宏观经济学（英文）：4-11Aggregate Demand II

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 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) 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 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 this traumatic economic downturn. | 281 11 Aggregate Demand II CHAPTER Science is a parasite: the greater the patient population the better the ad- vance 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 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 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 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 pur- chases of D G.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 D G/(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 Income, output, YY 1 Y 2 r 1 r 2 IS 1 B A IS 2 LM 2. . . . which raises income . . . 3. . . . and the interest rate. 1. The IS curve shifts to the right by H9004G/(1 H11002 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 Y 1 to Y 2 , and the interest rate rises from r 1 to r 2 . 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 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 D T.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 D T × 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 Income, output, YY 1 Y 2 r 1 r 2 IS 1 B A LM 2. . . . which raises income . . . IS 2 3. . . . and the interest rate. 1. The IS curve shifts to the right by H9004T H11003 MPC , ... 1 H11002 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 Y 1 to Y 2 , and the interest rate rises from r 1 to r 2 . 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 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 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 Income, output, YY 1 Y 2 r 2 r 1 IS B A LM 1 LM 2 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 Y 1 to Y 2 , and the interest rate falls from r 1 to r 2 . 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 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 other policymakers are doing. A change in one policy, therefore, may influ- 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- icy 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 in- 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 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 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 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 User JOEWA:Job EFF01427:6264_ch11:Pg 286:27333#/eps at 100%*27333* Wed, Feb 13, 2002 10:27 AM figure 11-4 Interest rate, r Interest rate, r Interest rate, r Income, output, Y Income, output, Y Income, output, Y LM 2 IS 1 IS 2 LM 1 2. . . . but because the Fed holds the money supply constant, the LM curve stays the same. 2. . . . and to hold the interest rate constant, the Fed contracts the money supply. LM IS 1 IS 2 1. A tax increase shifts the IS curve . . . 1. A tax increase shifts the IS curve . . . 2. . . . and to hold income constant, the Fed expands the money supply. 1. A tax increase shifts the IS curve . . . LM 1 IS 1 IS 2 LM 2 (a) Fed Holds Money Supply Constant (b) Fed Holds Interest Rate Constant (c) Fed Holds Income Constant The Response of the Economy to a Tax Increase How the economy responds to a tax increase depends on how the monetary authority responds. In panel (a) the Fed holds the money supply constant. In panel (b) the Fed holds the interest rate constant by reducing the money supply. In panel (c) the Fed holds the level of income constant by raising the money supply. User JOEWA:Job EFF01427:6264_ch11:Pg 287:27334#/eps at 100%*27334* Wed, Feb 13, 2002 10:27 AM CHAPTER 11 Aggregate Demand II | 287 CASE STUDY Policy Analysis With Macroeconometric Models The IS–LM model shows how monetary and fiscal policy influence the equilib- rium level of income.The predictions of the model, however, are qualitative, not quantitative. The IS–LM model shows that increases in government purchases raise GDP and that increases in taxes lower GDP. But when economists analyze specific policy proposals, they need to know not only the direction of the effect but also the size. For example, if Congress increases taxes by $100 billion and if monetary policy is not altered, how much will GDP fall? To answer this question, economists need to go beyond the graphical representation of the IS–LM model. Macroeconometric models of the economy provide one way to evaluate policy proposals. A macroeconometric model is a model that describes the economy quanti- tatively, rather than only qualitatively. Many of these models are essentially more complicated and more realistic versions of our IS–LM model. The economists who build macroeconometric models use historical data to estimate parameters such as the marginal propensity to consume, the sensitivity of investment to the interest rate, and the sensitivity of money demand to the interest rate. Once a model is built, economists can simulate the effects of alternative policies with the help of a computer. Table 11-1 shows the fiscal-policy multipliers implied by one widely used macroeconometric model, the Data Resources Incorporated (DRI) model, named for the economic forecasting firm that developed it.The multipliers are given for two assumptions about how the Fed might respond to changes in fiscal policy. One assumption about monetary policy is that the Fed keeps the nominal in- terest rate constant.That is, when fiscal policy shifts the IS curve to the right or to the left, the Fed adjusts the money supply to shift the LM curve in the same direction. Because there is no crowding out of investment due to a changing in- terest rate, the fiscal-policy multipliers are similar to those from the Keynesian cross.The DRI model indicates that, in this case, the government-purchases mul- tiplier is 1.93, and the tax multiplier is ?1.19.That is, a $100 billion increase in government purchases raises GDP by $193 billion, and a $100 billion increase in taxes lowers GDP by $119 billion. VALUE OF MULTIPLIERS Assumption About Monetary Policy D Y/ D G D Y/ D T Nominal interest rate held constant 1.93 ?1.19 Money supply held constant 0.60 ?0.26 Note: This table gives the fiscal-policy multipliers for a sustained change in government purchases or in personal income taxes. These multipliers are for the fourth quarter after the policy change is made. Source: Otto Eckstein, The DRI Model of the U.S. Economy (New York: McGraw-Hill, 1983), 169. The Fiscal-Policy Multipliers in the DRI Model table 11-1 User JOEWA:Job EFF01427:6264_ch11:Pg 288:27335#/eps at 100%*27335* Wed, Feb 13, 2002 10:27 AM Shocks in the IS–LM Model Because the IS–LM model shows how national income is determined in the short run, we can use the model to examine how various economic disturbances affect income. So far we have seen how changes in fiscal policy shift the IS curve and how changes in monetary policy shift the LM curve. Similarly, we can group other disturbances into two categories: shocks to the IS curve and shocks to the LM curve. Shocks to the IS curve are exogenous changes in the demand for goods and services. Some economists, including Keynes, have emphasized that such changes in demand can arise from investors’ animal spirits—exogenous and perhaps self- fulfilling waves of optimism and pessimism. For example, suppose that firms be- come pessimistic about the future of the economy and that this pessimism causes them to build fewer new factories.This reduction in the demand for investment goods causes a contractionary shift in the investment function: at every interest rate, firms want to invest less.The fall in investment reduces planned expenditure and shifts the IS curve to the left, reducing income and employment.This fall in equilibrium income in part validates the firms’ initial pessimism. Shocks to the IS curve may also arise from changes in the demand for consumer goods. Suppose, for instance, that the election of a popular president increases con- sumer confidence in the economy.This induces consumers to save less for the fu- ture and consume more today.We can interpret this change as an upward shift in the consumption function. This shift in the consumption function increases planned expenditure and shifts the IS curve to the right, and this raises income. 288 | PART IV Business Cycle Theory: The Economy in the Short Run The second assumption about monetary policy is that the Fed keeps the money supply constant so that the LM curve does not shift. In this case, the inter- est rate rises, and investment is crowded out, so the multipliers are much smaller. The government-purchases multiplier is only 0.60, and the tax multiplier is only ?0.26.That is, a $100 billion increase in government purchases raises GDP by $60 billion, and a $100 billion increase in taxes lowers GDP by $26 billion. Table 11-1 shows that the fiscal-policy multipliers are very different under the two assumptions about monetary policy.The impact of any change in fiscal pol- icy depends crucially on how the Fed responds to that change. Calvin and Hobbes ? 1992 W att er son. Dist. by Univer sal Pr ess Syndicat e. User JOEWA:Job EFF01427:6264_ch11:Pg 289:27336#/eps at 100%*27336* Wed, Feb 13, 2002 10:27 AM Shocks to the LM curve arise from exogenous changes in the demand for money. For example, suppose that new restrictions on credit-card availability increase the amount of money people choose to hold.According to the theory of liquidity preference, when money demand rises, the interest rate necessary to equilibrate the money market is higher (for any given level of income and money supply). Hence, an increase in money demand shifts the LM curve up- ward, which tends to raise the interest rate and depress income. In summary, several kinds of events can cause economic fluctuations by shift- ing the IS curve or the LM curve. Remember, however, that such fluctuations are not inevitable. Policymakers can try to use the tools of monetary and fiscal policy to offset exogenous shocks. If policymakers are sufficiently quick and skillful (ad- mittedly, a big if ), shocks to the IS or LM curves need not lead to fluctuations in income or employment. CHAPTER 11 Aggregate Demand II | 289 CASE STUDY The U.S. Slowdown of 2001 In 2001, the U.S. economy experienced a pronounced slowdown in economic activity.The unemployment rate rose from 3.9 percent in October 2000 to 4.9 percent in August 2001, and then to 5.8 percent in December 2001. In many ways, the slowdown looked like a typical recession driven by a fall in aggregate demand. Two notable shocks can help explain this event.The first was a decline in the stock market. During the 1990s, the stock market experienced a boom of his- toric proportions, as investors became optimistic about the prospects of the new information technology. Some economists viewed the optimism as excessive at the time, and in hindsight this proved to be the case.When the optimism faded, average stock prices fell by about 25 percent from August 2000 to August 2001. The fall in the market reduced household wealth and thus consumer spending. In addition, the declining perceptions of the profitability of the new technologies led to a fall in investment spending. In the language of the IS–LM model, the IS curve shifted to the left. The second shock was the terrorist attacks on New York and Washington on September 11, 2001. In the week after the attacks, the stock market fell another 12 percent, its biggest weekly loss since the Great Depression of the 1930s. Moreover, the attacks increased uncertainty about what the future would hold. Uncertainty can reduce spending because households and firms postpone some of their plans until the uncertainty is resolved.Thus, the terrorist attacks shifted the IS curve further to the left. Fiscal and monetary policymakers were quick to respond to these events. Congress passed a tax cut in 2001, including an immediate tax rebate. One goal of the tax cut was to stimulate consumer spending. After the terrorist attacks, Congress increased government spending by appropriating funds to rebuild New York and to bail out the ailing airline industry. Both of these fiscal measures shifted the IS curve to the right. User JOEWA:Job EFF01427:6264_ch11:Pg 290:27337#/eps at 100%*27337* Wed, Feb 13, 2002 10:27 AM What Is the Fed’s Policy Instrument—The Money Supply or the Interest Rate? Our analysis of monetary policy has been based on the assumption that the Fed influences the economy by controlling the money supply. By contrast, when the media report on changes in Fed policy, they often simply say that the Fed has raised or lowered interest rates. Which is right? Even though these two views may seem different, both are correct, and it is important to understand why. In recent years, the Fed has used the federal funds rate—the interest rate that banks charge one another for overnight loans—as its short-term policy instrument.When the Federal Open Market Committee meets every six weeks to set monetary policy, it votes on a target for this interest rate that will apply until the next meeting.After the meeting is over, the Fed’s bond traders in New York are told to conduct the open-market operations necessary to hit that target.These open-market operations change the money supply and shift the LM curve so that the equilibrium interest rate (determined by the intersection of the IS and LM curves) equals the target in- terest rate that the Federal Open Market Committee has chosen. As a result of this operating procedure, Fed policy is often discussed in terms of changing interest rates. Keep in mind, however, that behind these changes in interest rates are the necessary changes in the money supply.A newspaper might report, for instance, that “the Fed has lowered interest rates.” To be more precise, we can translate this statement as meaning “the Federal Open Market Commit- tee has instructed the Fed bond traders to buy bonds in open-market operations so as to increase the money supply, shift the LM curve, and reduce the equilib- rium interest rate to hit a new lower target.” Why has the Fed chosen to use an interest rate, rather than the money supply, as its short-term policy instrument? One possible answer is that shocks to the LM curve are more prevalent than shocks to the IS curve.When the Fed targets interest rates, it automatically offsets LM shocks by altering the money supply, but the policy exacerbates IS shocks. If LM shocks are the more prevalent type, then a policy of targeting the interest rate leads to greater economic stability than a policy of targeting the money supply. (Problem 7 at the end of this chapter asks you to analyze this issue more fully.) Another possible reason for using the interest rate as the short-term policy in- strument is that interest rates are easier to measure than the money supply.As we 290 | PART IV Business Cycle Theory: The Economy in the Short Run At the same time, the Fed pursued expansionary monetary policy, shifting the LM curve to the right. Money growth accelerated, and interest rates fell.The in- terest rate on three-month Treasury bills fell from 6.4 percent in November of 2000 to 3.3 percent in August 2001, and then to 2.1 percent in September 2001 in the immediate aftermath of the terrorist attacks. The magnitude of the slowdown of 2001 was not yet determined as this book was going to press. The big question was whether the policy measures under- taken were sufficient to offset the shocks that the economy had suffered. By the time you are reading this, you may know the answer. 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 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 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 P 1 to P 2 , and income falls from Y 1 to Y 2 .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 CHAPTER 11 Aggregate Demand II | 291 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 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 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 determi- nation 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 Y 1 IS LM(P 1 ) LM(P 2 ) Y 2 P 2 P 1 Y 1 AD Y 2 (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 P 1 to P 2 lowers real money balances and thus shifts the LM curve upward. The shift in the LM curve lowers income from Y 1 to Y 2 . 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. User JOEWA:Job EFF01427:6264_ch11:Pg 293:27340#/eps at 100%*27340* Wed, Feb 13, 2002 10:27 AM Panel (a) of Figure 11-7 shows the three curves that are necessary for under- standing the short-run and long-run equilibria: the IS curve, the LM curve, and the vertical line representing the natural rate of output Y ? .The LM curve is, as always, drawn for a fixed price level, P 1 .The short-run equilibrium of the econ- omy is point K, where the IS curve crosses the LM curve. Notice that in this short-run equilibrium, the economy’s income is less than its natural rate. CHAPTER 11 Aggregate Demand II | 293 figure 11-6 Interest rate, r Price level, P Interest rate, r Price level, P Income, output, Y Income, output, Y Income, output, Y Income, output, Y IS LM 2 (P H11005 P 1 ) Y 1 Y 2 Y 1 Y 2 Y 1 Y 2 Y 1 Y 2 LM 1 (P H11005 P 1 ) AD 2 AD 1 IS 1 IS 2 AD 2 AD 1 1. A fiscal expansion shifts the IS curve, . . . P 1 LM(P H11005 P 1 ) P 1 (a) Expansionary Monetary Policy (b) Expansionary Fiscal Policy 1. A monetary expansion shifts the LM curve, . . . 2. . . . increasing aggregate demand at any given price level. 2. . . . increasing aggregate demand at any given price level. How Monetary and Fiscal Policies Shift the Aggregate Demand Curve Panel (a) shows a monetary expansion. For any given price level, an increase in the money supply raises real money balances, shifts the LM curve downward, and raises income. Hence, an increase in the money supply shifts the aggregate demand curve to the right. Panel (b) shows a fiscal expansion, such as an increase in government purchases or a decrease in taxes. The fiscal expansion shifts the IS curve to the right and, for any given price level, raises income. Hence, a fiscal expansion shifts the aggregate demand curve to the right. User JOEWA:Job EFF01427:6264_ch11:Pg 294:27341#/eps at 100%*27341* Wed, Feb 13, 2002 10:27 AM Panel (b) of Figure 11-7 shows the same situation in the diagram of aggregate supply and aggregate demand. At the price level P 1 , the quantity of output de- manded is below the natural rate. In other words, at the existing price level, there is insufficient demand for goods and services to keep the economy producing at its potential. In these two diagrams we can examine the short-run equilibrium at which the economy finds itself and the long-run equilibrium toward which the econ- omy gravitates. Point K describes the short-run equilibrium, because it assumes that the price level is stuck at P 1 . Eventually, the low demand for goods and ser- vices causes prices to fall, and the economy moves back toward its natural rate. When the price level reaches P 2 , the economy is at point C, the long-run equi- librium.The diagram of aggregate supply and aggregate demand shows that at point C, the quantity of goods and services demanded equals the natural rate of output.This long-run equilibrium is achieved in the IS–LM diagram by a shift in the LM curve: the fall in the price level raises real money balances and therefore shifts the LM curve to the right. We can now see the key difference between Keynesian and classical ap- proaches to the determination of national income. The Keynesian assumption (represented by point K) is that the price level is stuck. Depending on monetary policy, fiscal policy, and the other determinants of aggregate demand, output may deviate from the natural rate.The classical assumption (represented by point C) is that the price level is fully flexible.The price level adjusts to ensure that national income is always at the natural rate. 294 | PART IV Business Cycle Theory: The Economy in the Short Run figure 11-7 Interest rate, r Price level, P Income, output, Y Income, output, YY P 1 P 2 LRAS SRAS 1 SRAS 2 AD K C Y LM(P 1 ) LM(P 2 ) LRAS IS K C (a) The IS–LM Model (b) The Model of Aggregate Supply and Aggregate Demand The Short-Run and Long-Run Equilibria We can compare the short-run and long-run equilibria using either the IS–LM diagram in panel (a) or the aggregate supply– aggregate demand diagram in panel (b). In the short run, the price level is stuck at P 1 . The short-run equilibrium of the economy is therefore point K. In the long run, the price level adjusts so that the economy is at the natural rate. The long-run equilibrium is therefore point C. User JOEWA:Job EFF01427:6264_ch11:Pg 295:27342#/eps at 100%*27342* Wed, Feb 13, 2002 10:27 AM To make the same point somewhat differently, we can think of the economy as being described by three equations.The first two are the IS and LM equations: Y = C(Y ? T ) + I(r) + GIS, M/P = L(r, Y ) LM. The IS equation describes the goods market, and the LM equation describes the money market. These two equations contain three endogenous variables: Y, P, and r.The Keynesian approach is to complete the model with the assumption of fixed prices, so the Keynesian third equation is P = P 1 . This assumption implies that r and Y must adjust to satisfy the IS and LM equa- tions.The classical approach is to complete the model with the assumption that output reaches the natural rate, so the classical third equation is Y = Y ? . This assumption implies that r and P must adjust to satisfy the IS and LM equations. Which assumption is most appropriate? The answer depends on the time horizon.The classical assumption best describes the long run. Hence, our long- run analysis of national income in Chapter 3 and prices in Chapter 4 assumes that output equals the natural rate.The Keynesian assumption best describes the short run.Therefore, our analysis of economic fluctuations relies on the assump- tion of a fixed price level. 11-3 The Great Depression Now that we have developed the model of aggregate demand, let’s use it to ad- dress the question that originally motivated Keynes: What caused the Great Depression? Even today, more than half a century after the event, economists continue to debate the cause of this major economic downturn.The Great De- pression provides an extended case study to show how economists use the IS–LM model to analyze economic fluctuations. 1 Before turning to the explanations economists have proposed, look at Table 11-2, which presents some statistics regarding the Depression.These statistics are the battlefield on which debate about the Depression takes place.What do you think happened? An IS shift? An LM shift? Or something else? CHAPTER 11 Aggregate Demand II | 295 1 For a flavor of the debate, see Milton Friedman and Anna J. Schwartz, A Monetary History of the United States, 1867–1960 (Princeton, NJ: Princeton University Press, 1963); Peter Temin, Did Mon- etary Forces Cause the Great Depression? (New York:W.W. Norton, 1976); the essays in Karl Brunner, ed., The Great Depression Revisited (Boston: Martinus Nijhoff, 1981); and the symposium on the Great Depression in the Spring 1993 issue of the Journal of Economic Perspectives. User JOEWA:Job EFF01427:6264_ch11:Pg 296:27343#/eps at 100%*27343* Wed, Feb 13, 2002 10:27 AM The Spending Hypothesis: Shocks to the IS Curve Table 11-2 shows that the decline in income in the early 1930s coincided with falling interest rates.This fact has led some economists to suggest that the cause of the decline may have been a contractionary shift in the IS curve.This view is sometimes called the spending hypothesis, because it places primary blame for the Depression on an exogenous fall in spending on goods and services. Economists have attempted to explain this decline in spending in several ways. Some argue that a downward shift in the consumption function caused the con- tractionary shift in the IS curve.The stock market crash of 1929 may have been partly responsible for this shift: by reducing wealth and increasing uncertainty about the future prospects of the U.S. economy, the crash may have induced con- sumers to save more of their income rather than spending it. Others explain the decline in spending by pointing to the large drop in invest- ment in housing. Some economists believe that the residential investment boom of the 1920s was excessive and that once this “overbuilding’’ became apparent, the demand for residential investment declined drastically. Another possible ex- planation for the fall in residential investment is the reduction in immigration in the 1930s: a more slowly growing population demands less new housing. Once the Depression began, several events occurred that could have reduced spending further. First, many banks failed in the early 1930s, in part because of inadequate bank regulation, and these bank failures may have exacerbated the fall in investment spending. Banks play the crucial role of getting the funds available 296 | PART IV Business Cycle Theory: The Economy in the Short Run Unemployment Real GNP Consumption Investment Government Year Rate (1) (2) (2) (2) Purchases (2) 1929 3.2 203.6 139.6 40.4 22.0 1930 8.9 183.5 130.4 27.4 24.3 1931 16.3 169.5 126.1 16.8 25.4 1932 24.1 144.2 114.8 4.7 24.2 1933 25.2 141.5 112.8 5.3 23.3 1934 22.0 154.3 118.1 9.4 26.6 1935 20.3 169.5 125.5 18.0 27.0 1936 17.0 193.2 138.4 24.0 31.8 1937 14.3 203.2 143.1 29.9 30.8 1938 19.1 192.9 140.2 17.0 33.9 1939 17.2 209.4 148.2 24.7 35.2 1940 14.6 227.2 155.7 33.0 36.4 Source: Historical Statistics of the United States, Colonial Times to 1970, Parts I and II (Washington, DC: U.S. Department of Commerce, Bureau of Census, 1975). Note: (1) The unemployment rate is series D9. (2) Real GNP, consumption, investment, and government purchases are series F3, F48, F52, and F66, and are measured in billions of 1958 dollars. (3) The interest rate is the prime Commercial What Happened During the Great Depression? table 11-2 User JOEWA:Job EFF01427:6264_ch11:Pg 297:27344#/eps at 100%*27344* Wed, Feb 13, 2002 10:27 AM for investment to those households and firms that can best use them.The closing of many banks in the early 1930s may have prevented some businesses from get- ting the funds they needed for capital investment and, therefore, may have led to a further contractionary shift in the investment function. 2 In addition, the fiscal policy of the 1930s caused a contractionary shift in the IS curve. Politicians at that time were more concerned with balancing the bud- get than with using fiscal policy to keep production and employment at their natural rates.The Revenue Act of 1932 increased various taxes, especially those falling on lower- and middle-income consumers. 3 The Democratic platform of that year expressed concern about the budget deficit and advocated an “immedi- ate and drastic reduction of governmental expenditures.’’ In the midst of histori- cally high unemployment, policymakers searched for ways to raise taxes and reduce government spending. There are, therefore, several ways to explain a contractionary shift in the IS curve. Keep in mind that these different views may all be true.There may be no single explanation for the decline in spending. It is possible that all of these changes coincided and that together they led to a massive reduction in spending. CHAPTER 11 Aggregate Demand II | 297 Nominal Money Supply Price Level Inflation Real Money Year Interest Rate (3) (4) (5) (6) Balances (7) 1929 5.9 26.6 50.6 ? 52.6 1930 3.6 25.8 49.3 ?2.6 52.3 1931 2.6 24.1 44.8 ?10.1 54.5 1932 2.7 21.1 40.2 ?9.3 52.5 1933 1.7 19.9 39.3 ?2.2 50.7 1934 1.0 21.9 42.2 7.4 51.8 1935 0.8 25.9 42.6 0.9 60.8 1936 0.8 29.6 42.7 0.2 62.9 1937 0.9 30.9 44.5 4.2 69.5 1938 0.8 30.5 43.9 ?1.3 69.5 1939 0.6 34.2 43.2 ?1.6 79.1 1940 0.6 39.7 43.9 1.6 90.3 Paper rate, 4–6 months, series ×445. (4) The money supply is series ×414, currency plus demand deposits, measured in billions of dollars. (5) The price level is the GNP deflator (1958 = 100), series E1. (6) The inflation rate is the percentage change in the price level series. (7) Real money balances, calculated by dividing the money supply by the price level and multiplying by 100, are in billions of 1958 dollars. 2 Ben Bernanke, “Non-Monetary Effects of the Financial Crisis in the Propagation of the Great Depression,’’ American Economic Review 73 (June 1983): 257–276. 3 E. Cary Brown,“Fiscal Policy in the ’Thirties:A Reappraisal,’’ American Economic Review 46 (De- cember 1956): 857–879. User JOEWA:Job EFF01427:6264_ch11:Pg 298:27345#/eps at 100%*27345* Wed, Feb 13, 2002 10:27 AM The Money Hypothesis: A Shock to the LM Curve Table 11-2 shows that the money supply fell 25 percent from 1929 to 1933, dur- ing which time the unemployment rate rose from 3.2 percent to 25.2 percent. This fact provides the motivation and support for what is called the money hy- pothesis, which places primary blame for the Depression on the Federal Reserve for allowing the money supply to fall by such a large amount. 4 The best-known advocates of this interpretation are Milton Friedman and Anna Schwartz, who defend it in their treatise on U.S. monetary history. Friedman and Schwartz argue that contractions in the money supply have caused most economic down- turns and that the Great Depression is a particularly vivid example. Using the IS–LM model, we might interpret the money hypothesis as ex- plaining the Depression by a contractionary shift in the LM curve. Seen in this way, however, the money hypothesis runs into two problems. The first problem is the behavior of real money balances. Monetary policy leads to a contractionary shift in the LM curve only if real money balances fall. Yet from 1929 to 1931 real money balances rose slightly, because the fall in the money supply was accompanied by an even greater fall in the price level. Al- though the monetary contraction may be responsible for the rise in unemploy- ment from 1931 to 1933, when real money balances did fall, it cannot easily explain the initial downturn from 1929 to 1931. The second problem for the money hypothesis is the behavior of interest rates. If a contractionary shift in the LM curve triggered the Depression, we should have observed higher interest rates.Yet nominal interest rates fell continu- ously from 1929 to 1933. These two reasons appear sufficient to reject the view that the Depression was instigated by a contractionary shift in the LM curve. But was the fall in the money stock irrelevant? Next, we turn to another mechanism through which monetary policy might have been responsible for the severity of the Depres- sion—the deflation of the 1930s. The Money Hypothesis Again: The Effects of Falling Prices From 1929 to 1933 the price level fell 25 percent. Many economists blame this deflation for the severity of the Great Depression.They argue that the deflation may have turned what in 1931 was a typical economic downturn into an un- precedented period of high unemployment and depressed income. If it is correct, this argument gives new life to the money hypothesis. Because the falling money supply was, plausibly, responsible for the falling price level, it could have been re- sponsible for the severity of the Depression.To evaluate this argument, we must discuss how changes in the price level affect income in the IS–LM model. 298 | PART IV Business Cycle Theory: The Economy in the Short Run 4 We discuss the reasons for this large decrease in the money supply in Chapter 18, where we ex- amine the money supply process in more detail. In particular, see the case study “Bank Failures and the Money Supply in the 1930s.” User JOEWA:Job EFF01427:6264_ch11:Pg 299:27346#/eps at 100%*27346* Wed, Feb 13, 2002 10:27 AM The Stabilizing Effects of Deflation In the IS–LM model we have developed so far, falling prices raise income. For any given supply of money M, a lower price level implies higher real money balances M/P.An increase in real money balances causes an expansionary shift in the LM curve, which leads to higher income. Another channel through which falling prices expand income is called the Pigou effect. Arthur Pigou, a prominent classical economist in the 1930s, pointed out that real money balances are part of households’ wealth. As prices fall and real money balances rise, consumers should feel wealthier and spend more. This increase in consumer spending should cause an expansionary shift in the IS curve, also leading to higher income. These two reasons led some economists in the 1930s to believe that falling prices would help stabilize the economy. That is, they thought that a decline in the price level would automatically push the economy back toward full employ- ment.Yet other economists were less confident in the economy’s ability to cor- rect itself. They pointed to other effects of falling prices, to which we now turn. The Destabilizing Effects of Deflation Economists have proposed two theo- ries to explain how falling prices could depress income rather than raise it.The first, called the debt-deflation theory, describes the effects of unexpected falls in the price level.The second explains the effects of expected deflation. The debt-deflation theory begins with an observation from Chapter 4: unan- ticipated changes in the price level redistribute wealth between debtors and cred- itors. If a debtor owes a creditor $1,000, then the real amount of this debt is $1,000/P, where P is the price level.A fall in the price level raises the real amount of this debt—the amount of purchasing power the debtor must repay the creditor. Therefore, an unexpected deflation enriches creditors and impoverishes debtors. The debt-deflation theory then posits that this redistribution of wealth affects spending on goods and services. In response to the redistribution from debtors to creditors, debtors spend less and creditors spend more. If these two groups have equal spending propensities, there is no aggregate impact. But it seems reasonable to assume that debtors have higher propensities to spend than creditors—perhaps that is why the debtors are in debt in the first place. In this case, debtors reduce their spending by more than creditors raise theirs.The net effect is a reduction in spending, a contractionary shift in the IS curve, and lower national income. To understand how expected changes in prices can affect income, we need to add a new variable to the IS–LM model. Our discussion of the model so far has not distinguished between the nominal and real interest rates.Yet we know from previous chapters that investment depends on the real interest rate and that money demand depends on the nominal interest rate. If i is the nominal interest rate and p e is expected inflation, then the ex ante real interest rate is i ? p e .We can now write the IS–LM model as Y = C(Y ? T ) + I(i ? p e ) + GIS, M/P = L(i, Y ) LM. Expected inflation enters as a variable in the IS curve.Thus, changes in expected inflation shift the IS curve. CHAPTER 11 Aggregate Demand II | 299 User JOEWA:Job EFF01427:6264_ch11:Pg 300:27347#/eps at 100%*27347* Wed, Feb 13, 2002 10:27 AM Let’s use this extended IS–LM model to examine how changes in expected inflation influence the level of income.We begin by assuming that everyone ex- pects the price level to remain the same. In this case, there is no expected infla- tion ( p e = 0), and these two equations produce the familiar IS–LM model. Figure 11-8 depicts this initial situation with the LM curve and the IS curve labeled IS 1 . The intersection of these two curves determines the nominal and real interest rates, which for now are the same. Now suppose that everyone suddenly expects that the price level will fall in the future, so that p e becomes negative. The real interest rate is now higher at any given nominal interest rate.This increase in the real interest rate depresses planned investment spending, shifting the IS curve from IS 1 to IS 2 .Thus, an expected de- flation leads to a reduction in national income from Y 1 to Y 2 .The nominal inter- est rate falls from i 1 to i 2 , whereas the real interest rate rises from r 1 to r 2 . Here is the story behind this figure. When firms come to expect deflation, they become reluctant to borrow to buy investment goods because they believe they will have to repay these loans later in more valuable dollars.The fall in in- vestment depresses planned expenditure, which in turn depresses income. The fall in income reduces the demand for money, and this reduces the nominal in- terest rate that equilibrates the money market.The nominal interest rate falls by less than the expected deflation, so the real interest rate rises. Note that there is a common thread in these two stories of destabilizing deflation. In both, falling prices depress national income by causing a contrac- tionary shift in the IS curve. Because a deflation of the size observed from 1929 to 1933 is unlikely except in the presence of a major contraction in the money supply, these two explanations give some of the responsibility for the Depression—especially its severity—to the Fed. In other words, if falling prices are destabilizing, then a contraction in the money supply can lead to a fall in income, even without a decrease in real money balances or a rise in nominal interest rates. 300 | PART IV Business Cycle Theory: The Economy in the Short Run figure 11-8 Y 2 Y 1 i 2 r 1 H11005 i 1 r 2 IS 2 IS 1 LM p e Interest rate, i Income, output, Y Expected Deflation in the IS–LM Model An expected deflation (a negative value of p e ) raises the real interest rate for any given nominal interest rate, and this depresses investment spending. The reduction in investment shifts the IS curve downward. The level of income falls from Y 1 to Y 2 . The nominal interest rate falls from i 1 to i 2 , and the real interest rate rises from r 1 to r 2 . User JOEWA:Job EFF01427:6264_ch11:Pg 301:27348#/eps at 100%*27348* Wed, Feb 13, 2002 10:27 AM Could the Depression Happen Again? Economists study the Depression both because of its intrinsic interest as a major economic event and to provide guidance to policymakers so that it will not hap- pen again. To state with confidence whether this event could recur, we would need to know why it happened. Because there is not yet agreement on the causes of the Great Depression, it is impossible to rule out with certainty another de- pression of this magnitude. Yet most economists believe that the mistakes that led to the Great Depression are unlikely to be repeated.The Fed seems unlikely to allow the money supply to fall by one-fourth. Many economists believe that the deflation of the early 1930s was responsible for the depth and length of the Depression. And it seems likely that such a prolonged deflation was possible only in the presence of a falling money supply. The fiscal-policy mistakes of the Depression are also unlikely to be repeated. Fiscal policy in the 1930s not only failed to help but actually further depressed aggregate demand. Few economists today would advocate such a rigid adherence to a balanced budget in the face of massive unemployment. In addition, there are many institutions today that would help prevent the events of the 1930s from recurring. The system of Federal Deposit Insurance makes widespread bank failures less likely.The income tax causes an automatic reduction in taxes when income falls, which stabilizes the economy. Finally, economists know more today than they did in the 1930s. Our knowledge of how the economy works, limited as it still is, should help policymakers formulate better policies to combat such widespread unemployment. CHAPTER 11 Aggregate Demand II | 301 CASE STUDY The Japanese Slump During the 1990s, after many years of rapid growth and enviable prosperity, the Japanese economy experienced a prolonged downturn. Real GDP grew at an average rate of only 1.3 percent over the decade, compared with 4.3 percent over the previous twenty years.The unemployment rate, which had historically been very low in Japan, rose from 2.1 percent in 1990 to 4.7 percent in 1999. In Au- gust 2001, unemployment hit 5.0 percent, the highest rate since the government began compiling the statistic in 1953. Although the Japanese slump of the 1990s is not even close in magnitude to the Great Depression of the 1930s, the episodes are similar in several ways. First, both episodes are traced in part to a large decline in stock prices. In Japan, stock prices at the end of the 1990s were less than half the peak level they had reached about a decade earlier. Like the stock market, Japanese land prices had also skyrocketed in the 1980s before crashing in the 1990s. (At the peak of Japan’s land bubble, it was said that the land under the Imperial Palace was worth more than the entire state of California.) When stock and land prices collapsed, Japanese citizens saw their wealth plummet.This decline in wealth, like that during the Great Depression, de- pressed consumer spending. User JOEWA:Job EFF01427:6264_ch11:Pg 302:27349#/eps at 100%*27349* Wed, Feb 13, 2002 10:27 AM 11-4 Conclusion The purpose of this chapter and the previous one has been to deepen our under- standing of aggregate demand.We now have the tools to analyze the effects of monetary and fiscal policy in the long run and in the short run. In the long run, prices are flexible, and we use the classical analysis of Parts II and III of this book. In the short run, prices are sticky, and we use the IS–LM model to examine how changes in policy influence the economy. 302 | PART IV Business Cycle Theory: The Economy in the Short Run Second, during both episodes, banks ran into trouble and exacerbated the slump in economic activity. Japanese banks in the 1980s had made many loans that were backed by stock or land.When the value of this collateral fell, bor- rowers started defaulting on their loans. These defaults on the old loans re- duced the banks’ ability to make new loans. The resulting “credit crunch” made it harder for firms to finance investment projects and, thus, depressed in- vestment spending. Third, both episodes saw a fall in economic activity coincide with very low interest rates. In Japan in the 1990s, as in the United States in the 1930s, short- term nominal interest rates were less than 1 percent.This fact suggests that the cause of the slump was primarily a contractionary shift in the IS curve, because such a shift reduces both income and the interest rate.The obvious suspects to explain the IS shift are the crashes in stock and land prices and the problems in the banking system. Finally, the policy debate in Japan mirrored the debate over the Great Depres- sion. Some economists recommended that the Japanese government pass large tax cuts to encourage more consumer spending. Although this advice was fol- lowed to some extent, Japanese policymakers were reluctant to enact very large tax cuts because, like the U.S. policymakers in the 1930s, they wanted to avoid budget deficits. In Japan, this reluctance to increase government debt arose in part because the government was facing a large unfunded pension liability and a rapidly aging population. Other economists recommended that the Bank of Japan expand the money supply more rapidly. Even if nominal interest rates could not go much lower, then perhaps more rapid money growth could raise expected inflation, lower real interest rates, and stimulate investment spending.Thus, although econo- mists differed about whether fiscal or monetary policy was more likely to be effective, there was wide agreement that the solution to Japan’s slump, like the solution to the Great Depression, rested in more aggressive expansion of ag- gregate demand. 5 5 To learn more about this episode, see Adam S. Posen, Restoring Japan’s Economic Growth (Washing- ton, DC: Institute for International Economics, 1998). User JOEWA:Job EFF01427:6264_ch11:Pg 303:27350#/eps at 100%*27350* Wed, Feb 13, 2002 10:27 AM Although the model presented in this chapter provides the basic framework for analyzing aggregate demand, it is not the whole story. In later chapters, we examine in more detail the elements of this model and thereby refine our under- standing of aggregate demand. In Chapter 16, for example, we study theories of consumption. Because the consumption function is a crucial piece of the IS–LM model, a deeper analysis of consumption may modify our view of the impact of monetary and fiscal policy on the economy.The simple IS–LM model presented in Chapters 10 and 11 provides the starting point for this further analysis. CHAPTER 11 Aggregate Demand II | 303 FYI In Japan in the 1990s and the United States in the 1930s, interest rates reached very low levels. As Table 11-2 shows, U.S. interest rates were well under 1 percent throughout the second half of the 1930s. The same was true in Japan during the second half of the 1990s. In 1999, Japanese short-term interest rates fell to about one-tenth of 1 percent. Some economists describe this situation as a liquidity trap. According to the IS–LM model, ex- pansionary monetary policy works by reducing interest rates and stimulating investment spend- ing. But if interest rates have already fallen al- most to zero, then perhaps monetary policy is no longer effective. Nominal interest rates cannot fall below zero: rather than making a loan at a negative nominal interest rate, a person would simply hold cash. In this environment, expan- sionary monetary policy raises the supply of money, making the public more liquid, but be- cause interest rates can’t fall any further, the extra liquidity might not have any effect. Aggre- gate demand, production, and employment may be “trapped” at low levels. Other economists are skeptical about this ar- gument. One response is that expansionary mon- etary policy might raise inflation expectations. Even if nominal interest rates cannot fall any fur- ther, higher expected inflation can lower real in- The Liquidity Trap terest rates by making them negative, which would stimulate investment spending. A second response is that monetary expansion would cause the currency to lose value in the market for foreign-currency exchange. This depreciation would make the nation’s goods cheaper abroad, stimulating export demand. This second argu- ment goes beyond the closed-economy IS–LM model we have used in this chapter, but it has merit in the open-economy version of the model developed in the next chapter. Is the liquidity trap something about which monetary policymakers need to worry? Might the tools of monetary policy at times lose their power to influence the economy? There is no consensus about the answers. Skeptics say we shouldn’t worry about the liquidity trap. But others say the possibility of a liquidity trap argues for a target rate of inflation greater than zero. Under zero inflation, the real interest rate, like the nominal interest, can never fall below zero. But if the normal rate of inflation is, say, 3 percent, then the central bank can easily push the real interest rate to negative 3 percent by lowering the nominal interest rate toward zero. Thus, moderate inflation gives monetary policy- makers more room to stimulate the economy when needed, reducing the risk of falling into a liquidity trap. 6 6 To read more about the liquidity trap, see Paul R. Krugman,“It’s Baaack: Japan’s Slump and the Return of the Liquidity Trap,” Brookings Panel on Economic Activity (1998): 137–205. User JOEWA:Job EFF01427:6264_ch11:Pg 304:27351#/eps at 100%*27351* Wed, Feb 13, 2002 10:27 AM Summary 1. The IS–LM model is a general theory of the aggregate demand for goods and services.The exogenous variables in the model are fiscal policy, monetary policy, and the price level.The model explains two endogenous variables: the interest rate and the level of national income. 2. The IS curve represents the negative relationship between the interest rate and the level of income that arises from equilibrium in the market for goods and services.The LM curve represents a positive relationship between the in- terest rate and the level of income that arises from equilibrium in the market for real money balances. Equilibrium in the IS–LM model—the intersection of the IS and LM curves—represents simultaneous equilibrium in the market for goods and services and in the market for real money balances. 3. The aggregate demand curve summarizes the results from the IS–LM model by showing equilibrium income at any given price level.The aggregate de- mand curve slopes downward because a lower price level increases real money balances, lowers the interest rate, stimulates investment spending, and thereby raises equilibrium income. 4. Expansionary fiscal policy—an increase in government purchases or a de- crease in taxes—shifts the IS curve to the right.This shift in the IS curve in- creases the interest rate and income. The increase in income represents a rightward shift in the aggregate demand curve. Similarly, contractionary fiscal policy shifts the IS curve to the left, lowers the interest rate and income, and shifts the aggregate demand curve to the left. 5. Expansionary monetary policy shifts the LM curve downward.This shift in the LM curve lowers the interest rate and raises income.The increase in in- come represents a rightward shift of the aggregate demand curve. Similarly, contractionary monetary policy shifts the LM curve upward, raises the inter- est rate, lowers income, and shifts the aggregate demand curve to the left. 304 | PART IV Business Cycle Theory: The Economy in the Short Run 1. Explain why the aggregate demand curve slopes downward. 2. What is the impact of an increase in taxes on the interest rate, income, consumption, and invest- ment? KEY CONCEPTS Monetary transmission mechanism QUESTIONS FOR REVIEW Pigou effect Debt-deflation theory 3. What is the impact of a decrease in the money supply on the interest rate, income, consumption, and investment? 4. Describe the possible effects of falling prices on equilibrium income. User JOEWA:Job EFF01427:6264_ch11:Pg 305:27352#/eps at 100%*27352* Wed, Feb 13, 2002 10:28 AM CHAPTER 11 Aggregate Demand II | 305 PROBLEMS AND APPLICATIONS 1. According to the IS–LM model, what happens to the interest rate, income, consumption, and in- vestment under the following circumstances? a. The central bank increases the money supply. b. The government increases government pur- chases. c. The government increases taxes. d. The government increases government pur- chases and taxes by equal amounts. 2. Use the IS–LM model to predict the effects of each of the following shocks on income, the in- terest rate, consumption, and investment. In each case, explain what the Fed should do to keep in- come at its initial level. a. After the invention of a new high-speed com- puter chip, many firms decide to upgrade their computer systems. b. A wave of credit-card fraud increases the fre- quency with which people make transactions in cash. c. A best-seller titled Retire Rich convinces the public to increase the percentage of their in- come devoted to saving. 3. Consider the economy of Hicksonia. a. The consumption function is given by C = 200 + 0.75(Y ? T ). The investment function is I = 200 ? 25r. Government purchases and taxes are both 100. For this economy, graph the IS curve for r ranging from 0 to 8. b. The money demand function in Hicksonia is (M/P) d = Y ? 100r. The money supply M is 1,000 and the price level P is 2. For this economy, graph the LM curve for r ranging from 0 to 8. c. Find the equilibrium interest rate r and the equilibrium level of income Y. d. Suppose that government purchases are raised from 100 to 150. How much does the IS curve shift? What are the new equilibrium interest rate and level of income? e. Suppose instead that the money supply is raised from 1,000 to 1,200. How much does the LM curve shift? What are the new equilib- rium interest rate and level of income? f. With the initial values for monetary and fiscal policy, suppose that the price level rises from 2 to 4.What happens? What are the new equilib- rium interest rate and level of income? g. Derive and graph an equation for the aggre- gate demand curve. What happens to this ag- gregate demand curve if fiscal or monetary policy changes, as in parts (d) and (e)? 4. Explain why each of the following statements is true. Discuss the impact of monetary and fiscal policy in each of these special cases. a. If investment does not depend on the interest rate, the IS curve is vertical. b. If money demand does not depend on the in- terest rate, the LM curve is vertical. c. If money demand does not depend on income, the LM curve is horizontal. d. If money demand is extremely sensitive to the interest rate, the LM curve is horizontal. 5. Suppose that the government wants to raise investment but keep output constant. In the IS–LM model, what mix of monetary and fiscal policy will achieve this goal? In the early 1980s, the U.S. government cut taxes and ran a budget deficit while the Fed pursued a tight monetary policy. What effect should this policy mix have? 6. Use the IS–LM diagram to describe the short- run and long-run effects of the following changes on national income, the interest rate, the price level, consumption, investment, and real money balances. a. An increase in the money supply. b. An increase in government purchases. c. An increase in taxes. User JOEWA:Job EFF01427:6264_ch11:Pg 306:27353#/eps at 100%*27353* Wed, Feb 13, 2002 10:28 AM 7. The Fed is considering two alternative monetary policies: ? holding the money supply constant and let- ting the interest rate adjust, or ? adjusting the money supply to hold the inter- est rate constant. In the IS–LM model, which policy will better stabilize output under the following conditions? a. All shocks to the economy arise from exogenous changes in the demand for goods and services. b. All shocks to the economy arise from exoge- nous changes in the demand for money. 306 | PART IV Business Cycle Theory: The Economy in the Short Run 8. Suppose that the demand for real money balances depends on disposable income.That is, the money demand function is M/P = L(r, Y ? T ). Using the IS–LM model, discuss whether this change in the money demand function alters the following: a. The analysis of changes in government pur- chases. b. The analysis of changes in taxes. User JOEWA:Job EFF01427:6264_ch11:Pg 307:27354#/eps at 100%*27354* Wed, Feb 13, 2002 10:28 AM CHAPTER 11 Aggregate Demand II | 307 The chapter analyzes the IS–LM model with graphs of the IS and LM curves. Here we analyze the model algebraically rather than graphically.This alternative presentation offers additional insight into how monetary and fiscal policy influ- ence aggregate demand. The IS Curve One way to think about the IS curve is that it describes the combinations of in- come Y and the interest rate r that satisfy an equation we first saw in Chapter 3: Y = C(Y ? T ) + I(r) + G. This equation combines the national income accounts identity, the consumption function, and the investment function. It states that the quantity of goods pro- duced, Y, must equal the quantity of goods demanded, C + I + G. We can learn more about the IS curve by considering the special case in which the consumption function and investment function are linear.We begin with the national income accounts identity Y = C + I + G. Now suppose that the consumption function is C = a + b(Y ? T ), where a and b are numbers greater than zero, and the investment function is I = c ? dr, where c and d also are numbers greater than zero.The parameter b is the mar- ginal propensity to consume, so we expect b to be between zero and one.The parameter d determines how much investment responds to the interest rate; because investment rises when the interest rate falls, there is a minus sign in front of d. From these three equations, we can derive an algebraic expression for the IS curve and see what influences the IS curve’s position and slope. If we substitute the consumption and investment functions into the national income accounts identity, we obtain Y = [a + b(Y ? T )] + (c ? dr) + G. The Simple Algebra of the IS–LM Model and the Aggregate Demand Curve APPENDIX User JOEWA:Job EFF01427:6264_ch11:Pg 308:27355#/eps at 100%*27355* Wed, Feb 13, 2002 10:28 AM Note that Y shows up on both sides of this equation.We can simplify this equa- tion by bringing all the Y terms to the left-hand side and rearranging the terms on the right-hand side: Y ? bY = (a + c) + (G ? bT ) ? dr. We solve for Y to get Y = + G + T + r. This equation expresses the IS curve algebraically. It tells us the level of income Y for any given interest rate r and fiscal policy G and T. Holding fiscal policy fixed, the equation gives us a relationship between the interest rate and the level of in- come: the higher the interest rate, the lower the level of income.The IS curve graphs this equation for different values of Y and r given fixed values of G and T. Using this last equation, we can verify our previous conclusions about the IS curve. First, because the coefficient of the interest rate is negative, the IS curve slopes downward: higher interest rates reduce income. Second, because the coef- ficient of government purchases is positive, an increase in government purchases shifts the IS curve to the right.Third, because the coefficient of taxes is negative, an increase in taxes shifts the IS curve to the left. The coefficient of the interest rate, ?d/(1 ? b), tells us what determines whether the IS curve is steep or flat. If investment is highly sensitive to the interest rate, then d is large, and income is highly sensitive to the interest rate as well. In this case, small changes in the interest rate lead to large changes in income: the IS curve is relatively flat. Conversely, if investment is not very sensitive to the interest rate, then d is small, and income is also not very sensitive to the interest rate. In this case, large changes in interest rates lead to small changes in income: the IS curve is relatively steep. Similarly, the slope of the IS curve depends on the marginal propensity to consume b.The larger the marginal propensity to consume, the larger the change in income resulting from a given change in the interest rate.The reason is that a large marginal propensity to consume leads to a large multiplier for changes in investment.The larger the multiplier, the larger the impact of a change in invest- ment on income, and the flatter the IS curve. The marginal propensity to consume b also determines how much changes in fiscal policy shift the IS curve.The coefficient of G, 1/(1 ? b), is the govern- ment-purchases multiplier in the Keynesian cross. Similarly, the coefficient of T, ?b/(1 ? b), is the tax multiplier in the Keynesian cross.The larger the mar- ginal propensity to consume, the greater the multiplier, and thus the greater the shift in the IS curve that arises from a change in fiscal policy. The LM Curve The LM curve describes the combinations of income Y and the interest rate r that satisfy the money market equilibrium condition M/P = L(r, Y ). ?d ? 1 ? b ?b ? 1 ? b 1 ? 1 ? b a + c ? 1 ? b 308 | PART IV Business Cycle Theory: The Economy in the Short Run User JOEWA:Job EFF01427:6264_ch11:Pg 309:27356#/eps at 100%*27356* Wed, Feb 13, 2002 10:28 AM This equation simply equates money supply and money demand. We can learn more about the LM curve by considering the case in which the money demand function is linear—that is, L(r, Y ) = eY ? fr, where e and f are numbers greater than zero. The value of e determines how much the demand for money rises when income rises.The value of f determines how much the demand for money falls when the interest rate rises.There is a minus sign in front of the interest rate term because money demand is inversely related to the interest rate. The equilibrium in the money market is now described by M/P = eY ? fr. To see what this equation implies, rearrange the terms so that r is on the left- hand side.We obtain r = (e/f )Y ? (1/f )M/P. This equation gives us the interest rate that equilibrates the money market for any values of income and real money balances.The LM curve graphs this equa- tion for different values of Y and r given a fixed value of M/P. From this last equation, we can verify some of our conclusions about the LM curve. First, because the coefficient of income is positive, the LM curve slopes upward: higher income requires a higher interest rate to equilibrate the money market. Second, because the coefficient of real money balances is negative, de- creases in real balances shift the LM curve upward, and increases in real balances shift the LM curve downward. From the coefficient of income, e/f, we can see what determines whether the LM curve is steep or flat. If money demand is not very sensitive to the level of income, then e is small. In this case, only a small change in the interest rate is necessary to offset the small increase in money demand caused by a change in income: the LM curve is relatively flat. Similarly, if the quantity of money demanded is not very sensitive to the interest rate, then f is small. In this case, a shift in money demand caused by a change in income leads to a large change in the equilibrium interest rate: the LM curve is relatively steep. The Aggregate Demand Curve To find the aggregate demand equation, we must find the level of income that satisfies both the IS equation and the LM equation.To do this, substitute the LM equation for the interest rate r into the IS equation to obtain Y =+G + T + ( Y ? ) . M ? P 1 ? f e ? f ?d ? 1 ? b ?b ? 1 ? b 1 ? 1 ? b a + c ? 1 ? b CHAPTER 11 Aggregate Demand II | 309 User JOEWA:Job EFF01427:6264_ch11:Pg 310:27357#/eps at 100%*27357* Wed, Feb 13, 2002 10:28 AM With some algebraic manipulation, we can solve for Y. The final equation for Y is Y =+G + T + , where z = f/[f + de/(1 ? b)] is a composite of some of the parameters and is be- tween zero and one. This last equation expresses the aggregate demand curve algebraically. It says that income depends on fiscal policy G and T, monetary policy M, and the price level P. The aggregate demand curve graphs this equation for different values of Y and P given fixed values of G, T, and M. We can explain the slope and position of the aggregate demand curve with this equation. First, the aggregate demand curve slopes downward, because an in- crease in P lowers M/P and thus lowers Y. Second, increases in the money supply raise income and shift the aggregate demand curve to the right. Third, increases in government purchases or decreases in taxes also raise income and shift the ag- gregate demand curve to the right. Note that, because z is less than one, the mul- tipliers for fiscal policy are smaller in the IS–LM model than in the Keynesian cross. Hence, the parameter z reflects the crowding out of investment discussed earlier. Finally, this equation shows the relationship between the aggregate demand curve derived in this chapter from the IS–LM model and the aggregate demand curve derived in Chapter 9 from the quantity theory of money. The quantity theory assumes that the interest rate does not influence the quantity of real money balances demanded. Put differently, the quantity theory assumes that the parameter f equals zero. If f equals zero, then the composite parameter z also equals zero, so fiscal policy does not influence aggregate demand.Thus, the ag- gregate demand curve derived in Chapter 9 is a special case of the aggregate de- mand curve derived here. M ? P d ??? (1 ? b)[f + de/(1 ? b)] ?zb ? 1 ? b z ? 1 ? b z(a + c) ? 1 ? b 310 | PART IV Business Cycle Theory: The Economy in the Short Run CASE STUDY The Effectiveness of Monetary and Fiscal Policy Economists have long debated whether monetary or fiscal policy exerts a more powerful influence on aggregate demand. According to the IS–LM model, the answer to this question depends on the parameters of the IS and LM curves. Therefore, economists have spent much energy arguing about the size of these parameters.The most hotly contested parameters are those that describe the in- fluence of the interest rate on economic decisions. Those economists who believe that fiscal policy is more potent than mone- tary policy argue that the responsiveness of investment to the interest rate— measured by the parameter d—is small. If you look at the algebraic equation for aggregate demand, you will see that a small value of d implies a small effect of the money supply on income. The reason is that when d is small, the IS curve is nearly vertical, and shifts in the LM curve do not cause much of a User JOEWA:Job EFF01427:6264_ch11:Pg 311:27358#/eps at 100%*27358* Wed, Feb 13, 2002 10:28 AM CHAPTER 11 Aggregate Demand II | 311 change in income. In addition, a small value of d implies a large value of z, which in turn implies that fiscal policy has a large effect on income.The reason for this large effect is that when investment is not very responsive to the inter- est rate, there is little crowding out. Those economists who believe that monetary policy is more potent than fiscal policy argue that the responsiveness of money demand to the interest rate— measured by the parameter f—is small.When f is small, z is small, and fiscal policy has a small effect on income; in this case, the LM curve is nearly vertical. In addi- tion, when f is small, changes in the money supply have a large effect on income. Few economists today endorse either of these extreme views. The evidence indicates that the interest rate affects both investment and money demand.This finding implies that both monetary and fiscal policy are important determinants of aggregate demand. 1. Give an algebraic answer to each of the following questions. Then explain in words the economics that underlies your answer. a. How does the sensitivity of investment to the interest rate affect the slope of the aggregate demand curve? MORE PROBLEMS AND APPLICATIONS b. How does the sensitivity of money demand to the interest rate affect the slope of the aggre- gate demand curve? c. How does the marginal propensity to consume affect the response of aggregate demand to changes in government purchases?