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Chapter Eleven 1
CHAPTER 11Aggregate Demand II
A PowerPointTutorial
To Accompany
MACROECONOMICS,6th. ed.N. Gregory Mankiw
By
Mannig J. Simidian
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Chapter Eleven 2
Now that weve assembled the
IS-LMmodel of aggregate
demand, lets apply it to threeissues:
1) Causes of fluctuations in
national income
2) HowIS-LMfits into the
model of aggregate supply and
aggregate demand in Chapter 9
3) The Great Depression
r
Y
LM(P0)IS
r0
Y0
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Chapter Eleven 3
The intersection of theIScurve and theLM
curve determines the level of national income,
and the interest rate for a given price level. If the
ISorLMcurve 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.
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Chapter Eleven 4
ISLM
r
y
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Chapter Eleven 5
LMr
Y
IS
A
+G Consider an increase in government purchases.This will raise the level of income by G/(1-MPC)
IS
B
TheIScurve shifts to the right by G/(1-MPC) which raises income
and the interest rate.
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Chapter Eleven 6
LMr
Y
IS
A
-T Consider a decrease in taxes ofT.This will raise the level of income byTMPC/(1-MPC)
IS
B
The IS curve shifts to the right by TMPC/(1-MPC) which raises
income and the interest rate.
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Chapter Eleven 7
ISLM
r
y
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Chapter Eleven 8
ISr
Y
LM
A LM
B
+M Consider an increase in the money supply.
TheLMcurve shifts downward and lowers the interest rate which raises
income. Why? Because when the Fed increases the supply of money, people
have more money than they want to hold at the prevailing interest rate. As a
result, they start depositing this extra money in banks or use it to buy bonds.
The interest rate rthen falls until people are willing to hold all the extramoney that the Fed has created; this brings the money market to a new
equilibrium. The lower interest rate, in turn, has ramifications for the goods
market. A lower interest rate stimulates planned investment, which increases
planned expenditure, production, and income Y.
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Chapter Eleven 9
TheIS-LMmodel shows that monetary policy influences income by
changing the interest rate. This conclusion sheds light on our analysisof monetary policy in Chapter 9. In that chapter we showed that in
the short run, when prices are sticky, an expansion in the money
supply raises income. But we didnt discuss how a monetary
expansion induces greater spending on goods and servicesa process
called the monetary transmission mechanism.
TheIS-LMmodel shows that an increase in the money supply lowers
the interest rate, which stimulates investment and thereby expands the
demand for goods and services.
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Chapter Eleven 10
The IS-LM model shows how monetary and fiscal policy influence
the equilibrium level of income. The predictions of the model,
however, are qualitative, not quantitative. TheIS-LMmodel that
shows that increases in government purchasesraise GDP and that
increases in taxes lower GDP. But, when economists analyze specific
policy proposals, they must know the direction and size of the effect.
Macroeconometric models describe the economy quantitatively,
rather than just qualitatively.
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Chapter Eleven 11
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Chapter Eleven 12
You probably noticed from theISandLMdiagrams that rand Ywere 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.
r
P Y
Y
IS
LM(P1)
A
A
AD
To deriveAD, start at pointA in the top
graph. Now increase the price level fromP1
toP2
.An increase inPlowers the value of real money
balances, and Y, shiftingLMleftward to pointB.
The +Ptriggers a sequence of events that end
with a -
Y, the inverse relationship that definesthe downward slope ofAD.
Notice that rincreased. Since rincreased, we know
that investment will decrease, as it just got more
costly to take on various investment projects. Thissets off a multiplier process since -Icauses a Y.
The - Ytriggers -Cas we move up theIScurve.
LM(P2)
B
BP2P1
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Chapter Eleven 13
+G
This translates into a rightward shift of theISandAD curves.LM(P2)
Suppose there is a +G.
In the short run, we move along SRASfrom
pointA to pointB.
But as the output market clears, in the long-run,
the price level will increase fromP0 toP2.
This +Pdecreases the value of real money
balances, which translates into a leftward shift
of theLMcurve.
Finally, this leaves us at point Cin both diagrams.
r
PY
Y
ISLM(P0)
A
D
P
0 AD
IS
SRASA
A
B
B
P2C
C
LRAS
Y = C (Y-T) + I(r) + G
M/ P = L (r, Y)
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Chapter Eleven 14
Now its time to determine the effects on the variables in the economy.For the variables Y, P, and r, you can read the effects right off the diagrams.
Remember that SR is the movement
fromA toB.
+, because Ymoved from Y* to Y
0, because prices are sticky in the SR.
+, because a +Yleads to a rise in r
asISslides along theLMcurve.+, because a +Yincreases the level of
consumption (
C=C(
Y-T))., since rincreased, the level of
investment decreased.
Y
P
r
C
I
r
PY
Y
IS LM(P0)
AD
P0
AD
IS
SRASA
A
B
B
P2C
C
LRAS
*Y Y
LM(P2)
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Chapter Eleven 15
+, in order to eliminate the excess demand atP0.
0, because risingPshiftsLMto left, returning
Yto Y* as required by long-runLRAS.
+, reflecting the leftward shift inLMdue
to +P0, since both Yand Tare back to their initial
levels (C=C(Y-T))
, since rhas risen even more due to the+P.
Y
Pr
C
I
For the variables Y, P, and r, you can read the effects right off the diagrams.
Remember thatLR is the movement fromA to C.
r
PY
Y
IS LM(P0)
A
D
P0AD
IS
SRASA
A
B
B
P2 C
C
LRAS
*Y Y
LM(P2)
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Chapter Eleven 16
LM
B
AD
B
Notice thatM/was increased, thus increasing the value of the real money
supply which translates into a rightward shift of the LMandAD curves.
Suppose there is a +M.
Look at the appropriate equation
that captures theMterm:
In the short run, we move along SRASfrom
pointA to pointB.But as the output market clears, in the long run,
the price level will increase fromP0 toP2.
This +Pdecreases the value of the
real money supply which translates into aleftward shift of theLMcurve.
Finally, this leaves us at point Cin both diagrams.
C
AD
ISr
PY
Y
LM(P0)
P
0
SRASA
A
LRAS
= C
P2
M/ P = L (r, Y)
M/ P = L (r, Y)
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Chapter Eleven 17
Now its time to determine the effects on the variables in the economy.
For the variables Y, P, and r, you can read the effects right off the diagrams.
Remember that SR is the
movement fromA toB.
+, because Ymoved from Y* to Y
0, because prices are sticky in the SR.
, because a +Yleads to a decrease in rasLMslides along theIScurve.+, because a +Yincreases the level of
consumption (C=C(Y-T)).+ , since rincreased, the level of
investment decreased.
Y
P
r
C
I
LM
B
AD
BC
AD
ISr
PY
Y
LM(P0)
P0 SRASA
A
LRAS
= C
P2
(P2)
YY*
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Chapter Eleven 18
+, in order to eliminate the excess demand atP0.
0, because risingPshiftsLMto left, returning
Yto Y* as required byLRAS.
0, reflecting the leftward shift inLMdueto +P, restoring rto its original level.0, since both Yand Tare back to their initial
levels (C=C(Y-T)).0, since Yor r has not changed.
Y
P
r
C
I
For the variables Y, P, and r, you can read the effects right off the diagrams.
Remember thatLR is the movement fromA to C.
Notice that the only LR impact of an
increase in the money supply was an
increase in the price level.
LM
B
AD
BC
= C
P2
AD
ISr
PY
Y
LM(P0)
P0 SRASA
A
LRAS
YY*
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Chapter Eleven 19
1) C h IS hif
LM(P )
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Chapter Eleven 20
LM(P0)
1) +Ccauses theIScurve to shift
right toIS.
LRAS
2) This leads to a rightward shift inAD
to AD.Short Run:
Move fromAto B.Long Run:
Market clears atP0 toP2
fromB to C.3) +PcausesLM(P0) to shift leftward
toLM(P2) due to the lowering of thereal value of the money supply.
r
YP
Y
IS
AD
IS'
P0
AD'
LRAS
LM(P2)
A
A
B
B
P2
C
C
Y = C (Y-T) + I(r) + G
M/ P = L (r, Y)
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Chapter Eleven 21
Short
Run:
Y +
P 0r +
C +
I -
Long
Run:
0
+++
+
--
SRAS
r
YP
Y
IS
AD
IS'
P0
AD'
LRAS
LM(P2)
A
A
B
B
P2
C
C
LM(P0)
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Chapter Eleven 22
Thespending hypothesis suggests that perhaps the cause of the
decline may have been a contractionary shift of theIScurve.
The money hypothesis attempts to explain the effects of the historical
fall of the money supply of 25 percent from 1929 to 1933, during which
time unemployment rose from 3.2 percent to 25.2 percent.
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 highunemployment 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 theIS-LMmodel.
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Chapter Eleven 23
In the IS-LMmodel, falling prices raise income. For any given
supply of moneyM, a lower price level implies higher real
money balances,M/P. An increase in real money balances causes
an expansionary shift in the LMcurve, which leads to higher
income.
Another way in which falling prices increase income is called
the Pigou effect. In the 1930s, economist Arthur Pigou pointed out
that real money balances are part of household wealth. As prices falland real money balances rise, households increase their
consumption spending and theIScurve shifts to the right.
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Chapter Eleven 24
There are two theories to explain how falling prices could depress
income rather than raise it.
1) Debt-deflation theory, unexpected falls in the price level
2) Effects of expected inflation
Debt-deflation theory redistributes wealth between creditors and
debtors. A fall in the price level raises the real amount of the debt.
The impoverishment of the debtors causes them to spend less, and
creditors to spend more. If their propensities to consume are the same,
there is no aggregate effect. But, if debtors reduce more than
the amount that creditors increase spending, the net effect on aggregate
demand is a reduction. This contractsIS, and reduces national income.
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Chapter Eleven 25
LM
Y
IS
A
IS
B
An expected deflation (a negative value ofpe) raises the real interest
rate for any given nominal interest rate, and this depresses investmentspending. The reduction in investment shifts theIScurve downward.
The level of income and the nominal interest rate (i) fall, but the real
interest rate (r) rises.
i2
r1
= i1
r2
interest rate, i
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Chapter Eleven 26
Monetary transmission mechanismPigou Effect
Debt-deflation theory
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