Mankiw6e chap11

Editor's Notes

• #2: This is a very substantial chapter, and among the most challenging in the text. I encourage you to go over this chapter a little more slowly than average, or at least recommend to your students that they study it extra carefully. I have included a number of in-class exercises to give students immediate reinforcement of concepts as they are covered, and also to break up the lecture. If you need to get through the material more quickly, you can omit some or all of these exercises (perhaps assigning them as homeworks, instead). A graph unfolds on slides 29-33. If you create handouts of this file for your students (or create a PDF version for them to download from the web), you might consider omitting slides 30 and 32 to save paper, as they contain intermediate animations.
• #5: Review/recap of the very end of Chapter 10.
• #7: Chapter 10 showed that an increase in G causes the IS curve to shift to the right by (  G)/(1-MPC).
• #8: Chapter 10 used the Keynesian Cross to show that a decrease in T causes the IS curve to shift to the right by (-MPC  T)/(1-MPC). If your students ask why the IS curve shifts to the right when there’s a negative sign in the expression for the shift, remind them that  T < 0 for a tax cut, so the expression actually is positive. The term showing the distance of the shift in the IS curve is almost the same as in the case of a government spending increase, where the numerator of the fraction equals (1) for government spending rather than (-MPC) for the tax cut. Here’s the intuition: Every dollar of a government spending increase adds to aggregate spending. However, for tax cuts, the fraction (1-MPC) of the tax cut leaks into saving, so aggregate spending only rises by MPC times the tax cut.
• #9: Chapter 10 showed that an increase in M shifts the LM curve to the right. Here is a richer explanation for the LM shift: The increase in M causes the interest rate to fall. [People like to keep optimal proportions of money and bonds in their portfolios; if money is increased, then people try to re-attain their optimal proportions by “exchanging” some of the money for bonds: they use some of the extra money to buy bonds. This increase in the demand for bonds drives up the price of bonds -- and causes interest rates to fall (since interest rates are inversely related to bond prices). The fall in the interest rate induces an increase in investment demand, which causes output and income to increase. The increase in income causes money demand to increase, which increases the interest rate (though doesn’t increase it all the way back to its initial value; instead, this effect simply reduces the total decrease in the interest rate).
• #15: The preceding slides show that the impact of fiscal policy on GDP depends on the Fed’s response (or lack thereof). This slide shows estimates of the fiscal policy multipliers under different assumptions about monetary policy; these estimates are consistent with the theoretical results on the preceding slides. First, the slide shows estimates of the government spending multiplier for the two different monetary policy scenarios. Then, the slide reveals the tax multiplier estimates. (If you wish, you can turn off the animation so that everything appearing on the slide appears at one time. Just click on the “Slide Show” pull-down menu, then on “Custom animation…”, then uncheck all of the boxes next to the elements of the screen that you do not wish to be animated. Regarding the estimates: First, note that the estimates of the fiscal policy multipliers are smaller (in absolute value) when the money supply is held constant than when the interest rate is held constant. This is consistent with the results from the IS-LM model presented in the preceding few slides. Second, notice that the tax multiplier is smaller than the government spending multiplier in each of the monetary policy scenarios. This should make sense from material presented earlier in this chapter: the government spending multiplier (for a constant money supply) is 1/(1-MPC), while the tax multiplier is only (-MPC)/(1-MPC).
• #18: Earlier slides showed how to use the IS-LM model to analyze fiscal and monetary policy. Now is a good time for students to get some hands-on practice with the model. Also, note that part (b) helps students learn that shocks and policies can potentially affect all of the model’s endogenous variables, not just the ones that are measured on the axes. After working this exercise, your students will better understand the case study on the 2001 U.S. recession that immediately follows. Suggestion: Instead of having students work on these exercises individually, get them into pairs. One student of each pair works on the first shock, the other student works on the second shock. Give them 5 minutes to work individually on the analysis of the shock. Then, allow 10 minutes (5 for each student) for students to present their results to their partners. This activity gives students immediate application and reinforcement of the concepts, so students learn them better and will then better understand and appreciate the remainder of your lecture on Chapter 11. Answers: 1a. The IS curve shifts to the right, because consumers feel they can afford to spend more given this exogenous increase in their wealth. This causes Y and r to rise. 1b. C rises for two reasons: the stock market boom, and the increase in income. I falls, because r is higher. u falls, because firms hire more workers to produce the extra output that is demanded. 2a. (This is a continuation of the in-class exercise at the end of the PowerPoint presentation of Chapter 10.) The increase in money demand shifts the LM curve to the left: We are assuming that all other exogenous variables, including M and P, remain unchanged, so an increase in money demand causes an increase in the value of r associated with each value of Y (this can be seen easily using the Liquidity Preference diagram). This translates to an upward (i.e. leftward) shift in the LM curve. This shift causes Y to fall and r to rise. 2b. The fall in income causes a fall in C . The increase in r causes a fall in I . The fall in Y causes an increase in u .
• #19: If you taught with the PowerPoints I did for the previous (orange) edition of this book, you will find that I have redone this case study. In addition to updating it to match the textbook, I have added two time-series graphs showing stock prices and the effects of the Fed’s policy response on short-term interest rates.
• #20: Starting in mid-2000, the S&P 500 begins a downward trend. The fall in stock prices eroded the wealth of millions of U.S. consumers. They responded by reducing consumption.
• #22: The war was a response to the 9/11 attacks, not to the recession. But wars involve significant fiscal policy expansion, which increases aggregate demand and alleviates or ends recessions.
• #23: Easier monetary policy shifted the LM curve to the right, causing interest rates to fall, as shown in this graph.
• #24: Chapter 18 discusses monetary policy in detail.
• #27: It might be useful to explain to students the reason why we draw P 1 before drawing the LM curve: The position of the LM curve depends on the value of M/P. M is an exogenous policy variable. So, if P is low (like P 1 in the lower panel of the diagram), then M/P is relatively high, so the LM curve is over toward the right in the upper diagram. If P is high, like P 2 , then M/P is relatively low, so the LM curve is more toward the left. Because the value of P affects the position of the LM curve, we label the LM curves in the upper panel as LM(P 1 ) and LM(P 2 ).
• #28: It’s worth taking a moment to explain why we are holding P fixed at P 1 : To find out whether the AD curve shifts to the left or right, we need to find out what happens to the value of Y associated with any given value of P. This is not to say that the equilibrium value of P will remain fixed after the policy change (though, in fact, we are assuming P is fixed in the short run). We just want to see what happens to the AD curve. Once we know how the AD curve shifts, we can then add the AS curves (short- or long-run) to find out what, if anything, happens to P (in the short- or long-run).
• #30: The next few slides put our IS-LM-AD in the context of the bigger picture - the AD-AS model in the short-run and long-run, which was introduced in Chapter 9.
• #31: Abbreviation: SR = short run, LR = long run The analysis that begins on this slide continues on the following slides.
• #35: A good thing to do: Go back through this experiment again, and see if your students can figure out what is happening to the other endogenous variables (C, I, u) in the short run and long run.
• #36: This exercise has two objectives: 1. To give students immediate reinforcement of the preceding concepts. 2. To show them that money is neutral in the long run, just like in chapter 4. You might have your students try other exercises using this framework: * the short-run and long-run effects of expansionary fiscal policy. Have them compare the long-run results in this framework with the results they obtained when doing the same experiment in Chapter 3 (the loanable funds model). * Immediately after a negative shock pushes output below its natural rate, show how monetary or fiscal policy can be used to restore full-employment immediately (i.e., without waiting for prices to adjust).
• #37: This chart presents data from Table 11-2 on pp.318-9 of the text. For data sources, see notes accompanying that table. Things to note: 1. The magnitude of the fall in output and increase in unemployment. In 1933, the unemployment rate is over 25%!! 2. There’s a very strong negative correlation between output and unemployment.
• #39: In item 2, I’m using the term “correction” in the stock market sense.
• #43: The textbook (starting p.322) uses an “extended” IS-LM model, which includes both the nominal interest rate (measured on the vertical axis) and the real interest rate (which equals the nominal rate less expected inflation). Because money demand depends on the nominal rate, which is measured on the vertical axis, the change in expected inflation doesn’t shift the LM curve. However, investment depends on the real interest rate, so the fall in expected inflation shifts the IS curve: each value of i is now associated with a higher value of r , which reduces investment and shifts the IS curve to the left. Results: income falls, i falls, and r rises --- which is exactly what happened from 1929 to 1931 (see table 11-2 on pp.318-9). This slide gives the basic intuition, which students often can grasp more quickly and easily than the graphical analysis. After you cover this material in your lecture, it will be easier for your students to grasp the analysis on pp.322-23.
• #45: Examples of automatic stabilizers: the income tax: people pay less taxes automatically if their income falls unemployment insurance: prevents income - and hence spending - from falling as much during a downturn This topic is discussed in Chapter 14.