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Macroeconomics of
Business Cycles
macr o
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m
Growth rates of real GDP, consumptionPercent
change
from 4quarters
earlier
Averagegrowth
rate
Real GDP growth rate
Consumptiongrowth rate
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Growth rates of real GDP, consumption,
investmentPercent
change
from 4quarters
earlier
Investment growth rate
Real GDP
growth rate
Consumptiongrowth rate
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Unemployment
Percent
of labor
force
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Facts about the business cycle
GDP growth averages 3–3.5 percent per year
over the long run with large fluctuations in theshort run.
Consumption and investment fluctuate with
GDP, but consumption tends to be less volatileand investment more volatile than GDP.
Unemployment rises during recessions andfalls during expansions.
Okun’s Law: the negative relationshipbetween GDP and unemployment.
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Index of Leading Economic
Indicators Published monthly by the Conference
Board.
Aims to forecast changes in economic
activity 6-9 months into the future.
Used in planning by businesses andgovt, despite not being a perfect
predictor.
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Components of the LEI index
Average workweek in manufacturing
Initial weekly claims for unemployment insurance
New orders for consumer goods and materials
New orders, nondefense capital goods
Vendor performance
New building permits issued
Index of stock prices
M2
Yield spread (10-year minus 3-month) on Treasuries
Index of consumer expectations
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Index of Leading Economic Indicators
Source:
ConferenceBoard
2004
=
100
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Time horizons in macroeconomics
Long runPrices are flexible, respond tochanges in supply or demand.
Short runMany prices are “sticky” at apredetermined level.
The economy behaves much
differently when prices are sticky.
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Recap of classical macro theory
Output is determined by the supply side:– supplies of capital, labor
– technology
Changes in demand for goods & services(C, I, G ) only affect prices, not quantities.
Assumes complete price flexibility.
Applies to the long run.
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When prices are sticky…
…output and employment alsodepend on demand, which isaffected by:
– fiscal policy (G and T )
– monetary policy (M )
– other factors, like exogenouschanges inC or I
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AD/AS Model
The paradigm most mainstream economistsand policymakers use to think about economicfluctuations and policies to stabilize the
economy Shows how the price level and aggregate
output are determined
Shows how the economy’s behavior isdifferentin the short run and long run
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Aggregate demand
The aggregate demand curve shows therelationship between the price level and thequantity of output demanded.
we use a simple theory of AD based on thequantity theory of money.
Recall the quantity equationM V = P Y
For given values of M and V ,this equation implies an inverse relationshipbetween P and Y :
Y = M V / P
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The downward-sloping AD curve
An increase in the
price level causes a
fall in real money
balances (M / P ),
causing a decrease in
the demand for
goods & services.
An increase in the
price level causes a
fall in real money
balances (M / P ),
causing a decrease inthe demand for
goods & services.
Y
P
AD
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Shifting the AD curve
An increase in
the money
supply shiftsthe AD curve
to the right.
An increase in
the money
supply shiftsthe AD curve
to the right.
Y
P
AD1
AD
2
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Aggregate supply in the long run
Recall from Chapter 3:In the long run, output is determined by
factor supplies and technology,= ( )Y F K L
is the full-employment or natural level of
output, at which the economy’s resources are
fully employed.
Y
“Full employment” means that
unemployment equals its natural rate (not zero).
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The long-run aggregate supply curve
Y
P LRAS
does notdepend on P,so LRAS isvertical.
does notdepend on P,so LRAS is
vertical.
Y
( )= ,
Y
F K L
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Long-run effects of an increase in M
Y
P
AD1
LRAS
Y
An increasein M shifts
AD to the
right.
P1
P2In the long run,
this raises the
price level…
…but leaves
output the same.
AD
2
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Aggregate supply in the short run
Many prices are sticky in the short run.
For now we assume– all prices are stuck at a predetermined
level in the short run.– firms are willing to sell as much at that
price level as their customers are willingto buy.
Therefore, the short-run aggregatesupply (SRAS) curve is horizontal:
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The short-run aggregate supply curve
Y
P
PSRAS
The SRAS curve ishorizontal:
The price level isfixed at apredeterminedlevel, and firms sellas much as buyersdemand.
The SRAS curve ishorizontal:
The price level isfixed at apredetermined
level, and firms sellas much as buyersdemand.
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Short-run effects of an increase in M
Y
P
AD1
In the short run
when prices are
sticky,…
…causes output
to rise.
PSRAS
Y 2Y 1
AD
2
…an increase inaggregate demand…
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From the short run to the long run
Over time, prices gradually become “unstuck.” When they do, will
they rise or fall?
Y Y >
Y Y <
Y Y =
rise
fall
remain constant
In the short-run
equilibrium, if
then over time,
P will…
The adjustment of prices is what moves
the economy to its long-run equilibrium.
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The SR & LR effects of ∆ M > 0
Y
P
AD1
LRAS
Y
PSRAS
P2
Y 2
A = initialequilibrium
A
B
CB = new short-
run eq’m
after Fed
increases M
C = long-run
equilibrium
AD
2
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How shocking!!!
shocks: exogenous changes in agg. supply ordemand
Shocks temporarily push the economy away fromfull employment.
Example: exogenous decrease in velocity
If the money supply is held constant, a decreasein V means people will be using their money in
fewer transactions, causing a decrease indemand for goods and services.
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PSRAS
LRAS
AD2
The effects of a negative demand shock
Y
P
AD
1
Y
P2
Y 2
AD shifts left,depressing outputand employmentin the short run.
AD shifts left,depressing outputand employmentin the short run.
AB
C
Over time,
prices fall and
the economy
moves down itsdemand curve
toward full-
employment.
Over time,
prices fall and
the economy
moves down itsdemand curve
toward full-
employment.
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Supply shocks
A supply shock alters production costs, affects the pricesthat firms charge. (also called price shocks)
Examples of adverse supply shocks:
– Bad weather reduces crop yields, pushing upfood prices.
– Workers unionize, negotiate wage increases.– New environmental regulations require firms to reduce
emissions. Firms charge higher prices to help cover thecosts of compliance.
Favorable supply shocks lower costs and prices.
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CASE STUDY:
The 1970s oil shocks
Early 1970s: OPEC coordinates areduction in the supply of oil.
Oil prices rose
11% in 197368% in 197416% in 1975
Such sharp oil price increases aresupply shocks because theysignificantly impact production costsand prices.
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1P
SRAS1
Y
P
AD
LRAS
Y Y 2
CASE STUDY:
The 1970s oil shocks
The oil price shock shiftsSRAS up, causing outputand employment to fall.
The oil price shock shiftsSRAS up, causing outputand employment to fall.
A
B
In absence of
further price
shocks, prices will
fall over time andeconomy moves
back toward full
employment.
In absence of
further price
shocks, prices will
fall over time andeconomy moves
back toward full
employment.
2P SRAS2
A
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CASE STUDY:
The 1970s oil shocks
Predicted effectsof the oil shock:
• inflation ↑
• output ↓
• unemployment ↑
…and then agradual recovery.
0%
10%
0%
0%
40%
50%
60%
70%
197 1974 1975 1976 1
Change in oil prices (left scale)
Inflation rate-CPI (right scale)
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CASE STUDY:
The 1970s oil shocks
Late 1970s:
As economywas recovering,oil prices shot up
again, causinganother hugesupply shock!!!
0%
10%
0%
30%
40%
50%
60%
1977 1978 1979 1980 1
Change in oil prices (left scale)
Inflation rate-CPI (right scale)
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CASE STUDY:
The 1980s oil shocks
1980s:
A favorablesupply shock--a significant
fall in oilprices.
As the modelpredicts,inflation andunemploymentfell:
-50%-40%
-30%
-0%
-10%0%
10%
0%
30%
40%
198 1983 1984 1985 1986 19
Change in oil prices (left scale)
Inflation rate-CPI (right scale)
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Stabilization policy
def: policy actions aimed atreducing the severity of short-runeconomic fluctuations.
Example: Using monetary policy tocombat the effects of adversesupply shocks…
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Stabilizing output with
monetary policy
1P
SRAS1
Y
P
AD
1
B
A
Y 2
LRAS
Y
The adverse
supply shock
moves the
economy to
point B.
The adverse
supply shock
moves the
economy to
point B.
2P SRAS2
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Stabilizing output with
monetary policy
1P
Y
P
AD
1
B
A
C
Y 2
LRAS
Y
But the Fed
accommodates
the shock by
raising agg.
demand.
But the Fed
accommodates
the shock by
raising agg.
demand.
results:
P is permanently
higher, but Y
remains at its full-
employment level.
results:
P is permanently
higher, but Y
remains at its full-
employment level.
2P SRAS2
AD
2
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Aggregate Demand I:Aggregate Demand I:
The The IS-LMIS-LM ModelModel
The IS - LM model determinesincome and the interest rate in
the short run when P is fixed
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The Big Picture
KeynesianCrossKeynesianCross
Theory of
Liquidity
Preference
Theory of
Liquidity
Preference
IS curve
IS curve
LM
curve
LM
curve
IS-LM
model
IS-LM
model
Agg.
demand
curve
Agg.
demand
curve
Agg.
supply
curve
Agg.
supply
curve
Model of
Agg.
Demandand Agg.
Supply
Model of
Agg.
Demandand Agg.
Supply
Explanation
of short-run
fluctuations
Explanation
of short-run
fluctuations
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The Keynesian Cross
A simple closed economy model in which incomeis determined by expenditure.(due to J.M. Keynes)
Notation:
I = planned investmentPE = C + I + G = planned expenditure
Y = real GDP = actual expenditure
Difference between actual & planned
expenditure = unplanned inventory investment
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Elements of the Keynesian Cross
( )C C Y T = −
I I=
,G G T T = =
= − + +( )PE C Y T I G
=Y PE
consumption function:
for now, planned
investment is exogenous:
planned expenditure:
equilibrium condition:
govt policy variables:
actual expenditure = planned expenditure
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Graphing planned expenditure
income, output, Y
PE
planned
expenditure
PE =C +I
+G
MPC 1
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Graphing the equilibrium condition
income, output, Y
PE
planned
expenditure
PE =Y
45º
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The equilibrium value of income
income, output, Y
PE
planned
expenditure
PE =Y
PE =C +I
+G
Equilibrium
income
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An increase in government purchases
Y
PE
P E = Y
PE =C +I
+G1
PE1 =
Y 1
PE =C +I
+G2
PE2 =
Y 2
∆ Y
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= ∆ + ∆
( MPC)− ×∆ = ∆Y G
MPC
∆ = × ∆ −
Y G
equilibrium condition
in changes
because I exogenous
because ∆ C = MPC
∆ Y
Collect terms with ∆ Y
on the left side of theequals sign:
Solve for ∆ Y :
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The government purchases multiplier
Example: If MPC = 0.8, then
Definition: the increase in incomeresulting from a $1 increase in G.
In this model, the govtpurchases multiplier equals
MPC
∆=
∆ −
Y
G
.∆ = =∆ −
Y
G
An increase in G
causes income to
increase 5 times
as much!
An increase in G
causes income to
increase 5 times
as much!
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Why the multiplier is greater than 1
Initially, the increase in G causes anequal increase in Y : ∆ Y = ∆ G.
But ↑Y ⇒ ↑C
⇒further
↑Y
⇒ further ↑C
⇒ further ↑Y
So the final impact on income is muchbigger than the initial ∆ G.
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An increase in taxes
Y
PE
P E
= Y PE =C2 +I
+G
PE2 = Y 2
PE =C1 +I
+G
PE1 =
Y 1
∆
Y
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 PE :
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Solving for ∆ Y
Y C I G∆ = ∆ + ∆ + ∆
( )MPC= × ∆ − ∆Y T
C= ∆
( MPC) MPC− × ∆ = − × ∆Y T
eq’m condition in
changes
I and G exogenous
Solving for
∆ Y :
MPC
MPC −∆ = × ∆ −
Y T Final result:
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The tax multiplier
def: the change in income resulting froma $1 increase in T :
MPC
MPC
∆ −=
∆ −
Y
T
. . . .2∆ − −= = = −∆ −
Y
T
If MPC = 0.8, then the tax multiplier equals
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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 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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The IS curve
def: a graph of all combinations of r and Y that result in goods marketequilibrium
i.e. actual output = planned expenditure
The equation for the IS curve is:
( ) ( )Y C Y T I r G= − + +
J.R. Hicks
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Why the IS curve is negatively sloped
A fall in the interest rate motivates firms toincrease investment spending, which drivesup total planned spending (PE ).
To restore equilibrium in the goods market,
output (a.k.a. actual expenditure, Y )must increase.
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Fiscal Policy and the IS curve
We can use the IS-LM
model to seehow fiscal policy (G and T ) affectsaggregate demand and output.
Let’s start by using the Keynesiancrossto 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 ⇒ ↑PE ⇒ ↑Y
Y
PE
r
Y
PE =C +I (r 1 )
+G1
PE =C +I (r 1
)
+G2
r 1
PE
=Y
IS1
The horizontal
distance of the
IS shift equals
IS2
…so the IS curve
shifts to the right.
11 MPC
∆ = ∆−
Y G ∆
Y
NOW YOU TRY:
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NOW YOU TRY:
Shifting the IS curve: ∆ T
Use the diagram of the Keynesiancross or loanable funds model toshow 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 andmoney demand.
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Equilibrium
The interestrate adjuststo equate thesupply anddemand for
money:
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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The LM curve
Now let’s put Y back into the moneydemand function:
( , )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 for real money balances (b) The LM curve
Wh h LM i d l i
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Why the LM curve is upward sloping
An increase in income raises moneydemand.
Since the supply of real balances isfixed, there is now excess demandin the money market at the initialinterest rate.
The interest rate must rise torestore equilibrium in the moneymarket.
H M hift th LM
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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
LM1
(a) The market for real money balances (b) The LM curve
2M
P
LM
2
Th h t ilib i
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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
P li l i ith th IS LM d l
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Policy analysis with the IS -LM model
We can use the IS-LM
model to analyze theeffects of
• fiscal policy: G and/orT
• monetary policy: M
( ) ( )Y C Y T I r G= − + +( , )M P L r Y =
IS
Y
r LM
r 1
Y 1
A i i t h
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causing output &
income to rise.
IS1
An increase in government purchases
1. IS curve shifts right
Y
r LM
r 1
Y 1
1by
1 MPCG∆
−
IS2
Y 2
r 2
1.2. This raises money
demand, causing the
interest rate to rise…
2.
3. …which reduces investment,so the final increase in Y
1is smaller than
1 MPCG∆
−
3.
A t t
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IS1
1.
A tax cut
Y
r LM
r 1
Y 1
IS2
Y 2
r
2
Consumers save (1−MPC )
of the tax cut, so the initial
boost in spending is
smaller for ∆ T than for
an equal ∆ G …
and the IS curve shifts by
MPC
1 MPCT
−∆
−1.
2.
2.…so the effects on r
and Y are smaller for ∆ T
than for an equal ∆ G .
2.
M t li A i i M
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2. …causing theinterest rate to fall
IS
Monetary policy: An increase in M
1. ∆ M > 0 shiftsthe LM curve down(or to the right)
Y
r LM1
r 1
Y 1 Y 2
r 2
LM2
3. …which increases
investment, causingoutput & income to
rise.
Th F d’ t G 0
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The Fed’s response to ∆ G > 0
Suppose Congress increases G.
Possible Fed responses:
1. hold M constant
2. hold r constant3. hold Y constant
In each case, the effects of the
∆ G are different…
Response 1: Hold M constant
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If Congress raises G ,the IS curve shifts right.
IS1
Response 1: Hold M constant
Y
r LM
1
r 1
Y 1
IS2
Y 2
r 2If Fed holds M constant,
then LM curve doesn’tshift.
Results:
2 1
Y Y Y
∆ = −2 1
r r r ∆ = −
Response 2: Hold r constant
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If Congress raises G ,the IS curve shifts right.
IS1
Response 2: Hold r constant
Y
r LM
1
r 1
Y 1
IS2
Y 2
r 2To keep r constant,
Fed increases M to shift LM curve right.
3 1Y Y Y ∆ = −0r ∆ =
LM
2
Y 3
Results:
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E ti t f fi l li lti li
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Estimates of fiscal policy multipliersfrom the DRI macroeconometric model
Assumption about
monetary policy
Estimated
value of
∆ Y / ∆ G
Fed holds nominalinterest rate constant
Fed holds money
supply constant
1.93
0.60
Estimated
value of
∆ Y / ∆ T
−1.19
−0.26
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Shocks in the IS LM model
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Shocks in the IS -LM model
LM shocks: exogenous changesin the demand for money.
Examples:
– a wave of credit card fraudincreases demand for money.
– more ATMs or the Internet reducemoney demand.
NOW YOU TRY:
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NOW YOU TRY:
Analyze shocks with the IS-LM Model
Use the IS-LM model to analyze the effects of 1. a boom in the stock market that makes
consumers wealthier.
2. after a wave of credit card fraud, consumers
using cash more frequently in transactions.
For each shock,
a. use the IS-LM diagram to show the effects of theshock on Y and r .
b.determine what happens to C, I, and theunemployment rate.
CASE STUDY:
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The U.S. recession of 2001 During 2001,
– 2.1 million jobs lost,unemployment rose from 3.9% to5.8%.
– GDP growth slowed to 0.8%(compared to 3.9% average annualgrowth during 1994-2000).
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CASE STUDY:
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The U.S. recession of 2001
Causes: 2) 9/11– increased uncertainty
– fall in consumer & business confidence
– result: lower spending, IS curve shiftedleft
Causes: 3) Corporate accounting scandals– Enron, WorldCom, etc.
– reduced stock prices, discouraged
investment
CASE STUDY:
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The U.S. recession of 2001
Fiscal policy response: shifted IS
curve right– tax cuts in 2001 and 2003– spending increases
•airline industry bailout•NYC reconstruction•Afghanistan war
CASE STUDY:
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The U.S. recession of 2001 Monetary policy response: shifted LM curve
right
Three-month
T-Bill Rate
Three-month
T-Bill Rate
0
1
2
3
4
5
6
7
0
1 / 0
1 / 2 0 0 0
0
4 / 0 2 / 2 0 0 0
0
7 / 0 3 / 2 0 0 0
1
0 / 0 3 / 2 0 0 0
0
1 / 0 3 / 2 0 0 1
0
4 / 0 5 / 2 0 0 1
0
7 / 0 6 / 2 0 0 1
1
0 / 0 6 / 2 0 0 1
0
1 / 0 6 / 2 0 0 2
0
4 / 0 8 / 2 0 0 2
0
7 / 0 9 / 2 0 0 2
1
0 / 0 9 / 2 0 0 2
0
1 / 0 9 / 2 0 0 3
0
4 / 1
1 / 2 0 0 3
IS-LM and aggregate demand
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IS-LM and aggregate demand
So far, we’ve been using the IS-LM model to analyze the short run,when the price level is assumedfixed.
However, a change in P would shiftLM and therefore affect Y .
The aggregate demand curve (introduced in Chap. 9) captures thisrelationship between P and Y.
Deriving the AD curve
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Y 1Y 2
Deriving the AD curve
Y
r
Y
P
IS
LM (P 1)
LM (P 2)
AD
P 1
P 2
Y 2 Y 1
r 2
r 1
Intuition for slope
of AD curve:
↑P ⇒ ↓(M / P )
⇒ LM shifts left
⇒ ↑r
⇒ ↓I
⇒ ↓Y
Monetary policy and the AD curve
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Monetary policy and the AD curve
Y
P
IS
LM (M 2 /P 1)
LM (M 1 /P 1)
AD1
P 1
Y 1
Y 1
Y 2
Y 2
r 1
r 2
The Fed can increaseaggregate demand:
↑M ⇒ LM shifts right
AD2
Y
r
⇒ ↓r
⇒ ↑I
⇒ ↑Y at each
value of P
Fiscal policy and the AD curve
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Y 2
Y 2
r 2
Y 1
Y 1
r 1
Fiscal policy and the AD curve
Y
r
Y
P
IS 1
LM
AD1
P 1
Expansionary fiscalpolicy (↑G and/or ↓T )
increases agg. demand:
↓T ⇒ ↑C
⇒ IS shifts right
⇒ ↑Y at each
value of P
AD2
IS 2
IS-LM and AD-AS
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IS LM and AD AS
in the short run & long run
Recall from Chapter 9: The force that movesthe economy from the short run to the long run
is the gradual adjustment of prices.
Y Y >
Y Y <Y Y =
rise
fall
remain constant
In the short-runequilibrium, if
then over time, theprice level will
The SR and LR effects of an IS shock
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The SR and LR effects of an IS shock
A negative IS shock shifts IS and AD left,causing Y to fall.
A negative IS shock shifts IS and AD left,causing Y to fall.
Y
r
Y
P LRAS
Y
LRAS
Y
IS1
SRAS 1P1
LM (P 1)
IS2
AD2
AD1
The SR and LR effects of an IS shock
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The SR and LR effects of an IS shock
Y
r
Y
P LRAS
Y
LRAS
Y
IS1
SRAS 1P1
LM (P 1)
IS2
AD2
AD1
In the new short-run
equilibrium,
In the new short-run
equilibrium, Y Y <
The SR and LR effects of an IS shock
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The SR and LR effects of an IS shock
Y
r
Y
P LRAS
Y
LRAS
Y
IS1
SRAS 1P1
LM (P 1)
IS2
AD2
AD1
In the new short-run
equilibrium,
In the new short-run
equilibrium, Y Y <
Over time, P gradually
falls, causing
• SRAS to move down
• M / P to increase,which causes LM
to move down
Over time, P gradually
falls, causing
• SRAS to move down
• M / P to increase,which causes LM
to move down
The SR and LR effects of an IS shock
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AD2
The SR and LR effects of an IS shock
Y
r
Y
P LRAS
Y
LRAS
Y
IS1
SRAS 1P1
LM (P 1)
IS2
AD1
SRAS 2P2
LM (P 2)
Over time, P gradually
falls, causing
• SRAS to move down
• M / P to increase,which causes LM
to move down
Over time, P gradually
falls, causing
• SRAS to move down
• M / P to increase,which causes LM
to move down
The SR and LR effects of an IS shock
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AD2
SRAS 2P2
LM (P 2)
The SR and LR effects of an IS shock
Y
r
Y
P LRAS
Y
LRAS
Y
IS1
SRAS 1P1
LM (P 1)
IS2
AD1
This process continues
until economy reaches a
long-run equilibrium withY Y =
NOW YOU TRY:
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Analyze SR & LR effects of ∆ M
a.Draw the IS-LM and AD- AS diagrams as shown
here.
b.Suppose Fed increases
M. Show the short-runeffects on your graphs.
c. Show what happens in
the transition from the
short run to the long run.
d.How do the new long-run
equilibrium values of the
endogenous variables
compare to their initial
values?
Y
r
Y
P LRAS
Y
LRAS
Y
IS
SRAS 1P1
LM (M1/P1)
AD1
The Great Depression
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The Great Depression
Unemployment (right scale)
Real GNP
(left scale)
120
140
160
180
200
220
240
1929 1931 1933 1935 1937 1939
b
illion
s
of1958
dollars
0
5
10
15
20
25
30
perce
ntofla
borforce
THE SPENDING HYPOTHESIS:
Sh k t th IS
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Shocks to the IS curve
asserts that the Depression was largelydue to an exogenous fall in the demandfor goods & services – a leftward shift of the IS curve.
evidence:output and interest rates both fell,which is what a leftward IS shift would
cause.
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THE MONEY HYPOTHESIS:
A h k t th LM
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A shock to the LM curve
asserts that the Depression was largelydue to huge fall in the money supply.
evidence:M1 fell 25% during 1929-33.
But, two problems with this hypothesis:– P fell even more, so M/P actually rose
slightly during 1929-31.
– nominal interest rates fell, which is theopposite of what a leftward LM shiftwould cause.
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THE MONEY HYPOTHESIS AGAIN:
The effects of falling prices
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The effects of falling prices
The destabilizing effects of expecteddeflation:
↓Eπ
⇒ r ↑ for each value of i ⇒ I ↓ because I = I (r )
⇒ planned expenditure & agg. demand ↓
⇒ income & output ↓
THE MONEY HYPOTHESIS AGAIN:
The effects of falling prices
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The effects of falling prices
The destabilizing effects of unexpected deflation:debt-deflation theory
↓P (if unexpected)
⇒ transfers purchasing power from borrowers
to lenders⇒ borrowers spend less,
lenders spend more
⇒ if borrowers’ propensity to spend is larger
than lenders’, then aggregate spending
falls,
the IS curve shifts left, and Y falls
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House price change and newforeclosures 2006:Q3 – 2009Q1
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foreclosures, 2006:Q3 2009Q1
New
forecl
osu
res,
%
ofal l
mo
rtgages
Cumulative change in house price index
Nevada
Georgia
Colorado
Texas
AlaskaWyoming
Arizona
California
Florida
S. Dakota
Illinois
Michigan
Rhode Island
N. Dakota
Oregon
Ohio
New Jersey
Hawaii
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Consumer sentiment and growth in consumer durables and investment spending
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du ab es a d est e t spe d g
Real GDP growth and Unemployment
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