Macroeconomics theory through application

Preface We have written a fundamentally different text for principles of economics, based on two premises: Students are motivated to study economics if they see that it relates to their own lives Students learn best from an inductive approach, in which they are first confronted with a question and then led through the process of how to answer that question The intended audience of the textbook is first-year undergraduates taking courses on the principles of macroeconomics and microeconomics Many may never take another economics course We aim to increase their economic literacy both by developing their aptitude for economic thinking and by presenting key insights about economics that every educated individual should know Applications ahead of Theory We present all the theory that is standard in books on the principles of economics But by beginning with applications, we also show students why this theory is needed We take the kind of material that other authors put in “applications boxes” and place it at the heart of our book Each chapter is built around a particular business or policy application, such as (for microeconomics) minimum wages, stock exchanges, and auctions, and (for macroeconomics) social security, globalization, and the wealth and poverty of nations Why take this approach? Traditional courses focus too much on abstract theory relative to the interests and capabilities of the average undergraduate Students are rarely engaged, and the formal theory is never integrated into the way students think about economic issues We provide students with a vehicle to understand the structure of economics, andwe train them how to use this structure A New Organization Traditional books are organized around theoretical constructs that mean nothing to students Our book is organized around the use of economics Our applications-first approach leads to a fundamental reorganization of the textbook Students will not see chapters with titles like “Cost Functions” or “Short-Run Fluctuations.” We introduce tools and ideas as, and when, they are needed Each chapter is designed with two goals First, the application upon which the chapter is built provides a “hook” that gets students’ attention Second, the application is a suitable vehicle for teaching the principles of economics Learning through Repetition Important tools appear over and over again, allowing students to learn from repetition and to see how one framework can be useful in many different contexts Saylor URL: http://www.saylor.org/books Saylor.org Each piece of economic theory is first introduced and explained in the context of a specific application Most are reused in other chapters, so students see them in action on multiple occasions As students progress through the book, they accumulate a set of techniques and ideas These are collected separately in a “toolkit” that provides students with an easy reference and also gives them a condensed summary of economic principles for exam preparation A Truly International Book International economics is not an afterthought in our book; it is integrated throughout Many other texts pay lip service to international content We have taught in numerous countries in Europe, North America, and Asia, and we use that expertise to write a book that deals with economics in a globalized world Rigor without Fear We hold ourselves to high standards of rigor yet use mathematical argument only when it is truly necessary We believe students are capable of grasping rigorous argument, and indeed are often confused by loose argumentation But rigor need not mean high mathematical difficulty Many students—even very bright ones—switch off when they see a lot of mathematics Our book is more rigorous yet less overtly mathematical than most others in the market We also include a math/stat toolkit to help students understand the key mathematical tools they need A Textbook for the 21st Century We introduce students to accessible versions of dynamic decision-making, choice under uncertainty, and market power from the beginning Students are aware that they live in an uncertain world, and their choices are made in a forward-looking manner Yet traditional texts emphasize static choices in a world of certainty Students are also aware that firms typically set prices and that most firms sell products that are differentiated from those of their competitors Traditional texts base most of their analysis on competitive markets Students end up thinking that economic theory is unrealistic and unrelated to the real world We not shy away from dynamics and uncertainty, but instead introduce students to the tools of discounted present value and decision-making under uncertainty We also place relatively more emphasis on imperfect competition and price-setting behavior, and then explain why the competitive model is relevant even when markets are not truly competitive We give more prominence than other texts to topics such as basic game theory, statistics, auctions, and asset prices Far from being too difficult for principles students, such ideas are in fact more intuitive, relevant, and easier to understand than many traditional topics Saylor URL: http://www.saylor.org/books Saylor.org At the same time, we downplay some material that is traditionally included in principles textbooks but that can seem confusing or irrelevant to students We discuss imperfect competition in terms of market power and strategic behavior, and say little about the confusing taxonomy of market structure We present a simplified treatment of costs that— instead of giving excruciating detail about different cost definitions—explains which costs matter for which decisions, and why A Non-Ideological Book We emphasize the economics that most economists agree upon, minimizing debates and schools of thought There is probably less ideological debate today among economists than there has been for almost four decades Textbooks have not caught up We not avoid all controversy, but we avoid taking sides We choose and present our material so that instructors will have all the tools and resources they need to discuss controversial issues in the manner they choose Where appropriate, we explain why economists sometimes disagree on questions of policy Most key economic ideas—both microeconomic and macroeconomic—can be understood using basic tools of markets, accounting identities, and budget sets These are simpler for students to understand, are less controversial within the profession, and not require allegiance to a particular school of thought A Single Voice The book is a truly collaborative venture Very often, coauthored textbooks have one author for microeconomics and another for macroeconomics Both of us have researched and taught both microeconomic and macroeconomic topics, and we have worked together on all aspects of the book This means that students who study both microeconomics and macroeconomics from our book will benefit from a completely integrated and consistent approach to economics Saylor URL: http://www.saylor.org/books Saylor.org Chapter What Is Economics? Fast-Food Economics You are just beginning your study of economics, but let us fast-forward to the end of your first economics course How will your study of economics affect the way you see the world? The final exam is over You are sitting at a restaurant table, waiting for your friends to arrive The place is busy and loud as usual Looking around, you see small groups of people sitting and talking animatedly Most of the customers are young; this is not somewhere your parents visit very often At the counter, people line up to buy food You watch a woman choose some items from the menu and hand some notes and coins to the young man behind the counter He is about the same age as you, and you think that he is probably from China After a few moments, he hands her some items, and she takes them to a table next to yours Where are you? Based on this description, you could be almost anywhere in the world This particular fast-food restaurant is a Kentucky Fried Chicken, or KFC, but it could easily have been a McDonald’s, a Burger King, or any number of other fast-food chains Restaurants like this can be found in Auckland, Buenos Aires, Cairo, Denver, Edinburgh, Frankfurt, Guangzhou, and nearly every other city in the world Here, however, the menu is written in French, and the customer paid in euros (€) Welcome to Paris While you are waiting, you look around you and realize that you are not looking at the world in the same way that you previously did The final exam you just completed was for an economics course, and—for good or for ill—it has changed the way you understand the world Economics, you now understand, is all around you, all the time 1.1 Microeconomics in a Fast-Food Restaurant LEARNING OBJECTIVE What kinds of problems we study in microeconomics? You watch another customer go to the counter and place an order She purchases some fried chicken, an order of fries, and a Coca-Cola The cost is €10 She hands over a bill and gets the food in exchange It’s a simple transaction; you have witnessed exchanges like it thousands of times before Now, though, you think about the fact that this exchange has made both the customer and the store better off than they were previously The customer has voluntarily given up money to get food Presumably, she would this only if having the food makes her happier than having the €10 KFC, meanwhile, voluntarily gave up the food to get the €10 Presumably, the managers of the store would sell the food only if they benefit from the deal as well They are willing to give up something of value (their food) in exchange for something else of value (the customer’s money) Think for a moment about all the transactions that could have taken place but did not For the same €10, the customer could have bought two orders of fried chicken But she didn’t So even though you have never met the person, you know something about her You know that—at this Saylor URL: http://www.saylor.org/books Saylor.org moment at least—she prefers having a Coca-Cola, fries, and one order of fried chicken to having two orders of fried chicken You also know that she prefers having that food to any number of other things she could have bought with those euros, such as a movie theater ticket, some chocolate bars, or a book From your study of economics, you know that her decision reflects two different factors The first is her tastes Each customer likes different items on the menu Some love the spicy fried chicken; others dislike it There is no accounting for differences in tastes The second is what she can afford She has a budget in mind that limits how much she is willing to spend on fast food on a given day Her decision about what to buy comes from the interaction between her tastes and her budget Economists have built a rich and complicated theory of decision making from this basic idea You look back at the counter and to the kitchen area behind it The kitchen, you now know, is an example of a production process that takes inputs and produces output Some of the inputs are perhaps obvious, such as basic ingredients like raw chicken and cooking oil Before you took the economics course, you might have thought only about those ingredients Now you know that there are many more inputs to the production process, including the following:        The building housing the restaurant The tables and chairs inside the room The people working behind the cash register and in the kitchen The people working at KFC headquarters managing the outlets in Paris The stoves, ovens, and other equipment in the kitchen used to cook the food The energy used to run the stoves, the ovens, the lighting, and the heat The recipes used to convert the ingredients into a finished product The outputs of KFC are all the items listed on the menu And, you realize, the restaurant provides not only the food but also an additional service, which is a place where you can eat the food Transforming these inputs (for example, tables, chickens, people, recipes) into outputs is not easy Let us examine one output—for example, an order of fried chicken The production process starts with the purchase of some uncooked chicken A cook then adds some spices to the chicken and places it in a vat of very hot oil in the huge pots in the kitchen Once the chicken is cooked, it is placed in a box for you and served to you at the counter That production process uses, to a greater or lesser degree, almost all the inputs of KFC The person responsible for overseeing this transformation is the manager Of course, she doesn’t have to analyze how to this herself; the head office provides a detailed organizational plan to help her KFC management decides not only what to produce and how to produce it but also how much to charge for each item Before you took your economics course, you probably gave very little thought to where those prices on the menu came from You look at the price again: €5 for an order of fried chicken Just as you were able to learn some things about the customer from observing her decision, you realize that you can also learn something about KFC You know that KFC wouldn’t sell an order of fried chicken at that price unless it was able to make a profit by doing so For example, if a piece of raw chicken cost €6, then KFC would obviously make a loss So the price charged must be greater than the cost of producing the fried chicken Saylor URL: http://www.saylor.org/books Saylor.org KFC can’t set the price too low, or it would lose money It also can’t set the price too high What would happen if KFC tried to charge, say, €100 for an order of chicken? Common sense tells you that no one would buy it at that price Now you understand that the challenge of pricing is to find a balance: KFC needs to set the price high enough to earn a good profit on each order sold but not so high that it drives away too many customers In general, there is a trade-off: as the price increases, each piece sold brings in more revenue, but fewer pieces are sold Managers need to understand this trade-off between price and quantity, which economists call demand It depends on many things, most of which are beyond the manager’s control These include the income of potential customers, the prices charged in alternative restaurants nearby, the number of people who think that going to KFC is a cool thing to do, and so on The simple transaction between the customer and the restaurant was therefore the outcome of many economic choices You can see other examples of economics as you look around you— for example, you might know that the workers earn relatively low wages; indeed, they may very well be earning minimum wage Across the street, however, you see a very different kind of establishment: a fancy restaurant The chef there is also preparing food for customers, but he undoubtedly earns a much higher wage than KFC cooks Before studying economics, you would have found it hard to explain why two cooks should earn such different amounts Now you notice that most of the workers at KFC are young— possibly students trying to earn a few euros a month to help support them through college They not have years of experience, and they have not spent years studying the art of cooking The chef across the street, however, has chosen to invest years of his life training and acquiring specialized skills and, as a result, earns a much higher wage The well-heeled customers leaving that restaurant are likewise much richer than those around you at KFC You could probably eat for a week at KFC for the price of one meal at that restaurant Again, you used to be puzzled about why there are such disparities of income and wealth in society—why some people can afford to pay €200 for one meal while others can barely afford the prices at KFC Your study of economics has revealed that there are many causes: some people are rich because, like the skilled chef, they have abilities, education, and experience that allow them to command high wages Others are rich because of luck, such as those born of wealthy parents Everything we have discussed in this section—the production process, pricing decisions, purchase decisions, and the employment and career choices of firms and workers—are examples of what we study in the part of economics called microeconomics Microeconomics is about the behavior of individuals and firms It is also about how these individuals and firms interact with each other through markets, as they when KFC hires a worker or when a customer buys a piece of fried chicken When you sit in a fast-food restaurant and look around you, you can see microeconomic decisions everywhere KEY TAKEAWAY  In microeconomics, we study the decisions of individual entities, such as households and firms We also study how households and firms interact with each other Saylor URL: http://www.saylor.org/books Saylor.org CHECKING YOUR UNDERSTANDING  List three microeconomic decisions you have made today 1.2 Macroeconomics in a Fast-Food Restaurant LEARNING OBJECTIVE What kinds of problems we study in macroeconomics? The economic decisions you witness inside Kentucky Fried Chicken (KFC) are only a few examples of the vast number of economic transactions that take place daily across the globe People buy and sell goods and services Firms hire and lay off workers Governments collect taxes and spend the revenues that they receive Banks accept deposits and make loans When we think about the overall impact of all these choices, we move into the realm of macroeconomics Macroeconomics is the study of the economy as a whole While sitting in KFC, you can also see macroeconomic forces at work Inside the restaurant, some young men are sitting around talking and looking at the newspaper It is early afternoon on a weekday, yet these individuals are not working Like many other workers in France and around the world, they recently lost their jobs Across the street, there are other signs that the economy is not healthy: some storefronts are boarded up because many businesses have recently been forced to close down You know from your economics class that the unemployed workers and closed-down businesses are the visible signs of the global downturn, or recession, that began around the middle of 2008 In a recession, several things typically happen One is that the total production of goods and services in a country decreases In many countries, the total value of all the goods and services produced was lower in 2008 than it was in 2007 A second typical feature of a recession is that some people lose their jobs, and those who don’t have jobs find it more difficult to find new employment And a third feature of most recessions is that those who still have jobs are unlikely to see big increases in their wages or salaries These recessionary features are interconnected Because people have lower income and perhaps because they are nervous about the future, they tend to spend less And because firms are finding it harder to sell their products, they are less likely to invest in building new factories And when fewer factories are being built, there are fewer jobs available both for those who build factories and for those who work in them Down the street from KFC, a large construction project is visible An old road and a nearby bridge are in the process of being replaced The French government finances projects such as these as a way to provide more jobs and help the economy recover from the recession The government has to finance this spending somehow One way that governments obtain income is by taxing people KFC customers who have jobs pay taxes on their income KFC pays taxes on its profits And customers pay taxes when they buy their food Saylor URL: http://www.saylor.org/books Saylor.org Unfortunately for the government, higher taxes mean that people and firms have less income to spend But to help the economy out of a recession, the government would prefer people to spend more Indeed, another response to a recession is to reduce taxes In the face of the recession, the Obama administration in the United States passed a stimulus bill that both increased government spending and reduced taxes Before you studied macroeconomics, this would have seemed quite mysterious If the government is taking in less tax income, how is it able to increase spending at the same time? The answer, you now know, is that the government borrows the money For example, to pay for the $787 billion stimulus bill, the US government issued new debt People and institutions (such as banks), both inside and outside the United States, buy this debt—that is, they lend to the government There is another institution—called the monetary authority—that purchases government debt It has specific names in different countries: in the United States, it is called the Federal Reserve Bank; in Europe, it is called the European Central Bank; in Australia, it is called the Reserve Bank of Australia; and so on When the US government issues more debt, the Federal Reserve Bank purchases some of it The Federal Reserve Bank has the legal authority to create new money (in effect, to print new currency) and then to use that to buy government debt When it does so, the currency starts circulating in the economy Similarly, decisions by the European Central Bank lead to the circulation of the euro notes and coins you saw being used to purchase fried chicken The decisions of the monetary authority have a big impact on the economy as well When the European Central Bank decides to put more euros into circulation, this has the effect of reducing interest rates, which means it becomes cheaper for individuals to get a student loan or a mortgage, and it is cheaper for firms to buy new machinery and build new factories Typically, another consequence is that the euro will become less valuable relative to other currencies, such as the US dollar If you are planning a trip to the United States now that your class is finished, you had better hope that the European Central Bank doesn’t increase the number of euros in circulation If it does, it will be more expensive for you to buy US dollars Today, the world’s economies are highly interconnected People travel from country to country Goods are shipped around the world If you were to look at the labels on the clothing worn by the customers in KFC, you would probably find that some of the clothes were manufactured in China, perhaps some in Malaysia, some in France, some in the United States, some in Guatemala, and so on Information also moves around the world The customer sitting in the corner using a laptop might be in the process of transferring money from a Canadian bank account to a Hong Kong account; the person at a neighboring table using a mobile phone might be downloading an app from a web server in Illinois This globalization brings many benefits, but it means that recessions can be global as well Your study of economics has taught you one more thing: the idea that you can take a trip to the United States would have seemed remarkable half a century ago Despite the recent recession, the world is a much richer place than it was 25, or 50, or 100 years ago Almost everyone in KFC has a mobile phone, and some people are using laptops Had you visited a similar fast-food restaurant 25 years ago, you would not have seen people carrying computers and phones A century ago, there was, of course, no such thing as KFC; automobiles were still a novelty; and if you cut your finger on the sharp metal edge of a table, you ran a real risk of dying from blood poisoning Understanding why world economies have grown so Saylor URL: http://www.saylor.org/books Saylor.org spectacularly—and why not all countries have shared equally in this growth—is one of the big challenges of macroeconomics KEY TAKEAWAY  In macroeconomics, we study the economy as a whole to understand why economies grow and why they sometimes experience recessions We also study the effects of different kinds of government policy on the overall economy CHECKING YOUR UNDERSTANDING  If the government and the monetary authority think that the economy is growing too fast, what could they to slow down the economy? 1.3 What Is Economics, Really? LEARNING OBJECTIVE What methods economists use to study the world? Economists take their inspiration from exactly the kinds of observations that we have discussed Economists look at the world around them—from the transactions in fast-food restaurants to the policies of central banks—and try to understand how the economic world works This means that economics is driven in large part by data In microeconomics, we look at data on the choices made by firms and households In macroeconomics, we have access to a lot of data gathered by governments and international agencies Economists seek to describe and understand these data But economics is more than just description Economists also build models to explain these data and make predictions about the future The idea of a model is to capture the most important aspects of the behavior of firms (like KFC) and individuals (like you) Models are abstractions; they are not rich enough to capture all dimensions of what people Yet a good model, for all its simplicity, is still capable of explaining economic data And what we with this understanding? Much of economics is about policy evaluation Suppose your national government has a proposal to undertake a certain policy—for example, to cut taxes, build a road, or increase the minimum wage Economics gives us the tools to assess the likely effects of such actions and thus to help policymakers design good public policies This is not really what you thought economics was going to be about when you walked into your first class Back then, you didn’t know much about what economics was You had a vague Saylor URL: http://www.saylor.org/books Saylor.org 10 thought that maybe your economics class would teach you how to make money Now you know that this is not really the point of economics You don’t have any more ideas about how to get rich than you did when you started the class But your class has taught you something about how to make better decisions and has given you a better understanding of the world that you live in You have started to think like an economist KEY TAKEAWAY  Economists gather data about the world and then build models to explain those data and make predictions CHECKING YOUR UNDERSTANDING  Suppose you were building a model of pricing at KFC Which of the following factors would you want to make sure to include in your model? Which factors you think would be irrelevant?      the age of the manager making the pricing decisions the price of chicken the number of customers who come to the store on a typical day the price of apples the kinds of restaurants nearby 1.4 End-of-Chapter Material In Conclusion Economics is all around us We all make dozens of economic decisions every day—some big, some small Your decisions—and those of others—shape the world we live in In this book, we will help you develop an understanding of economics by looking at examples of economics in the everyday world Our belief is that the best way to study economics is to understand how economists think about such examples With this in mind, we have organized our book rather differently from most economics textbooks It is built not around the theoretical concepts of economics but around different applications—economic illustrations as you encounter them in your own life or see them in the world around you As you read this book, we will show you how economists analyze these illustrations, introducing you to the tools of economics as we proceed After you have read the whole book, you will have been introduced to all the fundamental tools of economics, and you will also have seen them in action Most of the tools are used in several different applications, thus allowing you to practice using them and gain a deeper understanding of how they work You can see this organization at work in our table of contents In fact, there are two versions of the table of contents so that both students and instructors can easily see how the book is organized The student table of contents focuses on the applications and the questions that we Saylor URL: http://www.saylor.org/books Saylor.org 11   Fiscal policy through the choices of G and τ The level of economic activity (Y) The Main Uses of This Tool      Chapter 11 "Inflations Big and Small" Chapter 12 "Income Taxes" Chapter 13 "Social Security" Chapter 14 "Balancing the Budget" Chapter 15 "The Global Financial Crisis" 16.23 The Life-Cycle Model of Consumption The life-cycle model of consumption looks at the lifetime consumption and saving decisions of an individual The choices made about consumption and saving depend on income earned over an individual’s entire lifetime The model has two key components: the lifetime budget constraint and individual choice given that constraint Consider the consumption/saving decision of an individual who expects to work for a known number of years and be retired for a known number of years thereafter Suppose his disposable income is the same in every working year, and he will also receive an annual retirement income—again the same in every year According to the life-cycle model of consumption, the individual first calculates the discounted present value (DPV) of lifetime income: DPV of lifetime income = DPV of income from working + DPV of retirement income (If the real interest rate is zero, then the DPV calculation simply involves adding income flows across years.) We assume the individual wants to consume at the same level in each period of life This is called consumption smoothing In the special case of a zero real interest rate, we have the following: annual consumption = lifetime income number of years of life More Formally Suppose an individual expects to work for a total of N years and to be retired for R years Suppose his disposable income is equal to Yd in every year, and he receives annual retirement income of Z Then lifetime income, assuming a zero real interest rate, is given as follows: d lifetime income = NY + RZ If we suppose that he wants to have perfectly smooth consumption, equal to C in each year, then his total lifetime consumption will be C × (N + R) Saylor URL: http://www.saylor.org/books Saylor.org 666 The lifetime budget constraint says that lifetime consumption equals lifetime income: d C × (N + R) = NY + RZ To obtain his consumption, we simply divide this equation by the number of years he is going to live (N + R): d C + NY + RZ N+ R Provided that income during working years is greater than income in retirement years, the individual will save during his working years and dissave during retirement If the real interest rate is not equal to zero, then the basic idea is the same—an individual smooths consumption based on a lifetime budget constraint—but the calculations are more complicated Specifically, the lifetime budget constraint must be written in terms of the discounted present values of income and consumption The Main Uses of This Tool    Chapter "The Great Depression" Chapter 13 "Social Security" Chapter 14 "Balancing the Budget" 16.24 Aggregate Supply and Aggregate Demand The aggregate supply and aggregate demand (ASAD) model is presented here To understand the ASAD model, we need to explain both aggregate demand and aggregate supply and then the determination of prices and output The aggregate demand curve tells us the level of expenditure in an economy for a given price level It has a negative slope: the demand for real gross domestic product (real GDP) decreases when the price level increases The downward sloping aggregate demand curve does not follow from the microeconomic “law of demand.” As the price level increases, all prices in an economy increase together The substitution of expensive goods for cheap goods, which underlies the law of demand, does not occur in the aggregate economy Instead, the downward sloping demand curve comes from other forces First, as prices rise, the real value of nominal wealth falls, and this leads to a fall in household spending Second, as prices rise today relative to future prices, households are induced to postpone consumption Finally, a higher price level can lead to a higher interest rate through the response of monetary policy All these factors together imply that higher prices lead to lower overall demand for real GDP Aggregate supply is equal to potential output at all prices Potential output is determined by the available technology, physical capital, and labor force and is unaffected by the price level Thus the aggregate supply curve is vertical In contrast to a firm’s supply curve, as the price level increases, all prices in an economy increase This includes the prices of inputs, such as labor, into the production process Since no relative prices change when the price level Saylor URL: http://www.saylor.org/books Saylor.org 667 increases, firms are not induced to change the quantity they supply Thus aggregate supply is vertical The determination of prices and output depends on the horizon: the long run or the short run In the long run, real GDP equals potential GDP, and real GDP also equals aggregate expenditure This means that, in the long run, the price level must be at the point where aggregate demand and aggregate supply meet This is shown in Figure 16.15 "Aggregate Supply and Aggregate Demand in the Long Run" Figure 16.15 Aggregate Supply and Aggregate Demand in the Long Run In the short run, output is determined by aggregate demand at the existing price level Prices need not be at their long-run equilibrium levels If they are not, then output will not equal potential output This is shown in Figure 16.16 "Aggregate Supply and Aggregate Demand in the Short Run" Figure 16.16 Aggregate Supply and Aggregate Demand in the Short Run Saylor URL: http://www.saylor.org/books Saylor.org 668 The short-run price level is indicated on the vertical axis The level of output is determined by aggregate demand at that price level As prices are greater than the long-run equilibrium level of prices, output is below potential output The price level adjusts over time to its long-run level, according to the price-adjustment equation The Main Uses of This Tool We not explicitly use this tool in our chapter presentations However, the tool can be used to support the discussions in the following chapters     Chapter "The Great Depression" Chapter 10 "Understanding the Fed" Chapter 11 "Inflations Big and Small" Chapter 12 "Income Taxes" 16.25 The IS-LM Model The IS-LM model provides another way of looking at the determination of the level of shortrun real gross domestic product (real GDP) in the economy Like the aggregate expenditure model, it takes the price level as fixed But whereas that model takes the interest rate as exogenous—specifically, a change in the interest rate results in a change in autonomous spending—the IS-LM model treats the interest rate as an endogenous variable The basis of the IS-LM model is an analysis of the money market and an analysis of the goods market, which together determine the equilibrium levels of interest rates and output in the economy, given prices The model finds combinations of interest rates and output (GDP) such that the money market is in equilibrium This creates the LM curve The model also finds combinations of interest rates and output such that the goods market is in equilibrium This Saylor URL: http://www.saylor.org/books Saylor.org 669 creates the IS curve The equilibrium is the interest rate and output combination that is on both the IS and the LM curves LM Curve The LM curve represents the combinations of the interest rate and income such that money supply and money demand are equal The demand for money comes from households, firms, and governments that use money as a means of exchange and a store of value The law of demand holds: as the interest rate increases, the quantity of money demanded decreases because the interest rate represents an opportunity cost of holding money When interest rates are higher, in other words, money is less effective as a store of value Money demand increases when output rises because money also serves as a medium of exchange When output is larger, people have more income and so want to hold more money for their transactions The supply of money is chosen by the monetary authority and is independent of the interest rate Thus it is drawn as a vertical line The equilibrium in the money market is shown in Figure 16.17 "Money Market Equilibrium" When the money supply is chosen by the monetary authority, the interest rate is the price that brings the market into equilibrium Sometimes, in some countries, central banks target the money supply Alternatively, central banks may choose to target the interest rate (This was the case we considered in Chapter 10 "Understanding the Fed".) Figure 16.17 "Money Market Equilibrium" applies in either case: if the monetary authority targets the interest rate, then the money market tells us what the level of the money supply must be Figure 16.17 Money Market Equilibrium Saylor URL: http://www.saylor.org/books Saylor.org 670 To trace out the LM curve, we look at what happens to the interest rate when the level of output in the economy changes and the supply of money is held fixed Figure 16.18 "A Change in Income" shows the money market equilibrium at two different levels of real GDP At the higher level of income, money demand is shifted to the right; the interest rate increases to ensure that money demand equals money supply Thus the LM curve is upward sloping: higher real GDP is associated with higher interest rates At each point along the LM curve, money supply equals money demand We have not yet been specific about whether we are talking about nominal interest rates or real interest rates In fact, it is the nominal interest rate that represents the opportunity cost of holding money When we draw the LM curve, however, we put the real interest rate on the axis, as shown in Figure 16.19 "The LM Curve" The simplest way to think about this is to suppose that we are considering an economy where the inflation rate is zero In this case, by the Fisher equation, the nominal and real interest rates are the same In a more complete analysis, we can incorporate inflation by noting that changes in the inflation rate will shift the LM curve Changes in the money supply also shift the LM curve Saylor URL: http://www.saylor.org/books Saylor.org 671 Figure 16.18 A Change in Income Saylor URL: http://www.saylor.org/books Saylor.org 672 Figure 16.19 The LM Curve IS Curve The IS curve relates the level of real GDP and the real interest rate It incorporates both the dependence of spending on the real interest rate and the fact that, in the short run, real GDP equals spending The IS curve is shown in Figure 16.18 "A Change in Income" We label the horizontal axis “real GDP” since, in the short run, real GDP is determined by aggregate spending The IS curve is downward sloping: as the real interest rate increases, the level of spending decreases Figure 16.20 The IS Curve Saylor URL: http://www.saylor.org/books Saylor.org 673 In fact, we derived the IS curve in Chapter 10 "Understanding the Fed" The dependence of spending on real interest rates comes partly from investment As the real interest rate increases, spending by firms on new capital and spending by households on new housing decreases Consumption also depends on the real interest rate: spending by households on durable goods decreases as the real interest rate increases The connection between spending and real GDP comes from the aggregate expenditure model Given a particular level of the interest rate, the aggregate expenditure model determines the level of real GDP Now suppose the interest rate increases This reduces those components of spending that depend on the interest rate In the aggregate expenditure framework, this is a reduction in autonomous spending The equilibrium level of output decreases Thus the IS curve slopes downwards: higher interest rates are associated with lower real GDP Equilibrium Combining the discussion of the LM and the IS curves will generate equilibrium levels of interest rates and output Note that both relationships are combinations of interest rates and output Solving these two equations jointly determines the equilibrium This is shown graphically in Figure 16.21 This just combines the LM curve from Figure 16.19 "The LM Curve" and the IS curve from Figure 16.20 "The IS Curve" The crossing of these two curves is the combination of the interest rate and real GDP, denoted (r*,Y*), such that both the money market and the goods market are in equilibrium Saylor URL: http://www.saylor.org/books Saylor.org 674 Figure 16.21 Equilibrium in the IS-LM Model Comparative Statics Comparative statics results for this model illustrate how changes in exogenous factors influence the equilibrium levels of interest rates and output For this model, there are two key exogenous factors: the level of autonomous spending (excluding any spending affected by interest rates) and the real money supply We can study how changes in these factors influence the equilibrium levels of output and interest rates both graphically and algebraically Variations in the level of autonomous spending will lead to a shift in the IS curve, as shown in Figure 16.22 "A Shift in the IS Curve" If autonomous spending increases, then the IS curve shifts out The output level of the economy will increase Interest rates rise as we move along the LM curve, ensuring money market equilibrium One source of variations in autonomous spending is fiscal policy Autonomous spending includes government spending (G) Thus an increase in G leads to an increase in output and interest rates as shown in Figure 16.22 "A Shift in the IS Curve" Saylor URL: http://www.saylor.org/books Saylor.org 675 Figure 16.22 A Shift in the IS Curve Variations in the real money supply shift the LM curve, as shown in Figure 16.23 "A Shift in the LM Curve" If the money supply decreases, then the LM curve shifts in This leads to a higher real interest rate and lower output as the LM curve shifts along the fixed IS curve Figure 16.23 A Shift in the LM Curve Saylor URL: http://www.saylor.org/books Saylor.org 676 More Formally We can represent the LM and IS curves algebraically LM Curve Let L(Y,r) represent real money demand at a level of real GDP of Y and a real interest rate of r (When we say “real” money demand, we mean that, as usual, we have deflated by the price level.) For simplicity, suppose that the inflation rate is zero, so the real interest rate is the opportunity cost of holding money [1] Assume that real money demand takes a particular form: L(Y,r) = L + L Y – L r In this equation, L0, L1, and L2 are all positive constants Real money demand is increasing in income and decreasing in the interest rate Letting M/P be the real stock of money in the economy, then money market equilibrium requires M/P = L + L Y – L r Given a level of real GDP and the real stock of money, this equation can be used to solve for the interest rate such that money supply and money demand are equal This is given by Saylor URL: http://www.saylor.org/books Saylor.org 677 r = (1/L ) [L + L Y – M/P] From this equation we learn that an increase in the real stock of money lowers the interest rate, given the level of real GDP Further, an increase in the level of real GDP increases the interest rate, given the stock of money This is another way of saying that the LM curve is upward sloping IS Curve Recall the two equations from the aggregate expenditure model: Y=E and E = E (r) + βY Here we have shown explicitly that the level of autonomous spending depends on the real interest rate r We can solve the two equations to find the values of E and Y that are consistent with both equations We find Y equil = ( ) × E0 (r) 1− β Given a level of the real interest rate, we solve for the level of autonomous spending (using the dependence of consumption and investment on the real interest rate) and then use this equation to find the level of output Here is an example Suppose that C = 100 + 0.6Y, I = 400 − 5r, G = 300, and NX = 200 − 0.1Y, where C is consumption, I is investment, G is government purchases, and NX is net exports First group the components of spending as follows: C + I + G + NX = (100 + 400 − 5r + 300 + 200) + (0.6Y − 0.1Y) Adding together the first group of terms, we find autonomous spending: Saylor URL: http://www.saylor.org/books Saylor.org 678 E = 100 + 400 + 300 + 200 − 5r = 1000 − 5r Adding the coefficients on the income terms, we find the marginal propensity to spend: β = 0.6 − 0.1 = 0.5 Using β = 0.5, we calculate the multiplier: ( 1 )=( ) = 1− β 1−.5 We then calculate real GDP, given the real interest rate: Y = × (1000 − 5r) = 2000 − 10r Equilibrium Combining the discussion of the LM and the IS curves will generate equilibrium levels of interest rates and output Note that both relationships are combinations of interest rates and output Solving these two equations jointly determines the equilibrium Algebraically, we have an equation for the LM curve: r = (1/L ) [L + L Y – M/P] And we have an equation for the IS curve: Y = mE (r), where we let m = (1/(1 – β)) denote the multiplier If we assume that the dependence of spending in the interest rate is linear, so that E0(r) = e0 – e1r, then the equation for the IS curve is Y = m (e -e r), To solve the IS and LM curves simultaneously, we substitute Y from the IS curve into the LM curve to get r = (1/L ) [L + L m(e -e r) – M/P] 1 Solving this for r we get r = A – B M/P r r Saylor URL: http://www.saylor.org/books Saylor.org 679 where both Ar and Br are constants, with Ar = (L0 + L1me0)/(L1me1 + L2) and Br = 1/(L1me1 + L2) This equation gives us the equilibrium level of the real interest rate given the level of autonomous spending, summarized by e0, and the real stock of money, summarized by M/P To find the equilibrium level of output, we substitute this equation for r back into the equation for the IS curve This gives us Y = A + B (M/P), y y where both A and B are constants, with A = m(e – e A ) and B = me B This equation y y y r y r gives us the equilibrium level of output given the level of autonomous spending, summarized by e , and the real stock of money, summarized by M/P Algebraically, we can use the equations to determine the magnitude of the responses of interest rates and output to exogenous changes An increase in the autonomous spending, e , will increase both A and A , implying that both the interest rate and output increase [2] An r y increase in the real money stock will reduce interest rates by B and increase output by B A r y key part of monetary policy is the sensitivity of spending to the interest rate, given by e The more sensitive is spending to the interest rate, the larger ise and therefore the larger is B y The Main Uses of This Tool We not explicitly use this tool in our chapter presentations However, the tool can be used to support the discussions in the following chapters     Chapter "Money: A User’s Guide" Chapter 10 "Understanding the Fed" Chapter 11 "Inflations Big and Small" Chapter 14 "Balancing the Budget" [1] If we wanted to include inflation in our analysis, we could write the real demand for money as L(Y, r + π), where π is the inflation rate [2] To see that Ay increases with e0 requires a bit more algebra Saylor URL: http://www.saylor.org/books Saylor.org 680 ... heart of this book The basic methodology of macroeconomics is displayed in Figure 2.5 "Macroeconomics Methodology" Macroeconomics involves the interplay of theory, data, and policy We have already... our applications chapters contain very little mathematics This means that you can read and understand the applications without needing to work through a lot of mathematics Compared to our applications... microeconomic decisions you have made today 1.2 Macroeconomics in a Fast-Food Restaurant LEARNING OBJECTIVE What kinds of problems we study in macroeconomics? The economic decisions you witness