Economic Model

to Explain Economic Fluctuation

 The Big Picture
The Quantity
Theory of
Loanable Money
Funds Theory
IS Curve
Keynesian
Cross
AD Curve

Explanation of
Theory of AD & AS
LM Curve Short Run
Liquidity Model
Fluctuations
Preference
AS Curve
Deriving the IS Curve by Using The Loanable
Funds Model
(a) The L.F. model (b) The IS curve

r S2 S1 r

r2 r2

r1 r1
I (r )
IS
S, I Y2 Y1 Y
Deriving the IS Curve by Using The
Keynesian Cross

E E =Y E =C +I (r )+G
2
r  I
E =C +I (r1 )+G
 E
I
 Y
Y1 Y2 Y
r
r1

r2
IS
Y1 Y2 Y
Shifting the IS curve: an increase in government
purchases (G)
At any value of r,
E E =Y E =C +I (r )+G
1 2
G  E  Y
…so the IS curve shifts
E =C +I (r1 )+G1
to the right.

The horizontal
distance of the Y1 Y2 Y
r
IS shift equals
r1
1
Y  G
1 MPC Y
IS1 IS2
Y1 Y2 Y
Shifting the IS curve: a decrease in taxes (T)

At any value of r,
E E =Y E =C +I (r )+G
2 1
T  E  Y
…so the IS curve shifts
E =C1 +I (r1 )+G
to the right.

The horizontal
distance of the Y1 Y2 Y
r
IS shift equals
r1
 MPC
Y  T Y
1  MPC IS2
IS1
Y1 Y2 Y
Deriving the LM curve

 Theory of Liquidity Preference: A simple

theory in which the interest rate
is determined by money supply and
money demand.
Deriving the LM curve

(a) The market for

(b) The LM curve
real money balances
r r
LM

r2 r2

L (r , Y2 )
r1 r1
L (r , Y1 )
M1 M/P Y1 Y2 Y
P
How M shifts the LM curve
(a) The market for
(b) The LM curve
real money balances
r r
LM2

LM1
r2 r2

r1 r1
L ( r , Y1 )

M2 M1 M/P Y1 Y
P P
The short-run equilibrium

The short-run equilibrium is the r

combination of r and Y that LM
simultaneously satisfies the
equilibrium conditions in the
goods & money markets:

Y  C (Y  T )  I (r )  G IS
M P  L (r ,Y ) Y
Equilibrium
interest Equilibrium
rate level of
income
 Policy analysis with the IS -LM model
An increase in government purchases
1. IS curve shifts right r
1 LM
by G
1 MPC
causing output & r2
2.
income to rise. r1
2. This raises money
1. IS2
demand, causing the
interest rate to rise… IS1
Y
3. …which reduces investment, so Y1 Y2
the final increase in Y 3.
1
is smaller than G
1 MPC
 A tax cut
Consumers save (1MPC) of r
the tax cut, so the initial LM
boost in spending is smaller
for T than for an equal r2
G… 2.
r1
and the IS curve shifts by
1. IS2
MPC
1. T IS1
1 MPC
Y
Y1 Y2
2. …so the effects on r 2.
and Y are smaller for T
than for an equal G.
STRONG AND WEAK EFFECTS OF FISCAL
POLICY
 Monetary policy: An increase in M
r
1. M > 0 shifts LM1
the LM curve down
(or to the right) LM2

r1
2. …causing the interest
rate to fall r2

3. …which increases IS
investment, causing Y
Y1 Y2
output & income to
rise.
STRONG EFFECTS OF MONETERY EXPANSION
WEAK EFFECTS OF MONETERY EXPANSION
Policy Mix
Deriving the AD curve
r LM(P2)
Intuition for slope
LM(P1)
of AD curve: r2
P  (M/P ) r1

 LM shifts left IS
Y2 Y1 Y
 r P
 I P2
 Y P1
AD
Y2 Y1 Y
Deriving the AD curve with simple
algebra
 IS curve
Y = C(Y  T) + I(r) + G (1)
 Suppose that the consumption function is
C = a + b(Y – T) (2)
 and the investment function is
I = c – dr (3)
 Substitute eq.(2) and (3) into (1)
Y = [a + b(Y – T)] + (c – dr) + G (4)
 Deriving the AD curve with simple
algebra
 Bringing all the Y terms to left-hand side and
rearranging the terms on the right-hand side :
Y – bY = (a + c) + (G – bT) – dr (5)

and solve for Y

ac 1 b d
Y  G T r (6)
1 b 1 b 1 b 1 b
Deriving the AD curve with simple
algebra
 LM curve
 The money market equilibrium condition
M/P = L(r, Y) (1)
 Suppose that the money demand function is
linear, that is
L(r, Y) = eY – fr (2)
 Substitute eq.(2) into (1)
M/P = eY – fr (3)
 Rearranging (3) and solve for r
r = (e/f)Y – (1/f)M/P (4)
 Deriving the AD curve with simple
algebra
 AD curve
 Substitute r (eq.(4) of LM function) into IS function

ac 1 b d
Y  G T [(e / f )Y  (1 / f ) M / P]
1 b 1 b 1 b 1 b
z (a  c) z  zb d
Y  G T M /P
1 b 1 b 1 b (1  b)[ f  de /(1  b)]
where z  f /[ f  de /(1  b)]
 Deriving the AD curve by using the
quantity theory of money
 The quantity theory says
that P
MV = PY
 Rewrite in the term of the
supply and demand for real
balances
M/P = (M/P)d = kY P2
where k = 1/V
 Assume that V is constant P1
and M is fixed, then the AD
quantity equation yield a
negative relationship
Y2 Y1 Y
between the price level
P and output Y
Monetary policy and the AD curve
The Fed can increase r LM(M1/P1)
aggregate demand: r1 LM(M2/P1)
M  LM shifts right r2
 r IS

 I Y1 Y2 Y
P
 Y at each
value of P P1

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

AD2
AD1
Y1 Y2 Y
 IS-LM and AD-AS
in the short run & long run
The force that moves the economy from the short run
to the long run is the gradual adjustment of prices.

In the short-run then over time, the

equilibrium, if price level will
Y Y rise
Y Y fall

Y Y remain constant
The SR and LR effects of an IS shock

A r LRAS
A negative
negative ISIS shock
shock LM(P1)
shifts
shifts IS
IS and
and AD
AD left,
left,
causing
causing YY to
to fall.
fall.
IS1
IS2
Y Y
P LRAS
P1 SRAS1

AD1
AD2
Y Y
The SR and LR effects of an IS shock

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

AD1
AD2
Y Y
The SR and LR effects of an IS shock

r LRAS LM(P1)
In
In the
the new
new short-run
short-run
equilibrium, Y  Y
equilibrium,
IS1
IS2
Over
Over time,
time, PP gradually
gradually
Y Y
falls,
falls, which
which causes
causes
•• SRAS P LRAS
SRAS toto move
move down.
down.
•• M/P
M/P to
to increase,
increase, which
which P1 SRAS1

causes
causes LM
LM
to
to move
move down.
down. AD1
AD2
Y Y
The SR and LR effects of an IS shock

r LRAS LM(P1)
LM(P2)

IS1
IS2
Over
Over time,
time, PP gradually
gradually
Y Y
falls,
falls, which
which causes
causes
•• SRAS P LRAS
SRAS toto move
move down.
down.
•• M/P
M/P to
to increase,
increase, which
which P1 SRAS1

causes
causes LM
LM P2 SRAS2
to
to move
move down.
down. AD1
AD2
Y Y
The SR and LR effects of an IS shock

r LRAS LM(P1)
LM(P2)
This
This process
process continues
continues until
until
economy
economy reaches
reaches aa long-
long- IS1
run
run equilibrium
equilibrium with
with IS2
Y Y Y Y
P LRAS
P1 SRAS1
P2 SRAS2
AD1
AD2
Y Y
 EXERCISE:
Analyze SR & LR effects of M
r LRAS LM(M1/P1)
a. Draw the IS-LM and AD-AS
diagrams as shown here.
b. Suppose Fed increases M.
Show the short-run effects on IS
your graphs.
c. Show what happens in the Y Y
transition from the short run to
P LRAS
the long run.
d. How do the new long-run
equilibrium values of the P1 SRAS1

endogenous variables compare

to their initial values? AD1
Y Y
 The Great Depression
240 30
Unemployment
220 (right scale) 25
billions of 1958 dollars

percent of labor force

200 20

180 15

160 10

140 Real GNP 5

(left scale)
120 0
1929 1931 1933 1935 1937 1939
THE SPENDING HYPOTHESIS:
Shocks to the IS curve
 asserts that the Depression was largely due
to an exogenous fall in the demand for goods
& services – a leftward shift of the IS curve.
 evidence:
output and interest rates both fell, which is
what a leftward IS shift would cause.
THE SPENDING HYPOTHESIS:
Reasons for the IS shift
 Stock market crash  exogenous C
 Oct-Dec 1929: S&P 500 fell 17%
 Oct 1929-Dec 1933: S&P 500 fell 71%
 Drop in investment
 “correction” after overbuilding in the 1920s
 widespread bank failures made it harder to obtain
financing for investment
 Contractionary fiscal policy
 Politicians raised tax rates and cut spending to combat
increasing deficits.
THE MONEY HYPOTHESIS:
A shock to the LM curve
 asserts that the Depression was largely due
to huge fall in the money supply.
 evidence:
M1 fell 25% during 1929-33.
 But, two problems with this hypothesis:
 P fell even more, so M/P actually rose slightly
during 1929-31.
 nominal interest rates fell, which is the opposite of
what a leftward LM shift would cause.
THE MONEY HYPOTHESIS AGAIN:
The effects of falling prices
 asserts that the severity of the Depression
was due to a huge deflation:
P fell 25% during 1929-33.
 This deflation was probably caused by the fall
in M, so perhaps money played an important
role after all.
 In what ways does a deflation affect the
economy?
THE MONEY HYPOTHESIS AGAIN:
The effects of falling prices
 The stabilizing effects of deflation:
 P  (M/P )  LM shifts right  Y
 Pigou effect:
P  (M/P )
 consumers’ wealth 
 C
 IS shifts right
 Y
THE MONEY HYPOTHESIS AGAIN:
The 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 
THE MONEY HYPOTHESIS AGAIN:
The 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 IS curve shifts left, and Y falls
to be continued ....