曼昆第10版讲义mankiw10e-irm-ch12

|CHAPTER12 AggregateDemandII:ApplyingtheIS–LMModel

LectureNotes|

CHAPTER12

AggregateDemandII:

ApplyingtheIS–LMModel

NotestotheInstructor

ChapterSummary

ThischapterusestheIS–LMmodeltoshowtheshort-runeffectsoffiscalandmonetarypoliciesonoutputandtheinterestratewhenpricesarefixed.ItalsoexplainshowtheIS–LMmodelprovidesatheoryofaggregatedemand.ItappliesthemodeltostudytheGreatDepression.

Comments

Discussionofcrowdingoutandofthemonetarytransmissionmechanismprovidesagoodopportunitytolinktheshort-runmodelbacktotheclassicalmodel.

ThesectionontheGreatDepressionispopularwithstudents,bothbecauseitwassuchadramaticeventandbecauseoftheuncertaintyaboutwhetheritcouldhappenagain.Somestudentsmayfinditinterestingtocompareandcontrastthestockmarketcrashof1987withtheoneof1929.Theymayalsowanttodrawparallelswiththeburstingofthe“Internetbubble”andthesubsequentretreatofthestockmarketin2000–2001.ThelessonsthattheGreatDepressionteachesabouttheimportanceoffinancialandcreditmarketsarealsotimelygiventheproblemsofU.S.banksandsavingsinstitutionsintheearly1990s,theAsianfinancialcrisisofthelate1990s,andtheworldwidefinancialcrisisof2008–2009.(Forinstructorswhowishtopursuethesubjectofthestockmarket,Chapter18oftheInstructor’sResourcescontainsaseriesofchaptersupplementsonassetpricing,includingdiscussionsofstockmarketefficiency.)

UseoftheWebsite

TheChapter12modelcanbeusedtoderiveaggregatedemandcurvesbymakinguseofthefactthatincreasesinthepricelevelanddecreasesinthenominalmoneystockhaveidenticaleffects.(Thisisausefullessontodrivehomeanyway.)Thus,onecanfind{M,Y}pairsforwhichthemoneyandgoodsmarketsareinequilibriumandthenconvertthemtothecorresponding{P,Y}pairs.

UseoftheEWebsite

GotheEwebsiteandclickon“Tools”inthemenubaratthetopofthepage.Select“RiskofRecession.”Pickfivestatesandproposeexplanationsastowhytheirrecessionrisksdiffer.Howdothesedifferencesaffectthewaywemightvieweconomicrecession(orexpansion,forthatmatter)atthenationallevel?

ChapterSupplements

Thischapterincludesthefollowingsupplements:

12-1 DoHighDeficitsCauseHighInterestRates?

12-2 MacroeconometricModels

12-3 CreditRationingandtheGreatDepression

12-4 TheSimpleAlgebraoftheIS–LMModelandAggregateDemandCurve

12-5 ProportionalIncomeTaxesandtheISCurve

12-6 AdditionalReadings

LectureNotes

12-1 ExplainingFluctuationswiththeIS–LMModel

WehavenowdevelopedthebasicIS–LMmodeloftheeconomyandareinapositiontouseittotrytoexplainthebehavioroftheeconomyintheshortrun.OutputcanvaryintheIS–LMmodelwheneverexogenousshockstotheeconomycauseshiftsineithertheIScurveortheLMcurve.

HowFiscalPolicyShiftstheISCurveandChanges

TheShort-RunEquilibrium

Supplement12-1,“DoHighDeficitsCauseHighInterestRates?”

Figure12-1

Figure12-2

Letusfirstconsiderfiscal-policyshocks.Supposethatwestartinequilibriumandthatgovernmentspendingisincreasedby∆G.ThentheIScurveshiftstotheright.Theincreasedspendingincreasesincomeand,throughthemultipliereffectsfromthecircularflow,alsoincreasesconsumption;incomeincreasesfurther.[RecallthattherightwardshiftoftheIScurveequals∆G/(1–MPC).]Ifweonlyhadtoworryaboutthegoodsmarket,thiswouldbetheendofthestory.Buttheincreaseinincome,inturn,increasesthedemandformoneyfortransactionspurposes.Thisincreaseddemandformoneyforcesuptheinterestrate,leading,inturn,toadeclineininvestment.Thus,weobserveshort-runcrowdingout:theincreaseinGDPislessthanthesimpleKeynesiancrossmodelwouldhavepredictedbecausethatmodelomitschangesintheinterestrate.Adecreaseintaxes,likeanincreaseingovernmentspending,shiftstheIScurveout,causinginterestratesandGDPtorise.

HowMonetaryPolicyShiftstheLMCurveandChanges

TheShort-RunEquilibrium

Figure12-3

Nowconsidertheeffectsofanincreaseinthemoneysupply(anexpansionarymonetarypolicy).ThisshiftstheLMcurveout.Theincreasedmoneysupplycausesinterestratestofallinordertobringthedemandformoneyinlinewiththenewhighersupply.Thisfallininterestratesencouragesinvestment,leadingultimatelytoanincreaseinGDP.Thus,interestratesarelower,andGDPishigher.ThelinkagefromachangeinthemoneysupplytoGDPisknownasthemonetarytransmissionmechanism.

TheInteractionBetweenMonetaryandFiscalPolicy

Thepolicychangesdiscussedabovetooktheformofanexogenouschangeinonepolicy,holdingallotherexogenousvariablesconstant.Inreality,monetaryandfiscalpolicydonotexistinisolationfromeachother.TheFederalReserveandthefiscalauthoritiesbothpursuepolicygoalsthatmayormaynotbecompatible.Weconsiderthedetailsandproblemsofpolicy-makinginChapter16Herewenotesimplythattheultimateeffectsofafiscal-policychangedependuponhowthemonetaryauthoritiesreacttothatchange.

Figure12-4

Suppose,forexample,thatthefiscalauthoritiesincreasetaxes.Otherthingsbeingequal,thiswouldreduceoutputandinterestratesintheshortrun.IftheFedweretryingtokeepinterestratesstable,however,itwouldrespondtothischangebydecreasingthemoneysupply.Theresultwouldbealargerdecreaseinoutput.Alternatively,theFedmightbetryingtokeepoutputstable,inwhichcaseitwouldincreasethemoneysupply,drivinginterestratesdownfurther.Thebasiclessonisthattheultimateeffectsontheeconomydependuponthecombinationsofpolicieschosenbythemonetaryandfiscalauthorities.

ShocksintheIS–LMModel

Supplement12-2,“MacroeconometricModels”

TheISandLMcurvesshiftwhenevertheyarehitbyexogenousshocks.WehavealreadydiscussedhowchangesinfiscalpolicyshifttheIScurveandhowchangesinmonetarypolicyshifttheLMcurve.TheIScurvealsoshiftsifothercomponentsofplannedspendingchange.Forexample,the“animalspirits”ofbusinesspeopleshifttheIScurve.Similarly,changesinconsumerconfidencealterconsumptionbehaviorandcausetheIScurvetoshift.ShockstothefinancialsideoftheeconomycausetheLMcurvetoshift.Inparticular,anythingthatcausesanexogenousincreaseinmoneydemandimpliesaninwardshiftoftheLMcurve.

CaseStudy:TheU.S.Recessionof2001

TheU.S.economyslowedsharplyin2001,withunemploymentrisingandoutputgrowthstalling.Threemajorshockscanhelpunderstandtheonsetofthiseconomicrecession.First,thestock-marketboomofthe1990sendedabruptlyinthespringof2000asoptimismaboutnewinformationtechnologywaned.Thedeclineinthestockmarketloweredthewealthofhouseholdsand,inturn,loweredconsumerspending.Also,thedimmedoutlookfornewtechnologiesledtoapullbackinbusinessinvestment.TheseeffectscanbeinterpretedasashifttotheleftoftheIScurve.Second,theSeptember11terroristattacksonNewYorkandWashingtonledtoafurtherdeclineinthestockmarket—which,atthetime,wasthelargestone-weekdeclinesincetheGreatDepression—andledtoariseinuncertaintyaboutthefuture.Greateruncertaintycanreducethewillingnessofhouseholdsandbusinessestospend.Again,wecaninterpretthisasashifttotheleftintheIScurve.Third,anumberofaccountingscandalsatprominentcorporations,includingEnronandWorldCom,ledtoafurtherdeclineinstockpricesandinvestmentspending,therebyshiftingtheIScurveagaintotheleft.

Inresponsetotheslowdown,bothfiscalpolicyandmonetarypolicywereplacedonanexpansionaryfooting.TheFedadoptedanexpansionarymonetarypolicy,shiftingtheLMcurvetotheright.Moneygrowthincreased,andinterestratesfell.Congresspassedataxcut,includinganimmediaterebate,andalsopassedanemergencyspendingmeasuretohelprebuildNewYorkandbailouttheairlineindustry.ThesechangesinfiscalpolicyshiftedtheIScurvetotheright.Theshifttowardexpansionarymonetaryandfiscalpolicieshelpedtheeconomyrecoveraseconomicgrowthincreasedandunemploymentfelloverthenextseveralyears.

WhatIstheFed’sPolicyInstrument—

TheMoneySupplyortheInterestRate?

TheanalysisinthischapterassumesthattheFedinfluencestheeconomybycontrollingthemoneysupply,buttheFed’sshort-termpolicyinstrumentisaninterestratetarget(thefederalfundsrate).Thesearenotinconsistent.Tocontrolthefederalfundsrate(theratebankschargeoneanotherforovernightloans),theFedconductsopen-marketoperations.Theseopen-marketoperationschangethemoneysupply,shiftingtheLMcurveandthuschangingtheinterestrate.TheFed’sfocusoninterestratesratherthanthemoneysupplymayindicatethatshockstotheLMcurvearemoreprevalentthanshockstotheIScurveorthatinterestratesareeasiertomeasurethanisthemoneysupply.

Theseexpansionarymonetaryandfiscalpolicieshelpedtheeconomyrecoveraseconomicgrowthincreasedandunemploymentfelloverthenextseveralyears.

12-2 IS–LMasaTheoryofAggregateDemand

FromtheIS–LMModeltotheAggregateDemandCurve

WenowconsiderhowtheIS–LMmodelcanalsobeviewedasatheoryofaggregatedemand.WedefinedtheISandLMcurvesintermsofequilibriuminthegoodsandmoneymarkets,respectively.Aggregatedemandsummarizesequilibriuminbothofthesemarkets.

RecallthattheIS–LMmodelisconstructedonthebasisofafixedpricelevel.Foragivenvalueofthepricelevelandthenominalmoneysupply,thepositionoftheLMcurveisfixed.AnychangeintherealsupplyofmoneyshiftstheLMcurve.Therealmoneysupplychangesifeitherthenominalmoneysupplyorthepricelevelchanges.Thus,wecanseethatchangesinthepricelevelareassociatedwithchangesintheequilibriumlevelofGDPandinterestrates.Thisistherelationshipthatissummarizedbytheaggregatedemandcurve.

Figure12-5

Ifthepricelevelishigh,otherthingsbeingequal,therealmoneysupplyislow.Thisimplieshighinterestratesandthuslowinvestmentandoutput.Ifthepricelevelfalls,thentherealmoneysupplyincreases.Equilibriuminthemoneymarketimpliesthatinterestratesmustfall.EquilibriuminthegoodsmarketthusimpliesthatGDPmustrise,sinceinvestmentrises.Thuswefindthattheaggregatedemandcurveisdownwardsloping;highvaluesofthepricelevelareassociatedwithlowlevelsofGDPandviceversa.Noticethatthereasonthiscurveslopesdownissubtle;itisnotliketheregularmicroeconomicdemandcurveforagood.

Figure12-6

TheIS–LMdiagramandtheAD–ASdiagramwithafixedpricelevelarethustwodifferentwaysofrepresentingthesameidea—thelevelofincomeassociatedwithagivenpricelevelonthebasisofequilibriuminthegoodsandmoneymarkets.Changesingovernmentpoliciescanbeillustratedonbothdiagrams.

TheIS–LMModelintheShortRunandLongRun

WecanalsoanalyzethetransitiontothelongrunintheIS–LMmodel.Iftheeconomyisnotatfullemployment,thenthepriceleveladjusts.IntermsoftheAD–ASdiagram,theeconomymovesalongtheADcurve.IntermsoftheIS–LMdiagram,theLMcurveshifts.Thuswecanseethattheprocessofadjustmenttoequilibriumhassubtleeconomicforcesbehindit.If,forexample,westartinrecession,thenovertimepricesfall.Thisincreasestherealmoneysupply,pushingdowninterestratesandencouraginginvestment.Thisincreaseininvestment,inturn,leadstohigherspendingandhigherGDP.

Figure12-7

Asanotherexample,supposethat,startinginlong-runequilibriumatthenaturalrateofoutput,weincreasegovernmentspending.Intheshortrun,withthepricelevelfixed,thisleadstoanincreaseinoutput:theISandADcurvesbothshiftout.TheIS–LMmodelalsorevealsthatinterestratesrise,causingsomeshort-runcrowdingoutofinvestment.Overtime,thefactthatwearenowinaboompushespricesup,reducingtherealmoneysupplyandfurtherincreasinginterestrates.Inthelongrun,interestratesrisebyenoughtocauseafallininvestmentequaltotheinitialriseingovernmentspending.Thisisaresultthatwehavealreadyseeninourlong-runanalysis:completecrowdingout.

12-3 TheGreatDepression

Table12-1

Inthe1930s,theUnitedStatesandothereconomiesexperiencedaseveredepression.ThedesiretoexplainthisphenomenonwasKeynes’sprincipalmotivationforhisnewapproachtoeconomics.Themagnitudeoftheeconomicupheavalandtheaccompanyinghumanmisery,inturn,fascinateeconomistsandleadthemtostudytheGreatDepressiontoavoidanyrecurrenceofsuchanevent.ThedatafortheGreatDepressionyearsaresetoutinTable12-1.Economistshavesuggestedanumberofexplanationsforthesedata,eachofwhichmaycontainpartofthetruth.

TheSpendingHypothesis:ShockstotheISCurve

Supplement12-3,“CreditRationingandtheGreatDepression”

TheIS–LMmodelteachesthataninwardshiftintheIScurvereducesincomeandinterestrates.SincenominalinterestratesfellduringtheDepression,negativeshockstotheIScurveareonepossibleexplanation.Thisisthespendinghypothesis.Significantfallsoccurredinbothconsumptionandinvestmentspendingbetween1929and1933.Consumptionmayhavefallenbecauseofdecreasedconsumerconfidencefollowingthestockmarketcrashof1929.Housinginvestmentalsofell,perhapsbecauseofoverbuildinginthe1920s.IntheearlyyearsoftheDepression,bankfailuresmayalsohavecontributedtofurtherfallsininvestment,whiletaxincreasesin1932mayhavedecreasedconsumption.

TheMoneyHypothesis:AShocktotheLMCurve

AparticularlystrikingfeatureoftheDepression-eradataisthesubstantialfallinthemoneysupply(over25percentbetween1929and1933).AmonetarycontractionshowsupintheIS–LMmodelasaninwardshiftoftheLMcurve,whichwouldreduceoutput.Therearetwoproblemswiththismoneyhypothesis,however.Thefirstisthatpricesalsofellsubstantiallyoverthisperiod,sorealmoneybalancesactuallyincreasedslightlybetween1929and1931,althoughtheydidfallbetween1931and1933.ThesecondproblemisthataninwardshiftoftheLMcurveshouldbeassociatedwithrisinginterestrates.

TheMoneyHypothesisAgain:TheEffectsofFallingPrices

AnotheraspectofthemoneyhypothesisisthatevenifbothmoneyandpricesfellsothatrealmoneybalanceschangedlittleandtheLMcurvewashardlyaffected,thedeflationitselfmighthaveplayedamajorroleintheDepression.ThebasicIS–LMmodelsuggeststhatfallingpricesincreaseoutputbecausefallingpricesincreaserealmoneybalancesforanygivenmoneysupply.FallingpricesmightalsoincreaseoutputbecauseofthePigoueffect:decreasesinthepricelevelincreasetherealvalueofwealth,increasingconsumptionandshiftingtheIScurveout.

Otherarguments,however,suggestthatdeflationmightdecreaseoutput.Considerfirsttheeffectofanunexpectedfallinthepricelevel.AsexplainedinChapter5,thisrepresentsaredistributionofrealwealthfromdebtorstocreditors;agivennominaldebtbecomeslargerinrealterms.Nowsupposethatcreditorsanddebtorsalsodifferintermsoftheirmarginalpropensitiestoconsume.Inparticular,itisreasonabletothinkthatdebtorshavehigherpropensitiestoconsumethandocreditors.Thentheredistributionfromdebtorstocreditorsreducesaggregatespending,shiftingtheIScurvein.Thisisknownasthedebt-deflationtheory.

Nowconsidertheeffectsofanexpecteddeflation.Whentheexpectedinflationrateisnonzero,weknowfromtheFisherequationthatrealandnominalinterestratesdiffer:i=r+Eπ.Wealsoknowthatmoneydemanddependsuponthenominalinterestrate,whileinvestmentdemanddependsupontherealinterestrate.WecanwritetheequationsoftheLMandIScurvesmorecompletelyas

M/P=L(i,Y) LM

Y=C(Y–T)+I(i–Eπ)+G IS

Figure12-8

InanIS–LMdiagramwiththenominalinterestrateontheverticalaxisandincomeonthehorizontalaxis,thepositionoftheIScurvedependsupontheexpectedinflationrate.Anincreaseinexpectedinflationlowerstherealinterestrate,increasesinvestment,andshiftstheIScurvetotheright,therebyincreasingoutputandthenominalinterestrate.Conversely,lowerexpectedinflation(orhigherexpecteddeflation)raisestherealinterestrate,reducesinvestment,andshiftstheIScurvetotheleft,reducingoutputandloweringthenominalinterestrate.

Wethusseethatdeflationtendstoraiserealinterestrateswhileloweringnominalinterestrates.ThisisconsistentwiththeexperienceoftheGreatDepression:nominalinterestratesfell,butexpostrealinterestratesrose.ThesubstantialfallininvestmentintheearlyyearsoftheDepressioniscertainlyconsistentwiththeeffectsofhighrealinterestrates.Itisuncertainwhetherornotthedeflationwasanticipated,however,andsoitisunclearwhetherornotexanterealinterestratesactuallyweresohigh.

CouldtheDepressionHappenAgain?

AfterthemajorstockmarketfallofOctober1987,somecommentatorsworriedaboutwhetherthismightpresageaseveredeclineineconomicactivity,justasthe1929stockmarketcrashdid.Whileeconomistscannotbecompletelyconfidentthatsuchaseveredepressionwillneverrecur,ourgreaterunderstandingofthemacroeconomytodaydoesgivemodernpolicymakersasignificantadvantageovertheir1930scounterparts.Aboveall,theFedislikelytoavoidrepeatingamonetarycontractiononthescaleoftheoneinthe1930s.Afterthe1987fallinthestockmarket,thechairoftheFedtookstepstoeasecredit.Similarly,severelycontractionaryfiscalpoliciesofthesortadoptedintheearly1930sarenowunlikelytobeenactedwhentheeconomyisinadeeprecession.Indeed,automaticstabilizersliketheincometaxworktoexpandfiscalpolicyinadownturntoday.Finally,federaldepositinsurancemakesbankfailureslesslikely.

CaseStudy:TheFinancialCrisisandGreatRecessionof2008and2009

During2008,theU.S.economyexperiencedafinancialcrisisandeconomicdownturnthattosomeobserversmirroredeventsduringthe1930s.Thecrisisbeganwithaboominthehousingmarketafewyearsearlier,resultfromlowinterestratesthatmadebuyingahomemoreaffordable.Increaseduseofsecuritizationinthemortgagemarketfurtherfueledthehousingboombymakingiteasierforsubprimeborrowerstoobtaincredit.Theseborrowershadahigherriskofdefaultthatmaynothavebeenfullyappreciatedbythepurchasersofmortgage-backedsecurities(banksandinsurancecompanies).Thehighlevelofhousepricesprovedunsustainable,andpricesfellby30percentfrom2006to2009.Thisdeclinehadseveralrepercussionsthatintensifiedwhatwasamoderate-to-severehouse-pricecorrectionintoafull-blowncrisis.

First,mortgagedefaultsandhomeforeclosuresincreasedsharply,inlargepartduetoloosemortgage-lendingstandardsthathadpermittedlittleornomoneydownonhomepurchases.Aspricesfell,thesehomeownerswere“underwater,”andmanyofthemdecidedtostoppayingontheirmortgages.Salesofforeclosedpropertiesfurtherdepressedhouseprices.Second,numerousfinancialinstitutionssufferedheavylossesonthemortgage-backedsecuritiesthattheyowned.Asaresult,bankscutbackonlendingtootherbanksoutoffearanddistrustthattheymightnotberepaid.Third,companiesthatrelyonthefinancialsystemforfundstoruntheirbusinessfounditdifficulttoobtainshort-termloans.Concernabouttheprofitabilityofthesecompaniesledtosharpswingsintheirstockprices.Finally,gyrationsinstockprices,inturn,ledtoasharpdeclineinconsumerconfidenceandresultedinahugedropinconsumerspending.

Governmentrespondedstronglytothecrisis.TheFedlowereditstargetforthefederalfundsratefrom5.25percentinSeptember2007toapproximatelyzeroinDecember2008.Congressappropriated$700billionfortheTreasurytousetostabilizethefinancialsystembyprovidingfundsforbanksinreturnforatemporaryownershipstakeintheseinstitutions.TheObamaadministrationproposedandCongresspassedafiscalstimulusprogramtoexpandaggregatedemand.AndtheFedimplementedanumberofunconventionalmonetarypolicies,suchaspurchasinglong-termbonds,tolowerlong-terminterestratesandtherebysupportborrowingandprivatespending.Theseforcefulpolicyactionsweretakeninthehopeofpreventingthedownturnfrombecominganotherdepression,andtheyseemtohavesucceeded.Bytheendof2009,theeconomywasgrowingonceagain,andtheunemploymentratehadbeguntodecline,althoughtherecoveryremainedsluggishforseveralyears.PolicymakerscertainlycantakecreditforavoidinganotherGreatDepression.Theunemploymentratepeakedat10percent,comparedwith25percentin1933,andindustrialproductionfellby17percentoveraperiodof18monthsduringtheGreatRecession,comparedwithadeclineofmorethan50percentoverthreeyearsduringtheGreatDepression.

Figure12-9

TheLiquidityTrap(AlsoKnownastheZeroLowerBound)

InterestratesreachedlevelsclosetozerointheUnitedStatesduringthe1930sand,morerecently,duringlate2008,whentheFedlowereditstargetforthefederalfundsratetoarangeofzeroto0.25percentandkeptitthereforseveralyears.Economistsrefertothissituationasaliquiditytrap.Becausenominalinterestratescannotfallbelowzero,anexpansioninthemoneysupplywouldnotbeabletolowernominalinterestratesandthereforemightnotbeabletoaffectspending.Theeconomycouldbecome“trapped”atalowlevelofaggregatedemand,output,andincome.Butsincespendingdirectlydependsonrealinterestratesratherthannominalrates,ahigherrateofinflationcouldpushrealinterestratesbelowzeroandstimulatespending.Thisisthereasonwhysomeeconomistsarguefortargetingarateofinflationthatisabovezero—say,around4percentperyear.Suchaninflationtargetwouldgivethecentralbanktheabilitytolowertherealinterestratetonegative4percentandhelpspuraggregatedemand.Inotherwords,aninflationtargetof4percentimpliesahighernominalinterestrateinnormaltimesandmoreroomforthecentralbanktocutinterestratesinresponsetoarecession.

Othereconomistsdoubttherelevanceofliquiditytraps,arguingthatcentralbankshaveadditionalwaystostimulatetheeconomywhenitsinterestratetargetisnearzero.Oneoptioninvolvesraisingexpectedinflationbycommittingtoapolicyoffuturemonetaryexpansion,sometimescalled“forwardguidance,”therebyloweringrealinterestrates.Anotheroptionistolowerlong-terminterestratesbyconductingopen-marketoperationsinlong-termassetssuchasmortgagesorcorporatedebt—apolicysometimesreferredtoas“quantitativeeasing.”

FYI:TheCuriousCaseofNegativeInterestRates

Becausecashpaysaninterestrateofzero,economistsusuallythinkthatzeroisthelowerboundforinterestrates.Whylendmoneytosomeoneatanegativeinterestratewhenyoucansimplyholdcash?Azerorateofreturnisbetterthananegativeone.Butinrecentyears,centralbankshaveloweredinterestratesbelowzero,inattemptstofurtherstimulatetheireconomies.Thereasonthisispossibleisthatholdingcashiscostly.Cashissubjecttotheftorphysicalloss.Peoplemaybewillingtopayasmallfeetoguaranteethattheirmoneyissafeandsecure.Thisfeeisthenegativeinterestrate.Theextenttowhichinterestratescanbepushednegative,however,islimited.Atsomepoint,peoplewouldfinditcheapertopurchasesecuresafesinwhichtostorecashratherthanlenditoutandpaythefee.Sowhilethelowerboundoninterestratesisnotexactlyzero,interestratescannotfalltoofarbelowzero.

12-4 Conclusion

Supplement12-4,“TheSimpleAlgebraofthe

IS-LMModelandAggregateDemandCurve”

Supplement12-5,“ProportionalIncomeTaxesandtheISCurve”

TheIS–LMmodelwithfixedpricesisstillanincompletemodeloftheeconomyintheshortrun.Amoresatisfactorymodelrequiresabetterunderstandingofaggregatesupply.ThisisthesubjectofChapter14.Also,ourmodelisbasedonverysimpleideasaboutconsumption,investment,andmoneydemand.PartVIofthetextbookpresentsmoresophisticatedandsatisfactorytheoriesoftheseelementsofaggregatedemandandexamineshowsuchrefinementsaffectthebasicconclusionsoftheshort-runmodel.

AdditionalCaseStudy

12-1 DoHighDeficitsCauseHighInterestRates?

TheIS–LMmodelofChapter12predictsthatexpansionaryfiscalpolicy—thatis,increasesingovernmentspendingordecreasesintaxes,bothofwhichimplyincreasesinthedeficit—leadstohighinterestrates.IncreasesinthedeficitincreasethedemandforgoodsandservicesandthusshifttheIScurvetotheright.Theassociatedincreaseinincomeincreasesthedemandformoney,andsointerestratesmustrisetokeepthemoneymarketinequilibrium.Inthelongrun,theeffectisevenstronger:increasesinthepricelevelcausetheLMcurvetoshiftbacktotheleft,resultinginstillhigherinterestrates.ThiscanbeseenequivalentlyintheclassicalmodelofChapter3,whichshowshowincreasesinthedeficitdecreasenationalsavingandsoincreaseinterestrates.

Increasesininterestratesinturnimplyreducedinvestment—crowdingout—inboththeshortrunandthelongrun.Economistsworry,therefore,thathighdeficitsimplylowlevelsofinvestment,leadingultimatelytoalowercapitalstockandsolowerlivingstandards.Itis,therefore,importanttoseeifthispredictionthathighdeficitsleadtohighinterestratesissupportedbythedata.Someeconomiststhinkthatdeficitsarelessharmfulbecausechangesinprivatesavingmayoffsetchangesinpublicsaving.Thisidea,knownasRicardianequivalence,isdiscussedinChapter17ofthetextbook

Likemanyotherempiricalquestionsineconomics,thisoneisdifficulttoanswerunequivocally.Figure1showsascatterplotoftherealgovernmentdeficitandtheexpostrealinterestratebetween1960and2000.Whilethereissomeevidence