Chapter 10: Aggregate Demand I

10/7/2013Context Chapter 9 introduced the model of aggregatedemand and aggregate supply.Chapter 10:Aggregate Demand I Long run prices flexible output determined by factors of production &technology unemployment equals its natural rate Short run prices fixed output determined by aggregate demand unemployment negatively related to outputCHAPTER 10Aggregate Demand I0CHAPTER 10Aggregate Demand I1ContextThe Keynesian Cross This chapter develops the IS-LM model, A simple closed economy model in which incomeis determined by expenditure.(due to J.M. Keynes)the basis of the aggregate demand curve. We focus on the short run and assume the price Notation:level is fixed (so,(so SRAS curve is horizontal).horizontal)I planned investmentPE C I G planned expenditureY real GDP actual expenditure This chapter (and chapter 11) focus on theclosed-economy case.Chapter 12 presents the open-economy case. Difference between actual & planned expenditure unplanned inventory investmentCHAPTER 10Aggregate Demand I2Elements of the Keynesian Crossfor now, plannedinvestment is exogenous:3PEplannedexpenditureG G , T Tgovt policy variables:Aggregate Demand IGraphing planned expenditureC C (Y T )consumption function:planned expenditure:CHAPTER 10PE C I GI IMPC1PE C (Y T ) I Gequilibrium condition:income, output, Yactual expenditure planned expenditureY PECHAPTER 10Aggregate Demand I4CHAPTER 10Aggregate Demand I51

10/7/2013The equilibrium value of incomeGraphing the equilibrium conditionPEPEPE YplannedexpenditurePE YplannedexpenditurePE C I G45ºincome, output, Yincome, output, YEquilibriumincomeCHAPTER 10Aggregate Demand I6PEPE C I G2PE C I G1equilibrium condition Y C I Gin changes CHAPTER 10 C G MPC Y GCollect terms with Yon the left side of theequals sign:YPE1 Y1 Y(1 MPC) Y GPE2 Y2Aggregate Demand I8The government purchases multiplierCHAPTER 10because I exogenousbbecause C MPC YSolve for Y : 1 Y G 1MPC Aggregate Demand I9Why the multiplier is greater than 1 Initially, the increase in G causes an equal increaseDefinition: the increase in income resulting from a 1 increase in G.In this model, the govtpurchases multiplier equals7Y C I G G so firmsincrease output,and incomerises toward anew equilibrium.Aggregate Demand ISolving for YAn increase in government purchasesAt Y1,there is now anunplanned dropin inventory CHAPTER 10in Y: Y G. But Y C Y1 G1 MPC further Y further CExample: If MPC 0.8, then Y1 5 G1 0.8CHAPTER 10Aggregate Demand I further YAn increase in Gcauses income toincrease 5 timesas much! So the final impact on income is much bigger thanthe initial G.10CHAPTER 10Aggregate Demand I112

10/7/2013Solving for YAn increase in taxesPEInitially, the taxincrease reducesconsumption, andtherefore PE:PE C1 I G C MPC T so firmsreduce output,and income fallstoward a newequilibriumCHAPTER 10YPE2 Y2 Y12CHAPTER 10(1 MPC) Y MPC T MPC Y T 1 MPC Aggregate Demand I13 is negative:A tax increase reduces C,which reduces income. MPC1 MPC is greater than one(in absolute value):A change in taxes has amultiplier effect on income.If MPC 0.8, then the tax multiplier equals CHAPTER 10 The tax multiplierdef: the change in income resulting froma 1 increase in T : Y TSolving for Y :Final result:The tax multiplier MPC Y TPE1 Y1Aggregate Demand I Y TI and G exogenous CPE C2 I GAt Y1, there is nowan unplannedinventory buildup eq’m condition inchanges Y C I G 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. 0.8 0.8 41 0.80.2Aggregate Demand INOW YOU TRY:Practice with the Keynesian Cross Use a graph of the Keynesian crossto show the effects of an increase in plannedinvestment on the equilibrium level ofincome/output.14CHAPTER 10Aggregate Demand I15The IS curvedef: a graph of all combinations of r and Y thatresult in goods market equilibriumi.e. actual expenditure (output)planned expenditurep pThe equation for the IS curve is:Y C (Y T ) I (r ) GCHAPTER 10Aggregate Demand I173

10/7/2013Deriving the IS curvePE Y PE C I (r ) G2PE rWhy the IS curve is negatively sloped A fall in the interest rate motivates firms toincrease investment spending, which drives uptotal planned spending (PE ).PE C I (r1 ) G I PE I Y To restore equilibrium in the goods market,rY1Y2Y1Y2output (a(a.k.a.k a actual expenditureexpenditure, Y )must increase.Yr1r2CHAPTER 10ISYAggregate Demand I18rS219 We can use the IS-LM model to see(b) The IS curvehow fiscal policy (G and T ) affectsaggregate demand and output.rS1Aggregate Demand IFiscal Policy and the IS curveThe IS curve and the loanable funds model(a) The L.F. modelCHAPTER 10 Let’s start by using the Keynesian crossto see how fiscal policy shifts the IS curve curver2r2r1r1I (r )ISS, ICHAPTER 10Y2Y1YAggregate Demand I20PE Y PE C I (r ) G12PEPE C I (r1 ) G1 G PE Y Y rY1Shifting the IS curve: T Use the diagram of the Keynesian cross orYY2r11 G1 MPC YY1CHAPTER 1021loanable funds model to show how anincrease in taxes shifts the IS curve. so the IS curveshifts to the right.The horizontaldistance of theIS shift equalsAggregate Demand INOW YOU TRY:Shifting the IS curve: GAt any value of r,CHAPTER 10Aggregate Demand IIS1Y2IS2Y224

10/7/2013The Theory of Liquidity PreferenceMoney supply Due to John Maynard Keynes. A simple theory in which the interest raterThe supply ofreal moneybalancesis fixed:is determined by money supply andmoney demand. Minterestrate MP sP M PsM/PM PCHAPTER 10Aggregate Demand I24Money demand MP d MinterestrateP sThe interestrate adjuststo equate thesupply andddemandd fformoney: L (r )L (r )M PCHAPTER 10 MP sr1M/P26L (r )M PCHAPTER 10M/Preal moneybalancesAggregate Demand I27CASE STUDY:Monetary Tightening & Interest Ratesr Late 1970s: 10% Oct 1979: Fed Chairman Paul Volckerinterestrateannounces that monetary policywould aim to reduce inflationr2 Aug 1979-April 1980:r1Fed reduces M/P 8.0%L (r )M2PAggregate Demand IrinterestrateM P L (r )How the Fed raises the interest rateCHAPTER 1025real moneybalancesAggregate Demand ITo increase r,Fed reduces MAggregate Demand IEquilibriumrDemand forreal moneybalances:CHAPTER 10real moneybalancesM1PM/P Jan 1983: 3.7%How do you think this policy changewould affect nominal interest rates?real moneybalances28CHAPTER 10Aggregate Demand I295

10/7/2013Monetary Tightening & Interest Rates, cont.The LM curveThe effects of a monetary tighteningon nominal interest ratesmodelNow let’s put Y back into the money demandfunction:dshort runlong runLiquidity preferenceQuantity theory,Fisher effect MP L (r ,Y )pricesstickyflexibleThe LM curve is a graph of all combinations ofr and Y that equate the supply and demand forreal money balances.prediction i 0 i 0The equation for the LM curve is:actualoutcome8/1979: i 10.4%4/1980: i 15.8%8/1979: i 10.4%1/1983: i 8.2%(K(Keynesian)i )(Classical)M P L (r ,Y )CHAPTER 10Deriving the LM curver An increase in income raises money demand. Since the supply of real balances is fixed, there(b) The LM curveris now excess demand in the money market atthe initial interest rate.LMr2r2L (r , Y2 )r131Why the LM curve is upward sloping(a) The market forreal money balancesAggregate Demand I The interest rate must rise to restore equilibriumin the money market.r1L (r , Y1 )M/PM1PCHAPTER 10Y1YY2Aggregate Demand I32rreal money balances Suppose a wave of credit card fraud causesconsumers to use cash more frequently intransactions.LM2LM1r1L (r , Y1 )M2PCHAPTER 10 Use the liquidity preference modelr2r2M1PM/PAggregate Demand I33Shifting the LM curve(b) The LM curverAggregate Demand INOW YOU TRY:How M shifts the LM curve(a) The market forCHAPTER 10to show how these events shift theLM curve.r1Y1Y346

10/7/2013The Big PictureThe short-run equilibriumThe short-run equilibrium isthe combination of r and Ythat simultaneously satisfiesthe equilibrium conditions inthe ggoods & moneyy markets:rY C (Y T ) I (r ) GLMIScurveTheory teAgg.supplycurveEquilibriumlevel ofincomeAggregate Demand IChapter Summary3. Theory of Liquidity Preference basic model of interest rate determination takes money supply & price level as exogenous an increase in the money supply lowers theinterest rateModel ofAgg.Demandand Agg.SupplyChapter SummaryIn Chapter 11, we will use the IS-LM model to analyze the impact ofpolicies and shocks. learn how the aggregate demand curve comesfrom ISIS-LMLM. use the IS-LM and AD-AS models together toanalyze the short-run and long-run effects ofshocks. use our models to learn about theGreat Depression.Aggregate Demand IExplanationof short-runfluctuations36Preview of Chapter 11CHAPTER 10IS-LMmodelAgg.demandcurveISM P L (r ,Y )CHAPTER 10KeynesianCross1. Keynesian cross basic model of income determination takes fiscal policy & investment as exogenous fiscal policy has a multiplier effect on income2 IS curve2. comes from Keynesian cross when plannedinvestment depends negatively on interest rate shows all combinations of r and Ythat equate planned expenditure withactual expenditure on goods & services38Chapter Summary5. IS-LM model Intersection of IS and LM curves shows theunique point (Y, r ) that satisfies equilibrium inboth the goods and money markets.4. LM curve comes from liquidity preference theory whenmoney demand depends positively on income shows all combinations of r and Y that equatedemand for real money balances with supply7

CHAPTER 10 Aggregate Demand I 13 Solving for Y: (1 MPC) MPC Y T MPC 1MPC Final result: Y T The tax multiplier def: the change in income resulting from a 1 increase in T : MPC 1MPC Y T CHAPTER 10 Aggregate Demand I 14 0.8 0.8 4 10.8 0.2 Y T If MPC 0.8, then the tax multiplier equals The tax multiplier