Chapter 10: Aggregate

Demand I

The IS-LM Model

A short-run macroeconomic model which takes the price

level constant and shows how changes in the level of

Aggregate Demand cause changes in income.

The IS curve: The Keynesian Cross Theory

The LM curve: The Liquidity Preference Theory

Shift in Aggregate Demand

An increase in the level AD increases

the level of income, given the price level.

Price level

P

SRAS

AD3

AD2

AD1

Y1

Y2

Y3

Output, Income

The Keynesian Cross

Equilibrium in the product market:

Planned Expenditures: E = C(Y-T) + I + G

Actual Expenditures: Y

Aggregate Equilibrium: Y = C(Y-T) + I + G

Total income = Total planned expenditures

Aggregate Equilibrium

Actual Expenditure: Y = E

E

Planned Expenditure:

E=C+I+G

Keynesian Cross

Increase inventories

Y2

Y

Reduce inventories

Y1

Y

Adjustment to Equilibrium

Y1> Y indicates an excess supply of goods in the market.

So, businesses accumulate inventories to reduce Y1 to Y

Y2So, businesses reduce inventories to increase Y2 to Y

Effect of Stabilization Policy

A government policy of changing planned expenditure, C,

I, or G, would shift the Planned Expenditure line to

increase the level of income.

The increase in income is subject to a multiplier effect as

spending by consumers receiving the new income, creates

income for other consumers

Effect of Government Spending Policy

Y=E

E = C + I + G2

E

B

E = C + I + G1

ΔG

A

ΔY

Y1

Y2

Y

Government Spending Multiplier

ΔG = Increase in government purchases

ΔY = Increase in income

Multiplier effect: ΔY / ΔG = 1 / (1 – MPC)

Example, MPC = 0.6, Spending Multiplier = 2.50; Any $1

increase in G creates an additional $2.50 of income

Effect of Government Tax Policy

Y=E

E

B

ΔC

E = C2 + I + G

E = C 1+ I + G

A

ΔY

Y1

Y2

Y

Government Tax Multiplier

ΔT = Decrease in income taxes

ΔC = Increase in consumption = -MPC * ΔT

ΔY = Increase in income

Multiplier effect: ΔY / ΔT = -MPC / (1 – MPC)

Example, MPC = 0.6, Tax Multiplier = -1.50; Any $1

decrease in T creates an additional $1.50 of income

Derivation of IS Curve

IS shows level of income and interest rate that bring about

equilibrium to the product market

Assume an initial income level and interest rate. An

increases in interest rate reduces planned investment.

Then, the Planned Expenditure line shifts down, causing

income to decline.

IS Curve

Interest rate

r2

IS shows pairs of income and interest rate

such as (Y1, r1) and (Y2, r2) that bring

about equilibrium in the product market.

The higher the interest rate, the lower the

level of income.

B

A

r1

Y2

Y1

Income

Shift of IS Curve

Interest rate

An increase in planned expenditure (C, I, or G)

causes the IS to increase, hence increasing the

level of income through the multiplier effect.

IS2

IS1

Y1

Y2

Income

Theory of Liquidity Preference

Equilibrium in the money market

Demand for money: (M/P)d = L(r,Y)

Money supply: (M/P)s = M/P

Equilibrium: M/P = L(r, Y)

Money Market Equilibrium

r

_

M/P

r1

L(r, Y)

M/P

Derivation of LM Curve

An increase in the level of income causes the demand for

money to increase. As a result of a higher demand for

money, the interest rate goes up

The higher the level of income, the higher is the rate of

interest

Derivation of LM Curve

LM shows pairs of income and interest rate such as

(Y1, r1) and (Y2, r2) that bring bout equilibrium

in the money market.

r

_

LM

M/P

r2

r2

r1

r1

L(r, Y2)

L(r, Y1)

M/P

Y1

Y2

Shift in LM Curve

r

M1/P

LM1

M2/P

LM2

r1

r1

r2

r2

L(r, Y)

M/P

An increase in the money supply, lowers the

interest rate, making the LM curve to increase.

Y

Aggregate Equilibrium

Aggregate equilibrium is achieved when IS = LM

IS: Y = C(Y - T) + I(r) + G

LM: M/P = L(r, Y)

Aggregate Equilibrium

Interest rate

LM

r

IS

Y

Income

Theory of Short-Run Fluctuations

Keynesian

Cross

AD Curve

IS Curve

AD-AS

Model

IS-LM

Model

Theory of

Liquidity

Preference

LM Curve

AS Curve

Short-run

Fluctuations:

Income

Interest

Rate

Demand I

The IS-LM Model

A short-run macroeconomic model which takes the price

level constant and shows how changes in the level of

Aggregate Demand cause changes in income.

The IS curve: The Keynesian Cross Theory

The LM curve: The Liquidity Preference Theory

Shift in Aggregate Demand

An increase in the level AD increases

the level of income, given the price level.

Price level

P

SRAS

AD3

AD2

AD1

Y1

Y2

Y3

Output, Income

The Keynesian Cross

Equilibrium in the product market:

Planned Expenditures: E = C(Y-T) + I + G

Actual Expenditures: Y

Aggregate Equilibrium: Y = C(Y-T) + I + G

Total income = Total planned expenditures

Aggregate Equilibrium

Actual Expenditure: Y = E

E

Planned Expenditure:

E=C+I+G

Keynesian Cross

Increase inventories

Y2

Y

Reduce inventories

Y1

Y

Adjustment to Equilibrium

Y1> Y indicates an excess supply of goods in the market.

So, businesses accumulate inventories to reduce Y1 to Y

Y2

Effect of Stabilization Policy

A government policy of changing planned expenditure, C,

I, or G, would shift the Planned Expenditure line to

increase the level of income.

The increase in income is subject to a multiplier effect as

spending by consumers receiving the new income, creates

income for other consumers

Effect of Government Spending Policy

Y=E

E = C + I + G2

E

B

E = C + I + G1

ΔG

A

ΔY

Y1

Y2

Y

Government Spending Multiplier

ΔG = Increase in government purchases

ΔY = Increase in income

Multiplier effect: ΔY / ΔG = 1 / (1 – MPC)

Example, MPC = 0.6, Spending Multiplier = 2.50; Any $1

increase in G creates an additional $2.50 of income

Effect of Government Tax Policy

Y=E

E

B

ΔC

E = C2 + I + G

E = C 1+ I + G

A

ΔY

Y1

Y2

Y

Government Tax Multiplier

ΔT = Decrease in income taxes

ΔC = Increase in consumption = -MPC * ΔT

ΔY = Increase in income

Multiplier effect: ΔY / ΔT = -MPC / (1 – MPC)

Example, MPC = 0.6, Tax Multiplier = -1.50; Any $1

decrease in T creates an additional $1.50 of income

Derivation of IS Curve

IS shows level of income and interest rate that bring about

equilibrium to the product market

Assume an initial income level and interest rate. An

increases in interest rate reduces planned investment.

Then, the Planned Expenditure line shifts down, causing

income to decline.

IS Curve

Interest rate

r2

IS shows pairs of income and interest rate

such as (Y1, r1) and (Y2, r2) that bring

about equilibrium in the product market.

The higher the interest rate, the lower the

level of income.

B

A

r1

Y2

Y1

Income

Shift of IS Curve

Interest rate

An increase in planned expenditure (C, I, or G)

causes the IS to increase, hence increasing the

level of income through the multiplier effect.

IS2

IS1

Y1

Y2

Income

Theory of Liquidity Preference

Equilibrium in the money market

Demand for money: (M/P)d = L(r,Y)

Money supply: (M/P)s = M/P

Equilibrium: M/P = L(r, Y)

Money Market Equilibrium

r

_

M/P

r1

L(r, Y)

M/P

Derivation of LM Curve

An increase in the level of income causes the demand for

money to increase. As a result of a higher demand for

money, the interest rate goes up

The higher the level of income, the higher is the rate of

interest

Derivation of LM Curve

LM shows pairs of income and interest rate such as

(Y1, r1) and (Y2, r2) that bring bout equilibrium

in the money market.

r

_

LM

M/P

r2

r2

r1

r1

L(r, Y2)

L(r, Y1)

M/P

Y1

Y2

Shift in LM Curve

r

M1/P

LM1

M2/P

LM2

r1

r1

r2

r2

L(r, Y)

M/P

An increase in the money supply, lowers the

interest rate, making the LM curve to increase.

Y

Aggregate Equilibrium

Aggregate equilibrium is achieved when IS = LM

IS: Y = C(Y - T) + I(r) + G

LM: M/P = L(r, Y)

Aggregate Equilibrium

Interest rate

LM

r

IS

Y

Income

Theory of Short-Run Fluctuations

Keynesian

Cross

AD Curve

IS Curve

AD-AS

Model

IS-LM

Model

Theory of

Liquidity

Preference

LM Curve

AS Curve

Short-run

Fluctuations:

Income

Interest

Rate

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