Aggregate Demand |: Building the IS-LM Model 3 I shall argue that the postulates ofthe classical theory are applicable to a spe- cial case only and not fo the general case... Moreover, the characteristics of the special case assumed by the classical theory happen not to be those of the economic society in which we actually live, with the result that its teaching is misleading and disastrous if we attempt to apply it tothe facts of experience John Maynard Keynes, The General Theory fall the economic fluctuations in world history, the one that stands lout as particularly large, painful, and intellectually significant is the Great Depression of the 1930s, During this time, the United a + countries experienced massive unemployment and greatly eae In the worst year, 1933, one-fourth of the USS. labor force was nemployed, and real GDP was 30 percent below its 1929 level : trey devastating episode caused many economists to question the validity of clanizal economie theory—the theory we examined in Chapters 3 through 7, Crea theory seemed incapable of explaining the Depresion, According Chstica peony national income depends on factor supplies and the avalable aanerkither of which changed substantially from 1929 to 1939. After technology, rere Depression, many economists believed that a new model wat Serena Wich a large and sudden economic downturn and to sug- net fest government policies that might reduce the economic hardship so many ee British economist John Maynard Keynes revolusionized econom~ te 1936 OE The Genel They of Employment, Inert and Money. Keynes ics with is Om way to analyze the economy, which he presented as an alterna- peopaes re} theory. His vision of how the economy works quickly became Sve cise controversy Yet, 8 economists debated The General Theory, 2 new » eating of economic Auctuations gradually developed. (rer proposed that low aggreyate demand is responsible forthe low income snd yah goeraployment that characterie econdmic downturns, He criticizedsusiness Cycle Theory: The Economy in the Short Run Jone—capital, labor, and for assuming that aggregate supply al h, BDOF, an classical theory Or 1 Economists today reconcile these two technology—determines national income reer withthe model of aggregate demand and aBBreBAte supply introduced in Chapter 10. ln the long run, prices are exible, and aggregate supply determines income. But in the short run, prices are sticky, so changes in aggregate demand influence income. Keynes’ ideas about short-run fluctuations have been prominent since he proposed them in the 1930s, but they have ‘commanded renewed attention in recent yeas, In the aftermath of the financial crisis of 2008-2009, the United States and Europe descended into 4 deep recession, followed by a weak recovery. ‘As unemployment lingered at high levels, policymakers around the world debated how best to increase aggregate demand. Many of the issues that gripped tcconomists during the Great Depression were once again at the center of the economic policy debate. In this chapter and the next, we continue our study of economic fluctuations by looking more closely at aggregate demand, Our goal isto identify the variables that shift the aggregate demand curve, causing fluctuations in national income. We also examine more fully the tools policymakers can use to influence aggregate demand. In Chapter 10, we derived the aggregate demand curve from the quan- tity theory of money, and we showed that monetary policy can shift the aggregate demand'curve. In this chapter, we see that the government can influence aggre- gate demand with both monetary and fiscal policy. ees oki agers demaiid developed in this chapter, called the IS-LM Wakes mae Mspernen of Keynes's theory. The goal of the model Ss dere ee a national income for a given price level. There 2° Oe er eas ee eat the popes Seca ome ee TOC Saas cqobedcae Aa Fignall eerie interpretations of oe a sf tei gs ate ee oe ian er nadical ines changes in the equilibrium level Thé two parts of th Ears eee Ean eles pnp he Scare ie what's going on in the matket for goods and sents and the IS curve rrr in Chapter 3), LM stands for“liquidity"and “ences, (which we first discos what's happening to the supply ah ‘money;” and the iM curve rept ised in Chapter 5). Because the inte lemand for money (which we firs dis eit ate influences both investment and TOT") Slee ie variable that links the two halves of the IS-LM mod The "actions between the goods and money markets determine the position and slope of th raiconl nome te hiereerey i eeaoesane cute oo meres the level ‘3's pa ee ers 8 Tru. 121M model wae Ze TaraCHAP TER 11 Aggregate Demand I: Building the /S-LM Model | 313 Ficure @EE3 Price level, P Shifts In Aggregate Demand For a given price level, national income fluctuates because of shifts in the aggregate demand curve, The IS-LM model takes the price level as given and shows what causes income to change. The model therefore 1Ows what causes aggregate demandtoahif ¥,—%,——+¥, Income, output, ¥ §i5} The Goods Market and the IS Curve ‘The IS curve plots the relationship between the interest rate and the level of income that arises in the market for goods and services.To develop this relation ship, we start with a basic model called the Keynesian cross. This model i the simplest interpretation of Keynes’ theory of how national income is determined sani a building block for the more complex and realistic IS-LM model The Keynesian Cross In The General Theory, Keynes proposed that an economy’ total income is, in 1h, Shore ran, determined largely by the spending plans of households, busi- nesses, and government. The more people want to spend, the more goods and seeders firms can se. The more firms can sell,the more Oot they will choose to produce and the more workers they will choose to hire, Keynes believed that the problem during recessions and depressions is inadequate spending, The Keynesian cross is an attempt t0 ‘model this insight. planned Expenditure We begin our derivation of the Keynesian eros by {Teswing a distinction between actual and planned expendituts, ‘Actual expenditure the amount households, firms, and the government spend on ‘goods and ser- wa ane and as we fist saw in Chapter 2, it equals the economy's Bros domestic product (GDP). Planned expendtwe i the amount households, firms, and the governinent would like to spend on goods and services. “Why would actual expenditure ever differ from planned expenditure? The answer is chat firms might engage in unplanned inventory investment because reve es do not mect their expectations, When firms sell Tess of their productsineas Cycle The 314| pant ty Bus y ory: The Economy in the Short Run hey planned, their stock of inventories automatically rises; conversely, ae Ral ‘more than planned, their stock of inventories falls. Because these rapt’ changes in inventory are counted as investinent spending by firms, seul expenditure can be either above or below planned expenditure, Now consider the determinants of planned expenditure, Assuming that the economy is closed, so that net exports are zero, we write planned expenditure PE 4s the sum of consumption C, planned investment J,and government purchases G PE=C+I+G. “To this equation, we add the consumption function: c=cY-7). This equation states that consumption depends on disposable income (Y — T), which is total income Y minus taxes T,To keep things simple, for now we take planned investment as exogenously fixed: 1=T. Finally, as in Chapter 3, we assume that fiscal policy—the levels of government purchases and taxes—is fixed: G=G T=T. Combining these fie equations, we obtain PE=C(Y-T)+T+G. This equation shows that planned expenditure is a function of income Y, the level of planned investment'T, and the fiscal policy variables G and T. Figure 11-2 graphs planned expenditure as a function of the level of income. This line slopes upward because higher income leads to higher consumption and. Ficure (EE) Planned ‘expenditure, PE| Planned ependiu, PE = CY —T) +14 ‘expen the planned-expenditure function is the marginal pro- pensity o consume, MPC. Income, output, YCMAPTER 11 Aggregate Demand |: Building the IS-LM Model | 315 thus higher planued expenditure. The slo pe of this line is the marginal propen- sity to consume, MPC:it shows how much planned expenditure increases when income rises by $1. This planned-expenditure function is the first piece of the Keynesian cross The Economy in Equilibrium The next piece of the Keynesian cross is the assumption that the economy is in equilibrium when actual expenditure equals planned expenditure. This assumption is based on the idea that when People’s plans have been realized, they have no reason to change what they are doing. Recalling that Y as GDP equals not only total income but also total actual expenditure on goods and services, we can write this equilibrium condition as Actual Expenditure = Planned Expenditure Y= PE. The 45-degree line in Figure 11-3 plots the points where this condition holds. With the addition of the planned-expenditure function, this diagram becomes the Keynesian cross. The equilibrium of this economy is at point A, where the planned-expenditure function crosses the 45-degree line. ; How does the economy get to equilibrium? In this model, inventories play an important role in the adjustment process. Whenever an economy is not in equilibrium, firms experience unplanned changes in inventories, and this ey them to change production levels. Changes in ioe ene to i and expenditure, moving the economy toward equilibrium. ancteaeeet suppose the ace) finds itself with GDP at 2 rr greater than the equilibrium level, such as the level Y; in Figure 11-4. In this case, ‘The Keynesian Cross a Expenditure “The equilibrium in the Keynesian (Planned, PE cross is the poine at which ‘Actual, Y) income (actual expendicure) ‘equals planned expendicure Pe=c+i+G (point A). Equilibrium income316| rae ricure (EL Expenditure (Planned, PE, ‘Actual, Y) + av Business Cycle Theory: The Economy in the Short Run ‘The Adjustment to Equilibrium In Actual eperditure 0 Kaynestan Cross If firms are producing at level ¥;, then planned nditure PE, falls short of produc tion, and firms accumulate inven~ ‘ tories. This inventory sceumulston, is C firms to decrease produc Fantdependtre aay, is are producing at level Yp, then planned expenditure PE, exceeds production, and firms run down their inventories. This accumulation fallin inventories induces firms to increase production. In both cases, lacome fol the firms decisions drive the econo- my toward equilibrium. Income, output, ¥ Equilibrium. planned expenditure PE; is less than production Yj, 50 firms are selling less than they are producing. Firms add the unsold goods to their stock of inventories. This unplanned rise in inveritories induces firms to lay off workers and reduce production; these actions in turn reduce GDP.This process of unintended inven- tory accumulation and falling income continues until income Y falls to the equilibrium level. x “Similarly, suppose GDP is ata level lower than the . level Y2 oI Figure 11-4. In this case, planned Pera aperr neue en oe ae meet the high level of sales by drawing down their inventories. Bae ee their stock of inventories dwindle, they hire more workers Tease production. GDP rises, and the economy approaches equilibrium. In summary, the Keynesian cross sh ; : 'ows how income Y'is determined for given levels of planned inv'stment J and fiscal policy G and T. We can-use this baal exogenous variables changes. to show how income changes when one of these ‘ment purchases rise by AG, then the by AG, as in Figure 11-5. The equi Ato point B. oaCHAPTER 11 Agere Aggregate Demand |: Building the IS-LM Model | ricure (Ed Expenditure ‘An Increase In Government Purchases Inthe Keynesian Cross An increase in government purchases of AC raises planned expenditure by that amount for any shen lv ofincome. The eu ‘ium moves from point A to point Brandinceme rcs fom ¥ 2 [Note that the increase in income AY exceeds the increase in government purchases AG. Thus fiscal policy has J multiplied eect on income Actual expenditure ‘on income? The reason is that, Why does fiscal policy have a multiplied ees nding to the consumption function C= ay T), higher income causes soe When an increase in government purchases raises income ‘which further raises acct | higher consumption. elke saizes consumption, which further rics income, * cori on, Therefore, in this model, an increase in government ‘causes a greater increase in income, rh ape? To ans: hs queso we nc ome change in income, The process begins when cexpenditure:rises by "AG as well:This increase in income in turg raises consumption by MPC X “AC, where MPCis the marginal propensity to consume. sa consumption rates expenditure and income CHE ory vecond increase in income of MPC X AG again raises consump- by MPC X (MPC X AG), which 260” raises expenditure and me to consumption ~ ion, this time income, and s6 on. This feedback from consumption (0 incor ncinues indefinitely. The eta effect on Income i “Initial Change in Government Purchases = AG First Change in Consumption = MPC X AG ‘second Change in Consumption = MPC? X AG ‘Third Change in Consumption = MPC) X AG )a y= (1+ MPC + MPC? + MPC!= 25. In this case, a $1,00 increase in government pure by $2.50, Multiplit " Fiscal Policy and the Multiplier: Taxes Tom PAT immediately ries equilibrium income ler; Taxes Now consider how changes in taxes affect equilibrium income. A y disposable income Y - T by AT and, therefore, increases consumption by MPC X AT. For any given level of income Y, planned expenditure is now higher. As Figure 11-6 shows, the planned-expenditure schedule shifts upward by MPC X AT. The equilibrium of the economy moves from point A to point B. "Mathematical noe: We prove ths algebraic resul as follows. For |x| < 1, et zelbstette.. Malkiply both sides of this equation by 2: : seaxtated + Subtract the second equation from the first rmaz= 1, Rearrange this last equation to obtain XK al-ay=t, which implies FAIAL~ x), - , Ysay-n4 Holding T and I fixed, diferentiate to obtain Revd Wa cay and then rearrange to find ee AYHG = 1) i ‘This he ame athe equation in thete, ©“MAPTE 41 Aggregate Demand f: Building. ‘A Decrease in Taxes Inthe ‘Cross A decrease in taxes Keynesian of AT raises planned expendicure by MPC X AT for any given level of income. The equilibnum moves from point A to point B, and income rises from ¥; to Yo. Again, fiscal policy has ‘a multiplied effect on income. Just as an increase in govertiment purchases has a multiplied effect on income, so does a decrease in taxes. As before, the initial change in expenditure, now MPC X AT, is multiplied by 1/(1 — MPC).The overall effect on income of the change in taxes is AY/AT = —MPC/(1 — MPC). This expression is the tax multiplier, the amount income changes in response to a $1 change in taxes. (The negative sign indicates that income moves in the ‘opposite direction from taxes.) For example, if the marginal propensity to con- sume is 0.6, then the tax multiplier is AY/AT = -0.6/(1 — 0.6) = -15. * In this example, a $1.00 cut in taxes raises equilibrium income by $1.50. Ttathemarial note: As before, the multiplier is most easly derived using alee calculus. Begin with the equation Ye qy-1 +146 Holding J and G fixed, differentiate to obtain ays CUY- an), and then rearrange to find : aYT = -CKL -C). ‘This is the same as che equation in the textThe Kennedy and Bus! When John F Kennedy Bectme PA rest YOURE econotgs, who had been brought ro Washington some of the SORT rpege econonnes gscussions of work on his Council of Economic APT Keynesian ideas schooled in the economics of tty - sacome by reducing ‘economic policy at the highest level yas to expand nal ional in Sa incotae One of the council’ first PO ie personal and CO*P z taxes. This eventualy led to a substantial cut? rapendicare on cORSUMP taxes in 1964. The tax cut was intended to a etncane and employment. tion and invesument and thus lead to higher levels © 279°" ennedy replied, When a reporter asked Kennedy why he sence pepo 1017" “To stimula the economy. Dont you remember YOUR PT yas fol As Kennedy's economic advisers predicted, the eee 8 percent in 1964 and lowed by an economic boom. Growth in real GDP was ; ee sere 6.5 percent in 1965. The unemployment rate fell from 5.6 P' 5.2 percent in 1964 and then to 4.5 percent in 1965. pon Economists continee to debate the source of this rapid growth in the cay 1960s.A group called supply-siders argue that the economic boom resulted } the incentive effects of the cut in income tax rates. According to supply-siders, when workers ae allowed to keep a higher fraction of their earnings, they supply substantially more labor and expand the aggregate supply of goods and services. Keynesians, however, emphasize the impact of tax cuts on aggregate demand. Most likely, there is some truth to both views: Tax cuts stimulate aggregate supply by improving workers’ incentives and expand aggregate demand by raising households’ disposable income. * ‘AWhen George W. Bush was clected president in 2000, a major element of his platform was a cut in income taxes. Bush and his advisers used both supply- side and Keynesian rhetoric to make the cate for their policy. (Full disclosure: The author of this textbook was one of Bush’s economic advisers from 2003 to 2005.) During the campaign, when the economy was doing fine, they argued that lower marginal tax rates would improve work incentives. By chow a economy started to slow, and unemployment started t ; to emphasize thatthe tax cut would stimulate spen recover from the recession. Congress passed major tax cuts in 2001 and 20 weak recovery from the 2001 recession turned i in real GDP was 3.8 percent in 2004, of 6.3 percent in June 2003 to 4.9 pea emblem rate fell from its peak * When President Bush signed the 2003 tax bill honest oe the logic of aggregate demand:“When 1 ‘on goods and services. And in our meena money, they can spend it or a service, somebody will produce the good or 4 2 nan am additional good proauces that good or a service, it means som, 4 service, And when somebody tebody is more li © find a job.” The explanation could have come fen re likely to be able Man exam in Beonomics 10! ut when the ‘0 rise, the argument shifted ding and help the economy 03. After the second tax cut, the into a more robust one. Growthin a! Case Study in th re ny before he was inaugurate ulus package to increase the federal government The package included's text chapter and in more detail in Chapter 20.) Even ‘the president and his advisers proposed a sizable stim aggregate demand. As proposed, the package would cost about $800 billion, or about 5 percent of annual GDP. 2 ome tax cuts and higher transfer payments, but much of it was made up of increases in government moe aR aee erica Professional economists debated the merits ofthe plan. Advocates of the Obama plan argued that increased spending was better than reduced taxes because, according fo standard Keynesian theory, the gov emment-purchases_ multiplier exceeds the tax multiplier. The reason for this dif- ference is simple: when the government spends a dollar, that dollar gets spent, whereas when the government gives households a tax cut of a dollar, some of that dollar might be saved. According to an analysis by Obama administration economists, the government purchases multiplier is 1.57, whereas the’tax mul- tiplier is only 0.99. Thus, they argued that increased government spending on i! “Your Majesty, my voyage will not only forge a new route to the roads, schools, and other infrastructure spices of the East but also create over three thousand new jobs.” the better route to increase aggregate sronand snd crete jobs. The logic here i quintessentially Keynesian: asthe ec sinks into recession, the government is acting as the demander of last resort. ree » scinulus proposal was controversial among economists for vari= ne oon criticism was that the stimulus was not large enough given the aes Mfepth of the economic downturn, In March 2009, economist Paul Recah ‘wrote in the New York Times: 5 was too small and too cautious... Employment has already fallen ‘on than in the 1981-82 slump, considered the worst since Jon. As a result, Mr. Obama's promise that his plan will create f as Faien _jobs by the end of 2010 looks underwhelming, to say the Ove credible promise—bis economists used solidly mainstream exits deast 10 2 creer of tax and spending polices. But 35 million jobs almost 1wo OF th Pty int enough i the face of an economy tat has ale lot A million jobs, and is losing 600,000 mare each month The plan more in this recess 009 © 2009 The New York “opyright Laws of the United S March 09, Sfroun The New York Times indy pera rd pene be ing, redistribution, or retransmission eeis spending." ey os to sey snomists chought that using infrastructure spending ¢0 panae ‘might confice with the goal of obtaining the pee Pos con most needed. Here is how economist Gary Becker explained concern on his blog: a “pursing new infrastructure spending in depressed areas like Detroit have a big stimulating effect since infrastructure building projects in these areas ‘can utlize some of the considerable unemployed resources there. However, many of these areas are also declining because they bave been producing goods and services that are notin great demand, and will not be in demand in the furure. ‘Therefore, the overall valie added by improving their roads and other infra seructure is likely to be a lot less than if the new ifrastructure were located in ‘growing areas that might have relatively tle unemployment, but do have great demand for more roads, schools, and other types of Jong-term infrastructure. In the end, Congress went ahead with President Obama’s proposed stimulus plans with relatively minor modifications. The president signed the $787 billion bill on February 17, 2009. Did it work? The economy recovered from the recession, but more slowly than the Obama administration economists ini- tially forecast. Whether the slow recovery reflects the failure of stimulus policy or a sicker economy than the economists first appreciated is a question of continuing debate. m : Using Regional Data to Estimate Multipliers As the preceding two case studies show, policymakers often change taxes and government spending to influence the economy. The short-run effects of these Eee can be eed using Keynesian theory, such as the Keynesian cross ai ¢ IS-LM model. But do these policies work as well i practic they do in theory? : Shoes Unfortunately that question is hard to answer. When policymakers change fiscal policy, they usually do so for good reason. Because ie ther things are happening at the same time, there is no easy way to separate the effects n¢ the ‘Albeo Alcina sod Sivis Axdagad\ “Largs Chine bs Fiasl EAE eae “Alberto Alesina and Silvia Ardagna, Large Changes in Fiscal Polis Tanea a Policy and the Economy 24 (2010): 35-68, Another study reporting tax brite Tax the spending mulipher is Robert} Baro and Chades Reich "Macroeoos ea, saree Government Purchases and Taxes.” Quartey Journal of Ezonomics, 126 Dae oeIncreasingly, ¢ . eg using nant ie ee tried to estimate multipliers for fiscal policy Ss ass vcr Prom coc, Tha of regional States, for tate Fist itincreases the numberof observations the United ea » has only one national economy but 50 state. economies. ond, and more important, i is possible to find vari nal peat cere ee Pomel ood Fecaton eae Peesee eso ta pas cle i ee tea the regional Sconoty. By examining such random variation in government spending, a jore easily identify its macroeconomic effects without being led astray by other, confounding variables. In one such study, Emi Nakamura and Jén Steinsson looked at the impact of defense spending on state economies. They began with the fact that states vary considerably in the size of their defense industries. For example, military con- tractors are more important in California than in Illinois: when the US. federal government increases defense spending by 1% of U.S. GDP, defense spending in California rises on average by about 3% of California GDP, while defense spending in Illinois rises by only about 0.5% of Illinois GDP. By examining what happens to the California economy relative to the Illinois economy when the United States embarks on a military buildup; we can estimate the effects of government spending, Using data from all 50 states, Nakamura and Steinsson purchases multiplier of 1.5. That is, when the govern- pending in a state by $1.00, it increases that state's reported’a government ment increases defense GDP by $1.50. Tn another study, Antonio Acconcia, Giancarlo Corseti, and Saverio Simonelli used data from provinces within Italy to study che multiplier. Here the varia~ tion in government spending comes not from military buildups but from an Iioltan law cracking down on organized crime. According to the law, whenever the police uncover incriminating evidence that the Mafia has infiltrated a city aoe ghe coundll is dismissed and replaced by external commissioners. These coon joners typically implement an immediate, unanticipated, and temporary erin public investment projects The study reported that tis cut in government Seeing has 2 significant impact onthe provinee¥ GDP Once again, the mul- Perc ineacimaed co be about 1.5. Hence thee muds confirm the prediction ce rccynesian cheory shat changes in government purchates can have a sizeable effect on an economy’ output of ‘goods and services. ie tiaclear, however, how to use these estimates ffom regional economics ne met os sbout national economics, One problem is that the regions inference og these researchers stadied was not financed with regional Fra eee ding in California is largely paid for by federal taxes levied aa or 4 sates, and che public investment project in an Italian province aon eid for atthe national level. By contrat, when a nation increases its lassi paid Ming. thas increase taxes, either inthe present othe Rare, ¥ eal1+ 1v_ Business Cycle Theory: The Economy in the Short Run ic activity, leading © # activity, to pay for it. These higher taxes could depress economic 40°00 Ti severne smaller multiplier. second problem is that these eT banks focus on ment spending do not influence monetary policy, because ‘ional change in go national rather than regional conditions. By contrast, 3 at olicy. In its attempt moment spending could well induce a change in monetary POY oo to stabilize the economy, the central bank may offset some icy, making the multiplier smaller, = me i Pikes both of these problems suggest that national aaa sean smaller than regional multipliers, a third problem works in the spect ed In a small regional economy, such as a state, many of the goo salle? People buy are imported from neighboring states, whereas imports are a smal a share of a large national economy. When imports play a larger role, the marginal Propensity to consume on domestic goods (those made within the state) is smaller. As the Keynesian cross describes, a smaller marginal propensity to con- sume on domestic goods leads to smaller second- and third-round effects and, thereby, a smaller multiplier. For this reason, national multipliers could be larger than regional. multipliers, The bottom line from studies of regional economies is that the demand from Bovernment purchases can exert a strong influence on economic activity. But the size of that effect as measured by the multipliet at the national level remains open to debate.” m The Interest Rate, Investment, and the /S Curve ‘The Keynesian cross is only a stepping-stone on our path to the IS- which explains the econot ese M models mys aggregate demand curve. The i i useful because it shows how the spending plans of Sse ee era as Bovernment determine the economy’ income. Yet it makes the tim fying auumptin that the level of planned investment Is fed Ay aeons Chapter 3, an important macroeconomic relationship is that planned i = depends on the interest rate r: Planned investment To add this relaionship between the interest te and; te ‘model, we write the level of planned investment a5. iN? iVestment to our tion slopes downward. 7Eimi Nakamura and Jn Stinson, “Five Stamos Region Ameran Etoomle Revie 104 (Ment 2014) 1 eneatY Union; Evidence Bom US Conse and Swero imondl, "Mai an Steading bse ‘Acconci, Glance fm a Quasvexperinet” Aan Hone: Rew 104 Quy sven go th Ph Muli ate epored in Daniel how, "Using ne es Shock to Bains Fed oe, the Great Recension” Anerian Eamon: Rew 103 (Miyy 3513, gta® Pict Muiphers sincecHAPT 1 Aggregate Demand |: Building ine reer en Ficure (fE) Deriving the 18 Curve Pand (shows (0) The Koodo ee e inction: an increase in the ie interest rate from r, to 7; reduces planned *Penditure investment from I(r) to 1(r3). Panel (b) shows the Keynesian cosa decrease Planned investment from M(r,) to K(r; Shite the planned coendeue re downward and thereby reduces income from ¥, to Yp. Pane! (c) shows the IS curve summarizing this relationship between the interest rate and income! the higher the interest rate, the lower the level of income. Income, output, ¥ \ 4. .and lowers (a) The Investment Function a ee Interest Interest rate, rane fs 1. An increase in the intrest rate 5 Mae lowers t planned Br erage ry investment, 9) Z Ee Keyes) Investment, Y,—Y, Income, output, Y ‘To determine how income changes when the interest rate changes, we ean Tine she investment function with the Keynesin-cros diagram. Because invest combine te rrely related to the interest rate, an increase in the interest rate from fy mene es the quantity of investment fronr I(,) to I(,). The reduction in planned ie. Bee ik turn, shifts the planned-expenditure function downward, as in panel investment in Phe shift in the planined-expenditure function causes the level of (©) of Fig fiom Y to Y Hence, an increase in the interest rate lowers income. income tthurve, shown in panel (c) of Figure 11-7, summarizes ths relation The 1s canane interest rate and the level of income. In essence, the 1S curve ship between cceraction between rand I expressed by the investment function combines the Wry between Zand Y demonstrated by the Keynesian cross. Each and the intera’ curve represents equilibrium in the goods marker, and the curve Few the equilibrium level of income depends on the interest rate se in the interest fate causes planned investment ¢o fall, which ncome to fall, the JS curve slopes downward, point on illustrates Because an increa in curn causes equilibrium in26 | pant 4v_ Business Cyele Theory: The Economy in shore Run 4 How Fiscal Policy Shifts the /S curve’): eke eat rene hows wf any gin eT a oe ey poate ane ieno equibriam. AS we lard ab eipas oe eee ako ‘on government spending T. The 1S curve is drawn for a given fiscal policy: pat when we construct the IS The 1S cae i ed When feral obey chan eA : Te hs oes the Keynesian crs fo show HOM 20,00 4 oe purchases 1S eee eae bere eam EAE Figure (IED) : ‘An increase In Government Oe aya ~ Purchases shifts the /S Curve ‘Outward Panel (a) shows. that an increase in government purchases raises planned Expenditure. For any given interest rate, the upward shift in planned expenditure of AG leads to an increase ir OF AG/(1 — MPC). Therefore, in panel (b), the IS curve shifts to the right by this amount. (b) The IS Curve Interest rate, r 3... and shifts ‘the IS curve toCHAPTER 11 Aggregate Demand I: Building the /S-LM Mo and thus for a given level of planned investment, The Keynesian’ cross in panel @) shows that this change in fiscal policy raises planned expenditure and thereby increases equilibrium income from Y, to Y>. Therefore, in panel (b), the increase in government purchases shifts the IS curve outward. ‘We can use the Keynesian’cross to see how other changes in fiscal policy shift the IS curve. Because a decrease in taxes also expands expenditure and income, it, too, shifts the 1S curve outward. A decrease in government purchases or an increase in taxes reduces income; therefore, such a change in fiscal policy shifts the IS curve inward. 5 _In summary, the IS curve shows the combinations of the interest rate and the level of income that are consistent with equilibrium in the market for goods and services. The 1S curve is drawn for a given fiscal policy. Changes in fiscal policy that raise the demand for ‘goods and services shift the IS curve to the right. Changes in fiscal policy that reduce the demand for goods and services shift the IS curve to the left. 3 The Money Market and the LM Curve The LM curve plots the relationship between the interest rate and the level of income that arises in the market for money balances. To understand this relation- ship, we begin by looking at a theory of the interest rate called the theory of liquidity preference. . The Theory of Liquidity Preference In his classic work The General Theory, Keynes offered his view of how the inter- est rate is determined in the short run. His explanation is called the theory of liquidity preference because it posits that the interest rate adjusts to balance the supply and demand for the economy’s most liquid asset—money. Just as the Keynesian cross is a building block for the IS curve, the theory of liquidity pref- erence is a building block for the LM curve. “To develop this theory, we begin with 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 there is a fixed supply of real money balances. That is, ee (M/P)' = M/P ‘The money supply M is an exogenous policy variable chosen by a central bank, such as the Federal Reserve. The price level P is also an exogenous variable in this model. (We take the price level as given because the IS-LM model—our “ultimate goal in this chapter—explains the short run when the price level is fixed.) These assumptions imply that the supply of real money balances is fixed and, in particular, does not depend on the interest rate. Thus, when we plot the supply of real money balances against the interest rate in Figure 11-9, we obtain 4 vertical supply curve. fpee The Theory of Liquidity Preference The supply and demand for real money bal- ances determine the interest rate. The supply curve for real money balances is vertical because the supply does nor depend on the interest rate The demand curve is down- ward sloping because a higher interest rate raises the cost of holding money and thus low- ers the quantity demanded. At the equilibrium interest rate, the quantity of real money balances demanded Real money balances, M/P equals the quantity ‘supplied. one Next, consider the demand for real money balances. The theory of liquidity preference posits that the interest rate is one determinant of how much money people choose to hold. The underlying reason is that the interest rate is the opportunity cost of holding money: it is what you forgo by holding some of yout assets as money, which does not bear interest, instead of as interest-bearing bank'd bonds. When the interest rate risés, people yrant to hold less of their wealffPin the form of money. We can write the demand for real money balances'as : (M/P)t = Lin), where the function L() shows that the quantity of money, demanded depends on the interest rate. The demand curve in Figure 11-9 ApS downward feane ae interest rates reduce the quantity of real money balances demanded.* ae sean the theory of liquidity preference, the supply. and demand for u janey Ices determine what Interest rate prevails in the economy. That 3 ibe pe me ag one the money market. As the figure shows, ee ee € quantity of real money balances demanded "Note that is being wied to denote the interest rate here, a8 it was in our dh the IS curve. More accurately, its the nominal interest rate that determines money denund sd te rl interest rate that determines investment. To keep things simple, we are ignore ed infason which creates the difference between the real and nominal interent tree Fee orn interest rates move together. The role of expected inflation in the IS-LM model caplore! Chapter 12.money demand? The adjustment occurs because whenever the money mar- ket is not in equilibrium, People try to adjust their portfolios of assets and, in the process alter the interest rate, For instance, ifthe interest rate is sbowe the equilibrium level, the quantity of real money balances supplied exceeds the quantity demanded. Individuals holding the excess supply of money try HegonNert some of their non-interest-bearing money into interest-bearing bank deposits or bonds. Banks and bond issuers, which prefer to pay lower interest rates, respond to this excess supply of money by lowering the inter- 6st Fates they offer. Conversely, if the interest rate is below the equilibrium level, so that the quantity of money demanded exceeds the quantity supplied, individuals try to obtain money ty selling bonds or making bank withdrawals To attract now-scarcer funds, banks and bond issuers respond by increasing the interest rates they offer. Eventually, the interest rate reaches the equilib rium level, at which people are content with their portfolios of monetary and nonmonetary assets Now that we have seen how the interest rate is determined, we can use the theory of liquidity preference to show how the interest rate responds to changes in the supply of money. Suppose, for instance, that the Fed suddenly decreases the money supply. A fall in M reduces M/P because P is fixed in the model. The supply of real money balances shifts to the left, as in Figure 11-10. The equilibrium interest rate rises from r, tor, and the higher interest rate makes people satisfied to hold the smaller quantity of real money balances. The ‘opposite would occur if the Fed had suddenly increased the money supply. 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. Ficure (i Interest rate, r ‘A Reduction In the Money ‘Supply in the Theory of Liquidity Preference Ifthe price level is fixed, 4 reduction in the money supply from M, to My reduces the supply of reat ‘money balances. The équilib- ‘rium interest rate therefore rises from ry t0 rp.perrene ee eg ominal interest rates? icy influence 1 How does a ghtening of renee Pe developing, the answer depends on [According to the theories we BYE ey effect in Chapter 9 sugars that : action in money growth would in the long rum when Prices Yead to lower nominal interest ratesYet 7 flexible, a redi lower ee sa So % predicts that, in the short run when prices the of liquidity p falling real m ae a Ueaiatpetorg imonenry,pobey won 20 £0,050 08 2" MONT balances and higher interest rates. Both conclusions are consistent during the early 1980s, when the US. econot reduction in inflation in recent history. Se Here's the background: By the late 1970s, inflation in the U.S. economy had reached the double-digit range and was a major national problem. In 1979 ‘comsumer prices were rising at a rate of 11.3 percent per year. In October of that year, only two months after becoming the chairman of the Federal Reserve, Paul Volcker decided that it was time to change course. He announced that monetary policy would aim to reduce the rate of ination. This announcement began a period of tight money that, by 1983, brought the inflation rate down to 3.2 percent. Let's look at what happened to nominal interest rates. If we look at the period immediately after the October 1979 announcement of tighter monetary policy, We see a fall in real money balances and arise in the interest rate—just as the theory of liquidity preference predicts, Nominal interest rates on three-month Treasury bills rose from 10.3 percent just before the October 1979 announce- j ae a Al Percent in 1980 and 14.0 percent in 1981. Yet these high interest only temporary. AsVoleker’s change in monetary policy lowered infla- tion and expectations of infiati : s 60 percent in 1986 ‘on, nominal interest rates gradually fell, reaching. with experience. A ‘good illustration occurred my saw the largest and quickest This episode illustrates a general lessoy n: to understand the link between a pe a interest rates, we need to keep in mind both the Preterence and the Fisher effect. A monetary tightening leads to higher nominal interest rates i aheleg iia ® s in the short run and lower nominal interest rates Income, Money Demand, ang the LM Curve Having developed the theory of liquidity preference as an explanation for bow the interest rate is determined, We can now use the theory to derive the LI curve. We begin by considering the following question: How does a change i PeCHAPTER 11 Aggregate Desmand |; Building the /S-LM Model | BB the economy's level of income Y answer (which should be fami affects the people en, - ¥ affect the market for real money balances? The ow liar from Chapter 5) is that the level of income rand for money. When income is high, expenditure is high, so igage in more transactions that require the use of money. Thus, greater income implies greater money demand. We . : the money denen far. demand. We an express hese iden by, writing (M/Py! = Lie, Y). = The quantity of real money balances demanded is negatively related'to the interest rate and positively related to income. + ‘Using the theory of liquidity preference, we can figure out what happens to the equilibrium interest rate when the level of income changes. For example, consider what happens in Figure 11-11 when income increases from Y, to Yo. As panel (a) illustrates, this increase in income shifts the money demand curve «to the right. With the supply of real money balances unchanged, the interest Tate must rise from 1; to r2 to equilibrate the money market. Therefore, accord- ~ ing to the theory of liquidity preference, higher income leads to a higher interest rate. The LM curve shown in panel (b) of Figure 11-11 summarizes this rela- tionship between the level of income and the interest rate. Each point on the LM curve represents equilibrium in the money market, and the curve illus- trates how’the equilibrium interest rate depends on the level of income. The ~ Figure (ED eS ‘ Bt (a) The Market for Real Money Balances Incerest rate, Real money balances, M/P im lances: an increase ving the LM Curve Panel (a) shows the market for real money bal pore from Y; to Y; raises the demand for money ‘and chus raises the interest race from in incor rel (0) shows the LM curve summarizing this relationship between the interest 11 0 Fa Fame: the higher the level of income, the higher the interest rate.‘onomy in the Short Run a wy Business Cycle. Theol The Eci sazirant! e demand for real money balances hhe level of income, the higher th rate. For this reason, the LM curve higher dl vieMthe higher the equilibrium interest r slopes upward. Monetary Policy Shifts the LM Curve rate that equilibrates the money market at any dae cr iasome Yet as we sw earlier, the equilibrium interest rate 2)s0 depends on the supply of real money balances M/P. This means that the LM curve is aoa rec supply of real money balances. Ifreal money balances change — foe ample ithe Fed alters the money supply—the LM curve shifts We canine the theory of iguiity preference 0 understand how monetary policy shifts the LM curve. Suppose that the Fed decreases the moncy supply from M, to Mp, which causes the supply of real money balances to fall from : 1Mi/P wo My/P. Figure 11-12 shows what happens. Holding constant the amount of income and thus the demand curve for real money balances, we 58 that a ston inh ofral money balances ries the interest ate that quil- bees money marker Hene, a decrease in the money supply shi the LM ‘in summary, the LM cun’e shows the combinations of the interest Re Een eared ee set os eed ‘money balances. The LM { drawm for a given supply of real money balances. Decreases in th money blocs Sift the LM curve upward ony 1 supply of real shift the LM curve i Cae ar supply of real money balances How The LM curve tells us the interest Ficure (ERE) (0) The Maskat for Real Money Balances, Interest rate, r the interest ‘A Reduction In the Money Suppl Supply Shite for any given level of income ¥, a rode that equilibrates the money market. Therefore, x um tM Curve Upward Panel (a) shows chat money supply raises the interec race UM curve in panel (b) shifts upwardCHAPTER 11 Aggregate Derhand |: Building the IS-LM Model | 55 GS Conclusion: The Short-Run Equilibrium ‘We now have all the pieces of the IS-LM model. The two equations of this model are Y=OCY-T)+IN+G Is, M/P= L,Y) LM. ‘The 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 combi- nations of rand ¥ that satisfy the equation representing the goods market, and the LM curve provides the combinations of rand Y that satisfy the equation repre- senting the money market. These two curves are shown together in Figure 11-13. ‘The equilibrium of the economy is the point at which the 1S curve and the LM carve cross. This point gives the interest rate r and the level of income 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, and the demand for real money balances equals the supply. .As'we conclude this chapter, let’ recall that our ultimate goal in develop- ~ ing the IS-LM model is to analyze short-run fluctuations in economic activity. Figure 11-14 illustrates how the different pieces of our theory fit together. In this chapter we developed the Keynesian cross and the theory of liquidity preference 1s building blocks for the IS-LM model. As we see more fully in the next chapter, the IS-LM model helps explain the position and slope of the aggregate demand curve. The aggregate demand curve, in turn, isa piece of the model of aggregate supply and aggregate demand, which economists use to explain the short-run ‘effects of policy changes and other events on national income. : ricure @B~ es ‘ Interest race, r Equilibrium In the (5-2 . e Model The intersection of the [Sand LM curves represents simultaneous equilibrium in the market for goods und Services and in the market for Teal money balances for given’ values of government spend ing, taxes, the money supply, and the price level. Equiv lve! Income, output, ¥ of incomeenous and assumes that the interes demand for real money balances,The eh money supply lower the interest rate "peo the cory State il money balances to depend , the theory of liquidi A 68 t income and the ae higher ice yields a relationship — so ney acs adh tn hee ee ee loping LM curve summarizes this positi interest rate. The upward- Positive relationshi a ip between income and the interest rate,chapren ty B11 Aggregace Demand i: Building the IS-LM Model | 335 5: The IS-LM model co: the elements of dhe gn inet elements of the Keynesian com and the points thar satisfy cory of liquidity preference, The IS curve shows equilibri shows the points thay can Tim in the goods marke, and the LM curve Section of the IS and satisfy equilibrium in the money market. The inter- ee Leu : satisfy equilibrium in book eee sngieie that KEY CONCEPTS pan VEC ON CERT S Caeeieen aan ese bar IS-LM mot : IS. curve < Keynesian cross Tox multiplier LM cure Canieeotei 7 Theory of liquidity preference QUESTIONS FOR REVIEW 1. Use the Keynesian cross to explain why fiscal policy has a multiplied effect on national income. 2. Use the theory of liquidity preference to explain why an increase in the money supply lowers the interest rate. What does this explanation assume about the price level? 3, Why does the IS curve slope downward? 4. Why does the LM curve slope upward? PROBLEMS AND APPLICATIONS 1. Use the Keynesian cross model to predict the impact on equilibrium GDP of the following. In each case, state the direction of the change and give a formula for the size of the impact. ‘a. An increase in government purchases be An increase in txes €. Equil-sized increases in both government : and taxes 2. © arched «In the Keynesian cros mode, exe chat the consumption function is given by c= 120 +08(¥- 1D. is 200; government both 400. diture a8 a function of Planned investment purchases and taxcs 26 1. Graph planned expen income. tb. What is the equilibrium rament purchases increase to 420, what quilibriu income? What is the level of income? ©. If gover ig the mew ¢ tnultipber for government purchases? 4. What level of government purchases is needed to achieve an income of 2,400? (Taxes remain at 400.) ‘e. What level of taxes is needed to achieve an income of 2,400? (Government purchases remain at 400.) |. Although our development of the Keynesian cross in this chapter assumes that taxes are a fixed amount, most countries levy some taxes that rise automatically with national income. (Examples in the United States include the income tax and the payroll ax.) Let's represent che tax system by writing tax revenue as T=T+y, where T and ¢ are parameters of the tax code. ‘The parameter 1 is the marginal tax rate:if income rises by $1, taxes rise by 1X $1 ‘a. How does this tax system change the way consumption responds to chan in GDP?