1、Aggregate Demand I: Building the IS -LM Model,10,CHAPTER 10 Aggregate Demand I,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 and
2、 the interest rate in the short run when P is fixed,CHAPTER 10 Aggregate Demand I,Context,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 fi
3、xed output determined by aggregate demand unemployment negatively related to output,CHAPTER 10 Aggregate Demand I,Context,This chapter develops the IS-LM model, the basis of the aggregate demand curve. We focus on the short run and assume the price level is fixed (so, SRAS curve is horizontal). This
4、 chapter (and chapter 11) focus on the closed-economy case. Chapter 12 presents the open-economy case.,CHAPTER 10 Aggregate Demand I,The Keynesian Cross,A simple closed economy model in which income is determined by expenditure. (due to J.M. Keynes) Notation: I = planned investment E = C + I + G = p
5、lanned expenditure Y = real GDP = actual expenditure Difference between actual & planned expenditure = unplanned inventory investment,CHAPTER 10 Aggregate Demand I,Elements of the Keynesian Cross,consumption function:,for now, planned investment is exogenous:,planned expenditure:,equilibrium conditi
6、on:,govt policy variables:,actual expenditure = planned expenditure,CHAPTER 10 Aggregate Demand I,Graphing planned expenditure,income, output, Y,Eplannedexpenditure,CHAPTER 10 Aggregate Demand I,Graphing the equilibrium condition,income, output, Y,Eplannedexpenditure,45,CHAPTER 10 Aggregate Demand I
7、,The equilibrium value of income,income, output, Y,Eplannedexpenditure,E =Y,E =C +I +G,CHAPTER 10 Aggregate Demand I,An increase in government purchases,E =Y,so firms increase output, and income rises toward a new equilibrium.,CHAPTER 10 Aggregate Demand I,Solving for Y,equilibrium condition,in chan
8、ges,because I exogenous,because C = MPC Y,Collect terms with Y on the left side of the equals sign:,CHAPTER 10 Aggregate Demand I,The government purchases multiplier,Example: If MPC = 0.8, then,Definition: the increase in income resulting from a $1 increase in G. In this model, the govt purchases mu
9、ltiplier equals,An increase in G causes income to increase 5 times as much!,CHAPTER 10 Aggregate Demand I,Why the multiplier is greater than 1,Initially, the increase in G causes an equal increase in Y: Y = G. But Y C further Y further C further Y So the final impact on income is much bigger than th
10、e initial G.,CHAPTER 10 Aggregate Demand I,An increase in taxes,so firms reduce output, and income falls toward a new equilibrium,Initially, the tax increase reduces consumption, and therefore E:,CHAPTER 10 Aggregate Demand I,Solving for Y,eqm condition in changes,I and G exogenous,Solving for Y :,F
11、inal result:,CHAPTER 10 Aggregate Demand I,The tax multiplier,def: the change in income resulting from a $1 increase in T :,If MPC = 0.8, then the tax multiplier equals,CHAPTER 10 Aggregate Demand I,The tax multiplier,is negative: A tax increase reduces C, which reduces income. is greater than one (
12、in absolute value): A change in taxes has a multiplier 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 is smaller than from an equal increase in G.,CHAPTER 10 Aggregate Demand I,Exercise
13、:,Use a graph of the Keynesian cross to show the effects of an increase in planned investment on the equilibrium level of income/output.,CHAPTER 10 Aggregate Demand I,The IS curve,def: a graph of all combinations of r and Y that result in goods market equilibrium i.e. actual expenditure (output) = p
14、lanned expenditure The equation for the IS curve is:,CHAPTER 10 Aggregate Demand I,Y2,Y1,Y2,Y1,Deriving the IS curve,r I,E =C +I (r1 )+G,E =C +I (r2 )+G,r1,r2,E =Y,IS, E, Y,CHAPTER 10 Aggregate Demand I,Why the IS curve is negatively sloped,A fall in the interest rate motivates firms to increase inv
15、estment spending, which drives up total planned spending (E ). To restore equilibrium in the goods market, output (a.k.a. actual expenditure, Y ) must increase.,CHAPTER 10 Aggregate Demand I,The IS curve and the loanable funds model,r1,r2,r1,r2,(a) The L.F. model,(b) The IS curve,IS,CHAPTER 10 Aggre
16、gate Demand I,Fiscal Policy and the IS curve,We can use the IS-LM model to see how fiscal policy (G and T ) affects aggregate demand and output. Lets start by using the Keynesian cross to see how fiscal policy shifts the IS curve,CHAPTER 10 Aggregate Demand I,Y2,Y1,Y2,Y1,Shifting the IS curve: G,At
17、any value of r, G E Y,E =C +I (r1 )+G1,E =C +I (r1 )+G2,r1,E =Y,IS1,The horizontal distance of the IS shift equals,IS2,so the IS curve shifts to the right.,CHAPTER 10 Aggregate Demand I,Exercise: Shifting the IS curve,Use the diagram of the Keynesian cross or loanable funds model to show how an incr
18、ease in taxes shifts the IS curve.,CHAPTER 10 Aggregate Demand I,The Theory of Liquidity Preference,Due to John Maynard Keynes. A simple theory in which the interest rate is determined by money supply and money demand.,CHAPTER 10 Aggregate Demand I,Money supply,The supply of real money balances is f
19、ixed:,M/P real money balances,rinterestrate,CHAPTER 10 Aggregate Demand I,Money demand,Demand for real money balances:,M/P real money balances,rinterestrate,L (r ),CHAPTER 10 Aggregate Demand I,Equilibrium,The interest rate adjusts to equate the supply and demand for money:,M/P real money balances,r
20、interestrate,L (r ),r1,CHAPTER 10 Aggregate Demand I,How the Fed raises the interest rate,To increase r, Fed reduces M,M/P real money balances,rinterestrate,L (r ),r1,r2,CHAPTER 10 Aggregate Demand I,CASE STUDY: Monetary Tightening & Interest Rates,Late 1970s: 10% Oct 1979: Fed Chairman Paul Volcker
21、 announces that monetary policy would aim to reduce inflation Aug 1979-April 1980: Fed reduces M/P 8.0% Jan 1983: = 3.7%,How do you think this policy change would affect nominal interest rates?,Monetary Tightening & Rates, cont.,i 0,i 0,8/1979: i = 10.4% 1/1983: i = 8.2%,8/1979: i = 10.4% 4/1980: i
22、= 15.8%,flexible,sticky,Quantity theory, Fisher effect (Classical),Liquidity preference (Keynesian),CHAPTER 10 Aggregate Demand I,The LM curve,Now lets put Y back into the money demand function:,The LM curve is a graph of all combinations of r and Y that equate the supply and demand for real money b
23、alances. The equation for the LM curve is:,CHAPTER 10 Aggregate Demand I,Deriving the LM curve,r1,r2,r1,r2,(a) The market for real money balances,(b) The LM curve,CHAPTER 10 Aggregate Demand I,Why the LM curve is upward sloping,An increase in income raises money demand. Since the supply of real bala
24、nces is fixed, there is now excess demand in the money market at the initial interest rate. The interest rate must rise to restore equilibrium in the money market.,CHAPTER 10 Aggregate Demand I,How M shifts the LM curve,r1,r2,r1,r2,(a) The market for real money balances,(b) The LM curve,CHAPTER 10 A
25、ggregate Demand I,Exercise: Shifting the LM curve,Suppose a wave of credit card fraud causes consumers to use cash more frequently in transactions. Use the liquidity preference model to show how these events shift the LM curve.,CHAPTER 10 Aggregate Demand I,The short-run equilibrium,The short-run eq
26、uilibrium is the combination of r and Y that simultaneously satisfies the equilibrium conditions in the goods & money markets:,Equilibrium interest rate,Equilibrium level of income,CHAPTER 10 Aggregate Demand I,The Big Picture,Keynesian Cross,Theory of Liquidity Preference,IS curve,LM curve,IS-LM mo
27、del,Agg. demand curve,Agg. supply curve,Model of Agg. Demand and Agg. Supply,Explanation of short-run fluctuations,CHAPTER 10 Aggregate Demand I,Preview of Chapter 11,In Chapter 11, we will use the IS-LM model to analyze the impact of policies and shocks. learn how the aggregate demand curve comes f
28、rom IS-LM. use the IS-LM and AD-AS models together to analyze the short-run and long-run effects of shocks. use our models to learn about the Great Depression.,Chapter Summary,Keynesian cross basic model of income determination takes fiscal policy & investment as exogenous fiscal policy has a multip
29、lier effect on income.IS curve comes from Keynesian cross when planned investment depends negatively on interest rate shows all combinations of r and Y that equate planned expenditure with actual expenditure on goods & services,CHAPTER 10 Aggregate Demand I,slide 40,Chapter Summary,Theory of Liquidi
30、ty Preference basic model of interest rate determination takes money supply & price level as exogenous an increase in the money supply lowers the interest rateLM curve comes from liquidity preference theory when money demand depends positively on income shows all combinations of r and Y that equate demand for real money balances with supply,CHAPTER 10 Aggregate Demand I,slide 41,Chapter Summary,IS-LM model Intersection of IS and LM curves shows the unique point (Y, r ) that satisfies equilibrium in both the goods and money markets.,CHAPTER 10 Aggregate Demand I,slide 42,
