Macroeconomics

CHAPTER THREE
AGGREGGATE DEMAND IN CLOSED ECONOMY

By:- NejatK

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 Macroeconomic Fluctuations:
The IS-LM Approach
MACROECONOMIC FLUCTUATIONS
1. Quantity-Adjustment Vs Price-Adjustment Paradigms
The devastating episode of Great Depression caused many
economists to question the validity of classical economic
theory. B/C Classical theory seemed incapable of explaining
the Depression.
In 1936 the British economist John Maynard Keynes
revolutionized economics and proposed a new way to analyze
the economy.
He proposed that low AD is responsible for the low income
and high unemployment that characterize economic
downturns.
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 Continued….
 In the LR, prices are flexible, and AS determines income.
But in the SR, prices are sticky, so changes in AD influence
income.
The principal theme of classical price theory that underlies the
study of macroeconomics is: if there is an imbalance between
supply and demand in a competitive market, then prices change to
clear the market or establish equilibrium(price adjustment)

The simple Keynesian model is an application of the Quantity

adjustment paradigm. That is: if there is an imbalance between
supply (output or production) and demand (expenditure), then
producers will change the quantity of output produced.

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 The IS–LM Model
• In SR when P is fixed shift in AD curve leads to changes in NI.
• IS-LM is a model of AD, aims at showing what determines NI for
any given P level or equivalently at showing what causes the AD
curve to shift.
• IS stands for “Investment” and “Saving”, and the IS curve
represents what’s going on in the market for G&S.
• LM stands for “Liquidity” (which represents the demand for many)
and “Money”(which is the supply/stock of money), and the LM
curve represents what’s happening to the SS and DD for money.

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 The IS–LM Model
• Interest rate (r) is the variable that links the two halves of the IS-
LM model since it influences both investment and money demand.
• The IS – LM model shows how interactions between these markets
determine the position and slope of the AD curve and, therefore, the
level of national income in the short run.

The Goods Market and the IS Curve

The IS curve plots the r/p b/n the interest rate(r) and the level of
income(Y) that arises in the market for goods and services.

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 The IS–LM Model
The Keynesian Cross and Income Determination
To develop r/p b/n r&Y -i.e.,IS curve, we start with basic model
called Keynesian cross.
The K.C begins by drawing a distinction between actual
expenditure(AE) and planned expenditure(PE).
AE= is the amount households, firms and the government spend on
g&s, and it equals the economy’s GDP (income).
AE

Y=(output=GDP)
Figure 3.1 Actual expenditure 6
• Planned Expenditure (PE) is the amount households, firms, and the
government would like to spend on g&s.
• Assuming that THE ECONOMY IS CLOSED, so that net exports are zero, we
can write
• PE = C + I + G
• C = C(Y - T) b/c C depends on disposable income (Y-T)
• Assume that fiscal policy – the levels of G and T – is fixed: G = G & T = T .
• To keep things simple, also assume that planned investment is
exogenously fixed: I = I .
PE = C(Y - T ) + I + G

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PE
PE = C(Y - T ) + I + G

MPC=Slope of PE (It shows how much PE

increases when income(Y) increases by one unit.

Y
Figure 3.2 Planned expenditure
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 Why AE is different from PE?
B/C firms might engage in unplanned inventory investment because
their sales do not meet their expectations.
When firms sell less of their product than they planned, their stock of
inventories automatically rises.
Conversely, when firms sell more than planned, their stock of inventories
falls. Because these unplanned changes in inventory are counted as
investment spending by firms, AE can be either above or below PE.
AE = C(Y – T) + I + ∆inv +G, while PE = C(Y – T) + I +G.
 AE > PE if ∆inv > 0; AE < PE if ∆inv < 0; & AE =PE if ∆inv = 0

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Figure 3.3: The Keynesian Cross and Adjustment to the Equilibrium

The second piece of the Keynesian cross is the assumption that the
economy is in equilibrium when AE=PE
PE AE=PE
AE2 PE=C(Y -T )+ I +G

Ye PE2

PE1
AE1

Y1 Ye Y2 AE,Y 10
Some National Income Identities of the Closed Economy
1. Consumption and Saving Functions
We assume that consumption demand increases with the level of
disposable/after-tax income (Yd = Y – T): C = C + cYd
C (The intercept) represents the level of consumption when income
is zero.
c ( The slope /mpc) is the amount by which consumption increases
for every 1 unit increase in income.
O<c<1 i.e., mpc is always b/n zero and one b/c only some fraction
of income is spent on consumption.
The rest of the income 1-c must be saved, b/c income is either spent
or saved. S=Yd-C, S= Yd- (C+cYd)=Yd-C-cYd= -C+(1-c)Yd
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 Continued……
S=1-c, (marginal propensity to save = 1-mpc) example, if mpc=
o.75, then s= 0.25)
Planned versus Actual Investment
We have said
PE= C(Y – T) + I + G & AE = C(Y – T) + I + ∆inv + G , where
 I=Planned Investment (I planned) &
I + ∆inv = Actual Investment(I Actual)
Equating AE=PE is the same with equating Iplanned = Iactual
Therefore, at equilibrium ∆inv = 0.

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The Saving-Investment Identities
With our assumption of a closed economy (i.e., with zero net export),
the equilibrium condition PE = AE is the same as saying that
investment = saving.
We have PE=C+I+G & AE=Output or Y Hence, PE=AE=Y
Y=C+I+G We can re write this by subtracting T from both sides.
Y – T = C + I + G – T. Recall that Y-T Is disposable income (Yd )
which is either consumed or saved.
So, Yd = C + I + (G – T) .
If we take a hypothetical economy with no government (i.e., G = T
= 0), it follows that: Yd = C +I.
Subtracting C from both sides yields Yd – C = C + I – C.

S = I 13
 Continued….
For the case where there is the government in the economy,
subtracting C from both sides of Yd = C + I + (G – T) gives:
Yd – C = I + (G – T)
Moving (G – T) to the left of the equality sign, we will have:
Yd – C + (T – G) = I

SP + SG =I S (= SG + SP) = I

In sum, the condition S = I is merely another way of stating the

basic equilibrium condition.
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The Injection – Leakage Identity
.The national income identity of a closed economy Y = C + I + G
gives the sources of national income (Y) to be the (planned)
spending by households (C), by firms (I) & by the government
(G).
Viewed from the income allocation side, the income earned in such
a closed economy is shared among tax payments, consumption and
saving.
What is left over after paying taxes (T) – i.e., the
disposable income will either be consumed (C) or saved (S). Hence,
Y = T + C + S.
Bringing the two sides together: C + I + G = Y = T + C + S
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Continued….
.C + I + G = Y = T+C+S

Injections(additions) leakages(Withdrawals)
The total of the injections should be equal to the total of the
withdrawals at the equilibrium of the economy.
Thus, C + I + G = T + C + S (or after eliminating C from both sides)
I + G = S + T is another way of representing the eqm condn.

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 THE MULTIPLIER
First let us see how changes in G affect the economy B/C government purchases(G) is one
component of expenditure (PE = C + I + G), higher G result in higher PE for any given Y.

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• ∆G (from G1 to G2), causes the PE schedule to shift upward from PE1 to PE2 (by
∆G).
• Consequently, the eq’m of the economy moves from point A to point B.
• ∆Y is larger than ∆G.
• The ratio ∆Y/∆G is called the government purchases multiplier
• An implication of the K.C is that the government-purchases multiplier is larger
than 1.
• That means fiscal policy have multiplied effect on income. Why?
B/c, according to the consumption function C = C(Y - T), higher Y causes higher
C.
So, when G increase Y also increases and causes C to increase, which further
rises income, further rises consumption which further rises income and so on……
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How big is the multiplier? To answer this question, we trace
through each step of the change in income.

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• Dividing the two sides of the final equation in the last row of the
table above, the government purchases multiplier is given by:

• This expression for the multiplier is an example of an infinite

geometric series. With the first term of 1 and a common ratio equal
to MPC (0 < MPC < 1), the sum of this series converges to:

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Alternatively, the government-purchases multiplier can be derived using
calculus as follow: Begin with the equation Y = C(Y - T) + I + G. Next,
differentiate this equation with respect to G to obtain:

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CONTINUED….
• Inspection of the multiplier in this formula shows that the larger the
MPC, the larger the multiplier.
BUT, Why we focus on Multiplier?
B/C, We are developing an explanation of fluctuations in output(Y).
 We can derive the multiplier not only for changes in government
purchases but also for changes in any of the components of planned
expenditure. Substitute the consumption function C = Ca + c(Y -T )
(where Ca is autonomous consumption and c is the MPC) into the
equilibrium condition Y = C + I + G yields:

which, upon rearranging, gives:

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Continued….
• Taking the derivative of this equilibrium income, we will have:

• From this final expression, it is now easier to derive different

multipliers:

• That is, the multiplier we saw above, 1/(1-MPC) equally holds for
changes occurring to autonomous consumption spending as well as
changes in autonomous investment spending .
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• From the same expression we also obtain:

 This expression is the tax multiplier, the amount income changes in response to a
1 Birr change in taxes.
 What will be the change in Y if government raises both purchases and
autonomous taxes by the same amount, i.e., if ∆G = ∆T?
 While the increase in government purchases of ∆G pushes up the national income
by

 The rise in taxes pulls national income by the amount of

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CONTINUED….
• The net effect on income is therefore given by:

• Using the fact that ∆G = ∆T,

• Thus, the balanced budget multiplier is:

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 Interest Rate, Investment and the IS Curve
• Planned investment depends on the interest rate, r – i.e., I = I(r).
• Because, r is the cost of borrowing to finance investment projects, an
increase in the r reduces Iplanned.
• As a result, the investment function slopes downward.
• To determine how Y changes when the r changes, we can combine the
investment function with the K.C diagram.
• Due to that r and I are inversely related, the se in r reduces the quantity
of I.
• The reduction in I in turn reduces the PE or Y
• Hence, the se in r lowers the Y.
LOOK AT THE FOLLOWING CURVES CAREFULLY!
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Continued….
• The IS curve shows us, for any given r, the level of Y that brings the goods
market into equilibrium.
• The IS curve is drawn for a given fiscal policy; that is, when we
construct the IS curve, we hold G and T fixed.
• When fiscal policy changes, say G rises the IS curve shifts (to the right).
• We can use the K.C to see how changes in fiscal policy shift the IS curve.
• Because a se in T also expands expenditure and income, it too shifts the IS
curve outward.
• A se in G or an se in T reduces Y; therefore, such a change in fiscal policy
shifts the IS curve inward.

• The IS curve is also shifted by changes in autonomous (consumption

and investment) spending of the private economic agents.

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 The Money Market and the LM Curve
• The LM curve plots the r/p b/n the r and the level of Y that arises in
the market for money balances.
• The building block for this relationship is called the theory of
liquidity preference, a theory of the interest rate.
• The explanation of how the r is determined in the SR is called the
theory of liquidity preference, because it posits that the r adjusts to
balance the ss and dd for the economy’s most liquid asset –money.

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 The Theory of Liquidity Preference
• The supply of real money balances
If M stands for the supply of money and P stands for the price level, then M/P
is the supply of real money balances.
The theory of liquidity preference assumes that there is a fixed supply of
real money balances. That is,

The money supply M is an exogenous policy variable chosen by a central

bank (National Bank of Ethiopia in our case).
The price level P is also an exogenous variable in this model. b/c the IS-
LM model explains the SR when P is assumed as fixed.
These assumptions imply that the supply of real money balances is fixed
and, in particular, does not depend on the interest rate.

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 The Theory of Liquidity Preference, continued…
• The demand for real money balances
The demand for real balances increases with the level of real income and decreases
with the interest rate.
The demand for real balances is accordingly written as:

 The parameters k and h reflect the sensitivity of the demand for real balances to
the level of income(Y) and the interest rate(r), respectively.
When Y increases by 1 birr dd for real money increases by k &
When r increases by 1% dd for real money decreases by h.
According to the theory of liquidity preference, the supply of and demand for real
money balances determine what interest rate prevails in the economy. That is, the
interest rate adjusts to equilibrate the money market.

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The Theory of Liquidity Preference, continued…

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A fall in M reduces M/P, because P is fixed in the model.
The supply of real money balances shifts to the left,
The equilibrium interest rate rises from r1 to r2, and the higher
interest rate makes people satisfied to hold the smaller quantity of
real money balances.
The opposite would occur if the money supply is increased.
Thus, according to the theory of liquidity preference, a decrease in
the money supply raises the interest rate, and an increase in the
money supply lowers the interest rate.

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Income(Y), Money Demand, and the LM Curve
When income is high, expenditure is high, so people engage in more
transactions that require the use of money.
Thus, greater income implies greater money demand.
We have , the quantity is negatively related to the r and
positively related to Y.
Therefore, according to the theory of liquidity preference, higher Y leads to a
higher r.
The LM curve plots this r/p b/n the level of Y and the r.
The higher the Y, the higher the demand for real money balances will
be, and the higher the eq’m r.
For this reason, the LM curve slopes upward.
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• The LM curve can be obtained directly by combining the demand
curve for real balances, and the fixed supply of real balances.
• For the money market to be in equilibrium, demand has to equal
supply, or……………………………….

• Solving for interest rate(r)…………..

• This relationship between r and Y is the LM curve.
• The slope of the LM curve is given by : dr/dy = k/h
• The greater the responsiveness of the demand for money to income
(larger k), and the lower the responsiveness of the demand for money
to the interest rate (lower h) the steeper the LM curve will be.

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• If National Bank of Ethiopia (NBE) alters the money supply – the LM
curve shifts. Suppose that NBE decreases the money supply, which
causes the supply of real money balances to fall

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 At points to the right of the LM curve, there is an excess demand for
money, and at points to its left, there is an excess supply of money.
The LM curve is drawn for a given supply of real money balances.
 Decreases in the supply of real money balances shift the LM curve
upward.
 Increases in the supply of real money balances shift the LM curve
downward.
The LM curve by itself does not determine either income Y or the
interest rate r that will prevail in the economy. Like the IS curve, the LM
curve is only a relationship between these two endogenous variables,
(r &Y).
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Simultaneous Equilibrium in the Goods and Money Markets
 The IS and LM curves together determine the economy’s
equilibrium.
Our model takes fiscal policy, G and T, monetary policy M, and the
price level P as exogenous.
Given these exogenous variables, the IS curve provides the
combinations of r and Y that satisfy the equation representing
the goods market [Y = C(Y–T) + I(r) + G],
And the LM curve provides the combinations of r and Y that satisfy
the equation representing the money market [M/P = L(r, Y)].

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Simultaneous Equilibrium in the Goods and Money Markets
The IS-LM model.
 The equilibrium of the economy is the point at which
the IS curve and the LM curve cross.
 This point gives the r and the Y that satisfy
conditions for equilibrium in both the goods market
and the money market.
 In other words, at this intersection, actual
expenditure equals planned expenditure (AE=PE),
and the demand for real money balances equals the
supply.

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Explaining fluctuations with the IS-LM model
• Changes in Fiscal Policy

 Fiscal policy is more effective at influencing national

income if:
1. The LM curve is flatter – when demand for real
money balances is less sensitive to changes in
income and/or more sensitive to changes in interest
rate, and
2. The MPC and the shift in the IS curve are larger, and
investment demand is less sensitive to changes in
interest rate – steeper IS curve.

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Explaining fluctuations with the IS-LM model
• Changes in Monetary Policy
 The IS – LM model shows that an increase in the money
supply lowers the interest rate, which stimulates
investment and thereby expands the demand for goods
and services a process called the monetary transmission
mechanism.

 Monetary policy is more effective at influencing national

income if:
1. The IS curve is flatter –lower MPC and sensitive investment
to changes in interest rate is, and
2. The LM curve is steeper – if the demand for real money
balances is more sensitive to changes in income and less
sensitive to changes in interest rate.

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Explaining fluctuations with the IS-LM model
• The Interaction between Monetary and Fiscal Policies
Panel (a), The CB holds the MS constant. The T increase
shifts the IS curve to the left. Y falls (because higher taxes
reduce consumer spending), and the r falls (b/c lower Y
reduces the MD). The fall in income indicates that the tax
hike causes a recession.

Panel (b), The CB wants to hold the r constant. In

this case, when the T increase shifts the IS curve to the
left, the CB must decrease the MS to keep the r at its
original level. This fall in the MS shifts the LM curve
upward (to the left).

Panel (c), The CB wants to prevent the T increase from

lowering Y. It must, therefore, raise the MS and shift the
LM curve downward enough to offset the shift in the IS
curve. In this case, the T increase does not cause a
recession, but it does cause a large fall in the r.

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From the IS–LM Model to the AD Curve
• The AD curve describes a r/p b/n the price level and the level of
national income.(P & Y) We use the IS – LM model to show why
national income falls as the price level rises – that is, why the AD
curve is downward sloping.
• We also examine what causes the AD curve to shift.
• To explain why the AD curve slopes downward, we examine what
happens in the IS – LM model, when the P changes.
• If P level changes while everything else (including the nominal
money supply, M) remains the same, then the resulting change in
the real money supply (M/P) causes the IS-LM equilibrium to
change.
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From the IS–LM Model to the AD Curve
• For any given money supply M, a higher price level P reduces the
supply of real money balances M/P.
• A lower supply of real money balances shifts the LM curve upward,
which raises the equilibrium r and lowers the equilibrium Y.
• An increase in the P with a given nominal MS is equivalent to a
contractionary monetary policy; it reduces the real MS.
• Similarly, for each value of the P there will be a d/t AD equilibrium.
Since a higher P contracts the real money supply, the output (Y)
equilibrium is lower when the P increases.
• The AD curve plots this negative r/p b/n national income (Y) and the
price level (P)
• In other words, the AD curve shows the set of equilibrium points that
arise in the IS – LM model as we vary the price level and see what
happens to income.
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THE AGGREGATE DEMAND(AD) CURVE

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WHAT COUSES THE AD TO SHIFT?
Due to that the AD curve is merely a summary of results from the
IS–LM model, events that shift the IS curve or the LM curve (for a
given P) cause the AD curve to shift.
An important point is the distinction between movements along and
shifts of the aggregate demand curve.
A G, T, or nominal MS will affect the AD equilibrium for
every P and thereby affect the position of the AD curve.

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SHIFT IN AD CURVE
 Increase in the MS raises Y in the IS – LM
model for any given P; it thus shifts the AD
curve to the right

 Similarly, An increase in G or a decrease in T raises

income in the IS–LM model for a given P; it also shifts
the AD curve to the right

 Conversely, a decrease in the MS, a decrease in G, or

an increase in T lowers Y in the IS – LM model and
shifts the AD curve to the left.

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 Mathematical derivation of AD

 Let us now derive the aggregate demand (AD) mathematically and examine its properties. As a
first step to this, recall that the IS equation Y = Ca + c(Y – T) + Ia – br + G can be rewritten as:

 We can now substitute equation (1) into equation (2) and solve for the level of Y, the equilibrium output
in the IS – LM model. We will then see how Y and P are related – the AD function we are looking for.

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Mathematical derivation of AD continued…

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 As all the parameters (b, k, h, (1 – c)) and as well as M and are strictly non-
negative,
 The slope is negative – verifying that the AD curve is downward sloping!

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• From the AD function we can also infer factors that shift the AD
curve.
• For a given P, the AD curve shifts to the right (and upward) for an
autonomous increase in Ca, Ia, G or M, and for an autonomous
reduction in T. This fact is clearer from the following partial
derivatives:

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