Chapter 10: Aggregate Demand I

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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
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
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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
Actual Expenditure Y E
E
Planned Expenditure E C I G
Keynesian Cross
Reduce inventories
Increase inventories
Y2
Y
Y1
Y
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Adjustment to Equilibrium

• Y1gt Y indicates an excess supply of goods in the
  market. So, businesses accumulate inventories to
  reduce Y1 to Y
• Y2ltY indicates an excess demand for goods in the
  market. So, businesses reduce inventories to
  increase Y2 to Y

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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
Y E
E C I G2
E
E C I G1
?G
B
A
?Y
Y
Y1
Y2
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Government Spending Multiplier

• ?G Increase in government purchases
• ?Y Increase in income
• Multiplier effect ?Y / ?G 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
Y E
E C2 I G
E
E C 1 I G
?C
B
A
?Y
Y1
Y2
Y
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Government Tax Multiplier

• ?T Decrease in income taxes
• ?C Increase in consumption -MPC ?T
• ?Y Increase in income
• Multiplier effect ?Y / ?T -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
Interest rate
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.
r2
B
A
r1
Y1
Y2
Income
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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
Income
Y2
Y1
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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
_ M/P
r
r1
L(r, Y)
M/P
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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
LM shows pairs of income and interest rate such
as (Y1, r1) and (Y2, r2) that bring bout
equilibrium in the money market.
_ M/P
r
LM
r2
r2
r1
r1
L(r, Y2)
L(r, Y1)
Y1
Y2
M/P
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Shift in LM Curve
LM1
M1/P
M2/P
r
LM2
r1
r1
r2
r2

L(r, Y)
Y
M/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
Interest rate
LM
r
IS
Income
Y
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Theory of Short-Run Fluctuations
AD Curve
Keynesian Cross
IS Curve
Short-run Fluctuations Income Interest Rate
AD-AS Model
IS-LM Model
Theory of Liquidity Preference
LM Curve
AS Curve