CHAPTER 10 Aggregate Demand I slide 1

 Aggregate Demand I:
Building the IS -LM Model
 Chapter 11

CHAPTER 10 Aggregate Demand I slide 2

 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

CHAPTER 10 Aggregate Demand I slide 3

 The Keynesian Cross

 A simple closed economy model in which income

is determined by expenditure.
(due to J.M. Keynes)
 Notation:
I = planned investment
E = C + I + G = planned expenditure
Y = real GDP = actual expenditure
 Difference between actual & planned expenditure
= unplanned inventory investment
CHAPTER 10 Aggregate Demand I slide 4
 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: E  C (Y  T )  I  G

equilibrium condition:
actual expenditure = planned expenditure
Y  E
CHAPTER 10 Aggregate Demand I slide 5
 Graphing planned expenditure

planned E = C +I +G
expenditure
MPC
1

income, output, Y

CHAPTER 10 Aggregate Demand I slide 6

 Graphing the equilibrium condition

E E =Y

planned

expenditure

45º

income, output, Y

CHAPTER 10 Aggregate Demand I slide 7

 The equilibrium value of income

E E =Y

planned E = C +I +G
expenditure

income, output, Y
Equilibrium
income
CHAPTER 10 Aggregate Demand I slide 8
 An increase in government purchases
E Y

=
At Y1, E E = C +I +G2
there is now an
unplanned drop E = C +I +G1
in inventory…

G

…so firms
increase output,
and income Y
rises toward a
new equilibrium. E1 = Y 1 Y E2 = Y 2

CHAPTER 10 Aggregate Demand I slide 9

 Solving for Y
Y  C  I  G equilibrium condition

Y  C  I  G in changes

 C  G because I exogenous

 MPC  Y  G because C = MPC Y

Collect terms with Y Solve for Y :

on the left side of the
equals sign:  1 
Y     G
(1  MPC)  Y  G  1  MPC 

CHAPTER 10 Aggregate Demand I slide 10

 The government purchases multiplier
Definition: the increase in income resulting from a
$1 increase in G.
In this model, the govt Y 1

purchases multiplier equals G 1  MPC

Example: If MPC = 0.8, then

Y 1 An
An increase
increase in
in G
G
  5 causes
causes income
income to
to
G 1  0.8
increase
increase 55 times
times
as
as much!
much!
CHAPTER 10 Aggregate Demand I slide 11
 Why the multiplier is greater than 1

 Initially, the increase in G causes an equal increase

in Y: Y = G.
 But Y  C
 further Y
 further C
 further Y
 So the final impact on income is much bigger than
the initial G.

CHAPTER 10 Aggregate Demand I slide 12

 An increase in taxes
E Y

=
Initially, the tax E E = C1 +I +G
increase reduces
consumption, and E = C2 +I +G
therefore E:

C = MPC T At Y1, there is now

an unplanned
…so firms inventory buildup…
reduce output,
and income falls Y
toward a new E2 = Y 2 Y E1 = Y 1
equilibrium

CHAPTER 10 Aggregate Demand I slide 13

 Solving for Y
eq’m condition in
Y  C  I  G
changes
 C I and G exogenous

 MPC   Y  T 
Solving for Y : (1  MPC)  Y   MPC  T

  MPC 
Final result: Y     T
 1  MPC 

CHAPTER 10 Aggregate Demand I slide 14

 The tax multiplier

def: the change in income resulting from

a $1 increase in T :
Y  MPC

T 1  MPC

If MPC = 0.8, then the tax multiplier equals

Y  0.8  0.8
   4
T 1  0.8 0.2

CHAPTER 10 Aggregate Demand I slide 15

 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.
CHAPTER 10 Aggregate Demand I slide 16
 Exercise:

 Use a graph of the Keynesian cross

to show the effects of an increase in planned
investment on the equilibrium level of
income/output.

CHAPTER 10 Aggregate Demand I slide 17

 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

CHAPTER 10 Aggregate Demand I slide 18

 Deriving the IS curve
E E =Y
E =C +I (r2 )+G
r  I E =C +I (r1 )+G

 E I

 Y Y1 Y2 Y
r
r1

r2
IS
Y1 Y2 Y

CHAPTER 10 Aggregate Demand I slide 19

 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 (E ).
 To restore equilibrium in the goods market,
output (a.k.a. actual expenditure, Y )
must increase.

CHAPTER 10 Aggregate Demand I slide 20

 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

CHAPTER 10 Aggregate Demand I slide 21

 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…

CHAPTER 10 Aggregate Demand I slide 22

 Shifting the IS curve: G
E E =Y E =C +I (r )+G
At any value of r, 1 2

G  E  Y E =C +I (r1 )+G1
…so the IS curve
shifts to the right.

The horizontal Y1 Y2 Y
r
distance of the
r1
IS shift equals
1 Y
Y  G IS2
1 MPC IS1
Y1 Y2 Y

CHAPTER 10 Aggregate Demand I slide 23

CHAPTER 10 Aggregate Demand I slide 24
 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.

CHAPTER 10 Aggregate Demand I slide 25

 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

CHAPTER 10 Aggregate Demand I slide 26

 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

CHAPTER 10 Aggregate Demand I slide 27

 Equilibrium
r
M P
s
The interest 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

CHAPTER 10 Aggregate Demand I slide 28

 How the Fed raises the interest rate
r
interest
To increase r, rate
Fed reduces M
r2

r1
L (r )

M/P
M2 M1
real money
P P balances

CHAPTER 10 Aggregate Demand I slide 29

 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 )

CHAPTER 10 Aggregate Demand I slide 30

 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
CHAPTER 10 Aggregate Demand I slide 31
 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.

CHAPTER 10 Aggregate Demand I slide 32

 How M 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
CHAPTER 10 Aggregate Demand I slide 33
 Exercise: 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.

CHAPTER 10 Aggregate Demand I slide 34

CHAPTER 10 Aggregate Demand I slide 35
CHAPTER 10 Aggregate Demand I slide 36
 The short-run equilibrium
The short-run equilibrium is r
the combination of r and Y LM
that 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
CHAPTER 10 Aggregate Demand I slide 37
 The Big Picture

Keynesian
Keynesian IS
IS
Cross
Cross curve
curve
IS-LM
IS-LM
model Explanation
Explanation
Theory
Theory ofof model
LM
LM of
of short-run
short-run
Liquidity
Liquidity curve fluctuations
curve fluctuations
Preference
Preference
Agg.
Agg.
demand
demand
curve
curve Model
Model of
of
Agg.
Agg.
Demand
Demand
Agg.
Agg. and
and Agg.
Agg.
supply
supply Supply
Supply
curve
curve

CHAPTER 10 Aggregate Demand I slide 38

 Preview of Chapter 11

In Chapter 11, 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 10 Aggregate Demand I slide 39
 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

CHAPTER 10 Aggregate Demand I slide 40

 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

CHAPTER 10 Aggregate Demand I slide 41

 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.

CHAPTER 10 Aggregate Demand I slide 42