Tutorial CHAP11

7/28/2019 Tutorial CHAP11

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Chapter Eleven 1

CHAPTER 11Aggregate Demand II

A PowerPointTutorial

To Accompany

MACROECONOMICS,6th. ed.N. Gregory Mankiw

By

Mannig J. Simidian


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Chapter Eleven 2

Now that weve assembled the

IS-LMmodel of aggregate

demand, lets apply it to threeissues:

1) Causes of fluctuations in

national income

2) HowIS-LMfits into the

model of aggregate supply and

aggregate demand in Chapter 9

3) The Great Depression

r

Y

LM(P0)IS

r0

Y0


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Chapter Eleven 3

The intersection of theIScurve and theLM

curve determines the level of national income,

and the interest rate for a given price level. If the

ISorLMcurve shifts, the short-run equilibrium

of the economy changes, and national income

fluctuates. Lets examine how changes in policy

and shocks to the economy can cause these

curves to shift.


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Chapter Eleven 4

ISLM

r

y


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Chapter Eleven 5

LMr

Y

IS

A

+G Consider an increase in government purchases.This will raise the level of income by G/(1-MPC)

IS

B

TheIScurve shifts to the right by G/(1-MPC) which raises income

and the interest rate.


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Chapter Eleven 6

LMr

Y

IS

A

-T Consider a decrease in taxes ofT.This will raise the level of income byTMPC/(1-MPC)

IS

B

The IS curve shifts to the right by TMPC/(1-MPC) which raises

income and the interest rate.


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Chapter Eleven 7

ISLM

r

y


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Chapter Eleven 8

ISr

Y

LM

A LM

B

+M Consider an increase in the money supply.

TheLMcurve shifts downward and lowers the interest rate which raises

income. Why? Because when the Fed increases the supply of money, people

have more money than they want to hold at the prevailing interest rate. As a

result, they start depositing this extra money in banks or use it to buy bonds.

The interest rate rthen falls until people are willing to hold all the extramoney that the Fed has created; this brings the money market to a new

equilibrium. The lower interest rate, in turn, has ramifications for the goods

market. A lower interest rate stimulates planned investment, which increases

planned expenditure, production, and income Y.


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Chapter Eleven 9

TheIS-LMmodel shows that monetary policy influences income by

changing the interest rate. This conclusion sheds light on our analysisof monetary policy in Chapter 9. In that chapter we showed that in

the short run, when prices are sticky, an expansion in the money

supply raises income. But we didnt discuss how a monetary

expansion induces greater spending on goods and servicesa process

called the monetary transmission mechanism.

TheIS-LMmodel shows that an increase in the money supply lowers

the interest rate, which stimulates investment and thereby expands the

demand for goods and services.


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Chapter Eleven 10

The IS-LM model shows how monetary and fiscal policy influence

the equilibrium level of income. The predictions of the model,

however, are qualitative, not quantitative. TheIS-LMmodel that

shows that increases in government purchasesraise GDP and that

increases in taxes lower GDP. But, when economists analyze specific

policy proposals, they must know the direction and size of the effect.

Macroeconometric models describe the economy quantitatively,

rather than just qualitatively.


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Chapter Eleven 11


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Chapter Eleven 12

You probably noticed from theISandLMdiagrams that rand Ywere on

the two axes. Now were going to bring a third variable, the price level

(P) into the analysis. We can accomplish this by linking both two-dimensional graphs.

r

P Y

Y

IS

LM(P1)

A

A

AD

To deriveAD, start at pointA in the top

graph. Now increase the price level fromP1

toP2

.An increase inPlowers the value of real money

balances, and Y, shiftingLMleftward to pointB.

The +Ptriggers a sequence of events that end

with a -

Y, the inverse relationship that definesthe downward slope ofAD.

Notice that rincreased. Since rincreased, we know

that investment will decrease, as it just got more

costly to take on various investment projects. Thissets off a multiplier process since -Icauses a Y.

The - Ytriggers -Cas we move up theIScurve.

LM(P2)

B

BP2P1


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Chapter Eleven 13

+G

This translates into a rightward shift of theISandAD curves.LM(P2)

Suppose there is a +G.

In the short run, we move along SRASfrom

pointA to pointB.

But as the output market clears, in the long-run,

the price level will increase fromP0 toP2.

This +Pdecreases the value of real money

balances, which translates into a leftward shift

of theLMcurve.

Finally, this leaves us at point Cin both diagrams.

r

PY

Y

ISLM(P0)

A

D

P

0 AD

IS

SRASA

A

B

B

P2C

C

LRAS

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

M/ P = L (r, Y)


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Chapter Eleven 14

Now its time to determine the effects on the variables in the economy.For the variables Y, P, and r, you can read the effects right off the diagrams.

Remember that SR is the movement

fromA toB.

+, because Ymoved from Y* to Y

0, because prices are sticky in the SR.

+, because a +Yleads to a rise in r

asISslides along theLMcurve.+, because a +Yincreases the level of

consumption (

C=C(

Y-T))., since rincreased, the level of

investment decreased.

Y

P

r

C

I

r

PY

Y

IS LM(P0)

AD

P0

AD

IS

SRASA

A

B

B

P2C

C

LRAS

*Y Y

LM(P2)


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Chapter Eleven 15

+, in order to eliminate the excess demand atP0.

0, because risingPshiftsLMto left, returning

Yto Y* as required by long-runLRAS.

+, reflecting the leftward shift inLMdue

to +P0, since both Yand Tare back to their initial

levels (C=C(Y-T))

, since rhas risen even more due to the+P.

Y

Pr

C

I

For the variables Y, P, and r, you can read the effects right off the diagrams.

Remember thatLR is the movement fromA to C.

r

PY

Y

IS LM(P0)

A

D

P0AD

IS

SRASA

A

B

B

P2 C

C

LRAS

*Y Y

LM(P2)


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Chapter Eleven 16

LM

B

AD

B

Notice thatM/was increased, thus increasing the value of the real money

supply which translates into a rightward shift of the LMandAD curves.

Suppose there is a +M.

Look at the appropriate equation

that captures theMterm:

In the short run, we move along SRASfrom

pointA to pointB.But as the output market clears, in the long run,

the price level will increase fromP0 toP2.

This +Pdecreases the value of the

real money supply which translates into aleftward shift of theLMcurve.

Finally, this leaves us at point Cin both diagrams.

C

AD

ISr

PY

Y

LM(P0)

P

0

SRASA

A

LRAS

= C

P2

M/ P = L (r, Y)

M/ P = L (r, Y)


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Chapter Eleven 17

Now its time to determine the effects on the variables in the economy.


Remember that SR is the

movement fromA toB.

+, because Ymoved from Y* to Y

0, because prices are sticky in the SR.

, because a +Yleads to a decrease in rasLMslides along theIScurve.+, because a +Yincreases the level of

consumption (C=C(Y-T)).+ , since rincreased, the level of

investment decreased.

Y

P

r

C

I

LM

B

AD

BC

AD

ISr

PY

Y

LM(P0)

P0 SRASA

A

LRAS

= C

P2

(P2)

YY*


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Chapter Eleven 18

+, in order to eliminate the excess demand atP0.

0, because risingPshiftsLMto left, returning

Yto Y* as required byLRAS.

0, reflecting the leftward shift inLMdueto +P, restoring rto its original level.0, since both Yand Tare back to their initial

levels (C=C(Y-T)).0, since Yor r has not changed.

Y

P

r

C

I


Remember thatLR is the movement fromA to C.

Notice that the only LR impact of an

increase in the money supply was an

increase in the price level.

LM

B

AD

BC

= C

P2

AD

ISr

PY

Y

LM(P0)

P0 SRASA

A

LRAS

YY*


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Chapter Eleven 19

1) C h IS hif

LM(P )


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Chapter Eleven 20

LM(P0)

1) +Ccauses theIScurve to shift

right toIS.

LRAS

2) This leads to a rightward shift inAD

to AD.Short Run:

Move fromAto B.Long Run:

Market clears atP0 toP2

fromB to C.3) +PcausesLM(P0) to shift leftward

toLM(P2) due to the lowering of thereal value of the money supply.

r

YP

Y

IS

AD

IS'

P0

AD'

LRAS

LM(P2)

A

A

B

B

P2

C

C

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

M/ P = L (r, Y)


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Chapter Eleven 21

Short

Run:

Y +

P 0r +

C +

I -

Long

Run:

0

+++

+

--

SRAS

r

YP

Y

IS

AD

IS'

P0

AD'

LRAS

LM(P2)

A

A

B

B

P2

C

C

LM(P0)


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Chapter Eleven 22

Thespending hypothesis suggests that perhaps the cause of the

decline may have been a contractionary shift of theIScurve.

The money hypothesis attempts to explain the effects of the historical

fall of the money supply of 25 percent from 1929 to 1933, during which

time unemployment rose from 3.2 percent to 25.2 percent.

Some economists say that deflation worsened the Great Depression.

They argue that the deflation may have turned what in 1931 was a

typical economic downturn into an unprecedented period of highunemployment and depressed income. Because the falling money

supply was possibly responsible for the falling price level, it could

very well have been responsible for the severity of the depression. Lets

see how changes in the price level affect income in theIS-LMmodel.


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Chapter Eleven 23

In the IS-LMmodel, falling prices raise income. For any given

supply of moneyM, a lower price level implies higher real

money balances,M/P. An increase in real money balances causes

an expansionary shift in the LMcurve, which leads to higher

income.

Another way in which falling prices increase income is called

the Pigou effect. In the 1930s, economist Arthur Pigou pointed out

that real money balances are part of household wealth. As prices falland real money balances rise, households increase their

consumption spending and theIScurve shifts to the right.


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Chapter Eleven 24

There are two theories to explain how falling prices could depress

income rather than raise it.

1) Debt-deflation theory, unexpected falls in the price level

2) Effects of expected inflation

Debt-deflation theory redistributes wealth between creditors and

debtors. A fall in the price level raises the real amount of the debt.

The impoverishment of the debtors causes them to spend less, and

creditors to spend more. If their propensities to consume are the same,

there is no aggregate effect. But, if debtors reduce more than

the amount that creditors increase spending, the net effect on aggregate

demand is a reduction. This contractsIS, and reduces national income.


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Chapter Eleven 25

LM

Y

IS

A

IS

B

An expected deflation (a negative value ofpe) raises the real interest

rate for any given nominal interest rate, and this depresses investmentspending. The reduction in investment shifts theIScurve downward.

The level of income and the nominal interest rate (i) fall, but the real

interest rate (r) rises.

i2

r1

= i1

r2

interest rate, i


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Chapter Eleven 26

Monetary transmission mechanismPigou Effect

Debt-deflation theory

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