CHAPTER-THREE

AGGREGATE DEMAND IN A CLOSED ECONOMY:

BUILDING THE IS-LM MODEL

Lecture Note

 Compiled by: Tesfaslassie H. (MSc.)

slide 0
 3.1. Foundations of Theory of Aggregate Demand
 The great depression caused many economists to
question the validity of the classical economic theory.
 In 1930s, there was high unemployment and low
income.
 The classical theory was incapable to explain and
suggest solution to this economic disorder.
 Before the depression, the main focus of economists
was the long run and the problem of growth.
 However, in 1930s macroeconomists started focusing
on the short run macroeconomic issues.
slide 1
 Economists who focused on long-run
macroeconomic issues such as growth were called
classical economists and economists who focused
on the short-run macroeconomic issues were called
Keynesian economists.
 Classical economists
 They believed in the market’s ability to be self-
regulating through the invisible hand(price
mechanism of the market).
slide 2
 According to classicals, short-run problems were seen
as temporary glitches.
 That is; the economy would always return to its
potential output and its target(natural) rate of
unemployment in the long-run
 They support laissez-faire policies(leave the market
alone).
 According to this theory, national income depends on
factor supplies and the available technology.
 That is; Y = F(L,K,T).
slide 3
 Keynesian economists
 They were named because a leading advocate of the
short run focus was John Maynard Keynes, the author
of the General Theory of Employment, Interest and
Money in 1936.
 As the depression deepened, the classicals lost support.
This event was the beginning of the Keynesian theory.
 Keynes proposed a new way to analyze the economy,
which he presented as an alternative to classical theory.

slide 4
 Keynes proposed that low aggregate demand is
responsible for the low income and high
unemployment that characterize economic
downturns.
 He criticized classical theory for assuming that
aggregate supply alone-labor, capital and
technology determines national income.
 Now days, Economists reconcile these two views
with the model of aggregate demand and aggregate
supply.
slide 5
 In the long run, prices are flexible and aggregate
supply determines income.
 In the short run, prices are sticky so changes in
aggregate demand influence income.
 IS–LM model, is the leading interpretation of
Keynes’s theory.
 The goal of the model is to show what determines
national income for any given price level.

slide 6
 We can view the IS-LM model in two ways:
 What causes income to change in the short-run when price
level is fixed
 What causes aggregate demand curve to shift
 The two parts of the IS-LM model are the IS and LM.
 IS stands for “investment’’ and “saving,’’ and the IS
curve represents what’s going on in the market for goods
and services.
 In the short run, when the price level is fixed, shifts in the
aggregate demand curve lead to changes in the equilibrium
level of national income. slide 7
 LM stands for “liquidity’’ and “money,’’ and the LM
curve represents what’s happening to the supply and
demand for money.
 Since the interest rate influences both investment and
money demand, it is the variable that links the two
halves of the IS–LM model.
 The IS-LM model shows how the interactions b/n goods
market and money market determine the position and
slope of the aggregate demand curve and the level of
national income in the short-run.
slide 8
 3.2.The goods market and the IS curve

 The IS curve plots the r/ship between interest rate and

the level of income that arises in the market for goods
and services.
 To develop this r/ship , we start with a basic model
called the Keynesian cross.
 The Keynesian Cross
 The Keynesian cross shows how income Y is
determined for given levels of planned investment I
and fiscal policies G and T.
slide 9
 Actual expenditure is the amount households, firms
and the government spend on goods and
services(GDP).
 Planned expenditure is the amount households,
firms and the government would like to spend on
goods and services.
 The difference between actual and planned
expenditure results in unplanned inventory
investment.
slide 10
 Elements of the Keynesian Cross

 Assuming that the economy is closed( NX = 0), we

can write planned expenditure(E) as the sum of
consumption(C) , planned Investment (I) and
government purchases(G).
E = C +I +G
 Adding the consumption function to this equation;
C=c(y-T)
Assuming that planned investment is exogenously
fixed I  I
 Assuming that fiscal policy- the level of G & T is
fixed: G  G , T  T
slide 11
 Combining the above equations:
 E  C (Y  T )  I  G
 This equation shows that PE is a function of
income Y, the level of planned investment and Ḡ
and T .
 Equilibrium condition:
 Actual expenditure = planned expenditure
Y=E
slide 12
 Graphing planned expenditure
E
planned
expenditure
E = C + I +G

MPC
1

income, output, Y

Planned expenditure(E) depends on income b/c higher income

leads to higher consumption, which is part of planned expenditure.
MPC shows how much planned expenditure increases when
income rises by $1.
slide 13
Graphing the equilibrium condition
E
planned E =Y
expenditure

45º

income, output, Y

slide 14
 The equilibrium value of income
E
planned E =Y
expenditure
E = C + I +G
In equilibrium, E
(which is
measured on the
vertical axis)
equals Y (which is
measured on the
horizontal axis). income, output, Y
Equilibrium
income
slide 15
 Fiscal Policy and the Multiplier
Government purchases: since government
purchases are one component of expenditure,
higher purchases result in higher planned
expenditure for any given level of income.

 If government purchases rises by G, then the

planned expenditure shifts upward by G.

 However, an increase in government purchases

leads to greater increase in income(Y>G).

slide 16
 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 E2 = Y 2

slide 17
 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 

slide 18
 The government purchases multiplier
Definition: the change in income resulting from
a $1 change 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!

slide 19
 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.

slide 20
 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 Y
E2 = Y2 E1 = Y1
equilibrium

slide 21
 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

Final result:   MPC 

Y     T
 1  MPC 

slide 22
 The tax multiplier

def: the change in income resulting from

a $1 change 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

slide 23
 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.
slide 24
 Exercise:

 Use a graph of the Keynesian cross

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

slide 25
 The Interest Rate, Investment and the IS curve

The investment function can be written as:

I=I(r)
Since interest rate is the cost of borrowing to finance
investment projects, an increase in the interest rate reduces
planned investment.
As a result, the investment function slopes downward.
 IS curve is a graph of all combinations of r and Y that
result in goods market equilibrium. That is; actual
expenditure (output) = planned expenditure
The equation for the IS curve is: Y C(Y T ) I (r ) G
slide 26
 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

slide 27
 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
(actual expenditure, Y ) must increase.

slide 28
 A loanable-funds interpretation of
the IS curve
 The national income accounts identity can be written as:
 Y-C-G = I
 S=I, S: national saving, I: investment
 National saving represents the supply of loanable funds and
investment represents the demand for these funds.
 By substituting the consumption function for C and the
investment function for I so as to produce the IS curve
 Y-c(Y-T)-G =I(r)
 The left hand side of the equation shows that the supply of
loanable funds depends on income and fiscal policy.
 Whereas, the right hand side shows that the demand for
slide 29
loanable funds depends on the interest rate.
 That is; the interest rate adjusts to equilibrate the supply and
demand for loans.
 A decrease in income from Y1 to Y2 causes a fall in national
saving ( see the graph in the next slide ) .
 The fall in saving causes a reduction in the supply of loanable
funds.
 As a result, the interest rate rises to restore equilibrium to the
loanable funds market.
 When the loanable funds market is in equilibrium, investment =
saving.
 The IS curve shows the inverse relationship between income and
the interest rate. slide 30
 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

slide 31
 Fiscal Policy and the IS curve
 The IS curve shows, for any given interest rate, the level of
income that brings the goods market into equilibrium.
 It is drawn for a given fiscal policy.
 Changes in fiscal policy (G and T ) that raise the demand for
goods and services shift the IS curve to the right.
 Whereas, changes in fiscal policy that reduce the demand for
goods and services shift the IS curve to the left.
 Let’s start by using the Keynesian cross
to see how fiscal policy shifts the IS curve…

slide 32
 Shifting the IS curve: G
E E =Y E =C +I (r )+G
At any value of r, 1 2

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
IS shift equals r1

1 Y
Y  G IS2
1MPC IS1
Y1 Y2 Y

slide 33
 The Money Market and the LM Curve
 The LM curve plots the relationship b/n the interest
rate and the level of income that arises in the market
for money balances.
 The Theory of Liquidity Preference
 It focus on how the interest rate is determined in the
short-run.
 Just as the keynesian cross is a building block for the
IS curve, the theory of liquidity preference is a building
block for the LM curve.
 The interest rate adjusts to balance the SS and DD for
money.
slide 34
 Supply of Real Money Balances

 The money supply is exogenously fixed.

 Price is also fixed in the short run.
 Thus, the supply of real money balances (M/P)
is fixed and does not depend on the interest
rate.
 The supply curve of real money balances is
vertical b/c it does not depend on interest rate.

slide 35
 Graphically
r
s
The supply of interest M P
real money rate
balances
is fixed:
s
M P M P

M/P
M P real money
balances

slide 36
 Demand for Real Money Balances
The interest rate is r
one determinant for intere
the demand for real st
money balances.
rate
The higher the
interest rate, the lower
the quantity of real
money balances
demand.
L (r )
b/c r is the
opportunity cost of
holding money.
M/P
real money
Demand for real balances
money balances: d
M P   L (r )
slide 37
 Equilibrium
According to the theory r
s
of liquidity preference, the M P
interest rate adjusts
to equate the supply and
demand for money.
At the equilibrium
interest rate, the quantity r1
of real money balances
demanded equals the L (r )
quantity supplied.
M/P
M P real money
balances
M P  L (r )
slide 38
 Changes in the money supply and the interest rate

When the supply of money r

changes the interest rate also
changes.
Example: A fall in M reduces
M/P, b/c P is fixed.
r2
The supply of real money
balances shifts to the left.
As a result, the equilibrium r1
interest rate increases and the
higher the interest rate makes
L (r )
people to hold smaller quantity
of real money balances. M/P
M2 M1 real money
But an increase in money
supply lowers r, and raises
P P balances
demand for real money
balances. slide 39
 Income, 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.
Now let’s put Y back into the money demand function:
d
M P  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 )
slide 40
 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

slide 41
 Why the LM curve is upward sloping

 When income increases from Y1 to Y2, the demand for

real money balances shifts to the right( demand for real
money balances increases).
 With the supply of real money balances unchanged, the
interest rate rises from r to r2 to equilibrate the money
1

market.
 The higher the level of income, the higher the demand
for real money balances and the higher the equilibrium
interest rate. As a result, the LM curve slopes upward.

slide 42
 How the monetary policy shifts the LM curve

 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(to the left).
 Increases in the supply of real money balances shift
the LM curve downward( to the right).
 Example: suppose the money supply reduces from M1
to M2 which causes the supply of real money balances
to fall from M1/P to M2/P. See the graph in the next
slide:
slide 43
 Graphically

(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

slide 44
 Like the IS curve, the LM curve shows only the relationship b/n
income and interest rate,
 That is; the LM curve by itself does not determine either r or y .
 The IS and LM curves together determine the economy’s
equilibrium.
 The equilibrium of the economy is at the point at which the IS
curve and LM curve cross.
 At that point, we get the equilibrium interest rate and equilibrium
income that satisfy conditions for equilibrium in both the goods
market and the money market.
 At the intersection point ,actual expenditure equals planned
expenditure and the demand for real money balances equals supply.
slide 45
 The short-run equilibrium
The short-run equilibrium is r
the combination of r and Y
LM
that 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

slide 46
 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

slide 47
 Explaining fluctuations with the
IS-LM Model
 The intersection of the IS curve and the LM curve determines
the level of national income.
 When one of these curves shifts, the short-run equilibrium of the
economy changes and national income fluctuates.

How fiscal policy shifts the IS curve and changes the

short-run Equilibrium
 Change in government purchases:
 An increase in government purchases of ΔG raises the level of
income by ΔG/1-MPC at any given interest rate.
 The increase in government purchases raises both income and
the interest rate. slide 48
 An increase in government
purchases
1. IS curve shifts to the right r
1 LM
by G
1  MPC
r2
causing output & income to
rise. 2.
r1
2. This raises money
demand, causing the 1. IS2
interest rate to rise… IS1
Y
3. …which reduces investment, so the Y1 Y2
final increase in Y
3.
1
is smaller than G
1  MPC
slide 49
 Since the economy’s demand for money depends on
income, the rise in income increases the quantity of money
demanded at every interest rate.
 For a given supply of money, higher money demand causes
the equilibrium interest rate to rise.
 The higher interest rate makes firms to cut their investment
plans.
 This fall in investment partially offsets the expansionary
effect of the government purchases.
 Thus, the increase in income in response to a fiscal
expansion is smaller in the IS-LM model than it is in the
slide 50
keynesian cross.
 Changes in taxes
 Consider a decrease in taxes of ΔT.
 The tax cut encourages consumers to spend more and
therefore, increases planned expenditure.
 According to the tax multiplier, at any given interest rate, a
decrease in taxes raises the level of income by
ΔT*MPC/1-MPC.
 As a result, the IS curve shifts to the right by this amount.
 The tax cut raises both income and the interest rate.
 However, since the higher interest rate reduces investment,
the increase in income is smaller in the IS-LM model than
slide 51
it is in the keynesian cross.
 A tax cut
Because consumers r
save (1MPC) of the tax LM
cut, the initial boost in
spending is smaller for T
than for an equal G… r2
2. r
and the IS curve 1

shifts by 1. IS2
MPC IS1
1. T
1  MPC Y
Y1 Y2
2. …so the effects on r and Y 2.
are smaller for a T than
for an equal G.
slide 52
 How monetary policy shifts the LM curve
and changes the short-run equilibrium
 Consider an increase in the supply of money.
 An increase in the supply of money(M) leads to an
increase in real money balances M/P, b/c price is fixed in
the short-run.
 According to the theory of liquidity preference, for any
given level of income, an increase in real money
balances leads to a lower interest rate.
 As a result, the LM curve shifts downward( to the right).
 The increase in the supply of money lowers the interest
rate and raises the level of income.
slide 53
 An increase in M
r
1. M > 0 shifts LM1
the LM curve down
LM2
(or to the right)
r1
2. …causing the interest
rate to fall
r2

3. …which increases investment, IS

causing output & income to rise Y
Y1 Y2

 Thus, the IS-LM model shows

that monetary policy influences
income by changing the interest
rate.
slide 54
 The Interaction Between Monetary
and Fiscal Policy
 Model:
monetary & fiscal policy variables (M, G and T )
are exogenous
 Real world:
Monetary policymakers may adjust M in response
to changes in fiscal policy, or vice versa.
 Such interaction may alter the impact of the
original policy change.

slide 55
 Suppose the government increases G.
 Possible central Bank’s responses:
1. hold M constant
2. hold r constant
3. hold Y constant
 In each case, the effects of the G
are different:

slide 56
 Response 1: hold M constant
If the government raises r
G, the IS curve shifts right LM1

If central bank r2

holds M constant, r1

then LM curve IS2

doesn’t shift. IS1

Results: Y1 Y2
Y

Y  Y 2  Y1
r  r2  r1
slide 57
 Response 2: hold r constant
If Congress raises G, r
the IS curve shifts LM1

right LM2

To keep r constant, r2

central bank increases M r1

to shift LM curve right. IS2

IS1
Results: Y
Y1 Y2 Y3
Y  Y 3  Y1
r  0
slide 58
 Response 3: hold Y constant
LM2
If government raises G, r
the IS curve shifts right. LM1

r3
To keep Y r2
constant, central r1

bank reduces M to IS2

shift LM curve left. IS1
Results: Y
Y1 Y2
Y  0
r  r3  r1
slide 59
 IS-LM as a theory of Aggregate
Demand
 To see how the IS-LM model fits into the model of AS
and AD, we now examine what happens in the IS-LM
model if the price level is allowed to change.
 From the IS-LM model to the Aggregate Demand
Curve
 The AD curve describes the relationship b/n the price
level and the level of national income.
 The national income falls as price level rises. As a
result, the AD curve is downward sloping.

slide 60
 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 interest
rate and lowers the equilibrium level of income.
 When the price rises from P1 to P2, the income level
falls from Y1 to Y2.( see the graph below)

slide 61
 Deriving the AD curve
r LM(P2)
Intuition for slope LM(P1)
r2
of AD curve:
r1
P  (M/P )
IS
 LM shifts left Y2 Y1 Y
P
 r
P2
 I
P1
 Y AD
Y2 Y1 Y
slide 62 slide 62
 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.
 Since the AD curve is merely a summary of results from
the IS-LM model, events that shift the IS curve or the LM
curve causes the AD curve to shift.
 Example: an increase in the money supply raises income in
the IS-LM model for any given price level.
 Thus , it shifts the aggregate demand curve to the right.
 Increase in government purchases and decrease in taxes
have also similar effects.
 Whereas, a decrease in money supply, decrease in
government purchases and increase in taxes lower income
in the IS-LM model and shifts the AD curve to the left.slide 63
 Monetary policy and the AD curve
r LM(M1/P1)
The central bank can
r1 LM(M2/P1)
increase aggregate
demand: r2
M  LM shifts right IS
 r Y1 Y2 Y
P
 I
 Y at each P1
value of P AD2
AD1
Y1 Y2 Y

slide 64
 Fiscal policy and the AD curve
r LM
Expansionary fiscal
policy (G and/or T ) r2
increases agg. demand: r1 IS2
T  C IS1
 IS shifts right Y1 Y2 Y
P
 Y at each
value of P P1

AD2
AD1
Y1 Y2 Y

slide 65
 A change in income in the IS-LM model resulting
from a change in the price level represents a
movement along the AD curve.
 Whereas, a change in income in the IS-LM model for
a fixed price level represents a shift in the AD curve.

slide 66
 The IS-LM Model in the Short-Run
and the Long-Run
 The IS-LM model is designed to explain the economy
in the short-run when price is fixed.
 But now we can use it to describe the economy in the
long-run when price level adjusts to ensure that the
economy produces at its natural rate.
 Using the IS-LM model, we can see how the keynesian
model of income determination differs from the
classical model.

slide 67
The force that moves the economy from the short run to
the long run is the gradual adjustment of prices.
Y is natural rate of output and Y is income(actual output).

In the short-run then over time,

equilibrium, if the price level will
Y Y rise
Y Y fall

Y Y remain constant

slide 68
 The SR & LR effects of M > 0
A = initial equilibrium P LRAS

B = new short-run eq’m

after Fed increases M

P2 C
C = long-run
equilibrium B SRAS
P A
The adjustment of prices over AD2
time causes the economy to AD1
move from the short-run
equilibrium at point B to the
Y
long-run equilibrium at point C.
At point C, the quantity of G& Y Y2
S demanded(AD) equals the
natural rate of output(AS)
slide 69
 The effects of a negative demand
shock
The shock shifts P LRAS
AD left, causing
output and
employment to fall
in the short run
B A SRAS
P
Over time, prices fall
and the economy moves C
down its demand curve P2 AD1
toward full-employment. AD2
Y
Y2 Y

slide 70 slide 70
 The keynesians and classicals have a key difference
in the determination of national income.
 The keynesian assumption is that price is fixed.
 Depending on monetary, fiscal and other
determinants of AD , output may deviate from
natural rate.
 The classical assumption is that the price level is
fully flexible.
 The price level adjusts to ensure that national income
is always at its natural rate.
 NB. The keynesian assumption best describes the
short-run whereas the classical assumption best
describes the long-run. slide 71
END

slide 72