Macroeconomics of

macroBusiness Cycles
 Growth rates of real GDP, consumption
Percent Real GDP
change growth rate
from 4
quarters Consumption
earlier
growth rate

Average
growth
rate
 Growth rates of real GDP, consumption,
investment
Percent
Investment
change
growth rate
from 4
quarters
earlier

Real GDP
growth rate

Consumption
growth rate
 Unemployment
Percent
of labor
force
 Okun’s Law
Percentage ∆Y
change in
1966
= 3 − 2 ∆u
real GDP 1951 Y
1984

2003
1971
1987
2008

1975
2001
1991 1982

Change in unemployment rate

 Facts about the business cycle
 GDP growth averages 3–3.5 percent per year
over the long run with large fluctuations in the
short run.
 Consumption and investment fluctuate with
GDP, but consumption tends to be less volatile
and investment more volatile than GDP.
 Unemployment rises during recessions and
falls during expansions.
 Okun’s Law: the negative relationship
between GDP and unemployment.
 Index of Leading Economic
Indicators
 Published monthly by the Conference
Board.
 Aims to forecast changes in economic
activity 6-9 months into the future.
 Used in planning by businesses and
govt, despite not being a perfect
predictor.
 Components of the LEI index
 Average workweek in manufacturing
 Initial weekly claims for unemployment insurance
 New orders for consumer goods and materials
 New orders, nondefense capital goods
 Vendor performance
 New building permits issued
 Index of stock prices
 M2
 Yield spread (10-year minus 3-month) on
Treasuries
 Index of consumer expectations
 Index of Leading Economic Indicators
2004 = 100

Source:
Conference
Board
Time horizons in macroeconomics
 Long run
Prices are flexible, respond to
changes in supply or demand.
 Short run
Many prices are “sticky” at a
predetermined level.

The economy behaves much

differently when prices are sticky.
 Recap of classical macro theory
 Output is determined by the supply side:
– supplies of capital, labor
– technology

 Changes in demand for goods & services

(C, I, G ) only affect prices, not quantities.
 Assumes complete price flexibility.
 Applies to the long run.
 When prices are sticky…
…output and employment also
depend on demand, which is
affected by:
– fiscal policy (G and T )
– monetary policy (M )
– other factors, like exogenous
changes in
C or I
 AD/AS Model

 The paradigm most mainstream economists

and policymakers use to think about economic
fluctuations and policies to stabilize the
economy
 Shows how the price level and aggregate
output are determined
 Shows how the economy’s behavior is
different
in the short run and long run
 Aggregate demand
 The aggregate demand curve shows the
relationship between the price level and the
quantity of output demanded.
 we use a simple theory of AD based on the
quantity theory of money.
 Recall the quantity equation
MV = PY
 For given values of M and V,
this equation implies an inverse relationship
between P and Y :
Y= MV/P
 The downward-sloping AD curve

P
An
An increase
increase inin the
the
price
price level
level causes
causes aa
fall
fall in
in real
real money
money
balances
balances (M/P(M/P),),
causing
causing aa decrease
decrease in
in
the
the demand
demand for
for
goods
goods &
& services.
services.

AD
Y
 Shifting the AD curve

An
An increase
increase in
in
the
the money
money
supply
supply shifts
shifts
the
the AD
AD curve
curve
to
to the
the right.
right. AD
AD 2

1
Y
 Aggregate supply in the long run

 Recall from Chapter 3:

In the long run, output is determined by

factor supplies
Y = F (K and
, L) technology

Y is the full-employment or natural level of

output, at which the economy’s resources are
fully employed.
“Full employment” means that
unemployment equals its natural rate (not zero).
The long-run aggregate supply curve

P LRAS
Y does
does not
not
depend
depend on on P,
P,
so
so LRAS
LRAS isis
vertical.
vertical.

Y
Y
= F (K , L)
 Long-run effects of an increase in M

P LRAS
An increase
in M shifts
AD to the
right.
In the long run, P2
this raises the
price level… P1 AD
AD 2

1
…but leaves Y
Y
output the same.
 Aggregate supply in the short run

 Many prices are sticky in the short run.

 For now we assume
– all prices are stuck at a predetermined
level in the short run.
– firms are willing to sell as much at that
price level as their customers are willing
to buy.
 Therefore, the short-run aggregate
supply (SRAS) curve is horizontal:
 The short-run aggregate supply curve

The
P
The SRAS
SRAS curve
curve isis
horizontal:
horizontal:
The
The price
price level
level is
is
fixed
fixed at
at aa
predetermined
predetermined
level,
level, and
and firms
firms sell
sell
as
as much
much as as buyers
buyers
demand.
demand. SRAS
P

Y
Short-run effects of an increase in M

In the short run P

…an increase in
when prices are aggregate demand…
sticky,…

SRAS
P
AD
AD2
1
Y
…causes output Y1 Y2
to rise.
 From the short run to the long run
Over time, prices gradually become “unstuck.” When they do, will
they rise or fall?

In the short-run then over time,

equilibrium, if P will…
Y > Y rise
Y < Y fall

Y = Y remain constant

The adjustment of prices is what moves

the economy to its long-run equilibrium.
 The SR & LR effects of ∆ M > 0

A = initial P LRAS
equilibrium

B = new short-
P2 C
run eq’m
after Fed B SRAS
increases M
P
A AD
AD2
C = long-run 1
equilibrium Y
Y Y2
 How shocking!!!

 shocks: exogenous changes in agg. supply or

demand
 Shocks temporarily push the economy away from
full employment.
 Example: exogenous decrease in velocity
If the money supply is held constant, a decrease
in V means people will be using their money in
fewer transactions, causing a decrease in
demand for goods and services.
 The effects of a negative demand shock
AD
AD shifts
shifts left,
left, P
depressing
LRAS
depressing output
output
and
and employment
employment
in
in the
the short
short run.
run.

B A SRAS
Over
Over time,
time, P
prices
prices fall
fall and
and
P2 C AD
the
the economy
economy
moves
moves down
down its
its AD1
demand
demand curve
curve 2
Y
toward
toward full-
full- Y2 Y
employment.
employment.
 Supply shocks
 A supply shock alters production costs, affects the prices
that firms charge. (also called price shocks)
 Examples of adverse supply shocks:
– Bad weather reduces crop yields, pushing up
food prices.
– Workers unionize, negotiate wage increases.
– New environmental regulations require firms to reduce
emissions. Firms charge higher prices to help cover the
costs of compliance.
 Favorable supply shocks lower costs and prices.
 CASE STUDY:
The 1970s oil shocks
 Early 1970s: OPEC coordinates a
reduction in the supply of oil.
 Oil prices rose
11% in 1973
68% in 1974
16% in 1975
 Such sharp oil price increases are
supply shocks because they
significantly impact production costs
and prices.
 CASE STUDY:
The 1970s oil shocks
The
The oil
oil price
price shock
shock shifts
SRAS
shifts P LRAS
SRAS up,
up, causing
causing output
output
and
and employment
employment to to fall.
fall.

B SRAS2
P2
In
In absence
absence ofof
A SRAS1
further
further price
price P1
shocks,
shocks, prices
prices will
will AD
fall
fall over
over time
time and
and
economy
economy movesmoves Y
back
back toward
toward full
full Y2 Y
employment.
employment.
 CASE STUDY:
The 1970s oil shocks
70%
Predicted effects 60%
of the oil shock:
• inflation ↑ 50%
• output ↓ 40%
• unemployment ↑
30%
…and then a
20%
gradual recovery.
10%
0%
1973 1974 1975 1976 19

Change in oil prices (left scale)

Inflation rate-CPI (right scale)
 CASE STUDY:
The 1970s oil shocks
60%
Late 1970s:
50%
As economy
was recovering,
40%
oil prices shot up
again, causing
30%
another huge
supply shock!!!
20%

10%

0%
1977 1978 1979 1980 19

Change in oil prices (left scale)

Inflation rate-CPI (right scale)
 CASE STUDY:
The 1980s oil shocks
40%
1980s: 30%
A favorable 20%
supply shock--
10%
a significant
fall in oil 0%
prices. -10%
As the model -20%
predicts, -30%
inflation and -40%
unemployment
-50%
fell:
1982 1983 1984 1985 1986 198

Change in oil prices (left scale)

Inflation rate-CPI (right scale)
 Stabilization policy
 def: policy actions aimed at
reducing the severity of short-run
economic fluctuations.
 Example: Using monetary policy to
combat the effects of adverse
supply shocks…
 Stabilizing output with
monetary policy
P LRAS

The
The adverse
adverse
supply
supply shock
shock
moves
moves the
the B SRAS2
P2
economy
economy toto
A SRAS1
point
point B.
B. P1
AD
1

Y
Y2 Y
 Stabilizing output with
monetary policy
But
But the
the Fed
Fed P LRAS
accommodates
accommodates
the
the shock
shock by
by
raising
raising agg.
agg.
B C SRAS2
demand.
demand. P2
A
results:
results: P1 AD
P
P is
is permanently
permanently AD 2

higher,
higher, but
but YY 1

remains
remains atat its
its full-
full- Y
employment Y2 Y
employment level.level.
Aggregate Demand I:
The IS-LM Model

The IS-LM model determines

income and the interest rate in
the short run when P is fixed
 The Big Picture
Keynesian
Keynesian IS
IS
Cross
Cross curve
curve
IS-LM
IS-LM
model Explanation
Explanation
Theory
Theory ofof model
LM
LM of
of short-run
short-run
Liquidity
Liquidity curve fluctuations
curve fluctuations
Preference
Preference
Agg.
Agg.
demand
demand
curve
curve Model
Model of
of
Agg.
Agg.
Demand
Demand
Agg.
Agg. and
and Agg.
Agg.
supply
supply Supply
Supply
curve
curve
 The Keynesian Cross
 A simple closed economy model in which income
is determined by expenditure.
(due to J.M. Keynes)

 Notation:
I = planned investment
PE = C + I + G = planned expenditure
Y = real GDP = actual expenditure
 Difference between actual & planned
expenditure = unplanned inventory investment
Elements of the Keynesian Cross
consumption function: C = C (Y − T )
govt policy variables: G = G , T =T
for now, planned
investment is exogenous: I =I

planned expenditure: PE = C (Y − T ) + I + G

equilibrium condition:
actual expenditure = planned expenditure
Y = PE
Graphing planned expenditure

PE

planned PE =C +I
+G
expenditure
MPC
1

income, output, Y
Graphing the equilibrium condition

PE PE
=Y
planned

expenditure

45º

income, output, Y
The equilibrium value of income

PE PE
=Y
planned PE =C +I
+G
expenditure

income, output, Y
Equilibrium
income
 An increase in government purchases
PE

Y
=
E
At Y1,

P
PE =C +I
there is now an +G2
unplanned drop PE =C +I
in inventory… +G1

∆
G
…so firms
increase output,
and income Y
rises toward a
new equilibrium. PE1 = ∆ Y PE2 =
Y1 Y2
 Solving for ∆ Y
Y = C + I + G equilibrium condition

∆Y = ∆C + ∆I + ∆G in changes

= ∆C + ∆G because I exogenous

= MPC × ∆Y + ∆G because ∆ C = MPC

∆ Y
Collect terms with ∆ Y Solve for ∆ Y :
on the left side of the
equals sign:  1 
∆Y =   × ∆G
(1 − MPC) × ∆Y = ∆G  1 − MPC 
The government purchases multiplier

Definition: the increase in income

resulting from a $1 increase in G.
In this model, the govt ∆Y 1
=
purchases multiplier equals∆G 1 − MPC

Example: If MPC = 0.8, then

∆Y 1 An
An increase
increase in
in G
G
= = 5 causes
causes income
income to to
∆G 1 − 0.8
increase
increase 55 times
times
as
as much!
much!
Why the multiplier is greater than 1
 Initially, the increase in G causes an
equal increase in Y: ∆ Y = ∆ G.
 But ↑Y ⇒ ↑C
⇒ further ↑Y
⇒ further ↑C
⇒ further ↑Y
 So the final impact on income is much
bigger than the initial ∆ G.
 An increase in taxes
PE
Initially, the tax

= E
P
PE =C1 +I

Y
increase reduces
consumption, and +G
PE =C2 +I
therefore PE: +G

∆ C = −MPC At Y1, there is now

∆ T an unplanned
…so firms inventory buildup…
reduce output,
and income falls Y
toward a new PE2 = Y2 ∆ PE1 =
equilibrium Y Y1
 Solving for ∆ Y
eq’m condition in
∆Y = ∆C + ∆I + ∆G
changes
= ∆C I and G exogenous

= MPC × ( ∆Y − ∆T )

Solving for (1 − MPC) × ∆Y = − MPC × ∆ T

∆ Y:

 − MPC 
Final result: ∆Y =   × ∆T
 1 − MPC 
 The tax multiplier

def: the change in income resulting from

a $1 increase in T :
∆Y − MPC
=
∆T 1 − MPC

If MPC = 0.8, then the tax multiplier equals

∆Y − 0.8 − 0.8
= = = −4
∆T 1 − 0.8 0.2
 The tax multiplier
…is negative:
A tax increase reduces C,
which reduces income.
…is greater than one
(in absolute value):
A change in taxes has a
multiplier effect on income.
…is smaller than the govt spending multiplier:
Consumers save the fraction (1 – MPC) of a tax cut,
so the initial boost in spending from a tax cut is
smaller than from an equal increase in G.
 The IS curve
def: a graph of all combinations of r
and Y that result in goods market
equilibrium
i.e. actual output = planned expenditure

The equation for the IS curve is:

Y = C (Y −T ) + I (r ) + G
J.R. Hicks
 Deriving the IS curve
P PE =Y
PE =C +I (r2 )
E +G
↓r ⇒ ↑I PE =C +I (r1 )
+G
⇒ ↑PE ∆
I
⇒ ↑Y Y1 Y2 Y
r
r1

r2
IS
Y1 Y2 Y
Why the IS curve is negatively sloped
 A fall in the interest rate motivates firms to
increase investment spending, which drives
up total planned spending (PE ).
 To restore equilibrium in the goods market,
output (a.k.a. actual expenditure, Y )
must increase.
Fiscal Policy and the IS curve
 We can use the IS-LM model to see
how fiscal policy (G and T ) affects
aggregate demand and output.
 Let’s start by using the Keynesian
cross
to see how fiscal policy shifts the IS
curve…
 Shifting the IS curve: ∆ G
PE PE PE =C +I (r1 )
At any value of r, =Y
+G2=C +I (r )
PE
↑G ⇒ ↑PE ⇒ ↑Y 1
+G1
…so the IS curve
shifts to the right.

The horizontal Y1 Y2 Y
r
distance of the
IS shift equals r1

1
∆Y = ∆G ∆
1− MPC Y IS1 IS2
Y1 Y2 Y
 NOW YOU TRY:
Shifting the IS curve: ∆ T
 Use the diagram of the Keynesian
cross or loanable funds model to
show how an increase in taxes shifts
the IS curve.
The Theory of Liquidity Preference
 Due to John Maynard Keynes.
 A simple theory in which the interest
rate
is determined by money supply and
money demand.
 Equilibrium

The interest
r
(M P)
s
rate adjusts interest
to equate the rate
supply and
demand for
money:

r1
L (r )
M P = L( r )
M/P
M P
real money
balances
How the Fed raises the interest rate
r
interest
To increase r, rate
Fed reduces M
r2

r1
L (r )

M/P
M2 M1
real money
P P balances
 The LM curve

Now let’s put Y back into the money

demand function:
(M P)
d
= L(r ,Y )

The LM curve is a graph of all combinations of

r and Y that equate the supply and demand for
real money balances.
The equation for the LM curve is:
M P = L(r ,Y )
 Deriving the LM curve
(a) The market for
(b) The LM curve
real money balances
r r
LM

r2 r
2
L (r ,
r1 Y2 ) r
L (r , 1

Y1 )
M1 M/P Y1 Y2 Y
P
Why the LM curve is upward sloping
 An increase in income raises money
demand.
 Since the supply of real balances is
fixed, there is now excess demand
in the money market at the initial
interest rate.
 The interest rate must rise to
restore equilibrium in the money
market.
 How ∆ M shifts the LM curve
(a) The market for
(b) The LM curve
real money balances
r r
LM
2
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 r

the combination of r and Y
that simultaneously satisfies LM
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

Y = C (Y −T ) + I (r ) +G r
LM
M P = L(r ,Y )

We can use the IS-LM

model to analyze the r1
effects of
• fiscal policy: G and/or
T IS
• monetary policy: M Y
Y1
 An increase in government purchases
1. IS curve shifts right
r
1 LM
by ∆G
1− MPC
causing output & r2
income to rise. 2.
r1
2. This raises money
demand, causing the 1. IS2
interest rate to rise… IS1
3. …which reduces investment, Y
Y1 Y2
so the final increase in Y 3.
1
is smaller than ∆G
1− MPC
 A tax cut
Consumers save (1−MPC) r
of the tax cut, so the initial LM
boost in spending is
smaller for ∆ T than for
r
an equal ∆ G… 2.
r21
and the IS curve shifts by
−MPC 1. IS2
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.
 Monetary policy: An increase in M
1. ∆ M > 0 shifts r
the LM curve down LM1
(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.
The Fed’s response to ∆ G > 0

 Suppose Congress increases G.

 Possible Fed responses:
1. hold M constant
2. hold r constant
3. hold Y constant
 In each case, the effects of the
∆ G
are different…
Response 1: Hold M constant

If Congress raises G, r
the IS curve shifts right. LM
1

If Fed holds M constant,

r2
then LM curve doesn’t r1
shift.
IS2
Results: IS1
∆Y = Y2 − Y1 Y
Y1 Y2
∆r = r2 − r1
Response 2: Hold r constant

If Congress raises G, r
the IS curve shifts right. LM
1 LM
To keep r constant, 2
r2
Fed increases M r1
to shift LM curve right.
IS2
Results: IS1
∆Y = Y3 − Y1 Y
Y1 Y2 Y3

∆r = 0
Response 3: Hold Y constant

If Congress raises G, r LM
the IS curve shifts right. 2 LM
1
r3
To keep Y constant,
r2
Fed reduces M r1
to shift LM curve left.
IS2
Results: IS1
∆Y = 0 Y
Y1 Y2
∆r = r3 − r1
Estimates of fiscal policy multipliers
from the DRI macroeconometric model

Estimated Estimated
Assumption about value of value of
monetary policy ∆ Y/∆ G ∆ Y/∆ T

Fed holds money

0.60 −0.26
supply constant
Fed holds nominal
1.93 −1.19
interest rate constant
 Shocks in the IS -LM model

IS shocks: exogenous changes in

the demand for goods & services.
Examples:
– stock market boom or crash
⇒ change in households’ wealth
⇒∆ C
– change in business or consumer
confidence or expectations
⇒ ∆ I and/or ∆ C
 Shocks in the IS -LM model

LM shocks: exogenous changes

in the demand for money.
Examples:
– a wave of credit card fraud
increases demand for money.
– more ATMs or the Internet reduce
money demand.
 NOW YOU TRY:
Analyze shocks with the IS-LM Model
Use the IS-LM model to analyze the effects of
1. a boom in the stock market that makes
consumers wealthier.
2. after a wave of credit card fraud, consumers
using cash more frequently in transactions.

For each shock,

a. use the IS-LM diagram to show the effects of the
shock on Y and r.
b. determine what happens to C, I, and the
unemployment rate.
 CASE STUDY:
The U.S. recession of 2001
 During 2001,
– 2.1 million jobs lost,
unemployment rose from 3.9% to
5.8%.
– GDP growth slowed to 0.8%
(compared to 3.9% average annual
growth during 1994-2000).
 CASE STUDY:
The U.S. recession of 2001
Causes: 1) Stock market decline ⇒ ↓C

1500
S&P 500
Index (1942 = 100)

1200

900

600

300
1995 1996 1997 1998 1999 2000 2001 2002 2003
 CASE STUDY:
The U.S. recession of 2001
Causes: 2) 9/11
– increased uncertainty
– fall in consumer & business confidence
– result: lower spending, IS curve shifted
left
Causes: 3) Corporate accounting scandals
– Enron, WorldCom, etc.
– reduced stock prices, discouraged
investment
 CASE STUDY:
The U.S. recession of 2001
 Fiscal policy response: shifted IS
curve right
– tax cuts in 2001 and 2003
– spending increases
• airline industry bailout
• NYC reconstruction
• Afghanistan war
01
/01

0
1
2
3
4
5
6
7
/20

right
04 00
/02
/20
07 00
/03
/20
10 00
/03
/20
01 00
/03
/20
04 01
/05
/20
07 01
/06
/20
10 01
/06
/20
01 01
/06
/20
T-Bill

04 02
CASE STUDY:

/08
/20
07 02
T-Bill Rate
Rate

/09
Three-month
Three-month

/20
10 02
/09
/20
01 02
/09
The U.S. recession of 2001

/20
04 03
/11
/2 0
03
 Monetary policy response: shifted LM curve
IS-LM and aggregate demand
 So far, we’ve been using the IS-LM
model to analyze the short run,
when the price level is assumed
fixed.
 However, a change in P would shift
LM and therefore affect Y.
 The aggregate demand curve
(introduced in Chap. 9) captures this
relationship between P and Y.
 Deriving the AD curve
r LM(P2)
Intuition for slope LM(P1)
r2
of AD curve:
r1
↑P ⇒ ↓(M/P )
IS
⇒ LM shifts left Y2 Y1 Y
P
⇒ ↑r
P2
⇒ ↓I
P1
⇒ ↓Y AD
Y2 Y1 Y
Monetary policy and the AD curve
r LM(M1/P1)
The Fed can increase LM(M2/P1)
r1
aggregate demand:
r2
↑M ⇒ LM shifts right
IS
⇒ ↓r Y1 Y2 Y
P
⇒ ↑I
⇒ ↑Y at each P1
value of P
AD2
AD1
Y1 Y2 Y
 Fiscal policy and the AD curve
r LM
Expansionary fiscal
policy (↑G and/or ↓T ) r2
increases agg. demand: r1 IS2
↓T ⇒ ↑C IS1
Y1 Y2 Y
⇒ IS shifts right P
⇒ ↑Y at each
P1
value of P
AD2
AD1
Y1 Y2 Y
 IS-LM and AD-AS
in the short run & long run
Recall from Chapter 9: 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
r LRAS LM(P )
1

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

AD1
AD2
Y Y
The SR and LR effects of an IS shock
r LRAS LM(P )
1

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(P )
1

In
In the
the new
new short-run
short-run
equilibrium, Y < Y
equilibrium, IS1
IS2
Y Y
Over
Over time,
time, P
P gradually
gradually
falls,
falls, causing
causing P LRAS

•• SRAS
SRAS toto move
move down
down P1 SRAS1

•• M/P
M/P to
to increase,
increase,
which
which causes
causes LM
LM AD1
to AD2
to move
move down
down
Y Y
 The SR and LR effects of an IS shock
r LRAS LM(P )
1
LM(P2)

IS1
IS2
Y Y
Over
Over time,
time, P
P gradually
gradually
falls,
falls, causing
causing P LRAS

•• SRAS
SRAS toto move
move down
down P1 SRAS1

•• M/P
M/P to
to increase,
increase, P2 SRAS2
which
which causes
causes LM
LM AD1
to AD2
to move
move down
down
Y Y
 The SR and LR effects of an IS shock
r LRAS LM(P )
1
LM(P2)

This process continues IS1

until economy reaches a IS2
long-run equilibrium with Y Y
Y =Y P LRAS
P1 SRAS1
P2 SRAS2
AD1
AD2
Y Y
 NOW YOU TRY:
Analyze SR & LR effects of ∆ M
a. Draw the IS-LM and AD- r LRAS LM(M /P )
1 1
AS diagrams as shown
here.
b. Suppose Fed increases IS
M. Show the short-run
effects on your graphs. Y Y
c. Show what happens in P LRAS
the transition from the
short run to the long run. SRAS1
P1
d. How do the new long-run
equilibrium values of the AD1
endogenous variables
compare to their initial Y Y
values?
 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:
↓Eπ
⇒ 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
Why another Depression is unlikely
 Policymakers (or their advisors) 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.
 CASE STUDY
The 2008-09 Financial Crisis &
Recession
 2009: Real GDP fell, u-rate approached 10%
 Important factors in the crisis:
– early 2000s Federal Reserve interest rate policy
– sub-prime 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
Interest rates and house prices
 Change in U.S. house price index
and rate of new foreclosures, 1999-2009
 House price change and new
foreclosures, 2006:Q3 – 2009Q1

Nevada
Florida Illinois
Michigan Ohio
% of all mortgages
New foreclosures,

California Georgia

Arizona Colorado
Rhode Island
Texas
New Jersey
Hawaii S. Dakota
Oregon
Wyoming
Alaska
N. Dakota

Cumulative change in house price index

U.S. bank failures by year, 2000-2009

* as of July 24, 2009.

 Major U.S. stock indexes
(% change from 52 weeks earlier)
Consumer sentiment and growth in consumer
durables and investment spending
Real GDP growth and Unemployment