1. Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. 11-1 CHAPTER 11 Extending the Sticky-Price Model: IS-LM, International Side, and AS-AD

2. Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. 11-2 Questions What is money-market equilibrium? What is the LM curve? What determines the equilibrium level of real GDP when the central bank policy is to keep the money supply constant? What is the IS-LM framework?

3. Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. 11-3 Questions What is an IS shock? What is an LM shock? What is the relationship between shifts in the equilibrium on the IS-LM diagram and changes in the real exchange rate?

4. Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. 11-4 Questions What is the relationship between shifts in the equilibrium on the IS-LM diagram and changes in the balance of trade? What is the aggregate supply curve? What is the aggregate demand curve?

5. Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. 11-5 The Demand for Money Three facts about business and household demand for money –money demand is proportional to total nominal income (PY) –money demand has a time trend, the result of slow changes in the banking sector structure and technology –money demand is inversely related to the nominal interest rate

6. Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. 11-6 The Demand for Money Money demand is inversely related to the nominal interest rate (i=r+) because the nominal interest rate is the opportunity cost of holding money –money balances lose purchasing power at the rate of inflation () –if money balances were placed in some other asset, they would earn the prevailing market real interest rate (r)

7. Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. 11-7 The Demand for Money To keep our model simple, we will ignore the time trend in velocity The demand for money can be expressed as Money demand is proportional to real GDP and a decreasing function of the nominal interest rate

8. Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. 11-8 Money Market Equilibrium In a sticky-price model, the price level is predetermined –it cannot move instantly to make money supply equal to money demand The nominal interest rate must adjust to keep the money market in equilibrium

9. Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. 11-9 Figure 11.1 - Money Demand and Money Supply

10. Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. 11-10 Money Market Equilibrium If money supply < money demand –businesses and households want to hold larger money balances and try to borrow to increase their cash holdings –banks respond by raising interest rates –as the nominal interest rate rises, the quantity of money demanded falls –this process continues until the quantity of money demanded is equal to the money supply

11. Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. 11-11 Money Market Equilibrium If money supply > money demand –businesses and households are holding larger money balances than they want so they deposit them at the bank –banks want to increase loans and thus respond by lowering interest rates –as the nominal interest rate falls, the quantity of money demanded rises –this process continues until the quantity of money demanded is equal to the money supply

12. Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. 11-12 The LM Curve Because the demand for money depends on the level of real GDP, if the money stock is constant, the equilibrium nominal interest rate will vary whenever real GDP varies

13. Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. 11-13 Figure 11.2 - Money Demand Varies as Total Income Y Varies

14. Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. 11-14 The LM Curve The LM curve shows the relationship between the level of real GDP and the equilibrium nominal interest rate that clears the money market The LM curve slopes upward –at a higher level of real GDP, money demand is higher and therefore the equilibrium nominal interest rate is higher

15. Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. 11-15 Figure 11.3 - From Money Demand to the LM Curve

16. Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. 11-16 The LM Curve The equation for the LM curve is Increases in the money supply shift the LM curve to the right A decline in the price level shifts the LM curve to the right

17. Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. 11-17 The IS-LM Framework As long as we know the expected inflation rate, we can plot the IS and LM curves on the same axis The equilibrium levels of real GDP and the interest rate occur at the point where the IS and LM curves intersect –the economy is in equilibrium in both the goods market and the money market

18. Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. 11-18 Figure 11.4 - The IS-LM Diagram

19. Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. 11-19 IS-LM Equilibrium Example (assume that  is constant at 3%) –IS curve: Y = $10,000 - $20,000r –LM curve: Y = $1,000 + $100,000(r+)

20. Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. 11-20 Figure 11.5 - IS-LM Equilibrium Example

21. Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. 11-21 IS Shocks Any change in economic policy or the economic environment that increases autonomous spending shifts the IS curve to the right –the new equilibrium will have a higher level of real GDP and a higher real interest rate –how the total effect is divided between increased interest rates and increased real GDP depends on the slope of the LM curve

22. Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. 11-22 Figure 11.6 - Effect of a Positive IS Shock

23. Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. 11-23 An IS Shock Example –initial IS curve: Y = $10,000 - $20,000r –LM curve: Y = $1000 + $100,000(r+3) –initial equilibrium: r=5%; Y = $9,000 –autonomous spending increases –new IS curve: Y = $10,300 - $20,000r

24. Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. 11-24 Figure 11.7 - Calculating the Effect of an IS Shift

25. Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. 11-25 LM Shocks An increase in the money stock will shift the LM curve to the right –the new equilibrium position will have a higher level of equilibrium real GDP and a lower interest rate

26. Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. 11-26 Figure 11.8 - Effect of an Expansionary LM Shock

27. Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. 11-27 An LM Shock Example –IS curve: Y = $10,000 - $20,000r –initial LM curve: Y=$1000+$100,000(r+3) –initial equilibrium: r=5%; Y=$9,000 –the money supply increases –new LM curve: Y=$2200 + $100,000(r+3)

28. Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. 11-28 Figure 11.9 - An Expansionary Shift in the LM Curve

29. Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. 11-29 Interest Rate Targets The case in which the central bank is targeting the interest rate can be viewed in the IS-LM framework An interest rate target can be seen as a flat, horizontal LM curve at the target level of the interest rate

30. Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. 11-30 Figure 11.10 - IS-LM Framework with an Interest Rate Target

31. Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. 11-31 Changes that Affect the LM Curve Any change in the nominal money stock, in the price level, or in the trend velocity of money will shift the LM curve Any change in the interest sensitivity of money demand will change the slope of the LM curve

32. Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. 11-32 Changes that Affect the LM Curve The IS-LM diagram is drawn with the long-term, risky, real interest rate on the vertical axis The LM curve is a relationship between the short-run nominal interest rate and the level of real GDP at a fixed level of the money supply

33. Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. 11-33 Changes that Affect the LM Curve As long as the spread between the short-term, safe, nominal interest rate and the long-term, risky, real interest rate is constant, there are no complications in drawing the LM curve onto the same diagram as the IS curve

34. Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. 11-34 Changes that Affect the LM Curve If the expected rate of inflation, the risk premium, or the term premium between short- and long-term interest rates changes, the LM curve will shift –changes in financial market expectations of future Federal Reserve policy, future interest rates, or changes in the risk tolerance of bond traders will shift the LM curve

35. Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. 11-35 Figure 11.11 - An Increase in Expected Inflation Moves the LM Curve Downward

36. Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. 11-36 Changes that Affect the IS Curve Shifts in the IS curve are more frequent than shifts in the LM curve Any change in the interest sensitivity of investment, the sensitivity of exports to the exchange rate, or the sensitivity of the exchange rate to the domestic interest rate will change the slope of the IS curve

37. Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. 11-37 Changes that Affect the IS Curve Anything that affects MPE will change the slope and the position of the IS curve –this includes changes in the MPC, tax rates, and the propensity to import Any change in autonomous spending will shift the IS curve

38. Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. 11-38 The IS-LM Framework and the Exchange Rate In the sticky-price model, the real exchange rate () is equal to As long as the domestic real interest rate does not change, domestic conditions will have no impact on the exchange rate

39. Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. 11-39 The IS-LM Framework and the Exchange Rate Changes in the IS and LM curves that change the domestic real interest rate will alter the real exchange rate by an amount equal to ( r  r) –a rightward shift in the IS curve or a leftward shift in the LM curve will lower the real exchange rate –a leftward shift in the IS curve or a rightward shift in the LM curve will raise the real exchange rate

40. Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. 11-40 Figure 11.12 - IS-LM and the Exchange Rate

41. Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. 11-41 The IS-LM Framework and the Balance of Trade Changes in the domestic interest rate affect the real exchange rate which affects gross exports Changes in total income affect imports The effect on net exports is the difference between these two effects

42. Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. 11-42 Figure 11.13 - Effect of a Change in Domestic Conditions on the Exchange Rate and the Balance of Trade

43. Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. 11-43 An LM Shock and the Balance of Trade Example –initial IS curve: Y=$10,000 - $20,000r –initial LM curve: Y=$1000+$100,000(r+3) –initial equilibrium: r=5%; Y=$9,000 –the money supply increases –new LM curve: Y=$2200+$100,000(r+3) –new equilibrium: r=4%; Y=$9,200

44. Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. 11-44 Figure 11.14 - Effects of Expansionary Monetary Policy

45. Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. 11-45 An LM Shock and the Balance of Trade Example (continued) –the decrease in the real interest rate increases the exchange rate by [(- r  r)= -10  (-.01)=0.10] and the rise in the real exchange rate increases gross exports by [(X   )=$200  0.1=$20] –the increase in real national income increases imports by [(IM y  Y)=$0.15  $200=$30] –net exports falls by $10

46. Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. 11-46 International Shocks Three types of international shocks will affect the IS-LM equilibrium –a shift in foreign demand for exports –a shift in the foreign real interest rate –a change in foreign exchange speculators’ view about the fundamental value of the exchange rate

47. Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. 11-47 International Shocks An increase in export demand is an increase in autonomous spending (A 0 ) –the IS curve shifts rightward by an amount equal to A 0 /(1-MPS) –equilibrium real GDP rises and the real interest rate rises as well (if the LM curve is upward sloping)

48. Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. 11-48 Figure 11.15 - Effect of an Increase in Foreign Demand for Exports

49. Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. 11-49 International Shocks An increase in the foreign interest rate raises the value of the exchange rate and boosts exports –the IS curve shifts to the right –equilibrium real GDP rises and the real interest rate also increases (if the LM curve is upward sloping)

50. Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. 11-50 International Shocks If foreign exchange speculators lose confidence in their home currency, the exchange rate will rise –the IS curve will shift to the right –equilibrium real GDP will rise and the real interest rate will increase (assuming that the LM curve is upward sloping)

51. Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. 11-51 International Shocks Example –LM curve: Y = $1000 + $100,000(r+3) –initial IS curve: Y = $10,000 - $20,000r –initial equilibrium: r=5%; Y= $9,000 –foreign exchange speculators lose confidence in the value of home currency –new IS curve: Y = $10,120 - $20,000r –new equilibrium: r=5.1%; Y = $9,100

52. Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. 11-52 Aggregate Demand If the nominal money supply is fixed, an increase in the price level shifts the LM curve to the left –the equilibrium real interest rate rises –the equilibrium level of real GDP falls If we plot the level of equilibrium real GDP for each possible price level, we will get the aggregate demand curve –it will be downward sloping

53. Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. 11-53 Figure 11.16 - An Increase in the Price Level Shifts the LM Curve Left (If the Nominal Money Supply is Fixed)

54. Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. 11-54 Figure 11.17 - From the IS-LM Diagram to the Aggregate Demand Curve

55. Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. 11-55 Monetary Policy and Aggregate Demand Modern central banks alter the money supply in response to changes in the economy –when inflation rises, the central bank tends to increase the real interest rate

56. Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. 11-56 Monetary Policy and Aggregate Demand The Taylor rule is a simple model of how central banks act –the central bank has a target value of inflation (’) and an estimate of what the normal real interest rate should be (r*) –if inflation is higher than ’, the central bank raises the real interest rate –if inflation is lower than ’, the central bank lowers the real interest rate

57. Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. 11-57 Monetary Policy and Aggregate Demand The Taylor rule can be expressed in equation form: where ” determines how aggressively the central bank reacts to inflation

58. Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. 11-58 Monetary Policy and Aggregate Demand The Taylor rule can be substituted into the equation for the IS curve Simplifying, we get

59. Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. 11-59 Monetary Policy and Aggregate Demand The monetary policy function is a relationship between the inflation rate and real GDP –it assumes that the Federal Reserve is engaged in the economy trying to keep inflation close to its target

60. Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. 11-60 Figure 11.18 - The Monetary Policy Reaction Function

61. Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. 11-61 Aggregate Supply When real GDP is greater than potential output, inflation is likely to be higher than previously anticipated –inflation will like accelerate When real GDP is lower than potential output, inflation is likely to be lower than previously anticipated –the inflation rate will likely fall (may even end up with deflation)

62. Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. 11-62 Aggregate Supply The relationship between real GDP (relative to potential output) and the rate of inflation (relative to its previously-expected value) is the short-run aggregate supply curve

63. Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. 11-63 Aggregate Supply The short-run aggregate supply curve can be expressed in equation form

64. Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. 11-64 Figure 11.19 - Output Relative to Potential and the Inflation Rate

65. Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. 11-65 Aggregate Supply and Aggregate Demand Where the aggregate supply and aggregate demand curves cross is the current level of real GDP and the current inflation rate

66. Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. 11-66 Figure 11.20 - Aggregate Supply and Aggregate Demand

67. Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. 11-67 Short-Run Aggregate Supply High levels of real GDP are associated with high inflation and a high price level for many reasons –when demand for products is stronger than anticipated, firms raise their prices –when aggregate demand is higher than potential output, some industries may reach the limits of capacity

68. Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. 11-68 Chapter Summary The money market is in equilibrium when the level of total incomes and of the short-term nominal interest rate is just right to make households and businesses want to hold all the real money balances that exist in the economy

69. Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. 11-69 Chapter Summary When the central bank’s policy keeps the money supply fixed--or when there is no central bank--the LM curve consists of those combinations of interest rates and real GDP levels at which money demand equals money supply

70. Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. 11-70 Chapter Summary When the central bank’s policy keeps the money supply fixed--or when there is no central bank--then the point at which the IS and LM curves cross determines the equilibrium level of real GDP and the interest rate

71. Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. 11-71 Chapter Summary The IS-LM framework consists of two equilibrium conditions –the IS curve shows those combinations of interest rates and real GDP levels at which aggregate demand is equal to total production –the LM curve shows those combinations of interest rates and real GDP levels at which money demand is equal to money supply

72. Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. 11-72 Chapter Summary An IS shock is any shock to the level of total spending as a function of the domestic real interest rate –an IS shock shifts the position of the IS curve –an expansionary IS shock raises real GDP and the real interest rate

73. Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. 11-73 Chapter Summary An LM shock is a shock to money demand or money supply –an LM shock shifts the position of the LM curve –an expansionary LM shock raises real GDP and lowers the real interest rate

74. Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. 11-74 Chapter Summary Anything that affects the level of the real interest rate on the IS-LM diagram affects the real exchange rate –increases in the real interest rate reduce the value of the real exchange rate, holding other things constant

75. Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. 11-75 Chapter Summary A number of different international shocks can also affect the real exchange rate –a collapse in foreign exchange speculator confidence in the currency raises the real exchange rate –an increase in the real interest rate abroad also raises the real exchange rate

76. Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. 11-76 Chapter Summary The aggregate supply curve captures the relationship between aggregate demand and the price level –the higher is real GDP, the higher the price level and inflation rate are likely to be

77. Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. 11-77 Chapter Summary The aggregate demand relationship arises because changes in the price level and inflation rates cause shifts in the determinants of aggregate demand--either directly as changes in the price level change the money stock, or indirectly as changes in the inflation rate change the interest rate target of the central bank

78. Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. 11-78 Chapter Summary Together, the aggregate demand and aggregate supply curves make up the AS-AD framework, which allows us to analyze the impact of changes in economic policy and the economic environment not just on real GDP but also on the price level and the inflation rate as well