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Aggregate Demand I:
Building the IS-LM Model

Intermediate Macroeconomic Theory

 IN THIS CHAPTER, YOU WILL LEARN:

• the IS curve and its relation to:

• the Keynesian cross
• the loanable funds model
• the LM curve and its relation to:
• the theory of liquidity preference
• how the IS-LM model determines income and the
interest rate in the short run when P is fixed

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Context
• Chapter 10 introduced the model of aggregate
demand and aggregate supply.
• Long run:
• prices flexible
• output determined by factors of production &
technology
• unemployment equals its natural rate
• Short run:
• prices fixed
• output determined by aggregate demand
• unemployment negatively related to output
Context
• This chapter develops the IS-LM model,
the basis of the aggregate demand curve.
• We focus on the short run and assume the price
level is fixed (so the SRAS curve is horizontal).
• Chapters 11 and 12 focus on the closed-economy
case. Chapter 13 presents the open-economy case.
 The Keynesian cross
• A simple closed-economy model in which income is
determined by expenditure.
(due to J. M. Keynes)
• Notation:
I = planned investment
PE = C + I + G = planned expenditure
Y = real GDP = actual expenditure
• Difference between actual & planned expenditure =
unplanned inventory investment
Elements of the Keynesian cross
consumption function: C = C (Y -T )
govt policy variables: G = G , T =T
for now, planned
investment is exogenous: I =I
planned expenditure: PE = C (Y - T ) + I + G
equilibrium condition:
actual expenditure = planned expenditure
Y = PE
Graphing planned expenditure
PE
planned
expenditure
PE =C +I +G

MPC
1

income, output, Y
Graphing the equilibrium condition
PE
planned PE =Y
expenditure

45º

income, output, Y
The equilibrium value of income
PE
planned PE =Y
expenditure
PE =C +I +G

income, output, Y
Equilibrium
income
 An increase in government purchases
PE Y

=
At Y1, PE PE =C +I +G
2
there is now an
unplanned drop PE =C +I +G1
in inventory…

DG
…so firms
increase output,
and income Y
rises toward a
new equilibrium. PE1 = Y1 DY PE2 = Y2
Solving for DY
Y = C + I + G equilibrium condition

DY = DC + DI + DG in changes

= DC + DG because I exogenous

= MPC ´ DY + DG because DC = MPC DY

Collect terms with DY Solve for DY :

on the left side of the
equals sign: æ 1 ö
DY = ç ÷ ´ DG
(1 - MPC) ´DY = DG è 1 - MPC ø
The government purchases multiplier
Definition: the increase in income resulting from a $1
increase in G.
In this model, the govt
purchases multiplier equals DY 1
=
DG 1 - MPC

Example: If MPC = 0.8, then

An increase in G
DY 1
= = 5 causes income to
DG 1 - 0.8 increase 5 times
as much!
Why the multiplier is greater than 1

• Initially, the increase in G causes an equal increase in

Y: DY = DG.
• But ­Y Þ ­C
Þ further ­Y
Þ further ­C
Þ further ­Y
• So the final impact on income is much bigger than the
initial DG.
 An increase in taxes
PE Y

=
Initially, the tax PE PE =C +I +G
increase reduces 1

consumption and PE =C2 +I +G

therefore PE:

DC = -MPC DT At Y1, there is now

an unplanned
inventory buildup…
…so firms
reduce output,
and income falls Y
toward a new DY
PE2 = Y2 PE1 = Y1
equilibrium
Solving for DY
eq’m condition in
DY = DC + DI + DG changes
= DC I and G exogenous

= MPC ´ ( DY - DT )
Solving for DY : (1 - MPC) ´DY = - MPC ´ DT

æ - MPC ö
Final result: DY = ç ÷ ´ DT
è 1 - MPC ø
The tax multiplier
def: the change in income resulting from
a $1 increase in T:
DY - MPC
=
DT 1 - MPC

If MPC = 0.8, then the tax multiplier equals

DY - 0.8 - 0.8
= = = -4
DT 1 - 0.8 0.2
The tax multiplier
…is negative:
A tax increase reduces C,
which reduces income.

…is greater than one

(in absolute value):
A change in taxes has a
multiplier effect on income.

…is smaller than the govt spending multiplier:

Consumers save the fraction (1 – MPC) of a tax cut, so the
initial boost in spending from a tax cut is smaller than from
an equal increase in G.
NOW YOU TRY
Practice with the Keynesian cross
• Use a graph of the Keynesian cross
to show the effects of an increase in planned
investment on the equilibrium level of
income/output.

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ANSWERS
Practice with the Keynesian cross
PE Y

=
At Y1, PE PE =C +I +G
2
there is now an
unplanned drop PE =C +I1 +G
in inventory…

DI

…so firms
increase output,
and income Y
rises toward a
new equilibrium. PE1 = Y1 DY PE2 = Y2
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 The IS curve
def: a graph of all combinations of r and Y that result in
goods market equilibrium
i.e. actual expenditure (output)
= planned expenditure
The equation for the IS curve is:

Y = C (Y - T ) + I (r ) + G
Deriving the IS curve
PE PE =Y PE =C +I (r )+G
2

¯r Þ ­I PE =C +I (r1 )+G

Þ ­PE DI

Þ ­Y Y1 Y2 Y
r
r1

r2
IS
Y1 Y2 Y
Why the IS curve is negatively sloped

• A fall in the interest rate motivates firms to increase

investment spending, which drives up total planned
spending (PE).
• To restore equilibrium in the goods market, output
(a.k.a. actual expenditure, Y)
must increase.
The IS curve and the loanable funds model

(a) The L.F. model (b) The IS curve

r S2 S1 r

r2 r2

r1 r1
I (r )
IS
S, I Y2 Y1 Y
Fiscal Policy and the IS curve
• We can use the IS-LM model to see how fiscal
policy (G and T) affects aggregate demand and
output.
• Let’s start by using the Keynesian cross to see how
fiscal policy shifts the IS curve…
 Shifting the IS curve: DG
PE PE =Y PE =C +I (r )+G
At any value of r, ­G 1 2

Þ ­PE Þ ­Y PE =C +I (r1 )+G1

…so the IS curve shifts
to the right.

The horizontal Y1 Y2 Y
r
distance of the
IS shift equals r1

1
DY = DG DY
1- MPC IS1 IS2
Y1 Y2 Y
NOW YOU TRY
Shifting the IS curve: DT
• Use the diagram of the Keynesian cross or loanable
funds model to show how an increase in taxes shifts
the IS curve.
• If you can, determine the size of the shift.

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ANSWERS
Shifting the IS curve: DT
PE PE =Y PE =C +I (r )+G
At any value of r, 1 1

­T Þ ¯C Þ ¯PE PE =C2 +I (r1 )+G

…so the IS curve shifts
to the left.

Y2 Y1 Y
The horizontal r
distance of the r1
IS shift equals
-MPC DY
DY = DT
1- MPC IS2 IS1
Y2 Y1 Y
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The theory of liquidity preference
• Due to John Maynard Keynes.
• A simple theory in which the interest rate
is determined by money supply and
money demand.
Money supply
r
(M P )
s
The supply of interest
real money rate
balances
is fixed:

(M P) =M P
s

M/P
M P real money
balances
Money demand
r
(M P )
s
Demand for interest
real money rate
balances:

(M P)
d
= L (r )

L (r )

M/P
M P real money
balances
Equilibrium
r
The interest
(M P )
s
interest
rate adjusts rate
to equate the
supply and
demand for
money:
r1

M P = L (r ) L (r )

M/P
M P real money
balances
How the Fed raises the interest rate
r
interest
To increase r, Fed rate
reduces M
r2

r1
L (r )

M/P
M2 M1 real money
P P balances
CASE STUDY:
Monetary Tightening & Interest Rates
• Late 1970s: p > 10%
• Oct 1979: Fed Chairman Paul Volcker announces
that monetary policy
would aim to reduce inflation
• Aug 1979–April 1980:
Fed reduces M/P 8.0%
• Jan 1983: p = 3.7%

How do you think this policy change

would affect nominal interest rates?
Monetary Tightening & Interest Rates, cont.
The effects of a monetary tightening
on nominal interest rates

short run long run

Quantity theory, Fisher
liquidity preference
model effect
(Keynesian)
(Classical)

prices sticky flexible

prediction Di > 0 Di < 0

actual 8/1979: i = 10.4% 8/1979: i = 10.4%

outcome 4/1980: i = 15.8% 1/1983: i = 8.2%
The LM curve
Now let’s put Y back into the money demand function:

(M P )
d
= L (r ,Y )
The LM curve is a graph of all combinations of r and
Y that equate the supply and demand for real
money balances.
The equation for the LM curve is:
M P = L (r ,Y )
Deriving the LM curve
(a) The market for
(b) The LM curve
real money balances
r r
LM

r2 r2

L (r , Y2 )
r1 r1
L (r , Y1 )

M1 M/P Y1 Y2 Y
P
Why the LM curve is upward sloping

• An increase in income raises money demand.

• Since the supply of real balances is fixed, there is
now excess demand in the money market at the
initial interest rate.
• The interest rate must rise to restore equilibrium in
the money market.
How DM shifts the LM curve
(a) The market for
(b) The LM curve
real money balances
r r
LM2

LM1
r2 r2

r1 r1
L (r , Y1 )

M2 M1 M/P Y1 Y
P P
NOW YOU TRY
Shifting the LM curve
• Suppose a wave of credit card fraud causes
consumers to use cash more frequently in
transactions.
• Use the liquidity preference model to show how
these events shift the LM curve.

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ANSWERS
Shifting the LM curve
(a) The market for
(b) The LM curve
real money balances
r r
LM2

LM1
r2 r2
L (r , Y1 )
r1 r1
L (r , Y1 )

M1 M/P Y1 Y
P
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The short-run equilibrium
The short-run equilibrium is the r
combination of r and Y that
LM
simultaneously satisfies the
equilibrium conditions in the
goods & money markets:

Y = C (Y - T ) + I (r ) + G IS
M P = L (r ,Y ) Y
Equilibrium
interest Equilibrium
rate level of
income
 The Big Picture
Keynesian IS
cross curve
IS-LM
model Explanation
Theory of LM of short-run
liquidity curve fluctuations
preference
Agg.
demand
curve Model of
Agg.
Demand
Agg.
and Agg.
supply
Supply
curve
Preview of Chapter 13
In Chapter 13, we will
• use the IS-LM model to analyze the impact of policies
and shocks.
• learn how the aggregate demand curve comes from IS-
LM.
• use the IS-LM and AD-AS models together to analyze
the short-run and long-run effects of shocks.
• use our models to learn about the
Great Depression.
 CHAPTER SUMMARY
1. Keynesian cross
• basic model of income determination
• takes fiscal policy & investment as exogenous
• fiscal policy has a multiplier effect on income
2. IS curve
• comes from Keynesian cross when planned investment
depends negatively on interest rate
• shows all combinations of r and Y
that equate planned expenditure with
actual expenditure on goods & services

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 CHAPTER SUMMARY
3. Theory of liquidity preference
• basic model of interest rate determination
• takes money supply & price level as exogenous
• an increase in the money supply lowers the interest rate
4. LM curve
• comes from liquidity preference theory when
money demand depends positively on income
• shows all combinations of r and Y that equate demand
for real money balances with supply

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 CHAPTER SUMMARY
5. IS-LM model
• Intersection of IS and LM curves shows the unique
point (Y, r ) that satisfies equilibrium in both the goods
and money markets.

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