Chapter 16: Aggregate demand – I-B. This chapter sets up the IS-LM model, which chapter 11 then uses extensively to analyze the effects of policies and economic shocks. This chapter also introduces students to the Keynesian Cross and Liquidity Preference models, which underlie the IS curve and LM curve, respectively.
Review of the previous lecture Keynesian Cross § basic model of income determination § takes fiscal policy & investment as exogenous § fiscal policy has a multiplied impact on income IS curve § comes from Keynesian Cross when planned investment depends negatively on interest rate § shows all combinations of r and Y that equate planned expenditure with actual expenditure on goods & services Lecture 16 Aggregate demand – I-B Instructor: Prof Dr Qaisar Abbas Lecture Contents • • • The LM curve, and its relation to - the Theory of Liquidity Preference How the IS-LM model determines income and the interest rate in the short run when P is fixed Policy analysis with the IS-LM Model The Theory of Liquidity Preference • • Due to John Maynard Keynes A simple theory in which the interest rate is determined by money supply and money demand Money Supply The supply of real money balances is fixed: (M r interest rate (M P) s P) =M P s M P M/P real money balances Money Demand r Demand for real money balances: (M P) d interest rate (M P) s = L( r ) L (r ) M P M/P real money balances Equilibrium The interest rate adjusts to equate the supply and demand for money: r interest rate (M P) s r1 M P = L( r ) L (r ) M P M/P real money balances How the Fed raises the interest rate r interest rate To increase r, Fed reduces M r2 r1 L (r ) M2 M1 P P M/P real money balances CASE STUDY Volcker’s Monetary Tightening • • • • Late 1970s: > 10% Oct 1979: Fed Chairman Paul Volcker announced that monetary policy would aim to reduce inflation Aug 1979-April 1980: Fed reduces M/P 8.0% Jan 1983: = 3.7% How do you think this policy change would affect interest rates? Volcker’s Monetary Tightening, cont The effects of a monetary tightening on nominal interest rates model prices prediction actual outcome short run long run Liquidity Preference Quantity Theory, Fisher Effect (Keynesian) (Classical) sticky flexible i > 0 i shifts the LM curve down (or to the right) …causing the interest rate to fall …which increases investment, causing output & income to rise LM1 LM2 r1 r2 IS Y1 Y2 Y Interaction between monetary & fiscal policy • • • Model: monetary & fiscal policy variables (M, G and T ) are exogenous Real world: Monetary policymakers may adjust M in response to changes in fiscal policy, or vice versa Such interaction may alter the impact of the original policy change The Fed’s response to • Suppose Congress increases G • Possible Fed responses: • hold M constant • hold r constant • hold Y constant G >0 Response 1: hold M constant If Congress raises G, the IS curve shifts right If Fed holds M constant, then LM curve doesn’t shift r LM1 r2 r1 Results: IS2 ∆Y = Y − Y ∆r = r − r IS1 Y1 Y2 Y Response 2: hold r constant If Congress raises G, the IS curve shifts right r LM1 LM2 To keep r constant, Fed increases M to shift LM curve right r2 r1 IS2 Results: ∆Y = Y − Y ∆r = IS1 Y1 Y2 Y3 Y Response 3: hold Y constant If Congress raises G, the IS curve shifts right LM2 r LM1 r3 To keep Y constant, Fed reduces M to shift LM curve left r2 r1 IS2 IS1 Results: ∆Y = ∆r = r − r Y1 Y2 Y Estimates of fiscal policy multipliers from the DRI macroeconometric model Assumption about monetary policy Estimated value of Y/ G Estimated value of Y/ T Fed holds money supply constant 0.60 0.26 Fed holds nominal interest rate constant 1.93 1.19 Summary • • Theory of Liquidity Preference § basic model of interest rate determination § takes money supply & price level as exogenous § an increase in the money supply lowers the interest rate LM curve § comes from Liquidity Preference Theory when money demand depends positively on income § shows all combinations of r andY that equate demand for real money balances with supply Summary • IS-LM model § Intersection of IS and LM curves shows the unique point (Y, r ) that satisfies equilibrium in both the goods and money markets .. .Lecture 16 Aggregate demand – I-B Instructor: Prof Dr Qaisar Abbas Lecture Contents • • • The LM curve, and its relation to - the Theory of Liquidity Preference How the IS-LM model... Preference IS curve LM curve IS-LM model Agg demand curve Agg supply curve Explanation of short-run fluctuations Model of Agg Demand and Agg Supply Equilibrium in the IS-LM Model The IS curve represents... the Liquidity Preference model to show how these events shift the LM curve The short-run equilibrium The short-run equilibrium is the combination of r and Y that simultaneously satisfies the equilibrium