Aggregate Demand I: Building The IS LM Model
CHAPTER10Aggregate Demand I:Building the IS -LM ModelMACROECONOMICSSIXTH EDITIONN. GREGORY MANKIWPowerPoint Slides by Ron Cronovich 2008 Worth Publishers, all rights reserved
In this chapter, you will learn the IS curve, and its relation to the Keynesian cross the loanable funds model the LM curve, and its relation to the theory of liquidity preference how the IS-LM model determines income andthe interest rate in the short run when P is fixedCHAPTER 10Aggregate Demand Islide 1
Context Chapter 9 introduced the model of aggregatedemand and aggregate supply. Long run prices flexible output determined by factors of production & technologyunemployment equals its natural rate Short run prices fixed output determined by aggregate demand unemployment negatively related to outputCHAPTER 10Aggregate Demand Islide 2
Context This chapter develops the IS-LM model,the basis of the aggregate demand curve. We focus on the short run and assume the pricelevel is fixed (so, SRAS curve is horizontal). This chapter (and chapter 11) focus on theclosed-economy case.Chapter 12 presents the open-economy case.CHAPTER 10Aggregate Demand Islide 3
The Keynesian Cross A simple closed economy model in which incomeis determined by expenditure.(due to J.M. Keynes) Notation:I planned investmentE C I G planned expenditureY real GDP actual expenditure Difference between actual & planned expenditure unplanned inventory investmentCHAPTER 10Aggregate Demand Islide 4
Elements of the Keynesian Crossconsumption function:C C (Y T )govt policy variables:G G , T Tfor now, plannedinvestment is exogenous:planned expenditure:I IE C (Y T ) I Gequilibrium condition:actual expenditure planned expenditureY ECHAPTER 10Aggregate Demand Islide 5
Graphing planned expenditureEplannedexpenditureE C I G1MPCincome, output, YCHAPTER 10Aggregate Demand Islide 6
Graphing the equilibrium conditionEplannedexpenditureE Y45ºincome, output, YCHAPTER 10Aggregate Demand Islide 7
The equilibrium value of incomeEplannedexpenditureE YE C I Gincome, output, YEquilibriumincomeCHAPTER 10Aggregate Demand Islide 8
An increase in government purchasesEAt Y1,there is now anunplanned dropin inventory E C I G2E C I G1 G so firmsincrease output,and incomerises toward anew equilibrium.CHAPTER 10YE 1 Y1Aggregate Demand I YE 2 Y2slide 9
Solving for YY C I Gequilibrium condition Y C I Gin changes C G MPC Y GCollect terms with Yon the left side of theequals sign:(1 MPC) Y GCHAPTER 10Aggregate Demand Ibecause I exogenousbecause C MPC YSolve for Y : 1 Y G 1 MPC slide 10
The government purchases multiplierDefinition: the increase in income resulting from a 1 increase in G.In this model, the govtpurchases multiplier equals Y1 G1 MPCExample: If MPC 0.8, then Y1 5 G1 0.8CHAPTER 10Aggregate Demand IAn increase in Gcauses income toincrease 5 timesas much!slide 11
Why the multiplier is greater than 1 Initially, the increase in G causes an equal increasein Y: Y G. But Y C further Y further C further Y So the final impact on income is much bigger thanthe initial G.CHAPTER 10Aggregate Demand Islide 12
An increase in taxesEInitially, the taxincrease reducesconsumption, andtherefore E:E C1 I GE C2 I GAt Y1, there is nowan unplannedinventory buildup C MPC T so firmsreduce output,and income fallstoward a newequilibriumCHAPTER 10YE 2 Y2Aggregate Demand I YE 1 Y1slide 13
Solving for Yeq’m condition inchanges Y C I G CI and G exogenous MPC ( Y TSolving for Y :Final result:CHAPTER 10)(1 MPC) Y MPC T MPC Y T 1 MPC Aggregate Demand Islide 14
The tax multiplierdef: the change in income resulting froma 1 increase in T : Y T MPC 1 MPCIf MPC 0.8, then the tax multiplier equals Y TCHAPTER 10 0.8 0.8 41 0.80.2Aggregate Demand Islide 15
The tax multiplier is negative:A tax increase reduces C,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.CHAPTER 10Aggregate Demand Islide 16
Exercise: Use a graph of the Keynesian crossto show the effects of an increase in plannedinvestment on the equilibrium level ofincome/output.CHAPTER 10Aggregate Demand Islide 17
The IS curvedef: a graph of all combinations of r and Y thatresult in goods market equilibriumi.e. actual expenditure (output) planned expenditureThe equation for the IS curve is:Y C (Y T ) I (r ) GCHAPTER 10Aggregate Demand Islide 18
Deriving the IS curveE Y E C I (r ) G2E r I EE C I (r1 ) G I YrY1YY2r1r2ISY1CHAPTER 10Aggregate Demand IY2Yslide 19
Why the IS curve is negativelysloped A fall in the interest rate motivates firms toincrease investment spending, which drives uptotal planned spending (E ). To restore equilibrium in the goods market,output (a.k.a. actual expenditure, Y )must increase.CHAPTER 10Aggregate Demand Islide 20
The IS curve and the loanable fundsmodel(a) The L.F. modelrS2(b) The IS curverS1r2r2r1r1I (r )S, ICHAPTER 10Aggregate Demand IISY2Y1Yslide 21
Fiscal Policy and the IS curve We can use the IS-LM model to seehow fiscal policy (G and T ) affectsaggregate demand and output. Let’s start by using the Keynesian crossto see how fiscal policy shifts the IS curve CHAPTER 10Aggregate Demand Islide 22
Shifting the IS curve: GAt any value of r,E Y E C I (r ) G12E G E YE C I (r1 ) G1 so the IS curveshifts to the right.The horizontaldistance of theIS shift equalsrY1r11 Y G1 MPC YY1CHAPTER 10YY2Aggregate Demand IIS1Y2IS2Yslide 23
Exercise: Shifting the IS curve Use the diagram of the Keynesian cross orloanable funds model to show how an increasein taxes shifts the IS curve.CHAPTER 10Aggregate Demand Islide 24
The Theory of Liquidity Preference Due to John Maynard Keynes. A simple theory in which the interest rateis determined by money supply andmoney demand.CHAPTER 10Aggregate Demand Islide 25
Money supplyrThe supply ofreal moneybalancesis fixed:(Minterestrate(MP)sP) M PsM PCHAPTER 10Aggregate Demand IM/Preal moneybalancesslide 26
Money demandrDemand forreal moneybalances:(MP)dinterestrate(MP)s L (r )L (r )M PCHAPTER 10Aggregate Demand IM/Preal moneybalancesslide 27
EquilibriumThe interestrate adjuststo equate thesupply anddemand formoney:rinterestrate(MP)r1L (r )M P L (r )M PCHAPTER 10sAggregate Demand IM/Preal moneybalancesslide 28
How the Fed raises the interest raterTo increase r,Fed reduces Minterestrater2r1L (r )M2PCHAPTER 10Aggregate Demand IM1PM/Preal moneybalancesslide 29
CASE STUDY:Monetary Tightening & Interest Rates Late 1970s: π 10% Oct 1979: Fed Chairman Paul Volckerannounces that monetary policywould aim to reduce inflation Aug 1979-April 1980:Fed reduces M/P 8.0% Jan 1983: π 3.7%How do you think this policy changewould affect nominal interest rates?CHAPTER 10Aggregate Demand Islide 30
Monetary Tightening & Rates, cont.The effects of a monetary tighteningon nominal interest ratesmodelshort runlong runLiquidity preferenceQuantity theory,Fisher ediction i 0 i 0actualoutcome8/1979: i 10.4%8/1979: i 10.4%4/1980: i 15.8%1/1983: i 8.2%
The LM curveNow let’s put Y back into the money demandfunction:d(MP) L (r ,Y )The LM curve is a graph of all combinations ofr and Y that equate the supply and demand forreal money balances.The equation for the LM curve is:M P L (r ,Y )CHAPTER 10Aggregate Demand Islide 32
Deriving the LM curve(a) The market for(b) The LM curvereal money balancesrrLMr2r2L (r , Y 2 )r1r1L (r , Y 1 )M1PCHAPTER 10M/PAggregate Demand IY1Y2Yslide 33
Why the LM curve is upward sloping An increase in income raises money demand. Since the supply of real balances is fixed, thereis now excess demand in the money market atthe initial interest rate. The interest rate must rise to restore equilibriumin the money market.CHAPTER 10Aggregate Demand Islide 34
How M shifts the LM curve(a) The market for(b) The LM curvereal money balancesrrLM2LM1r2r2r1r1L (r , Y 1 )M2PCHAPTER 10M1PM/PAggregate Demand IY1Yslide 35
Exercise: Shifting the LM curve Suppose a wave of credit card fraud causesconsumers to use cash more frequently intransactions. Use the liquidity preference modelto show how these events shift theLM curve.CHAPTER 10Aggregate Demand Islide 36
The short-run equilibriumThe short-run equilibrium isthe combination of r and Ythat simultaneously satisfiesthe equilibrium conditions inthe goods & money markets:Y C (Y T ) I (r ) GrLMISM P L (r ,Y )YEquilibriuminterestrateCHAPTER 10Aggregate Demand IEquilibriumlevel ofincomeslide 37
The Big PictureKeynesianCrossTheory emandcurveAgg.supplycurveCHAPTER 10Aggregate Demand IExplanationof short-runfluctuationsModel ofAgg.Demandand Agg.Supplyslide 38
Preview of Chapter 11In Chapter 11, we will use the IS-LM model to analyze the impact ofpolicies and shocks. learn how the aggregate demand curve comesfrom IS-LM. 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.CHAPTER 10Aggregate Demand Islide 39
Chapter Summary1. Keynesian cross basic model of income determination takes fiscal policy & investment as exogenous fiscal policy has a multiplier effect on income.2. IS curve 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 & servicesCHAPTER 10Aggregate Demand Islide 40
Chapter 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 the interestrate4. 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 supplyCHAPTER 10Aggregate Demand Islide 41
Chapter Summary5. IS-LM model Intersection of IS and LM curves shows the uniquepoint (Y, r ) that satisfies equilibrium in both thegoods and money markets.CHAPTER 10Aggregate Demand Islide 42
Chapter 9 introduced the model of aggregate demand and aggregate supply. 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 output CHAPTE
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