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1 Econ 101 Intermediate Macro Theory Lecture notes Professor Cetorelli UC Davis Fall 2003 Lecture 15 CHAPTER 4CHAPTER 4Money and InflationMoney and Inflation slide 1 From last time CHAPTER 10CHAPTER 10Aggregate Demand IAggregate Demand I slide 2 The Keynesian CrossThe Keynesian Cross income output Y E planned expenditure E Y E C I G Equilibrium income Remember short run Price level is fixed Planned expenditure can differ from actual expenditure CHAPTER 10CHAPTER 10Aggregate Demand IAggregate Demand I slide 3 Example An increase in government Example An increase in government purchasespurchases Y E E Y E C I G1 E1 Y1 E C I G2 E2 Y2 Y At Y1 there is now an unplanned drop in inventory so firms increase output and income rises toward a new equilibrium G 2 CHAPTER 10CHAPTER 10Aggregate Demand IAggregate Demand I slide 4 The government purchases multiplierThe government purchases multiplier Example If MPC 0 8 then Definition the increase in income resulting from a 1 increase in G In this model the govt purchases multiplier equals 1 1MPC Y G 1 5 10 8 Y G An increase in G causes income to increase by 5 times as much CHAPTER 10CHAPTER 10Aggregate Demand IAggregate Demand I slide 5 Why the multiplier is greater than 1Why the multiplier is greater than 1 Initially the increase in Gcauses an equal increase in Y Y G But Y C further Y further C further Y So the final impact on income is much bigger than the initial G CHAPTER 10CHAPTER 10Aggregate Demand IAggregate Demand I slide 6 An increase in taxesAn increase in taxes Y E E Y E C2 I G E2 Y2 E C1 I G E1 Y1 Y At Y1 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 CHAPTER 10CHAPTER 10Aggregate Demand IAggregate Demand I slide 7 The Tax MultiplierThe Tax Multiplier is negative A tax hike reduces consumer spending which reduces income is greater than one in absolute value A change in taxes has a multiplier effect on income is smaller than the govt spending multiplier Consumers save the fraction 1 MPC of a tax cut so the initial boost in spending from a tax cut is smaller than from an equal increase in G 3 CHAPTER 10CHAPTER 10Aggregate Demand IAggregate Demand I slide 8 Y2Y1 Effect of a decrease in Effect of a decrease in r r r I Y E E C I r1 G E C I r2 G E Y I E Y CHAPTER 10CHAPTER 10Aggregate Demand IAggregate Demand I slide 9 The The ISIS curvecurve def a graph of all combinations of rand Y that result in goods market equilibrium i e actual expenditure output planned expenditure The equation for the IScurve is YC YTI rG CHAPTER 10CHAPTER 10Aggregate Demand IAggregate Demand I slide 10 Y2Y1 Y2Y1 Deriving the Deriving the ISIS curvecurve r I Y E r Y E C I r1 G E C I r2 G r1 r2 E Y IS I E Y CHAPTER 10CHAPTER 10Aggregate Demand IAggregate Demand I slide 11 Y2Y1 Y2Y1 Shifting the Shifting the ISIS curve curve G G At any value of r G E Y Y E r Y E C I r1 G1 E C I r1 G2 r1 E Y IS1 The horizontal distance of the IS shift equals IS2 so the IS curve shifts to the right 1 1 MPC YG Y 4 CHAPTER 10CHAPTER 10Aggregate Demand IAggregate Demand I slide 12 Question is is the new level of equilibrium output Y2really attainable Will interest rates really stay constant at r1 CHAPTER 10CHAPTER 10Aggregate Demand IAggregate Demand I slide 13 The Theory of Liquidity PreferenceThe Theory of Liquidity Preference Recall from ch 4 People choose how to allocate their income between liquid assets money and interest bearing illiquid assets depending on the level of the interest rate If interest rates go up they will want to hold less money and more assets such as savings accounts stocks bonds etc CHAPTER 10CHAPTER 10Aggregate Demand IAggregate Demand I slide 14 Money DemandMoney Demand Demand for real money balances M P real money balances r interest rate d M PL r Y L r Y Remember short run Prices sticky No inflation Hence r i CHAPTER 10CHAPTER 10Aggregate Demand IAggregate Demand I slide 15 Money SupplyMoney Supply The supply of real money balances is fixed s M PM P M P real money balances r interest rate s M P M P 5 CHAPTER 10CHAPTER 10Aggregate Demand IAggregate Demand I slide 16 EquilibriumEquilibrium The interest rate adjusts to equate the supply and demand for money M P real money balances r interest rate s M P M P M PL r Y L r Y r1 CHAPTER 10CHAPTER 10Aggregate Demand IAggregate Demand I slide 17 The LM curveThe LM curve M PL r Y The LMcurveis a graph of all combinations of rand Ythat equate the supply and demand for real money balances The equation for the LMcurve is CHAPTER 10CHAPTER 10Aggregate Demand IAggregate Demand I slide 18 Deriving the LM curveDeriving the LM curve M P r 1 M P L r Y1 r1 r2 r Y Y1 r1 L r Y2 r2 Y2 LM a The market for real money balances b The LM curve CHAPTER 10CHAPTER 10Aggregate Demand IAggregate Demand I slide 19 Why the Why the LMLM curve is upwardcurve is upward slopingsloping An increase in income raises money demand Since the supply of real balances is fixed there is now excess demand in the money market at the initial interest rate People will want to liquidate part of their overall wealth in order to fulfill their increased demand for money liquid assets This might mean for instance shifting resources from bond funds into banking checking accounts part of money 6 CHAPTER 10CHAPTER 10Aggregate Demand IAggregate Demand I slide 20 Why the Why the LMLM curve is upwardcurve is upward slopingsloping But now there is an excess supplyof bonds in the bond market In order to accommodate this excess supply the price of these bonds have to go down which consequently means the interest rate on those bonds will go up The bond market finds a new equilibrium where supply equals demand at a higher interest rate CHAPTER 10CHAPTER 10Aggregate Demand IAggregate Demand I slide 21 Little detourLittle detour Why is it that if the price of a bond goes down the interest rate on it goes up Let s show it with an example You just purchased a bond A bond is nothing else than a piece of paper which entitles you to receive a given sum at some point in the future You paid say 1000 for a bond which promises a payment of 1 100 a year later This means you will be receiving an interest payment of 100 or the original 1 000 investment yields a 10 interest rate 1100 1000 1 100 10 CHAPTER 10CHAPTER 10Aggregate Demand IAggregate Demand I slide 22 Little detourLittle detour Suppose now that after you bought the bond you learn that the Macroeconomics Encyclopedia that you had been dreaming about just came out and that in order to buy it you need to sell the bond and use the cash as a down payment for the encyclopedia Suppose also that all your other classmates are doing the same and so there is a flood of bond supply So I come in and offer to buy your bond but at 950 only I am a nice guy and you accept If the new price of the bond is 950 then it means that the interest rate on it is now 1100 800 1 100 15 8 CHAPTER 10CHAPTER 10Aggregate Demand IAggregate Demand I slide 23 How How MMshifts the LM curveshifts the LM curve M P r 1 M P L r Y1 r1 r2 r Y Y1 r1 r2 LM1 a The market for real money balances b The LM curve 2 M P LM2 7 CHAPTER 10CHAPTER 10Aggregate Demand IAggregate Demand I slide 24 How the Fed raises the interest rateHow the Fed raises the interest rate To increase r Fed reduces M M P real money balances r interest rate 1 M P L r r1 r2 2 M P CHAPTER 10CHAPTER 10Aggregate Demand IAggregate Demand I slide 25 CASE STUDY CASE STUDY Volcker sVolcker s Monetary TighteningMonetary 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 P8 0 Jan 1983 3 7 How do you think this policy change would affect interest rates How do you think this policy change How do you think this policy change would affect interest rates would affect interest rates CHAPTER 10CHAPTER 10Aggregate Demand IAggregate Demand I slide 26 Volcker sVolcker s Monetary Tightening Monetary Tightening cont cont i 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 actual outcome The effects of a monetary tightening on nominal interest rates prices model long runshort run CHAPTER 11CHAPTER 11Aggregate Demand IIAggregate Demand II slide 27 The intersection determines the unique combination of Yand r that satisfies equilibrium in both markets The LMcurve represents money market equilibrium Equilibrium in the Equilibrium in the ISIS LMLM ModelModel The IScurve represents equilibrium in the goods market YC YTI rG M PL r Y IS Y r LM r1 Y1 Remember we are in the short run 8 CHAPTER 10CHAPTER 10Aggregate Demand IAggregate Demand I slide 28 What next What next Now we can use the IS LMmodel to analyze the impact of policies and shocks learn how the aggregate demand curve comes from IS LM use the IS LMand AD ASmodels together to analyze the short run and long run effects of shocks CHAPTER 11CHAPTER 11Aggregate Demand IIAggregate Demand II slide 29 Policy analysis with the Policy analysis with the ISIS LMLM ModelModel Policymakers can affect macroeconomic variables with fiscal policy Gand or T monetary policy M We can use the IS LM model to analyze the effects of these policies YC YTI rG M PL r Y IS Y r LM r1 Y1 CHAPTER 11CHAPTER 11Aggregate Demand IIAggregate Demand II slide 30 causing output income to rise IS1 An increase in government purchasesAn increase in government purchases 1 IScurve shifts right Y r LM r1 Y1 1 by 1 MPCG IS2 Y2 r2 1 2 This raises money demand causing the interest rate to rise 2 3 which reduces investment so the final increase in Y 1 is smaller than 1 MPCG 3 CHAPTER 11CHAPTER 11Aggregate Demand IIAggregate Demand II slide 31 IS1 1 A tax cutA tax cut Y r LM r1 Y1 IS2 Y2 r2 Because consumers save 1 MPC of the tax cut the initial boost in spending is smaller for T than for an equal G and the IScurve shifts by MPC 1 MPC T 1 2 2 so the effects on rand Y are smaller for a Tthan for an equal G 2 9 CHAPTER 11CHAPTER 11Aggregate Demand IIAggregate Demand II slide 32 2 causing the interest rate to fall IS Monetary Policy an increase in Monetary Policy an increase in MM 1 M 0 shifts the LMcurve down or to the right Y r LM1 r1 Y1Y2 r2 LM2 3 which increases investment causing output income to rise CHAPTER 11CHAPTER 11Aggregate Demand IIAggregate Demand II slide 33 Interaction between Interaction between monetary fiscal policymonetary fiscal policy Model monetary fiscal policy variables M Gand T are exogenous Real world Monetary policymakers may adjust M in response to changes in fiscal policy or vice versa Such interaction may alter the impact of the original policy change CHAPTER 11CHAPTER 11Aggregate Demand IIAggregate Demand II slide 34 The Fed s response to The Fed s response to G G 0 0 Suppose Congress increases G Possible Fed responses 1 hold Mconstant 2 hold rconstant 3 hold Yconstant In each case the effects of the G are different CHAPTER 11CHAPTER 11Aggregate Demand IIAggregate Demand II slide 35 If Congress raises G the IScurve shifts right IS1 Response 1 hold Response 1 hold MMconstantconstant Y r LM1 r1 Y1 IS2 Y2 r2If Fed holds M constant then LM curve doesn t shift Results 21 YYY 21 rrr 10 CHAPTER 11CHAPTER 11Aggregate Demand IIAggregate Demand II slide 36 If Congress raises G the IScurve shifts right IS1 Response 2 hold Response 2 hold r r constantconstant Y r LM1 r1 Y1 IS2 Y2 r2To keep rconstant F