Now that we

1
(No Transcript)
2
Now that weve assembled the IS-LM model of
aggregate demand, lets apply it to three
issues 1) Causes of fluctuations in national
income 2) How IS-LM fits into the model of
aggregate supply and aggregate demand 3) The
Great Depression
3
1. Explaining Fluctuations with the IS-LM Model
The intersection of the IS curve and the LM curve
determines the level of national income. When one
of these curves 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.
IS-LM
4
How Fiscal Policy Shifts the IS Curve and
Changes the Short-run Equilibrium
5
The IS curve shifts to the right by ?G/(1- MPC)
which raises income and the interest rate.
6
How Monetary Policy Shifts the LM Curve and
Changes the Short-run Equilibrium
7
The LM curve shifts downward and lowers the
interest rate which raises income.
8
The IS-LM model shows that monetary policy
influences income by changing the interest rate.
Here we see how a monetary expansion induces
greater spending on goods and services--a process
called the monetary transmission mechanism. The
IS-LM model shows that an increase in the money
supply lowers the interest rate, which stimulates
investment and thereby expands the demand for
goods and services.
9
The interaction between monetary and fiscal
policy- How the economy responds to a tax
increase depends on how the monetary authority
responds
LM
The Central Bank holds money supply constant
Interest rate, r
IS1
IS2
Income, output, Y
10
The central bank holds interest rate constant, by
reducing the money supply - LM curve shifts upward
Interest rate, r
LM2
LM1
IS1
IS2
Income, output, Y
11
The central bank holds income constant, by
raising the money supply - the LM curve shifts
downward
Interest rate, r
LM1
LM2
IS1
IS2
Income, output, Y
12
2. IS-LM as a Theory of Aggregate Demand
13
From IS-LM to AD
You probably noticed from the IS and LM diagrams
that r and Y were 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.
To derive AD, start at point A in the top graph.
Now increase the price level from P1 to P2.
IS
r
LM(P1)
An increase in P lowers the value of real money
balances, and Y, shifting LM leftward to point B.
A
Notice that r increased. Since r increased, we
know that investment will decrease as it just
got more costly to take on various investment
projects. This sets off a multiplier process
since -DI causes a DY. The - DY triggers -DC as
we move up the IS curve.
Y
P
A
P1
The DP triggers a sequence of events that end
with a -DY, the inverse relationship that
defines the downward slope of AD.
AD
Y
14

• A change in income in the IS-LM model resulting
  from a change in the price level represents a
  movement along the AD curve.
• A change in income in the IS-LM model for a fixed
  price level represents a shift in the AD curve.

15
The IS-LM model in the Short Run and the Long Run
The model of aggregate demand and aggregate supply
The IS-LM model
LRAS
LRAS
Price level, P
Interest rate, r
LM(P1)
SRAS1
K
K
P1
LM(P2)
P2
SRAS2
C
C
IS
AD
Income, output, Y
Income, output, Y
16
3. The Great Depression

• - An extended case study to show how economists
  use the IS-LM model to analyze economic
  fluctuations
• 1. The Spending Hypothesis - Shocks to the IS
  curve
• - the cause of the decline may have been a
  contractionary shift of the IS curve
  fall in spending of goods and service
• - the decline in income in the 1930s coincided
  with falling interest rates
• Explanations for the decline in spending
• the stock market crash of 1929
• a large drop in investment in housing
  (residential boom of the 1920s was excessive, the
  reduction in immigration in the 1930s)

17

• After Depression
• bank failures
• the fiscal policy of the 1930s (more concern with
  balancing the budget that with using fiscal
  policy to keep production and employment at their
  natural rates )

18
2. The Money Hypothesis a Shock to the LM curve

• - It attempts to explain the effects of the
  historical fall of the money supply of 25 from
  1929 to 1933 (a contractionary shift in the LM
  curve)
• - It places primary blame on the Federal Reserve
  for allowing the money supply to fall by such a
  large amount (Milton Friedman and Anna Schwartz)
  
• 2 problems of this hypothesis
• the behavior of real money balances (they should
  fall). From 1929 to 1931 real money balances
  increased slightly, since the fall in the money
  supply was accompanied by an even greater fall in
  the price level.
• The behavior of interest rates (we should have
  observed higher interest rates because of the
  contractionary shift in the LM curve). Nominal
  interest rates fell continuously from 1929 to
  1933.

19
3. The Money Hypothesis the Effects of Falling
Prices (Deflation)

• - The price level fell 25 during 1929 to 1933
• - 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
  high unemployment 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 the IS-LM model.

20
The Stabilizing Effects of Deflation

• IS-LM model falling prices raise income, through
  an increase in real money balances
• Pigou effect another channel through which
  falling prices raise income
• - real money balances are part of households
  wealth
• - as prices fall and real money balances
  rise, consumers should feel wealthier and spend
  more. This would generate higher incomes and
  would cause an expansionary shift in the IS curve
• That is why some economists thought in the 1930s
  that deflation would help stabilize the economy.

21
The Destabilizing Effects of Deflation

• Falling prices could help depress income rather
  than raise it. 2 theories to explain this
• 1. The debt deflation theory - the effects of
  unexpected falls in the price level
• - unanticipated changes in the price level
  redistribute wealth between debtors and creditors
• - this redistribution of wealth affects spending
  on goods and services (debtors reduce their
  spending by more than creditors raise theirs)
  spending reduces, a contractionary shift in the
  IS curve and lower national income

22

• 2. The effects of expected fall in prices
  (expected deflation)
• - include a new variable in the IS-LM model
• - distinguish between the nominal and real
  interest rates
• YC(Y-T)I(i-pe)G IS
• M/PL(i,Y) LM
• i - nominal interest rate
• pe - expected inflation

23
Expected Deflation in the IS-LM modelAn expected
deflation raises the real interest rate for any
given nominal interest rate, and this depresses
investment spending. The reduction in investment
shifts the IS curve downward.
LM
The Central Bank holds money supply constant
Interest rate, i
IS1
IS2
Income, output, Y
24
What Happened During the Great Depression?
25
Key Concepts of Ch. 11
Monetary transmission mechanism Pigou
Effect Debt-deflation theory