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CHAPTER-THREE

AGGREGETE DEMAND ANALYSIS

3.1Aggregate Demand and Aggregate supply with more than two sectors
Aggregate demand and aggregate supply are used in macroeconomics in order to see how the
general price level, the total output level, and employment level are determined which have
direct impact on national income.

Aggregate demand: -

 It shows the total quantity of goods and services which will and able to purchase
at each possible price level in a given period of time, usually one year. The value
of aggregate demand in any year will depend on decisions taken by:
 Households(C)
 Firms (I)
 Government(G)
 Buyers in the oversees (international
trade)(NX)
 While market demand relates a price of a given good to its consumption level,
aggregate demand relates the general price level to total desired sending on
national outputs.
 In aggregate demand when income changes, it is necessary to know how this
affects real income which intern has effect on national output. When General
Price level changes it affects the money national income and will affect money
expenditures.
 Aggregate Demand:-
 Curve slopes Downward to the Right
 Have negative relation with general price level when
other things remain unchanged
 Highly influenced by the price level or price index.

AD=C+ I +G ± NX Where AD= aggregate demand

There are two main reasons why aggregate demand curve slopes down ward from left to right:-

1) The real balance effect

 A higher price level reduces the real value (purchasing power)
of wealth. Wealth can be held in the form of assets like cash
holdings, saving accounts, stock and Bonds ,etc. inflation

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erodes the real value of such assets so as the price level rises
economic agents will cut back on their expenditures
2) The interest Rate Effect
 Assuming that the government money supply is fixed, when the
general price level increases:
 Demand for money increases for more
expenditure.
 To stay or get more satisfaction people
borrow money from creditors.
 Interest rate increases since there is high
demand for money and fixed government
money supply.
 Since investment and interest rate have
inverse relations this increases the cost of
production for firms and in turn it had
increases the price of outputs.
 If the price increases sustainably it may
cause inflation which led the consumer not
to buy durable consumer goods

Therefore the aggregate demand has a curve rather than a straight line (market demand. This
because that there will be a big change in aggregate demand when there is a little change on
the general price level. Aggregate demand merely related to GDP measured through
expenditure method.

Fig 1 the aggregate demand curve

AD

Output, Y

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Determinant of Aggregate Demand

A) Price level: - have inverse relation with aggregate demand.

B) Government policy
C) Confidence (government agents expectation)

If expectation is Optimistic about the future Aggregate Demand increases and vice versa

D) Population income: - positively for some goods and negatively for others goods
E) Demographic change: - as population increases aggregate demand also increases
F) Foreign output (economic conditions): -one good of a given country needed more by
others exports will increases this in turn increases the aggregate demand.
G) Asset value: - as the asset value increases, population become more wealthier this will
increase the aggregate demand
H) Real interest rate: - inversely related to aggregate demand
I) The quantity of money in circulation: - positively related to the aggregate demand

Except the price level all determinates shifts the aggregate demand curve either to the right
or to the left.

Aggregate Supply: -

 It indicates the total quantities of all goods and services which will and
able to supply at different price (each price) level usually one year. it has
a positive relation with the price level.

Determinant of Aggregate supply

Price level is one aggregate supply determinant in both short and long run period. Short run
determinant of aggregate supply are: -

 Cost of production: - it has inverse relation with aggregate

supply
 Weather condition: - favorable weather condition has positive
impact on aggregate supply.
 Natural disaster: - inversely related to the aggregate supply
 Firms productive capacity

Long run determinants of aggregate supply are a change quantity and/or quality of factors of
production.

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3.2 The three aggregate supply curves and the two disputes of economists on
the slope of aggregate supply curve
P

a) p

Y Y

Fig 2 Classical range

Fig 1 Keynesian range

Fig 3 intermediate range

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Classical Macroeconomics: Output and Employment

The term macroeconomics originated in 1930’s, after a long period in which microeconomic
questions dominated the field of economics. The 1929’s depression added urgency to the study
of macroeconomics questions. A new orthodoxy in macro economic theory began By John
Maynard Keynes, “The general theory of employment, interest and money”. The process of
change in economic thinking that resulted from his work has been called the Keynesian
Revolution. But revolution against what? What was the old orthodoxy? Keynes termed it
“Classical Economics”. Keynes used the term classical to refer virtually all economists who had
written macroeconomics questions before 1936.

The classical revolution:

Classical economies emerged as a revolution against a body of economic doctrine known as

“Mercantilism”. The two tents of mercantilism were: -

1) Bullionism, power of a nation determined by stock of precious metals.

2) The belief in state actions to direct the development of capitalist system.

Bullionism led countries to attempt to secure an excess of exports over imports of Gold through
export subsidies, import duties and creating market through colonies. State action was
believed to be necessary to cause the developing capitalist system to further the interest of the
state.

In contrast to mercantilists, classiclas emphasized: -

 The important of real factors in determining the wealth of nations.

 The optimizing tendencies of free market in the absence of state control.
 They stated the growth of an economy was the result of increased stocks
of factors of production and advanced technology.
 Money is only a means of exchange, and has no intrinsic value
 They mistrusted government and want to have free market, except some
intervention to insure the market remains competitive.

Unlike these mercantilists viewed money as a spur to economic activity. In the short run
mercantilists argued that an increase in quantity of money would led to an increase in demand
for commodities and would stimulate production and employment. One role for the state
action in mercantilists view was to insure that markets exists for all goods produced. I.e.
consumption, both foreign and domestic must be encouraged to the extent that production
advanced. As against this J.S.MILL said once “consumption never needs encouragement.”

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For classiclas:

 Free market mechanism would work to provide market for all goods that were
produced.
 The legislator, therefore, need not give himself any concern about
consumption.
 The production of a given quantity of output will generate sufficient demand
for that output.
 Hence they gave a little explicit to factors that determine the overall demand
i.e. aggregate demand.

Thus, the two features of the classical analysis arose as part of the attack on mercantilism:

 Classiclas stressed the role of real as opposed to monetary factors in

determining output and employment.
 Classiclas stressed the self adjusting tendencies of the economy.
Government policies to insure an adequate demand for output were
considered unnecessary and generally harmful. To show their self adjusting
mechanism of market system they use the labor market as a brief
explanation.

Classical labor market assumes the following:

 Markets works well

 Firms and individual workers optimize
 Perfect information about relevant prices
 No barrier to the adjustment of money wages
 Market clears

CLASSICAL LABOR DEMAND

The labor demand curve is downward sloping. The higher real wage (w/p) the lower level of
labor input demanded by the firms and vice versa.

w
ND= f ( ) -----------------------------------------------labor demand equation
p

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CLASSICAL LABOR SUPPLY

The labor supply curve is upward sloping. The higher real wage (w/p) the higher level of labor supplied
by the individuals and vice versa.

w
NS= g ( ) -----------------------------------------------supply demand equation
p

At equilibrium ND=NS, this equilibrium determines output, employment and real wage which
are endogenous in the model.

W/p NS

W/p*

ND

N* N

Fig 4 LABOR MARKET EQUILIBRIUM

The Determinates of output and employment in classical

In classical model factors that determine the level of output and employment are those factors
that determine the positions of the labor demand and supply curves, and aggregate production
function. Labor productivity shifts the labor demand curve while change in demographic
character shifts the labor supply curve. The production function shifted by technical changes
and capital stock changes. In classical model, the level of output and employment are
determined solely by supply factors (the amount firms choose to produce.

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W/p NS3 P

W3/p3 NS1

W/p*

W1/p1 ND3

NS* ND*

ND1

N Y

Fig 5 derivation of long run Supply curve

From Fig 5 as we can see at higher prices like p3 given money wage constant labor supply will
decrease because at higher price given money wage corresponds to lower real wage and will
shift labor supply upward to the left (ND3) and for that given money wage and increased price
level (p3) more labor is demanded at a higher price level because that money wages
corresponds to lower real money wage for firms hence labor demand curve shifts up to the
right (ND3). Then the money wage increase up to W3 until the labor market come to the
equilibrium state. Hence aggregate supply curve is vertical and this vertical aggregate supply
curve illustrates the supply determined nature of output in classical model.

Classical: Factors that do not affect output

Because output and employment are supply determined, the level of aggregate demand will
have no effect on output. As J.S.MILL said so “the legislator, he did not give himself concern
over the demand for output.”

All demand side factors have no role in determining output and employment. Like: -

 Quantity of money
 Level of government spending
 Level of investment demand by business sector

In general

 The sticking feature of classical model is the supply determined nature of

output and employment. This property follows from the vertical aggregate
supply curve.
 The classical aggregate supply curve is vertical due to the assumption we
have made about the labor market.

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 Two assumptions implicit in classical representation of labor market are

I. Perfectly flexible prices and wages
II. Perfect information about prices by the participants of the
market
 If such a model is to explain employment and output in the short run,
prices and wages must be perfectly flexible in that time period.
 These two assumptions are the elements of classical theory that KEYNES
attacked.

The Keynesian thought

 By 1930’s our world face great economic depression. The economy was
unable to adjust or came at full employment level.
 John Maynard Keynes: -
 An English economist during this 1930’s.
 Developed a theory to explain that equilibrium is
not necessary established at full employment.
 Believed that an economy can become locked in
macroeconomic equilibrium with high cyclical
unemployment.
 Said classical self correction mechanism will not
work in high cyclical unemployment.
 According to this school of thought: -
 Wages and price are inflexible down ward at least
in the short run.
 Wages, rents and other production costs are set
by contracts in the short run and cannot be
reduced until the contract is expired sometime in
the future.
 Government role is important to influence
aggregate demand to ensure full employment.
 The key to Keynes analysis was the role of
aggregate demand

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 The equilibrium level of GNP determined by the

volume of expenditure planned by:
 Consumers
 Inventors
 Government
 Foreigners

Fig 6: An extreme Keynesian View of macroeconomic equilibrium

P AS

P* Ad2

Ad1

Q1 Q2 Q

Intermediate Range
They combined classical and Keynesian thought to form the present AS curve.

AS

P classical range

Fig 7 Aggregate supply curves

Intermediate range

Keynesian

Eq Q

Eq-indicates the maximum output the economy can produce (full employment output level).

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Equilibrium of Aggregate Supply and Aggregate Demand

Market equilibrium and aggregate demand and aggregate supply equilibrium reached through
the same method. Microeconomic equilibrium find through the interaction of market demand
market supply. Similarly macroeconomic equilibrium find through the interaction of aggregate
demand and aggregate supply. The interaction of aggregate demand and aggregate supply
determines: -

 The output
 The general price level and employment level in the economy.

3.2Aggregate Demand in the Closed Economy

3.3 Foundations of Theory of Aggregate Demand

Of all the economic fluctuations in world history, the one that stands out as particularly large,
painful, and intellectually significant is the Great Depression of the 1930s. During this time
countries experienced massive unemployment and greatly reduced incomes.

This devastating episode caused many economists to question the validity of classical economic
theory. According to that theory, national income depends on factor supplies and the available
technology, neither of which changed substantially from 1929 to 1933. In 1936 the British
economist John Maynard Keynes revolutionized economics with his book The General Theory of
Employment, Interest, and Money.

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—capital, labor, and technology—determines national income.
Unlike to this output also depends on the demand for goods and services. Demand, in turn, is
influenced by monetary policy, fiscal policy, and various other factors.

The Keynesian cross: is a model of Keynes designed to explain the relationship between
expenditure and output. Accordingly there are two types of expenditure:

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 Actual expenditure: it is the amount households, firms, and the government spends on
goods and services which is equal with the GDP.
 Planned expenditure: it is the amount households, firms, and the government would like
to spend on goods and services.
In closed economy, since net exports are zero, we write planned expenditure E as the sum of
consumption C, planned investment I, and government purchases G:
E=C+ I +G
To this equation, we add the consumption function
C=C (Y −T )
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:
I =I .
And assume that fiscal policy—the level of government purchases and taxes—is fixed:
G=G ,
T =T
Combining these five equations, we obtain
E=C(Y −T )+ I +G .
This equation shows that planned expenditure is a function of income Y, the level of planned
investment I , and the fiscal policy variables G andT .
Planned Expenditure as a function of Income
Planed Expenditure, E
E=C(Y −T )+ I +G

MPC
1

Income, output, Y
Planned expenditure depends on income because higher income leads to higher consumption,
which is part of planned expenditure. The slope of this planned-expenditure function is the
marginal propensity to consume, MPC.
At equilibrium of the economy:

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Actual Expenditure=Planned Expenditure

Y =E .
Actual Expenditure
Expenditure, E Y =E

Planed Expenditure

A E=C+ I +G

0
45 Y

Equilibrium Income

The equilibrium in the Keynesian cross is at point A, where income (actual expenditure) equals
planned expenditure.
The Adjustment to Equilibrium in the Keynesian Cross: If firms were producing at level Y1,
then planned expenditure E1 would fall short of production and firms would accumulate
inventories (a). This inventory accumulation would induce firms to reduce production. Similarly,
if firms were producing at level Y2, then planned expenditure E2 would exceed production, and
firms would run down their inventories (b). This fall in inventories would induce firms to raise
production. In both cases, the firms’ decisions drive the economy toward equilibrium.
Expenditure, E Actual Expenditure
Y1

a Planed Expenditure

E1 A

E2 b
0
Y2 45

Y1 Equilibrium Income Y2 Y

In summary, the Keynesian cross shows how income Y is determined for given levels of planned
investment I and fiscal policy G and T. We can use this model to show how income changes
when one of these exogenous variables changes.

Fiscal Policy and the Multiplier

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a. Government Purchases: Because government purchases are one component of

expenditure, higher government purchases result in higher planned expenditure for any
given level of income. If government purchases rise by∆ G , then the planned-expenditure
schedule shifts upward by∆ G . An increase in government purchases leads to an even greater
increase in income. That is, ∆ Y is larger than∆ G . The ratio ∆ Y /∆ G is called the government
purchases multiplier; it tells us how much income rises in response to a Birr 1 increase in
government purchases. An implication of the Keynesian cross is that the government-purchases
multiplier is larger than 1.

Expenditure, E Actual Expenditure

E2=Y2 B Planed Expenditure

∆Y (1) ∆ G

E1=Y1 A
0
45 (2)

Y1=E1 ∆ Y Y2=E2 Income, output, Y

An increase in government purchases of ∆ G raises planned expenditure by that amount for any
given level of income (1). The equilibrium moves from point A to point B, and income rises
from Y1 to Y2. Note that the increase in income ∆ Y (2) exceeds the increase in government
purchases∆ G . Thus, fiscal policy has a multiplied effect on income.

b) Taxes: A decrease in taxes of ∆ T immediately raises disposable income Y −T by ∆ T and,

therefore, increases consumption by MPC × ∆ T . Hence the planned-expenditure schedule shifts
upward by MPC × ∆ T .
Actual Expenditure

E2=Y2 B Planed Expenditure

∆Y MPC × ∆ T (1)

E1=Y1 A

(2)

Y1=E1 Y2=E2

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A decrease in taxes of ∆ T raises planned expenditure by MPC × ∆ T for any given level of
income. The equilibrium moves from point A to point B, and income rises from Y1 to Y2. Again,
fiscal policy has a multiplied effect on income.
Just as an increase in government purchases has a multiplied effect on income, so does a decrease in
taxes.

3.4The Keynesian system: Money Interest and Income

In this section:
 We explain the role of money and interest rate in the Keynesian
system
 We construct a model that shows how interest rate and income are
jointly determined

Money in the Keynesian system

 In this money affects income via interest rate.
 Increase in money supply(MS)-lowers interest rate(R)-increase investment(I)-
increase- aggregate demand(AGG DD) and income
 Hence we have two links
I. Relation between money and interest rate
II. Effects of interest rate on AGG DD

Interest Rate and AGG DD

 A home purchase financed by long term loans which includes high interest rates hence
high interest rate reduces the demand for purchasing a house(C).
 Private investment (I) also for huge materials financed by borrowing with high interest
rate which reduce the demand again.
 Government spending even if it is exogenously determined, financed by borrowing
through bond issue. High interest rate also discourages government spending (G).
 Therefore with closed economy AGG DD=E=C+I+G. hence AGG DD in this sense have an
inverse relation with rate of interest (fig 8 & 9 below).

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Fig 8 investment schedule

R0

 R1

I0  i1 I

Fig 9 Aggregate expenditure

C, I, G 450 E1= C+I1+G0

I E0= C+I0+G0

Y0 Y1 Y

A decrease in interest rate increases the investment from I0I1 and this shifts the aggregate
expenditure up.and y0 moves y1

The Keynesian theory of interest Rate

He believed that the quantity of money played a key role in determining the rate of interest
rate. Keynes divided all financial assets in to two: -

I. Money
II. Non money assets ( bonds)

Money

 Is the stock of assets that can be readily used to make transactions.

 Short term highly liquid asset
 Riskless
 Perfectly liquid

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Bonds

 less liquid long term assets

 risky assets
 less liquid

Liquidity is the property for an asset that measures the ease for that the asset can be turned in
to currency without lose of value.

Hence we have two alternative ways for equilibrium interest rate:

a. the rate that equates demand for and supply of bonds

b. the rate that equates demand for and supply of money

Keynes chose the second one to emphasis the relationship between interest rate and money.
This is because equilibrium in one market implies equilibrium in the other. Hence equilibrium
interest rate determined by factors affecting;

 Money supply (central bank).

 Money demands the (3 motives for demand for money).

Fig 10 Determination of equilibrium interest rate

R Ms

Where M quantity of money

R0

Md

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The Keynesian Theory of Money Demand

Agents demand money for three main reasons: -

1. Transaction demand for money

2. Precautionary demand for money
3. Speculative demand for money

Transaction Demand

 Individuals hold money for use in transaction.

 Money bridges the gap between the recipient of the income and
expenditure
 Amount of money held for transaction would vary positively with the
volume of transaction in which the individual engaged.
 Hence transaction demand for money is assumed to depend positively on
income.

Precautionary demand

 Money also hold for the case of unexpected expenditures such as medical
or repair bills
 Keynes believed that the amount held for this purpose depends positively
on income.

Keynes asked why an individual would hold any money above the two demands earlier
discussed. He answered this by speculative demand for money.

Speculative demand

 People hold money way beyond the two motives even when bonds pays
interest and money does not.
 As Keynes stated such additional demand for money exists because of
 Uncertainty about future interest rates
 The inverse relation between change in
interest rate and the price of bond.

For example assume that you bought a perpetual bond at a price of $ 1000 at interest rate of
5
5% ( =0.05=5 % ¿. The bond entitled you payment of $50 per year. Now if
100

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Table1

Interest rate Bond price

2% 50
=0.02 p=$2500
p
5% 50
=0.05 p=$1000
p
10% 50
=0.1 p=$500
p

A decline in interest rate results in capital gain on previously existing bonds and vice versa. At
high interest rate the expected return on bonds will be negative, and money will be the
preferred asset.

Money held in an anticipation of a fall in bond price (a rise in interest rate) is Keynes
speculative demand for money. Hence at a lower interest rate people expect the interest rate
tends to raise (a fall in bond price) in the future hence speculative demand for money will
increase. Therefore there is an inverse relationship between the speculative demand for money
and the interest rate (fig 11). At a very lower and lower interest rate the graph for speculative
demand for money flatten out. Keynes termed this as liquidity trap (a situation in which at very
lower and lower interest rate where the speculative demand for money becomes nearly
horizontal)(fig 12).

Fig 11 speculative demand for money fig 12 liquidity Trap

R R

Md Md

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The total demand for money

Transaction and precautionary demand for money are positively related to income and
negatively related to the interest rate. The speculative demand for money is negatively related
to the interest rate

Md=l( y ,r )

A rise in income increases the money demand and expectation of a rise in interest rate
decreases the money demand.

Md=C 0+C1Y-C2r where C1>0(increase money demand due to “Y” and C2>0(decline in money
demand due to “r”)

3.5 The IS-LM Model

Our task in this section is to find the values of interest rate and income that simultaneously
equilibrate the money market and the commodity market.

 First we identify combination of income and interest rate that equilibrate the money
market
 Second we identify combination of income and interest rate that equilibrate the
commodity market
 Third we will combine the two markets.

3.6 Money market equilibrium: The LM Curve

Construction of the LM curve

 Money demand in the Keynesian model: Md= L(y,r)↔ Md = C0+C1y-C2r and for
exogenously determined money supply (Ms ), at equilibrium Ms= Md= C0+C1y-C2r
 Fig 13 below shows an increase in income (Y0-Y1) increases the money demand at a
given interest rate due to transaction demand for money is positively related with
income. To restore the increased money demand to the fixed money supply, it requires
the interest rate to rise (ro-r1).
 The higher the interest rate the lower speculative demand for money. Hence the
interest rate must rise until the decline in money demand just equal to the initial income
induced increase in the transaction demand for money.
 The LM curve which shows combination of income and interest rate slopes upward. At
higher level of income, equilibrium in money market occurs at higher level of interest
rate.

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Fig 13 Equilibrium in money market and LM schedule

r r
Ms LM

R2 C r2 C

R1 B r1 B

R0 A Md (Y2) r0 A

Md (Y1)

Md (Y0) M y

Quantity of money income

Factors that determines the slope of LM curve

 At higher value of C1, the larger increase in money demand per unit increase in income.
Hence the larger upward adjustment in the interest rate required to restore the total
money demand to the level of fixed money supply. Hence at higher C1 the Steeper LM
will be.
 The other determinant of the slope of LM curve is the interest elasticity of money
demand depends on the value of C2 which measures the change in money demand for a
given change in interest rate:
 At low interest elasticity of money demand, money demand curve is
steeper, indicating that large change in interest rate will not
significantly change the level of money demand. Hence LM is steeper.
 At high interest elasticity of money demand, money demand curve is
flatter, indicating that large change in interest rate will significantly
change the level of money demand. Hence LM is flatter.
 We have two special cases for the of LM curve regarding interest elasticity of money
demand:
1. Money demand completely interest insensitive (C2=0): here money
demand completely not affected by the interest rate. I.e. there is no
possible rise in interest rate that would reduce money demand back to
the level of fixed money supply. Hence the LM curve will be similar to
those of classical vertical aggregate supply curve.

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2. Money demand completely interest sensitive (C2=∞): here people are

highly sensitive even for a small change in interest rate. Here a small
decrease in interest rate cause people any increase in money balance
(Keynes termed this phenomenon as liquidity Trap). Here LM curve is
nearly flat.

Factors that shifts the LM curve

We have two:

I. Changes in the exogenously fixed money supply: increases in the

money supply shift the LM curve to the right, and decreases in the
money supply shift the LM curve to the left.

Fig 14 shift in LM curve with a decrease in Quantity of Money

Ms2 Ms1 LM2 LM1

r2

r1
← Md

M1/P Real money Balance M/P Y

II. Shift in money demand (liquidity preference): LM shifts to the left

(right) with an increase (decrease) in amount of money demand at a
given level of income and interest rate.(fig 15 below)

r r LM2

R2 Ms LM1

↗ ↖

R1 Md2

Md1 M Y

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3.7 Commodity market equilibrium: The IS curve

Keynes wrote in his General theory that “saving and investment are necessarily equal in
amount for the community as a whole, being different aspects of the same thing.”

Symbolically for simple economy S= Y-C and I= Y-C then S=I

Or

Y= C+I and Y= S+C then S=I

For closed economy

Y= C+I+G equivalently  I+G=S+T then I(r) = S(Y)

Now our task is to find the combination of interest rate and income that equates saving and
investment (fig 16 below).

Investment Saving
A. R B. S S(Y)

R2 S2

R1 S1

R0 I(r) S0

I y

I2 I1 I0 Y2 Y1 Y0

c) The IS schedule

R2 C

R1 B

R0 A

Y2 y1 y0

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Illustration of fig 16

At interest rate R0, R1, R2 investment level will be I0, I1, and I3 in part a. to generate
saving savings S0, S1, and S2 equals to the level of investment, and income must be at Y0, Y1
and Y2 respectively. Therefore interest rate income combination (R0, Y0), (R1, Y1) and (R2, Y2)
are points along the IS curve in part C. Hence IS is downward slopping

Factors that determines the slope of the IS schedule

The slope of IS is related to the slope of the investment function. Investment curve is steep
then investment is less sensitive to change in interest rate while investment curve is flat then
investment is sensitive to change in interest rate.

Hence here IS will be steep if inertest elasticity of investment is low and IS will be flatter if
interest elasticity of investment is high.

Now if interest elasticity of investment is zero investment is completely insensitive to changes

in interest rate and IS will be vertical. When interest elasticity of investment is∞ investment is
completely sensitive to change in interest rate and IS will be flatter.

Factors that shifts the IS schedule

It will shift when any or all of the components of autonomous expenditures changes (A, T, I and G).

I ( R )+G=S ( Y −T ) +T …………..@
Investment plus government spending: fig 17

Since Y=C+I+G

Actual

Planned 2

G Planned 1 IS2

IS1

Y1 Y2 Y1 Y2

 The increase in tax shifts the IS to the left ( exercise)

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 The Unconditional

Equilibrium in the IS–LM Model

Interest

Equilibrium interest rate

Equilibrium level of income

The intersection of the IS and LM curves represents simultaneous equilibrium in the market for
goods and services and in the market for real money balances for given values of government
spending, taxes, the money supply, and the price level.
Note: A change in either fiscal or monetary policy leads to changes in equilibrium output and
equilibrium interest rate.
Fiscal policy: an increase in G or a reduction in T shifts the IS curve out, hence both equilibrium
output and equilibrium interest rate increases.
Monetary policy: an increase in money supply shifts the LM curve out. Hence it will increase
output but it will decrease equilibrium interest rate.
Interaction of Fiscal and Monetary policies:
What would happen to equilibrium when there is an increase in tax?
a. If the government keeps money supply constant?
LM curve stay the same IS curve shift down hence equilibrium r and Y decrease.
b. If the government wants to keep interest rate constant?
The government should decrease money supply. This shifts both the IS and LM curve
inward. Hence it greatly reduces Y greatly as compared to A.
c. If the government holds the income level constant?
Here the government should increase the money supply, the LM curve shifts out and the
IS curve shifts down. This will lead to a reduction in the equilibrium interest rate

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