Chap10 (Agg Demand I)

CHAPTER TEN
macro Aggregate Demand I
macroeconomics
fifth edition
N. Gregory Mankiw
PowerPoint® Slides
by Ron Cronovich
© 2004 Worth Publishers, all rights reserved

The Big Picture
Keynesian IS
Cross curve
IS-LM
model Explanation
Theory of LM of short-run
Liquidity curve fluctuations
Preference
Agg.
demand
curve Model of
Agg.
Demand
Agg.
and Agg.
supply
Supply
curve
CHAPTER 10 Aggregate Demand I slide 2

Context
 Chapter 9 introduced the model of aggregate
demand and aggregate supply.
 Long run
– prices flexible
– output determined by factors of production &
technology
– unemployment equals its natural rate
 Short run
– prices fixed
– output determined by aggregate demand
– unemployment is negatively related to output

Context
 This chapter develops the IS-LM model,
the theory that yields the aggregate demand
curve.
 We focus on the short run and assume the
price level is fixed.
 This chapter (and chapter 11) focus on the
closed-economy case. Chapter 12 presents
the open-economy case.

The Keynesian Cross
 A simple closed economy model in which
income is determined by expenditure.
(due to J.M. Keynes)
 Notation:
I = planned investment
E = C + I + G = planned expenditure
Y = real GDP = actual expenditure
 Difference between actual & planned
expenditure: unplanned inventory investment

Elements of the Keynesian Cross
consumption function: C  C (Y  T )
govt policy variables: G  G , T T
for now, planned
investment is exogenous: I I
planned expenditure: E  C (Y  T )  I  G
Equilibrium condition:
Actual expenditure  Planned expenditure
Y  E
Graphing planned expenditure
planned E =C +I +G
expenditure
MPC
1
income, output, Y

Graphing the equilibrium condition
E E =Y
planned
expenditure
45º
income, output, Y

The equilibrium value of income
E E =Y
planned E =C +I +G
expenditure
income, output, Y
Equilibrium
income
An increase in government purchases
E Y
=
At Y1, E E = C + I + G2
there is now an
unplanned drop E = C + I + G1
in inventory…
G
…so firms
increase output,
and income Y
rises toward a
new equilibrium E1 = Y 1 Y E2 = Y 2

Solving for Y
Y  C  I  G equilibrium condition
Y  C  I  G in changes
 C  G because I exogenous
 MPC  Y  G because C = MPC Y
Collect terms with Y Finally, solve for Y :

on the left side of the
equals sign:  1 
Y     G
(1  MPC)  Y  G  1  MPC 

The government purchases multiplier
Definition: the increase in income resulting
from a $1 increase in G.
In this model, the govt purchases
multiplier equals Y 1

G 1  MPC
Example: If MPC = 0.8, then
Y 1 An increase in G
  5 causes income to
G 1  0.8
increase by 5 times
as much!
Why the multiplier is greater than 1
 Initially, the increase in G causes an equal
increase in Y:  Y =  G.
 But Y  C
 further Y
 further C
 further Y
 So the final impact on income is much
bigger than the initial G.

An increase in taxes
E Y
=
Initially, the tax E E = C1 + I + G
increase reduces
consumption, and E = C2 + I + G
therefore E:
C = MPC T At Y1, there is now

an unplanned
…so firms inventory buildup…
reduce output,
and income falls Y
toward a new E2 = Y 2 Y E1 = Y 1
equilibrium

Solving for Y
eq’m condition in
Y  C  I  G
changes
 C I and G exogenous
 MPC   Y  T 
Solving for Y : (1  MPC)  Y   MPC  T
Final result:
  MPC 
Y     T
 1  MPC 

The Tax Multiplier
def: the change in income resulting from
a $1 increase in T :
Y  MPC

T 1  MPC
If MPC = 0.8, then the tax multiplier equals

Y  0.8  0.8
   4
T 1  0.8 0.2

The Tax Multiplier
…is negative:
A tax hike reduces
consumer spending,
which reduces income.
…is greater than one
(in absolute value):
A change in taxes has a
multiplier effect on income.
…is smaller than the govt spending multiplier:
Consumers save the fraction (1-MPC) of a tax cut,
so the initial boost in spending from a tax cut is
smaller than from an equal increase in G.
Exercise:
 Use a graph of the Keynesian Cross
to show the impact of an increase in
planned investment on the equilibrium
level of income/output.

The IS curve
def: a graph of all combinations of r and Y
that result in goods market equilibrium,
i.e. actual expenditure (output)
= planned expenditure
The equation for the IS curve is:

Y  C (Y  T )  I (r )  G

Deriving the IS curve
E E =Y E =C +I (r )+G
2
r  I E =C +I (r1 )+G
 E I
 Y Y1 Y2 Y
r
r1
r2
IS
Y1 Y2 Y

Why the IS curve is negatively sloped
 A fall in the interest rate motivates firms to
increase investment spending, which drives
up total planned spending (E ).
 To restore equilibrium in the goods market,
output (a.k.a. actual expenditure, Y ) must
increase.

The IS curve and the Loanable Funds model
(a) The L.F. model (b) The IS curve
r S2 S1 r
r2 r2
r1 r1
I (r )
IS
S, I Y2 Y1 Y

Fiscal Policy and the IS curve
 We can use the IS-LM model to see
how fiscal policy (G and T ) can affect
aggregate demand and output.
 Let’s start by using the Keynesian Cross
to see how fiscal policy shifts the IS
curve…

Shifting the IS curve: G
E E =Y E =C +I (r )+G
At any value of r, 1 2
G  E  Y E =C +I (r1 )+G1
…so the IS curve
shifts to the right.
Y1 Y2 Y
The horizontal r
distance of the r1
IS shift equals
1 Y
Y  G IS2
1  MPC IS1
Y1 Y2 Y

Exercise: Shifting the IS curve
 Use the diagram of the Keynesian Cross
or Loanable Funds model to show how
an increase in taxes shifts the IS curve.

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 r
M P
s
interest
real money
rate
balances
is fixed:
M P M P
s
M/P
M P
real money
balances

Money Demand
Demand for r
M P
s
interest
real money
rate
balances:
M P
d
 L (r )
L (r )
M/P
M P
real money
balances

Equilibrium
The interest r
M P
s
rate adjusts interest
rate
to equate the
supply and
demand for
money:
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,
r2
Fed reduces M
r1
L (r )
M/P
M2 M1
real money
P P 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
How do
do you
you think
think this
this policy
policy change
change
would
would affect
affect interest
interest rates?
rates?
Volcker’s Monetary Tightening, cont.
The effects of a monetary tightening
on nominal interest rates
short run long run
Quantity Theory,
Liquidity Preference
model Fisher Effect
(Keynesian)
(Classical)
prices sticky flexible
prediction i > 0 i < 0
actual 8/1979: i = 10.4%

1/1983: i = 8.2%
outcome 4/1980: i = 15.8%
The LM curve
Now let’s put Y back into the money demand
function:
M P
d
 L (r ,Y )
The LM curve is a graph of all combinations of

r and Y that equate the supply and demand
for real money balances.
The equation for the LM curve is:
M P  L (r ,Y )

Deriving the LM curve
(a) The market for
(b) The LM curve
real money balances
r r
LM
r2 r2
L (r , Y2 )
r1 r1
L (r , Y1 )
M1 M/P Y1 Y2 Y
P

Why the LM curve is upward-sloping
 An increase in income raises money
demand.
 Since the supply of real balances is fixed,
there is now excess demand in the money
market at the initial interest rate.
 The interest rate must rise to restore
equilibrium in the money market.

How M shifts the LM curve
(a) The market for
(b) The LM curve
real money balances
r r LM2
LM1
r2 r2
r1 r1
L (r , Y1 )
M2 M1 M/P Y1 Y
P P

Exercise: Shifting the LM curve
 Suppose a wave of credit card fraud
causes consumers to use cash more
frequently in transactions.
 Use the Liquidity Preference model
to show how these events shift the
LM curve.

The short-run equilibrium
The short-run equilibrium is r
the combination of r and Y LM
that simultaneously satisfies
the equilibrium conditions in
the goods & money markets:
Y  C (Y  T )  I (r )  G IS
M P  L (r ,Y ) Y
Equilibrium
interest Equilibrium
rate level of
income

The Big Picture
Keynesian IS
Cross curve
IS-LM
model Explanation
Theory of LM of short-run
Liquidity curve fluctuations
Preference
Agg.
demand
curve Model of
Agg.
Demand
Agg.
and Agg.
supply
Supply
curve

Chapter summary
1. Keynesian Cross
 basic model of income determination
 takes fiscal policy & investment as exogenous
 fiscal policy has a multiplier effect on income.
2. 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

Chapter summary
3. 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
4. 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

Chapter summary
5. 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.

Preview of Chapter 11
In Chapter 11, we will
 use the IS-LM model to analyze the impact
of policies and shocks
 learn how the aggregate demand curve
comes from IS-LM
 use the IS-LM and AD-AS models together
to analyze the short-run and long-run
effects of shocks
 use our models to learn about
the Great Depression

CHAPTER TEN
macroeconomics
fifth edition
N. Gregory Mankiw
PowerPoint® Slides
by Ron Cronovich

Context
 Chapter 9 introduced the model of aggregate
demand and supply.
 Chapter 10 developed the IS-LM model, the
basis of the aggregate demand curve.
 In Chapter 11, we will use the IS-LM model to
– see how policies and shocks affect income
and the interest rate in the short run when
prices are fixed
– derive the aggregate demand curve
– explore various explanations for the
Great Depression
Equilibrium in the IS-LM Model
The IS curve represents r
equilibrium in the goods LM
market.
Y  C (Y  T )  I (r )  G
The LM curve represents r1

money market equilibrium.
M P  L (r ,Y ) IS
Y
Y1
The intersection determines
the unique combination of Y and r
that satisfies equilibrium in both markets.
Policy analysis with the IS-LM Model
Y  C (Y  T )  I (r )  G r
M P  L (r ,Y ) LM
Policymakers can affect

macroeconomic variables r1
with
• fiscal policy: G and/or T
• monetary policy: M IS
Y
We can use the IS-LM Y1
model to analyze the
effects of these policies.

An increase in government purchases
1. IS curve shifts right r
1 LM
by G
1  MPC
causing output & r2
income to rise. 2.
r1
2. This raises money
demand, causing the
1. IS2
interest rate to rise… IS1
Y
3. …which reduces investment, Y1 Y2
so the final increase in Y 3.
1
is smaller than G
1  MPC
A tax cut
Because consumers save r
(1MPC) of the tax cut, LM
the initial boost in
spending is smaller for T
than for an equal G… r2
2.
and the IS curve r1
shifts by 1. IS2
MPC
1. T IS1
1  MPC
Y
Y1 Y2
2. …so the effects on r and Y 2.
are smaller for a T than
for an equal G.
Monetary Policy: an increase in M
r
1. M > 0 shifts LM1
the LM curve down
(or to the right) LM2
2. …causing the r1
interest rate to fall r2
3. …which increases IS
investment, causing Y
Y1 Y2
output & income to
rise.

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 G > 0
 Suppose Congress increases G.
 Possible Fed responses:
1. hold M constant
2. hold r constant
3. hold Y constant
 In each case, the effects of the G
are different:

Response 1: hold M constant
If Congress raises G, r
the IS curve shifts LM1
right
If Fed holds M r2
constant, then LM r1
curve doesn’t shift. IS2
Results: IS1
Y
Y  Y 2  Y1 Y1 Y2
r  r2  r1

Response 2: hold r constant
If Congress raises G, r
right LM2
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
r  0

Response 3: hold Y constant
If Congress raises G, r LM2
right
r3
To keep Y constant, r2
Fed reduces M to r1
shift LM curve left. IS2
Results: IS1
Y  0 Y
Y1 Y2
r  r3  r1

Estimates of fiscal policy multipliers
from the DRI macroeconometric model
Estimated Estimated
Assumption about value of value of
monetary policy Y / G Y / T
Fed holds money

0.60 0.26
supply constant
Fed holds nominal
1.93 1.19
interest rate constant

Shocks in the IS-LM Model
IS shocks: exogenous changes in the
demand for goods & services.
Examples:
• stock market boom or crash
 change in households’ wealth
 C
• change in business or consumer
confidence or expectations
 I and/or C

Shocks in the IS-LM Model
LM shocks: exogenous changes in the
demand for money.
Examples:
• a wave of credit card fraud increases
demand for money
• more ATMs or the Internet reduce money
demand

EXERCISE:
Analyze shocks with the IS-LM model
Use the IS-LM model to analyze the effects of
1. A boom in the stock market makes
consumers wealthier.
2. After a wave of credit card fraud, consumers
use cash more frequently in transactions.
For each shock,
a. use the IS-LM diagram to show the effects
of the shock on Y and r .
b. determine what happens to C, I, and the
unemployment rate.

CASE STUDY
The U.S. economic slowdown of 2001
~What happened~
1. Real GDP growth rate
1994-2000: 3.9% (average annual)
2001: 0.8% for the year,
March 2001 determined to be the end of
the longest expansion on record.
2. Unemployment rate
Dec 2000: 3.9%
Dec 2001: 5.8%
The number of unemployed people
rose by 2.1 million during 2001!
CASE STUDY
~Shocks that contributed to the slowdown~
1. Falling stock prices
From Aug 2000 to Aug 2001: -25%
Week after 9/11: -12%
2. The terrorist attacks on 9/11
• increased uncertainty
• fall in consumer & business confidence
Both shocks reduced spending and

shifted the IS curve left.

CASE STUDY
~The policy response~
1. Fiscal policy
• large long-term tax cut,
immediate $300 rebate checks
• spending increases:
aid to New York City & the airline industry,
war on terrorism
2. Monetary policy
• Fed lowered its Fed Funds rate target
11 times during 2001, from 6.5% to 1.75%
• Money growth increased, interest rates fell

CASE STUDY
~The recovery~
 The recession officially ended in November
2001.
 Real GDP recovered, growing
2.3% in 2002 and 4.4% in 2003.
 The unemployment rate lagged:
5.8% in 2002, 6.0% in 2003.
 The Fed cut interest rates in 11/02 and 6/03.
 Unemployment finally appears to be
responding: 5.6% for the first half of 2004.
What is the Fed’s policy instrument?
What the newspaper says:
“the Fed lowered interest rates by one-half point today”
What actually happened:
The Fed conducted expansionary monetary policy to
shift the LM curve to the right until the interest rate fell
0.5 points.
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.
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)

IS-LM and Aggregate Demand
 So far, we’ve been using the IS-LM model
to analyze the short run, when the price
level is assumed fixed.
 However, a change in P would shift the
LM curve and therefore affect Y.
 The aggregate demand curve
(introduced in chap. 9 ) captures this
relationship between P and Y

Deriving the AD curve
r LM(P2)
Intuition for slope LM(P1)
r2
of AD curve:
r1
P  (M/P ) IS
 LM shifts left Y2 Y1 Y
P
 r
P2
 I P1
 Y AD
Y2 Y1 Y

Monetary policy and the AD curve
r LM(M1/P1)
The Fed can increase
r1 LM(M2/P1)
aggregate demand:
r2
M  LM shifts right
IS
 r
Y1 Y2 Y
 I P
 Y at each P1
value of P
AD2
AD1
Y1 Y2 Y

Fiscal policy and the AD curve
r LM
Expansionary fiscal policy
(G and/or T ) r2
increases agg. demand: r1 IS2
T  C IS1
Y1 Y2 Y
 IS shifts right P
 Y at each
value P1
of P AD2
AD1
Y1 Y2 Y

IS-LM and AD-AS
in the short run & long run
Recall from Chapter 9: The force that moves
the economy from the short run to the long run
is the gradual adjustment of prices.
In the short-run then over time,

equilibrium, if the price level will
Y Y rise
Y Y fall
Y Y remain constant

The SR and LR effects of an IS shock
r LRAS LM(P )
1
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
r LRAS LM(P )
1
In the new short-run

equilibrium, Y  Y
IS1
IS2
Y Y
P LRAS
P1 SRAS1
AD1
AD2
Y Y
r LRAS LM(P )
1
In the new short-run

equilibrium, Y  Y
IS1
IS2
Over time, Y Y
P gradually falls, P LRAS
which causes
P1 SRAS1
• SRAS to move down
• M/P to increase,
which causes LM AD1
to move down AD2
Y Y
r LRAS LM(P )
1
LM(P2)
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
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
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
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

The Spending Hypothesis:
Shocks to the IS Curve
 asserts that the Depression was largely due
to an exogenous fall in the demand for
goods & services -- a leftward shift of the IS
curve
 evidence:
output and interest rates both fell, which is
what a leftward IS shift would cause

The Spending Hypothesis:
Reasons for the IS shift
1. Stock market crash  exogenous C
 Oct-Dec 1929: S&P 500 fell 17%
 Oct 1929-Dec 1933: S&P 500 fell 71%
2. Drop in investment
 “correction” after overbuilding in the 1920s
 widespread bank failures made it harder to
obtain financing for investment
3. Contractionary fiscal policy
 in the face of falling tax revenues and
increasing deficits, politicians raised tax rates
and cut spending
The Money Hypothesis:
A Shock to the LM Curve
 asserts that the Depression was largely due
to huge fall in the money supply
 evidence:
M1 fell 25% during 1929-33.
But, two problems with this hypothesis:
1. P fell even more, so M/P actually rose
slightly during 1929-31.
2. nominal interest rates fell, which is the
opposite of what would result from a
leftward LM shift.

The Money Hypothesis Again:
The Effects of Falling Prices
 asserts that the severity of the Depression
was due to a huge deflation:
P fell 25% during 1929-33.
 This deflation was probably caused by
the fall in M, so perhaps money played
an important role after all.
 In what ways does a deflation affect the
economy?

The stabilizing effects of deflation:
 P  (M/P )  LM shifts right  Y

 Pigou effect:
P  (M/P )
 consumers’ wealth 
 C
 IS shifts right
 Y

The destabilizing effects of unexpected deflation:
debt-deflation theory
P (if unexpected)
 transfers purchasing power from borrowers
to lenders
 borrowers spend less,
lenders spend more
 if borrowers’ propensity to spend is larger
than lenders, then aggregate spending falls,
the IS curve shifts left, and Y falls

The destabilizing effects of expected deflation:
e
 r  for each value of i
 I  because I = I (r )
 planned expenditure & agg. demand 
 income & output 

Why another Depression is unlikely
 Policymakers (or their advisors) now know
much more about macroeconomics:
 The Fed knows better than to let M fall
so much, especially during a contraction.
 Fiscal policymakers know better than to raise
taxes or cut spending during a contraction.
 Federal deposit insurance makes widespread
bank failures very unlikely.
 Automatic stabilizers make fiscal policy
expansionary during an economic downturn.

Chapter summary
1. IS-LM model
 a theory of aggregate demand
 exogenous: M, G, T,
P exogenous in short run, Y in long run
 endogenous: r,
Y endogenous in short run, P in long run
 IS curve: goods market equilibrium
 LM curve: money market equilibrium

Chapter summary
2. AD curve
 shows relation between P and the IS-LM
model’s equilibrium Y.
 negative slope because
P  (M/P )  r  I  Y
 expansionary fiscal policy shifts IS curve right,
raises income, and shifts AD curve right
 expansionary monetary policy shifts LM curve
right, raises income, and shifts AD curve right
 IS or LM shocks shift the AD curve

CHAPTER TWELVE
CHAPTER TEN
macro Aggregate
AggregateDemand
Demand I
in the Open Economy
macroeconomics
fifth edition
N. Gregory Mankiw
PowerPoint® Slides
by Ron Cronovich

Learning objectives
 The Mundell-Fleming model:
IS-LM for the small open economy
 Causes and effects of interest rate
differentials
 Arguments for fixed vs. floating
exchange rates
 The aggregate demand curve for the
small open economy

The Mundell-Fleming Model
 Key assumption:
Small open economy with perfect capital
mobility.
r = r*
 Goods market equilibrium---the IS* curve:
Y  C (Y  T )  I (r *)  G  NX (e )
where
e = nominal exchange rate
= foreign currency per unit of domestic
currency
The IS* curve: Goods Market Eq’m
Y  C (Y  T )  I (r *)  G  NX (e )
The IS* curve is drawn e

for a given value of r*.
Intuition for the slope:
 e   NX   Y
IS*
Y

The LM* curve: Money Market Eq’m
M P  L (r *,Y )
The LM* curve
 is drawn for a given e LM*
value of r*
 is vertical because:
given r*, there is
only one value of Y
that equates money
demand with supply, Y
regardless of e.

Equilibrium in the Mundell-Fleming model
Y  C (Y  T )  I (r *)  G  NX (e )
M P  L (r *,Y )
e LM*
equilibrium
exchange
rate
IS*
equilibrium Y
level of
income
Floating & fixed exchange rates
 In a system of floating exchange rates,

e is allowed to fluctuate in response to
changing economic conditions.
 In contrast, under fixed exchange rates,
the central bank trades domestic for foreign
currency at a predetermined price.
 We now consider fiscal, monetary, and
trade policy: first in a floating exchange
rate system, then in a fixed exchange rate
system.
Fiscal policy under floating exchange rates
Y  C (Y  T )  I (r *)  G  NX (e )
M P  L (r *,Y )
e LM 1*
At any given value of e,
a fiscal expansion e2
increases Y,
e1
shifting IS* to the right.
IS 2*
Results: IS 1*
e > 0, Y = 0 Y
Y1

Lessons about fiscal policy
 In a small open economy with perfect capital
mobility, fiscal policy cannot affect real GDP.
 “Crowding out”
• closed economy:
Fiscal policy crowds out investment by
causing the interest rate to rise.
• small open economy:
Fiscal policy crowds out net exports by
causing the exchange rate to appreciate.

Mon. policy under floating exchange rates
Y  C (Y  T )  I (r *)  G  NX (e )
M P  L (r *,Y )
e LM 1*LM 2*
An increase in M shifts
LM* right because Y
must rise to restore eq’m
e1
in the money market.
e2
Results: IS 1*
e < 0, Y > 0 Y
Y1 Y2

Lessons about monetary policy
 Monetary policy affects output by affecting
one (or more) of the components of aggregate
demand:
closed economy: M r  I  Y
small open economy: M e  NX  Y
 Expansionary mon. policy does not raise world

aggregate demand, it shifts demand from
foreign to domestic products.
Thus, the increases in income and employment
at home come at the expense of losses abroad.
Trade policy under floating exchange rates
Y  C (Y  T )  I (r *)  G  NX (e )
M P  L (r *,Y )
e LM 1*
At any given value of e,
a tariff or quota reduces e2
imports, increases NX,
and shifts IS* to the right. e1
IS 2*
Results: IS 1*
Y
e > 0, Y = 0 Y1

Lessons about trade policy
 Import restrictions cannot reduce a trade deficit.
 Even though NX is unchanged, there is less trade:
– the trade restriction reduces imports
– the exchange rate appreciation reduces exports
Less trade means fewer ‘gains from trade.’
 Import restrictions on specific products save jobs in
the domestic industries that produce those products,
but destroy jobs in export-producing sectors.
Hence, import restrictions fail to increase total
employment.
Worse yet, import restrictions create “sectoral
shifts,” which cause frictional unemployment.
Fixed exchange rates
 Under a system of fixed exchange rates, the
country’s central bank stands ready to buy or
sell the domestic currency for foreign currency
at a predetermined rate.
 In the context of the Mundell-Fleming model,
the central bank shifts the LM* curve as
required to keep e at its preannounced rate.
 This system fixes the nominal exchange rate.
In the long run, when prices are flexible,
the real exchange rate can move
even if the nominal rate is fixed.

Fiscal policy under fixed exchange rates
floating rates,
Under floating rates,
fiscal policy
a fiscal ineffective
expansion
at changing
would raise output.
e. e LM 1*LM 2*
To keep e from rising,
Under fixed rates,
the central
fiscal policybank must
is very
sell domestic
effective currency,
at changing
e1
output.increases M
which
and shifts LM* right. IS 2*
Results:
IS 1*
Y
e = 0, Y > 0 Y1 Y2

Mon. policy under fixed exchange rates
An increase
Under in Mrates,
floating would shift
LM* right and
monetary reduce
policy e.
is very
effective at the
changing e LM 1*LM 2*
To prevent fall in e,
output.
the central bank must
Under fixed rates,
buy domestic currency,
monetary
which reducespolicyMcannot
and e1
be used
shifts LM* to affect output.
back left.
Results: IS 1*
Y
e = 0, Y = 0 Y1

Trade policy under fixed exchange rates
Under floating
A restriction onrates,
imports puts
import
upwardrestrictions e. not
pressure ondo
affect Y or NX.
e LM 1*LM 2*
Under fixederates,
To keep from rising,
import restrictions
the central bank must
increase Y and NX.
sell domestic currency,
But, these gains come e1
which increases M at
theand
expense of other
shifts LM* right. IS 2*
countries, as the policy IS 1*
Results:
merely shifts demand from Y
foreigne to=domestic
0, Y goods.
>0 Y1 Y2

M-F: summary of policy effects
type of exchange rate regime:

floating fixed
impact on:
Policy Y e NX Y e NX
fiscal expansion 0    0 0
mon. expansion    0 0 0
import restriction 0  0  0 

Interest-rate differentials
Two reasons why r may differ from r*
 country risk:
The risk that the country’s borrowers will default
on their loan repayments because of political or
economic turmoil.
Lenders require a higher interest rate to
compensate them for this risk.
 expected exchange rate changes:
If a country’s exchange rate is expected to fall,
then its borrowers must pay a higher interest
rate to compensate lenders for the expected
currency depreciation.
Differentials in the M-F model
r  r * 
where  is a risk premium.
Substitute the expression for r into the
IS* and LM* equations:
Y  C (Y  T )  I (r *   )  G  NX (e )
M P  L (r *   ,Y )

The effects of an increase in 
IS* shifts left, because
 r  I
e LM 1*LM 2*
LM* shifts right, because
 r  (M/P )d, e1
so Y must rise to restore
money market eq’m.
e2 IS 1*
Results: IS 2*
e < 0, Y > 0 Y
Y1 Y2

The effects of an increase in 
 The fall in e is intuitive:
An increase in country risk or an expected
depreciation makes holding the country’s
currency less attractive.
Note: an expected depreciation is a
self-fulfilling prophecy.
 The increase in Y occurs because
the boost in NX
(from the depreciation)
is even greater than the fall in I
(from the rise in r ).
Why income might not rise
 The central bank may try to prevent the
depreciation by reducing the money supply
 The depreciation might boost the price of
imports enough to increase the price level
(which would reduce the real money supply)
 Consumers might respond to the increased
risk by holding more money.
Each of the above would shift LM* leftward.

CASE STUDY:
The Mexican Peso Crisis
35
U.S. Cents per Mexican Peso
30
25
20
15
10
7/10/94 8/29/94 10/18/94 12/7/94 1/26/95 3/17/95 5/6/95

CASE STUDY:
The Mexican Peso Crisis
35
U.S. Cents per Mexican Peso
30
25
20
15
10
7/10/94 8/29/94 10/18/94 12/7/94 1/26/95 3/17/95 5/6/95

The Peso Crisis didn’t just hurt Mexico
 U.S. goods more expensive to Mexicans

– U.S. firms lost revenue
– Hundreds of bankruptcies along
U.S.-Mex border
 Mexican assets worth less in dollars
– Affected retirement savings of
millions of U.S. citizens

Understanding the crisis
In the early 1990s, Mexico was an attractive
place for foreign investment.
During 1994, political developments caused
an increase in Mexico’s risk premium ( ):
• peasant uprising in Chiapas
• assassination of leading presidential
candidate
Another factor:
The Federal Reserve raised U.S. interest rates
several times during 1994 to prevent U.S.
inflation. (So, r* > 0)
Understanding the crisis
 These events put downward pressure on
the peso.
 Mexico’s central bank had repeatedly
promised foreign investors that it
would not allow the peso’s value to fall,
so it bought pesos and sold dollars to
“prop up” the peso exchange rate.
 Doing this requires that Mexico’s central
bank have adequate reserves of dollars.
Did it?
Dollar reserves of
Mexico’s central bank
December
December1993
1993………………
……………… $28
$28billion
billion
August
August17,
17, 1994
1994………………
……………… $17
$17billion
billion
December
December1,
1,1994
1994……………
…………… $$99billion
billion
December
December15,
15,1994
1994…………
………… $$77billion
billion
During 1994, Mexico’s central bank hid the

fact that its reserves were being depleted.

 the disaster 
 Dec. 20: Mexico devalues the peso by 13%
(fixes e at 25 cents instead of 29 cents)
 Investors are shocked ! ! !
…and realize the central bank must be running
out of reserves…
 , Investors dump their Mexican assets and
pull their capital out of Mexico.
 Dec. 22: central bank’s reserves nearly gone.
It abandons the fixed rate and lets e float.
 In a week, e falls another 30%.
The rescue package
 1995: U.S. & IMF set up $50b line of
credit to provide loan guarantees to
Mexico’s govt.
 This helped restore confidence in Mexico,
reduced the risk premium.
 After a hard recession in 1995, Mexico
began a strong recovery from the crisis.

Floating vs. Fixed Exchange Rates
Argument for floating rates:
 allows monetary policy to be used to
pursue other goals (stable growth, low
inflation)
Arguments for fixed rates:
 avoids uncertainty and volatility, making
international transactions easier
 disciplines monetary policy to prevent
excessive money growth & hyperinflation

Mundell-Fleming and the AD curve
 So far in M-F model, P has been fixed.
 Next: to derive the AD curve, consider the
impact of a change in P in the M-F model.
 We now write the M-F equations as:
(IS* ) Y  C (Y  T )  I (r *)  G  NX (ε )
(LM* ) M P  L (r *,Y )
(Earlier in this chapter, P was fixed, so we

could write NX as a function of e instead of .)

Deriving the AD curve
 LM*(P2) LM*(P1)
Why AD curve has
2
negative slope:
1
P  (M/P )
IS*
 LM shifts left Y2 Y1 Y
P
 
P2
 NX P1
 Y AD
Y2 Y1 Y

From the short run to the long run
If Y1  Y ,  LM*(P1) LM*(P2)
then there is
1
downward pressure
2
on prices.
IS*
Over time, P will
move down, causing Y1 Y Y
P LRAS
(M/P )
P1 SRAS1

P2 SRAS2
NX 
Y AD
Y1 Y Y

Large: between small and closed
 Many countries - including the U.S. - are neither
closed nor small open economies.
 A large open economy is in between the
polar cases of closed & small open.
 Consider a monetary expansion:
• Like in a closed economy,
M > 0  r  I (though not as much)
• Like in a small open economy,
M > 0    NX (though not as much)

Chapter summary
1. Mundell-Fleming model
 the IS-LM model for a small open economy.
 takes P as given
 can show how policies and shocks affect
income and the exchange rate
2. Fiscal policy
 affects income under fixed exchange rates,
but not under floating exchange rates.

Chapter summary
3. Monetary policy
 affects income under floating exchange
rates.
 Under fixed exchange rates, monetary policy
is not available to affect output.
4. Interest rate differentials
 exist if investors require a risk premium to
hold a country’s assets.
 An increase in this risk premium raises
domestic interest rates and causes the
country’s exchange rate to depreciate.
Chapter summary
5. Fixed vs. floating exchange rates
 Under floating rates, monetary policy is
available for can purposes other than
maintaining exchange rate stability.
 Fixed exchange rates reduce some of the
uncertainty in international transactions.

CHAPTER TEN
macroeconomics
fifth edition
N. Gregory Mankiw
PowerPoint® Slides
by Ron Cronovich

Chapter objectives
 difference between short run & long run
 introduction to aggregate demand
 aggregate supply in the short run & long
run
 see how model of aggregate supply and
demand can be used to analyze short-run
and long-run effects of “shocks”

Real GDP Growth in the U.S., 1960-2004
Percent change from previous
15
Average growth
quarter, at annual rate
rate = 3.4%
10
-5
-10
1960 1965 1970 1975 1980 1985 1990 1995 2000 2005

Time horizons
 Long run:
Prices are flexible, respond to changes in
supply or demand
 Short run:
many prices are “sticky” at some
predetermined level
The economy behaves much

differently when prices are sticky.

In Classical Macroeconomic Theory,
(what we studied in chapters 3-8)
 Output is determined by the supply side:
– supplies of capital, labor
– technology
 Changes in demand for goods & services
(C, I, G ) only affect prices, not quantities.
 Complete price flexibility is a crucial
assumption,
so classical theory applies in the long run.

When prices are sticky
…output and employment also depend on
demand for goods & services,
which is affected by
 fiscal policy (G and T )
 monetary policy (M )
 other factors, like exogenous changes
in C or I.

The model of
aggregate demand and supply
 the paradigm that most mainstream
economists & policymakers use to think
about economic fluctuations and policies
to stabilize the economy
 shows how the price level and aggregate
output are determined
 shows how the economy’s behavior is
different in the short run and long run

Aggregate demand
 The aggregate demand curve shows the
relationship between the price level and the
quantity of output demanded.
 For this chapter’s intro to the AD/AS model,
we use a simple theory of aggregate
demand based on the Quantity Theory of
Money.
 Chapters 10-12 develop the theory of
aggregate demand in more detail.

The Quantity Equation as Agg. Demand
 From Chapter 4, recall the quantity equation
MV = PY
 For given values of M and V, these

equations imply an inverse relationship
between P and Y:

The downward-sloping AD curve
An increase in the P
price level causes
a fall in real
money balances
(M/P ),
causing a
decrease in the
demand for goods
& services. AD
Y

Shifting the AD curve
An increase in
the money
supply shifts
the AD curve
to the right.
AD2
AD1
Y

Aggregate Supply in the Long Run
 Recall from chapter 3:
In the long run, output is determined by
factor supplies and technology
Y  F (K , L )
Y is the full-employment or natural level of
output, the level of output at which the
economy’s resources are fully employed.
“Full employment” means that
unemployment equals its natural rate.
Aggregate Supply in the Long Run
 Recall from chapter 3:
In the long run, output is determined by
factor supplies and technology
Y  F (K , L )
 Full-employment output does not depend on
the price level,
so the long run aggregate supply (LRAS)
curve is vertical:

The long-run aggregate supply curve
P LRAS
The LRAS curve

is vertical at the
full-employment
level of output.
Y
Y

Long-run effects of an increase in M
P LRAS
An increase
in M shifts
the AD curve
to the right.
In the long run, P2
this increases
the price level… P1 AD2
AD1
…but leaves Y
output the same.
Y

Aggregate Supply in the Short Run
 In the real world, many prices are sticky in
the short run.
 For now (and throughout Chapters 9-12),
we assume that all prices are stuck at a
predetermined level in the short run…
 …and that firms are willing to sell as much
at that price level as their customers are
willing to buy.
 Therefore, the short-run aggregate supply
(SRAS) curve is horizontal:
The short run aggregate supply curve
P
The SRAS curve
is horizontal:
The price level
is fixed at a
predetermined SRAS
P
level, and firms
sell as much as
buyers demand.
Y

Short-run effects of an increase in M
P
In the short run
when prices are …an increase
sticky,… in aggregate
demand…
SRAS
P
AD2
AD1
Y
…causes output Y1 Y2
to rise.
From the short run to the long run
Over time, prices gradually become “unstuck.”
When they do, will they rise or fall?
In the short-run then over time,
equilibrium, if the price level will
Y Y rise
Y Y fall
Y Y remain constant
This adjustment of prices is what moves
the economy to its long-run equilibrium.
The SR & LR effects of M > 0
A = initial P LRAS
equilibrium
B = new short-
run eq’m P2 C
after Fed
B SRAS
increases M P A AD2
AD1
C = long-run
equilibrium Y
Y Y2

How shocking!!!
 shocks: exogenous changes in aggregate
supply or demand
 Shocks temporarily push the economy away
from full-employment.
 An example of a demand shock:
exogenous decrease in velocity
 If the money supply is held constant, then a
decrease in V means people will be using their
money in fewer transactions, causing a
decrease in demand for goods and services:

The effects of a negative demand shock
The shock shifts P LRAS

AD left, causing
output and
employment to fall
in the short run
B A SRAS
P
Over time, prices
fall and the P2 C AD1
economy moves AD2
down its demand
curve toward full- Y
Y2 Y
employment.

Supply shocks
A supply shock alters production costs,
affects the prices that firms charge.
(also called price shocks)
Examples of adverse supply shocks:
 Bad weather reduces crop yields, pushing up
food prices.
 Workers unionize, negotiate wage increases.
 New environmental regulations require firms to
reduce emissions. Firms charge higher prices to
help cover the costs of compliance.
(Favorable supply shocks lower costs and prices.)
CASE STUDY:
The 1970s oil shocks
 Early 1970s: OPEC coordinates a reduction
in the supply of oil.
 Oil prices rose
11% in 1973
68% in 1974
16% in 1975
 Such sharp oil price increases are supply
shocks because they significantly impact
production costs and prices.

CASE STUDY:
The oil price shock P LRAS
shifts SRAS up,
causing output and
employment to fall.
B SRAS2
In absence of
P2
further price A SRAS1
P1
shocks, prices will
fall over time and AD
economy moves
back toward full Y
employment. Y2 Y

CASE STUDY:
70%
12%
60%
Predicted effects of
50% 10%
the oil price shock:
40%
• inflation 
8%
30%
• output 
20%
• unemployment  6%
10%
…and then a 0% 4%
gradual recovery. 1973 1974 1975 1976 1977
Change in oil prices (left scale)

Inflation rate-CPI (right scale)
Unemployment rate (right scale)

CASE STUDY:
60% 14%
50%
12%
Late 1970s: 40%
As economy 30%
10%
was recovering, 8%
oil prices shot up 20%
again, causing 10%

6%
another huge 0% 4%
supply shock!!! 1977 1978 1979 1980 1981
Change in oil prices (left scale)

Inflation rate-CPI (right scale)

CASE STUDY:
40% 10%
1980s: 30%
8%
A favorable 20%
10%
supply shock-- 0%
6%
a significant fall -10%

4%
in oil prices. -20%
As the model -30% 2%

-40%
would predict, -50% 0%
inflation and 1982 1983 1984 1985 1986 1987
unemployment Change in oil prices (left scale)

fell: Inflation rate-CPI (right scale)

Stabilization policy
 def: policy actions aimed at reducing the
severity of short-run economic fluctuations.
 Example: Using monetary policy to
combat the effects of adverse supply
shocks:

Stabilizing output with
monetary policy
The adverse P LRAS

supply shock
moves the
economy to
B SRAS2
point B. P2
P1 A SRAS1
AD1
Y
Y2 Y

Stabilizing output with
monetary policy
But the Fed P LRAS

accommodates
the shock by
raising agg.
demand. B C SRAS2
P2
A
results: P1 AD2
P is permanently AD1
higher, but Y
remains at its full- Y
employment level. Y2 Y

Chapter summary
1. Long run: prices are flexible, output and
employment are always at their natural
rates, and the classical theory applies.
Short run: prices are sticky, shocks can
push output and employment away from
their natural rates.
2. Aggregate demand and supply:

a framework to analyze economic
fluctuations

Chapter summary
3. The aggregate demand curve slopes
downward.
4. The long-run aggregate supply curve is

vertical, because output depends on
technology and factor supplies, but not
prices.
5. The short-run aggregate supply curve is

horizontal, because prices are sticky at
predetermined levels.

Chapter summary
6. Shocks to aggregate demand and supply
cause fluctuations in GDP and employment
in the short run.
7. The Fed can attempt to stabilize the
economy with monetary policy.


Chap10 (Agg Demand I)

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CHAPTER TEN

macro Aggregate Demand I

© 2004 Worth Publishers, all rights reserved

CHAPTER 10 Aggregate Demand I slide 2

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 MPC  Y  G because C = MPC Y

Collect terms with Y Finally, solve for Y :

CHAPTER 10 Aggregate Demand I slide 12

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C = MPC T At Y1, there is now

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If MPC = 0.8, then the tax multiplier equals

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The equation for the IS curve is:

CHAPTER 10 Aggregate Demand I slide 20

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(a) The L.F. model (b) The IS curve

CHAPTER 10 Aggregate Demand I slide 23

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prices sticky flexible

prediction i > 0 i < 0

actual 8/1979: i = 10.4%

The LM curve is a graph of all combinations of

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The LM curve represents r1

Policymakers can affect

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Fed holds money

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