Worth: Mankiw Economics 5e CHAPTER ELEVEN Aggregate Demand ll Science is a parasite: the greater the patient population the better the ad ance in physiology and pathology; and out of pathology arises therapy The year 1932 was the trough of the great depression, and from its rotten soil was belatedly begot a new subject that today we call macroeconomics In Chapter 10 we assembled the pieces of the IS-LM model. We saw that the IS curve represents the equilibrium in the market for goods and services, that the LM curve represents the equilibrium in the market for real money balances, and that the IS and LM curves together determine the interest rate and national in- come in the short run when the price level is fixed. Now we turn our attention to applying the IS-LM model to analyze three issues First, we examine the potential causes of fluctuations in national income. We use the IS-LM model to see how changes in the exogenous variables (govern- ment purchases, taxes, and the money supply) infuence the endogenous variables (the interest rate and national income). We also examine how various shocks to he goods markets(the IS curve)and the money market(the LM curve)affect he interest rate and national income in the short run Second, we discuss how the IS-LM model fits into the model of aggregate supply and aggregate demand we introduced in Chapter 9. In particular, we ex- amine how the IS-LM model provides a theory of the slope and position of the aggregate demand curve. Here we relax the assumption that the price level is fixed, and we show that the IS-LM model implies a negative relationship be- tween the price level and national income. The model can also tell us what events shift the aggregate demand curve and in what direction. Third, we examine the Great Depression of the 1930s. As this chapter's open ing quotation indicates, this episode gave birth to short-run macroeconomic the- ory, for it led Keynes and his many followers to think that aggregate demand was the key to understanding fluctuations in national income. With the benefit of hindsight, we can use the IS-LM model to discuss the various explanations of 281 User JoEkA: Job EFFo1427: 6264_chl1: Pg 281: 25874#/eps at 10045 wed,Feb13,200210:264
User JOEWA:Job EFF01427:6264_ch11:Pg 281:25874#/eps at 100% *25874* Wed, Feb 13, 2002 10:26 AM In Chapter 10 we assembled the pieces of the IS–LM model.We saw that the IS curve represents the equilibrium in the market for goods and services, that the LM curve represents the equilibrium in the market for real money balances, and that the IS and LM curves together determine the interest rate and national income in the short run when the price level is fixed. Now we turn our attention to applying the IS–LM model to analyze three issues. First, we examine the potential causes of fluctuations in national income.We use the IS–LM model to see how changes in the exogenous variables (government purchases, taxes, and the money supply) influence the endogenous variables (the interest rate and national income).We also examine how various shocks to the goods markets (the IS curve) and the money market (the LM curve) affect the interest rate and national income in the short run. Second, we discuss how the IS–LM model fits into the model of aggregate supply and aggregate demand we introduced in Chapter 9. In particular, we examine how the IS–LM model provides a theory of the slope and position of the aggregate demand curve. Here we relax the assumption that the price level is fixed, and we show that the IS–LM model implies a negative relationship between the price level and national income. The model can also tell us what events shift the aggregate demand curve and in what direction. Third, we examine the Great Depression of the 1930s.As this chapter’s opening quotation indicates, this episode gave birth to short-run macroeconomic theory, for it led Keynes and his many followers to think that aggregate demand was the key to understanding fluctuations in national income. With the benefit of hindsight, we can use the IS–LM model to discuss the various explanations of this traumatic economic downturn. | 281 Aggregate Demand II 11 CHAPTER Science is a parasite: the greater the patient population the better the advance in physiology and pathology; and out of pathology arises therapy. The year 1932 was the trough of the great depression, and from its rotten soil was belatedly begot a new subject that today we call macroeconomics. — Paul Samuelson ELEVEN
Worth: Mankiw Economics 5e 282 PART IV Business Cycle Theory: The Economy in the Short Run 17-7 Explaining Fluctuations With the s-LM Model The intersection of the IS curve and the LM curve determines the level of na tional income. When one of these curves shifts, the short-run equilibrium of the economy changes,and national income fluctuates. In this section we examine how changes in policy and shocks to the economy can cause these curves to shift. How Fiscal Policy Shifts the /S Curve and Changes the short-Run Equilibrium We begin by examining how changes in fiscal policy(government purchases and taxes)alter the economy 's short-run equilibrium. Recall that changes in fiscal olicy influence planned expenditure and thereby shift the IS curve. The IS-LM model shows how these shifts in the is curve affect income and the interest rate Changes in Government Purchases Consider an increase in government pur chases of AG. The government-purchases multiplier in the Keynesian cross tells us that, at any given interest rate, this change in fiscal policy raises the level of income by AG/(1-MPC)Therefore, as Figure 11-1 shows, the IS curve shifts to the right by this amount. The equilibrium of the economy moves from point a to point B The increase in government purchases raises both income and the interest rate. To understand fully what's happening in Figure 11-1, it helps to keep in mind the building blocks for the IS-LM model from the preceding chapter--the Keynesian cross and the theory of liquidity preference. Here is the story. When the government figure 11-1 An Increase in Government Purchases in the s-LM Model purchases shifts the /S curve to right. The moves from point A to point B. Income rises from Y, to Y2 and the interest rate rises from r1 to r2 3.: and the interest 1. The /S curve shifts 2. which Y1 Y2 me,output, Y User JoENA: Job EFFo1427:6264_chl1: Pg 282: 27329#/eps at 100s wed,Feb13,200210:264
User JOEWA:Job EFF01427:6264_ch11:Pg 282:27329#/eps at 100% *27329* Wed, Feb 13, 2002 10:26 AM 11-1 Explaining Fluctuations With the IS–LM Model The intersection of the IS curve and the LM curve determines the level of national income.When one of these curves shifts, the short-run equilibrium of the economy changes, and national income fluctuates. In this section we examine how changes in policy and shocks to the economy can cause these curves to shift. How Fiscal Policy Shifts the IS Curve and Changes the Short-Run Equilibrium We begin by examining how changes in fiscal policy (government purchases and taxes) alter the economy’s short-run equilibrium. Recall that changes in fiscal policy influence planned expenditure and thereby shift the IS curve.The IS–LM model shows how these shifts in the IS curve affect income and the interest rate. Changes in Government Purchases Consider an increase in government purchases of DG.The government-purchases multiplier in the Keynesian cross tells us that, at any given interest rate, this change in fiscal policy raises the level of income by DG/(1 − MPC).Therefore,as Figure 11-1 shows,the IS curve shifts to the right by this amount.The equilibrium of the economy moves from point A to point B. The increase in government purchases raises both income and the interest rate. To understand fully what’s happening in Figure 11-1,it helps to keep in mind the building blocks for the IS–LM model from the preceding chapter—the Keynesian cross and the theory of liquidity preference.Here is the story.When the government 282 | PART IV Business Cycle Theory: The Economy in the Short Run figure 11-1 Interest rate, r Y Income, output, Y 1 Y2 r 1 r 2 IS1 B A IS2 LM 2. . . . which raises income . . . 3. . . . and the interest rate. 1. The IS curve shifts to the right by G/(1 MPC), . .. An Increase in Government Purchases in the IS–LM Model An increase in government purchases shifts the IS curve to the right. The equilibrium moves from point A to point B. Income rises from Y1 to Y2, and the interest rate rises from r1 to r2.
Worth: Mankiw Economics 5e CHAPTER 11 Aggregate Demand ll 283 increases its purchases of goods and services, the economy's planned expenditure rises. The increase in planned expenditure stimulates the production of goods and services which causes total income y to rise. These effects should be familiar from he Keynesian cross. Now consider the money market, as described by the theory of liquidity pref erence. Because the economy's demand for money depends on income, the rise in total income increases the quantity of money demanded at every interest rate. The supply of money has not changed, however, so higher money demand causes the equilibrium interest rate r to rise. The higher interest rate arising in the money market, in turn, has ramifications back in the goods market. When the interest rate rises, firms cut back on their in- vestment plans. This fall in investment partially offsets the expansionary effect of the increase in government purchases. Thus, the increase in income in response to a fiscal expansion is smaller in the IS-LM model than it is in the Keynesian cross(where investment is assumed to be fixed). You can see this in Figure 11-1 The horizontal shift in the IS curve equals the rise in equilibrium income in the Keynesian cross. This amount is larger than the increase in equilibrium income here in the IS-LM model. The difference is explained by the crowding out of in- vestment caused by a higher interest rate Changes in Taxes In the IS-LM model, changes in taxes affect the economy much the same as changes in government purchases do, except that taxes affect expenditure through consumption. Consider, for instance, a decrease in taxes of AT. The tax cut encourages consumers to spend more and, therefore, increases planned expenditure. The tax multiplier in the Keynesian cross tells us that, at any given interest rate, this change in policy raises the level of income by ATX MPC/(1-MPC) Therefore, as Figure 11-2 illustrates, the IS curve shifts to the figure 11-2 Interest rate, r A Decrease in Taxes in the /S-LM Model a decrease in LM from point A to pointB c c axes shifts the Is curve to the right. The equilibrium mov Income rises from Y, to y2 and the interest rate rises from Lo 3.. and 1. The /S curve the interest User JOENA: Job EFF01427: 6264_ch11: Pg 283: 27330 #/eps at 100s Wed,Feb13,200210:26M
User JOEWA:Job EFF01427:6264_ch11:Pg 283:27330#/eps at 100% *27330* Wed, Feb 13, 2002 10:26 AM increases its purchases of goods and services, the economy’s planned expenditure rises.The increase in planned expenditure stimulates the production of goods and services, which causes total income Y to rise.These effects should be familiar from the Keynesian cross. Now consider the money market, as described by the theory of liquidity preference. Because the economy’s demand for money depends on income, the rise in total income increases the quantity of money demanded at every interest rate. The supply of money has not changed, however, so higher money demand causes the equilibrium interest rate r to rise. The higher interest rate arising in the money market, in turn, has ramifications back in the goods market.When the interest rate rises, firms cut back on their investment plans.This fall in investment partially offsets the expansionary effect of the increase in government purchases.Thus, the increase in income in response to a fiscal expansion is smaller in the IS–LM model than it is in the Keynesian cross (where investment is assumed to be fixed).You can see this in Figure 11-1. The horizontal shift in the IS curve equals the rise in equilibrium income in the Keynesian cross.This amount is larger than the increase in equilibrium income here in the IS–LM model.The difference is explained by the crowding out of investment caused by a higher interest rate. Changes in Taxes In the IS–LM model, changes in taxes affect the economy much the same as changes in government purchases do, except that taxes affect expenditure through consumption. Consider, for instance, a decrease in taxes of DT.The tax cut encourages consumers to spend more and, therefore, increases planned expenditure.The tax multiplier in the Keynesian cross tells us that, at any given interest rate, this change in policy raises the level of income by DT × MPC/(1 − MPC).Therefore, as Figure 11-2 illustrates, the IS curve shifts to the CHAPTER 11 Aggregate Demand II | 283 figure 11-2 Interest rate, r Y Income, output, Y 1 Y2 r 1 r 2 IS1 B A LM 2. . . . which raises income . . . IS2 3. . . . and the interest rate. 1. The IS curve shifts to the right by T MPC , ... 1 MPC A Decrease in Taxes in the IS–LM Model A decrease in taxes shifts the IS curve to the right. The equilibrium moves from point A to point B. Income rises from Y1 to Y2, and the interest rate rises from r1 to r2.
Worth: Mankiw Economics 5e 284 PART IV Business Cycle Theory: The Economy in the Short Run right by this amount. The equilibrium of the economy moves from point a to point B. The tax cut raises both income and the interest rate. Once again, because he higher interest rate depresses investment, the increase in income is smaller in the IS-LM model than it is in the Keynesian cross How Monetary Policy Shifts the LM Curve and Changes the Short-Run Equilibrium We now examine the effects of monetary policy. Recall that a change in the money supply alters the interest rate that equilibrates the money market for any given level of income and, thereby, shifts the LM curve. The IS-LM model shows how a shift in the lm curve affects income and the interest rate Consider an increase in the money supply. An increase in M leads to an in crease in real money balances M/P, because the price level P is fixed in the short run. The theory of liquidity preference shows that for any given level of income, an increase in real money balances leads to a lower interest rate. Therefore, the LM curve shifts downward, as in Figure 11-3.The equilibrium moves from point a to point B. The increase in the money supply lowers the interest rate and raises the level of income Once again, to tell the story that explains the economy's adjustment from point A to point B, we rely on the building blocks of the IS-LM modeh-the Keynesian cross and the theory of liquidity preference. This time, we begin with the money market, where the monetary-policy action occurs When the Federal Reserve increases the supply of money, people have more money than the want to hold at the prevailing interest rate. As a result, they start depositing this extra money in banks or use it to buy bonds. The interest rate r then falls until people are willing to hold all the extra money that the Fed has created; this brings the money market to a new equilibrium. The lower interest rate, in turn, fi Interest rater An Increase in the Money Supply in the IS-LM Model An increase in the money supply shifts the LM curve downward. The equilib moves from point A to point B Income rises from Y, to Y2 1. An increase in the and the interest rate falls from supply shifts lowers the Interest rate User JoENA: Job EFFo1427:6264_chl1: Pg 284: 27331#/eps at 100s wed,Feb13,200210:264
User JOEWA:Job EFF01427:6264_ch11:Pg 284:27331#/eps at 100% *27331* Wed, Feb 13, 2002 10:26 AM right by this amount.The equilibrium of the economy moves from point A to point B.The tax cut raises both income and the interest rate. Once again, because the higher interest rate depresses investment, the increase in income is smaller in the IS–LM model than it is in the Keynesian cross. How Monetary Policy Shifts the LM Curve and Changes the Short-Run Equilibrium We now examine the effects of monetary policy. Recall that a change in the money supply alters the interest rate that equilibrates the money market for any given level of income and, thereby, shifts the LM curve.The IS–LM model shows how a shift in the LM curve affects income and the interest rate. Consider an increase in the money supply. An increase in M leads to an increase in real money balances M/P, because the price level P is fixed in the short run.The theory of liquidity preference shows that for any given level of income, an increase in real money balances leads to a lower interest rate.Therefore, the LM curve shifts downward, as in Figure 11-3.The equilibrium moves from point A to point B.The increase in the money supply lowers the interest rate and raises the level of income. Once again, to tell the story that explains the economy’s adjustment from point A to point B, we rely on the building blocks of the IS–LM model—the Keynesian cross and the theory of liquidity preference.This time, we begin with the money market, where the monetary-policy action occurs.When the Federal Reserve increases the supply of money, people have more money than they want to hold at the prevailing interest rate.As a result, they start depositing this extra money in banks or use it to buy bonds.The interest rate r then falls until people are willing to hold all the extra money that the Fed has created; this brings the money market to a new equilibrium.The lower interest rate, in turn, 284 | PART IV Business Cycle Theory: The Economy in the Short Run figure 11-3 Interest rate, r Y Income, output, Y 1 Y2 r 2 r 1 IS B A LM1 LM2 3. . . . and lowers the interest rate. 2. . . . which raises income . . . 1. An increase in the money supply shifts the LM curve downward, ... An Increase in the Money Supply in the IS–LM Model An increase in the money supply shifts the LM curve downward. The equilibrium moves from point A to point B. Income rises from Y1 to Y2, and the interest rate falls from r1 to r2
Worth: Mankiw Economics 5e CHAPTER 11 Aggregate Demand Il 285 has ramifications for the goods market. A lower interest rate stimulates planned investment, which increases planned expenditure, production, and income y Thus, the IS-LM model shows that monetary policy influences income by changing the interest rate. This conclusion sheds light on our analysis of mone- tary policy in Chapter 9. In that chapter we showed that in the short run, when prices are sticky, an expansion in the money supply raises income. But we did not discuss how a monetary expansion induces greater spending on goods and ser vices--a process called the monetary transmission mechanism. The IS-LM model shows that an increase in the money supply lowers the interest rate, which stimulates investment and thereby expands the demand for goods and services The Interaction Between Monetary and Fiscal Policy When analyzing any change in monetary or fiscal policy, it is important to keep in mind that the policymakers who control these policy tools are aware of what the policymakers are doing. A change in one policy, therefore, may infu- ence the other, and this interdependence may alter the impact of a policy change For example, suppose Congress were to raise taxes. What effect should this pol ve on the economy? According to the IS-LM model, the answer on how the Fed responds to the tax increase Figure 11-4 shows three of the many possible outcomes In panel (a), the Fed holds the money supply constant. The tax increase shifts the Is curve to the left Income falls(because higher taxes reduce consumer spending), and the interest rate falls(because lower income reduces the demand for money). The fall inin- come indicates that the tax hike causes a recession In panel(b), the Fed wants to hold the interest rate constant. In this case, when he tax increase shifts the IS curve to the left, the Fed must decrease the money supply to keep the interest rate at its original level. This fall in the money supply shifts the LM curve upward. The interest rate does not fall, but income falls by a larger amount than if the Fed had held the money supply constant. Whereas in panel(a)the lower interest rate stimulated investment and partially offset the contractionary effect of the tax hike, in panel(b) the Fed deepens the recession by keeping the interest rate high In panel(c), the Fed wants to prevent the tax increase from lowering income It must, therefore, raise the money supply and shift the LM curve downward enough to offset the shift in the Is curve. In this case. the tax increase does not cause a recession, but it does cause a large fall in the interest rate. Although the level of income is not changed, the combination of a tax increase and a monetary expansion does change the allocation of the economy's resources. The higher Income is not affected because these two effects exactly balane ates investment From this example we can see that the impact of a change in fiscal policy de- pends on the policy the Fed pursues--that is, on whether it holds the money sup- ply, the interest rate, or the level of income constant. More generally, whenever alyzing a change in one policy, we must make an assumption about its effect on the other policy. The most appropriate assumption depends on the case at hand and the many political considerations that lie behind economic policymaking User JoENA: Job EFFo1427:6264_chl1: Pg 285: 27332#/eps at 100s wed,Feb13,200210:264
User JOEWA:Job EFF01427:6264_ch11:Pg 285:27332#/eps at 100% *27332* Wed, Feb 13, 2002 10:26 AM has ramifications for the goods market.A lower interest rate stimulates planned investment, which increases planned expenditure, production, and income Y. Thus, the IS–LM model shows that monetary policy influences income by changing the interest rate.This conclusion sheds light on our analysis of monetary policy in Chapter 9. In that chapter we showed that in the short run, when prices are sticky, an expansion in the money supply raises income. But we did not discuss how a monetary expansion induces greater spending on goods and services—a process called the monetary transmission mechanism.The IS–LM model shows that an increase in the money supply lowers the interest rate, which stimulates investment and thereby expands the demand for goods and services. The Interaction Between Monetary and Fiscal Policy When analyzing any change in monetary or fiscal policy, it is important to keep in mind that the policymakers who control these policy tools are aware of what the other policymakers are doing. A change in one policy, therefore, may influence the other, and this interdependence may alter the impact of a policy change. For example, suppose Congress were to raise taxes.What effect should this policy have on the economy? According to the IS–LM model, the answer depends on how the Fed responds to the tax increase. Figure 11-4 shows three of the many possible outcomes. In panel (a), the Fed holds the money supply constant. The tax increase shifts the IS curve to the left. Income falls (because higher taxes reduce consumer spending), and the interest rate falls (because lower income reduces the demand for money). The fall in income indicates that the tax hike causes a recession. In panel (b), the Fed wants to hold the interest rate constant. In this case, when the tax increase shifts the IS curve to the left, the Fed must decrease the money supply to keep the interest rate at its original level.This fall in the money supply shifts the LM curve upward.The interest rate does not fall, but income falls by a larger amount than if the Fed had held the money supply constant.Whereas in panel (a) the lower interest rate stimulated investment and partially offset the contractionary effect of the tax hike, in panel (b) the Fed deepens the recession by keeping the interest rate high. In panel (c), the Fed wants to prevent the tax increase from lowering income. It must, therefore, raise the money supply and shift the LM curve downward enough to offset the shift in the IS curve. In this case, the tax increase does not cause a recession, but it does cause a large fall in the interest rate. Although the level of income is not changed, the combination of a tax increase and a monetary expansion does change the allocation of the economy’s resources. The higher taxes depress consumption, while the lower interest rate stimulates investment. Income is not affected because these two effects exactly balance. From this example we can see that the impact of a change in fiscal policy depends on the policy the Fed pursues—that is, on whether it holds the money supply, the interest rate, or the level of income constant. More generally, whenever analyzing a change in one policy, we must make an assumption about its effect on the other policy.The most appropriate assumption depends on the case at hand and the many political considerations that lie behind economic policymaking. CHAPTER 11 Aggregate Demand II | 285