Financial Markets and Aggregate Demand

1
Financial Markets and Aggregate Demand

• Chapter 8

2
Outline

• Investment and the Interest Rate
• Net Exports and the Interest Rate
• The Demand for and Supply of Money
• The IS Curve and the LM Curve
• Policy Analysis with IS-LM
• The Aggregate-Demand Curve
• Determination of Output and Unemployment in the
  Short Run

3
8.1. Investment and the Interest Rate

• Investment depends negatively on interest rates.
  Why?
• Most investments are financed through borrowing
  or with funds from selling financial securities.
  If interest rates are high, then there are high
  borrowing costs or high losses in income
• Investment function
• I e - dR
• e, d constants
• d how much investment falls when the interest
  rate increases by 1

4
Fig. 8.1
5
Investment and the Interest Rate

• By making investment endogenous, we have
  introduced a new endogenous variable the
  interest rate, R
• We focus here on the average interest rate (which
  represents the behavior of all the different
  types of rates long-term, short-term securities,
  etc.)
• Note distinguish between real and nominal
  interest rates
• Real interest rate (R) Nominal interest rate
  (i) Inflation real interest rate R
• Here we use the real interest rate R

6
8.2. Net Exports and the Interest Rate

• Net exports depend negatively on the interest
  rate. Why?
• If U.S. interest rates are higher than rates in
  other countries, dollars become more attractive,
  which drive up the price of dollars U.S. goods
  become more expensive and foreign goods cheaper,
  thus net exports fall
• X g mY -- nR
• n measures the decrease in net exports when the
  interest rate rises by 1

7
8.3. The Demand for and Supply of Money

• Money is
• Currency issued by the Federal Reserve (coins,
  dollar bills) together with checking account
  balances held by public in banks
• It does not include larger amount of wealth, such
  as mutual funds, bonds, corporate stock, etc.

8
The Demand for Money

1. People want to hold less money when the interest
   rate is high and more money when the interest
   rate is low.
2. People want to hold more money when income is
   higher and less money when income is lower.
3. People want to hold more money when price level
   is higher and less money when price level is
   lower.

9
The Demand for Money

• Money demand function
• M (kY hR)P
• M demand for money
• R interest rate
• P price level
• k, h coefficients
• k how much money demand increases when income
  increases
• h how much money demand declines when interest
  rate raises

10
The Supply of Money

• Money Supply level determined by the Federal
  Reserve System
• For now, we assume that the Fed picks a certain
  level, M
• In the short-run model, when prices are
  predetermined, income and interest rates adjust
  to keep the demand for money equal to its fixed
  supply

11
8.4. The IS Curve and the LM Curve

• Five relations in the IS LM framework
• Y C I G X
• C a b(1-t)Y
• I e dR
• X g mY - nR
• M (kY hR)P
• Endogenous variables Y, C, I, X, and R
• Exogenous variables G and M
• Predetermined variable P

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a) The IS Curve

• The IS curve shows all combinations of R and Y
  that satisfy the income identity, the consumption
  function, the investment function, and the
  net-export function.
• It is the set of points for which spending
  balance occurs.
• When the curve slopes downward -- higher interest
  rate reduces investment and net exports and
  thereby reduces GDP through the multiplier
  process
• Shifts an increase in government spending
  increases GDP through the multiplier and shifts
  the IS curve to the right

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FIGURE 8.2 THE IS CURVE
INTEREST RATE (R) ()
INTEREST RATE (R) ()
1
Government spending increases by ?G
10 9 8 7 6 5 4 3 2 1
10 5
2 IS Curve shifts right by 1
?G 1- b (1-t) m
IS curve
New IS
Old IS
5,800 5,900 6,000 6,100 6,200
5,800 5,900 6,000 6,100 6,200
GDP (Y)
GDP (Y)
14
FIGURE 8.3 GRAPH DERIVATION OF THE IS CURVE
45º line
SPENDING
6,100 6,000 5,900 5,800
Old spending line
New spending line
5,800 5,900 6,000
6,100 6,200
GDP (Y)
INTEREST RATE
8
New interest rate
7
6.2

5
Old interest rate
4
3
Old Level of GDP
New Level of GDP
IS Curve
2
1
5,800 5,900 6,000
6,100 6,200
GDP (Y)
15
The LM Curve

• The LM curve shows all combinations of R and Y
  that satisfy the money demand relationship for a
  fixed level of the money supply and a
  predetermined value of the price level.
• When the curve slopes upward if the interest
  rate increases, money demand decreases
  therefore, to have equilibrium in the money
  market there should be an increase in income. So,
  an interest-rate increase is associated with a
  rise in income.

16
The LM Curve

• Note Real money money supply M divided by
  price level P
• M/P kY hR
• The demand for real money depends positively on
  real GDP and negatively on the interest rate
• Shifts an increases in money supply shifts the
  LM curve to the right

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FIGURE 8.4 THE LM CURVE
INTEREST RATE (R) ()
INTEREST RATE (R) ()
10 9 8 7 6 5 4 3 2 1
10 9 8 7 6 5 4 3 2 1
Money supply increases by ?M
LM curve
Old LM
New LM
LM curve shifts to right by 1/k ?M
5,800 5,900 6,000 6,100 6,200
5,800 5,900 6,000 6,100 6,200
GDP (Y)
GDP (Y)
18
FIGURE 8.5 GRAPHICAL DERIVATION OF THE LM
CURVE
INTEREST RATE (R) ()
INTEREST RATE (R) ()
10 9 8 7 6 5 4 3 2 1
10 9 8 7 6 5 4 3 2 1
Money supply
LM Curve
New interest rate
R 8.17
Old interest rate
New money demand
Old money demand
850 900 950
5,800 5,900 6,000 6,100 6,200
GDP (Y)
GDP (Y)
Old GDP
New GDP
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Algebraic Derivation of the IS and LM Curves

• IS curve
• LM curve
• To satisfy all five relationships of the model,
  the values of R and Y must be on both the IS
  curve and the LM curve that is, at their
  intersection (next figure)

20
FIGURE 8.6 THE INTERSECTION OF THE IS CURVE
AND THE LM CURVE
INTEREST RATE (R) ()
10 5
LM
IS
5,800 5,900 6,000 6,100 6,200
GDP (Y)
21
8.5.Policy Analysis with IS-LM

• Monetary Policy changes in the money supply
• What happens in the economy when the Fed
  increases the money supply?
• Immediately after the increase, more money is in
  the economy than people demand. This makes the
  interest rate fall, so the demand for money
  increases.
• The lower interest rate stimulates investment and
  net exports.
• This raises GDP through the multiplier process
  GDP rises and the interest rate falls
• LM curve shifts to the right (increase in real
  money)

22
Policy Analysis with IS-LM

• Fiscal Policy the use of tax rates and
  government spending to influence the economy
• Ex. Congress passes a bill that increases
  government spending or decrease in taxes
• An increase in government spending increases the
  interest rate (through the increase in the demand
  for money) and increases income (through the
  multiplier)
• Increasing the interest rate reduces investment
  and net exports, thereby offsetting some of the
  increase in income crowding out

23
Policy Analysis with IS-LM

• These are short-run results with the price
  level predetermined. When the time frame is
  lengthened in the next chapter, so that the price
  level can adjust, these results will have to be
  modified.

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FIGURE 8.7 EFFECTS OF MONETARY AND FISCAL
POLICIES
INTEREST RATE (R) ()
INTEREST RATE (R) ()
10 9 8 7 6 5 4 3 2 1
10 9 8 7 6 5 4 3 2 1
IS curve shifts right
LM
Old LM
LM curve shifts right
New LM
Interest rate rises
Interest rate falls
New IS
GDP rises
IS
Old IS
GDP rises
5,800 5,900 6,000 6,100 6,200
5,800 5,900 6,000 6,100 6,200
GDP (Y)
GDP (Y)
Old level of GDP
New level of GDP
Old level of GDP
New level of GDP
Increase in Money Supply
Increase in Government spending
25
8.6 The Aggregate Demand Curve

• The AD curve shows combinations of price levels
  and output where the IS and LM curves intersect,
  or where spending balance occurs and money demand
  equals money supply.
• Note Even though they look similar, the ideas
  behind the aggregate demand curve are much
  different from those that underlie the typical
  demand curve of microeconomics.
• The financial system the demand for and supply
  of money lies behind the aggregate demand curve.

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The Aggregate Demand Curve

• The AD curve slopes downward therefore, a
  decrease in prices increases real money,
  shifting the LM curve to the right, lowering
  interest rates, increasing investment and
  increasing output.

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FIGURE 8.8 THE AGGREGATE DEMAND CURVE
PRICE LEVEL (P)
PRICE LEVEL (P)
AD curve shifts right if (1) money (M)
increases, or (2) government spending (G)
increases
1.2 1.1 1.0 .9 .8
1.2 1.1 1.0 .9 .8
Aggregate demand curve (AD)
New AD
Old AD
5,700 5,900 6,100 6,300 6,500
GDP (Y)
GDP (Y)
5,700 5,900 6,100 6,300 6,500
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FIGURE 8.9 DERIVATION OF THE AD CURVE
INTEREST RATE (R) ()
New LM
8
Old LM
7
6
5
4
3
IS
2
1
5,800 5,900 6,000
6,100 6,200
GDP (Y)
PRICE LEVEL (P)
1.15 1.10 1.05 1.00 .95 .90
New price level
Old price level
AD
5,800 5,900 6,000
6,100 6,200
GDP (Y)
Old level of GDP
New level of GDP
29
The Aggregate Demand Curve

• Changes in the money supply and in government
  spending both shift the aggregate demand curve.
• Monetary Policy
• An increase in M at a given price level results
  in an increase in aggregate demand
• Rationale? More money means that a lower interest
  rate equates money demand with money supply. A
  lower interest rate stimulates more investment
  and net exports, which in turn require a higher
  level of GDP for spending balance
• The aggregate demand curve shifts to the right
  when the money supply increases

30
The Aggregate Demand Curve

• Fiscal policy
• An increase in government spending shifts the
  aggregate demand curve to the right.
• At a given price level, more government spending
  means more aggregate demand.

31
8.7. Determination of Output in the Short Run

• Recall Prices are sticky they take some time to
  adjust in response to demand conditions.
• The level of output at a predetermined price
  level is determined by the point on the aggregate
  demand curve corresponding to the price level.
• In the short run, output can be above or below
  its potential level.

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FIGURE 8.10 DETERMINATION OF OUTPUT WITH A
PREDETERMINED PRICE
PRICE LEVEL (P)
PRICE LEVEL (P)
Predetermined-price line
Predetermined-price line
P0
P0
Aggregate demand curve (AD)
New AD
Old AD
5,800 6,200
Y0
Y0
Y1
GDP (Y)
GDP (Y)
5,800 6,200
33
FIGURE 8.10 DETERMINATION OF OUTPUT WITH A
PREDETERMINED PRICE
PRICE LEVEL (P)
PRICE LEVEL (P)
Y
Y
Predetermined-price line
Predetermined-price line
P0
P0
Aggregate demand curve
Aggregate demand curve
5,800 6,000 6,200
5,800 6,000 6,200
Y0
Y0
GDP (Y)
GDP (Y)
Output below potential
Output above potential
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8.7. Determination of Unemployment in the Short
Run

• If GDP declines, most workers who are laid off
  become unemployed (and it becomes harder for
  people who are looking for work to find jobs).
• Because of the importance of hours reductions and
  the common pattern of retaining workers during
  temporary declines in demand (called labor
  hoarding), a 3 percent decline in GDP is
  associated with only a 1 percentage point
  increase in unemployment (Okuns Law).

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FIGURE 8.12 DETERMINATION OF EMPLOYMENT
PRICE
1 The AD curve shifts inward
AD
2 Y declines from Y to Y
AD
Y
Y
GDP
GDP GAP
GDP gap
GDP GAP
Okuns law
3 (Y Y)/Y declines from 0
to a negative amount
0
4 Okuns law shows how much
unem-ployment rises
-3.6
5,784 6,000
U
U
GDP
6
7.2
UNEMPLOYMENT RATE
36
Numerical Example

• Consider the following economy
• Y C I G X
• C 100 0.9Yd
• I 200 500R
• X 100 0.12Y 500R
• M (0.8Y -2000R)P
• G 200, t 0.2, M 800, P 1
• Yd Y - 0.2Y
• Note All quantities are in billions of dollars

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Numerical Example

• What is the IS curve?
• Substitute C, I and X in the income identity
• Y 100 0.9(Y-0.2Y) 200 500R 200 100
  -0.12Y 500R
• Y 600 0.6Y -1000R
• 0.4Y 600 1000R
• IS curve Y 1500 2500R

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Numerical Example

• What is the LM curve?
• Derive from the equation for money demand
• M (0.8Y -2000R)P
• 800 0.8Y - 2000R,
• 0.8Y 800 2000R
• So LM curve Y 1000 2500R

39
Numerical Example

• What are the values of income and interest rate
  if spending balance occurs and the demand for
  money equals the supply for money?
• Y (from IS curve) Y (from LM curve)
• 1500 2500R 1000 2500R
• 500 500R
• R 0.10 (10)
• Substitute R into IS or LM Y 1250

40
Numerical Example

• What are the values of consumption, investment
  and net exports?
• C 1000
• I 150
• X 100

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Numerical Example

• Derive the aggregate demand curve
• 1) To derive the effects of increases in
  government spending or real money on income,
  start with the equation for the LM curve, do not
  substitute a specific value for real money, and
  solve for output.
• M/P 0.8Y-2000R
• Y 1.25 (M/P) 2500R

42
Numerical Example

• Derive the aggregate demand curve
• 2) Now use the income identity, substitute the
  consumption, investment and net export equations,
  but not a specific value for government spending,
  and solve for 2500 times the interest rate
• Y 100 0.9(Y-0.2Y) 200 500R G 100
  -0.12Y 500R
• Y 400 0.6Y 1000R G
• 1000R 400 0.4Y G
• 2500R 1000 Y 2.5G

43
Numerical Example

• Derive the aggregate demand curve
• 3) Then substitute the spending balance equation
  into the LM curve, and solve for Y
• Y 1.25 (M/P) 1000 Y 2.5G
• 2Y 1.25 (M/P) 1000 2.5G
• AD curve Y 0.625(M/P) 500 1.25G

44
Numerical Example

• How much does an increase in government spending
  or real money of 100 bill increase GDP?
• AD curve Y 0.625(M/P) 500 1.25G
• An increase in government spending of 100
  raises real GDP by 125. An increase in the money
  supply of 100, with the price level constant,
  raises real GDP by 62.5.