Sanja Samirana PattnayakIIM Trichy

Aggregate Demand and IS-LM

Economic Activity-real GDPEconomic activity fluctuates from year to year.

Production of goods and services rises due to increase in labor force, capital stock and advances in technological knowledge.

On an average real GDP grows at a certain rate in the long run.

In some years economy experiences contraction rather than growth. *

Economic Activity-real GDPWith firms producing fewer goods and services, real GDP and other measures of income fall.

Such a period of falling income and rising unemployment is called recession.

A severe recession is called depression.

Example: downturn occurred in 2008 and 2009. From 4th quarter of 2007 to the second quarter of 2009, real GDP for USA economy fell by 4 percent. *

Economic Activity-real GDPThe rate of unemployment rose from 4.4 percent in May 2007 to 10.1 percent in October 2009.

What causes short-run fluctuations?

What if anything, can govt. do to prevent this situation?How can the policy makers reduce their length and severity?We take up these questions in this topic.*

Economic Activity-real GDPThe variables that we study largely include GDP, unemployment, interest rate and price level.

We are also familiar with the policy instruments of govt. spending, taxes and the money supply.

In the previous discussions so far we have explained the behaviour of these variables in the long run.

Our objective in this topic is to explain their short run deviations from long run trends.*

Economic Activity-real GDPSo we need to focus on the forces that explain economic fluctuations from year to year rather than the growth.

Most economists use the model of aggregate demand and aggregate supply.

We will introduce these concepts in this lecture.*

Business CycleShort-run fluctuations in output and employment are called the business cycle.

GDP is the first place to start when analyzing the business cycle, since it is the largest gauge of economic conditions.

A recession is usually defined by a period in which there are two consecutive declines in real GDP.

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Okuns LawIn recessions, unemployment rises.

This negative (when one rises, the other falls) relationship between unemployment and GDP is called Okuns Law, after Arthur Okun, the economist who first studied it.

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Classical DichotomyMany macroeconomic variables are quantities, such as real GDP, relative prices (real wages, real interest rate) and so on.

The real wage is the quantity of output a worker earns for each hour of work. Real interest rate is the quantity of output a person earns in future by lending one unit of output today.

All variables are measured in physical units. And these variables are called real variables.*

Classical DichotomyBut nominal variables are measured in terms of money.

Examples of nominal variables are: price level, inflation rate, and dollar wage a person earns.

The theoretical separation of real and nominal variables known as classical dichotomy.

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Aggregate DemandAggregate demand (AD) is the relationship between the quantity of output demanded and the aggregate price level.

It tells us the quantity of goods and services people want to buy at any given level of prices.

Recall the Quantity Theory of Money (MV=PY), where M is the money supply, V is the velocity of money, P is the price level, and Y is the amount of output.

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Aggregate DemandWe had the assumption that velocity is constant over time.

So money supply determine the nominal value of output (PY)Recall that the quantity equation can be rewritten in terms of the supply and demand for real money balances: M/P = (M/P)d = kY

where k = 1/V is a parameter determining how much money people want to hold for every dollar of income.*

Aggregate DemandThis equation states that supply of money balances M/P is equal to the demand and that demand is proportional to output.

If we assume the velocity V is constant and money supply M is fixed by central bank, then quantity equation yields a negative relation between P and Y.

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Aggregate Demand CurveThe Aggregate Demand (AD) curve shows the negative relationship between the price level P and quantity of goods and services demanded Y.

It is drawn for a given value of the money supply M.

The aggregate demand curve slopes downward: the higher the price level P, the lower the level of real balances M/P, and therefore the lower the quantity of goods and services demanded Y.*

Aggregate Demand CurveAs the price level decreases, wed move down along the AD curve.

Any changes in M or V would shift the AD curve.

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Aggregate Demand CurveRemember that the demand for real output varies inversely with the price level.

Why the AD curve slopes downward?

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Why the AD curve slopes downward?Think about the supply and demand for real money balances. If output is higher, people engage in more transactions and need higher real balances M/P.

For a fixed money supply M, higher real balances imply a lower price level.

Conversely, if the price level is lower, real money balances are higher; the higher level of real balances allows a greater volume of transactions, which means a greater quantity of output is demanded.

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Shift in Aggregate DemandThe aggregate demand curve is drawn for a fixed value of the money supply. In other words, it tells us the possible combinations of P and Y for a given value of M.

If the Central Bank changes the money supply, then the possible combinations of P and Y change, which means the aggregate demand curve shifts.

Lets see how it works?*

Shift in Aggregate DemandA decrease in the money supply M reduces the nominal value of output PY.

Thus, a decrease in the money supply shifts the AD curve inward from AD to AD'.

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Shift in Aggregate DemandAn increase in the money supply M raises the nominal value of output PY.

Thus, an increase in the money supply shifts the AD curve outward from AD to AD'.

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Aggregate SupplyAggregate supply (AS) is the relationship between the quantity of goods and services supplied and the price level.

Because the firms that supply goods and services have flexible prices in the long run but sticky prices in the short run, the aggregate supply relationship depends on the time horizon.*

Aggregate SupplyThere are two different aggregate supply curves: the long-run aggregate supply curve (LRAS) and the short-run aggregate supply curve (SRAS).

We also must discuss how the economy makes the transition from the short run to the long run.

But, first, lets build the long-run aggregate supply curve (LRAS).

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The Long Run: A Vertical AS CurveRecall the classical model that describes how the economy behaves in the long-run.

Recall (previous lecture) the amount of output produced depends on the fixed amounts of capital and labor and on the available technology.

To show this, we write Y = F(K, L) = Y

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The Long Run: A Vertical AS CurveAccording the classical model, output does not depend on the price level.

If the AS curve is vertical then change in AD affects price but not output.

For example if money supply falls, the AD shifts downward. The economy moves from old intersection of AD and AS to new intersection of AD and AS.

The shift in AD affects only price.

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The Long Run: A Vertical AS Curve

The vertical line suggests that changes in the price level will have no lasting impact on full employment.

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The Short Run: The Horizontal AS CurveClassical model and vertical LARS apply only in the long-run. In short run some prices are sticky and therefore do not adjust to the changes in demand.

Due to the price stickiness, the SARS is not vertical.

Here we simplify by assuming an extreme example.

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The Short Run: The Horizontal AS Curve

Suppose all firms issue price catalog and that it is too costly for them issue new ones. Thus all prices are stuck at a predetermined level.

At these prices firms are willing to supply as much as their customers are willing to buy.*

The Short Run: The Horizontal AS CurveAnd they hire just enough labor to produce these output.

As the price level is fixed we say that SARS is a horizontal line.

The short-run equilibrium of the is the intersection of AD and horizontal SARS

In this case changes in AD affects the level of output.*

The Short Run: The Horizontal AS CurveExample: if the Central bank suddenly reduces the money supply, the AD shifts inward from AD1 to AD2. (economy moves from A to B)

The movement from A to B represents a decline in output at a fixed price level.

This fall in AD reduces output in the short run because prices do not adjust instantly.*

The Short Run: The Horizontal AS CurveAfter the sudden fall in AD firms are stuck with high prices.

When demand low and prices high, firms sell less, so reduce production and lay off workers. The economy experiences recession.

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The Long-Run EquilibriumIn the long run, the economy finds itself at the intersection of the long-run aggregate supply curve and aggregate demand curve.

Because prices have adjusted to this level, the SRAS crosses this point as well.

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A reduction in ADThe economy begins in long-run equilibrium at point A.*

A reduction in ADThen, a reduction in aggregate demand, perhaps caused by a decrease in the money supply M, moves the economy from point A to point B, where output is below its natural level.

As prices fall, the economy recovers from the recession, moving from point B to point C.*

Stabilization PolicyExogenous changes in aggregate supply or aggregate demand are called shocks.

A shock that affects aggregate supply is called a supply shock. A shock that affects aggregate demand is called a demand shock.

These shocks that disrupt the economy and push output and unemployment away from their natural levels.

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Stabilization PolicyA goal of the aggregate demand/aggregate supply model is to help explain how shocks cause economic fluctuations.

Economists use the term stabilization policy to refer to the policy actions taken to reduce the severity of short-run economic fluctuations.*

Stabilization PolicyStabilization policy seeks to dampen the business cycle by keeping output and employment as close to their natural rate as possible.

The model in this chapter is a simpler version of the one well see in coming chapters.

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Shocks to ADThe economy begins in long-run equilibrium at point A.

An increase in aggregate demand, due to an increase in the velocity of money, moves the economy from point A to point B, where output is above its natural level.

As prices rise, output gradually returns to its natural rate, and the economy moves from point B to point C.

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Shocks to AD*

Shocks to ASAn adverse supply shock pushes up costs and prices.

If AD is held constant, the economy moves from point A to point B, leading to stagflationa combination of increasing prices and declining level of output.

Eventually, as prices fall, the economy returns to the natural rate at point A.

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Shocks to AS*

Accommodating an Adverse Supply ShockIn response to an adverse supply shock, the Central Bank can increase aggregate demand to prevent a reduction in output.

The economy moves from point A to point B. The cost of this policy is a permanently higher level of prices.

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Accommodating an Adverse Supply Shock*

AD and Building IS-LM ModelSanja Samirana PattnayakIIM Trichy*

IntroductionThe Great Depression caused many economists to question the validity of classical economic theory.

They believed they needed a new model to explain such a pervasive economic downturn and to suggest that government policies might ease some of the economic hardship that society was experiencing.

In 1936, John Maynard Keynes wrote The General Theory of Employment, Interest, and Money. *

IntroductionIn it, he proposed a new way to analyze the economy, which he presented as an alternative to the classical theory.

Keynes proposed that low aggregate demand is responsible for the low income and high unemployment that characterize economic downturns.

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IntroductionHe criticized classical theory for assuming that aggregate supply alone capital, labor and technology determines national income.

Economists today reconcile these views with the model of aggregate demand and aggregate supply discussed last lecture.

In the long run, prices are flexible and AS determines income but in the short run, prices are sticky, so changes in AD influence income.*

IntroductionThe model of aggregate demand (AD) can be split into two parts:

IS model of the goods market and the

LM model of the money market. IS stands for Investment Saving.

Whereas LM stands for Liquidity Money.

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IntroductionWe continue our study of economic fluctuations by looking more closely at AD

Our objective is to identify the variables that shifts the AD curve causing fluctuations in national Income. Also examine the tools policymakers can use to influence AD.

The model of aggregate demand developed called the IS-LM is the leading interpretation of Keynes work.

The IS-LM model takes the price level as given and shows what causes income to change. It shows what causes AD to shift.

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IntroductionShifts in AD ( at a given price level, NI fluctuates because in shifts in AD curve)*

IS-LM: Model of Aggregate DemandIS implies investment and Saving model of the goods market.

LM implies (liquidity and money) model of the money market.

The IS curve (which stands for investment saving) plots the relationship between the interest rate and the level of income that arises in the market for goods and services

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IS-LM: Model of Aggregate DemandThe LM curve (which stands for liquidity and money) plots the relationship between the interest rate and the level of income that arises in the money market.

Because the interest rate influences both investment and money demand, it is the variable that links the two parts of the IS-LM model.

The model shows how interactions between these markets determine the position and slope of the aggregate demand curve, and therefore, the level of national income in the short run.

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IS-LM: Model of Aggregate DemandIn the General Theory of Money, Interest and Employment (1936), Keynes proposed that an economys total income was, in the short run, determined largely by the desire to spend by households, firms, and the government.

The more people want to spend, the more goods and services firms can sell.

The more firms can sell, the more output they will choose to produce and the more workers they will choose to hire.*

The Keynesian CrossThus, the problem during recessions, according to Keynes, was inadequate spending.

The Keynesian cross is an attempt to model this insight.

The Keynesian cross shows how income Y is determined for given levels of planned investment I and fiscal policy G and T.

We can use this model to show how income changes when one of the exogenous variables change.*

The Keynesian CrossActual expenditure is the amount households, firms and the government spend on goods and services (GDP).

Planned expenditure is the amount households, firms, and the government would like to spend on goods and services.

The economy is in equilibrium when: Actual Expenditure = Planned Expenditure or Y = EWhy would actual exp. ever differ from planned exp.? firms might engage in unplanned inventory investment because their sales dont match expectation.

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The Keynesian CrossThe 45-degree line (Y=E) plots the points where this condition holds. With the addition of the planned-expenditure function, this diagram becomes the Keynesian cross.

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The Keynesian CrossHow does the economy get to this equilibrium? Inventories play an important role in the adjustment process.

Whenever the economy is not in equilibrium, firms experience unplanned changes in inventories, and this induces them to change production levels.

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The Keynesian CrossChanges in production in turn influence total income and expenditure, moving the economy toward equilibrium.

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The Keynesian CrossConsider how changes in government purchases affect the economy.

Because government purchases are one component of expenditure, higher government purchases result in higher planned expenditure, for any given level of income.

An increase in government purchases of DG raises planned expenditure by that amount for any given level of income.

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The Keynesian CrossThe equilibrium moves from A to B and income rises. Note that the increase in income Y exceeds the increase in government purchases DG. Thus, fiscal policy has a multiplied effect on income.

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Fiscal Policy and MultiplierIf government spending were to increase by $1, then you might expect equilibrium output (Y) to also rise by $1.

But it doesnt! The multiplier shows that the change in demand for output (Y) will be larger than the initial change in spending.

Heres why:When there is an increase in government spending (G), income rises by G as well.*

Fiscal Policy and MultiplierThe increase in income will raise consumption by MPC G, where MPC is the marginal propensity to consume.

The increase in consumption raises expenditure and income again.

The second increase in income of MPC G again raises consumption, this time by MPC (MPC G), which again raises income and so on.

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Fiscal Policy and MultiplierSo, the multiplier process helps explain fluctuations in the demand for output.

For example, if something in the economy decreases investment spending, then people whose incomes have decreased will spend less, thereby driving equilibrium demand down even further.

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Fiscal Policy and MultiplierThe government-purchases multiplier is:

DY/DG = 1 + MPC + MPC2 + MPC3 + DY/DG = 1 / 1 MPC

The tax multiplier is: DY/DT = - MPC / (1 - MPC)

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Increasing Govt. purchases to stimulate the EconomyThe Obama Spending Plan:

When President Obama took office in 2009, the economy was undergoing a significant recession.

He proposed a package that would cost the government about $800 billion, or about 5% of annual GDP.

The package included some tax cuts and higher transfer payments, but much of it was made up of increases in government purchases of goods and services.

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The Interest Rate Investment and IS curveKeynesian cross is a first step towards building IS-LM model which explains the economys AD curve.

It is useful because it tells us how the spending plan of the households, firms and government determines the income.

It makes a simplifying assumption that planned I is fixed.Lets now add the relationship between the interest rate and investment to our model, writing the level of planned investment as: I = I (r).

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The Interest Rate Investment and IS curveThe investment function is downward sloping showing the inverse relationship between investment and the interest rate.

Interest rate is the cost of borrowing to finance investment projects, an increase in r reduces planned I

To determine how income changes when the interest rate changes, we combine the investment function with the Keynesian-cross diagram*

Deriving IS curveAn increase in the interest rate (in graph a), lowers planned investment, which shifts planned expenditure downward (in graph b) and lowers income (in graph c).

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SummaryThe IS curve summarizes this relationship between the interest rate and the level of income.

In essence, the IS curve combines the interaction between I and Y demonstrated by the Keynesian cross and interaction between r and I.

Because an increase in the interest rate causes planned investment to fall, which in turn causes income to fall, the IS curve slopes downward.

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Fiscal policy and Shifts of IS curveIS curve shows for a given level of r and income the goods market is in equilibrium.

We know from Keynesian cross, equilibrium level of income also depends on government purchases, and taxes.

We draw IS curve for a given level of G and T. so change in fiscal policy shifts IS curve.

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Change in G and shift of IS curveWe draw the figure for a given r and planned investment I

Increase in G raises planned expenditure and thus increases equilibrium income from Y1 to Y2. Thus IS curve shifts outward.

Other changes in fiscal policy also shift IS curve. Decreases in tax also expands expenditure and income and thus shifts IS curve outward.

Similarly, a decrease in G and increase in taxes reduces income and shifts IS curve inward.*

Loanable fund and interpretation of IS curveWe recall from our earlier lecture that there is an equivalence between supply and demand for goods and services and supply demand for loanable funds.

This equivalence provides us another way to interpret IS curve.

Recall NI identity, Y-C G=I or S=ILeft hand side is national savings S and right hand side is investment I.*

Loanable fund and interpretation of IS curveNational saving represents supply of loanable fund and investment represents demand for loanable funds.

How market for loanable funds produces the IS curve?

Substitute consumption function for C and investment function for I

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

Loanable fund and interpretation of IS curveThe left hand side of the equation tells us that supply of loanable funds depends on income and fiscal policy.

The right hand side shows the demand depends on interest rate.

Thus, interest rate adjusts to equilibrate the supply and demand for money.

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Loanable fund and interpretation of IS curveNow we can interpret the IS curve as showing the interest rate that equilibrates the market for loanable fund for a given level of income.

As income rises from Y1 to Y2, national savings (Y-C-G), increases.

So increase supply of loanable funds drives down the interest rate from r1 to r2*

Loanable fund and interpretation of IS curveThe IS curve summarizes this relationship: higher income implies higher saving, which in turn implies a lower equilibrium interest rate.

Hence IS curve slopes downward.

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The Money Market and LM curveNow that weve derived the IS part of AD, we can complete the model of AD by adding a money market equilibrium schedule, the LM curve.

LM curve plots relationship between the interest rate r and level of income that arises in money market.

Theory of interest rate, called theory of liquidity preference will help understand this relationship.

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The Money Market and LM curveThe theory tells us that the interest rate adjusts to balance demand and supply of the economys most liquid asset- money.

To develop this theory, we begin with the supply of real money balances (M/P); both of these variables are taken to be exogenously given.

The theory assumes that there is a fixed supply of real money balances.

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The Money Market and LM curveThe assumption implies that supply of real money balances is fixed and does not depend on interest rate r

This yields a vertical supply curve.

Now, consider the demand for real money balances, L(.).

Theory of liquidity preference tells us that interest is one determinant of how much money people choose to hold.

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The Money Market and LM curveThe theory of liquidity preference suggests that a higher interest rate lowers the quantity of real balances demanded, because r is the opportunity cost of holding money.

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The Money Market and LM curveThe supply and demand for real money balances determine the interest rate.

At the equilibrium interest rate, the quantity of money balances demanded equals the quantity supplied. Money market equilibrium shown below:

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Equilibrium of money supply and money demandHow does interest rate gets to the equilibrium of money supply and money demand?

When not in equilibrium people adjust their portfolios of assets and in the process alter the interest rate.

Case I: when the interest rate is above equilibrium level, then the quantity of real money balances supply exceeds demand and individuals holding excess supply would try to convert them into some interest bearing bonds or deposits.*

Equilibrium of money supply and money demandExcess supply drives down the interest rate.

Case II: when interest rate is below equilibrium interest rate, the quantity of money demand exceeds money supply and thus individuals try to obtain money by selling bonds and making withdrawals of deposits.

To attract scarcer funds banks and bond issuers responds by offering an increase in interest rate.

Eventually, the interest rate reaches equilibrium level.

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A Reduction in the Money Supply: -M/P

Since the price level is fixed, a reduction in the money supply reduces the supply of real balances. Notice the equilibrium interest rate rose.

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Money demand and LM curveTheory of liquidity preference gave us an idea as to what determines the interest rate.

Also we need to understand how does a change in the economys level of income Y affects the market for real money balances?(M/P)d= L(r,Y)

The quantity of real money balances demanded is negatively related to the interest rate (because r is the opportunity cost of holding money) and positively related to income.

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Money demand and LM curveLiquidity preference theory helps us to understand what happens to the equilibrium interest rate when income changes?

When income increases from Y to Y`, it shifts the money demand curve to the right and with supply of real money balances unchanged, interest rate must rise from r1 to r2 to equilibrate the money market.

Therefore, according to the liquidity preference theory, higher income leads to higher interest rate.

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Deriving the LM CurveThe LM curve summarizes the relationship between the level of income and the interest rate.Each point on the LM curve represents equilibrium in the money market and the curve shows how equilibrium interest rate depends on the level of income.

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Shifting the LM CurveA contraction in the money supply raises the interest rate that equilibrates the money market. Why?

Because a higher interest rate is needed to convince people to hold a smaller quantity of real balances.As a result of the decrease in the money supply, LM shifts upward.

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IS-LM model of ADThe intersection of the IS curve/equation, Y= C (Y-T) + I(r) + G and the LM curve/equation M/P = L(r, Y) determines the level of aggregate demand.

The intersection of the IS and LM curves represents simultaneous equilibrium in the market for goods and services and in the market for real money balances for given values of government spending, taxes, the money supply, and the price level.

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IS-LM model of AD*