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1 Econ 101 Intermediate Macro Theory Lecture notes Professor Cetorelli UC Davis Fall 2003 Lecture 17 CHAPTER 4CHAPTER 4Money and InflationMoney and Inflation slide 1 Back to the IS LM CHAPTER 10CHAPTER 10Aggregate Demand IAggregate Demand I slide 2 Let me repeat this Let me repeat this How does the Fed reduce or increase the money supply To reduce money in circulation the Fed will actually go in the bond market and sell big quantities of government bonds to commercial banks The cash received by banks is not put back in circulation Hence money supply is reduced Also by creating an excess supply of bonds the Fed make their price go down hence the interest rate to go up CHAPTER 10CHAPTER 10Aggregate Demand IAggregate Demand I slide 3 Clarification pointClarification point The government bonds used by the Fed are bonds previouslyissued by the government The Fed does notissue government bonds She goes in the secondary market for government bonds and trade them Hence selling bonds does not imply any effect on the government deficit nor on its debt 2 CHAPTER 10CHAPTER 10Aggregate Demand IAggregate Demand I slide 4 How the Fed raises the interest rateHow the Fed raises the interest rate To increase r Fed sells government bonds It does so until the price of bonds goes down enough that the correspondent interest rate goes up where it was intended to In the process the cash received from the sale is taken away from circulation M P real money balances r interest rate 1 M P L r r1 r2 2 M P CHAPTER 11CHAPTER 11Aggregate Demand IIAggregate Demand II slide 5 The intersection of IS and LM determines the unique combination of Yand r that satisfies equilibrium in both markets Equilibrium in the Equilibrium in the ISIS LMLM ModelModel For the economy to be in equilibrium all markets must be in equilibrium at the same time YC YTI rG M PL r Y IS Y r LM r1 Y1 Remember we are in the short run IS LM CHAPTER 11CHAPTER 11Aggregate Demand IIAggregate Demand II slide 6 With the IS LM model you can analyze the total effect of any change in fiscal policy taxes and or government spending and monetary policy money supply You can also analyze the effect of any exogenous shock to the economy CHAPTER 11CHAPTER 11Aggregate Demand IIAggregate Demand II slide 7 Example from last timeExample from last time Stock market boom Firms are getting bigger more production hence more income hence more consumption Consequently IS shifts to the right Now because income increases people need more money The increase in money demand makes interest rates to go up This is a movement ALONG the LM curve following the shift in IS There is no shift in the LM curve Because r goes up investment will slow down So eventually the increase in Y is not as high as it could have had interest rates stayed constant 3 CHAPTER 11CHAPTER 11Aggregate Demand IIAggregate Demand II slide 8 Important point to remember Important point to remember In reality monetary policymakers may adjust Min 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 9 ISIS LM and Aggregate DemandLM and Aggregate Demand So far we ve been using the IS LMmodel to analyze the short run when the price level is assumed fixed However a change in Pwould shift the LMcurve and therefore affect Y The aggregate demand curve introduced in chap 9 captures this relationship between Pand Y CHAPTER 11CHAPTER 11Aggregate Demand IIAggregate Demand II slide 10 Monetary policy and the Monetary policy and the ADAD curvecurve Y P IS LM M2 P1 LM M1 P1 AD1 P1 Y1 Y1 Y2 Y2 r1 r2 The Fed can increase aggregate demand M LMshifts right AD2 Y r r I Yat each value of P CHAPTER 11CHAPTER 11Aggregate Demand IIAggregate Demand II slide 11 Y2 Y2 r2 Y1 Y1 r1 Fiscal policy and the Fiscal policy and the ADAD curvecurve Y r Y P IS1 LM AD1 P1 Expansionary fiscal policy Gand or T increases agg demand T C IS shifts right Yat each value of P AD2 IS2 4 CHAPTER 11CHAPTER 11Aggregate Demand IIAggregate Demand II slide 12 ISIS LMLM and and ADAD AS AS in the short run long runin the short run long run Recall from Chapter 9 The force that moves the economy from the short run to the long run is the gradual adjustment of prices YY YY YY rise fall remain constant In the short run equilibrium if then over time the price level will CHAPTER 11CHAPTER 11Aggregate Demand IIAggregate Demand II slide 13 The SR and LR effects of an The SR and LR effects of an ISIS shockshock A negative ISshock shifts ISand ADleft causing Yto fall Y r Y PLRAS Y LRAS Y IS1 SRAS1 P1 LM P1 IS2 AD2 AD1 CHAPTER 11CHAPTER 11Aggregate Demand IIAggregate Demand II slide 14 The SR and LR effects of an The SR and LR effects of an ISIS shockshock Y r Y PLRAS Y LRAS Y IS1 SRAS1 P1 LM P1 IS2 AD2 AD1 In the new short run equilibrium YY CHAPTER 11CHAPTER 11Aggregate Demand IIAggregate Demand II slide 15 The SR and LR effects of an The SR and LR effects of an ISIS shockshock Y r Y PLRAS Y LRAS Y IS1 SRAS1 P1 LM P1 IS2 AD2 AD1 In the new short run equilibrium YY Over time Pgradually falls which causes SRASto move down M Pto increase which causes LM to move down 5 CHAPTER 11CHAPTER 11Aggregate Demand IIAggregate Demand II slide 16 AD2 The SR and LR effects of an The SR and LR effects of an ISIS shockshock Y r Y PLRAS Y LRAS Y IS1 SRAS1 P1 LM P1 IS2 AD1 Over time Pgradually falls which causes SRASto move down M Pto increase which causes LM to move down SRAS2 P2 LM P2 CHAPTER 11CHAPTER 11Aggregate Demand IIAggregate Demand II slide 17 AD2 SRAS2 P2 LM P2 The SR and LR effects of an The SR and LR effects of an ISIS shockshock Y r Y PLRAS Y LRAS Y IS1 SRAS1 P1 LM P1 IS2 AD1 This process continues until economy reaches a long run equilibrium with YY CHAPTER 11CHAPTER 11Aggregate Demand IIAggregate Demand II slide 18 EXERCISE EXERCISE Analyze SR LR effects of Analyze SR LR effects of MM a Draw the IS LMand AD AS diagrams as shown here b Suppose Fed increases M Show the short run effects on your graphs c Show what happens in the transition from the short run to the long run d How do the new long run equilibrium values of the endogenous variables compare to their initial values Y r Y PLRAS Y LRAS Y IS SRAS1 P1 LM M1 P1 AD1 CHAPTER 11CHAPTER 11Aggregate Demand IIAggregate Demand II slide 19 The Great DepressionThe Great Depression 120 140 160 180 200 220 240 192919311933193519371939 billions of 1958 dollars 0 5 10 15 20 25 30 percent of labor force Unemployment right scale Real GNP left scale 6 CHAPTER 11CHAPTER 11Aggregate Demand IIAggregate Demand II slide 20 CHAPTER 11CHAPTER 11Aggregate Demand IIAggregate Demand II slide 21 CHAPTER 11CHAPTER 11Aggregate Demand IIAggregate Demand II slide 22 The Spending Hypothesis The Spending Hypothesis Shocks to the IS CurveShocks to the IS Curve asserts that the Depression was largely due to an exogenous fall in the demand for goods services a leftward shift of the IS curve evidence output and interest rates both fell which is what a leftward ISshift would cause CHAPTER 11CHAPTER 11Aggregate Demand IIAggregate Demand II slide 23 The Spending Hypothesis The Spending Hypothesis Reasons for the IS shiftReasons for the IS shift 1 Stock market crash exogenous C Oct Dec 1929 S P 500 fell 17 Oct 1929 Dec 1933 S P 500 fell 71 2 Drop in investment correction after overbuilding in the 1920s widespread bank failures made it harder to obtain financing for investment 3 Contractionary fiscal policy in the face of falling tax revenues and increasing deficits politicians raised tax rates and cut spending major concern was balancing the budget 7 CHAPTER 11CHAPTER 11Aggregate Demand IIAggregate Demand II slide 24 The Money Hypothesis The Money Hypothesis A Shock to the LM CurveA Shock to the LM Curve asserts that the Depression was largely due to huge fall in the money supply was the Fed s fault evidence M1 fell 25 during 1929 33 But two problems with this hypothesis 1 Pfell even more so M Pactually rose slightly during 1929 31 2 nominal interest rates fell which is the opposite of what would result from a leftward LMshift CHAPTER 11CHAPTER 11Aggregate Demand IIAggregate Demand II slide 25 The Money Hypothesis Again The Money Hypothesis Again The Effects of Falling PricesThe Effects of Falling Prices asserts that the severity of the Depression was due to a huge deflation Pfell 25 during 1929 33 This deflation was probably caused by the fall in M so perhaps money played an important role after all In what ways does a deflation affect the economy CHAPTER 11CHAPTER 11Aggregate Demand IIAggregate Demand II slide 26 The Money Hypothesis Again The Money Hypothesis Again The Effects of Falling PricesThe Effects of Falling Prices The stabilizing effects of deflation P M P LMshifts right Y Pigou effect P M P consumers wealth C ISshifts right Y Economists in the 30 s believed this and hoped drop in P would stabilize economy CHAPTER 11CHAPTER 11Aggregate Demand IIAggregate Demand II slide 27 The Money Hypothesis Again The Money Hypothesis Again The Effects of Falling PricesThe Effects of Falling Prices The destabilizing effects of unexpected deflation debt deflation theory P if unexpected transfers purchasing power from borrowers to lenders borrowers spend less lenders spend more if borrowers propensity to spend is larger than lenders then aggregate spending falls the IScurve shifts left and Yfalls 8 CHAPTER 11CHAPTER 11Aggregate Demand IIAggregate Demand II slide 28 The Money Hypothesis Again The Money Hypothesis Again The Effects of Falling PricesThe Effects of Falling Prices The destabilizing effects of expected deflation e r for each value of i I because I I r planned expenditure agg demand income output CHAPTER 11CHAPTER 11Aggregate Demand IIAggregate Demand II slide 29 So what happened So what happened Falling prices seem the leading cause of the depression Such a big fall can only be explained as a result of falling M So may be the Fed got that wrong

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