chap10.ad.gm

8/12/2019 Chap10.Ad.gm

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macroeconomics fifth edition

N. Gregory Mankiw

PowerPoint® Slides

by Ron Cronovich

CHAPTER TEN

Aggregate Demand I

m a c r o

© 2003 Worth Publishers, all rights reserved

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m

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 rate

Short 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,the theory that yields the aggregate demandcurve.

We focus on the short run and assume the

price level is fixed.

This chapter (and chapter 11) focus on theclosed-economy case. Chapter 12 presents

the open-economy case.

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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 investment

E = C + I + G = planned expenditure

Y = 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 expenditure

Y E

consumption function:

for now, plannedinvestment is exogenous:

planned expenditure:

Equilibrium condition:

govt policy variables:

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Graphing planned expenditure

income, output, Y

E planned

expenditure

E =C +I +G

MPC1

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Graphing the equilibrium condition

income, output, Y

E planned

expenditureE =Y

45º

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The equilibrium value of income

income, output, Y

E planned

expenditureE =Y

E =C +I +G

Equilibrium

income

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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 an

unplanned drop

in inventory…

…so firms

increase output,

and income

rises toward a

new equilibrium

G

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Solving for Y

Y C I G Y C I G

MPC Y G

C G

(1 MPC) Y G

1

1 MPCY 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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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 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 :

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Solving for Y

Y C I G

MPC Y T

C

(1 MPC) MPCY T

eq’m condition inchanges

I and G exogenous

Solving for Y :

MPC

1 MPCY T

Final result:

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The Tax Multiplier

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

MPC

1 MPC

Y

T

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 Multiplier

…is 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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Exercise:

Use a graph of the Keynesian Crossto show the impact of an increase in

planned investment 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 2Y 1

Y 2Y 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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Why the IS curve is negatively sloped

A fall in the interest rate motivates firms toincrease 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.

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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.

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

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Y 2Y 1

Y 2Y 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 horizontal

distance of the

IS shift equals

IS 2

…so the IS curve

shifts to the right.

1

1 MPCY G

Y

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Exercise: Shif t ing the IS curve

Use the diagram of the Keynesian Crossor Loanable Funds model to show how

an 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 ofreal money

balances

is 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 money

balances:

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 adjusts

to equate the

supply and

demand formoney:

M/P real money

balances

r interest

rate

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 interest

rate

1M

P

L (r )

r 1

r 2

2M

P

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CASE STUDY

Volcker’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 changewould affect interest rates?

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Volcker’s 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 tightening

on nominal interest rates

prices

model

long runshort run

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The LM curve

Now let’s 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 demand

for 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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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: Shif t ing the LM cu rve

Suppose a wave of credit card fraudcauses consumers to use cash more

frequently in transactions.

Use the Liquidity Preference modelto show how these events shift the

LM curve.

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The short-run equilibrium

The short-run equilibrium isthe 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

Equilibrium

interest

rate

Equilibrium

level of

income

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The B ig Pictu re

KeynesianCross

Theory of

Liquidity

Preference

IS curve

LM

curve

IS-LM

model

Agg.

demand

curve

Agg.

supply

curve

Model of

Agg.

Demandand Agg.

Supply

Explanation

of short-run

fluctuations

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Chapter 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

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Chapter summary

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.

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Prev iew 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 togetherto analyze the short-run and long-run

effects of shocks use our models to learn about

the Great Depression

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