Worth: Mankiw Economics 5e CHAPTER 11 Aggregate Demand Il 291 aw in Chapter 4, the Fed has several different measures of money--M1, M2, and so onwhich sometimes move in different directions. Rather than deciding which measure is best, the Fed avoids the question by using the federal funds rate as its policy instrument 77-2 IS-LM as a Theory of Aggregate Demand We have been using the IS-LM model to explain national income in the short run when the price level is fixed To see how the IS-LM model fits into the nodel of aggregate supply and aggregate demand introduced in Chapter 9, we now examine what happens in the IS-LM model if the price level is allowed to change. As was promised when we began our study of this model, the IS-LM model provides a theory to explain the position and slope of the aggregate de- mand curve From the IS-LM Model to the Aggregate Demand Curve Recall from Chapter 9 that the aggregate demand curve describes a relationship between the price level and the level of national income. In Chapter 9 this rela tionship was derived from the quantity theory of money. The analysis showed that for a given money supply, a higher price level implies a lower level of income. In- creases in the money supply shift the aggregate demand curve to the right, and decreases in the money supply shift the aggregate demand curve to the left. To understand the determinants of aggregate demand more fully, we now use the IS-LM model, rather than the quantity theory, to derive the aggregate de- mand curve. First, we use the IS-LM model to show why national income falls the price level rises--that is, why the aggregate demand curve is downward sloping. Second, we examine what causes the aggregate demand curve to shift To explain why the aggregate demand curve slopes downward, we examine what happens in the IS-LM model when the price level changes. This is done in Figure 11-5. For any given money supply M, a higher price level P reduces the supply of real money balances M/P. A lower supply of real money balances shifts the LM curve upward, which raises the equilibrium interest rate and lowers the equilibrium level of income, as shown in panel (a). Here the price level rises from P, to P2, and income falls from Yi to Y2 The aggregate demand curve in panel (b) plots this negative relationship between national income and the price level In other words, the aggregate demand curve shows the set of equilibrium points that arise in the IS-LM model as we vary the price level and see what happens to Income What causes the aggregate demand curve to shift? Because the aggregate demand curve is merely a summary of results from the IS-LM model, events that shift the IS curve or the LM curve(for a given price level) cause the ag- gregate demand curve to shift. For instance, an increase in the money supply raises income in the IS-LM model for any given price level; it thus shifts the User JoENA: Job EFFo1427:6264_chl1: Pg 291: 27338#/eps at 100s wed,Feb13,200210:27M
User JOEWA:Job EFF01427:6264_ch11:Pg 291:27338#/eps at 100% *27338* Wed, Feb 13, 2002 10:27 AM saw in Chapter 4, the Fed has several different measures of money—M1, M2, and so on—which sometimes move in different directions. Rather than deciding which measure is best, the Fed avoids the question by using the federal funds rate as its policy instrument. 11-2 IS–LM as a Theory of Aggregate Demand We have been using the IS–LM model to explain national income in the short run when the price level is fixed. To see how the IS–LM model fits into the model of aggregate supply and aggregate demand introduced in Chapter 9, we now examine what happens in the IS–LM model if the price level is allowed to change. As was promised when we began our study of this model, the IS–LM model provides a theory to explain the position and slope of the aggregate demand curve. From the IS–LM Model to the Aggregate Demand Curve Recall from Chapter 9 that the aggregate demand curve describes a relationship between the price level and the level of national income. In Chapter 9 this relationship was derived from the quantity theory of money.The analysis showed that for a given money supply, a higher price level implies a lower level of income. Increases in the money supply shift the aggregate demand curve to the right, and decreases in the money supply shift the aggregate demand curve to the left. To understand the determinants of aggregate demand more fully, we now use the IS–LM model, rather than the quantity theory, to derive the aggregate demand curve. First, we use the IS–LM model to show why national income falls as the price level rises—that is, why the aggregate demand curve is downward sloping. Second, we examine what causes the aggregate demand curve to shift. To explain why the aggregate demand curve slopes downward, we examine what happens in the IS–LM model when the price level changes.This is done in Figure 11-5. For any given money supply M, a higher price level P reduces the supply of real money balances M/P.A lower supply of real money balances shifts the LM curve upward, which raises the equilibrium interest rate and lowers the equilibrium level of income, as shown in panel (a). Here the price level rises from P1 to P2, and income falls from Y1 to Y2.The aggregate demand curve in panel (b) plots this negative relationship between national income and the price level. In other words, the aggregate demand curve shows the set of equilibrium points that arise in the IS–LM model as we vary the price level and see what happens to income. What causes the aggregate demand curve to shift? Because the aggregate demand curve is merely a summary of results from the IS–LM model, events that shift the IS curve or the LM curve (for a given price level) cause the aggregate demand curve to shift. For instance, an increase in the money supply raises income in the IS–LM model for any given price level; it thus shifts the CHAPTER 11 Aggregate Demand II | 291
Worth: Mankiw Economics 5e 292 PART IV Business Cycle Theory: The Economy in the Short Run (a)The IS-LM Model (b)The Aggregate Demand Curve Interest rate r 1.Ah rice level. P LM curve upward 3. The ad curve summarizes LM(P the relationship between P y income Y Income Deriving the Aggregate Demand Curve With the IS-LM Model Panel (a)shows the IS-LM model: an increase in the price level from P, to P2 lowers real money balances and thus shifts the LM curve upward. The shift in the LM curve lowers income from Y, to Y2 Panel (b)shows the aggregate demand curve summarizing this relationship between the price level and income: the higher the price level, the lower the level of Income aggregate demand curve to the right, as shown in panel (a)of Figure 11-6 Similarly, an in crease in government purchases or a decrease in taxes raises in come in the IS-LM model for a given price level; it also shifts the aggregate demand curve to the right, as shown in panel(b)of Figure 11-6. Conversely,a decrease in the money supply, a decrease in government purchases, or an in- crease in taxes lowers income in the IS-LM model and shifts the aggregate demand curve to the left We can summarize these results as follows: A change in income in the IS-LM model resulting from a change in the price level represents a movement along the aggregate demand curve. A change in income in the IS-LM model for a fixed price level represents a shift in the aggregate demand curve The IS-LM Model in the Short Run and Long Run The IS-LM model is designed to explain the economy in the short run when che price level is fixed. Yet, now that we have seen how a change in the price level influences the equilibrium in the IS-LM model, we can also use the model to escribe the economy in the long run when the price level adjusts to ensure that he economy produces at its natural rate By using the IS-LM model to describe the long run, we can show clearly how the Keynesian model of income determi nation differs from the classical model of Chapter 3 User JoENA: Job EFFo1427:6264_chl1: Pg 292: 27339#/eps at 100s wea,Feb13,200210:27AM
User JOEWA:Job EFF01427:6264_ch11:Pg 292:27339#/eps at 100% *27339* Wed, Feb 13, 2002 10:27 AM aggregate demand curve to the right, as shown in panel (a) of Figure 11-6. Similarly, an increase in government purchases or a decrease in taxes raises income in the IS-LM model for a given price level; it also shifts the aggregate demand curve to the right, as shown in panel (b) of Figure 11-6. Conversely, a decrease in the money supply, a decrease in government purchases, or an increase in taxes lowers income in the IS–LM model and shifts the aggregate demand curve to the left. We can summarize these results as follows: A change in income in the IS–LM model resulting from a change in the price level represents a movement along the aggregate demand curve.A change in income in the IS–LM model for a fixed price level represents a shift in the aggregate demand curve. The IS–LM Model in the Short Run and Long Run The IS–LM model is designed to explain the economy in the short run when the price level is fixed.Yet, now that we have seen how a change in the price level influences the equilibrium in the IS–LM model, we can also use the model to describe the economy in the long run when the price level adjusts to ensure that the economy produces at its natural rate. By using the IS–LM model to describe the long run, we can show clearly how the Keynesian model of income determination differs from the classical model of Chapter 3. 292 | PART IV Business Cycle Theory: The Economy in the Short Run figure 11-5 Interest rate, r Price level, P Income, output, Y Income, output, Y Y1 IS LM(P1) LM(P2) Y2 P2 P1 Y1 AD Y2 (a) The IS–LM Model (b) The Aggregate Demand Curve 2. . . . lowering income Y. 1. A higher price level P shifts the LM curve upward, . . . 3. The AD curve summarizes the relationship between P and Y. Deriving the Aggregate Demand Curve With the IS–LM Model Panel (a) shows the IS–LM model: an increase in the price level from P1 to P2 lowers real money balances and thus shifts the LM curve upward. The shift in the LM curve lowers income from Y1 to Y2. Panel (b) shows the aggregate demand curve summarizing this relationship between the price level and income: the higher the price level, the lower the level of income