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macroeconomics
fifth edition
N. Gregory Mankiw
PowerPoint® Slides
by Ron Cronovich
2. …causing the r1
interest rate to fall r2
3. …which increases IS
investment, causing Y
Y1 Y2
output & income to
rise.
To keep r constant, r2
Fed increases M to r1
shift LM curve right. IS2
Results: IS1
Y
Y Y 3 Y1 Y1 Y2 Y3
Estimated Estimated
Assumption about value of value of
monetary policy Y / G Y / T
r1 LM2
r2
IS
The
TheFed
Fedtargets
targetsthe
theFederal
FederalFunds
Fundsrate:
rate:
ititannounces
announcesaatarget
targetvalue,
value,
and
anduses
usesmonetary
monetarypolicy
policyto
toshift
shiftthe
theLM
LMcurve
curve
as
asneeded
neededto toattain
attainits
itstarget
targetrate.
rate.
CHAPTER 11 Aggregate Demand II slide 21
What is the Fed’s policy instrument?
Why does the Fed target interest rates
instead of the money supply?
1) They are easier to measure than the
money supply
2) The Fed might believe that LM shocks are
more prevalent than IS shocks. If so,
then targeting the interest rate stabilizes
income better than targeting the money
supply.
(See Problem 7 on p.306)
Y at each P1
value of P
AD2
AD1
Y1 Y2 Y
Y Y remain constant
IS1
A negative IS shock IS2
shifts IS and AD left, Y
causing Y to fall. Y
P LRAS
P1 SRAS1
AD1
AD2
Y Y
CHAPTER 11 Aggregate Demand II slide 28
The SR and LR effects of an IS shock
r LRAS LM(P )
1
AD1
AD2
Y Y
CHAPTER 11 Aggregate Demand II slide 29
The SR and LR effects of an IS shock
r LRAS LM(P )
1
IS1
IS2
Over time, Y Y
P gradually falls, P LRAS
which causes
P1 SRAS1
• SRAS to move down
• M/P to increase, P2 SRAS2
which causes LM AD1
to move down AD2
Y Y
CHAPTER 11 Aggregate Demand II slide 31
The SR and LR effects of an IS shock
r LRAS LM(P )
1
LM(P2)
This process continues
until economy reaches IS1
a long-run equilibrium IS2
with Y Y Y
Y
P LRAS
P1 SRAS1
P2 SRAS2
AD1
AD2
Y Y
CHAPTER 11 Aggregate Demand II slide 32
EXERCISE:
Analyze SR & LR effects of M
a. Draw the IS-LM and AD-AS r LRAS LM(M /P )
1 1
diagrams as shown here.
b. Suppose Fed increases M.
Show the short-run effects IS
on your graphs.
c. Show what happens in the Y
Y
transition from the short
P LRAS
run to the long run.
d. How do the new long-run
P1 SRAS1
equilibrium values of the
endogenous variables
compare to their initial AD1
values? Y Y
CHAPTER 11 Aggregate Demand II slide 33
The Great Depression
240 30
240 Unemployment 30
(right scale)
220 25
220 25
dollars
force
1958dollars
laborforce
200 20
200 20
percentofoflabor
billionsofof1958
180 15
180 15
percent
billions
160 10
160 10
Real GNP
140 5
140 (left scale) 5
120 0
120 0
1929 1931 1933 1935 1937 1939
1929 1931 1933 1935 1937 1939