Intermediate macroeconomics chapt10

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