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macroeconomics fifth editionN. Gregory Mankiw
PowerPoint Slidesby Ron Cronovich
CHAPTER TEN
Aggregate Demand I
a c r o
2002 Worth Publishers, all rights reserved
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CHAPTER 10 Aggregate Demand I slide 2
Context
Chapter 9 introduced the model of aggregatedemand and aggregate supply.Long run prices flexible output determined by factors of production &
technology unemployment equals its natural rateShort run prices fixed output determined by aggregate demand unemployment is negatively related to output
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CHAPTER 10 Aggregate Demand I slide 3
Context
This chapter develops the IS-LM model, thetheory that yields the aggregate demandcurve.
We focus on the short run and assume theprice level is fixed.
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CHAPTER 10 Aggregate Demand I slide 4
The Keynesian Cross
A simple closed economy model in whichincome is determined by expenditure.(due to J.M. Keynes)
Notation:I = planned investmentE = C + I + G = planned expenditureY = real GDP = actual expenditure
Difference between actual & plannedexpenditure: unplanned inventory investment
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CHAPTER 10 Aggregate Demand I slide 5
Elements of the Keynesian Cross
= -( )C C Y T
=I I
= = ,G G T T
= - + +( )E C Y T I G
=
=
Actual expenditure Planned expenditureY E
consumption function:
for now,investment is exogenous:
planned expenditure:
Equilibrium condition:
govt policy variables:
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CHAPTER 10 Aggregate Demand I slide 6
Graphing planned expenditure
income, output, Y
E plannedexpenditure
E = C + I + G
MPC1
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Graphing the equilibrium condition
income, output, Y
E plannedexpenditure
E = Y
45
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The equilibrium value of income
income, output, Y
E plannedexpenditure
E = Y
E = C + I + G
Equilibriumincome
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CHAPTER 10 Aggregate Demand I slide 9
An increase in government purchases
Y
E
E = C + I + G 1
E 1 = Y 1
E = C + I + G 2
E 2 = Y 2Y
At Y 1,there is now anunplanned dropin inventory
so firmsincrease output,and incomerises toward anew equilibrium
G
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CHAPTER 10 Aggregate Demand I slide 10
Solving for Y
= + +Y C I G D = D + D + DY C I G
= D + DMPC Y G
= D + DC G
- D = D(1 MPC) Y G
D = D -
11 MPC
Y G
equilibrium conditionin changes
because I exogenous
because C = MPC Y
Collect terms with Y on the left side of theequals sign:
Finally, solve for Y :
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CHAPTER 10 Aggregate Demand I slide 11
The government purchases multiplier
Example: MPC = 0.8
D = D-
= D = D = D-
11 MPC
1 1 51 0 8 0 2. .
Y G
G G G
The increase in G causes income to increaseby 5 times as much!
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CHAPTER 10 Aggregate Demand I slide 12
The government purchases multiplier
In the example with MPC = 0.8,
Definition: the increase in income resultingfrom a $1 increase in G .
In this model, the G multiplier equals
D =D - 11 MPCY G
D= =
D -
15
1 0.8Y G
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CHAPTER 10 Aggregate Demand I slide 13
Why the multiplier is greater than 1
Initially, the increase in G causes an equalincrease in Y : Y = G .
But Y C
further Y further C
further Y
So the final impact on income is muchbigger than the initial G .
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CHAPTER 10 Aggregate Demand I slide 14
An increase in taxes
Y
E
E = C 2 + I + G
E 2 = Y 2
E = C 1 + I + G
E 1 = Y 1Y
At Y 1, there is nowan unplannedinventory buildup
so firms
reduce output,and income fallstoward a newequilibrium
C = MPC T
Initially, the taxincrease reducesconsumption, andtherefore E :
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CHAPTER 10 Aggregate Demand I slide 15
Solving for Y
D = D + D + DY C I G
( )= D - DMPC Y T
= D C
- D = - D(1 MPC) MPCY T
eqm condition inchanges
I and G exogenous
Solving for Y :
- D = D -
MPC1 MPC
Y T Final result:
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CHAPTER 10 Aggregate Demand I slide 16
The Tax Multiplier
def: the change in income resulting froma $1 increase in T :
D -=
D -
MPC
1 MPC
Y
T
D - -= = = -D -
0 8 0 8 41 0 8 0 2
. .. .
Y T
If MPC = 0.8, then the tax multiplier equals
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CHAPTER 10 Aggregate Demand I slide 17
The Tax Multiplieris negative :
A tax hike reducesconsumer spending,which reduces income.
is greater than one (in absolute value ): A change in taxes has amultiplier 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 issmaller than from an equal increase in G .
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CHAPTER 10 Aggregate Demand I slide 18
The Tax Multiplier
is negative : An increase in taxes reduces consumer spending,which reduces equilibrium income.
is greater than one (in absolute value ): A change in taxes has a multiplier effect onincome.
is smaller than the govt spending multiplier :
Consumers save the fraction (1-MPC) of a taxcut, so the initial boost in spending from a taxcut is smaller than from an equal increase in G .
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CHAPTER 10 Aggregate Demand I slide 19
Exercise:
Use a graph of the Keynesian Crossto show the impact of an increase ininvestment on the equilibrium level of income/output.
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CHAPTER 10 Aggregate Demand I slide 20
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
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CHAPTER 10 Aggregate Demand I slide 21
Y 2 Y 1
Y 2 Y 1
Deriving the IS curve
r I
Y
E
r
Y
E = C + I (r 1 )+ G E = C + I (r 2 )+ G
r 1
r 2
E = Y
IS
I E
Y
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CHAPTER 10 Aggregate Demand I slide 22
Understanding the IS curves slope
The IS curve is negatively sloped.Intuition:
A fall in the interest rate motivates firms toincrease investment spending, which drivesup total planned spending ( E ).To restore equilibrium in the goods market,output (a.k.a. actual expenditure, Y ) must
increase.
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CHAPTER 10 Aggregate Demand I slide 23
The IS curve and the Loanable Funds model
S , I
r
I (r ) r 1
r 2
r
Y Y 1
r 1
r 2
(a) The L.F. model (b) The IS curve
Y 2
S 1S 2
IS
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CHAPTER 10 Aggregate Demand I slide 24
Fiscal Policy and the IS curve
We can use the IS-LM model to seehow fiscal policy ( G and T ) can affectaggregate demand and output.
Lets start by using the Keynesian Crossto see how fiscal policy shifts the IS curve
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CHAPTER 10 Aggregate Demand I slide 25
Y 2 Y 1
Y 2 Y 1
Shifting the IS curve: G
At any value of r ,G E Y
Y
E
r
Y
E = C + I (r 1 )+ G 1 E = C + I (r 1 )+ G 2
r 1
E = Y
IS 1
The horizontaldistance of theIS shift equals
IS 2
so the IS curveshifts to the right.
D = D-
1
1 MPCY G
Y
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CHAPTER 10 Aggregate Demand I slide 26
Exercise: Shifting the IS curve
Use the diagram of the Keynesian Crossor Loanable Funds model to show howan increase in taxes shifts the IS curve.
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CHAPTER 10 Aggregate Demand I slide 27
The Theory of Liquidity Preference
due to John Maynard Keynes. A simple theory in which the interest rateis determined by money supply and
money demand.
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CHAPTER 10 Aggregate Demand I slide 28
Money Supply
The supply of real moneybalancesis fixed:
( ) =s
M P M P
M/P real money
balances
r interest
rate( )
s M P
M P
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CHAPTER 10 Aggregate Demand I slide 29
Money Demand
Demand forreal moneybalances:
M/P real money
balances
r interest
rate( )
s M P
M P
( ) = ( )d
M P L r
L (r )
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CHAPTER 10 Aggregate Demand I slide 30
Equilibrium
The interestrate adjuststo equate thesupply and
demand formoney:
M/P real money
balances
r interestrate
( )s
M P
M P
= ( )M P L r L (r )
r 1
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CHAPTER 10 Aggregate Demand I slide 31
How the Fed raises the interest rate
To increase r ,
Fed reduces M
M/P real money
balances
r interestrate
1M
P
L (r )
r 1
r 2
2M
P
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CHAPTER 10 Aggregate Demand I slide 32
CASE STUDYVolckers Monetary Tightening
Late 1970s: > 10%Oct 1979: Fed Chairman Paul Volckerannounced that monetary policywould aim to reduce inflation.
Aug 1979-April 1980:Fed reduces M / P 8.0%
Jan 1983: = 3.7%
How do you think this policy change would affect interest rates?
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CHAPTER 10 Aggregate Demand I slide 33
Volckers Monetary Tightening, cont.
i < 0i > 0
1/1983: i = 8.2%8/1979: i = 10.4%4/1980: i = 15.8%
flexiblesticky
Quantity Theory,Fisher Effect
(Classical) Liquidity Preference(Keynesian)
prediction
actualoutcome
The effects of a monetary tighteningon nominal interest rates
prices
model
long runshort run
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CHAPTER 10 Aggregate Demand I slide 34
The LM curve
Now lets put Y back into the money demandfunction:
= ( , )M P L r Y
The LM curve is a graph of all combinations of r and Y that equate the supply and demandfor real money balances.
The equation for the LM curve is:
( ) = ( , )d
M P L r Y
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CHAPTER 10 Aggregate Demand I slide 35
Deriving the LM curve
M/P
r
1M
P
L (r , Y 1 )
r 1
r 2
r
Y Y 1
r 1 L (r , Y 2 )
r 2
Y 2
LM
(a) The market forreal money balances (b) The LM curve
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CHAPTER 10 Aggregate Demand I slide 36
Understanding the LM curves slope
The LM curve is positively sloped.Intuition:
An increase in income raises moneydemand.Since the supply of real balances is fixed,there is now excess demand in the moneymarket at the initial interest rate.
The interest rate must rise to restoreequilibrium in the money market.
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CHAPTER 10 Aggregate Demand I slide 37
How M shifts the LM curve
M/P
r
1M
P
L
(r
,
Y 1
)
r 1
r 2
r
Y Y 1
r 1
r 2
LM 1
(a) The market forreal money balances (b) The LM curve
2M
P
LM 2
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CHAPTER 10 Aggregate Demand I slide 38
Exercise: Shifting the LM curve
Suppose a wave of credit card fraudcauses consumers to use cash morefrequently in transactions.
Use the Liquidity Preference modelto show how these events shift theLM curve.
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CHAPTER 10 Aggregate Demand I slide 39
The short-run equilibrium
The short-run equilibrium isthe combination of r and Y that simultaneously satisfiesthe equilibrium conditions in
the goods & money markets:
= - + +( ) ( )Y C Y T I r G
Y
r
= ( , )M P L r Y
IS
LM
Equilibriuminterestrate
Equilibriumlevel of income
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CHAPTER 10 Aggregate Demand I slide 40
The Big Picture
KeynesianCross
Theory of Liquidity
Preference
IS curve
LM curve
IS-LM model
Agg.demand
curve
Agg.supplycurve
Model of Agg.
Demandand Agg.Supply
Explanationof short-runfluctuations
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CHAPTER 10 Aggregate Demand I slide 41
Chapter summary1. Keynesian Cross
basic model of income determinationtakes fiscal policy & investment as exogenousfiscal policy has a multiplied impact on income.
2. IS curvecomes from Keynesian Cross when plannedinvestment depends negatively on interest rate
shows all combinations of r and Y thatequate planned expenditure with actualexpenditure on goods & services
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CHAPTER 10 Aggregate Demand I slide 42
Chapter summary3. Theory of Liquidity Preference
basic model of interest rate determinationtakes money supply & price level as exogenousan increase in the money supply lowers the
interest rate4. LM curve
comes from Liquidity Preference Theory when
money demand depends positively on incomeshows all combinations of r and Y that equatedemand for real money balances with supply
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CHAPTER 10 Aggregate Demand I slide 43
Chapter summary5. IS-LM model
Intersection of IS and LM curves shows theunique point ( Y , r ) that satisfies equilibriumin both the goods and money markets.
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CHAPTER 10 Aggregate Demand I slide 44
Preview of Chapter 11
In Chapter 11, we willuse the IS-LM model to analyze the impactof policies and shockslearn how the aggregate demand curvecomes from IS-LM use the IS-LM and AD-AS models togetherto analyze the short-run and long-run
effects of shockslearn about the Great Depression using ourmodels
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