CHAPTER 11: Introduction to Economic Fluctuations

Aggregate Demand Curve: shows the relationship between the PRICE LEVEL and the
quantity of OUTPUT DEMANDED
• For the AD/AS model, we use a simple theory of aggregate demand based on the Quantity
Theory of Money (MV = PY)

• The Downward-Sloping AD Curve: the lower the P, the greater the aggregate quantity of
goods & services demanded; ↓r → ↑I → ↑PE → ↑Y
• ↑ Price Level —> ↓ Real Money Balances (M/P) —> ↓ Demand for Goods & Services
• Increase in Money Supply —> shifts aggregate demand curve to the RIGHT
• Shifting AD Curve RIGHT:
1. ↑M
2. ↑V

1. Aggregate Supply in the Long Run: output is determined by factor supplies &
technology (C, I, G)
• Long-Run E ects of a Decrease in M:
• ↓ in Aggregate Demand
• ↓P
• Output remains unchanged

2. Aggregate Supply in the Short Run: output determined by aggregate demand

• Okun’s Law says that UNEMPLOYMENT and OUTPUT/GDP are negatively related
• %ΔY = 3% – 2Δu
• Long-Run E ects of a Decrease in M:
• Prices remain unchanged
• ↓ Aggregate Demand
• ↓ Output

3. The Short-Run & Long-Run E ects of Change in M > 0

• Feds add money —> ↑ Aggregate Demand —> ↑ Output —> ↑ Prices
• Short-Run: output rises
• Long-Run: prices rise & remain higher
• If feds increase money supply then PRICE STAYS ELEVATED for good

4. Supply Shocks: alters production costs; ex. Increase cost of oil

• SRAS: price moves up, unemployment & output fall
• LRAS: price moves back down & back to full employment
• Stabilization Policy: policy actions aimed at reducing the severity of short-run economic
uctuations; ex. Using monetary policy to combat e ects of adverse supply shocks

Problems:
1. Stag ation — lower output and higher prices — is caused by: an adverse shock to
aggregate supply; Ex. 1970’s Oil Shock
• This can occur due to factors such as increased production costs (e.g., rising oil prices
or supply chain disruptions) that reduce the overall supply of goods and services in the
economy, leading to higher prices and lower output simultaneously.

• Contraction in Aggregate Demand: ↓ Output, ↑ U, ↓ Price Levels

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 CHAPTER 12: Aggregate Demand I: Building the IS-LM Model

IS Curve: the negative relationship b/t INTEREST RATE & LEVEL OF INCOME that arises in
the market for goods and services; r & Y; DOWNWARD sloping

• The Keynesian Cross: a simple closed-economy consumption function : C = C(Y − T)

model in which income is determined by government policyvariables : G = G , T = T
expenditure; an economy’s total income is, in the
for now, plannedinvestment is exogenous : I = I
short run, determined largely by the spending plans
of households, businesses, and government planned expenditure : PE = C(Y − T ) + I + G

• I & G exogenous; only component of (C + I + G)

that changes when income changes is consumption ΔY 1
=
What Shifts IS Curve to the RIGHT? ΔG 1− MPC
1. Increase in G: shifts IS Curve outwards
• The Government Purchases Multiplier: the increase in income
resulting from a $1 increase in G; an increase in government
purchases causes a greater increase in income
2. Decrease in T: shifts IS Curve outwards
• Tax Multiplier: the amount income changes in
response to a $1 change in taxes Di erence between actual & planned
3. ↑ Consumer Con dence expenditure = unplanned inventory
4. ↑ Business Con dence investment
5. ↑ Wealth (Stock Prices or Housing Prices) • PE depends on INCOME b/c higher
income leads to higher Consumption
• Slope of PE Function: Marginal
Propensity to Consume MPC
The Interest Rate, Investment, & IS Curve

Equilibrium Condition: actual expenditure = planned expenditure

Y = PE

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 LM Curve: the positive relationship b/t INTEREST RATE & LEVEL OF INCOME (while
holding the price level xed) that arises in the market for real money balances
• UPWARD sloping
• The LM Curve slopes upward because higher income increases money demand and, in
turn, the interest rate

• The Theory of Liquidity Preference: a simple theory in which the interest rate is
determined by money supply & money demand
• According to this theory, the central bank can increase the supply of money & lower the
interest rate

•Increase Income
•Raise Money Demand
•Increase r
•Doesn’t move LM Curve

•↑Income → ↑Money Demand → ↑r

What Factors Shift LM Curve LEFT?

1. ↓Money Supply → ↑r
• if holding income constant
2. ↑Money Demand

What Factors Shift LM Curve RIGHT?

1. ↑Nominal Money Supply (M)
2. ↓Price Level (P)
3. Exogenous ↓ in Money Demand
• Caused by nancial innovations leading to more frequent use of credit cards

Keynesian Cross Theory of Liquidity Preference

1. Fiscal Policy 1. Money Supply

Exogenous Variables
2. Investment 2. Price Level

Derived Which Curve? IS Curve LM Curve

↓r → ↑M/P
Deriving the Curve ↓r → ↑I → ↑PE → ↑Y ↑Income→ ↑Money Demand → ↑r

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 CHAPTER 13: Aggregate Demand II: Applying the IS-LM Model

The Stabilizing E ects of De ation:

• Pigou E ect: falling prices expand income
• As prices fall & real money balances rise, consumers should feel wealthier & spend more
• This ↑ in consumer spending should cause an expansionary shift in the IS curve, also
leading to higher income
• ↓ P —> ↑ (M/P ) In the short run equilibrium, if then over time, the price level will
• Consumers’ wealth ↑ Y >Y rise
• ↑C Y <Y fall
• IS shifts right Y =Y remain constant
• ↑Y

The Destabilizing E ects of EXPECTED De ation:

• Debt-De ation Theory: an unexpected de ation enriches creditors & impoverishes debtors
• ↓Eπ
• ↑ r (real interest rate) for each value of i
• I b/c I = I (r)
• Planned Expenditure & Aggregate Demand ↓
• Income & Output ↓

Not responsible to changes in r then Slopes are Steep

• The steeper the slope of the IS CURVE, the LESS EFFECTIVE is MONETARY policy
• Use Fiscal Policy; Monetary Policy is e ective if IS Curve is Flat

• The steeper the slope of the LM CURVE, the LESS EFFECTIVE is FISCAL policy
• Use Monetary Policy; Fiscal Policy is e ective if LM Curve is Flat

• Monetary & Fiscal Policy variables (M, G, & T) are exogenous

Examples
1. If output is above its natural level, over time the price level will RISE, shifting the LM
curve & moving the economy towards its long-run equilibrium

2. Feds INCREASE TAXES:

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 3. Consumers using cash in transactions more often in response to increase in identity
theft: LM Curve shifts LEFT; ↑ r & ↓ Y & ↓ C (due to lower income); higher money demand
• ↓ I (b/c r is higher); ↑ U (b/c Y is lower; Okun’s Law)

• Fed’s Policy Instrument: Fed’s policy changes as interest rate changes, as if the Fed has
direct control over market interest rates
• The Fed targets the federal funds rate—the interest rate banks charge one another on
overnight loans; the Fed changes money supply & shifts the LM curve to achieve its target

• IS & LM Curves determine the interest rate & national income in the SHORT RUN when the
price level is xed

WHEN PRICE ISN’T FIXED:

Monetary Policy & the AD Curve Fiscal Policy & the AD Curve
• The Fed can increase aggregate demand: • Expansionary fiscal policy (↑ G and/or ↓ T)
• ↑ M → LM shifts RIGHT increases aggregate demand:
• ↓ r • ↓T→↑C
• ↑ I • IS shifts RIGHT
• ↑ Y at each value of P • ↑ Y at each value of P

The IS-LM Model When Expected In ation is Equal to Zero

(π^e=0)

The IS-LM Model When Expected In ation is NOT Equal

to Zero:
• Substitute i with “r+π” in the LM Equation, OR,
• Substitute r with I in the IS Equation

•Rise in Prices reduces

Real Money Balances (M/P)
so the LM Curve shifts to
the left

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 CHAPTER 14

• As r falls, CF increases

1. Fiscal Policy: second image shown above

• Suppose that in the short-run the economy’s output level is below the natural output level
is; in this case, expansionary scal policy can be used to stabilize GDP around as follows:
• ↑G or ↓T shifts IS right→↑r and ↑Y
• ↑r →↓CF→↑e →↓NX
• I ↓ due to ↑r & C ↑ due to ↑ in (Y-T)

Expansionary Foreign Fiscal Policy: increases the foreign real interest rate (r*)
• Increase in r* relative to the domestic real interest rate r increases CF at home at every r
• This shifts CF(r ) right
• This leads to a rightward shift of IS since Y=C(Y-T)+I(r)+G+CF(r), which increases both r & Y
• Increase in CF depreciates e & the depreciation of e causes a rise in NX
• I decreases as r rises & C increases due to an increase in Y-T

2. Monetary Policy
• Figure in the next slide shows how monetary policy can be used for stabilization
purposes
• Suppose that in the short-run the economy’s output level is but the natural output level is;
in this case, expansionary monetary policy can be used to stabilize GDP around as
follows:
• ↑M shifts LM right→↓r and ↑Y
• ↓r → ↑ CF→↓e → ↑ NX
• I ↑ due to ↓ r and C ↑ due to ↑in (Y-T)

Expansionary Foreign Monetary Policy: reduces the foreign real interest rate (r*)
• Decrease in r* relative to the domestic real interest rate r reduces CF at home at every r
• This shifts CF(r) left
• This leads to a leftward shift of IS since Y=C(Y-T)+I(r)+G+CF(r), which reduces both r & Y
• Decrease in CF appreciates e & the appreciation of e causes a decline in NX
• I increases as r decreases & C decreases due to a decrease in Y-T

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 Trade Policies (Increase in Tari s or Quotas)
• Due to a trade de cit the policy makers decide to impose tari s on goods imported from
other countries (to decrease imports)
• Shifts NX to the Right
• Holding the exchange rate constant would mean an increase in net exports
• Exchange rate starts appreciating in value —> decrease in NX
• No change in NX
• No change in r, Y, CF, & NX

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 CHAPTER 15

1. Sticky-Price Model
2. Imperfect-Information Model

In ation, Employment, & the Phillips Curve

• Phillips Curve: states that π (in ation) depends
on:
1. Expected In ation, Eπ
2. Cyclical Unemployment: deviation of actual
unemployment (u) of from natural rate (un)
3. Supply Shocks, ν (Greek letter nu)

• is a parameter that measures the response of in ation to cyclical unemployment

Comparing SRAS & the Phillips Curve

• SRAS Curve: OUTPUT is related to unexpected
movements in the PRICE LEVEL

• Phillips Curve: UNEMPLOYMENT is related to

unexpected movements in the INFLATION RATE
• Implies In ation Has Inertia - in the absence of supply shocks
or cyclical unemployment, in ation will continue inde nitely at its
current rate

Two Causes of Rising & Falling In ation

1. Cost-Push In ation: in ation resulting from supply shocks
• Adverse supply shocks are events that push up the costs
of production
• Induces rms to raise prices
2. Demand-Pull In ation: in ation resulting from demand
shocks
• Positive shocks to aggregate demand cause unemployment to fall below its natural rate,
which pulls the in ation rate up

Shifting the Phillips Curve

• People adjust their expectations over time, so the tradeo only holds in the short run
• Example: an increase in Eπ shifts the short-run Phillips curve upward

• Factors that Shift the Short-Run Phillips Curve (SP) RIGHT

1. An increase in expected in ation (Eπ)
2. An increase in the natural unemployment rate (u^n )
3. A negative supply shock (v)

• Long-Run Phillips Curve

• A vertical line drawn at shows the Long-Run Phillips Curve (LP)
• An increase in natural unemployment (u^n) shifts LP right

• The Sacri ce Ratio measures the percentage of a year’s real GDP that must be forgone to
reduce in ation by 1 percentage point

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 • To reduce in ation, policymakers can contract aggregate demand, causing unemployment
to rise above the natural rate
• A typical estimate of the ratio is 5
• That is, to reduce in ation by 1 percentage point,
5 percent of one year’s GDP must be sacri ced

Rational Expectations
1. Adaptive Expectations: an approach that
assumes people form their expectations of future
in ation based on recently observed in ation
• Expected In ation = Last Year’s Actual In ation

2. Rational Expectations: people base their

expectations on all available information, including
information about current & prospective future
policies

GDP loss = (in ation reduction) × (sacri ce ratio)

Sacri ce ratio = (lost GDP) / (total disin ation)

• Natural-Rate Hypothesis: changes in aggregate demand a ect output & employment only
in the short run; in the long run, the economy returns to the levels of output, employment, &
unemployment described by the classical model

• Hysteresis: the long-lasting in uence of history on variables such as the natural rate of
unemployment

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 REVIEW QUESTIONS

1. An increase in income raises money DEMAND and RAISES the equilibrium interest
rate.

2. An increase in the demand for money, at any given income level and level of interest
rates, will, within the IS–LM framework, LOWER output and RAISE interest rates.

3. If the short-run IS–LM equilibrium occurs at a level of income below the natural level
of output, then in the long run the price level will DECREASE, shifting the LM curve to
the right and returning output to the natural level.

4. Starting from the natural level of output, an unexpected monetary contraction will
cause output and the price level to DECREASE in the short run; and in the long run
the level will DECREASE, causing the level of output to return to the natural level.

5. In the short run, with and upward sloping aggregate supply curve, if the price level is
greater than the expected price level, then in the long run the aggregate: supply curve
will shift leftward.

6. If only unanticipated changes in the money supply a ect real GDP, the public has
rational expectations, & everyone has the same information about the state of the
economy, then: monetary policy cannot be used to systematically stabilize output.

7. If a computer glitch at credit card companies makes stores start accepting only cash
payments, the demand for money will INCREASE. If the money supply is held
constant, the aggregate demand curve will shift to the LEFT.
• Holding the money supply constant would result in limited cash being available so a
reduction in spending —> causes aggregate demand curve to decrease.

Aggregate Demand: Price Level & Output Demanded

IS Curve: negative r/t between interest rate & income for goods & services
LM Curve: positive r/t between interest rate & income for real money balances
Okan’s Law: inverse r/t between unemployment & real GDP

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