1

Chapter Three
AGGREGATE DEMAND IN
CLOSED ECONOMY

BY ESHETIE W.
 2
Introduction:A Simple Economy Model

 Assume an economy in which there is no government and

foreign trade.
 In such a case national Y accounts divide total E into two
categories. (Note that in the simplest form of a circular
flow, output is equals to income that in turn equals to
expenditure.):Consumption (C)& I spending.
 The first key identity is that b/n output produced & sold.
 Output sold can be written in terms of the components of
demand as the sum of C and I spending.
 Accordingly, we can write the identity of output
produced and output sold:
 Cont.
3

Y = C +I..................................(1)
 Since there is no government and external sector in our
economy (by assumption), the
private sector receives the whole of the disposable
income (Y).
 The income will be partly spent on consumption and
partly will be saved.
 Thus we can write
Y = C + S..................................(2)
Cont.
4

Identity (2) tells us that the whole of income is

allocated to either C or S .
Next, identity (1) and (2) can be combined to give us
C +I =Y = C + S..................................(3)
o The left-hand side of identity (3) shows the
components of demand, & the right hand sides
shows the allocation of income.
Cont.
5

Identity (3) can be reformulated to let us look at the

r/ship b/n S and I.
Subtracting C from each part of identity (3),
 we have
I=Y-C=S..................................(4)
 Identity (4) shows that in this simple economy I is
identically equals S.
 An Economy With Government and Foreign Trade
6

 We denote the government purchases of all goods and

services by (G) and its tax receipt by (TA).
 The government also makes transfer to the private sector
(TR).
 The foreign sector is composed on imports (M) and
exports (X). Net exports (exports minus imports) are
denoted by NX.
 With government and foreign trade, identity (1) can be
rewritten by adding G and NX -i.e
Y = C + I + G + NX...............................(5)
Cont.
7

 Now we have to recognize that part of income is

spent on taxes and that the private sector receives
net transfers (TR) in addition to national income.
 Disposable income (YD) is thus equal to income
plus transfers less taxes:
YD =Y +TR -TA..................................(6)
 Disposable income, in turn, is allocated to
consumption and saving:
YD = C +S..................................(7)
Cont.
8
Combining (6) & (7), se have:

Identity (8a) states that C is Yd less S or, alternatively,

that C is equal to Y plus transfers less taxes and S.

Substituting the right hand side of (8a) into (5) and rearranging, we get

S-I=(G+TR TA)+NX.............................(9)
Cont.
9

 The first term on the right-hand side (G+TR-TA) is

the government budget deficit i.e.
 The excess of government spending over its
receipts.
 The second term on the right-hand
side is the excess of X over M, or Nx
 Thus, identity (9) states that the
excess of S over I (S –I) of the private sector is
equal to the government
budget deficit plus the trade surplus.
Cont.
10

 The identity suggests that there are important

relations among the excess of private S over I (S –I), the
government budget (G+TR-TA), & the external sector.

 E.g., if, for the private sector, S is equal to I, then the

government’s budget deficit (surplus) is reflected in an
equal external deficit (surplus).

 In the 1980s there was much discussion of the twin

deficit- the budget deficit and the trade deficit.
Cont.
11

 Identity (9) is helpful is seeing that budget deficit

must have a counterpart:
 if the government spends more than it receives in
revenue, then it has to borrow, either at home
(private S exceeds I) or abroad (M exceeded X).

 The identity makes it clear that budget deficits need

not be matched one-for-one by negative net exports.

 Thus, there is no inevitable one-to-one link between

the two deficits.
 3.2. The Goods Market and The IS curve
The Keynesian Cross
12

 At the heart of the Keynesian perspective is the importance of demand and all its
components: C, I, G(and Nx in an open economy).

 Our starting point for the analysis of how shifts in these components affect demand is
the Keynesian cross.

 The Keynesian equilibrium is achieved when planned aggregate demand (planned

expenditure) is equal to actual expenditure.
 The difference between actual and planned expenditure arises from unplanned
inventory investment.
 When firms sell less of their
product than planned, their stock of inventories automatically rises. Conversely, when
firms sell more than planned, their stock of inventories falls.
Cont.
13

 Because these unplanned changes in inventory are counted as spending by firms, actual
expenditure can be either above or below planned expenditure.
 Assuming that the economy is closed, the planned expenditure is given by,
AD = C + I +G..................................(10)

 Let us suppose for the moment that all the things that influence aggregate consumption
expenditure over and above current income
 (e.g., demographics, expectations of future income, levels of wealth, and so on) can be held
constant as current income varies.
 Suppose also the link between changes in current income and spending is proportional so that a
given rise in available birr of income always raises consumption by a given fraction of that rise —
say c.
 Hence, consumption is determined by disposable income.

Mathematically,
C=C(Y-T)………………………………….(11) or C= c0+c1(Y-T)
 Cont.
14

AD = C(Y –T)+ I+G..................(12)

 The equation describes aggregate

demand as a function of planned
consumption, which in its
self is a function of disposable
income, and the exogenous values
of planned investment, tax
and government expenditure.

 The aggregate demand may be

depicted as in the following
graph.
 Cont.
15
 Since all other components except
planned expenditure and Y are
constant, the graph shows the
relationship between these two
variables.

 As the graph clearly shows, when

Y increases E also increases.

 Hence the slope, which indicates

MPC, is positive.

 This can be derived using simple

calculus as follows.
 The Keynesian equilibrium

16

The economy is in equilibrium when

actual aggregate demand equals
planned aggregate demand.

Total output of the economy Y equals

not only total income but also actual
aggregate demand.
The equilibrium condition is given by

Y=AD..................................(14)Or;

Actual aggregate demand=actual

aggregate demand
Cont.
17

 The above graph shows that Keynesian equilibrium is achieved when the actual
expenditure line crosses the 45◦ line.
 At any point along the 45◦ line, planned and actual aggregate
demand are equal.
 In the Keynesian cross, equilibrium is achieved through inventory adjustment.
 Unplanned change in inventories induce producers to change production
accordingly.
 Suppose, GDP in the current period is greater than planned aggregate demand,
and as a result firms sell less than they produce.

 The unsold goods will be added to the stock of inventories. This unplanned
inventory investment induce firms to reduce production.
Cont.
18

The opposite happens when production falls short of actual

aggregate demand, which leads to a fall in stock of inventories and
induce firms to produce more.
This process will continue until planned aggregate demand equals to
actual aggregate demand (income).
In summary, the Keynesian cross shows how income Y is
determined for given levels of planned investment (I) and fiscal
policy G and T.

We can use this model to show how income changes when one of
these exogenous variables changes.
 Fiscal Policy and the Multiplier: Government Purchases

19

Since government purchases are one component of

expenditure, high government purchases imply, for
any given level of income, higher planned aggregate
demand.
If government purchases rise by ∆G, then the
planned aggregate demand schedule shifts upward by
∆G, as shown in the figure below.
20
 The graph shows that an increase
in government purchases leads to
an even greater increase
in income.
 That is, ∆Y > ∆G. The ratio
∆Y/∆G is called the government
purchase multiplier;
 and it tells how much income rises
in response to a one-unit increase
in government purchases.
 An implication of the Keynesian
cross is that the government
purchases multiplier is larger than
one
Cont.
21

Why does fiscal policy have a multiplied effect on income?

The reason is that, according to the consumption function,
higher income causes higher consumption.
 Because an increase in government purchases raises income,
it also raises consumption, which further raises consumption,
and so on.

Therefore, in this model, an increase in government

purchases causes
a greater increase in income.
 22

When government purchase increase by

∆G, national income will also rise by ∆G.
This in turn raises consumption by
MPC*∆G.
Once again, the increase in consumption
raises income
by MPC*∆G which increases
consumption by MPC (MPC*∆G).
This process continues although
its impact in each next cycle is
decreasing.

 Mathematically, the increase in income

can be
written as,
23
24
 25

Alternatively, the multiplier can be derived using

calculus as follows.
Y =C(Y –T) + I +G
 Fiscal Policy and the Multiplier: Taxes

26

A decrease in taxes of ∆T immediately raises disposable income Y-T by ∆T

and,
therefore, consumption by MPC * ∆T. For any level of income Y, aggregate
demand
is now higher. As shown in the figure below, the aggregate demand
schedule shifts
upward by MPC*∆T. The equilibrium of the economy moves from point A
to point B.

Just like the government spending, tax also has a multiplier impact on
income. Starting with
the national income identity,
Y= C(Y – T) + I + G
27
 28

The multiplier implies that, income and tax are negatively related.
Moreover, a unit
increase in tax will result in a more than proportionate decrease in
income and vice versa.
So far, we assumed that tax is a fixed lump sum. In reality, however, tax
is a function of
income. In this case, the government expenditure multiplier is given by
Cont.
29
The result clearly shows that a change in the government
expenditure has smaller impact
The Interest rate, Investment and the IS Curve

30

The Keynesian cross is useful because it shows what

determines the economy’s income for any given level of
planned investment.
Yet it makes the unrealistic assumption that the level of
planned investment is fixed.
However, planned investment depends negatively on
the interest rate.
The transition from the Keynesian cross model to the IS
curve is achieved by noting that if the real interest rate
changes, this changes planned investment.
Cont.
31

 The Keynesian cross analysis tells us that change in

planned investment change GDP.
Thus, for example, if interest rates increase, planned
investment falls, and so does output. Thus higher levels of
the interest rate are associated with lower level of output.
 To add the relationship between the interest rate and
investment,
 we write the level of planned investment as I = I(r)
 The national income equation becomes,
Y = C(Y - T )+ I(r)+G
 and the IS curve can be derived mathematically
Cont.
32
 Why IS Curve Slopes Downward
33

The IS curve summarizes the relationship between

the interest rate and the level of income that results
from the investment function and the Keynesian
cross.
 The higher the interest rate, the lower the level of
planned investment, and thus the lower level
of income.
For this reason the IS curve slopes downward.
 Interest rate and slope of the IS curve

34

A given change in the r will have a bigger impact on output the

flatter the IS curve.
That is, if either:

 The interest sensitivity of planned expenditure (via investment I’)

is high ⇒ planned expenditure line shifts further, so output falls
further.

 The marginal propensity to consume out of disposable income

(MPC) is large
⇒ higher MPC implies steeper planned expenditure line, so output
must fall further in response to a given downward shift of the
planned expenditure line to return to planned = actual expenditure
 Factors that shift the IS curve

35

The IS curve shows us the level of income for any given interest rate.
The IS curve is drawn for a given fiscal policy; that is, it holds G and
T fixed.
When fiscal policy changes, the IS curve shifts. Here are some
factors that shift the IS curve

1. Changes in Autonomous Consumer Expenditure:

A rise in autonomous consumer expenditure (for a given level of G, I
and T) shifts the aggregate demand function upward
and shifts the IS curve to the right.
The reverse happens when autonomous consumption decrease.
2. Changes in Investment Spending Unrelated to the
Interest Rate:
36

As we have seen a change in r causes a change in

investment spending but causes a movement along the
IS curve and not a shift.
 A rise in planned investment spending unrelated to the
interest rate (say, due to increase in business
optimism) shifts the aggregate demand function
upward.
 Hence, equilibrium level of output will be higher for
any given level of r.
 Cont.
37

On the contrary, a decrease in investment spending

due to factors other than a change in interest rate
(say, because companies become more pessimistic
about investment profitability) shifts the aggregate
demand function downward for any given interest
rate;
 The equilibrium level of aggregate output falls,
shifting the IS curve to the left.
 3. Changes in Government Spending
38

 An increase in government spending will also cause the

aggregate demand function at any given interest rate to
shift upward.
 The equilibrium level of aggregate output rises at any given
interest rate, and the IS curve shifts to the right.
 Conversely, a decline in government spending shifts the
aggregate demand function downward, and the equilibrium
level of output falls, shifting the IS curve to the left.
Mathematically,
 3. Changes in Taxes

39

 Unlike changes in other factors that directly affect the aggregate

demand function,

 a decline in taxes shifts the aggregate demand function by

raising consumer expenditure and shifting the aggregate
demand function upward at any given interest rate.
 A decline in taxes raises the equilibrium level of aggregate
output at & shifts the IS curve to the right.

 However, a rise in taxes shifts the IS curve to the left.

Cont.
40
Cont.
41

In summary, the IS curve shows the relationship between the

interest rate and the level of income that arises from the market
for goods and services.
The IS curve takes fiscal policy as given. Hence,

 Changes in fiscal policy that raise the demand for goods and
services shift the IS curve to the right.

 Changes in fiscal policy that reduce the demand for goods and
services (such as an increase in tax) shift the IS curve to the left.
 The Money market and the LM curve
42

 The LM curve is the r/ship between the interest rate and the level of
income that arises in the market for money balances.
A. The Theory of Liquidity Preference

 The theory of liquidity preference explains how the supply and demand
for real money balance determines the interest rate.
 We begin with the supply of real money balances.
 If M stands for the supply of money and P stands for the price level, then
M/P is the supply of real money balances.

 The theory of liquidity preference assumes there is a fixed supply of real

balance. That is,
Cont.
43

 The money supply M is an exogenous policy variable

chosen by the central bank.
The price level P is also an exogenous variable in this
model.
 (We take the price level as given because the IS-LM
model considers the short run when the price level is
fixed).
These assumptions imply that the supply of real
balances is fixed and, in particular, does not depend on
the interest rate as shown in the figure below.
Cont.
44
Cont.
45

 Consider the demand for real money balances.

People hold money because it is a “liquid” asset-
That is, because it is easily used to make transactions.
The theory of liquidity preference postulates that the
quantity of real money balances demanded depends on
the interest rate.
The interest rate is the opportunity cost of holding money.
When the interest rate rises, people want to hold less of
their wealth in the form of money.
We write the demand for real money balances as,
Cont.
46

 Where the function L( ) denotes

the demand for the liquid asset-
money.

 This equation
states that the quantity of real
balances demanded is a function
of the r.

 This inverse r/ship b/n Md & r can

be shown as a
downward sloping demand curve.
Cont.
47

To obtain the theory of the interest rate,

we combine the SS and the DD for real
money balances.

According to the theory of liquidity

preference, the interest rate adjusts to
equilibrate the money market.

At the equilibrium r, the quantity of real

balances demanded equals the quantity
supplied.
Cont.
48

The adjustment of the r to this equilibrium of Ms and Md

occurs because people try to adjust their portfolios of assets if r
is not at the equilibrium level.
If the r is too high, the quantity of real balances supplied
exceeds the quantity demanded.
Banks and other financial institutes respond to this excess
supply of money by lowering the interest rates they offer.
Conversely, if the r is too low, so that the quantity of Md
exceeds the Md , individuals try to obtain money by making
bank withdrawals, which drives the r up.
At the equilibrium r people are content with their portfolios of
monetary & non-monetary assets.
 49

The theory of liquidity preference

implies that decreases in the Ms
raise the r and that increases in the
Ms lower the r.
 Suppose there is a reduction in Ms.
A reduction in M reduces M/P,
since P is fixed in the model.
The supply of real balances shift to
the left, The equilibrium r rises
from r1 to r2.
The higher interest rate induces
people to hold a smaller quantity of
real money balances.
Income, Money Demand, and the LM Curve

50

So far we have assumed that only the r influences the

quantity of real balances demanded.
More realistically, the level of income Y also affects
money demand.
When income is high, expenditure is high, so people
engage in more transactions that require the use of
money.
Thus, greater income implies greater money demand. We
now write the money demand function as
Cont.
51

 The quantity of real money

balances demanded is negatively
related to the r and positively
related to income.

 Using the theory of liquidity

preference, we can see what
happens to the r when the level of
income changes.

 For example, consider

what happens when income
increases from Y1 to Y2.
Cont.
52

As the above figure shows the increase in income shifts the
Md curve outward.
To equilibrate the market for real money balances, the r must
rise from r1 to r2.
Therefore, higher income leads to a higher r .
The LM curve plots this r/ship b/n the level of income & the r.
The higher the level of income, the higher the demand for real
money balances, & the higher the equilibrium
r.
For this reason the LM curve slopes upward
Cont.
53

Mathematically, the equilibrium in the money

market (LM) is expressed as
where k and L are coefficients of Y & r. For the
reason discussed above, k>0 & L<0.
Interest rate and Slope of the LM curve
The LM curve slopes upward in the (r, y) space. This
can be seen by totally differentiating the
LM equation above
 How Monetary Policy Shifts the LM Curve
54

 The LM curve tells us the interest rate that equilibrates the

money market for any given level of income.
 The theory of liquidity preference shows that the equilibrium
interest rate depends on the supply of real balances.
 The LM curve is drawn for a given supply of real money
balances. If real balances change, the LM curve will shift.
Suppose that the money supply is decreased from M1 to M2,
which causes the supply of real balances
to fall from M1/P to M2/P.
 55

 Holding constant the

amount of income.
 thus the demand curve for
real balances, a reduction in
the supply of real balances
raises the
r that equilibrates the money
market.
 Hence, a decrease in real
balances shifts the
LM curve upward.
Cont.
56

In summary, the LM curve shows the relationship b/n

the r and the level of income that arises in the market for
real money balances.
The LM curve is drawn for a given supply of real money
balances.
Decreases in the supply of real money balances shift
the LM curve upward.
Increases in the supply of real money balances shift the
LM curve downward.
A Quantity-Equation Interpretation of the LM Curve
57

 The quantity theory of money states that MV (r)=PY

Where V is velocity.
A higher interest rate raises the cost of holding money
and reduces money demand.
As people respond to a higher interest rate by reducing
the amount of money they hold, each currency in the
economy circulates from person to person more quickly
i.e. velocity of money increases.
This implies that r and V are positively related.
Cont.
58

An increase in the r raises the velocity of money.

For a given money supply and price level, it raises the level of income
(to maintain the equality).
The LM curve expresses this positive relationship between the
interest rate and income.
This equation also shows why changes in the money supply shift the
LM curve.
 For any given interest rate (i.e. constant velocity) and price level, an
increase in the money supply raises the level of income.
 Thus, increases in the money supply shift the LM curve to the right,
and decreases in the money supply shift the LM curve to the left.
 3.4. The Short Run Equilibrium

59

The ISLM model takes FP: G and

T, MP: M, and the price level P as
exogenous.
 Given these exogenous variables,
the IS curve provides the
combination of r and Y that
satisfy the equation representing
the goods market,
 And the LM curve provides the
combinations of r and Y that
satisfy the equation representing
the money market. See figure
below
 60
MP and FP Analysis in the IS-LM curve
 The equilibrium of the economy is the  Y may changes because of a shift in ISLM
point at which the IS curve and the curve which is attributed to a change in
LM curve policies.
cross. Change in Fiscal Policy
 This point gives the r and the level of Y
that satisfy both the goods market  Suppose that we start in equilibrium and
equilibrium and the money market that government spending is increased by
equilibrium condition. ∆G.

 In other words, at this  Then the IS curve shifts to the right.

intersection,
 Actual expenditure equals planned  The increased spending increases Y and,
expenditure, through the multiplier effects from the
 The demand for real money circular flow, also increases C; Y increases
further.
balances equals the supply.
Cont.
61

 (Recall that the rightward shift of the IS curve equals ∆G/(1-MPC))

 If we only had to worry about the goods market, this would be the end of the
story.
 But the increase in income, in turn, increases the demand for money for
transaction purposes.
 This increased demand for money forces up the interest rate, leading, in turn, to a
decline in investment.
 Thus, we observe short-run crowding out:
 The increase in GDP is less than the simple Keynesian cross model would have
predicted because that model omits changes
in the r.
 A decline in taxes, like an increase in government spending, shifts the IS curve
out, causing interest rates and GDP to rise.
Mathematical derivation of the impact of Fiscal policy is as follow.
62
63
Cont.
64

The last term in the above equation is positive due to the fact that both the
numerator and the denominator are positive.
Let’s see each term in the denominator; the numerator, 1, is clearly
positive.
C’ is the MPC which, obviously, is between zero and one.
1-C’, MPS is therefore positive.
I’=dI/dr is negative given that investment is negatively related with interest
rate;
 And k, the coefficient of Y in the LM equation, is positive indicating that an
increase in income increases the transaction demand for money.
On the other hand, L, the coefficient of r in the LM equation is negative due to
the fact that the demand for cash balance decrease as interest rate increases.
Generally, (1-C’) is positive and (I’k/L) is also negative since it is a ratio of two
negatives.
Hence,dY/ispositive.
 Changes in Monetary Policy
65

 Consider the effects of an increase in the Ms.

 This shifts the LM curve out.
 The increased Ms causes r to fall in order to bring the
demand for money in line with the new higher supply.
 This fall in interest rates encourages investment, leading
ultimately to an increase in GDP.
 Thus, interest rates are lower and GDP is higher.
 The linkage from a change in the Ms to GDP is known as
the monetary transmission mechanism.
 Mathematically, the impact of change in Ms can be derived
 66

 This shows that an increase in money supply raises the level

of income.
 The transmission mechanism in the context of the IS-LM
model is that an increase in the Ms lowers the interest rate,
which stimulates I & thereby expands the demand for g, s
 Interaction between Monetary and Fiscal Policy
67

When analyzing any change in MP or FP, it is important to

note that these policies may not be independent of each other.
 A change in one may influence the other.
This interdependence may alter the impact of a policy change.
Suppose that the fiscal authorities increase taxes.
Other things equal, this would reduce output and r in the
short run (Case 1).
 If the monetary authority is trying to keep r
 However, it would respond to this change by decreasing the
Ms.
The result would be a larger decrease in output (Case 2).
Cont.
68

 Alternatively, the monetary authorities might be trying to

keep output stable, in which case it would
increase the Ms, driving r down further (Case 3).

 The basic issue is that the ultimate effects on the economy

depend upon the combinations of policies chosen by the
monetary and fiscal authorities.
Cont.
69
Effectiveness of Monetary Versus Fiscal Policy

70

So far, the government can bring the desired outcomes in the
economy by using a set of FP and MP instruments.
But how can policymakers decide which of these
policies to use if faced with too much unemployment?
 Should they decrease taxes, increase government spending,
raise the Ms, or do all three?
And if they decide to increase the money supply, by how much?
Although the ISLM model will not clear the path to aggregate
economic bliss, it can help policymakers decide which policies
may be most effective under certaincircumstances.
 Cont.
71

For the sake of clarification, let’s consider a case when money

demand is interest rate inelastic.
In this case, the LM curve will be vertical as shown in the
figure below.
Suppose that the economy is suffering from a high rate of
unemployment, which policymakers try to eliminate with
either expansionary fiscal or monetary policy.
 If an expansionary fiscal policy (either increasing G or
decreasing T) is implemented, the IS will shift outward (in
panel a below) resulting in a higher interest rate while output
remains the same.
If the policy makers choose expansionary monetary policy
instead, the LM curve shifts to the right (as in panel b above).
Cont.
72

 In this case, since the LM is vertical, a rightward shift in IS

results in higher interest rate which causes investment
spending and net exports to fall enough to offset completely
the increased spending of the expansionary fiscal policy.
Put another way, increased spending that results from
expansionary fiscal policy has crowded out investment
spending and net exports, which decrease because of the rise
in the interest rate.
This situation in which expansionary fiscal policy does not
lead to a rise in
output is frequently referred to as a case of complete
crowding out.
73
Cont.
74

From panel b, equilibrium is achieved with a lower interest

rate and higher
aggregate output; monetary policy is effective.
Therefore, the less interest-sensitive money demand is, the
more effective monetary policy is relative to fiscal policy.
Moreover, it can be shown that
 If the IS curve is more unstable than the LM curve, a money
supply target is preferred.

 If the LM curve is more unstable than the IS curve, an

interest-rate target is preferred
 3.5. From the IS-LM to Aggregate demand

75

We now consider how the ISLM model can also be viewed as a theory of
aggregate demand.
We defined the IS and LM curves in terms of equilibrium in the goods and
money markets, respectively.
Aggregate demand summarizes equilibrium in both of these
markets.
Recall that the ISLM model is constructed on the basis of a fixed price level.
For a given value of the price level and the nominal Ms, the position of the
LM curve is fixed.
The real Ms changes if either the nominal money supply or the price level
changes.
Thus we can see that changes in the price level are associated with changes
in the equilibrium level of output and interest rates.
This is the relationship that is summarized by the aggregate demand curve.
Cont.
76

If the price level is high, other things equal, the real money supply is low.
This implies high interest rates, and thus low investment & output.
If the price level falls, then the real Ms increases.
Equilibrium in the money market implies that r must fall.
Equilibrium in the goods market thus implies that output must rise, since
investment rises.
Thus, we find that the aggregate demand curve is downward sloping;
High values of the price level are associated with low level of output, and
vice versa.
Notice that the reason this curve slopes downward is not easy to describe;
It is not like the regular microeconomic demand curve for a good.
77
Cont.
78

 Because the AD curve summarizes the results of the ISLM

model, shocks that sift the IS curve or the LM curve cause
the aggregate demand curve to shift.
 Thus, the result can be summarized as follows:
 A change in income in the IS-LM model resulting from a
change in the price level represents a movement along the
aggregate demand curve.
 A change in income in the IS-LM model for a fixed price
level represents a shift in the aggregate demand curve.
 The aggregate demand curve can also be derived
either from equation [17] above or the quantity theory.
79
 Example and exercise
80

 
 81
  Soln. LM equation
Derived from MONEY
market equilibrium
condition
Md = 0.4Y – 60r = 1,000
0.4Y =1000 + 60r
Y = 2,500 + 150r LM
Equ ----- [2]
Soln b) :- use the
equilibrium Condition. We82
Once we got the equilibrium
should solve the two
interest rate, we can use it in
equations simultaneously or either of the two equations to
simply by setting the two equilibrium income:
equations are equal: Y = 3,500 – 100r = 3500 –
3,500 – 100r = 2,500 100(4)
Y = 3500 – 400 = 3100 or
+150r
Y = 2,500 + 150r = 2500 + 150(4)
3,500 – 2,500 = 150r + = 2500 + 600 = 3100
100r
1000 = 250r Thus, equilibrium income is birr
3100
r = 1000/250 = 4
Equilibrium interest rate is
4
 83

Soln c) :- use equilibrium interest rate and income that we have

obtained:
Md = 0.4Y – 60r = 0.4(3100) – 60(4) = 1240 – 240 = 1000
birr
Equilibrium money demanded is birr 1000
soln d) investment and consumption expenditure at equilibrium
income and interest
C = 80 + 0.8(y – T) = 80 + 0.8(3100 -100) = 80 + 0.8(300) = 2480
Consumption expenditure is birr 2480
I = 500 - 20r = 500 - 20(4) = 500 – 80 = 420
Investment expenditure is birr 420
 84

 
A Reward for Your Attention
85