The

TheGreat
GreatDepression
Depressioncaused
causedmany
manyeconomists
economiststotoquestion
questionthe
the
validity
validityof
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classicaleconomic
economictheory
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(fromChapters
Chapters3-6).
3-6).They
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suchaapervasive
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A PowerPointTutorial
to Accompany macroeconomics, 5th ed.
economic
economicdownturn
downturnandandto
tosuggest
suggestthat
thatgovernment
governmentpolicies
policiesmight
might
N. Gregory Mankiw ease
easesome
someof ofthe
theeconomic
economichardship
hardshipthat
thatsociety
societywas
wasexperiencing.
experiencing.

In
In1936,
1936,John
JohnMaynard
MaynardKeynes
Keyneswrote
wroteThe
TheGeneral
GeneralTheory
Theoryofof
Employment,
Employment,Interest
Interestand
andMoney.
Money.In
Init,
it,he
heproposed
proposedaanew
newway
wayto
to
CHAPTER TEN analyze
analyzethe
theeconomy,
economy,which
whichhe
hepresented
presentedasasan
analternative
alternativeto
to
Aggregate Demand I the
theclassical
classicaltheory.
theory.

Keynes
Keynesproposed
proposedthat
thatlow
lowaggregate
aggregatedemand
demandisisresponsible
responsiblefor
forthe
thelow
low
income
incomeand
andhigh
highunemployment
unemploymentthat thatcharacterize
characterizeeconomic
economicdownturns.
downturns.
He
Hecriticized
criticizedthe
thenotion
notionthat
thataggregate
aggregatesupply
supplyalone
alonedetermines
determinesnational
national
Mannig J. Simidian
income.
income.
Chapter Ten 1 Chapter Ten 2

‘Keynesian’ means different things to different

people. It’s useful to think of the basic textbook
Keynesian model as an elaboration and extension
of the ‘classical theory’. Its variable velocity
of money and ‘sticky’ prices reflects Keynes’
belief that the Classical model’s shortcomings arose
from its overly-strict assumptions of constant
velocity and highly flexible wages and prices.

The model of aggregate demand (AD) can be split into two parts:
IS model of the ‘goods market’ and the
LM model of the ‘money market’.
Chapter Ten 3 Chapter Ten 4

The Keynesian model can be viewed as showing what

causes the aggregate demand curve to shift.
In the short run, when the price level is fixed, shifts in
the aggregate demand curve lead to changes in
national income, Y. The IS curve (which stands for investment
The model of aggregate demand developed in this chapter called saving) plots the relationship between the
the IS-LM is the leading interpretation of Keynes’ work. The IS-LM interest rate and the level of income that
model takes the price level as given and shows what causes income to arises in the market for goods and services.
change. It shows what causes AD to shift.

Price Level, P
The LM curve (which stands for liquidity and
money) plots the relationship between the
SRAS interest rate and the level of income that
AD''
AD' arises in the money market.
AD
Chapter Ten 5 Chapter Ten 6
Y* Y*'Y*'' Income, Output, Y

1
 Because
Becausethe theinterest
interestrate
rateinfluences
influencesboth
bothinvestment
investmentand
andmoney
money
demand,
demand,ititisisthe
thevariable
variablethat
thatlinks
linksthe
thetwo
twoparts
partsof
ofthe
theIS-LM
IS-LMmodel.
model. The Keynesian cross shows how income Y is determined for given levels
of planned investment I and fiscal policy G and T. We can use this
The
Themodel
modelshows
showshowhowinteractions
interactionsbetween
betweenthese
thesemarkets
marketsdetermine
determine model to show how income changes when one of the exogenous
the
theposition
positionand
andslope
slopeof
ofthe
theaggregate
aggregatedemand
demandcurve,
curve,and
andtherefore,
therefore, variables change. Actual expenditure is the amount households, firms
the
thelevel
levelof
ofnational
nationalincome
incomein
inthe
theshort
shortrun.
run. and the government spend on goods and services (GDP). Planned
expenditure is the amount households, firms and the government
In
Inthe
theGeneral
GeneralTheory
Theoryof ofMoney,
Money,Interest
Interestand
andEmployment
Employment(1936),
(1936), would like to spend on goods and services. The economy is in
Keynes
Keynesproposed
proposedthat
thatananeconomy’s
economy’stotal
totalincome
incomewas,
was,ininthe
theshort
short equilibrium when: Actual Expenditure = Planned Expenditure or Y=E
run,
run,determined
determinedlargely
largelybybythe
thedesire
desireto
tospend
spendbybyhouseholds,
households,firms
firms
and Expenditure, E Actual Expenditure, Y=E
andthethegovernment.
government. The Themore
morepeople
peoplewant
wanttotospend,
spend,the
themore
moregoods
goods
and
andservices
servicesfirms
firmscan
cansell.
sell. The
Themore
morefirms
firmscan
cansell,
sell,the
themore
more Planned Expenditure,
output
outputthey theywill
willchoose
choosetotoproduce
produceand
andthe
themore
moreworkers
workersthey
theywill
will E=C+I+G
choose
chooseto tohire.
hire. Thus,
Thus,thetheproblem
problemduring
duringrecessions
recessionsand
anddepressions,
depressions,
according
accordingto toKeynes,
Keynes,was wasinadequate
inadequatespending.
spending. The
TheKeynesian
Keynesian
Chapter Ten
cross
crossisisan
anattempt
attempttotomodel
modelthis
thisinsight.
insight. 7 Chapter Ten 8

Y2 Y* Y1 Income, Output, Y

The 45-degree line (Y=E) plots the points where this condition holds.
With the addition of the planned-expenditure function, this diagram Consider how changes in government purchases affect the economy.
becomes the Keynesian Cross. Because government purchases are one component of expenditure,
higher government purchases result in higher planned expenditure,
How does the economy get to this equilibrium? Inventories play an for any given level of income.
important role in the adjustment process. Whenever the economy is
not in equilibrium, firms experience unplanned changes in inventories, Expenditure, E Actual Expenditure, Y=E
and this induces them to change production levels. Changes in B Planned Expenditure,
production in turn influence total income and expenditure, moving the A E=C+I+G
economy toward equilibrium. ∆G

Expenditure, E Actual Expenditure, Y=E

Y* Y1 Income, Output, Y
Planned Expenditure,
E=C+I+G An increase in government purchases of ∆G raises planned expenditure
by that amount for any given level of income. The equilibrium moves
from A to B and income rises. Note that the increase in income Y
exceeds the increase in government purchases ∆G. Thus, fiscal policy
Chapter Ten Y2 Y* Y1 Income, Output, Y 9 Chapter Ten has a multiplied effect on income. 10

If government spending were to increase by $1, then you might expect

equilibrium output (Y) to also rise by $1.
The
Thegovernment-purchases
government-purchasesmultiplier
multiplieris:
is:
But it doesn’t! The multiplier shows that the change in demand for
∆Y/∆G
∆Y/∆G==11++MPC
MPC++MPC
MPC2++MPC
2
MPC3++…
3
…
output (Y) will be larger than the initial change in spending. Here’s why:
When there is an increase in government spending (∆G), income rises by ∆Y/∆G
∆Y/∆G==11//11--MPC
MPC
∆G as well. The increase in income will raise consumption by MPC ×
∆G, where MPC is the marginal propensity to consume. The increase in The
consumption raises expenditure and income again. The second increase Thetax
taxmultiplier
multiplieris:
is:
∆Y/∆T
∆Y/∆T==--MPC
MPC//(1(1--MPC)
MPC)
in income of MPC × ∆G again raises consumption, this time by MPC ×
(MPC × ∆G), which again raises income and so on.
So, the multiplier process helps explain fluctuations in the demand for
output. For example, if something in the economy decreases investment
spending, then people whose incomes have decreased will spend less,
thereby driving equilibrium demand down even further.
Chapter Ten 11 Chapter Ten 12

2
 (b)
An increase in the interest
Let’s now add the relationship between the interest rate and investment E
rate (in graph a), lowers Y=E
to our model, writing the level of planned investment as: I = I (r). planned investment, Planned Expenditure,
which shifts planned E=C+I+G
On the next slide, the investment function is graphed downward- expenditure downward (in
sloping showing the inverse relationship between investment graph b) and lowers
and the interest rate. To determine how income changes when the income (in graph c).
interest rate changes, we combine the investment function with the Income, Output, Y
Keynesian-cross diagram. (a) (c)
r r
The IS curve summarizes this relationship between the interest rate
and the level of income. In essence, the IS curve combines the interaction
between I and Y demonstrated by the Keynesian cross. Because an
increase in the interest rate causes planned investment to fall, which in
turn causes income to fall, the IS curve slopes downward. I(r) IS
Chapter Ten 13 Chapter Ten
Investment, I Income, Output,
14 Y

Now that we’ve derived the IS part of AD, it’s now time to complete the
model of AD by adding a money market equilibrium schedule, the LM
In curve. To develop this theory, we begin with the supply of real money
Insummary,
summary,thetheISIScurve
curveshows
showsthe
thecombinations
combinationsof ofthe
theinterest
interestrate
rate
and balances (M/P); both of these variables are taken to be exogenously
andthe
thelevel
levelofofincome
incomethat
thatare
areconsistent
consistentwith
withequilibrium
equilibriumin inthe
the
market given. This yields a vertical supply curve.
marketfor
forgoods
goodsandandservices.
services.The
TheISIScurve
curveisisdrawn
drawnforforaagiven
givenfiscal
fiscal
policy. Now, consider the demand for real money balances,
policy.Changes
Changesin infiscal
fiscalpolicy
policythat
thatraise
raisethe
thedemand
demandfor forgoods
goodsandand
services L. The theory of liquidity preference suggests that a
servicesshift
shiftthe
theISIScurve
curvetotothe
theright.
right.Changes
Changesin infiscal
fiscalpolicy
policythat
that r
reduce
reducethe
thedemand
demandfor forgoods
goodsandandservices
servicesshift
shiftthe
theIS
IScurve
curveto tothe
theleft.
left. Supply higher interest rate lowers the quantity of real
balances demanded, because r is the opportunity
cost of holding money.
The supply and demand for real money balances
determine the interest rate. At the equilibrium
interest rate, the quantity of money balances
demanded equals the quantity supplied.
Demand, L (r)
Chapter Ten 15 Chapter Ten 16

M/P M/P

L(r) == M/P
L(r) M/P (M/P)dd == LL (r,Y)
(M/P) (r,Y)

The quantity of real money balances demanded is negatively related

to the interest rate (because r is the opportunity cost of holding money)
Money Demand equals Real Money Balances and positively related to income (because of transactions demand).

Chapter Ten 17 Chapter Ten 18

3
A
A Reduction
Reduction in
in the
the
Money
Money Supply:
Supply: -∆M/P
-∆M/P
r Supply r LM
r Supply' Supply

r2
r1
L (r,Y)'
L (r,Y)
Demand, L (r,Y)
M/P M/P Y
M/P M/P An increase in income raises money demand, which increases the
Since the price level is fixed, a reduction in the money supply reduces interest rate; this is called an increase in transactions demand
the supply of real balances. Notice the equilibrium interest rate rose. for money. The LM curve summarizes these changes in the money
market equilibrium.
Chapter Ten 19 Chapter Ten 20

LM' r IS LM(P0)
r Supply' Supply r LM

r2 r2 r0
r1 r1

L (r,Y)
Y0 Y
M´/P M/P M/P Y
The
Theintersection
intersectionof ofthe
theIS
IScurve/equation,
curve/equation,Y=Y=CC(Y-T)
(Y-T)++I(r)
I(r)++GGand
and
A contraction in the money supply raises the interest rate that equilibrates the
theLM
LMcurve/equation
curve/equationM/P M/P==L(r,
L(r,Y)
Y)determines
determinesthethelevel
levelofof
the money market. Why? Because a higher interest rate is needed to aggregate
aggregatedemand.
demand. The Theintersection
intersectionof
ofthe
theIS
ISand
andLMLMcurves
curves
convince people to hold a smaller quantity of real balances. represents
representssimultaneous
simultaneousequilibrium
equilibriumininthe
themarket
marketfor
forgoods
goodsandand
As a result of the decrease in the money supply, the LM shifts upward. services
servicesand andin
inthe
themarket
marketforforreal
realmoney
moneybalances
balancesfor
forgiven
givenvalues
valuesofof
Chapter Ten 21
government
government spending, taxes, the money supply, and the pricelevel.
Chapter Ten
spending, taxes, the money supply, and the price 22
level.

IS-LM
IS-LMModel
Model
IS
ISCurve
Curve
LM
LMCurve
Curve
Keynesian
Keynesiancross
cross
Government-purchases
Government-purchasesmultiplier
multiplier
Tax
Taxmultiplier
multiplier
Theory
Theoryof
ofliquidity
liquiditypreference
preference

Chapter Ten 23