Chapter 12/11 Aggregate Demand II: Applying the IS-LM Model Part 3 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 Real side of economy: Every measure hit the bottom in 1933

Great Depression: Observations Real side of economy: Output: falling - 30% Consumption: falling - 20% Investment: falling a lot Gov. purchases: fall (with a delay)

Nominal Side of the Economy Nominal side of economy

Great Depression: Observations Nominal side: Nominal interest rate: falling dramatically Money supply (nominal): falling Price level: falling (deflation) Real Money balance (M/P) initially rises and then falls

What Happened? 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 1929 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. There are 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 - more: 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. How does a deflation affect the economy?

THE MONEY HYPOTHESIS AGAIN: The effects deflation - falling prices 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 deflation – 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 - expectations 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 spending and helped cause the depression. planned expenditure falls => aggregate demand falls 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, E() ≠ 0 IS-Curve: Y = C(Y – T) + I(i - e) + G LM-Curve: M/P = L( i, Y) Expect inflation enters the model in the IS-curve if we put i on the vertical axis.

E(π) ≠ 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, E(π) = 0, on IS1 and r1 = i1. If E(π) < 0, IS1 shifts to IS2. At B, r2 = i2 – E(π) => r2 = i2 - (-E(π)).

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, E(π) = 0, on IS1 and r1 = i1 If E(π) > 0, IS1 to IS2, at B, r2 = i2 – E(π)

Money Demand - Money Supply, Liquidity Trap MS1 MS2 MS4 r MS3 r1 A B C D r0 Md M/P Liquidity Trap - At very low interest rates, investors are indifferent between bonds and money – money demand becomes perfectly elastic. Increase in the money supply is held as cash.

Derivation of the LM-Curve With Liquidity Trap MS1 πe = 0 Md (Y1) LM Slope = (g/h) A r1 A r1 Md (Y2) (M/P)d = f + gY - hi B r2 B r2 Md (Y3) C r0 C r0 Y M/P Y3 Y2 Y1 As income falls below Y3 , ΔM has no effect on the interest rate. The LM-curve is horizontal.

Conventional Monetary Policy in a Liquidity Trap The economy is at Y0 which is below full employment potential. Monetary policy is ineffective in pushing the economy beyond Y1. πe = 0 r IS LM0 LM1 LM2 A r B Y0 Y1 YF Y Argh!!!

Fiscal Policy in a Liquidity Trap πe = 0 r IS1 IS2 LM Y0 Y1 YF Y But, fiscal policy seems to work and you get the full multiplier effect as you move from Y0 to Y1. Why do you get the full multiplier effect?

Fiscal Policy in a Liquidity Trap πe = 0 r IS3 IS1 IS2 LM Y0 Y1 YF Y

Unconventional Monetary Policy in a Liquidity Trap IS1 (πe =2%) IS2 (πe =4%) LM Y0 YF Y The Fed increases the money supply and signals its intention is to increase inflation and inflationary expectations.