Chapter 12/11 Aggregate Demand II: Applying the IS-LM Model This is a very substantial chapter, and among the most challenging in the text. I encourage you to go over this chapter a little more slowly than average, or at least recommend to your students that they study it extra carefully. I have included a number of in-class exercises to give students immediate reinforcement of concepts as they are covered, and also to break up the lecture. If you need to get through the material more quickly, you can omit some or all of these exercises (perhaps assigning them as homeworks, instead). To complement the book’s case study on the 2008-2009 financial crisis and recession, these slides include lots of data for you to show and discuss with your students. Your students will need to read the Case Study in their textbooks, preferably before you present this data. My hope is that the data will help bring the theory to life, and convey to students the excitement of studying macroeconomics in the current era.

Unemployment (right scale) The Great Depression 240 30 Unemployment (right scale) 220 25 200 20 billions of 1958 dollars 180 percent of labor force 15 160 10 This chart presents data from Table 12-1 on pp.352-353 of the text. For data sources, see the notes accompanying that table. Things to note: 1. The magnitude of the fall in output and increase in unemployment. In 1933, the unemployment rate is over 25%!! 2. There’s a very strong negative correlation between output and unemployment. Real GNP (left scale) 140 5 120 1929 1931 1933 1935 1937 1939

Real side of economy: Every measure hit the bottom in 1933

Great Depression: Observations Real side of economy: Output: falling Consumption: falling Investment: falling a lot Gov. purchases: fall (with a delay)

Nominal side of economy

Great Depression: Observations Nominal side: Nominal interest rate: falling Money supply (nominal): falling Price level: falling (deflation)

THE SPENDING HYPOTHESIS: Shocks to the IS curve Asserts 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 reduced consumption Oct 1929–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. (M/P increased from 52.6 to 54.5) 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 The stabilizing effects of deflation: iP g h(M/P) g LM shifts right g hY Pigou effect: iP g h(M/P ) g consumers’ wealth h g hC g IS shifts right g hY

THE MONEY HYPOTHESIS AGAIN: The effects of falling prices The destabilizing effects of unexpected deflation: debt-deflation theory iP (if unexpected) g transfers purchasing power from borrowers to lenders g borrowers spend less and lenders spend more g if borrowers’ propensity to spend is larger than lenders’, then aggregate spending falls, the IS curve shifts left, and Y falls

THE MONEY HYPOTHESIS AGAIN: The effects of falling prices There was a big deflation: P fell 25% 1929-33. A sudden fall in expected inflation means the ex-ante real interest rate rises for any given nominal rate (i ) ex ante real interest rate = i – e This could have discouraged the investment expenditure and helped cause the depression. g planned expenditure & agg. demand i g income & output i Since the deflation likely was caused by fall in M, monetary policy may have played a role here.

New Stuff: IS-LM Model with e ≠0 Y = C(Y – T) + I(i - e) + G : IS-Curve M/P = L( i, Y) : LM-Curve Expect inflation enters the model in the IS-curve

πe ≠ 0, i on the vertical axis Expected deflation shifts the IS-curve to the left LM r2 A r1 = i1 πe i2 B Y Y2 Y1 The IS-curve is drawn for a given expected inflation. At point A, πe = 0, on IS1 and r1 = i1 πe < 0 shifts IS to IS2, at B, r2 = i2 - πe => r2 = i2 - (-πe).

πe ≠ 0, i on the vertical axis Expected inflation shifts the IS-curve to the right LM B i2 r = i1 A πe r2 Y Y1 Y2 The IS-curve is drawn for a given expected inflation. At point A, πe = 0, on IS1 and r1 = i1 πe > 0 shifts IS to IS2, at B, r2 = i2 - πe

Unconventional Monetary Policy in a Liquidity Trap IS1 (πe =2%) IS2 (πe =4%) LM Y0 YF Y The Fed increases inflation and inflationary expectations.

Why another Depression is unlikely Policymakers (or their advisers) now know much more about macroeconomics: The Fed knows better than to let M fall so much, especially during a contraction. Fiscal policymakers know better than to raise taxes or cut spending during a contraction. Federal deposit insurance makes widespread bank failures very unlikely. Automatic stabilizers make fiscal policy expansionary during an economic downturn. Examples of automatic stabilizers: * the income tax: people pay less taxes automatically if their income falls * unemployment insurance: prevents income—and hence spending—from falling as much during a downturn

CASE STUDY The 2008–09 financial crisis & recession 2009: Real GDP fell to about 6% below potential, unemployment rate approached 10% Important factors in the crisis: early 2000s Federal Reserve interest rate policy subprime mortgage crisis bursting of house price bubble, rising foreclosure rates falling stock prices failing financial institutions declining consumer confidence, drop in spending on consumer durables and investment goods The following slides are meant to complement rather than substitute for the Case Study appearing in the textbook. These slides contain a wealth of data on various aspects of the current economic crisis. My hope is that these slides will spark lively discussion in your class, as students develop a context for understanding key parts of the crisis and evaluate how the parts fit together (and fit with the textbook models). Of course, the crisis is more complicated than can be captured by a few slides or a two-page case study in a textbook. I encourage you to assign your students additional readings, writing projects, or class presentations on the crisis. This is an exciting time to be learning macroeconomics!

CHAPTER SUMMARY 1. IS-LM model a theory of aggregate demand exogenous: M, G, T, P exogenous in short run, Y in long run endogenous: r, Y endogenous in short run, P in long run IS curve: goods market equilibrium LM curve: money market equilibrium 19

CHAPTER SUMMARY 2. AD curve shows relation between P and the IS-LM model’s equilibrium Y. negative slope because hP g i(M/P) g hr g iI g iY expansionary fiscal policy shifts IS curve right, raises income, and shifts AD curve right. expansionary monetary policy shifts LM curve right, raises income, and shifts AD curve right. IS or LM shocks shift the AD curve. 20