1、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 the interest rate in the short run when P is fixed CHAPTER 10 Aggregate Demand IC
2、ontext 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 outputCHA
3、PTER 10 Aggregate Demand IContext 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 chapter(and chapter 11)focus on the closed-economy case.Chapter 12 presents the open-economy
4、 case.CHAPTER 10 Aggregate Demand IThe Keynesian Cross A simple closed economy model in which income is 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 in
5、ventory investmentCHAPTER 10 Aggregate Demand IElements of the Keynesian CrossCHAPTER 10 Aggregate Demand I()CC YTII,GGTT()EC YTIGYEconsumption function:for now,plannedinvestment is exogenous:planned expenditure:equilibrium condition:govt policy variables:actual expenditure=planned expenditureGraphi
6、ng planned expenditureCHAPTER 10 Aggregate Demand Iincome,output,Y EplannedexpenditureE=C+I+G MPC1Graphing the equilibrium conditionCHAPTER 10 Aggregate Demand Iincome,output,Y EplannedexpenditureE=Y 45The equilibrium value of incomeCHAPTER 10 Aggregate Demand Iincome,output,Y EplannedexpenditureE=Y
7、 E=C+I+G Equilibrium incomeAn increase in government purchasesCHAPTER 10 Aggregate Demand IY EE=Y E=C+I+G1E1=Y1E=C+I+G2E2=Y2 YAt Y1,there is now an unplanned drop in inventoryso firms increase output,and income rises toward a new equilibrium.GSolving for YCHAPTER 10 Aggregate Demand IYCIGYCIG MPC YG
8、CG(1MPC)YG11MPC YGequilibrium conditionin changesbecause I exogenousbecause C =MPC Y Collect terms with Y on the left side of the equals sign:Solve for Y:The government purchases multiplierDefinition:the increase in income resulting from a$1 increase in G.In this model,the govt purchases multiplier
9、equalsCHAPTER 10 Aggregate Demand IExample:If MPC=0.8,then11MPCYG1510.8YGAn increase in G causes income to increase 5 times as much!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 i
10、s much bigger than the initial G.CHAPTER 10 Aggregate Demand IAn increase in taxesCHAPTER 10 Aggregate Demand IY EE=Y E=C2+I+GE2=Y2E=C1+I+GE1=Y1 YAt Y1,there is now an unplanned inventory buildupso firms reduce output,and income falls toward a new equilibrium C=MPC TInitially,the tax increase reduce
11、s consumption,and therefore E:Solving for YCHAPTER 10 Aggregate Demand IYCIG MPC YTC(1MPC)MPC YTeqm condition in changesI and G exogenousSolving for Y:MPC1MPC YTFinal result:The tax multiplierdef:the change in income resulting from a$1 increase in T:CHAPTER 10 Aggregate Demand IMPC1MPCYT0.80.8410.80
12、.2 YTIf MPC=0.8,then the tax multiplier equalsThe tax multiplieris negative:A tax increase reduces C,which 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
13、 in G.CHAPTER 10 Aggregate Demand IExercise: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 IThe IS curvedef:a graph of all combinations of r and Y that result in goods market equilibriu
14、mi.e.actual expenditure(output)=planned expenditureThe equation for the IS curve is:CHAPTER 10 Aggregate Demand I()()YC YTI rGDeriving the IS curver ICHAPTER 10 Aggregate Demand IY2Y1Y2Y1Y ErY E=C+I(r1)+G E=C+I(r2)+G r1r2E=YIS I E YWhy the IS curve is negatively sloped A fall in the interest rate mo
15、tivates 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 IThe IS curve and the loanable funds modelCHAPTER 10 Aggregate Demand IS,IrI(r )r1r2rYY1r1r2(
16、a)The L.F.model(b)The IS curveY2S1S2ISCHAPTER 10 Aggregate Demand IThe IS curve can also be derived from the(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 sup
17、ply of loanable funds.The interest rate must rise to restore equilibrium to the loanable funds market.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
18、(S).Hence,“IS curve.”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 curveCHAPTER 10 Aggregate Demand IShifting the IS curve:GAt any value of
19、r,G E YCHAPTER 10 Aggregate Demand IY2Y1Y2Y1Y ErY E=C+I(r1)+G1 E=C+I(r1)+G2 r1E=YIS1The horizontal distance of the IS shift equals IS2so the IS curve shifts to the right.11 MPCYG YExercise:Shifting the IS curve Use the diagram of the Keynesian cross or loanable funds model to show how an increase in
20、 taxes shifts the IS curve.CHAPTER 10 Aggregate Demand IThe 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 IMoney supplyThe supply of real money balances is fixed:CHAPTER
21、10 Aggregate Demand IsM PM PM/P real money balancesrinterestratesM PM PMoney demandDemand forreal money balances:CHAPTER 10 Aggregate Demand IM/P real money balancesrinterestratesM PM P()dM PL rL(r)EquilibriumThe interest rate adjusts to equate the supply and demand for money:CHAPTER 10 Aggregate De
22、mand IM/P real money balancesrinterestratesM PM P()M PL rL(r)r1How the Fed raises the interest rateTo increase r,Fed reduces MCHAPTER 10 Aggregate Demand IM/P real money balancesrinterestrate1MPL(r)r1r22MPCASE STUDY:Monetary Tightening&Interest Rates Late 1970s:10%Oct 1979:Fed Chairman Paul Volcker
23、announces that monetary policy would aim to reduce inflation Aug 1979-April 1980:Fed reduces M/P 8.0%Jan 1983:=3.7%CHAPTER 10 Aggregate Demand IHow do you think this policy change would affect nominal interest rates?Monetary Tightening&Rates,cont.i 08/1979:i =10.4%1/1983:i =8.2%8/1979:i =10.4%4/1980
24、:i =15.8%flexiblestickyQuantity theory,Fisher effect(Classical)Liquidity preference(Keynesian)predictionactual outcomeThe effects of a monetary tightening on nominal interest ratespricesmodellong runshort runThe quantity theory of money,cont.(from Chapter4)Y/Y depends on growth in the factors of pro
25、duction and on technological progress(all of which we take as given,for now).CHAPTER 4 Money and InflationHence,the Quantity Theory predicts a one-for-one relation between changes in the money growth rate and changes in the inflation rate.The LM curveNow lets put Y back into the money demand functio
26、n:CHAPTER 10 Aggregate Demand I(,)M PL r YThe 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:dM PL r Y(,)Deriving the LM curveCHAPTER 10 Aggregate Demand IM/P r1MPL(r,Y1)r1r2rYY1r1L(r,Y2)r2Y2LM(a)The marke
27、t for real money balances(b)The LM curveWhy the LM curve is upward sloping 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
28、market.CHAPTER 10 Aggregate Demand IHow M shifts the LM curveCHAPTER 10 Aggregate Demand IM/P r1MPL(r,Y1)r1r2rYY1r1r2LM1(a)The market for real money balances(b)The LM curve2MPLM2Exercise:Shifting the LM curve Suppose a wave of credit card fraud causes consumers to use cash more frequently in transac
29、tions.Use the liquidity preference model to show how these events shift the LM curve.CHAPTER 10 Aggregate Demand IThe short-run equilibriumThe short-run equilibrium is the combination of r and Y that simultaneously satisfies the equilibrium conditions in the goods&money markets:CHAPTER 10 Aggregate
30、Demand I()()YC YTI rGY r(,)M PL r YISLMEquilibriuminterestrateEquilibriumlevel ofincomeThe Big PictureCHAPTER 10 Aggregate Demand IKeynesianCrossTheory of Liquidity PreferenceIScurveLM curveIS-LMmodelAgg.demandcurveAgg.supplycurveModel of Agg.Demand and Agg.SupplyExplanation of short-run fluctuation
31、sPreview of Chapter 11In 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.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 D
32、epression.CHAPTER 10 Aggregate Demand I1.Keynesian crossbasic model of income determinationtakes fiscal policy&investment as exogenousfiscal policy has a multiplier effect on income.2.IS curvecomes from Keynesian cross when planned investment depends negatively on interest rateshows all combinations
33、 of r and Y that equate planned expenditure with actual expenditure on goods&servicesCHAPTER 10 Aggregate Demand Islide 413.Theory of Liquidity Preferencebasic model of interest rate determinationtakes money supply&price level as exogenousan increase in the money supply lowers the interest rate4.LM
34、curvecomes from liquidity preference theory when money demand depends positively on incomeshows all combinations of r and Y that equate demand for real money balances with supplyCHAPTER 10 Aggregate Demand Islide 425.IS-LM modelIntersection 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 Islide 43
