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C H A P T E R 2 4 Monetary and Fiscal Policy in the ISLM Model 581
QUIZ Questions and Problems
Questions marked with an asterisk are answered at the end of the book in an appendix, ÒAnswers to Selected Questions and Problems.Ó
1.If taxes and government spending rise by equal amounts, what will happen to the position of the IS curve? Explain this with a Keynesian cross diagram.
*2. What happened to the IS curve during the Great Depression when investment spending collapsed? Why?
3.What happens to the position of the L M curve if the Fed decides that it will decrease the money supply to fight inflation and if, at the same time, the demand for money falls?
*4. ÒAn excess demand for money resulting from a rise in the demand for money can be eliminated only by a rise in the interest rate.Ó Is this statement true, false, or uncertain? Explain your answer.
In Problems 5Ð15, demonstrate your answers with an ISLM diagram.
5.In late 1969, the Federal Reserve reduced the money supply while the government raised taxes. What do you think should have happened to interest rates and aggregate output?
*6. ÒThe high level of interest rates and the rapidly growing economy during Ronald ReaganÕs third and fourth years as president can be explained by a tight monetary policy combined with an expansionary fiscal policy.Ó Do you agree? Why or why not?
7.Suppose that the Federal Reserve wants to keep interest rates from rising when the government
sharply increases military spending. How can the Fed do this?
*8. Evidence indicates that lately the demand for money has become quite unstable. Why is this finding important to Federal Reserve policymakers?
9.ÒAs the price level rises, the equilibrium level of output determined in the ISL M model also rises.Ó Is this statement true, false, or uncertain? Explain your answer.
*10. What will happen to the position of the aggregate demand curve if the money supply is reduced when government spending increases?
11.An equal rise in government spending and taxes will have what effect on the position of the aggregate demand curve?
*12. If money demand is unaffected by changes in the interest rate, what effect will a rise in government spending have on the position of the aggregate demand curve?
Using Economic Analysis to Predict the Future
13.Predict what will happen to interest rates and output if a stock market crash causes autonomous consumer expenditure to fall.
*14. Predict what will happen to interest rates and aggregate output when there is an autonomous export boom.
15.If a series of defaults in the bond market make bonds riskier and as a result the demand for money rises, predict what will happen to interest rates and aggregate output.
Web Exercises
1. We can continue our study of the ISLM framework by |
www.worldbank.org.ru/wbimo/islmcl/islmcl.html. This |
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reviewing a dynamic interactive site. Go to http://nova |
site, sponsored by the World Bank, allows you to |
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.umuc.edu/~black/econ0.html. Assume that the |
make changes and to observe immediately their |
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change in government spending is $25, the tax rate is |
impact on the ISLM model. |
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30%, the velocity of money is 12, and the money sup- |
a. Increase G from 1,200 to 1,400. What happens to |
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ply is increased by $2. What is the resulting change in |
the interest rate? |
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interest rates? (Be sure to check the button above |
b. Reduce T0 to .08. What happens to aggregate out- |
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ISLM.) |
put Y ? |
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2. An excellent way to learn about how changes in vari- |
c. Increase the M to 1,100. What happens to the |
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interest rate and aggregate output? |
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ous factors affect the IS and LM curves is to visit |
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ap pendi x |
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to chap ter |
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24 |
Algebra of the ISLM Model |
The use of algebra to analyze the ISLM model allows us to extend the multiplier analysis in Chapter 23 and to obtain many of the results of Chapters 23 and 24 very quickly.
Basic Closed-Economy ISLM Model
The goods market can be described by the following equations:
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Consumption function: |
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Investment function: |
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Government spending: |
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Goods market equilibrium condition: |
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The money market is described by these equations: |
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Money demand function: |
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Money supply: |
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Money market equilibrium condition: |
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The uppercase terms are the variables of the model; G, T, and M, are the values of the
policy variables that are set exogenously (outside the model); and C, I, and Md are autonomous components of consumer expenditure, investment spending, and money demand that are also determined exogenously (outside the model). Except for the interest rate i, the lowercase terms are the parameters, the givens of the model, and all are assumed to be positive. The definitions of these variables and parameters are as follows:
C consumer spending I investment spending
G G government spending Y output
T T taxes
Md money demand
Ms M money supply i interest rate
C autonomous consumer spending
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2 Appendix to Chapter 24
d interest sensitivity of investment spending
I autonomous investment spending related to business confidence Md autonomous money demand
e income sensitivity of money demand f interest sensitivity of money demand
mpc marginal propensity to consume
IS and LM Curves |
Substituting for C, I, and G in the goods market equilibrium condition and then solv- |
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ing for Y, we obtain the IS curve: |
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Solving for i from Equations 6, 7, and 8, we obtain the LM curve:
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Solution of the
Model
Implications
The solution to the model occurs at the intersection of the IS and LM curves, which involves solving for Y and i simultaneously, using Equations 9 and 10, as follows:
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The conclusions reached with these algebraic solutions are the same as those reached in Chapters 23 and 24; for example:
1.Because all the coefficients are positive, Equation 11 indicates that a rise in C, I, G, and M leads to a rise in Y and that a rise in T or Md leads to a fall in Y.
2.Equation 12 indicates that a rise in C, I, G, and Md leads to a rise in i and that a rise in M or T leads to a fall in i.
3.As f, the interest sensitivity of money demand, increases, the multiplier term:
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1 mpc de f
increases, and so fiscal policy (G, T) has more effect on output; conversely, the term multiplying M,
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declines, so monetary policy has less effect on output.
4.By similar reasoning, as d, the interest sensitivity of investment spending, increases, monetary policy has more effect on output and fiscal policy has less effect on output.
Algebra of the ISLM Model 3
Open-Economy ISLM Model
To make the basic ISLM model into an open-economy model, we need to include net exports in the goods market equilibrium condition so that Equation 5 becomes Equation 5':
Y Yad C I G NX |
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As the discussion in Chapter 24 suggests, the net exports and exchange rate relations can be written:
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where NX net exports
NX autonomous net exports
h exchange rate sensitivity of net exports
E exchange rate (value of domestic currency) E autonomous exchange rate
j interest sensitivity of exchange rate
Substituting for net exports in the goods market equilibrium condition (Equation 5') using the net exports and exchange rate relations and then solving for Y as in the basic model, we obtain the open-economy IS curve:
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3C I mpc T G NX hE (d hj )i 4 |
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The LM curve is the same as in the basic model, and so the solutions for Y and i are as follows:
Y |
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1 mpc (d hj )e f |
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Implications
1.As the IS curve in Equation 15 indicates, including net exports in aggregate demand provides an additional reason for the negative relationship between Y and i (the downward slope of the IS curve). This additional reason for the negative relationship of Y and i is represented by hj in the term (d hj)i.
4 Appendix to Chapter 24
2.Equations 16 and 17 indicate that all the results we found for the basic model still hold.
3.Equation 16 indicates that a rise in NX leads to a rise in Y, and an autonomous rise in the value of the domestic currency E leads to a decline in Y.
4.Equation 17 indicates that a rise in NX leads to a rise in i, and a rise in E leads to a decline in i.
C h a p t e r
25 Aggregate Demand and Supply Analysis
PREVIEW
In earlier chapters, we focused considerable attention on monetary policy, because it touches our everyday lives by affecting the prices of the goods we buy and the quantity of available jobs. In this chapter, we develop a basic tool, aggregate demand and supply analysis, that will enable us to study the effects of money on output and prices. Aggregate demand is the total quantity of an economyÕs final goods and services demanded at different price levels. Aggregate supply is the total quantity of final goods and services that firms in the economy want to sell at different price levels. As with other supply and demand analyses, the actual quantity of output and the price level are determined by equating aggregate demand and aggregate supply.
Aggregate demand and supply analysis will enable us to explore how aggregate output and the price level are determined. (The ÒFollowing the Financial NewsÓ box indicates when data on aggregate output and the price level are published.) Not only will the analysis help us interpret recent episodes in the business cycle, but it will also enable us to understand the debates on how economic policy should be conducted.
Aggregate Demand
Monetarist View
of Aggregate
Demand
The first building block of aggregate supply and demand analysis is the aggregate demand curve, which describes the relationship between the quantity of aggregate output demanded and the price level when all other variables are held constant. Monetarists (led by Milton Friedman) view the aggregate demand curve as downwardsloping with one primary factor that causes it to shiftÑchanges in the quantity of money. Keynesians (followers of Keynes) also view the aggregate demand curve as downward-sloping, but they believe that changes in government spending and taxes or in consumer and business willingness to spend can also cause it to shift.
The monetarist view of aggregate demand links the quantity of money M with total nominal spending on goods and services P Y (P price level and Y aggregate real output or, equivalently, aggregate real income). To do this it uses the concept of the velocity of money: the average number of times per year that a dollar is spent on
582
C H A P T E R 2 5 Aggregate Demand and Supply Analysis 583
Following the Financial News
Aggregate Output, Unemployment, and the Price Level
Newspapers and Internet sites periodically report data that provide information on the level of aggregate output, unemployment, and the price level. Here is a list of the relevant data series, their frequency, and when they are published.
Aggregate Output and Unemployment
Real GDP: Quarterly (JanuaryÐMarch, AprilÐJune, JulyÐSeptember, OctoberÐDecember); published three to four weeks after the end of a quarter.
Industrial production: Monthly. Industrial production is not as comprehensive a measure of aggregate output as real GDP, because it measures only manufacturing output; the estimate for the previous month is reported in the middle of the following month.
Unemployment rate: Monthly; previous monthÕs figure is usually published on the Friday of the first week of the following month.
Price Level
GDP deflator: Quarterly. This comprehensive measure of the price level (described in the appendix to Chapter 1) is published at the same time as the real GDP data.
Consumer price index (CPI): Monthly. The CPI is a measure of the price level for consumers (also described in the appendix to Chapter 1); the value for the previous month is published in the third or fourth week of the following month.
Producer price index (PPI): Monthly. The PPI is a measure of the average level of wholesale prices charged by producers and is published at the same time as industrial production data.
www.bls.gov/data/home.htm
The home page of the Bureau of Labor Statistics lists information on unemployment and price levels.
final goods and services. More formally, velocity V is calculated by dividing nominal spending P Y by the money supply M:
V P M Y
Suppose that the total nominal spending in a year was $2 trillion and the money supply was $1 trillion; velocity would then be $2 trillion/$1 trillion 2. On average, the money supply supports a level of transactions associated with 2 times its value in final goods and services in the course of a year. By multiplying both sides by M, we obtain the equation of exchange, which relates the money supply to aggregate spending:
M V P Y |
(1) |
At this point, the equation of exchange is nothing more than an identity; that is, it is true by definition. It does not tell us that when M rises, aggregate spending will rise as well. For example, the rise in M could be offset by a fall in V, with the result that M V does not rise. However, FriedmanÕs analysis of the demand for money (discussed in detail in Chapter 22) suggests that velocity varies over time in a predictable manner unrelated to changes in the money supply. With this analysis, the equation of
584 P A R T V I Monetary Theory
exchange is transformed into a theory of how aggregate spending is determined and is called the modern quantity theory of money.
To see how the theory works, letÕs look at an example. If velocity is predicted to be 2 and the money supply is $1 trillion, the equation of exchange tells us that aggregate spending will be $2 trillion (2 $1 trillion). If the money supply doubles to $2 trillion, FriedmanÕs analysis suggests that velocity will continue to be 2 and aggregate spending will double to $4 trillion (2 $2 trillion). Thus FriedmanÕs modern quantity theory of money concludes that changes in aggregate spending are determined primarily by changes in the money supply.
Deriving the Aggregate Demand Curve. To learn how the modern quantity theory of money generates the aggregate demand curve, letÕs look at an example in which we measure aggregate output in trillions of 1996 dollars, with the price level in 1996 having a value of 1.0. As just shown, with a predicted velocity of 2 and a money supply of $1 trillion, aggregate spending will be $2 trillion. If the price level is given at 2.0, the quantity of aggregate output demanded is $1 trillion because aggregate spending P Y then continues to equal 2.0 $1 trillion $2 trillion, the value of M V. This combination of a price level of 2.0 and aggregate output of 1 is marked as point A in Figure 1. If the price level is given as 1.0 instead, aggregate output demanded is $2 trillion (point B), so aggregate spending continues to equal $2 trillion ( 1.0 2 trillion). Similarly, at an even lower price level of 0.5, the quantity of output demanded rises to $4 trillion, shown by point C. The curve connecting these points, marked AD1, is the aggregate demand curve, given a money supply of $1 trillion. As you can see, it has the usual downward slope of a demand curve, indicating that as the price level falls (everything else held constant), the quantity of output demanded rises.
Shifts in the Aggregate Demand Curve. In FriedmanÕs modern quantity theory, changes in the money supply are the primary source of the changes in aggregate spending and shifts in the aggregate demand curve. To see how a change in the money supply shifts the aggregate demand curve in Figure 1, letÕs look at what happens when the money supply increases to $2 trillion. Now aggregate spending rises to 2 $2 trillion $4 trillion,
F I G U R E 1 Aggregate Demand
Curve
An aggregate demand curve is drawn for a fixed level of the money supply. A rise in the money supply from $1 trillion to $2 trillion leads to a shift in the aggregate demand curve from AD1 to
AD2.
Aggregate Price
Level, P (1996 = 1.0 )
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Aggregate Output, Y ($ trillions, 1996)
Keynesian View of
Aggregate
Demand
C H A P T E R 2 5 Aggregate Demand and Supply Analysis 585
and at a price level of 2.0, the quantity of aggregate output demanded will rise to $2 trillion so that 2.0 2 trillion $4 trillion. Therefore, at a price level of 2.0, the aggregate demand curve moves from point A to A . At a price level of 1.0, the quantity of output demanded rises from $2 to $4 trillion (from point B to B ), and at a price level of 0.5, output demanded rises from $4 to $8 trillion (from point C to C ). The result is that the rise in the money supply to $2 trillion shifts the aggregate demand curve outward to AD2.
Similar reasoning indicates that a decline in the money supply lowers aggregate spending proportionally and reduces the quantity of aggregate output demanded at each price level. Thus a decline in the money supply shifts the aggregate demand curve to the left.
Rather than determining aggregate demand from the equation of exchange, Keynesians analyze aggregate demand in terms of its four component parts: consumer expenditure, the total demand for consumer goods and services; planned investment spending,1 the total planned spending by business firms on new machines, factories, and other inputs to production, plus planned spending on new homes; government spending, spending by all levels of government (federal, state, and local) on goods and services (paper clips, computers, computer programming, missiles, government workers, and so on); and net exports, the net foreign spending on domestic goods and services, equal to exports minus imports. Using the symbols C for consumer expenditure, I for planned investment spending, G for government spending, and NX for net exports, we can write the following expression for aggregate demand Y ad:
Y ad C I G NX |
(2) |
Deriving the Aggregate Demand Curve. Keynesian analysis, like monetarist analysis, suggests that the aggregate demand curve is downward-sloping because a lower price level (P↓ ), holding the nominal quantity of money (M ) constant, leads to a larger quantity of money in real terms (in terms of the goods and services that it can buy, M/P ↑ ). The larger quantity of money in real terms (M/P ↑ ) that results from the lower price level causes interest rates to fall (i↓ ), as suggested in Chapter 5 and 24. The resulting lower cost of financing purchases of new physical capital makes investment more profitable and stimulates planned investment spending (I ↑ ). Because, as shown in Equation 2, the increase in planned investment spending adds directly to aggregate demand (Y ad ↑ ), the lower price level leads to a higher level of aggregate demand (P↓
Y ad↑ ). Schematically, we can write the mechanism just described as follows:
P↓ M/P ↑ i↓ I ↑ Y ad ↑
Another mechanism that generates a downward-sloping aggregate demand curve operates through international trade. Because a lower price level (P↓ ) leads to a larger quantity of money in real terms (M/P ↑ ) and lower interest rates (i↓ ), U.S. dollar bank deposits become less attractive relative to deposits denominated in foreign currencies, thereby causing a fall in the value of dollar deposits relative to other currency deposits
1Recall that economists restrict use of the word investment to the purchase of new physical capital, such as a new machine or a new house, that adds to expenditure.
586 P A R T V I Monetary Theory
(a decline in the exchange rate, denoted by E↓ ). The lower value of the dollar, which makes domestic goods cheaper relative to foreign goods, then causes net exports to rise, which in turn increases aggregate demand:
P↓ M / P ↑ i↓ E↓ NX ↑ Y ad ↑
The Crowding-Out
Debate
Shifts in the Aggregate Demand Curve. The mechanisms described also indicate why Keynesian analysis suggests that changes in the money supply shift the aggregate demand curve. For a given price level, a rise in the money supply causes the real money supply to increase (M / P ↑ ), which leads to an increase in aggregate demand, as shown. Thus an increase in the money supply shifts the aggregate demand curve to the right (as in Figure 1), because it lowers interest rates and stimulates planned investment spending and net exports. Similarly, a decline in the money supply shifts the aggregate demand curve to the left.2
In contrast to monetarists, Keynesians believe that other factors (manipulation of government spending and taxes, changes in net exports, and changes in consumer and business spending) are also important causes of shifts in the aggregate demand curve. For instance, if the government spends more (G ↑ ) or net exports increase (NX ↑ ), aggregate demand rises, and the aggregate demand curve shifts to the right. A decrease in government taxes (T↓ ) leaves consumers with more income to spend, so consumer expenditure rises (C ↑ ). Aggregate demand also rises, and the aggregate demand curve shifts to the right. Finally, if consumer and business optimism increases, consumer expenditure and planned investment spending rise (C ↑ , I ↑ ), again shifting the aggregate demand curve to the right. Keynes described these waves of optimism and pessimism as Òanimal spiritsÓ and considered them a major factor affecting the aggregate demand curve and an important source of business cycle fluctuations.
You have seen that both monetarists and Keynesians agree that the aggregate demand curve is downward-sloping and shifts in response to changes in the money supply. However, monetarists see only one important source of movements in the aggregate demand curveÑchanges in the money supplyÑwhile Keynesians suggest that other factorsÑfiscal policy, net exports, and Òanimal spiritsÓÑare equally important sources of shifts in the aggregate demand curve.
Because aggregate demand can be written as the sum of C I G NX, it might appear that any factor affecting one of its components must cause aggregate demand to change. Then it would seem that a fiscal policy change such as a rise in government spending (holding the money supply constant) would necessarily shift the aggregate demand curve. Because monetarists view changes in the money supply as the only important source of shifts in the aggregate demand curve, they must be able to explain why the foregoing reasoning is invalid.
Monetarists agree that an increase in government spending will raise aggregate demand if the other components of aggregate demandÑC, I, and NXÑremained unchanged after the government spending rise. They contend, however, that the increase in government spending will crowd out private spending (C, I, and NX ), which will fall by exactly the amount of the government spending increase. For example, an increase of $50 billion in government spending might be offset by a decline of $30 billion in consumer expenditure, $10 billion in investment spending, and $10
2A complete demonstration of the Keynesian analysis of the aggregate demand curve is given in Chapters 23 and 24.