Aggregate Demand - Trinity College DublinAggregate Demand Curve The AD Curve represents combinations of the price level and real output such that the money market clears and actual

Aggregate Demand

Dudley Cooke

Trinity College Dublin

Dudley Cooke (Trinity College Dublin) Aggregate Demand 1 / 37

Reading

Mankiw, Macroeconomics: Chapter 9.3 and 11.2, .3 and Appendix.


Plan

AD Curve:

1 Keynes Effect.

2 Monetary and Fiscal Policy (again).

3 Pigou Effect (real balances effect).

4 Tobin-Fisher Effect (debt deflation effect).


Aggregate Demand Curve

The AD Curve represents combinations of the price level and realoutput such that the money market clears and actual and plannedexpenditure on real output are equal.

The points of intersection of IS=LM, for different price levels, P.

Recall, last time:

y = a + δ (y − t) + h0 − γr + g : IS

ms − p = ky − εr : LM


Solution for the ISLM Model

As before, we can solve the equilibrium for ISLM and get thefollowing:

y ∗ = Ω[a− δt + h0 + g +

γ

ε(ms − p)

];

Ω ≡(

1− δ +γk

ε

)−1

It is now clear that output and price have a negative relationship. Ifwe vary P,

∆y ∗

∆p= − 1

(1− δ) (ε/γ) + k< 0 (1)

which is the slope of the AD curve in (p, y)-space.

Intuition: ↑ p affects the LM directly. There must be a change in theinterest rate and output. The connection? Investment behavior.Implies a movement along the IS (recall L2).


Continued ...

Q: Is there a simpler way of getting here? A: Yes - use a quantityequation and ignore the change in the interest rate.

m− p = y

The LM is vertical in this case.

And the LM alone determines the AD (i.e., we don’t need to sub. theIS into the LM to eliminate the interest rate term)

Output and price must have the following relationship: ∆y ∗

∆p = −1.This is the same as (1) with ε→ 0 and k = 1.

In the both cases, the price level drops from p0 to p1 (p0 > p1).This implies the LM shifts. There is a rise in real balances, a fall inthe interest rate, and higher output.


The ISLM Model and AD Curve

Diagram: The AD Curve

r = i

yp, Price Level

yy0 y1

p1

p0

i1

i0

IS

LM(m− p0)

LM(m− p1)

AD


Keynes Effect

We say the Keynes effect operates if a fall in the price level isassociated with higher output.

as before: ↓ p ⇒↑ (ms − p)⇒↓ i ⇒↑ investment ⇒↑ y .

More detailed intuition

Lower price level leads to higher real balances. For a given interestrate and income ms > md , ⇒ agents reallocate their portfolio frommoney to bonds.

Portfolio reallocation from money into bonds causes an increase inthe price of bonds.


Continued...

..... continued .....

The price of bonds is inversely related to the interest rate, the interestrate reduces to clear the money market for a given level of income.

If investment demand is interest-sensitive, this causes an increase inreal demand for output.

Note: the idea of portfolio reallocation is always present. But sincemoney and bond markets clear together we usually skip that part ofthe story.


Significance of the Keynes Effect

A key implication:

There is no Keynes effect if the AD is vertical.

But when is the AD vertical?

1 when the interest rate can’t fall anymore.

2 why? that is the basic transmission mechanism of monetary policy.

3 it is why ∆y ∗

∆p < 0.


The Liquidity Trap - Again

Initially, prices fall. The interest rate falls. Prices fall some more.Eventually the nominal interest rate hits zero.

This means money and bonds are perfect substitutes.

Say we are in a recession. We want to use monetary policy to lower iand stimulate the economy. We can’t.

Another way of putting that: when i = 0⇒ when we are stuck in aliquidity trap.

So? As we mentioned before, this happened in the US in the 1930’sand more recently in Japan.


Aggregate Demand and the Liquidity Trap

Diagram: AD in a Liquidity Trap

r = i

p, Price Level

yy0y1

p1

p0

imin

AD

IS

p2

LM(m− p0) LM(m− p1) LM(m− p2)


Aggregate Demand, Price Level and Policies

Since we have assumed p is exogenous it is valid to consider whathappens to income as a result of a price change.

Note:

1 A change in y in the ISLM model, resulting from a change in prices,produces a movement along the AD curve

2 A change in y in the ISLM model (say due to a policy), for a given p,will produce a shift in the AD curve.

This leads us to consider the effects of different policies (i.e.monetary and fiscal policy).

Although we studied this before it is important to understand howeach affects the AD curve, not just the IS and LM curves.


Monetary Policy (recap)

From the money market, a rise in ms implies that ms > md , and atgiven i , individuals buy bonds.

However, i falls to clear the market (price of bonds, PB , rises) suchthat people are happy to hold additional money balances and themoney market returns to equilibrium at a lower interest rate.

This impacts the goods market, as a reduction in i stimulatesinvestment. This raises Ep and subsequently Y . We called this the‘monetary transmission mechanism’.

Now we see that, for a given price level, output rises, which impliesan outward shift in the AD curve ↑ m⇒↓ i ⇒↑ y.


AD Curve and Monetary Policy

The AD Curve and Monetary Policy

r = i

yp, Price Level

yy0 y1

p0

i0

i1

AD(m0)

AD(m1)

LM(m0 − p)

LM(m1 − p)

IS


Fiscal Policy (recap)

From the Keynesian cross analysis, a rise in G shifts the Ep → Ep′

line such that Ep′ > Y . There is also a resulting change inconsumption and a multiplier effect such that Ep′ = Y ′ > Y .

However, the Keynesian cross analysis holds interest rates constant.Once we account for the money market, we can also describe thechange in the interest rate.

For a given money supply and price level, higher income requires ahigher interest rate. This impacts investment demand negatively sothere is a crowding out effect. Output still rises but by less than inthe Keynesian cross case.

For a given price level we find that output rises. Thus, there is anoutward shift in the AD curve ↑ g ⇒↑ i ⇒↑ y.


AD Curve and Fiscal Policy

The AD Curve and Fiscal Policy

r = i

yp, Price Level

yy0 y1

p0

i1

i0

AD(g0)

AD(g1)

IS(g0)

IS(g1)

LM


More on Deflation and Aggregate Demand

There are other channels through which deflation can affect aggregatedemand. The first we will consider is the Pigou Effect.

Basic argument for the Pigou (or ‘real balances’) effect.

Money balances are part of household wealth. If prices fall, thispart of wealth rises. Wealthier agents spend more. This stimulatesaggregate demand.

1 Implication 1: in a depression with falling prices there is astabilizing effect to deflation.

2 Implication 2: we can escape a liquidity trap with monetary policy(less obvious).


The Pigou Effect

How does the Pigou effect work in our model? It changes the IScurve.

For example, we can write the following:

y = a + Λ + h0 − γr + g : IS

Λ ≡ δ (y − t) + δm (ms − p)

where δ is the MPC out of disposable income (i.e. y − t), as before

Here δm is the MPC of real balances.

Note that 0 ≤ δm < 1 and if δm = 0 we have our old model back.


Deflation and the Pigou Effect

↓ p ⇒ ↑ consumers’ net real wealth ⇒ ↓ savings and ↑ currentconsumption demand ⇒ IS schedule shifts outwards for any givenlevel of the interest rate.

Implications:

1 The AD Curve is Flatter than before.

2 It cannot be vertical.

3 Price deflation is more expansionary, i.e. a reduction in the price levelboosts output more than usual. (hence, stabilizes output in adepression)


Monetary Policy and the Pigou Effect

The ISLM Model:

y = a + δ (y − t) + δm (ms − p) + h0 − γr + g : IS


Equilibrium is still (y ∗, i∗) but now the ‘money multiplier’, ∆y ∗/∆ms ,will change.

In particular, monetary policy is more expansionary (for a given pricelevel).

Need to be careful: a change in p produces a “Pigou effect”. Butif the Pigou effect operates this also affects how monetary policyaffects output.


A Fall in the Price Level

Diagram: A fall in the price level

r = i

yp, Price Level

yy0 y1,k y1,kp

i0

p0

ADk

ADkp

p1

LM(m− p0)

LM(m− p1)

IS(m− p0)

IS(m− p1)


The Money Multiplier

Equilibrium output is found in the same way as before (i.e. IS=LM):

y ∗ = Ω[a− δt + h0 +

[δm +

γ

ε

](ms − p) + g

]⇒ ∆y ∗/∆ms

=εδm + γ

(1− δ) ε + kγ>

γ

(1− δ) ε + γk︸︷︷︸if δm=0

if (δm, ε) > 0.

Liquidity trap: where LM is flat and ε→ ∞. In this case:∆y ∗/∆ms > 0! So Monetary Policy works.

But how much wealth is composed of cash? Answer: not much. Thisimplies δm is small and the Pigou effect is probably weak.


Monetary Policy with and without the Pigou EffectDiagram: AD Curve and Monetary Policy

with/without the Pigou Effect

p, Price Level

y, Output

p0

y0

Keynes Effect

Keynes and Pigou Effect

ADkp(m0)ADkp(m1)

ADk(m0)ADk(m1)

Absent the Keynes effect, the AD is still not

vertical.Dudley Cooke (Trinity College Dublin) Aggregate Demand 24 / 37

Tobin-Fisher (debt-deflation) Effect

The ‘Tobin-Fisher effect’ also alters the IS curve.

Basic mechanism: changes in the price level redistribute wealthbetween debtors and creditors.

1 If debtors and creditors have different MPC’s (δ in our notation) thenthere will be an additional effect on aggregate demand (in addition tothe Keynes effect) when prices fall.

2 In a depression with falling prices, this is destabilizing.


Intuition for the TF Effect

Debt contracts are usually set in nominal terms, i.e. they specifyinterest payments in money value.

Suppose that there is a reduction in the price level that was notanticipated by either creditors or debtors at the time of signing thedebt contract.

Borrowers see that the real value of their debt has increased, whichimplies that lenders receive more payments in real terms. In otherwords, there is a redistribution from debtors to creditors - and thesehave different MPCs.


House Prices and TF Effect

The TF effect is similar to a ‘credit channel’, where credit could referto bank loans. This channel can amplify the effect of shocks anddeflation on aggregate demand.

One example is the housing market.

1 In the early 1990’s prices of houses fell sharply causing negative equity(around one million homes). The same happened in Hong-Kong inthe 1998-2003 period.

2 Negative equity is a situation in which the market value of the houseis lower than the amount outstanding on the loan used to purchase it.


House Prices

Real house prices (Source: The Economist)

• The real price of houses fell dramatically

post 1989.

• Inflation was also very low in the early 1990’s,

which was also a time of recession in the

UK economy.


Irish House Prices

Year

s' ea

rnin

gs

4

6

8

10

12

14

16

1980 1985 1990 1995 2000 2005 2010

Dublin Secondhand

Dublin New

Secondhand

New

Figure 4: Irish house prices relative to average earnings, 1980–2009.

Particularly large rises occurred in property lending, both in mortgages to households and

in loans to builders and developers. As Figure 3 shows, at the start of the credit bubble in

1997 banks were lending €20 Bn in mortgages in 2009 prices, and €10 Bn to developers.9 By

2008, the value of mortgage lending (including the quarter of mortgages that were securitised)

had risen to seven times its 1997 value, while lending to developers was 11 times its 1997

value.

For comparison, during this time, thanks in large part to the construction activity gen-

erated by this lending, real GNP rose by 75%. To put these number in further perspective,

the total value of bank lending to the non-financial private sector in 2000 was around €80

Bn in 2009 prices. Irish banks were therefore lending 75% more in mortgages than they had

been lending to everyone in Ireland 8 years earlier, and 40% more to developers.

8


Irish Construction Activity and Houses

% o

f GNP

4

6

8

10

12

14

1970 1975 1980 1985 1990 1995 2000 2005 2010

Housing

Other

Figure 8: Share of construction in GNP, 1970–2008.

holding earnings constant, a 10 per cent rise in house prices is associated with a 15 per cent

rise in completions.

Figure 8 shows the marked impact of house building on GNP. Until 1997 Ireland, like

any other industrial economy, got from 4 to 6 per cent of its GNP from building houses.

By 2006–07 this had risen to 13%. For comparison, in the other major European housing

boom, in Spain, housing investment peaked at 9% of GDP. Adding other construction (but

not roads), building was accounting for an extraordinary one fifth of Irish national income

at the peak of the bubble in 2007.15

If we look at the increase of Irish GNP between 2000 and 2007, 28 per cent is accounted

for directly by the growth of construction output.

This construction boom created two serious distortions in the Irish economy. First,

as labour demand rose, particularly for less skilled labour, wage rates across the economy

were driven up out of proportion to productivity growth, leading to a fall in international

competitiveness. Between 2000 and 2008 hourly earnings in manufacturing relative to major

15These data somewhat overstate the contribution of construction to Irish GNP to the extent that theyinclude imported inputs. However the bulky nature of building materials ensures that most are produceddomestically.

13


The Tobin-Fisher Effect in an ISLM Model

How does the TF effect work in our model?

y = a + Φ + h0 − γr + g : IS

Φ ≡ αδd (y − t) + (1− α) δc (y − t)


where δd , the MPC of debtors, is larger than δc , the MPC ofcreditors, i.e. δd > δc .

where α is the proportion of debtors (this has to have been rising overtime in the Ireland, for example).

Main implication: this changes Ω (from earlier) directly. Ifδd = δc or α = 1 then we get the standard model, as above.


Intuition

If debtors have a higher marginal propensity to consume (MPC) thancreditors, this redistribution effect causes a reduction in AD.

Creditors spend a smaller fraction of their additional income, anddebtors are forced to cut back consumption and investment toreduce/repay their debts.

Eventually, debtors can become insolvent (e.g. firms can shut downplants).

This is essentially a propagation mechanism for shocks.


Tobin-Fisher Effect

Diagram: Tobin-Fisher Effect

r = i

yp, Price Level

yy0

p0

ADktf

ADk

p1

LM(m− p0)

y1,ktf y1,k

i0

LM(m− p1)

IS(.; p1)

IS(.; p0)


Is the TF Effect Realistic?

Possibly! Again - the negative equity problem in the UK in the1990’s.

Interestingly, the Bank of England is also very wary of the housingmarket and consumer debt levels (as is the Federal Reserve).

It is perhaps best to view the TF effect as proxying for a broadercredit channel. This can apply both to firms and households.Negative equity and firm shutdown are events that arise from largeshocks.

More generally, we would expect the credit channel to add toobserved business cycle patterns.


Extreme Implications from TF Effect

If price deflation is large and the Tobin Fisher effect strong the ADcurve may become backward bending.

That is, tot only is deflation less expansionary - it may becontractionary.


Extreme Implications

Extreme Implications

If price deflation is large and the Tobin Fisher

effect strong the AD curve may become back-

ward bending.

p, Price Level

y

ADtf>k ADtf<k

p0

p1

y0

• Not only is deflation less expansionary - it

may be contractionary.


Recap on the AD curve

The AD is down ward sloped in (p, y)-space. This is because Keyneseffect implies a lower price level contributes to a lower interest ratewhich, all else equal, stimulates aggregate demand.

We can extend the basic model to generate some interesting results:

1 Pigou Effect: δ ∈ [0, 1) and δm ∈ [0, 1) is MPC of real balances.This implies there are wealth effects from Monetary Policy and pricechanges. If δm = 0 only a Keynes effect is possible.

2 TF Effect: δd and δc ∈ [0, 1) for debtors and creditors. If δd 6= δc

price changes redistribute wealth in the economy. If δd = δc = δ wecame back to the Keynes effect only.


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Aggregate Demand - Trinity College DublinAggregate Demand Curve The AD Curve represents combinations of the price level and real output such that the money market clears and actual