(BQ) Part 1 book Macroeconomics has contents: National income accounting, growth and accumulation, policy preview, income and spending, aggregate supply and demand, the anatomy of inflation and unemployment,... and other contents.
www.downloadslide.net www.downloadslide.net MA C R O E C O N O M I C S www.downloadslide.net The McGraw-Hill Series Economics ESSENTIALS OF ECONOMICS Brue, McConnell, and Flynn Essentials of Economics Second Edition Mandel Economics: The Basics First Edition Schiller Essentials of Economics Eighth Edition PRINCIPLES OF ECONOMICS Colander Economics, Microeconomics, and Macroeconomics Eighth Edition Frank and Bernanke Principles of Economics, Principles of Microeconomics, Principles of Macroeconomics Fourth Edition Frank and Bernanke Brief Editions: Principles of Economics, Principles of Microeconomics, Principles of Macroeconomics Second Edition McConnell, Brue, and Flynn Economics, Microeconomics, and Macroeconomics Nineteenth Edition McConnell, Brue, and Flynn Brief Editions: Microeconomics and Macroeconomics First Edition Miller Principles of Microeconomics First Edition Samuelson and Nordhaus Economics, Microeconomics, and Macroeconomics Nineteenth Edition dor75926_fm_i-xx.indd ii Schiller The Economy Today, The Micro Economy Today, and The Macro Economy Today Twelfth Edition Slavin Economics, Microeconomics, and Macroeconomics Tenth Edition ECONOMICS OF SOCIAL ISSUES Guell Issues in Economics Today Fifth Edition Sharp, Register, and Grimes Economics of Social Issues Nineteenth Edition ECONOMETRICS Gujarati and Porter Basic Econometrics Fifth Edition Gujarati and Porter Essentials of Econometrics Fourth Edition MANAGERIAL ECONOMICS Baye Managerial Economics and Business Strategy Eighth Edition Brickley, Smith, and Zimmerman Managerial Economics and Organizational Architecture Fifth Edition Thomas and Maurice Managerial Economics Tenth Edition INTERMEDIATE ECONOMICS Bernheim and Whinston Microeconomics First Edition ADVANCED ECONOMICS Romer Advanced Macroeconomics Third Edition MONEY AND BANKING Cecchetti and Schoenholtz Money, Banking, and Financial Markets Third Edition URBAN ECONOMICS O’Sullivan Urban Economics Seventh Edition LABOR ECONOMICS Borjas Labor Economics Fifth Edition McConnell, Brue, and Macpherson Contemporary Labor Economics Ninth Edition PUBLIC FINANCE Rosen and Gayer Public Finance Ninth Edition Seidman Public Finance First Edition ENVIRONMENTAL ECONOMICS Field and Field Environmental Economics: An Introduction Fifth Edition INTERNATIONAL ECONOMICS Appleyard, Field, and Cobb International Economics Seventh Edition Dornbusch, Fischer, and Startz Macroeconomics Eleventh Edition King and King International Economics, Globalization, and Policy: A Reader Fifth Edition Frank Microeconomics and Behavior Eighth Edition Pugel International Economics Fourteenth Edition 03/11/10 7:50 PM www.downloadslide.net MA C R O E C O N O M I C S Eleventh Edition RUDIGER DORNBUSCH Late of Massachusetts Institute of Technology Ford Professor of Economics and International Management ◆ STANLEY FISCHER Bank of Israel Governor ◆ RICHARD STARTZ University of Washington Castor Professor of Economics www.downloadslide.net MACROECONOMICS, ELEVENTH EDITION Published by McGraw-Hill, a business unit of The McGraw-Hill Companies, Inc., 1221 Avenue of the Americas, New York, NY 10020 Copyright © 2011 by The McGraw-Hill Companies, Inc All rights reserved Previous editions © 2008, 2004, and 2001 No part of this publication may be reproduced or distributed in any form or by any means, or stored in a database or retrieval system, without the prior written consent of The McGraw-Hill Companies, Inc., including, but not limited to, in any network or other electronic storage or transmission, or broadcast for distance learning Some ancillaries, including electronic and print components, may not be available to customers outside the United States This book is printed on acid-free paper DOC/DOC ISBN 978-0-07-3375922 MHID 0-07-3375926 Vice President & Editor-in-Chief: Brent Gordon Vice President, EDP/Central Publishing Services: Kimberly Meriwether David Publisher: Douglas Reiner Senior Marketing Manager: Melissa Larmon Managing Development Editor: Christina Kouvelis Editorial Coordinator: Alyssa Otterness Senior Project Manager: Jane Mohr Design Coordinator: Margarite Reynolds Cover Designer: Studio Montage, St Louis, Missouri Cover Credit: © David Wasserman/Jupiter Images Buyer: Susan K Culbertson Media Project Manager: Balaji Sundararaman Compositor: Glyph International Typeface: 10/12 Times New Roman PS Printer: R R Donnelley All credits appearing on page or at the end of the book are considered to be an extension of the copyright page Library of Congress Cataloging-in-Publication Data Dornbusch, Rudiger Macroeconomics/Rudiger Dornbusch, Stanley Fischer, Richard Startz.—11th ed p cm Includes index ISBN 978-0-07-337592-2 (alk paper) Macroeconomics I Fischer, Stanley II Startz, Richard, 1952- III Title HB172.5.D67 2011 339—dc22 2010038615 www.mhhe.com dor75926_fm_i-xx.indd iv 03/11/10 7:50 PM www.downloadslide.net To Rhoda and Shelly and to the memory of Rudi, teacher/colleague/friend dor75926_fm_i-xx.indd v 03/11/10 7:50 PM www.downloadslide.net ABOUT THE AUTHORS RUDI DORNBUSCH (1942–2002) was Ford Professor of Economics and International Management at MIT He did his undergraduate work in Switzerland and held a PhD from the University of Chicago He taught at Chicago, at Rochester, and from 1975 to 2002 at MIT His research was primarily in international economics, with a major macroeconomic component His special research interests included the behavior of exchange rates, high inflation and hyperinflation, and the problems and opportunities that high capital mobility pose for developing economies He lectured extensively in Europe and in Latin America, where he took an active interest in problems of stabilization policy, and held visiting appointments in Brazil and Argentina His writing includes Open Economy Macroeconomics and, with Stanley Fischer and Richard Schmalensee, Economics STANLEY FISCHER is governor of the Bank of Israel Previously he was vice chairman of Citigroup and president of Citigroup International, and from 1994 to 2002 he was first deputy managing director of the International Monetary Fund He was an undergraduate at the London School of Economics and has a PhD from MIT He taught at the University of Chicago while Rudi Dornbusch was a student there, starting a long friendship and collaboration He was a member of the faculty of the MIT Economics Department from 1973 to 1998 From 1988 to 1990 he was chief economist at the World Bank His main research interests are economic growth and development; international economics and macroeconomics, particularly inflation and its stabilization; and the economics of transition www.iie.com/fischer RICHARD STARTZ is Castor Professor of Economics at the University of Washington He was an undergraduate at Yale University and received his PhD from MIT, where he studied under Stanley Fischer and Rudi Dornbusch He taught at the Wharton School of the University of Pennsylvania before moving on to the University of Washington, and he has taught, while on leave, at the University of California–San Diego, the Stanford Business School, and Princeton His principal research areas are macroeconomics, econometrics, and the economics of race In the area of macroeconomics, much of his work has concentrated on the microeconomic underpinnings of macroeconomic theory His work on race is part of a long-standing collaboration with Shelly Lundberg www econ.washington.edu/user/startz vi dor75926_fm_i-xx.indd vi 03/11/10 7:50 PM www.downloadslide.net PREFACE The 11th edition of Macroeconomics is published 31 years after the first We have been both amazed and flattered by the response our book has received over those years Besides its use in the classrooms of many U.S universities, it has been translated into many languages and used in many countries, from Canada to Argentina to Australia; all over Europe; in India, Indonesia, and Japan; and from China and Albania to Russia Even before the Czech Republic gained independence from communism, an underground translation was secretly used in macroeconomics seminars at Charles University in Prague There is no greater pleasure for teachers and textbook authors than to see their efforts succeed so concretely around the world We believe that the success of our textbook reflects the unique features it brings to the universe of undergraduate macroeconomics These features can be summarized as follows: Through the years we have held the conviction that the best textbook is one written with an abiding respect for both student and instructor What does this mean exactly? In practice it means that we explore more state-ofthe-art research than is customary in undergraduate textbooks, allowing students a point of departure for deeper exploration of various topics and teachers the flexibility to emphasize topics in greater detail At the same time, however, we have reduced the book’s level of difficulty by providing straightforward explanations, emphasizing concepts over technique, and fitting difficult material into a larger framework so students can see its relevance We also emphasize how empirical data can explain and test macroeconomic theory by providing numerous illustrations using real-world data • Focus on Models The best economists have a rich toolbox of simple models they can use to analyze various facets of the economy and know when to apply the right model to answer specific questions We have consistently focused our textbook on the presentation of a series of simple models relevant to particular issues We strive to help students understand the importance of a model-based approach to macroeconomic analysis as well as how the various models are connected Our goal is to produce students who have the capacity to analyze current economic issues in the context of an economic frame of reference, namely, a set of macroeconomic models • International Perspective It has always been important for students living in countries with highly open economies to understand the important links connecting foreign economies to their own This is also becoming ever more true in the United States as international goods and financial markets become more intertwined Recognizing this, we provide two detailed chapters discussing international linkages The first, Chapter 12, provides a discussion of mainstream intermediate • “Compassionate Difficulty” vii dor75926_fm_i-xx.indd vii 03/11/10 7:50 PM www.downloadslide.net viii PREFACE macroeconomic topics The second, Chapter 20, gives advanced students the opportunity to explore modern theories of balance-of-payments crises, determinants of exchange rates, and the choice of exchange rate regimes These chapters give instructors the flexibility to range from touching on a few international topics to a thorough discussion lasting several weeks • Focus on Changing Times We have strived to present updated data throughout the book, demonstrating key trends and thorough discussions of how such trends might be explained by traditional macroeconomic models WHAT’S NEW The 11th edition of Macroeconomics is thoroughly updated to reflect the newest data, and the story of the Great Recession Graphs, data tables, and empirical homework questions use the latest data available New boxes include “Who Calls Recessions?,” “The Chinese Growth Miracle,” “A Sticky Experiment” (a story about the great French deflation in the 1700s), “The Multiplier in Practice” (a discussion of estimates of empirical multipliers), “What Did Happen When the Interest Rate Hit Zero?,” “The Fed as Market Maker of Last Resort,” and “Hyperinflation Ends with a Bang or a Whimper?” (a review of the end of Zimbabwe’s runaway hyperinflation) New sections discuss alternative measures of unemployment, the reasons we see “jobless recoveries,” unorthodox monetary policy during the Great Recession as well as the enormous fiscal stimulus, and, of course, a discussion of the bubbles and bust that led up to the Great Recession ORGANIZATIONAL ALTERNATIVES A major goal in writing this textbook is to provide one that is comprehensive yet flexible enough to allow teachers to focus a class on their particular interests and time constraints Our personal preference is to begin at the beginning and work through the entire book (which is, of course, why we organized the material in the way we did), but a number of approaches can be taken to give a different emphasis or simply to reduce the breadth of material covered Examples of these approaches include An overview course should contain what we feel is the core of the textbook: Chapters and 2, which introduce the book and provide details on national income accounting; Chapter 5, which gives an overview of aggregate supply and demand; Chapter 6, which presents the aggregate supply curve in more detail; Chapter 7, which discusses the headline issues of inflation and unemployment; Chapter 8, which gives a media-level view on stabilization policy and Chapters 9, 10, and 11, which introduce the goods market, asset market, and some basics of monetary and fiscal policy Beyond these core chapters the course can be shortened substantially by omitting chapters that focus on the microeconomic detail beneath macroeconomic theory—Chapters 13–16, 18, and 20, for example, which supply such detail for consumption, investment, money markets, and advanced topics respectively And Chapters 17 and 19, which detail several current issues in policymaking, can be omitted or done only in part In the United States, Chapters 4, 12, and 20, which present • An Overview Course dor75926_fm_i-xx.indd viii 03/11/10 7:50 PM www.downloadslide.net PREFACE ix many basic issues of international interdependence and growth policy, might also be omitted (although probably everyone should Sections 12-1 and 12-2) • A Traditional Aggregate Demand-Oriented Course For a Keynesian, short-run treatment of the course, the core chapters for the overview course should be emphasized and Chapter 17, which discusses policy, added Chapter 19, which discusses big macroeconomic events, can be moved ahead of Chapter 13 Chapters and 4, on growth and policies to promote growth, can be moved to the end of the course And for advanced students, the sections on New Keynesian economics in Chapter 21 might be included • A Classical “Supply-Side” Course For a classical treatment of the course the core chapters for the overview course can be shortened by de-emphasizing the IS-LM material in Chapters 9–11 And in the early chapters greater emphasis might be given to Chapters and on long-run growth The microeconomics of macroeconomic theory in Chapters 13–15 might also be emphasized, as might the discussion of hyperinflation in Chapter 19 Advanced students may wish to explore the sections on the random walk in GDP and on real business cycles in Chapter 21 • A Business School Course In addition to the core chapters for the overview course, a business school course should emphasize Chapters 16 and 18, which deal with the Federal Reserve and financial markets And Chapters and on growth can be de-emphasized, while the advanced topics in Chapter 21 can be omitted For students with an international perspective, Chapter 12 and parts of Chapter 20, especially the discussion of exchange rate determination, might be emphasized Throughout the book, we have labeled some material that is technically difficult as “optional.” Many of the optional sections will be fun for students who enjoy a technical challenge, but the instructor should specify clearly which of these sections are required and which are truly optional COURSESMART CourseSmart is a new way for faculty to find and review eTextbooks It’s also a great option for students interested in accessing their course materials digitally CourseSmart offers thousands of the most commonly adopted textbooks across hundreds of courses from a wide variety of higher education publishers It is the only place for faculty to review and compare the full text of a textbook online At CourseSmart, students can save up to 50 percent off the cost of a print book, reduce their impact on the environment, and gain access to powerful Web tools for learning including full-text search, notes and highlighting, and email tools for sharing notes between classmates Your eBook also includes tech support in case you ever need help Finding your eBook is easy Visit www.CourseSmart.com and search by title, author, or ISBN SUPPLEMENTARY MATERIAL There are several learning and teaching aids that accompany the eleventh edition of Macroeconomics These resources can be found on the text Web site at www.mhhe.com/dornbusch11e Instructor supplements reside under a passwordprotected section of the text Web site dor75926_fm_i-xx.indd ix 03/11/10 7:50 PM www.downloadslide.net CHAPTER 10•MONEY, INTEREST, AND INCOME BOX 10-2 233 Real and Nominal Money Demand At this stage we have to reinforce the crucial distinction between real and nominal variables The nominal demand for money is the individual’s demand for a given number of dollars Similarly, the nominal demand for bonds is the demand for a given number of dollars’ worth of bonds The real demand for money is the demand for money expressed in terms of the number of units of goods that money will buy: It is equal to the nominal demand for money divided by the price level If the nominal demand for money is $100 and the price level is $2 per good—meaning that the representative basket of goods cost $2—the real demand for money is 50 goods If the price level later doubles to $4 per good and the demand for nominal money likewise doubles to $200, the real demand for money is unchanged at 50 goods Real money balances—real balances, for short—are the quantity of nominal money divided by the price level The real demand for money is called the demand for real balances hold money for what it will buy The higher the price level, the more nominal balances a person has to hold to be able to purchase a given quantity of goods If the price level doubles, an individual has to hold twice as many nominal balances in order to be able to buy the same amount of goods The demand for real balances depends on the level of real income and the interest rate It depends on the level of real income because individuals hold money to pay for their purchases, which, in turn, depend on income The demand for money depends also on the cost of holding money The cost of holding money is the interest that is forgone by holding money rather than other assets The higher the interest rate, the more costly it is to hold money and, accordingly, the less cash will be held at each level of income.8 Individuals can economize on their holdings of cash when the interest rate rises by being more careful in managing their money and by making transfers from money to bonds whenever their money holdings become large If the interest rate is percent, there is very little benefit from holding bonds rather than money However, when the interest rate is 10 percent, it is worth some effort not to hold more money than is needed to finance day-to-day transactions On these simple grounds, then, the demand for real balances increases with the level of real income and decreases with the interest rate The demand for real balances, which we denote as L, is accordingly expressed as L ϭ kY Ϫ hi k, h Ͼ (6) Some types of money, including most bank deposits, earn interest, but at a lower rate than bonds Several sizable parts of money holding—including currency—earn no interest; so, overall, money earns less interest than other assets Thus, there is an interest cost to holding money dor75926_ch10_219-247.indd 233 03/11/10 3:21 PM www.downloadslide.net PART 3•FIRST MODELS 234 Interest rate i kΔY L2 = kY2 – hi L1 = kY1 – hi L1 L2 L Demand for money FIGURE 10-8 DEMAND FOR REAL BALANCES AS A FUNCTION OF THE INTEREST RATE AND REAL INCOME The higher the rate of interest, the lower the quantity of real balances demanded, given the level of income An increase in income raises the demand for money, as shown by the rightward shift in the money demand schedule The parameters k and h reflect the sensitivity of the demand for real balances to the level of income and the interest rate, respectively A $5 increase in real income raises money demand by k ϫ real dollars An increase in the interest rate of percentage point reduces real money demand by h real dollars The demand function for real balances, equation (6), implies that for a given level of income, the quantity demanded is a decreasing function of the rate of interest Such a demand curve is shown in Figure 10-8 for a level of income Y1 The higher the level of income, the larger the demand for real balances and, therefore, the farther to the right the demand curve The demand curve for a higher level of real income, Y2, is also shown in Figure 10-8 THE SUPPLY OF MONEY, MONEY MARKET EQUILIBRIUM, AND THE LM CURVE To study equilibrium in the money market, we have to say how the supply of money is determined The nominal quantity of money, M, is controlled by the Federal Reserve System (“the Fed”) in the United States The central bank has other names in other countries, and, of course, through much of history the nominal quantity of money was determined by gold discoveries or similar events We take the nominal quantity of dor75926_ch10_219-247.indd 234 03/11/10 3:21 PM www.downloadslide.net CHAPTER 10•MONEY, INTEREST, AND INCOME 235 −− − money as given at the level M We assume the price level is constant at the level P, so −− − the real money supply is at the level M͞P In Figure 10-9 we show combinations of interest rates and income levels such that the demand for real balances exactly matches the available supply Starting with the level of income, Y1, the corresponding demand curve for real balances, L1, is shown in Figure 10-9a It is drawn, as in Figure 10-8, as a decreasing function of the interest rate −− − The existing supply of real balances, M͞P, is shown by the vertical line, since it is given and therefore is independent of the interest rate At interest rate i1, the demand for real balances equals the supply Therefore, point E1 is an equilibrium point in the money market That point is recorded in Figure 10-9b as a point on the money market equilibrium schedule, or the LM curve Consider next the effect of an increase in income to Y2 In Figure 10-9a the higher level of income causes the demand for real balances to be higher at each level of the interest rate, so the demand curve for real balances shifts up and to the right, to L2 The interest rate increases to i2 to maintain equilibrium in the money market at that higher level of income Accordingly, the new equilibrium point is E2 In Figure 10-9b we record point E2 as a point of equilibrium in the money market Performing the same exercise for all income levels, we generate a series of points that can be linked to give us the LM schedule The LM schedule, or money market equilibrium schedule, shows all combinations of interest rates and levels of income such that the demand for real balances is equal to the supply Along the LM schedule, the money market is in equilibrium The LM curve is positively sloped An increase in the interest rate reduces the demand for real balances To maintain the demand for real balances equal to the fixed supply, the level of income has to rise Accordingly, money market equilibrium implies that an increase in the interest rate is accompanied by an increase in the level of income The LM curve can be obtained directly by combining the demand curve for real balances, equation (6), and the fixed supply of real balances For the money market to be in equilibrium, demand has to equal supply, or −− M _ (7) − ϭ kY Ϫ hi P Solving for the interest rate, −− M i ϭ _ akY Ϫ _ (7a) −b h P The relationship (7a) is the LM curve Next we ask the same question about the properties of the LM curve that we asked about the IS curve (i.e., what determines its slope and position?) THE SLOPE OF THE LM CURVE The greater the responsiveness of the demand for money to income, as measured by k, and the lower the responsiveness of the demand for money to the interest rate, h, the Since, for the present, we are holding constant the money supply and price level, we denote that fact by a bar dor75926_ch10_219-247.indd 235 03/11/10 3:21 PM dor75926_ch10_219-247.indd 236 Interest rate DERIVATION OF THE LM CURVE Real balances (a) M/P E1 E2 L1 = kY1 – hi L2 = kY2 – hi L Interest rate i1 i2 i Y1 E1 Income, output (b) Y2 E2 LM −− − Panel (a) shows the money market The supply of real balances is the vertical line M͞P L1 and L2 represent money demand at different levels of income ( Y1 and Y2 ) FIGURE 10-9 i1 i2 i Y www.downloadslide.net 236 03/11/10 3:21 PM www.downloadslide.net CHAPTER 10•MONEY, INTEREST, AND INCOME 237 steeper the LM curve will be This point can be established by experimenting with Figure 10-9 It can also be confirmed by examining equation (7a), where a given change in income, ⌬Y, has a larger effect on the interest rate, i, the larger is k and the smaller is h If the demand for money is relatively insensitive to the interest rate and thus h is close to zero, the LM curve is nearly vertical If the demand for money is very sensitive to the interest rate and thus h is large, the LM curve is close to horizontal In that case, a small change in the interest rate must be accompanied by a large change in the level of income in order to maintain money market equilibrium THE POSITION OF THE LM CURVE The real money supply is held constant along the LM curve It follows that a change in the real money supply will shift the LM curve In Figure 10-10 we show the effect of an increase in the real money supply Panel (a) shows the demand for real money −− − balances for a level of income Y1 With the initial real money supply, M͞ P, the equilibrium is at point E1, with the interest rate i1 The corresponding point on the LM schedule is E1 −− − Now the real money supply increases to MЈ͞ P, which we represent by a rightward shift of the money supply schedule To restore money market equilibrium at the income level Y1, the interest rate has to decline to i2 The new equilibrium is, therefore, at point E2 This implies that in Figure 10-10b, the LM schedule shifts to the right and down to LMЈ At each level of income the equilibrium interest rate has to be lower to induce people to hold the larger real quantity of money Alternatively, at each level of the interest rate the level of income has to be higher to raise the transactions demand for money and thereby absorb the higher real money supply These points can be noted, too, from inspection of the money market equilibrium condition in equation (7) RECAP The following are the major points about the LM curve: The LM curve is the schedule of combinations of interest rates and levels of income such that the money market is in equilibrium • The LM curve is positively sloped Given the fixed money supply, an increase in the level of income, which increases the quantity of money demanded, has to be accompanied by an increase in the interest rate This reduces the quantity of money demanded and thereby maintains money market equilibrium • The LM curve is steeper when the demand for money responds strongly to income and weakly to interest rates • The LM curve is shifted by changes in the money supply An increase in the money supply shifts the LM curve to the right • We are now ready to discuss the joint equilibrium of the goods and assets markets That is to say, we can now discuss how output and interest rates are determined dor75926_ch10_219-247.indd 237 03/11/10 3:21 PM dor75926_ch10_219-247.indd 238 Interest rate FIGURE 10-10 i2 i1 i Real balances (a) M’/P E2 L1 L Interest rate i2 i1 AN INCREASE IN THE SUPPLY OF MONEY SHIFTS THE LM CURVE TO THE RIGHT M/P E1 i Income, output (b) Y1 E2 E1 LM LM' Y www.downloadslide.net 238 03/11/10 3:21 PM www.downloadslide.net CHAPTER 10•MONEY, INTEREST, AND INCOME 239 10-3 EQUILIBRIUM IN THE GOODS AND MONEY MARKETS The IS and LM schedules summarize the conditions that have to be satisfied in order for the goods and money markets, respectively, to be in equilibrium The task now is to determine how these markets are brought into simultaneous equilibrium For simultaneous equilibrium, interest rates and income levels have to be such that both the goods market and the money market are in equilibrium This condition is satisfied at point E in Figure 10-11 The equilibrium interest rate is therefore i0 and the equilibrium level of income is Y0, given the exogenous variables, in particular, the real money supply and fiscal policy.10 At point E, both the goods market and the money market are in equilibrium Figure 10-11 summarizes our analysis: The interest rate and the level of output are determined by the interaction of the money (LM ) and goods (IS ) markets i Interest rate LM E i0 IS Y0 Y Income, output FIGURE 10-11 GOODS AND MONEY MARKET EQUILIBRIUM At point E, interest rates and income levels are such that the public holds the existing money stock and planned spending equals output 10 In general, exogenous variables are those whose values are not determined within the system being studied dor75926_ch10_219-247.indd 239 03/11/10 3:21 PM www.downloadslide.net PART 3•FIRST MODELS 240 It is worth stepping back now to review our assumptions and the meaning of the equilibrium at E The major assumption is that the price level is constant and that firms are willing to supply whatever amount of output is demanded at that price level Thus, we assume that the level of output Y0 in Figure 10-11 will be willingly supplied by firms − at the price level P We repeat that this assumption is one that is temporarily needed for the development of the analysis; it corresponds to the assumption of a flat, short-run aggregate supply curve CHANGES IN THE EQUILIBRIUM LEVELS OF INCOME AND THE INTEREST RATE The equilibrium levels of income and the interest rate change when either the IS or the LM curve shifts Figure 10-12, for example, shows the effects of an increase in the rate of autonomous investment on the equilibrium levels of income and the interest rate − Such an increase raises autonomous spending, A, and therefore shifts the IS curve to the right That results in a rise in the level of income and an increase in the interest rate at point EЈ − Recall that an increase in autonomous investment spending, ⌬l, shifts the IS curve − to the right by the amount ␣G⌬I, as we show in Figure 10-12 In Chapter 9, where we i LM E' Interest rate i’ E i0 αG ΔI IS' IS ΔY0 Y0 Y’ Y Income, output FIGURE 10-12 AN INCREASE IN AUTONOMOUS SPENDING SHIFTS THE IS CURVE TO THE RIGHT The equilibrium interest rate and level of income both rise dor75926_ch10_219-247.indd 240 03/11/10 3:21 PM www.downloadslide.net CHAPTER 10•MONEY, INTEREST, AND INCOME 241 − dealt only with the goods market, we would have argued that ␣G⌬I would be the change − in the level of income resulting from the change of ⌬I in autonomous spending But it can be seen in Figure 10-12 that the change in income here is only ⌬Y0, which is clearly − less than the shift in the IS curve, ␣G⌬I What explains the fact that the increase in income is smaller than the increase in − autonomous spending, ⌬I times the simple multiplier, ␣G? Diagrammatically, it is clear that the explanation is the slope of the LM curve If the LM curve were horizontal, there would be no difference between the extent of the horizontal shift of the IS curve and the change in income If the LM curve were horizontal, the interest rate would not change when the IS curve shifts But what is the economics of what is happening? The increase in autonomous spending does tend to increase the level of income But an increase in income increases the demand for money With the supply of money fixed, the interest rate has to rise to ensure that the demand for money stays equal to the fixed supply When the interest rate rises, investment spending is reduced because investment is negatively related to the interest rate Accordingly, the equilibrium change in income is less than the horizontal − shift of the IS curve, ␣G⌬I We have now provided an example of the use of the IS-LM apparatus That apparatus is very helpful for studying the effects of monetary and fiscal policy on income and the interest rate, and we use it to so in Chapter 11 To anticipate what is coming, you might want to experiment with how equilibrium income and interest rates change when expansionary fiscal policy moves the IS curve to the right or expansionary monetary policy moves the LM curve to the right 10-4 DERIVING THE AGGREGATE DEMAND SCHEDULE In earlier chapters we used the aggregate demand–aggregate supply apparatus Here we derive the aggregate demand schedule The aggregate demand schedule maps out the IS-LM equilibrium holding autonomous spending and the nominal money supply constant and allowing prices to vary In other words, in learning to use the IS-LM model, you’ve already learned everything about deriving the aggregate demand schedule Put simply, a higher price level means a lower real money supply, an LM curve shifted to the left, and lower aggregate demand Suppose the price level in the economy is P1 Panel (a) of Figure 10-13 shows the IS-LM equilibrium Note that the real money supply, which determines the position of −− − the LM1 curve, is M͞ P1 The intersection of the IS and LM1 curves gives the level of aggregate demand corresponding to price P1 and is so marked in the lower panel (b) Suppose, instead, that the price is higher, say P2 The curve LM2 shows the LM curve based −− − −− − −− − on the real money supply M͞ P2 LM2 is to the left of LM1 since M͞ P2, M͞ P1 Point E2 shows the corresponding point on the aggregate demand curve Repeat this operation for a variety of price levels, and connect the points to derive the aggregate demand schedule dor75926_ch10_219-247.indd 241 03/11/10 3:21 PM www.downloadslide.net 242 PART 3•FIRST MODELS i LM2 Interest rate i2 E2 LM1 E1 i1 IS Y2 Y1 Y Income, output (a) Price level P E2 P2 E1 P1 AD Y2 Y1 Y Income, output (b) FIGURE 10-13 dor75926_ch10_219-247.indd 242 DERIVATION OF THE AGGREGATE DEMAND SCHEDULE 03/11/10 3:21 PM www.downloadslide.net CHAPTER 10•MONEY, INTEREST, AND INCOME 243 ◆OPTIONAL◆ 10-5 A FORMAL TREATMENT OF THE IS-LM MODEL Our exposition so far has been verbal and graphical We now round off the analysis with a more formal, algebraic, treatment of the IS-LM model EQUILIBRIUM INCOME AND THE INTEREST RATE The intersection of the IS and LM schedules determines equilibrium income and the equilibrium interest rate We now derive expressions for these equilibrium values by using the equations of the IS and LM schedules Recall from earlier in the chapter that the goods market equilibrium equation is IS schedule: − Y ϭ ␣G (A Ϫ bi) (5) and that the equation for the money market equilibrium is LM schedule: −− M i ϭ _ akY Ϫ _ −b h P (7a) The intersection of the IS and LM schedules in the diagrams corresponds to a situation in which both the IS and the LM equations hold: The same interest rate and income levels ensure equilibrium in both the goods and the money market In terms of the equations, that means we can substitute the interest rate from the LM equation (7a) into the IS equation (5): −− − b M Y ϭ ␣G cA Ϫ _ akY Ϫ _ − bd h P Collecting terms and solving for the equilibrium level of income, we obtain −− h␣G − b␣G M Yϭ_Aϩ − h ϩ kb␣G h ϩ kb␣G P (8) −− − b M Y ϭ ␥A ϩ ␥ _ _ − h P (8a) or equivalently where ␥ ϭ ␣G ͞(1 ϩ k␣G b͞h).11 Equation (8) shows that the equilibrium level of income − depends on two exogenous variables: (1) autonomous spending ( A ), including − − autonomous consumption and investment ( C and I ) and fiscal policy parameters 11 Equations (8) and (8a) are two different ways to write the same formula Work with whichever one you find more convenient in a particular situation dor75926_ch10_219-247.indd 243 03/11/10 3:21 PM www.downloadslide.net 244 PART 3•FIRST MODELS −− − (G, TR), and (2) the real money stock (M͞ P) Equilibrium income is higher the higher − the level of autonomous spending, A, and the higher the stock of real balances Equation (8) is the aggregate demand schedule It summarizes the IS-LM rela− −− tion, relating Y and P for given levels of A and M Since P is in the denominator, the aggregate demand curve slopes downward The equilibrium rate of interest, i, is obtained by substituting the equilibrium income level, Y0, from equation (8) into the equation of the LM schedule (7a): −− k␣G − M iϭ_AϪ − h ϩ kb␣G h ϩ kb␣G P (9) −− k− M iϭ␥_AϪ␥ − h h␣G P (9a) or equivalently Equation (9) shows that the equilibrium interest rate depends on the parameters of − fiscal policy captured in the multiplier and the term A and on the real money stock A higher real money stock implies a lower equilibrium interest rate For policy questions we are interested in the precise relation between changes in fiscal policy or changes in the real money stock and the resulting changes in equilibrium income Monetary and fiscal policy multipliers provide the relevant information THE FISCAL POLICY MULTIPLIER The fiscal policy multiplier shows how much an increase in government spending changes the equilibrium level of income, holding the real money supply constant Examine equation (8) and consider the effect of an increase in government spending on −− income The increase in government spending, ⌬G, is a change in autonomous spend− −− −− ing, so ⌬A ϭ ⌬G The effect of the change in G is given by ⌬Y _ −− ϭ ␥ ⌬G h␣G ␥ϭ_ h ϩ kb␣G (10) The expression ␥ is the fiscal or government spending multiplier once interest rate adjustment is taken into account Consider how this multiplier, ␥, differs from the simpler expression ␣G that applied under constant interest rates Inspection shows that ␥ is less than ␣G since 1͞(1 ϩ k␣G b͞h) is less than This represents the dampening effect of increased interest rates associated with a fiscal expansion in the IS-LM model We note that the expression in equation (10) is almost zero if h is very small and that it is equal to ␣G if h approaches infinity This corresponds, respectively, to vertical and horizontal LM schedules Similarly, a large value of either b or k serves to reduce the effect of government spending on income Why? A high value of k implies a large increase in money demand as income rises and hence a large increase in interest rates required to maintain money market equilibrium In combination with a high b, this implies a large reduction in private aggregate demand dor75926_ch10_219-247.indd 244 03/11/10 3:21 PM www.downloadslide.net CHAPTER 10•MONEY, INTEREST, AND INCOME 245 THE MONETARY POLICY MULTIPLIER The monetary policy multiplier shows how much an increase in the real money supply increases the equilibrium level of income, keeping fiscal policy unchanged Using equation (8) to examine the effects of an increase in the real money supply on income, we have b␣G ⌬Y _ _b _ (11) −− − ϭ h ␥ ϭ h ϩ kb␣ ⌬(M͞ P) G The smaller h and k and the larger b and ␣G, the more expansionary the effect of an increase in real balances on the equilibrium level of income Large b and ␣G correspond to a very flat IS schedule SUMMARY The IS-LM model presented in this chapter is the basic model of aggregate demand that incorporates the money market as well as the goods market It lays particular stress on the channels through which monetary and fiscal policy affect the economy The IS curve shows combinations of interest rates and levels of income such that the goods market is in equilibrium Increases in the interest rate reduce aggregate demand by reducing investment spending Thus, at higher interest rates, the level of income at which the goods market is in equilibrium is lower: The IS curve slopes downward The demand for money is a demand for real balances The demand for real balances increases with income and decreases with the interest rate, the cost of holding money rather than other assets With an exogenously fixed supply of real balances, the LM curve, representing money market equilibrium, is upward-sloping The interest rate and level of output are jointly determined by simultaneous equilibrium of the goods and money markets This occurs at the point of intersection of the IS and LM curves Monetary policy affects the economy first by affecting the interest rate and then by affecting aggregate demand An increase in the money supply reduces the interest rate, increases investment spending and aggregate demand, and thus increases equilibrium output The IS and LM curves together determine the aggregate demand schedule Changes in monetary and fiscal policy affect the economy through the monetary and fiscal policy multipliers KEY TERMS aggregate demand schedule central bank demand for real balances fiscal policy multiplier dor75926_ch10_219-247.indd 245 goods market equilibrium schedule IS curve IS-LM model LM curve monetary policy multiplier money market equilibrium schedule real money balances 03/11/10 3:21 PM www.downloadslide.net PART 3•FIRST MODELS 246 PROBLEMS Conceptual How does the IS-LM model developed in this chapter relate to the model of aggregate demand developed in Chapter 9? a Explain in words how and why the multiplier ␣G and the interest sensitivity of aggregate demand affect the slope of the IS curve b Explain why the slope of the IS curve is a factor in determining the working of monetary policy Explain in words how and why the income and interest sensitivities of the demand for real balances affect the slope of the LM curve a Why does a horizontal LM curve imply that fiscal policy has the same effects on the economy as those derived in Chapter 9? b What is happening in this case in terms of Figure 10-3? c Under what circumstances might the LM curve be horizontal? It is possible that the interest rate might affect consumption spending An increase in the interest rate could, in principle, lead to increases in saving and therefore a reduction in consumption, given the level of income Suppose that consumption is, in fact, reduced by an increase in the interest rate How will the IS curve be affected? 6.* Between January and December 1991, while the U.S economy was falling deeper into its recession, the interest rate on Treasury bills fell from 6.3 percent to 4.1 percent Use the IS-LM model to explain this pattern of declining output and interest rates Which curve must have shifted? Can you think of a reason—historically valid or simply imagined—that this shift might have occurred? Technical The following equations describe an economy (Think of C, I, G, etc., as being measured in billions and i as a percentage; a percent interest rate implies i = 5.) C ϭ 0.8(1 Ϫ t)Y t ϭ 0.25 I ϭ 900 Ϫ 50i −− G ϭ 800 L ϭ 0.25Y Ϫ 62.5i −− − M͞ P ϭ 500 a b c d e (P1) (P2) (P3) (P4) (P5) (P6) What is the equation that describes the IS curve? What is the general definition of the IS curve? What is the equation that describes the LM curve? What is the general definition of the LM curve? What are the equilibrium levels of income and the interest rate? *An asterisk denotes a more difficult problem dor75926_ch10_219-247.indd 246 03/11/10 3:21 PM www.downloadslide.net CHAPTER 10•MONEY, INTEREST, AND INCOME 247 Continue with the same equations a What is the value of ␣G which corresponds to the simple multiplier (with taxes) of Chapter 9? −− b By how much does an increase in government spending of ⌬G increase the level of income in this model, which includes the money market? −− c By how much does a change in government spending of ⌬ G affect the equilibrium interest rate? d Explain the difference between your answers to parts (a) and (b) a How does an increase in the tax rate affect the IS curve? b How does the increase affect the equilibrium level of income? c How does the increase affect the equilibrium interest rate? 4.* a Show that a given change in the money stock has a larger effect on output the less interest-sensitive is the demand for money Use the formal analysis of Section 10-5 b How does the response of the interest rate to a change in the money stock depend on the interest sensitivity of money demand? Discuss, using the IS-LM model, what happens to interest rates as prices change along a given AD schedule Show, using IS and LM curves, why money has no effect on output in the classical supply case Suppose there is a decline in the demand for money At each output level and interest rate the public now wants to hold lower real balances a In the Keynesian case, what happens to equilibrium output and to prices? b In the classical case, what is the effect on output and on prices? Empirical By the end of this chapter you learned that increases in interest rates reduce aggregate demand Is this true in practice? Let us take a look at how interest rates are related to the growth rate of the U.S economy Go to http://research.stlouisfed.org/fred2 Download data for the following two variables: (a) Real Gross Domestic Product, Annual percentage changes (under “Gross Domestic Product (GDP) and Components,” “GDP/GNP,” click on the series “GDPCA,” click on “Download series,” and select “Percent change from Year Ago.”); and (b) Bank Prime Loan Rate (under “Interest Rates,” “Prime Bank Loan Rate,” click on and download the series “MPRIME,” then transform the monthly observations into annual data using the average function in EXCEL.) Use EXCEL to plot these two series on the same graph What can you say by examining the graph? On average, the two variables evolve in opposite directions? dor75926_ch10_219-247.indd 247 03/11/10 3:21 PM ... dor75926_ch 01_ 0 01- 0 21. indd 03 /11 /10 3 :18 PM www.downloadslide.net 50 45 40 35 30 25 20 15 10 44 43 42 41 (a) FIGURE 1- 1 08 09 20 20 07 20 06 05 20 20 19 19 30 19 19 19 19 70 19 19 20 0 20 10 19 00 40 19 ... Theory 382 15 -4 Empirical Evidence 386 15 -5 The Income Velocity of Money 390 16 THE FED, MONEY, AND CREDIT 16 -1 16-2 16 -3 16 -4 16 -5 16 -6 16 -7 17 POLICY 17 -1 17-2 17 -3 17 -4 17 -5 17 -6 17 -7 18 397 Money... percent of output dor75926_ch 01_ 0 01- 0 21. indd 03 /11 /10 3 :18 PM www.downloadslide.net AS Y3 AS AS Y3 Y2 Y1 Y0 0 t0 t1 Time (a) FIGURE 1- 3 Y0Y1 Y2 AS P Price level Output Y PART 1 INTRODUCTION AND NATIONAL