Chapter 10 Aggregate Demand I: Building the IS LM Model

Chapter 10 Aggregate Demand I: Building the IS LM Model Zhengyu Cai Ph.D. Institute of Development Southwestern University of Finance and Economics All rights reserved http://www.escience.cn/people/zhengyucai/index.html

Building the blocks Goods Money IS LM IS-LM model Chapter 10: today Chapter 11 Explanation of short-run fluctuations demand supply Model of Demand and Supply Chapter 12 Zhengyu Cai - 2017 Spring Macroeconomics Chapter 10 2/39

Building the blocks Goods Money IS LM IS-LM model Explanation of short-run fluctuations demand supply Model of Demand and Supply Zhengyu Cai - 2017 Spring Macroeconomics Chapter 10 3/39

Goods We only look at closed economy. Consider the demand side, which can be measured by planned expenditure (PE): Function Identity = CC + II + GG What s the difference between PE = C + I + G & Y C + I + G? Actual expenditure Now, we assume investment is given for simplicity. And we will relax this assumption later. Zhengyu Cai - 2017 Spring Macroeconomics Chapter 10 4/39

Goods Recall the demand of consumption: CC = CC YY TT Assuming this function has a linear form. Plug consumption demand into the PE equation: = CC YY TT + II + GG How to plot? Endogenous variables? Exogenous variables? Zhengyu Cai - 2017 Spring Macroeconomics Chapter 10 5/39

Goods PE = CC YY TT + II + GG 1 MPC Why positive? Y Zhengyu Cai - 2017 Spring Macroeconomics Chapter 10 6/39

Goods Goods equilibrium: = YY Why? To answer this question, we plot the equilibrium first. PE PE =Y 45º Y Zhengyu Cai - 2017 Spring Macroeconomics Chapter 10 7/39

Goods PE PE =Y = CC YY TT + II + GG Equilibrium income Zhengyu Cai - 2017 Spring Macroeconomics Chapter 10 8/39 Y

Goods PE YY 1 1 2 PE =Y = CC YY TT + II + Actual > Planned Inventory Y GG Actual < Planned Inventory Y YY 2 YY 2 YY 1 Equilibrium income Zhengyu Cai - 2017 Spring Macroeconomics Chapter 10 9/39 Y

Goods : implication What s the difference between here and long run? Why? Fiscal policy GG YY? ΔGG ΔYY? At Y 1, there is now an unplanned drop in inventory PE PE =C +I +G 2 PE =C +I +G 1 ΔG ΔGG < ΔYY Meaning? Why? so firms increase output, and income rises toward a new equilibrium. PE 1 = Y 1 ΔY Y PE 2 = Y 2 Zhengyu Cai - 2017 Spring Macroeconomics Chapter 10 10/39

Goods : implication Why 1 unit increase in government spending will increase output more than 1 unit? GG YY CC YY CC Will this process converge? Yes. MPC < 1 Mathematically, YY = CC YY TT + II + GG Total derivative w.r.t. G: dddd dddd = dddd dd YY TT + 0 + 1 dd YY TT dddd dddd dddd = dddd dddd + 1 dddd dddd = 1 0< 1 Exercise: MPS=0.4, g? 0< MPC <1 Government spending multiplier (0<g<1): dddd = gg dddd > 1 dddd < dddd Zhengyu Cai - 2017 Spring Macroeconomics Chapter 10 11/39 <1

Goods : implication How about TT? Plot? What is the change in intercept? Mathematically derive tax multiplier (t). MPS=0.4, t? Effectiveness of fiscal policy: tt gg? Zhengyu Cai - 2017 Spring Macroeconomics Chapter 10 12/39

Building the blocks Goods Money IS LM IS-LM model Explanation of short-run fluctuations demand supply Model of Demand and Supply Zhengyu Cai - 2017 Spring Macroeconomics Chapter 10 13/39

Building the blocks Goods Money IS LM IS-LM model Explanation of short-run fluctuations demand supply Model of Demand and Supply Zhengyu Cai - 2017 Spring Macroeconomics Chapter 10 14/39

Goods IS Now, we relax the assumption of fixed investment demand. II = II( rr ) Then, planned expenditure becomes: = CC YY TT + II rr + GG Equilibrium condition: If real interest rate decreases YY = Zhengyu Cai - 2017 Spring Macroeconomics Chapter 10 15/39

Goods IS IS represents the negative relationship between rr and YY: rr II YY ( CC YY ) rr rr 1 AA AA BB ΔII 45 = CC YY TT + II rr 2 + GG = CC YY TT + II rr 1 + GG YY Every point on the IS represents an equilibrium in the goods rr 2 BB YY 1 YY 2 IS YY Zhengyu Cai - 2017 Spring Macroeconomics Chapter 10 16/39

IS Where the name comes from? I(nvestment)S(aving) Model in Chapter 3 r S 2 S 1 r r 2 r 2 r 1 dddd I (r ) S, I r 1 Y 2 Y 1 IS Y dddd? Zhengyu Cai - 2017 Spring Macroeconomics Chapter 10 17/39

Implication: fiscal policy Increase government spending At any given real interest rate, GG YY ( CC YY ) dddd =? dddd So, increase in government spending shifts IS to the right. How about decrease in government spending? rr rr AA BB 45 YY 1 Zhengyu Cai - 2017 Spring Macroeconomics Chapter 10 18/39 ΔGG YY 2 IISS AA IISS BB = CC YY TT + II rr + GG = CC YY TT + II rr + GG YY YY

Implication: fiscal policy Exercise: tax cut Plot dddd =? dddd Direction? Effectiveness? Zhengyu Cai - 2017 Spring Macroeconomics Chapter 10 19/39

A summary Fiscal Policy Expansionary Contractionary IS Zhengyu Cai - 2017 Spring Macroeconomics Chapter 10 20/39

Building the blocks Goods Money IS LM IS-LM model Explanation of short-run fluctuations demand supply Model of Demand and Supply Zhengyu Cai - 2017 Spring Macroeconomics Chapter 10 21/39

Building the blocks Goods Money IS LM IS-LM model Explanation of short-run fluctuations demand supply Model of Demand and Supply Zhengyu Cai - 2017 Spring Macroeconomics Chapter 10 22/39

Money Theory of liquidity preference How is the interest rate determined in short run? Money demand and money supply Recall: how is the interest rates (how many?) determined in long run? Money demand Recall the money demand function: Plug in the Fisher equation: dd dd = LL( ii, YY ) + = LL(rr + EEEE, YY) Zhengyu Cai - 2017 Spring Macroeconomics Chapter 10 23/39

Money In short run, P is stickiness. Thus, EEEE =? The money demand function: dd = LL(rr, YY) The money supply function: ss = Equilibrium condition: dd = ss Zhengyu Cai - 2017 Spring Macroeconomics Chapter 10 24/39

Money The money demand function: dd = LL(rr, YY) The money supply function: ss = Equilibrium condition: dd = ss rr rr ss dd = LL(rr, YY) Zhengyu Cai - 2017 Spring Macroeconomics Chapter 10 25/39

Money Shift of money supply If central bank increases M Monetary policy Expansionary: rr Contractionary: rr rr rr 1 rr 2 ss ss dd = LL(rr, YY) 1 2 Zhengyu Cai - 2017 Spring Macroeconomics Chapter 10 26/39

Money A case study: Monetary Tightening & Interest Rates Late 1970s: π > 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: π = 3.7% How do you think this policy change would affect nominal interest rates? Zhengyu Cai - 2017 Spring Macroeconomics Chapter 10 27/39

The effects of a monetary tightening on nominal interest rates model prices prediction short run liquidity preference (Keynesian) sticky Δi > 0 long run Quantity theory, Fisher effect (Classical) flexible Δi < 0 actual outcome 8/1979: i = 10.4% 4/1980: i = 15.8% 8/1979: i = 10.4% 1/1983: i = 8.2% Zhengyu Cai - 2017 Spring Macroeconomics Chapter 10 28/39

Building the blocks Goods Money IS LM IS-LM model Explanation of short-run fluctuations demand supply Model of Demand and Supply Zhengyu Cai - 2017 Spring Macroeconomics Chapter 10 29/39

Building the blocks Goods Money IS LM IS-LM model Explanation of short-run fluctuations demand supply Model of Demand and Supply Zhengyu Cai - 2017 Spring Macroeconomics Chapter 10 30/39

Money LM Shift of money demand: YY rr ss dd = LL( rr, YY ) + rr Every point on the LM represents an equilibrium in the money LM rr 2 rr 1 BB AA dd dd = LL(rr, YY 2 ) = LL(rr, YY 1 ) AA YY 1 BB YY 2 YY Zhengyu Cai - 2017 Spring Macroeconomics Chapter 10 31/39

LM LM represents the positive relationship between YY and rr: YY dd rr Where the name comes from? L(iquidity)M(oney) Zhengyu Cai - 2017 Spring Macroeconomics Chapter 10 32/39

Implication: monetary policy Increase money supply At any given income level, ss rr So, increase in money supply shifts LM downward. How about decrease in money supply? rr ss ss rr LL AA LL BB rr 1 AA rr 2 BB dd = LL(rr, YY ) 1 Δ 2 YY YY Zhengyu Cai - 2017 Spring Macroeconomics Chapter 10 33/39

Implication: monetary policy Exercise: Suppose a wave of credit card fraud causes consumers to use cash more frequently in transactions. Plot Direction? Zhengyu Cai - 2017 Spring Macroeconomics Chapter 10 34/39

A summary Monetary Policy Expansionary Contractionary LM Zhengyu Cai - 2017 Spring Macroeconomics Chapter 10 35/39

Building the blocks Goods Money IS LM IS-LM model Explanation of short-run fluctuations demand supply Model of Demand and Supply Zhengyu Cai - 2017 Spring Macroeconomics Chapter 10 36/39

Building the blocks Goods Money IS LM IS-LM model Explanation of short-run fluctuations demand supply Model of Demand and Supply Zhengyu Cai - 2017 Spring Macroeconomics Chapter 10 37/39

IS-LM model Put everything together IIII: YY = CC YY TT + II rr LLLL: = LL(rr, YY) + GG Exogenous: T, G, M, P Endogenous: r, Y This model has an unique solution (r*, Y*) at the short-run equilibrium. Zhengyu Cai - 2017 Spring Macroeconomics Chapter 10 38/39

IS-LM model: short-run equilibrium Equilibrium of equilibria 45 = CC YY TT + II rr + GG rr ss rr YY LM rr dd = LL(rr, YY ) IS YY YY Zhengyu Cai - 2017 Spring Macroeconomics Chapter 10 39/39