BUS 530: ECONOMIC CONDITIONS ANALYSIS LECTURE: 8

1. BUS 530: ECONOMIC CONDITIONS ANALYSIS LECTURE: 8 Business Cycle Theory: The Economy in the Short Run:IS-LM Model

2. Introduction • The IS curve, and its relation to • the Keynesian cross • the loanable funds model • The LM curve, and its relation to • the theory of liquidity preference • How the IS-LM model determines income and the interest rate in the short run when P (price level) is fixed CHAPTER 10 Aggregate Demand I

3. Introduction, contd. • Earlier we introduced the model of aggregate demand 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 negatively related to output CHAPTER 10 Aggregate Demand I

4. Introduction, contd. • This lecture develops the IS-LM model, the basis of the aggregate demand curve. • We focus on the short run and assume the price level is fixed (so, SRAS curve is horizontal). • This lecture and the next chapter focus on the closed-economy case. The next lecture presents the open-economy case. CHAPTER 10 Aggregate Demand I

5. P Y Shift in Aggregate Demand AD3 AD2 AD1 Fixed price level(SRAS) Y2 Y3 Y1 CHAPTER 10 Aggregate Demand I

6. The Goods Market and the IS Curve • The IS curve plots the relationship between the interest rate and the level of income that arises in the market for goods and services. • To develop this relationship, we start with a basic model called the Keynesian Cross. CHAPTER 10 Aggregate Demand I

7. The Keynesian Cross • A simple closed economy model in which income 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 & planned expenditure = unplanned inventory investment CHAPTER 10 Aggregate Demand I

8. Elements of the Keynesian Cross consumption function: government policy variables: for now, plannedinvestment is exogenous: planned expenditure: equilibrium condition: actual expenditure = planned expenditure CHAPTER 10 Aggregate Demand I

9. E =C(Y-T̅)+I̅ +G̅ MPC Tk1 Graphing Planned Expenditure E planned expenditure income, output,Y CHAPTER 10 Aggregate Demand I

10. Equilibrium income The Keynesian Cross: The Equilibrium Value of Income E planned expenditure Actual Expenditure E =Y Planned Expenditure E =C +I +G A income, output,Y CHAPTER 10 Aggregate Demand I

11. E E =C +I +G1 Y E1 = Y1 The Adjustment to Equilibrium in the Keynesian Cross E =Y Y1 E1 Unplanned inventory accumulation causes income to fall E2 Unplanned drop in inventory causes income to rise Y2 Y2 Y1 CHAPTER 10 Aggregate Demand I

12. E E =C +I +G2 E =C +I +G1 Y E1 = Y1 E2 = Y2 Y Fiscal Policy and the Multiplier: An Increase in Government Purchases E =Y B E2 = Y2 G Y A 1.An increase in government purchases shifts planned expenditure upward.. E1 = Y1 2. ..which increases equilibrium income CHAPTER 10 Aggregate Demand I

13. Solve for Y : Solving for Y equilibrium condition in changes because I exogenous because C= MPCY Collect terms with Yon the left side of the equals sign: CHAPTER 10 Aggregate Demand I

14. The Government Purchases Multiplier Definition: the increase in income resulting from a Tk1 increase in G. In this model, the governmentpurchases multiplier equals Example: If MPC = 0.8, then An increase in G causes income to increase 5 times as much! CHAPTER 10 Aggregate Demand I

15. Why the Multiplier is greater than 1 • Initially, the increase in G causes an equal increase in Y:Y = G. • But Y  C  furtherY  furtherC  furtherY • So the final impact on income is much bigger than the initial G. CHAPTER 10 Aggregate Demand I

16. E E =Y E =C1+I +G E =C2+I +G 1. An increase in tax reduces consumption, and shifts planned expenditure downward,.. Y E2 = Y2 E1 = Y1 Y Fiscal Policy and the Multiplier: An Increase in Taxes A E1 = Y1 MPC X T B E2 = Y2 At Y1, there is now an unplanned inventory buildup… …so firms reduce output, and income falls toward a new equilibrium 2. ..which decreases equilibrium income CHAPTER 10 Aggregate Demand I

17. Solving for Y eq’m condition in changes Iand G exogenous Solving for Y : Final result: CHAPTER 10 Aggregate Demand I

18. The Tax Multiplier Definition: the change in income resulting from a Tk1 increase in T : If MPC = 0.8, then the tax multiplier equals CHAPTER 10 Aggregate Demand I

19. The Tax Multiplier …is negative:A tax increase reduces C, which reduces income. …is greater than one (in absolute value): A change in taxes has a multiplier 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 is smaller than from an equal increase in G. CHAPTER 10 Aggregate Demand I

20. Class Exercise: • Use a graph of the Keynesian cross to show the effects of an increase in planned investment on the equilibrium level of income/output. CHAPTER 10 Aggregate Demand I

21. Answer: When there is an increase in planned investment then the planned expenditure curve(E) shifts upward that results in a higher the equilibrium level of income/output. CHAPTER 10 Aggregate Demand I

22. The IS curve Definition: a graph of all combinations of interest rates(r) and income, output(Y) that result in goods market equilibrium i.e. actual expenditure (output) = planned expenditure The equation for the IS curve is: CHAPTER 10 Aggregate Demand I

23. E I Y r r I Y Deriving the IS curve (b)The Keynesian Cross  E E =Y E =C +I(r1)+G  Y  r  I E =C +I(r2)+G 3. ..which shifts planned expenditure downward 4. ..and lowers income (a) The Investment Function 1. An increase in the interest rate.. Y2 Y1 (c) The IS Curve r2 r2 5.The IS curve summaries these changes in the goods market equilibrium r1 r1 I IS I(r) Y2 I(r2) I(r1) Y1 2. .lowers planned investment,..

24. Fiscal Policy and the IS curve • We can use the IS-LM model to see how fiscal policy (G and T) affects aggregate demand and output. • Let’s start by using the Keynesian cross to see how fiscal policy shifts the IS curve… CHAPTER 10 Aggregate Demand I

25. E Y r Y Y Shifting the IScurve: An increase in Government Purchase(G) (a) The Keynesian Cross E =Y E =C +I(r1)+G2 At any value of r, G  E  Y Y2 E =C +I(r1)+G1 …so the IS curve shifts to the right. Y1 Y1 Y2 The horizontal distance of the IS shift equals (b) The IS Curve r1 IS2 IS1 Y1 Y2 CHAPTER 10 Aggregate Demand I

26. r r S2 S1 I(r) Y S, I Y1 Y2 The IScurve and the Loanable Funds Model (a) The market for Lonable Funds (b) The IScurve 3. The IS curves summarizes these changes 1. A decrease in income reduces saving.. r2 r2 r1 r1 IS 2. .causing the interest rate to rise CHAPTER 10 Aggregate Demand I

27. The Money Market and the LM Curve: The Theory of Liquidity Preference • John Maynard Keynes offered his view of how the interest rate is determined in the short run-this explanation is called the theory of liquidity preference. • A simple theory in which the interest rate is determined by money supply and money demand. CHAPTER 10 Aggregate Demand I

28. Money Supply r interest rate The supply of real money balances is fixed: M/P real money balances CHAPTER 10 Aggregate Demand I

29. Money Demand r interest rate Demand forreal money balances: (M/P)s L(r) M/P real money balances M̅/P̅ CHAPTER 10 Aggregate Demand I

30. Equilibrium r interest rate The interest rate adjusts to equate the supply and demand for money: r1 L(r) M/P real money balances CHAPTER 10 Aggregate Demand I

31. How the Bangladesh Bank raises the Interest Rate 1. A fall in the money supply r interest rate To increase r, Bangladesh Bank reduces Money Supply r2 r1 2. ..raises the interest rate L(r) M/P real money balances CHAPTER 10 Aggregate Demand I

32. CASE STUDY: Monetary Tightening & Interest Rates • Late 1970s:  > 10% • Oct 1979: Fed Chairman Paul Volcker announces 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 change would affect nominal interest rates? CHAPTER 10 Aggregate Demand I

33. The Effects of a Monetary Tightening on Nominal Interest Rates Short run Long run Model Prices Prediction Actual Outcome Monetary Tightening & Rates, cont. Liquidity preference (Keynesian) Quantity theory, Fisher effect (Classical) Sticky Flexible i > 0 i < 0 8/1979: i= 10.4% 4/1980: i= 15.8% 8/1979: i= 10.4% 1/1983: i= 8.2%

34. The LM curve Now let’s put Y back into the money demand function: The LMcurve is a graph of all combinations of r and Y that equate the supply and demand for real money balances. The equation for the LMcurve is: CHAPTER 10 Aggregate Demand I

35. r r LM L(r,Y2) L(r,Y1) Y M/P Y1 Y2 Deriving the LM curve (a) The Market for Real Money Balances (b) The LM curve 1. An increase in income raises money demand r2 r2 r1 r1 2. ..increasing the interest 3. The LM curve summarizes these changes in the money market equilibrium CHAPTER 10 Aggregate Demand I

36. r r LM2 LM1 L(r,Y1) Y M/P Y̅ Monetary Policy and Shifts in the LM curve (a)The market for real money balances (b) The LM curve 1. The Bangladesh Bank reduces the money supply r2 r2 3. …and shifting the LM curve upward r1 r1 2. …raising the interest rate CHAPTER 10 Aggregate Demand I

37. Class Exercise: Shifting the LM curve • Suppose a wave of credit card fraud causes consumers to use cash more frequently in transactions. • Use the liquidity preference model to show how these events shift the LM curve. CHAPTER 10 Aggregate Demand I

38. Answer: This causes an increase in money demand. In the Liquidity Preference diagram, the money demand curve shifts up. Hence, at the initial value of income, the interest rate must rise to restore equilibrium in the money market. As a result, the LM curve shifts up: each value of income (such as the initial income) is associated with a higher interest rate than before. CHAPTER 10 Aggregate Demand I

39. r LM Y The Short-Run Equilibrium The short-run equilibrium is the combination of r and Y that simultaneously satisfies the equilibrium conditions in the goods & money markets: IS Equilibrium interest rate Equilibrium level of income CHAPTER 10 Aggregate Demand I

40. The Theory of Short-Run Fluctuation KeynesianCross ISCurve IS-LMModel Explanation of Short-Run Economic Fluctuations Theory of Liquidity Preference LM Curve Aggregate DemandCurve Model of Aggregate Demand and Aggregate Supply Aggregate SupplyCurve CHAPTER 10 Aggregate Demand I

41. Preview of Next Lecture In the next chapter, 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 together to analyze the short-run and long-run effects of shocks. • Use our models to learn about the Great Depression. CHAPTER 10 Aggregate Demand I

42. Lecture Summary • Keynesian cross • basic model of income determination • takes fiscal policy & investment as exogenous • fiscal policy has a multiplier effect on income. • IScurve • comes from Keynesian cross when planned investment depends negatively on interest rate • shows all combinations of r and Ythat equate planned expenditure with actual expenditure on goods & services CHAPTER 10 Aggregate Demand I slide 41

43. Lecture Summary • Theory of Liquidity Preference • basic model of interest rate determination • takes money supply & price level as exogenous • an increase in the money supply lowers the interest rate • LMcurve • comes from liquidity preference theory when money demand depends positively on income • shows all combinations of rand Y that equate demand for real money balances with supply CHAPTER 10 Aggregate Demand I slide 42

44. Lecture Summary • IS-LMmodel • Intersection of ISand LMcurves shows the unique point (Y, r ) that satisfies equilibrium in both the goods and money markets. CHAPTER 10 Aggregate Demand I slide 43