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1、CHAPTER 11Extending the Sticky-Price Model:IS-LM,International Side,and AS-AD1Copyright 2002 by The McGraw-Hill Companies,Inc.All rights reserved.QuestionsWhat is money-market equilibrium?What is the LM curve?What determines the equilibrium level of real GDP when the central bank policy is to keep t
2、he money supply constant?What is the IS-LM framework?2Copyright 2002 by The McGraw-Hill Companies,Inc.All rights reserved.QuestionsWhat is an IS shock?What is an LM shock?What is the relationship between shifts in the equilibrium on the IS-LM diagram and changes in the real exchange rate?3Copyright
3、2002 by The McGraw-Hill Companies,Inc.All rights reserved.QuestionsWhat is the relationship between shifts in the equilibrium on the IS-LM diagram and changes in the balance of trade?What is the aggregate supply curve?What is the aggregate demand curve?4Copyright 2002 by The McGraw-Hill Companies,In
4、c.All rights reserved.The Demand for MoneyThree facts about business and household demand for moneymoney demand is proportional to total nominal income(PY)money demand has a time trend,the result of slow changes in the banking sector structure and technologymoney demand is inversely related to the n
5、ominal interest rate5Copyright 2002 by The McGraw-Hill Companies,Inc.All rights reserved.The Demand for MoneyMoney demand is inversely related to the nominal interest rate(i=r+)because the nominal interest rate is the opportunity cost of holding moneymoney balances lose purchasing power at the rate
6、of inflation()if money balances were placed in some other asset,they would earn the prevailing market real interest rate(r)6Copyright 2002 by The McGraw-Hill Companies,Inc.All rights reserved.The Demand for MoneyTo keep our model simple,we will ignore the time trend in velocityThe demand for money c
7、an be expressed asMoney demand is proportional to real GDP and a decreasing function of the nominal interest rate7Copyright 2002 by The McGraw-Hill Companies,Inc.All rights reserved.Money Market EquilibriumIn a sticky-price model,the price level is predeterminedit cannot move instantly to make money
8、 supply equal to money demandThe nominal interest rate must adjust to keep the money market in equilibrium8Copyright 2002 by The McGraw-Hill Companies,Inc.All rights reserved.Figure 11.1-Money Demand andMoney Supply9Copyright 2002 by The McGraw-Hill Companies,Inc.All rights reserved.Money Market Equ
9、ilibriumIf money supply money demandbusinesses and households are holding larger money balances than they want so they deposit them at the bankbanks want to increase loans and thus respond by lowering interest ratesas the nominal interest rate falls,the quantity of money demanded risesthis process c
10、ontinues until the quantity of money demanded is equal to the money supply11Copyright 2002 by The McGraw-Hill Companies,Inc.All rights reserved.The LM CurveBecause the demand for money depends on the level of real GDP,if the money stock is constant,the equilibrium nominal interest rate will vary whe
11、never real GDP varies12Copyright 2002 by The McGraw-Hill Companies,Inc.All rights reserved.Figure 11.2-Money Demand Varies as Total Income Y Varies13Copyright 2002 by The McGraw-Hill Companies,Inc.All rights reserved.The LM CurveThe LM curve shows the relationship between the level of real GDP and t
12、he equilibrium nominal interest rate that clears the money marketThe LM curve slopes upwardat a higher level of real GDP,money demand is higher and therefore the equilibrium nominal interest rate is higher14Copyright 2002 by The McGraw-Hill Companies,Inc.All rights reserved.Figure 11.3-From Money De
13、mand to theLM Curve15Copyright 2002 by The McGraw-Hill Companies,Inc.All rights reserved.The LM CurveThe equation for the LM curve isIncreases in the money supply shift the LM curve to the rightA decline in the price level shifts the LM curve to the right16Copyright 2002 by The McGraw-Hill Companies
14、,Inc.All rights reserved.The IS-LM FrameworkAs long as we know the expected inflation rate,we can plot the IS and LM curves on the same axisThe equilibrium levels of real GDP and the interest rate occur at the point where the IS and LM curves intersectthe economy is in equilibrium in both the goods
15、market and the money market17Copyright 2002 by The McGraw-Hill Companies,Inc.All rights reserved.Figure 11.4-The IS-LM Diagram18Copyright 2002 by The McGraw-Hill Companies,Inc.All rights reserved.IS-LM EquilibriumExample(assume that is constant at 3%)IS curve:Y=$10,000-$20,000rLM curve:Y=$1,000+$100
16、,000(r+)19Copyright 2002 by The McGraw-Hill Companies,Inc.All rights reserved.Figure 11.5-IS-LM Equilibrium Example20Copyright 2002 by The McGraw-Hill Companies,Inc.All rights reserved.IS ShocksAny change in economic policy or the economic environment that increases autonomous spending shifts the IS
17、 curve to the rightthe new equilibrium will have a higher level of real GDP and a higher real interest ratehow the total effect is divided between increased interest rates and increased real GDP depends on the slope of the LM curve21Copyright 2002 by The McGraw-Hill Companies,Inc.All rights reserved
18、.Figure 11.6-Effect of a Positive IS Shock22Copyright 2002 by The McGraw-Hill Companies,Inc.All rights reserved.An IS ShockExampleinitial IS curve:Y=$10,000-$20,000rLM curve:Y=$1000+$100,000(r+3)initial equilibrium:r=5%;Y=$9,000autonomous spending increasesnew IS curve:Y=$10,300-$20,000r23Copyright
19、2002 by The McGraw-Hill Companies,Inc.All rights reserved.Figure 11.7-Calculating the Effect of anIS Shift24Copyright 2002 by The McGraw-Hill Companies,Inc.All rights reserved.LM ShocksAn increase in the money stock will shift the LM curve to the rightthe new equilibrium position will have a higher
20、level of equilibrium real GDP and a lower interest rate25Copyright 2002 by The McGraw-Hill Companies,Inc.All rights reserved.Figure 11.8-Effect of an ExpansionaryLM Shock26Copyright 2002 by The McGraw-Hill Companies,Inc.All rights reserved.An LM ShockExampleIS curve:Y=$10,000-$20,000rinitial LM curv
21、e:Y=$1000+$100,000(r+3)initial equilibrium:r=5%;Y=$9,000the money supply increasesnew LM curve:Y=$2200+$100,000(r+3)27Copyright 2002 by The McGraw-Hill Companies,Inc.All rights reserved.Figure 11.9-An Expansionary Shift in theLM Curve28Copyright 2002 by The McGraw-Hill Companies,Inc.All rights reser
22、ved.Interest Rate TargetsThe case in which the central bank is targeting the interest rate can be viewed in the IS-LM frameworkAn interest rate target can be seen as a flat,horizontal LM curve at the target level of the interest rate29Copyright 2002 by The McGraw-Hill Companies,Inc.All rights reserv
23、ed.Figure 11.10-IS-LM Framework with an Interest Rate Target30Copyright 2002 by The McGraw-Hill Companies,Inc.All rights reserved.Changes that Affect theLM CurveAny change in the nominal money stock,in the price level,or in the trend velocity of money will shift the LM curveAny change in the interes
24、t sensitivity of money demand will change the slope of the LM curve31Copyright 2002 by The McGraw-Hill Companies,Inc.All rights reserved.Changes that Affect theLM CurveThe IS-LM diagram is drawn with the long-term,risky,real interest rate on the vertical axisThe LM curve is a relationship between th
25、e short-run nominal interest rate and the level of real GDP at a fixed level of the money supply32Copyright 2002 by The McGraw-Hill Companies,Inc.All rights reserved.Changes that Affect theLM CurveAs long as the spread between the short-term,safe,nominal interest rate and the long-term,risky,real in
26、terest rate is constant,there are no complications in drawing the LM curve onto the same diagram as the IS curve33Copyright 2002 by The McGraw-Hill Companies,Inc.All rights reserved.Changes that Affect theLM CurveIf the expected rate of inflation,the risk premium,or the term premium between short-an
27、d long-term interest rates changes,the LM curve will shiftchanges in financial market expectations of future Federal Reserve policy,future interest rates,or changes in the risk tolerance of bond traders will shift the LM curve34Copyright 2002 by The McGraw-Hill Companies,Inc.All rights reserved.Figu
28、re 11.11-An Increase in Expected Inflation Moves the LM Curve Downward35Copyright 2002 by The McGraw-Hill Companies,Inc.All rights reserved.Changes that Affect theIS CurveShifts in the IS curve are more frequent than shifts in the LM curveAny change in the interest sensitivity of investment,the sens
29、itivity of exports to the exchange rate,or the sensitivity of the exchange rate to the domestic interest rate will change the slope of the IS curve36Copyright 2002 by The McGraw-Hill Companies,Inc.All rights reserved.Changes that Affect theIS CurveAnything that affects MPE will change the slope and
30、the position of the IS curvethis includes changes in the MPC,tax rates,and the propensity to importAny change in autonomous spending will shift the IS curve37Copyright 2002 by The McGraw-Hill Companies,Inc.All rights reserved.The IS-LM Framework and the Exchange RateIn the sticky-price model,the rea
31、l exchange rate()is equal toAs long as the domestic real interest rate does not change,domestic conditions will have no impact on the exchange rate38Copyright 2002 by The McGraw-Hill Companies,Inc.All rights reserved.The IS-LM Framework and the Exchange RateChanges in the IS and LM curves that chang
32、e the domestic real interest rate will alter the real exchange rate by an amount equal to(r r)a rightward shift in the IS curve or a leftward shift in the LM curve will lower the real exchange ratea leftward shift in the IS curve or a rightward shift in the LM curve will raise the real exchange rate
33、39Copyright 2002 by The McGraw-Hill Companies,Inc.All rights reserved.Figure 11.12-IS-LM and the Exchange Rate40Copyright 2002 by The McGraw-Hill Companies,Inc.All rights reserved.The IS-LM Framework and the Balance of TradeChanges in the domestic interest rate affect the real exchange rate which af
34、fects gross exportsChanges in total income affect importsThe effect on net exports is the difference between these two effects41Copyright 2002 by The McGraw-Hill Companies,Inc.All rights reserved.Figure 11.13-Effect of a Change in Domestic Conditions on the Exchange Rate and the Balance of Trade42Co
35、pyright 2002 by The McGraw-Hill Companies,Inc.All rights reserved.An LM Shock and the Balance of TradeExampleinitial IS curve:Y=$10,000-$20,000rinitial LM curve:Y=$1000+$100,000(r+3)initial equilibrium:r=5%;Y=$9,000the money supply increasesnew LM curve:Y=$2200+$100,000(r+3)new equilibrium:r=4%;Y=$9
36、,20043Copyright 2002 by The McGraw-Hill Companies,Inc.All rights reserved.Figure 11.14-Effects of Expansionary Monetary Policy44Copyright 2002 by The McGraw-Hill Companies,Inc.All rights reserved.An LM Shock and the Balance of TradeExample(continued)the decrease in the real interest rate increases t
37、he exchange rate by(-r r)=-10 (-.01)=0.10 and the rise in the real exchange rate increases gross exports by(X )=$200 0.1=$20the increase in real national income increases imports by(IMy Y)=$0.15$200=$30net exports falls by$1045Copyright 2002 by The McGraw-Hill Companies,Inc.All rights reserved.Inter
38、national ShocksThree types of international shocks will affect the IS-LM equilibriuma shift in foreign demand for exportsa shift in the foreign real interest ratea change in foreign exchange speculators view about the fundamental value of the exchange rate46Copyright 2002 by The McGraw-Hill Companie
39、s,Inc.All rights reserved.International ShocksAn increase in export demand is an increase in autonomous spending(A0)the IS curve shifts rightward by an amount equal to A0/(1-MPS)equilibrium real GDP rises and the real interest rate rises as well(if the LM curve is upward sloping)47Copyright 2002 by
40、The McGraw-Hill Companies,Inc.All rights reserved.Figure 11.15-Effect of an Increase in Foreign Demand for Exports48Copyright 2002 by The McGraw-Hill Companies,Inc.All rights reserved.International ShocksAn increase in the foreign interest rate raises the value of the exchange rate and boosts export
41、sthe IS curve shifts to the rightequilibrium real GDP rises and the real interest rate also increases(if the LM curve is upward sloping)49Copyright 2002 by The McGraw-Hill Companies,Inc.All rights reserved.International ShocksIf foreign exchange speculators lose confidence in their home currency,the
42、 exchange rate will risethe IS curve will shift to the rightequilibrium real GDP will rise and the real interest rate will increase(assuming that the LM curve is upward sloping)50Copyright 2002 by The McGraw-Hill Companies,Inc.All rights reserved.International ShocksExampleLM curve:Y=$1000+$100,000(
43、r+3)initial IS curve:Y=$10,000-$20,000rinitial equilibrium:r=5%;Y=$9,000foreign exchange speculators lose confidence in the value of home currencynew IS curve:Y=$10,120-$20,000rnew equilibrium:r=5.1%;Y=$9,10051Copyright 2002 by The McGraw-Hill Companies,Inc.All rights reserved.Aggregate DemandIf the
44、 nominal money supply is fixed,an increase in the price level shifts the LM curve to the leftthe equilibrium real interest rate risesthe equilibrium level of real GDP fallsIf we plot the level of equilibrium real GDP for each possible price level,we will get the aggregate demand curveit will be down
45、ward sloping52Copyright 2002 by The McGraw-Hill Companies,Inc.All rights reserved.Figure 11.16-An Increase in the Price Level Shifts the LM Curve Left(If the Nominal Money Supply is Fixed)53Copyright 2002 by The McGraw-Hill Companies,Inc.All rights reserved.Figure 11.17-From the IS-LM Diagram to the
46、 Aggregate Demand Curve54Copyright 2002 by The McGraw-Hill Companies,Inc.All rights reserved.Monetary Policy and Aggregate DemandModern central banks alter the money supply in response to changes in the economywhen inflation rises,the central bank tends to increase the real interest rate55Copyright
47、2002 by The McGraw-Hill Companies,Inc.All rights reserved.Monetary Policy and Aggregate DemandThe Taylor rule is a simple model of how central banks actthe central bank has a target value of inflation()and an estimate of what the normal real interest rate should be(r*)if inflation is higher than,the
48、 central bank raises the real interest rate if inflation is lower than,the central bank lowers the real interest rate56Copyright 2002 by The McGraw-Hill Companies,Inc.All rights reserved.Monetary Policy and Aggregate DemandThe Taylor rule can be expressed in equation form:where”determines how aggres
49、sively the central bank reacts to inflation57Copyright 2002 by The McGraw-Hill Companies,Inc.All rights reserved.Monetary Policy and Aggregate DemandThe Taylor rule can be substituted into the equation for the IS curveSimplifying,we get58Copyright 2002 by The McGraw-Hill Companies,Inc.All rights res
50、erved.Monetary Policy and Aggregate DemandThe monetary policy function is a relationship between the inflation rate and real GDPit assumes that the Federal Reserve is engaged in the economy trying to keep inflation close to its target59Copyright 2002 by The McGraw-Hill Companies,Inc.All rights reser