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MACROECONOMICS Chapter 10 Aggregate Demand I: Building the IS-LM Model

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2 Can We Ignore Short Run? In 1933, unemployment rate was 25% and GDP was one-third below its 1929 level. In 1933, unemployment rate was 25% and GDP was one-third below its 1929 level. Classics: supply creates its own demand. Classics: supply creates its own demand. Keynes: aggregate demand fluctuates independent of the supply. Keynes: aggregate demand fluctuates independent of the supply. Classics: prices adjust fast. Classics: prices adjust fast. Keynes: prices are sticky. Keynes: prices are sticky.

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3 Expenditures PE = C + I + G + NX Leave NX for Ch. 12; NX=0 C = c(Y-T)Consumption is determined by MPC times disposable income. T, I, G are exogenous: values given outside of the model.

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4 Keynesian Cross For the economy to be in equilibrium (the circular flow to have top and bottom flows matched) the horizontal distance has to equal to the vertical distance. The 45-degree line represents Y=PE.

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5 Equilibrium in Keynesian Cross FirmsHouseholds Review your circular flow diagram: Ch. 2, slide #5

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6 Multiplier: Response of Y to a Change in Expenditure If ΔG=700 and MPC=0.33, what is ΔY?

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7 Multiplier for a Tax Cut Which fiscal policy gives more bang for the buck? Increasing government expenditures or reducing taxes?

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8 Derivation of IS Curve G,T, and r are exogenous.

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9 Shifts in IS What shifts Keynesian PE curve? Any increase in the components of PE: C, I, G. Any decrease in taxes. If real interest rate drops and PE shifts up, what will happen to IS? Movement along the IS!

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10 Monetary Sector and Nominal Interest Rate How does the sector move from the first equilibrium to the second?

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11 Derivation of the LM Curve Demand for money (liquidity preference) increases with real income but decreases with higher interest rates.

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12 Shifts in LM Money supply increases will shift LM right; money supply decreases will shift it to the left.

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13 Equilibrium: r* and Y* IS: LM: John Hicks

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14 Theory of Short Run Fluctuations Y=C+I+G M/P=L(r,Y) Y=f(r) Y=f(r,M/P) Equate Ys solve for r Equate rs solve for Y Y=f(P) LR: Y=f(K,L) SR: Y=f(AD)

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15 Contradiction? IS-LM Model says if the Central Bank increases the money supply, interest rates will fall. IS-LM Model says if the Central Bank increases the money supply, interest rates will fall. Fisher effect said that if inflation rises, interest rates will rise. Fisher effect said that if inflation rises, interest rates will rise. Money supply increases trigger inflation. Money supply increases trigger inflation. What is going on? What is going on?

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16 Contradiction? M/P r r MsLM IS Y Fisher effect: Nominal interest rate = real interest rate + inflation

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