Topic 10: TEN

CHAPTER
macro Aggregate
Aggregate Demand
Demand II
(chapter 10, Mankiw)

Eva Hromadkova

PowerPoint Slides
by Ron Cronovich

2002 Worth Publishers, all rights reserved

 Motivation
The Great Depression caused a
rethinking of the Classical Theory of the
macroeconomy. It could not explain:
Drop in output by 30% from 1929 to 1933
Rise in unemployment to 25%
In 1936, J.M. Keynes developed a theory
to explain this phenomenon.
Focus on the role of aggregate demand
We will learn a version of this theory,
called the IS-LM model.

CHAPTER 10 Aggregate Demand I

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 Context
We have already 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 is negatively related to
output
CHAPTER 10 Aggregate Demand I
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 Context
This chapter develops the IS-LM model,
the theory that yields the aggregate
demand curve.
We focus on the short run and assume
the price level is fixed.

CHAPTER 10 Aggregate Demand I

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 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 = planned expenditure
Y = real GDP = actual expenditure
Difference between actual & planned
expenditure: unplanned inventory
investment
CHAPTER 10 Aggregate Demand I
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 Elements of the Keynesian Cross
consumption C C (Y T )
function:
govt policy G G , T T
variables:
for now,
investment is I I
exogenous:
planned E C (Y T ) I G
expenditure:
Equilibrium
condition:
Actual expenditure Planned expenditure
Y E
CHAPTER 10 Aggregate Demand I
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Graphing planned expenditure

planned E =C +I +G

expenditure Slope
is MPC

income, output, Y

CHAPTER 10 Aggregate Demand I

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Graphing the equilibrium condition

E E =Y

planned

expenditure

45

income, output, Y

CHAPTER 10 Aggregate Demand I

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The equilibrium value of income

E E =Y

planned E =C +I +G

expenditure

income, output, Y
Equilibrium
income
CHAPTER 10 Aggregate Demand I
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The equilibrium value of income

E E =Y

planned E =C +I +G
E<Y
expenditure
E>Y

income, output, Y
E>Y: depleting inventories: must produce more.
E<Y: accumulating inventories: must produce less.
CHAPTER 10 Aggregate Demand I
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An increase in government purchases
E

Y
=
At Y1, E =C +I

E
there is now an +G2
unplanned drop E =C +I
in inventory +G1

G Looks like
so firms Y>G
increase output,
and income Y
rises toward a
new equilibrium E1 = Y1 Y E2 = Y2

CHAPTER 10 Aggregate Demand I

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Why is change in Y > change in G?
Y
Def: Government purchases multiplier:
G

Initially, the increase in G causes an equal

increase in Y: Y = G.
But Y C (Y-T)
further Y
further C
further Y
So the government purchases multiplier will
be greater than one.

CHAPTER 10 Aggregate Demand I

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An increase in government purchases
E

Y
=
E
C even more
C more
C
Y even more
Y more
G
Y once

CHAPTER 10 Aggregate Demand I

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Sum up changes in expenditure
Y G MPC G MPC MPC G
MPC MPC MPC G ...

G MPC 1G MPC 2G MPC 3G ...
This is a standard geometric series from algebra:
1
G
1 MPC
So the multiplier is:
Y 1
1 for 0 < MPC < 1
G 1 MPC
CHAPTER 10 Aggregate Demand I
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 An increase in taxes
E

Y
=
Initially, the tax
E =C1 +I

E
increase reduces
consumption, and +G
E =C2 +I
therefore E: +G

C = MPC At Y1, there is now

T an unplanned
so firms inventory buildup
reduce output,
and income falls Y
toward a new E2 = Y2 Y E1 = Y1
equilibrium

CHAPTER 10 Aggregate Demand I

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 Solving for Y
eqm condition in
Y C I G
changes
C I and G exogenous

MPC Y T

Solving for Y (1 MPC) Y MPC T

:

Final result:
MPC
Y T
1 MPC

CHAPTER 10 Aggregate Demand I

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 The Tax Multiplier
Question: how is this different from the government
spending multiplier considered previously?

The tax multiplier:

is negative:
An increase in taxes reduces consumer spending,
which reduces equilibrium income.
is smaller than the govt spending multiplier:
(in absolute value) 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

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 Building 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:

Y C (Y T ) I (r ) G

CHAPTER 10 Aggregate Demand I

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 Deriving the IS curve
E E =Y
E =C +I (r2 )+G
r I E =C +I (r1 )+G

E I

Y Y1 Y2 Y
r
r1

r2
IS
Y1 Y2 Y

CHAPTER 10 Aggregate Demand I

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Understanding the IS curves slope
The IS curve is negatively sloped.
Intuition:
A fall in the interest rate motivates
firms to increase investment 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

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Fiscal Policy and the IS curve
We can use the IS-LM model to see
how fiscal policy (G and T ) can
affect 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

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 Shifting the IS curve: G
E E =Y E =C +I (r )+G
At given value of r, 1 2

G E Y E =C +I (r1 )
so the IS curve +G1
shifts to the right.

The horizontal Y1 Y2 Y
r
distance of the
r1

IS shift 1
equals Y
Y G IS2
1 MPC IS1
Y1 Y2 Y

CHAPTER 10 Aggregate Demand I

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Algebra example for IS curve
Suppose the expenditure side of the
economy is characterized by:
C =95 + 0.75(Y-T)
I = 100 100r
G = 20, T=20

Use the goods market equilibrium condition

Y=C+I+G
Y = 215 + 0.75 (Y-20) 100r
0.25Y = 200 100r
IS: Y = 800 400r or write as
IS: r = 2 - 0.0025Y
CHAPTER 10 Aggregate Demand I
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 Graph the IS curve

2 Slope = -0.0025

IS

IS: r = 2 - 0.0025Y

CHAPTER 10 Aggregate Demand I

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 Slope of IS curve
Suppose that investment expenditure is
more responsive to the interest rate:
I = 100 100r 200r
Use the goods market equilibrium condition
Y=C+I+G
Y = 215 + 0.75 (Y-20) 200r
0.25Y = 200 200r
IS: Y = 800 800r or write as
IS: r = 1 - 0.00125Y (slope is
lower)
So this makes the IS curve flatter: A fall in r
raises I more, which raises Y more.
CHAPTER 10 Aggregate Demand I
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 Building the LM Curve:
The Theory of Liquidity Preference
Developed by John Maynard Keynes.
A simple theory in which the interest
rate
is determined by money supply and
money demand.

CHAPTER 10 Aggregate Demand I

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 Money Supply
The supply of r
M P
s
real money interest
balances rate
is fixed:

M P
s
M P

M/P
M P
real money
balances

CHAPTER 10 Aggregate Demand I

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 Money Demand

Demand for r
M P
s
real money interest
rate
balances:

M P
d
L(r )

L (r )

M/P
M P
real money
balances

CHAPTER 10 Aggregate Demand I

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 Equilibrium

The interest r
M P
s
rate adjusts interest
rate
to equate
the supply
and demand
for money:
r1
M P L(r ) L (r )

M/P
M P
real money
balances

CHAPTER 10 Aggregate Demand I

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How can CB affect the interest rate
r
interest
rate
To increase r,
CB reduces M r2

r1
L (r )

M/P
M2 M1
real money
P P balances

CHAPTER 10 Aggregate Demand I

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 The LM curve
Now lets put Y back into the money
demand function: d
M P L(r ,Y )

The LM curve is a graph of all

combinations of r and Y that equate the
supply and demand for real money
balances.
The equation for the LM curve is:
M P L(r ,Y )

CHAPTER 10 Aggregate Demand I

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 Deriving the LM curve
(a) The market for
(b) The LM curve
real money
r balances r
LM

r2 r2

L (r ,
r1 Y2 ) r1
L (r ,
Y1 )
M1 M/P Y1 Y2 Y
P

CHAPTER 10 Aggregate Demand I

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Understanding the LM curves slope
The LM curve is positively sloped.
Intuition:
An increase in income raises money
demand.
Since the supply of real balances 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

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 How M shifts the LM curve
(a) The market for
(b) The LM curve
real money
r balances r
LM
2
LM1
r2 r2

r1 r1
L (r , Y1 )

M2 M1 M/P Y1 Y
P P

CHAPTER 10 Aggregate Demand I

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 The short-run equilibrium
The short-run equilibrium r
is the combination of r
LM
and Y that simultaneously
satisfies the equilibrium
conditions in the goods &
money markets:
Y C (Y T ) I (r ) G IS
M P L(r ,Y ) Y
Equilibrium
interest Equilibrium
rate level of
income

CHAPTER 10 Aggregate Demand I

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 The Big Picture (preview)
Keynesian IS
Cross curve
IS-LM
model Explanation
Theory of LM of short-run
Liquidity curve fluctuations
Preference
Agg.
demand
curve Model of
Agg.
Demand
Agg.
and Agg.
supply
Supply
curve

CHAPTER 10 Aggregate Demand I

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 Chapter summary
1. Keynesian Cross
basic model of income determination
takes fiscal policy & investment as exogenous
fiscal policy has a multiplied impact on
income.
2. 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
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 Chapter summary
3. 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
interest rate
4. LM curve
comes from Liquidity Preference Theory when
money demand depends positively on income
shows all combinations of r andY that equate
demand for real money balances with supply

CHAPTER 10 Aggregate Demand I

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 Chapter summary
5. 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

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