade restriction reduces imports – the exchange rate appreciation reduces exports

Less trade means fewer ‘gains from trade.’ Import restrictions on specific products save jobs

in the domestic industries that produce those products, but destroy jobs in export-producing sectors. Hence, import restrictions fail to increase total employment. Worse yet, import restrictions create “sectoral shifts,” which cause frictional unemployment.


Fixed exchange ratesFixed exchange rates

Under a system of fixed exchange rates, the country’s central bank stands ready to buy or sell the domestic currency for foreign currency at a predetermined rate.

In the context of the Mundell-Fleming model, the central bank shifts the LM* curve as required to keep e at its preannounced rate.

This system fixes the nominal exchange rate.

In the long run, when prices are flexible, the real exchange rate can move even if the nominal rate is fixed.


Fiscal policy under fixed exchange ratesFiscal policy under fixed exchange rates

Y

e

Y1

e1

1*LM

1*IS2*IS

Under floating rates, a fiscal expansion would raise e.

Results:

e = 0, Y > 0 Y2

2*LM

To keep e from rising, the central bank must sell domestic currency, which increases M and shifts LM* right.

Under floating rates, fiscal policy ineffective at changing output.

Under fixed rates,fiscal policy is very effective at changing output.


Mon. policy under fixed exchange ratesMon. policy under fixed exchange rates

2*LM

An increase in M would shift LM* right and reduce e.

Y

e

Y1

1*LM

1*IS

e1

To prevent the fall in e, the central bank must buy domestic currency, which reduces M and shifts LM* back left.

Results:

e = 0, Y = 0

Under floating rates, monetary policy is very effective at changing output.

Under fixed rates,monetary policy cannot be used to affect output.

2*LM


Trade policy under fixed exchange ratesTrade policy under fixed exchange rates

Y

e

Y1

e1

1*LM

1*IS2*IS

A restriction on imports puts upward pressure on e.

Results:

e = 0, Y > 0 Y2

2*LM

To keep e from rising, the central bank must sell domestic currency, which increases M and shifts LM* right.

Under floating rates, import restrictions do not affect Y or NX.

Under fixed rates,import restrictions increase Y and NX.

But, these gains come at the expense of other countries, as the policy merely shifts demand from foreign to domestic goods.


M-F: summary of policy effectsM-F: summary of policy effects

type of exchange rate regime:

floating fixed

impact on:

Policy Y e NX Y e NX

fiscal expansion

0 0 0

mon. expansion

0 0 0

import restriction

0 0 0


Interest-rate differentialsInterest-rate differentials

Two reasons why r may differ from r* country risk:

The risk that the country’s borrowers will default on their loan repayments because of political or economic turmoil. Lenders require a higher interest rate to compensate them for this risk.

expected exchange rate changes:If a country’s exchange rate is expected to fall, then its borrowers must pay a higher interest rate to compensate lenders for the expected currency depreciation.


Differentials in the M-F modelDifferentials in the M-F model

where is a risk premium.

Substitute the expression for r into the IS* and LM* equations:

( , )*M P L r Y

( ) ( ) ( )*Y C Y T I r G NX e

*r r


The effects of an increase in The effects of an increase in

2*LM

IS* shifts left, because

r I

Y

e

Y1

e1

1*LM

1*IS

LM* shifts right, because r (M/P )d,so Y must rise to restore money market eq’m.

Results: e < 0, Y > 0

2*IS

e2

Y2


The fall in e is intuitive: An increase in country risk or an expected depreciation makes holding the country’s currency less attractive.

Note: an expected depreciation is a self-fulfilling prophecy.

The increase in Y occurs because the boost in NX

(from the depreciation)is even greater than the fall in I

(from the rise in r ).

The effects of an increase in The effects of an increase in


Why income might not riseWhy income might not rise

The central bank may try to prevent the depreciation by reducing the money supply

The depreciation might boost the price of imports enough to increase the price level (which would reduce the real money supply)

Consumers might respond to the increased risk by holding more money.

Each of the above would shift LM* leftward.


CASE STUDY: CASE STUDY: The Mexican Peso CrisisThe Mexican Peso Crisis

10

15

20

25

30

35

7/10/94 8/29/94 10/18/94 12/7/94 1/26/95 3/17/95 5/6/95

U.S

. Cen

ts p

er M

exic

an P

eso


10

15

20

25

30

35

7/10/94 8/29/94 10/18/94 12/7/94 1/26/95 3/17/95 5/6/95

U.S

. Cen

ts p

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exic

an P

eso

CASE STUDY: CASE STUDY: The Mexican Peso CrisisThe Mexican Peso Crisis


The Peso Crisis didn’t just hurt MexicoThe Peso Crisis didn’t just hurt Mexico

U.S. goods more expensive to Mexicans

– U.S. firms lost revenue– Hundreds of bankruptcies along

U.S.-Mex border

Mexican assets worth less in dollars– Affected retirement savings of

millions of U.S. citizens


Understanding the crisisUnderstanding the crisis

In the early 1990s, Mexico was an attractive place for foreign investment.

During 1994, political developments caused an increase in Mexico’s risk premium ( ):• peasant uprising in Chiapas • assassination of leading presidential

candidate

Another factor: The Federal Reserve raised U.S. interest rates several times during 1994 to prevent U.S. inflation. (So, r* > 0)


Understanding the crisisUnderstanding the crisis

These events put downward pressure on the peso.

Mexico’s central bank had repeatedly promised foreign investors that it would not allow the peso’s value to fall,so it bought pesos and sold dollars to “prop up” the peso exchange rate.

Doing this requires that Mexico’s central bank have adequate reserves of dollars.

Did it?


Dollar reserves of Dollar reserves of Mexico’s central bankMexico’s central bank

December 1993 ………………$28 billion

August 17, 1994 ……………… $17 billion

December 1, 1994 …………… $ 9 billion

December 15, 1994 …………$ 7 billion

December 1993 ………………$28 billion

August 17, 1994 ……………… $17 billion

December 1, 1994 …………… $ 9 billion

December 15, 1994 …………$ 7 billion

During 1994, Mexico’s central bank hid the fact that its reserves were being depleted.


the disasterthe disaster

Dec. 20: Mexico devalues the peso by 13%(fixes e at 25 cents instead of 29 cents)

Investors are shocked shocked ! ! !…and realize the central bank must be running out of reserves…

, Investors dump their Mexican assets and pull their capital out of Mexico.

Dec. 22: central bank’s reserves nearly gone. It abandons the fixed rate and lets e float.

In a week, e falls another 30%.


The rescue packageThe rescue package

1995: U.S. & IMF set up $50b line of credit to provide loan guarantees to Mexico’s govt.

This helped restore confidence in Mexico, reduced the risk premium.

After a hard recession in 1995, Mexico began a strong recovery from the crisis.


Floating vs. Fixed Exchange RatesFloating vs. Fixed Exchange Rates

Argument for floating rates:

allows monetary policy to be used to pursue other goals (stable growth, low inflation)

Arguments for fixed rates:

avoids uncertainty and volatility, making international transactions easier

disciplines monetary policy to prevent excessive money growth & hyperinflation


Mundell-Fleming and the Mundell-Fleming and the ADAD curve curve

So far in M-F model, P has been fixed.

Next: to derive the AD curve, consider the impact of a change in P in the M-F model.

We now write the M-F equations as:

(Earlier in this chapter, P was fixed, so we could write NX as a function of e instead of .)

( ) ( , )*M P L r YLM*

( ) ( ) ( ) ( )*Y C Y T I r G NX ε IS*


Y1Y2

Deriving the Deriving the ADAD curve curve

Y

Y

P

IS*

LM*(P1)LM*(P2)

AD

P1

P2

Y2 Y1

2

1

Why AD curve has negative slope:

P

LM shifts left

NX

Y

(M/P )


From the short run to the long runFrom the short run to the long run

LM*(P1)

1

2

then there is downward pressure on prices.

Over time, P will move down, causing

(M/P )

NX Y

P1 SRAS1

1Y

1Y Y

Y

P

IS*

AD

Y

YLRAS

LM*(P2)

P2 SRAS2

1If ,Y Y


Large: between small and closedLarge: between small and closed

Many countries - including the U.S. - are neither closed nor small open economies.

A large open economy is in between the polar cases of closed & small open.

Consider a monetary expansion:• Like in a closed economy,

M > 0 r I (though not as much)• Like in a small open economy,

M > 0 NX (though not as much)



1. Mundell-Fleming model the IS-LM model for a small open

economy. takes P as given can show how policies and shocks

affect income and the exchange rate

2. Fiscal policy affects income under fixed exchange

rates, but not under floating exchange rates.



3. Monetary policy affects income under floating exchange

rates. Under fixed exchange rates, monetary

policy is not available to affect output.

4. Interest rate differentials exist if investors require a risk premium

to hold a country’s assets. An increase in this risk premium raises

domestic interest rates and causes the country’s exchange rate to depreciate.



5. Fixed vs. floating exchange rates Under floating rates, monetary policy is

available for can purposes other than maintaining exchange rate stability.

Fixed exchange rates reduce some of the uncertainty in international transactions.



N. Gregory Mankiw


CHAPTER TEN

Aggregate Demand Im

acro



Chapter objectivesChapter objectives

difference between short run & long run

introduction to aggregate demand

aggregate supply in the short run & long run

see how model of aggregate supply and demand can be used to analyze short-run and long-run effects of “shocks”


-10

-5

0

5

10

15

1960 1965 1970 1975 1980 1985 1990 1995 2000 2005

Per

cen

t ch

ang

e fr

om

pre

vio

us

qu

arte

r, a

t an

nu

al r

ate

Real GDP Growth in the U.S., Real GDP Growth in the U.S., 1960-20041960-2004

Average growth rate = 3.4%


Time horizonsTime horizons

Long run: Prices are flexible, respond to changes in supply or demand

Short run:many prices are “sticky” at some predetermined level

The economy behaves much differently when prices are sticky.


In Classical Macroeconomic Theory,In Classical Macroeconomic Theory,

(what we studied in chapters 3-8)

Output is determined by the supply side:– supplies of capital, labor– technology

Changes in demand for goods & services (C, I, G ) only affect prices, not quantities.

Complete price flexibility is a crucial assumption,so classical theory applies in the long run.


When prices are stickyWhen prices are sticky

…output and employment also depend on demand for goods & services,which is affected by

fiscal policy (G and T )

monetary policy (M )

other factors, like exogenous changes in C or I.


The model of The model of aggregate demand and supplyaggregate demand and supply

the paradigm that most mainstream economists & policymakers use to think about economic fluctuations and policies to stabilize the economy

shows how the price level and aggregate output are determined

shows how the economy’s behavior is different in the short run and long run


Aggregate demandAggregate demand

The aggregate demand curve shows the relationship between the price level and the quantity of output demanded.

For this chapter’s intro to the AD/AS model, we use a simple theory of aggregate demand based on the Quantity Theory of Money.

Chapters 10-12 develop the theory of aggregate demand in more detail.


The Quantity Equation as Agg. DemandThe Quantity Equation as Agg. Demand

From Chapter 4, recall the quantity equation

M V = P Y

For given values of M and V, these equations imply an inverse relationship between P and Y:


The downward-sloping The downward-sloping ADAD curve curve

An increase in the price level causes a fall in real money balances (M/P ),

causing a decrease in the demand for goods & services.

Y

P

AD


Shifting the Shifting the ADAD curve curve

An increase in the money supply shifts the AD curve to the right.

Y

P

AD1

AD2


Aggregate Supply in the Long RunAggregate Supply in the Long Run

Recall from chapter 3: In the long run, output is determined by factor supplies and technology

, ( )Y F K L

is the full-employment or natural level of output, the level of output at which the economy’s resources are fully employed.

Y

“Full employment” means that unemployment equals its natural

rate.


Aggregate Supply in the Long RunAggregate Supply in the Long Run

Recall from chapter 3: In the long run, output is determined by factor supplies and technology

Full-employment output does not depend on the price level,

so the long run aggregate supply (LRAS) curve is vertical:

, ( )Y F K L


The long-run aggregate supply curveThe long-run aggregate supply curve

Y

P LRAS

Y

The LRAS curve is vertical at the full-employment level of output.


Long-run effects of an increase in Long-run effects of an increase in MM

Y

P

AD1

AD2

LRAS

Y

An increase in M shifts the AD curve to the right.

P1

P2In the long run, this increases the price level…

…but leaves output the same.


Aggregate Supply in the Short RunAggregate Supply in the Short Run

In the real world, many prices are sticky in the short run.

For now (and throughout Chapters 9-12), we assume that all prices are stuck at a predetermined level in the short run…

…and that firms are willing to sell as much at that price level as their customers are willing to buy.

Therefore, the short-run aggregate supply (SRAS) curve is horizontal:


The short run aggregate supply curveThe short run aggregate supply curve

Y

P

PSRAS

The SRAS curve is horizontal:

The price level is fixed at a predetermined level, and firms sell as much as buyers demand.


Short-run effects of an increase in Short-run effects of an increase in MM

Y

P

AD1

AD2

…an increase in aggregate demand…

In the short run when prices are sticky,…

…causes output to rise.

PSRAS

Y2Y1


From the short run to the long runFrom the short run to the long run

Over time, prices gradually become “unstuck.” When they do, will they rise or fall?

Y Y

Y Y

Y Y

rise

fall

remain constant

In the short-run equilibrium, if

then over time, the price level

will

This adjustment of prices is what moves the This adjustment of prices is what moves the economy to its long-run equilibrium.economy to its long-run equilibrium.


The SR & LR effects of The SR & LR effects of MM > 0 > 0

Y

P

AD1

AD2

LRAS

Y

PSRAS

P2

Y2

A = initial equilibrium

AB

CB = new short-

run eq’m after Fed increases M

C = long-run equilibrium


How shocking!!!How shocking!!!

shocks: exogenous changes in aggregate supply or demand

Shocks temporarily push the economy away from full-employment.

An example of a demand shock:exogenous decrease in velocity

If the money supply is held constant, then a decrease in V means people will be using their money in fewer transactions, causing a decrease in demand for goods and services:


LRAS

AD2

PSRAS

The effects of a negative demand shockThe effects of a negative demand shock

Y

P

AD1

Y

P2

Y2

The shock shifts AD left, causing output and employment to fall in the short run

AB

COver time, prices fall and the economy moves down its demand curve toward full-employment.


Supply shocksSupply shocks

A supply shock alters production costs, affects the prices that firms charge. (also called price shocks)

Examples of adverse supply shocks: Bad weather reduces crop yields, pushing up

food prices. Workers unionize, negotiate wage increases. New environmental regulations require firms

to reduce emissions. Firms charge higher prices to help cover the costs of compliance.

(Favorable supply shocks lower costs and prices.)


CASE STUDY: CASE STUDY: The 1970s oil shocksThe 1970s oil shocks

Early 1970s: OPEC coordinates a reduction in the supply of oil.

Oil prices rose11% in 1973 68% in 1974 16% in 1975

Such sharp oil price increases are supply shocks because they significantly impact production costs and prices.


1P SRAS1

Y

P

AD

LRAS

YY2

The oil price shock shifts SRAS up, causing output and employment to fall.

A

BIn absence of further price shocks, prices will fall over time and economy moves back toward full employment.

2P SRAS2


A



Predicted effects of the oil price shock:• inflation • output • unemployment

…and then a gradual recovery. 0%

10%

20%

30%

40%

50%

60%

70%

1973 1974 1975 1976 1977

4%

6%

8%

10%

12%

Change in oil prices (left scale)

Inflation rate-CPI (right scale)

Unemployment rate (right scale)



Late 1970s:

As economy was recovering, oil prices shot up again, causing another huge supply shock!!! 0%

10%

20%

30%

40%

50%

60%

1977 1978 1979 1980 1981

4%

6%

8%

10%

12%

14%






1980s: A favorable supply shock--a significant fall in oil prices.

As the model would predict, inflation and unemployment fell:

-50%

-40%

-30%

-20%

-10%

0%

10%

20%

30%

40%

1982 1983 1984 1985 1986 1987

0%

2%

4%

6%

8%

10%





Stabilization policyStabilization policy

def: policy actions aimed at reducing the severity of short-run economic fluctuations.

Example: Using monetary policy to combat the effects of adverse supply shocks:


Stabilizing output with Stabilizing output with monetary policymonetary policy

1P SRAS1

Y

P

AD1

B2P SRAS2

A

Y2

LRAS

Y

The adverse supply shock moves the economy to point B.


Stabilizing output with Stabilizing output with monetary policymonetary policy

1P

Y

P

AD1

B2P SRAS2

A

C

Y2

LRAS

Y

AD2

But the Fed accommodates the shock by raising agg. demand.

results: P is permanently higher, but Y remains at its full-employment level.



1. Long run: prices are flexible, output and employment are always at their natural rates, and the classical theory applies.

Short run: prices are sticky, shocks can push output and employment away from their natural rates.

2. Aggregate demand and supply: a framework to analyze economic fluctuations



3. The aggregate demand curve slopes downward.

4. The long-run aggregate supply curve is vertical, because output depends on technology and factor supplies, but not prices.

5. The short-run aggregate supply curve is horizontal, because prices are sticky at predetermined levels.



6. Shocks to aggregate demand and supply cause fluctuations in GDP and employment in the short run.

7. The Fed can attempt to stabilize the economy with monetary policy.


Documents

Macroeconomics fifth edition N. Gregory Mankiw PowerPoint ® Slides by Ron Cronovich CHAPTER TEN Aggregate Demand I macro © 2004 Worth Publishers, all rights