PJJ TEORI EKONOMI MAKRO

TINGKAT DASAR

BUILDING THE IS-LM MODEL

SOURCE : MACROECONOMICS SIXTH EDITION
N. GREGORY MANKIW
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
ELEMENTS OF THE KEYNESIAN CROSS

consumption function: C  C (Y T )
govt policy variables: G  G , T T

I I

planned expenditure: E  C (Y T )  I  G

equilibrium condition:
actual expenditure = planned expenditure
Y  E
THE EQUILIBRIUM VALUE OF INCOME

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

income, output, Y
Equilibrium
income
 AN INCREASE IN GOVERNMENT PURCHASES

E
At Y1, E = C +I + G2
there is now an
unplanned drop E = C +I + G1
in inventory…

G
…so firms
increase output,
and income Y
rises toward a
new equilibrium. E1 = Y1 Y E 2 = Y2
SOLVING FOR Y

Y  C  I  G equilibrium condition

Y  C  I  G in changes

 C  G because I exogenous

 MPC  Y  G because C = MPC Y

Collect terms with Y Solve for Y :

on the left side of the
equals sign:  1 
Y     G
(1  MPC)Y  G  1  MPC 
 THE GOVERNMENT PURCHASES MULTIPLIER

Definition: the increase in income resulting from a $1

increase in G.
In this model, the govt
Y 1
purchases multiplier equals 
G 1  MPC

Example: If MPC = 0.8, then

An increase in G
Y 1
  5 causes income to
G 1  0.8 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 is much bigger than the
initial G.
 AN INCREASE IN TAXES

E
Initially, the tax
increase reduces E = C1 +I + G
consumption, and E = C2 +I + G
therefore E:

C = MPC T At Y1, there is now

an unplanned
inventory buildup…
…so firms
reduce output,
and income falls Y
toward a new
E2 = Y2 Y E 1 = Y1
equilibrium
SOLVING FOR Y

eq’m condition in
Y  C  I  G
changes
 C I and G exogenous

 MPC   Y  T 
Solving for Y : (1  MPC)Y   MPC  T

  MPC 
Final result: Y     T
 1  MPC 
 THE TAX MULTIPLIER

def: the change in income resulting from

a $1 increase in T :
Y  MPC

T 1  MPC

If MPC = 0.8, then the tax multiplier equals

Y  0.8  0.8
   4
T 1  0.8 0.2
THE TAX MULTIPLIER
…is negative:
A tax increase reduces C, 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.
 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
DERIVING THE IS CURVE

E E =Y E =C +I (r )+G
2

r  I E =C +I (r1 )+G

 E I

 Y Y1 Y2 Y
r
r1

r2
IS
Y1 Y2 Y
 WHY THE IS CURVE IS NEGATIVELY SLOPED

• 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.
 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.
• Let’s start by using the Keynesian cross to see
how fiscal policy shifts the IS curve…
 SHIFTING THE IS CURVE: G

E E =Y E =C +I (r )+G
At any value of r, G 1 2

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

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

Y 
1
G Y
1 MPC IS1 IS2
Y1 Y2 Y
 EXERCISE: SHIFTING THE IS CURVE

• Use the diagram of the Keynesian cross to show

how an increase in taxes shifts the IS curve.
 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.
MONEY SUPPLY

r
M P
s
The supply of interest
real money rate
balances
is fixed:

M P M P
s

M/P
M P real money
balances
MONEY DEMAND

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

M P
d
 L (r )

L (r )

M/P
M P real money
balances
EQUILIBRIUM

The interest M P
s

rate adjusts
to equate the
supply and
demand for
money: r1

M P  L (r ) L (r )

M/P
M P real money
balances
 HOW THE C.B. RAISES THE INTEREST RATE

r
interest
To increase r, rate
C.B. reduces M
r2

r1
L (r )

M/P
M2 M1 real money
P P balances
 THE LM CURVE

Now let’s put Y back into the money demand function:

M P
d
 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 )
 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
 WHY 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 market.
 HOW M 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 , Y1 )

M2 M1 M/P Y1 Y
P P
 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.
 THE SHORT-RUN EQUILIBRIUM

The short-run equilibrium is the r

combination of r and Y that
LM
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
 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