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Chapter 10: Aggregate Demand I

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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

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Shift in Aggregate Demand Output, Income Price level AD 2 An increase in the level AD increases the level of income, given the price level. SRAS P AD 1 AD 3 Y1Y1 Y2Y2 Y3Y3

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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

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Aggregate Equilibrium E Y Actual Expenditure: Y = E Keynesian Cross Y Planned Expenditure: E = C + I + G Y2Y2 Y1Y1 Reduce inventoriesIncrease inventories

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Adjustment to Equilibrium Y 1 > Y indicates an excess supply of goods in the market. So, businesses accumulate inventories to reduce Y 1 to Y Y 2

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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

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Effect of Government Spending Policy E Y Y = E A Y1Y1 E = C + I + G 1 Y2Y2 E = C + I + G 2 ΔG B ΔY

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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

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Effect of Government Tax Policy E Y Y = E A Y1Y1 E = C 1+ I + G Y2Y2 E = C2 + I + G ΔC B ΔY

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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

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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.

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IS Curve Income Interest rate Y1Y1 Y2Y2 r1r1 r2r2 A B IS shows pairs of income and interest rate such as (Y 1, r 1 ) and (Y 2, r 2 ) that bring about equilibrium in the product market. The higher the interest rate, the lower the level of income.

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Shift of IS Curve Income Interest rate Y2Y2 Y1Y1 An increase in planned expenditure (C, I, or G) causes the IS to increase, hence increasing the level of income through the multiplier effect. IS 1 IS 2

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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)

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Money Market Equilibrium r M/P L(r, Y) _ M/P r1

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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

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Derivation of LM Curve r r2r2 r1r1 M/P r2r2 Y1Y1 Y2Y2 r1r1 L(r, Y 1 ) L(r, Y 2 ) _ M/P LM LM shows pairs of income and interest rate such as (Y1, r1) and (Y2, r2) that bring bout equilibrium in the money market.

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Shift in LM Curve r r2r2 r1r1 M/P r2r2 Y r1r1 L(r, Y) LM 1 LM 2 M 1 /PM 2 /P An increase in the money supply, lowers the interest rate, making the LM curve to increase.

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Aggregate Equilibrium Aggregate equilibrium is achieved when IS = LM IS: Y = C(Y - T) + I(r) + G LM: M/P = L(r, Y)

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Aggregate Equilibrium Income Interest rate Y r IS LM

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Theory of Short-Run Fluctuations Keynesian Cross Theory of Liquidity Preference IS Curve LM Curve IS-LM Model AD Curve AS Curve AD-AS Model Short-run Fluctuations: Income Interest Rate

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