CHAPTER TEN

macro Aggregate Demand I

macroeconomics
fifth edition

N. Gregory Mankiw
PowerPoint® Slides
by Ron Cronovich

© 2002 Worth Publishers, all rights reserved

 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 I slide 1

 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 fixed
– output determined by aggregate demand
– unemployment is negatively related to output
CHAPTER 10 Aggregate Demand I slide 2
 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 slide 3

 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 slide 4

 Elements of the Keynesian Cross
consumption function: C = C (Y − T )
govt policy variables:
G =G , T =T
for now,
investment is exogenous: I =I
planned expenditure: E = C (Y − T ) + I +
G
Equilibrium condition:
Actual expenditure = Planned
expenditure
CHAPTER 10 Aggregate Y = EI
Demand slide 5
Graphing planned expenditure
E
planned
expenditure
E =C +I +G

MPC
1

income, output, Y

CHAPTER 10 Aggregate Demand I slide 6

Graphing the equilibrium condition
E
planned E =Y
expenditure

45º

income, output, Y

CHAPTER 10 Aggregate Demand I slide 7

The equilibrium value of income
E
planned E =Y
expenditure
E =C +I +G

income, output, Y
Equilibrium
income
CHAPTER 10 Aggregate Demand I slide 8
An increase in government purchases
E
Y

=
At Y1, E E =C +I +G 2
there is now an
unplanned drop E =C +I +G 1
in inventory…

ΔG
…so firms
increase output,
and income Y
rises toward a
E1 = Y 1 ΔY E2 = Y 2
new equilibrium

CHAPTER 10 Aggregate Demand I slide 9

 Solving for
ΔY
Y =C +I +G equilibrium condition

ΔY = ΔC + Δ I + Δ G in changes
because I
= ΔC + ΔG
= MPC × ΔY + exogenous because
ΔG
ΔC = MPC ΔY
Collect terms with ΔY
1
on the left side of the ⎛ ⎞
Y= ⎜ solve for⎟Δ×YΔ:G
ΔFinally,
equals sign: ⎝ 1 − MPC ⎠
(1 − MPC)×ΔY = ΔG
CHAPTER 10 Aggregate Demand I slide 10
The government purchases multiplier
Example: MPC =
0.8
1
ΔY= ΔG
1 − MPC
1 1
= ΔG ΔG = 5
1 − 0.8 0.2= ΔG

The increase in G causes income to

increase by 5 times as much!

CHAPTER 10 Aggregate Demand I slide 11

The government purchases multiplier
Definition: the increase in income resulting
from a $1 increase in G.
In this model, the G multiplier equals
ΔY 1
=
ΔG 1 − MPC

In the example with MPC = 0.8,

ΔY 1
= =
ΔG 1 − 0.8 5

CHAPTER 10 Aggregate Demand I slide 12

Why the multiplier is greater than 1
▪ Initially, the increase in G causes an
increase
equal in Y: ΔY = ΔG.
▪ But ↑Y ⇒ ↑C
⇒ further ↑Y
⇒ further ↑C
⇒ further ↑Y
▪ So the final impact on income is much
bigger than the initial ΔG.

CHAPTER 10 Aggregate Demand I slide 13

 An increase in taxes
E
Y
Initially, the tax

=
E E =C 1 +I +G
increase reduces
consumption, and E =C 2 +I +G
therefore E:

ΔC = −MPC At Y1, there is now

ΔT an unplanned
inventory buildup…
…so firms
reduce output,
and income Y
falls toward a E2 = Y 2 ΔY E1 = Y 1
new equilibrium

CHAPTER 10 Aggregate Demand I slide 14

 Solving for
ΔY eq’m condition in
ΔY = ΔC + Δ I + Δ G
changes
= ΔC I and G exogenous

= MPC × ΔY − ΔT
( )
Solving for ΔY : (1 − MPC)× ΔY = −MPC × ΔT

Final result: ⎜⎛ ⎟⎞
1− −MPC
MPC
ΔY = ⎝ ⎠ × ΔT

CHAPTER 10 Aggregate Demand I slide 15

 The Tax Multiplier
def: the change in income resulting
from a $1 increase in T :
ΔY −MPC
=
ΔT 1 − MPC

If MPC = 0.8, then the tax multiplier equals

ΔY
= − 0.8 − 0.8
= −=4
ΔT 1 − 0.8 0.2

CHAPTER 10 Aggregate Demand I slide 16

 The Tax Multiplier
…is negative:
A tax hike reduces
consumer spending,
which reduces income.
…is greater than one
(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 slide 17
 The Tax Multiplier
…is negative:
An increase in taxes reduces consumer
spending, which reduces equilibrium income.
…is greater than (in absolute
A change in taxes has value
one ):
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 equal10 Aggregate
CHAPTER in G. I
increase Demand slide 18
 Exercise:

▪ Use a graph of the Keynesian Cross

to show the impact of an increase in
investment on the equilibrium level of
income/output.

CHAPTER 10 Aggregate Demand I slide 19

 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 slide 20

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

↑Y r Y1 Y2 Y
r1

r2
IS
Y1 Y2 Y

CHAPTER 10 Aggregate Demand I slide 21

Understanding the IS curve’s 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 slide 22

The IS curve and the Loanable Funds model

(a) The L.F. model (b) The IS curve

r S2 S1 r

r2 r2

r1 r1
I (r
) IS
S, I Y2 Y1 Y

CHAPTER 10 Aggregate Demand I slide 23

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.

▪ Let’s start by using the Keynesian Cross

to see how fiscal policy shifts the IS
curve…

CHAPTER 10 Aggregate Demand I slide 24

 Shifting the IS curve: ΔG
E E =Y
At any value of r, E =C +I (r1 )+G2
↑G ⇒ ↑E ⇒ ↑Y E =C +I (r1 )+G1
…so the IS curve
shifts to the right.

The horizontal Y1 Y2 Y
r
distance of the
r1
IS shift equals

1 ΔY
ΔY = 1−MP
ΔG IS1 IS2
C Y1 Y2 Y

CHAPTER 10 Aggregate Demand I slide 25

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 Aggregate Demand I slide 26

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 slide 27

 Money Supply

The supply of r
s
interest
real money MP
rate ( )
balances
is fixed:
s
M P =M
( )
P
M/P
M P real money
balances

CHAPTER 10 Aggregate Demand I slide 28

 Money Demand

Demand for r
s
interest
real money MP
rate ( )
balances:
= L( r
M P
( )
d
) L (r
)
M/P
M P real money
balances

CHAPTER 10 Aggregate Demand I slide 29

 Equilibrium

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

CHAPTER 10 Aggregate Demand I slide 30

How the Fed raises the interest rate
r
interest
rate
To increase r,
Fed reduces M r2

r1
L (r
)
M/P
M M real money
2 1 balances
P P
CHAPTER 10 Aggregate Demand I slide 31
CASE STUDY
Volcker’s Monetary Tightening
▪ Late 1970s: π > 10%
▪ Oct 1979: Fed Chairman Paul
Volcker announced that monetary
policy would aim to reduce inflation.
▪ Aug 1979-April 1980:
Fed reduces M/P 8.0%
▪ Jan 1983: π = 3.7%
How do
How do you
you think
think this
this policy
policy
change would
change would affect
affect interest
interest
rates? Demand I
rates?
CHAPTER 10 Aggregate slide 32
 Volcker’s Monetary Tightening, cont.
The effects of a monetary tightening
on nominal interest rates

short run long run

Quantity Theory,
Liquidity Preference
model Fisher Effect
(Keynesian)
(Classical)
prices sticky flexible

prediction Δi > 0 Δi < 0

actual 8/1979: i = 10.4%

1/1983: i = 8.2%
outcome 4/1980: i = 15.8%
CHAPT Aggregate
CHA Aggregate slide 33
 The LM curve
Now let’s put Y back into the money
demand
function:
= L (r , Y )
M P
(
The LM curve dis 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 slide 34

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

r2 r2

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

CHAPTER 10 Aggregate Demand I slide 35

Understanding the LM curve’s 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 slide 36

 How ΔM shifts the LM
curve
(a) The market for
(b) The LM curve
real money balances
r r
LM2

LM1
r2 r2

r1 r1
L (r,Y 1)

M M M/P Y1 Y
2 1

P P
CHAPTER 10 Aggregate Demand I slide 37
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 slide 38

 The short-run equilibrium
The short-run equilibrium is r
the combination of r and LM
Y
that simultaneously satisfies
the equilibrium conditions in
the goods & money markets:

Y = C (Y −T ) + I (r ) + IS
G
M P = L (r , Y Y
) Equilibrium
interest Equilibrium
rate level of
income

CHAPTER 10 Aggregate Demand I slide 39

 The Big Picture
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 slide 40

 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 slide 41

 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 slide 42
 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 slide 43

 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
▪ use the IS-LM and AD-AS models
together to analyze the short-run and
long-run effects of shocks
▪ learn about the Great Depression using our
models
CHAPTER 10 Aggregate Demand I slide 44
CHAPTER 10 Aggregate Demand I slide 45