# Mankiw 5/e Chapter 9: Intro to Economic Fluctuations

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```							CASE STUDY
Volcker’s Monetary Tightening
 Late 1970s:  > 10%
 Oct 1979: Fed Chairman Paul Volcker
announced that monetary policy
would aim to reduce inflation.
 Aug 1979-April 1980:
Fed reduces M/P 8.0%
 Jan 1983:  = 3.7%
How do you think this policy change
would affect interest rates?

slide 0
Volcker’s Monetary Tightening, cont.
The effects of a monetary tightening
on nominal interest rates

short run             long run
Quantity Theory,
Liquidity Preference
model                               Fisher Effect
(Keynesian)
(Classical)
prices            sticky               flexible

prediction         i > 0                i < 0

actual      8/1979: i = 10.4%
1/1983: i = 8.2%
outcome      4/1980: i = 15.8%
slide 1
EXERCISE:
Analyze shocks with the IS-LM model
Use the IS-LM model to analyze the effects of
1. A boom in the stock market makes
consumers wealthier.
2. After a wave of credit card fraud, consumers
use cash more frequently in transactions.
For each shock,
a. use the IS-LM diagram to show the effects
of the shock on Y and r .
b. determine what happens to C, I, and the
unemployment rate.

slide 2
What is the Fed’s policy instrument?
What the newspaper says:
“the Fed lowered interest rates by one-half point today”
What actually happened:
The Fed conducted expansionary monetary policy to
shift the LM curve to the right until the interest rate fell
0.5 points.

The Fed targets the Federal Funds rate:
it announces a target value,
and uses monetary policy to shift the LM curve
as needed to attain its target rate.

slide 3
What is the Fed’s policy instrument?
Why does the Fed target interest rates
1) They are easier to measure than the
money supply
2) The Fed might believe that LM shocks are
more prevalent than IS shocks. If so, then
targeting the interest rate stabilizes income
better than targeting the money supply.

slide 4
Interaction between
monetary & fiscal policy
 Model:
monetary & fiscal policy variables
(M, G and T ) are exogenous
 Real world:
in response to changes in fiscal policy,
or vice versa.
 Such interaction may alter the impact of
the original policy change.

slide 5
The Fed’s response to G > 0
 Suppose Congress increases G.
 Possible Fed responses:
1. hold M constant
2. hold r constant
3. hold Y constant
 In each case, the effects of the G
are different:

slide 6
Response 1: hold M constant
If Congress raises G,    r
the IS curve shifts                  LM1
right
If Fed holds M          r2
constant, then LM       r1
curve doesn’t shift.
IS2
Results:                             IS1
Y
Y  Y 2  Y 1           Y1 Y2

r  r2  r1

slide 7
Response 2: hold r constant
If Congress raises G,    r
the IS curve shifts                     LM1
right                                         LM2
To keep r constant,     r2
Fed increases M to      r1
shift LM curve right.
IS2
Results:                                IS1
Y
Y  Y 3  Y 1           Y1 Y2 Y3

r  0

slide 8
Response 3: hold Y constant
If Congress raises G,    r           LM2
the IS curve shifts                    LM1
right
r3
To keep Y constant,     r2
Fed reduces M to        r1
shift LM curve left.
IS2
Results:                              IS1
Y  0                                   Y
Y1 Y2
r  r3  r1

slide 9
CASE STUDY
The U.S. economic slowdown of 2001
~What happened~
1. Real GDP growth rate
1994-2000: 3.9% (average annual)
2001: 1.2%
2. Unemployment rate
Dec 2000: 4.0%
Dec 2001: 5.8%

slide 10
CASE STUDY
The U.S. economic slowdown of 2001
~Shocks that contributed to the slowdown~
1. Falling stock prices
From Aug 2000 to Aug 2001: -25%
Week after 9/11: -12%
2. The terrorist attacks on 9/11
• increased uncertainty
• fall in consumer & business confidence
Both shocks reduced spending and
shifted the IS curve left.

slide 11
The Great Depression
240                                             30
Unemployment
(right scale)
220                                             25
billions of 1958 dollars

percent of labor force
200                                             20

180                                             15

160                                             10

Real GNP
140                                             5
(left scale)
120                                             0
1929    1931   1933    1935     1937   1939

slide 12
The Spending Hypothesis:
Shocks to the IS Curve
 asserts that the Depression was largely due
to an exogenous fall in the demand for
goods & services -- a leftward shift of the IS
curve
 evidence:
output and interest rates both fell, which is
what a leftward IS shift would cause

slide 13
The Spending Hypothesis:
Reasons for the IS shift
1. Stock market crash  exogenous C
 Oct-Dec 1929: S&P 500 fell 17%
 Oct 1929-Dec 1933: S&P 500 fell 71%
2. Drop in investment
 “correction” after overbuilding in the 1920s
obtain financing for investment
3. Contractionary fiscal policy
 in the face of falling tax revenues and
increasing deficits, politicians raised tax rates
and cut spending
slide 14
The Money Hypothesis:
A Shock to the LM Curve
 asserts that the Depression was largely due
to huge fall in the money supply
 evidence:
M1 fell 25% during 1929-33.
But, two problems with this hypothesis:
1. P fell even more, so M/P actually rose
slightly during 1929-31.
2. nominal interest rates fell, which is the
opposite of what would result from a
leftward LM shift.

slide 15
The Money Hypothesis Again:
The Effects of Falling Prices
 asserts that the severity of the Depression
was due to a huge deflation:
P fell 25% during 1929-33.
 This deflation was probably caused by
the fall in M, so perhaps money played
an important role after all.
 In what ways does a deflation affect the
economy?

slide 16
The Money Hypothesis Again:
The Effects of Falling Prices
The stabilizing effects of deflation:

 P  (M/P )  LM shifts right  Y
 Pigou effect:
P  (M/P )
 consumers’ wealth 
 C
 IS shifts right
 Y

slide 17
The Money Hypothesis Again:
The Effects of Falling Prices
The destabilizing effects of unexpected deflation:
debt-deflation theory
P (if unexpected)
 transfers purchasing power from borrowers
to lenders
 borrowers spend less,
lenders spend more
 if borrowers’ propensity to spend is larger
than lenders, then aggregate spending falls,
the IS curve shifts left, and Y falls

slide 18
The Money Hypothesis Again:
The Effects of Falling Prices
The destabilizing effects of expected deflation:
e
    r  for each value of i
    I  because I = I (r )
    planned expenditure & agg. demand 
    income & output 

slide 19
Why another Depression is unlikely
 Policymakers (or their advisors) now know
 The Fed knows better than to let M fall
so much, especially during a contraction.
 Fiscal policymakers know better than to raise
taxes or cut spending during a contraction.
 Federal deposit insurance makes widespread
bank failures very unlikely.
 Automatic stabilizers make fiscal policy
expansionary during an economic downturn.

slide 20

```
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