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.

Chapter 10: Aggregate Demand IChapter 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 TheoryThe LM curve: The Liquidity Preference Theory

Shift in Aggregate Demand

Output, Income

Price level

AD2

An increase in the level AD increases the level of income, given the price level.

SRASP

AD1

AD3

Y1 Y2 Y3

The Keynesian Cross

Equilibrium in the product market:

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

Total income = Total planned expenditures

Aggregate Equilibrium

E

Y

Actual Expenditure: Y = E

Keynesian Cross

Y

Planned Expenditure:E = C + I + G

Y2 Y1

Reduce inventoriesIncrease inventories

Adjustment to Equilibrium

Y1> Y indicates an excess supply of goods in the market. So, businesses accumulate inventories to reduce Y1 to Y

Y2<Y indicates an excess demand for goods in the market. So, 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

E

Y

Y = E

A

Y1

E = C + I + G1

Y2

E = C + I + G2

ΔGB

ΔY

Government Spending Multiplier

ΔG = Increase in government purchasesΔY = 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

E

Y

Y = E

A

Y1

E = C 1+ I + G

Y2

E = C2 + I + G

ΔCB

ΔY

Government Tax Multiplier

ΔT = Decrease in income taxesΔC = Increase in consumption = -MPC * ΔTΔY = Increase in incomeMultiplier 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

Income

Interest rate

Y1Y2

r1

r2

A

B

IS shows pairs of income and interest ratesuch 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.

Shift of IS Curve

Income

Interest rate

Y2Y1

An increase in planned expenditure (C, I, or G)causes the IS to increase, hence increasing the level of income through the multiplier effect.

IS1

IS2

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

L(r, Y)

_M/P

r1

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

r

r2

r1

M/P

r2

Y1 Y2

r1

L(r, Y1)

L(r, Y2)

_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.

Shift in LM Curve

r

r2

r1

M/P

r2

Y

r1

L(r, Y)

LM1

LM2

M1/P M2/P

An increase in the money supply, lowers the interest rate, making the LM curve to increase.

Aggregate Equilibrium

Aggregate equilibrium is achieved when IS = LM

IS: Y = C(Y - T) + I(r) + GLM: M/P = L(r, Y)

Aggregate Equilibrium

Income

Interest rate

Y

r

IS

LM

Theory of Short-Run Fluctuations

KeynesianCross

Theory of Liquidity

Preference

IS Curve

LM Curve

IS-LM Model

AD Curve

AS Curve

AD-AS Model

Short-run Fluctuations:

Income Interest

Rate