Ch 10 Aggregate Demand I

7/31/2019 Ch 10 Aggregate Demand I

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macroeconomics fifth editionN. Gregory Mankiw

PowerPoint Slidesby Ron Cronovich

CHAPTER TEN

Aggregate Demand I

a c r o

2002 Worth Publishers, all rights reserved


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CHAPTER 10 Aggregate Demand I slide 2

Context

Chapter 9 introduced the model of aggregatedemand and aggregate supply.Long run prices flexible output determined by factors of production &

technology unemployment equals its natural rateShort run prices fixed output determined by aggregate demand unemployment is negatively related to output


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Context

This chapter develops the IS-LM model, thetheory that yields the aggregate demandcurve.

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


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The Keynesian Cross

A simple closed economy model in whichincome 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 & plannedexpenditure: unplanned inventory investment


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Elements of the Keynesian Cross

= -( )C C Y T

=I I

= = ,G G T T

= - + +( )E C Y T I G

=

=

Actual expenditure Planned expenditureY E

consumption function:

for now,investment is exogenous:

planned expenditure:

Equilibrium condition:

govt policy variables:


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Graphing planned expenditure

income, output, Y

E plannedexpenditure

E = C + I + G

MPC1


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Graphing the equilibrium condition

income, output, Y


E = Y

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The equilibrium value of income

income, output, Y


E = Y

E = C + I + G

Equilibriumincome


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An increase in government purchases

Y

E

E = C + I + G 1

E 1 = Y 1

E = C + I + G 2

E 2 = Y 2Y

At Y 1,there is now anunplanned dropin inventory

so firmsincrease output,and incomerises toward anew equilibrium

G


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Solving for Y

= + +Y C I G D = D + D + DY C I G

= D + DMPC Y G

= D + DC G

- D = D(1 MPC) Y G

D = D -

11 MPC

Y G

equilibrium conditionin changes

because I exogenous

because C = MPC Y

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

Finally, solve for Y :


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The government purchases multiplier

Example: MPC = 0.8

D = D-

= D = D = D-

11 MPC

1 1 51 0 8 0 2. .

Y G

G G G

The increase in G causes income to increaseby 5 times as much!


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The government purchases multiplier

In the example with MPC = 0.8,

Definition: the increase in income resultingfrom a $1 increase in G .

In this model, the G multiplier equals

D =D - 11 MPCY G

D= =

D -

15

1 0.8Y G


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Why the multiplier is greater than 1

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

But Y C

further Y further C

further Y

So the final impact on income is muchbigger than the initial G .


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An increase in taxes

Y

E

E = C 2 + I + G

E 2 = Y 2

E = C 1 + I + G

E 1 = Y 1Y

At Y 1, there is nowan unplannedinventory buildup

so firms

reduce output,and income fallstoward a newequilibrium

C = MPC T

Initially, the taxincrease reducesconsumption, andtherefore E :


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Solving for Y

D = D + D + DY C I G

( )= D - DMPC Y T

= D C

- D = - D(1 MPC) MPCY T

eqm condition inchanges

I and G exogenous

Solving for Y :

- D = D -

MPC1 MPC

Y T Final result:


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The Tax Multiplier

def: the change in income resulting froma $1 increase in T :

D -=

D -

MPC

1 MPC

Y

T

D - -= = = -D -

0 8 0 8 41 0 8 0 2

. .. .

Y T

If MPC = 0.8, then the tax multiplier equals


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The Tax Multiplieris negative :

A tax hike reducesconsumer spending,which reduces income.

is greater than one (in absolute value ): A change in taxes has amultiplier 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 issmaller than from an equal increase in G .


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The Tax Multiplier

is negative : An increase in taxes reduces consumer spending,which reduces equilibrium income.

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

is smaller than the govt spending multiplier :

Consumers save the fraction (1-MPC) of a taxcut, so the initial boost in spending from a taxcut is smaller than from an equal increase in G .


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Exercise:

Use a graph of the Keynesian Crossto show the impact of an increase ininvestment on the equilibrium level of income/output.


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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:

= - + +( ) ( )Y C Y T I r G


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Y 2 Y 1

Y 2 Y 1

Deriving the IS curve

r I

Y

E

r

Y

E = C + I (r 1 )+ G E = C + I (r 2 )+ G

r 1

r 2

E = Y

IS

I E

Y


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Understanding the IS curves slope

The IS curve is negatively sloped.Intuition:

A fall in the interest rate motivates firms toincrease investment spending, which drivesup total planned spending ( E ).To restore equilibrium in the goods market,output (a.k.a. actual expenditure, Y ) must

increase.


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The IS curve and the Loanable Funds model

S , I

r

I (r ) r 1

r 2

r

Y Y 1

r 1

r 2

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

Y 2

S 1S 2

IS


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Fiscal Policy and the IS curve

We can use the IS-LM model to seehow fiscal policy ( G and T ) can affectaggregate demand and output.

Lets start by using the Keynesian Crossto see how fiscal policy shifts the IS curve


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Y 2 Y 1

Y 2 Y 1

Shifting the IS curve: G

At any value of r ,G E Y

Y

E

r

Y

E = C + I (r 1 )+ G 1 E = C + I (r 1 )+ G 2

r 1

E = Y

IS 1

The horizontaldistance of theIS shift equals

IS 2

so the IS curveshifts to the right.

D = D-

1

1 MPCY G

Y


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Exercise: Shifting the IS curve

Use the diagram of the Keynesian Crossor Loanable Funds model to show howan increase in taxes shifts the IS curve.


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The Theory of Liquidity Preference

due to John Maynard Keynes. A simple theory in which the interest rateis determined by money supply and

money demand.


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Money Supply

The supply of real moneybalancesis fixed:

( ) =s

M P M P

M/P real money

balances

r interest

rate( )

s M P

M P


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Money Demand

Demand forreal moneybalances:

M/P real money

balances

r interest

rate( )

s M P

M P

( ) = ( )d

M P L r

L (r )


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Equilibrium

The interestrate adjuststo equate thesupply and

demand formoney:

M/P real money

balances

r interestrate

( )s

M P

M P

= ( )M P L r L (r )

r 1


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How the Fed raises the interest rate

To increase r ,

Fed reduces M

M/P real money

balances

r interestrate

1M

P

L (r )

r 1

r 2

2M

P


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CASE STUDYVolckers Monetary Tightening

Late 1970s: > 10%Oct 1979: Fed Chairman Paul Volckerannounced that monetary policywould 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 would affect interest rates?


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Volckers Monetary Tightening, 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

actualoutcome

The effects of a monetary tighteningon nominal interest rates

prices

model

long runshort run


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The LM curve

Now lets put Y back into the money demandfunction:

= ( , )M P L r Y

The LM curve is a graph of all combinations of r and Y that equate the supply and demandfor real money balances.

The equation for the LM curve is:

( ) = ( , )d

M P L r Y


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Deriving the LM curve

M/P

r

1M

P

L (r , Y 1 )

r 1

r 2

r

Y Y 1

r 1 L (r , Y 2 )

r 2

Y 2

LM

(a) The market forreal money balances (b) The LM curve


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Understanding the LM curves slope

The LM curve is positively sloped.Intuition:

An increase in income raises moneydemand.Since the supply of real balances is fixed,there is now excess demand in the moneymarket at the initial interest rate.

The interest rate must rise to restoreequilibrium in the money market.


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How M shifts the LM curve

M/P

r

1M

P

L

(r

,

Y 1

)

r 1

r 2

r

Y Y 1

r 1

r 2

LM 1

(a) The market forreal money balances (b) The LM curve

2M

P

LM 2


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Exercise: Shifting the LM curve

Suppose a wave of credit card fraudcauses consumers to use cash morefrequently in transactions.

Use the Liquidity Preference modelto show how these events shift theLM curve.


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The short-run equilibrium

The short-run equilibrium isthe combination of r and Y that simultaneously satisfiesthe 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 of income


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The Big Picture

KeynesianCross

Theory of Liquidity

Preference

IS curve

LM curve

IS-LM model

Agg.demand

curve

Agg.supplycurve

Model of Agg.

Demandand Agg.Supply

Explanationof short-runfluctuations


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Chapter summary1. Keynesian Cross

basic model of income determinationtakes fiscal policy & investment as exogenousfiscal policy has a multiplied impact on income.

2. IS curvecomes from Keynesian Cross when plannedinvestment depends negatively on interest rate

shows all combinations of r and Y thatequate planned expenditure with actualexpenditure on goods & services


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Chapter summary3. Theory of Liquidity Preference

basic model of interest rate determinationtakes money supply & price level as exogenousan increase in the money supply lowers the

interest rate4. LM curve

comes from Liquidity Preference Theory when

money demand depends positively on incomeshows all combinations of r and Y that equatedemand for real money balances with supply


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Chapter summary5. IS-LM model

Intersection of IS and LM curves shows theunique point ( Y , r ) that satisfies equilibriumin both the goods and money markets.


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Preview of Chapter 11

In Chapter 11, we willuse the IS-LM model to analyze the impactof policies and shockslearn how the aggregate demand curvecomes from IS-LM use the IS-LM and AD-AS models togetherto analyze the short-run and long-run

effects of shockslearn about the Great Depression using ourmodels


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Documents

Ch 10 Aggregate Demand I