Economics 3307
Main Points of
Mankiw, Chapter 11
1. We know from Chapter 9 that fluctuations in aggregate demand can cause fluctuations in output. This occurs to the extent that prices are "sticky."
2. This chapter demonstrates that we can use the ISLM model to gain additional understanding of aggregate demand determination.
3. When the price level (P) changes, this shifts the LM curve and causes movement along the AD curve. A lower price level shifts LM right and moves down and right along AD. A higher price level shifts LM left and moves up and left along AD.
4. Anything other than a change in P that shifts the LM curve also shifts AD. LM and AD shift right with increases in the money supply and with exogenous decreases in money demand. LM and AD shift left with decreases in the money supply and exogenous increases in money demand. [An exogenous change in money demand is a change not caused by Y or r. Exogenous changes in money demand might be caused by technological improvements in the payments system -- which would decrease money demand, or by fears of a stock market crash --which would increase money demand.]
5. Anything that shifts the IS curve also shifts the AD curve. Things that shift IS right also shift AD right. Things that shift IS left also shift AD left. IS and AD shift right with increases in G, decreases in T, and exogenous increases in C or I. IS and AD shift left with decreases in G, increases in T, and exogenous decreases in C or I. [An exogenous change in C or I is a change not caused by Y or r, such as a decrease in C caused by a collapse in consumer confidence or an increase in I caused by the enactment of an investment tax credit.]
6. We can use the ISLM model to explain why the Great Depression occurred. [This note explains my theory and differs a bit from the text, which tries to be more balanced.]
- The IS curve shifted left by a LOT because of the stock market crash in 1929 (which made consumers feel less wealthy and thereby caused a decline in consumer spending), a decrease in housing construction (and hence a decline in investment) due to overbuilding in the 1920s, a decline in investment spending because of bank failures (banks channel funds from savers to firms, which use the funds to purchase new capital), and a contractionary fiscal policy.
- As the IS shifted left, output and interest rates began to fall.
- The Fed interpreted the falling interest rates as a sign that monetary policy was too easy, so they too steps to tighten policy! The money supply fell by a third between 1929 and 1933. This caused a further leftward shift in the AD curve. Taken together, the IS and LM shifts caused a massive leftward AD shift.
- This massive leftward AD shift also caused the IS curve to become very steep. When output is very far below full employment, changes in interest rates will not have much of an effect on desired spending.
- When the IS curve is steep, the AD curve is also very steep. Thus the leftward IS shift caused a lefttward AD shift and the AD curve became very steep.
- With a steep AD curve, a falling price level will not cause output to rise very much. Thus the adjustment mechanisms of the economy failed during the Great Depression: there was considerable deflation, but the deflation did not move the economy back to full employment.
- The deflation reduced expected inflation (people began to expect deflation, so expected inflation became negative), which caused nominal interest rates to become very, very low.
- The Great Depression ended only with the massive increase in government spending associated with World War II, which shifted the IS and AD curves back to the right (and made them flatter as well).