1、CHAPTER 10 Aggregate Demand I,Chapter 10,Aggregate Demand I: Building the IS -LM Model,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
2、 the IS-LM model determines income and 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 equal
3、s its natural rate Short run prices fixed 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 fixe
4、d (so, SRAS curve is horizontal). This 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
5、= planned investment E = C + I + G = planned 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:,pl
6、anned expenditure:,equilibrium condition:,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,Eplannedexpend
7、iture,45,CHAPTER 10 Aggregate Demand I,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,Solvi
8、ng for Y,equilibrium condition,in changes,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
9、. In this model, the govt purchases multiplier 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 i
10、mpact on income is much bigger than the 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 chang
11、es,I and G exogenous,Solving for Y :,Final 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
12、 reduces 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:,Use a graph of the Keynesian cross to show the effects
13、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) = planned expenditure The equation for the IS curve is:,CHAP
14、TER 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 investment spending, which drives up total planned spending
15、(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 Aggregate Demand I,The IS curve can also be derived from the (
16、hopefully now familiar) loanable funds model from chapter 3. A decrease in income from Y1 to Y2 causes a fall in national saving. (Recall, S = Y-C-G) The fall in saving causes a reduction in the supply of loanable funds. The interest rate must rise to restore equilibrium to the loanable funds market
17、. Now we can see where the IS curve gets its name: When the loanable funds market is in equilibrium, investment = saving. The IS curve shows all combinations of r and Y such that investment (I) equals saving (S). Hence, “IS curve.”,CHAPTER 10 Aggregate Demand I,Fiscal Policy and the IS curve,We can
18、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 any value of r, G E Y,E =C +I (r1 )+G1,E =C +I (r1 )
19、+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 increase in taxes shifts the IS curve.,CHAPTER 10 Aggreg
20、ate 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 fixed:,M/P real money balances,rinterestrate,CHAPTER
21、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,rinterestrate,L (r ),r1,CHAPTER 10 Aggregate Demand I
22、,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 announces that monetary policy would aim to reduce
23、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 = 15.8%,flexible,sticky,Quantity theory, Fisher effe
24、ct (Classical),Liquidity preference (Keynesian),CHAPTER 4 Money and Inflation,The quantity theory of money, cont.(from Chapter4),Y/Y depends on growth in the factors of production and on technological progress (all of which we take as given, for now).,Hence, the Quantity Theory predicts a one-for-on
25、e relation between changes in the money growth rate and changes in the inflation rate.,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 balances. The
26、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 balances is fixed
27、, 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 Aggregate Dema
28、nd 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 equilibrium is
29、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 model,Agg. dema
30、nd 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 from IS-LM. us
31、e 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 multiplier effect o
32、n 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 42,Chapter Summary,Theory of Liquidity Preference
33、 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 43,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 44,
