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Transcript of Chap10.Ad.gm
8/12/2019 Chap10.Ad.gm
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macroeconomics fifth edition
N. Gregory Mankiw
PowerPoint® Slides
by Ron Cronovich
CHAPTER TEN
Aggregate Demand I
m a c r o
© 2003 Worth Publishers, all rights reserved
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m
CHAPTER 10 Aggregate Demand I slide 2
Context
Chapter 9 introduced the model of aggregatedemand 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
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CHAPTER 10 Aggregate Demand I slide 3
Context
This chapter develops the IS-LM model,the theory that yields the aggregate demandcurve.
We focus on the short run and assume the
price level is fixed.
This chapter (and chapter 11) focus on theclosed-economy case. Chapter 12 presents
the open-economy case.
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CHAPTER 10 Aggregate Demand I slide 4
The Keynesian Cross
A simple closed economy model in whichincome 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 & plannedexpenditure: unplanned inventory investment
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CHAPTER 10 Aggregate Demand I slide 5
Elements of the Keynesian Cross
( )C C Y T
I I
,G G T T
( )E C Y T I G
Actual expenditure Planned expenditure
Y E
consumption function:
for now, plannedinvestment is exogenous:
planned expenditure:
Equilibrium condition:
govt policy variables:
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CHAPTER 10 Aggregate Demand I slide 6
Graphing planned expenditure
income, output, Y
E planned
expenditure
E =C +I +G
MPC1
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CHAPTER 10 Aggregate Demand I slide 7
Graphing the equilibrium condition
income, output, Y
E planned
expenditureE =Y
45º
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CHAPTER 10 Aggregate Demand I slide 8
The equilibrium value of income
income, output, Y
E planned
expenditureE =Y
E =C +I +G
Equilibrium
income
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CHAPTER 10 Aggregate Demand I slide 9
An increase in government purchases
Y
E
E =C +I +G 1
E 1 = Y 1
E =C +I +G 2
E 2 = Y 2Y
At Y 1,
there is now an
unplanned drop
in inventory…
…so firms
increase output,
and income
rises toward a
new equilibrium
G
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CHAPTER 10 Aggregate Demand I slide 10
Solving for Y
Y C I G Y C I G
MPC Y G
C G
(1 MPC) Y G
1
1 MPCY G
equilibrium conditionin changes
because I exogenous
because C = MPC Y
Collect terms with Y on the left side of theequals sign:
Finally, solve for Y :
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CHAPTER 10 Aggregate Demand I slide 13
An increase in taxes
Y
E
E =C 2 +I +G
E 2 = Y 2
E =C 1 +I +G
E 1 = Y 1Y
At Y 1, there is now
an unplanned
inventory buildup… …so firms
reduce output,and income falls
toward a new
equilibrium
C = MPC T
Initially, the tax
increase reduces
consumption, and
therefore E :
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CHAPTER 10 Aggregate Demand I slide 14
Solving for Y
Y C I G
MPC Y T
C
(1 MPC) MPCY T
eq’m condition inchanges
I and G exogenous
Solving for Y :
MPC
1 MPCY T
Final result:
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CHAPTER 10 Aggregate Demand I slide 15
The Tax Multiplier
def: the change in income resulting froma $1 increase in T :
MPC
1 MPC
Y
T
0 8 0 8 41 0 8 0 2
. .. .
Y T
If MPC = 0.8, then the tax multiplier equals
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CHAPTER 10 Aggregate Demand I slide 16
The Tax Multiplier
…is negative : A tax hike reducesconsumer spending,which reduces income.
…is greater than one (in absolute value ): A change in taxes has amultiplier 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 issmaller than from an equal increase in G .
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CHAPTER 10 Aggregate Demand I slide 17
Exercise:
Use a graph of the Keynesian Crossto show the impact of an increase in
planned investment on the equilibrium
level of income/output.
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CHAPTER 10 Aggregate Demand I slide 18
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
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CHAPTER 10 Aggregate Demand I slide 19
Y 2Y 1
Y 2Y 1
Deriving the IS curve
r I
Y
E
r
Y
E =C +I (r 1 )+G E =C +I (r 2 )+G
r 1
r 2
E =Y
IS
I E
Y
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CHAPTER 10 Aggregate Demand I slide 20
Why the IS curve is negatively sloped
A fall in the interest rate motivates firms toincrease 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.
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CHAPTER 10 Aggregate Demand I slide 21
The IS curve and the Loanable Funds model
S , I
r
I (r )
r 1
r 2
r
Y Y 1
r 1
r 2
(a) The L.F. model (b) The IS curve
Y 2
S 1S 2
IS
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CHAPTER 10 Aggregate Demand I slide 22
Fiscal Policy and the IS curve
We can use the IS-LM model to seehow fiscal policy (G and T ) can affectaggregate demand and output.
Let’s start by using the Keynesian Crossto see how fiscal policy shifts the IS curve…
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CHAPTER 10 Aggregate Demand I slide 23
Y 2Y 1
Y 2Y 1
Shifting the IS curve: G
At any value of r ,G E Y
Y
E
r
Y
E =C +I (r 1 )+G 1 E =C +I (r 1 )+G 2
r 1
E =Y
IS 1
The horizontal
distance of the
IS shift equals
IS 2
…so the IS curve
shifts to the right.
1
1 MPCY G
Y
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CHAPTER 10 Aggregate Demand I slide 24
Exercise: Shif t ing the IS curve
Use the diagram of the Keynesian Crossor Loanable Funds model to show how
an increase in taxes shifts the IS curve.
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CHAPTER 10 Aggregate Demand I slide 25
The Theory of Liquidity Preference
due to John Maynard Keynes.
A simple theory in which the interest rateis determined by money supply and
money demand.
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CHAPTER 10 Aggregate Demand I slide 26
Money Supply
The supply ofreal money
balances
is fixed:
s
M P M P
M/P real money
balances
r interest
rate
s M P
M P
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CHAPTER 10 Aggregate Demand I slide 27
Money Demand
Demand forreal money
balances:
M/P real money
balances
r interest
rate
s M P
M P
( )d
M P L r
L (r )
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CHAPTER 10 Aggregate Demand I slide 28
Equilibrium
The interestrate adjusts
to equate the
supply and
demand formoney:
M/P real money
balances
r interest
rate
s M P
M P
( )M P L r L (r )
r 1
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CHAPTER 10 Aggregate Demand I slide 29
How the Fed raises the interest rate
To increase r ,
Fed reduces M
M/P real money
balances
r interest
rate
1M
P
L (r )
r 1
r 2
2M
P
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CHAPTER 10 Aggregate Demand I slide 30
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 changewould affect interest rates?
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CHAPTER 10 Aggregate Demand I slide 31
Volcker’s Monetary Tightening, cont.
i < 0i > 0
1/1983: i = 8.2%8/1979: i = 10.4%
4/1980: i = 15.8%
flexiblesticky
Quantity Theory,
Fisher Effect(Classical)
Liquidity Preference
(Keynesian)
prediction
actualoutcome
The effects of a monetary tightening
on nominal interest rates
prices
model
long runshort run
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CHAPTER 10 Aggregate Demand I slide 32
The LM curve
Now let’s put Y back into the money demandfunction:
( , )M P 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:
d
M P L r Y ( , )
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CHAPTER 10 Aggregate Demand I slide 33
Deriving the LM curve
M/P
r
1M
P
L (r , Y 1 )
r 1
r 2
r
Y Y 1
r 1
L (r , Y 2 )
r 2
Y 2
LM
(a) The market forreal money balances(b) The LM curve
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CHAPTER 10 Aggregate Demand I slide 35
How M shifts the LM curve
M/P
r
1M
P
L
(r
,
Y 1
)
r 1
r 2
r
Y Y 1
r 1
r 2 LM 1
(a) The market forreal money balances(b) The LM curve
2M
P
LM 2
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CHAPTER 10 Aggregate Demand I slide 36
Exercise: Shif t ing the LM cu rve
Suppose a wave of credit card fraudcauses consumers to use cash more
frequently in transactions.
Use the Liquidity Preference modelto show how these events shift the
LM curve.
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CHAPTER 10 Aggregate Demand I slide 37
The short-run equilibrium
The short-run equilibrium isthe combination of r and Y
that simultaneously satisfies
the equilibrium conditions in
the goods & money markets:
( ) ( )Y C Y T I r G
Y
r
( , )M P L r Y
IS
LM
Equilibrium
interest
rate
Equilibrium
level of
income
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CHAPTER 10 Aggregate Demand I slide 38
The B ig Pictu re
KeynesianCross
Theory of
Liquidity
Preference
IS curve
LM
curve
IS-LM
model
Agg.
demand
curve
Agg.
supply
curve
Model of
Agg.
Demandand Agg.
Supply
Explanation
of short-run
fluctuations
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CHAPTER 10 Aggregate Demand I slide 39
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
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CHAPTER 10 Aggregate Demand I slide 41
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.
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CHAPTER 10 Aggregate Demand I slide 42
Prev iew 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 togetherto analyze the short-run and long-run
effects of shocks use our models to learn about
the Great Depression
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