2H03

INTERMEDIATE
MACROECONOMICS

Fall-2019
Rizwan Tahir

1
AGGREGATE DEMAND I:
BUILDING THE IS–LM
MODEL

Coverage: Chapter 10

2
 LEARNING OUTCOMES

 the IS curve and its relation to:

◦ the Keynesian cross
◦ the loanable funds model
 the LM curve and its relation to:
◦ the theory of liquidity preference
 how the IS-LM model determines income and the interest rate in the short
run when P is fixed

3
 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
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 DERIVATION OF THE IS CURVE

• Definition
• Steps to derive the IS curve

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 DEFINITION

• IS stands for “Investment” and

“Saving”
• and the IS curve plots different
combinations of interest rate and level
of income at which the market for
goods & services is in equilibrium

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 THE KEYNESIAN CROSS

• How national income is determined by aggregate

expenditures, in the short run.
• Distinction between Actual Expenditures (AE) and
Planned Expenditures (PE)
• Actual expenditures (AE): firms/households/government
actually spend.
• Planned expenditure (PE): firms/households/government
would like to spend on goods and services.

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 THE KEYNESIAN CROSS

• What is the Difference between actual & planned

expenditures?
• Unplanned inventory investment
• Notion of Equilibrium:
• No unplanned changes in inventories &
• Actual Expenditures (AE) equals Planned Expenditures
(PE)

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 THE KEYNESIAN CROSS

For a closed economy

PE = C + I + G = planned expenditure
Y = real GDP = actual expenditure
• Where
• C = planned consumption expenditures

• I = planned Investment expenditures

• G = planned Govt. Expenditures

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 THE KEYNESIAN CROSS

Vertical
Intercept

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 GRAPHING PLANNED EXPENDITURE

PE
planned
expenditure

∆PE
∆Y

income, output, Y
Shifting of the PE curve:
Shifts up → if a, I or G ↑ or T ↓
ShiftsCopyright,
down → if(2014)
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a, [Modified/Edited or TTahir]:↑ Winter 11
2017
 GRAPHING THE EQUILIBRIUM
CONDITION
PE
planned PE =Y
expenditure

45º

income, output, Y

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 THE EQUILIBRIUM LEVEL OF INCOME

PE Income = expenditure
Y = PE PE =Y
Y = (a + I + G –cT) +cY

Y –cY = (a + I + G - cT)

Y(1 –c) = (a + I + G - cT)

Ye = 1/(1 – c) [a + I + G - cT]
income, output, Y
∆Ye = 1/(1 – c) [∆a + ∆I + ∆G - c∆T] Equilibrium
income
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 AN INCREASE IN PLANNED INVESTMENT
EXPENDITURES
∆Ye = 1/(1 – c) [∆a + ∆I + ∆G - c∆T]
PE
At Y1, (PE>Y) PE =C + I2 + G
there is now an
unplanned drop PE =C + I1 + G
in inventory…

I
…so firms
increase output,
and income rises Y
toward a new
equilibrium. PE1 = Y1 Y PE2 = Y2

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 PLANNED INVESTMENT EXPENDITURE
MULTIPLIER

Definition: the increase in income resulting from a

one-unit increase in I.
In this model, the investment expenditure multiplier
equals

Example: If MPC = 0.6, then

An increase in I
causes income to
increase 2.5 times
as much!
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 THE GOVERNMENT PURCHASES
MULTIPLIER

Definition: the increase in income resulting from a

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

Example: If MPC = 0.8, then

An increase in G
Y 1
  5 causes income to
G 1  0.8 increase 5 times
as much!
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 WHY THE MULTIPLIER IS GREATER THAN 1
• Suppose ΔG = 100, & MPC = 0.8
• Initially, the increase in G causes an equal increase in Y: ΔY
= ΔG = 100
• But #Y g #C (0.8* 100 = 80)
g further #Y (80)
g further #C (0.8*80= 64)
g further #Y (64)
…………..
• So the final impact on income is much bigger than the initial
ΔG.
• ΔY = 100 + 80 + 64 + …..
• ΔY = 100( 1 + 0.8 + 0.64 + …..) = 100 *[(1 / 1 – 0.8) ] =
=100* 5 = 500

• In general : ΔY = [1/(1 – c) ]ΔG 17

AN INCREASE
IN TAXES ∆Ye = 1/(1 – c) [∆a + ∆I + ∆G - c∆T]
PE
Initially, the tax
∆Ye = -c/(1 – c) [∆T] PE =C1 +I +G
increase reduces
consumption and PE =C2 +I +G
therefore PE:

ΔC = −MPC×ΔT At Y1, there is now

an unplanned
inventory
…so firms
buildup…
reduce output,
and income falls Y
toward a new
PE2 = Y2 ΔY PE1 = Y1
equilibrium
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 THE TAX MULTIPLIER

def: the change in income resulting from

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

If MPC = 0.8, then the tax multiplier equals

Y  0.8  0.8
   4
T 1  0.8 0.2

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 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.

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 STEP 2: INVESTMENT FUNCTION

•The level of planned investment as a function of real

interest rate:

I = I(r)
•Interest rate is the cost of borrowing to finance projects,
an increase in the interest rate reduces planned
investment
•As a result, investment function slopes downward

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 Investment function

r2

r1

I
I2 I1

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COMBINING INVESTMENT FUNCTION
AND KEYNESIAN CROSS
The equation for the IS curve is:

Y  C (Y  T )  I (r )  G

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 DERIVING THE IS CURVE

PE PE =Y
PE =C +I (r2 )+G
r  I PE =C +I (r1 )+G

 PE I

 Y Y1 Y2 Y
r
r1

r2
IS
Y1 Y2 Y
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FISCAL POLICY AND THE IS CURVE

• We can use the IS-LM model to see how fiscal

policy (G and T ) affects
aggregate demand and output.
• Let’s start by using the Keynesian cross to see
how fiscal policy shifts the IS curve…

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 SHIFTING THE IS CURVE:  G

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

G  PE  Y PE =C +I (r1 )+G1

…so the IS curve
shifts to the right.

The horizontal Y1 Y2 Y
r
distance of the
r1
IS shift equals
1
Y  G Y
1 MPC IS1 IS2
Y1 Y2 Y
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 SHIFTING THE IS CURVE:  T
PE =Y PE = C +I (r )+G
At any value of r, ↓T  PE 2 1

PE (by c∆T)  Y PE = C1 +I (r1 )+G

…so the IS curve

shifts to the right.

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

Y
IS1 IS2
Y1 Y2 Y
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 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

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 THE THEORY OF LIQUIDITY
PREFERENCE

• Due to John Maynard Keynes.

• A simple theory in which the interest rate is
determined by money supply and money
demand.

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 MONEY SUPPLY

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

M P M P
s

P is fixed by
assumption (short-
run), and M is an
exogenous policy M/P
variable M P real money
balances
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 MONEY DEMAND

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

M P
d
 L (r )

Here, we are
assuming the price L (r )
level is fixed,
so π = 0 and r = i. M/P
M P real money
balances
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 EQUILIBRIUM

r
M P
s
The interest interest
rate adjusts rate
to equate the
supply and
demand for
money: r1

M P  L (r ) L (r )

M/P
M P real money
balances
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 THE LM CURVE

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

M P
d
 L (r ,Y )
The LM curve is a graph of all combinations of r
and Y that equate the supply and demand for
real money balances.
The equation for the LM curve is:
M P  L (r ,Y )
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 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
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 WHY THE LM CURVE IS UPWARD
SLOPING

• An increase in income raises money demand.

• Since the supply of real balances is fixed, there
is now excess demand in the money market at
the initial interest rate.
• The interest rate must rise to restore
equilibrium in the money market.

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 HOW ΔM SHIFTS THE LM CURVE

(a) The market for

(b) The LM curve
real money balances
r r
LM2

LM1
r2 r2

r1 r1
L ( r , Y1 )

M2 M1 M/P Y1 Y
P P
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 SHIFTING THE LM CURVE
 Suppose a wave of credit card fraud causes
consumers to use cash more frequently in
transactions.
 Use the liquidity preference model to show how
these events shift the LM curve.

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 SHIFTING THE LM CURVE

(a) The market for

(b) The LM curve
real money balances
r r
LM2

LM1
r2 r2
L (r , Y1 )
r1 r1
L (r , Y1 )

M1 M/P Y1 Y
2017
P (2014) [Modified/Edited by Rizwan Tahir]: Winter
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 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
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 CHAPTER SUMMARY

1. Keynesian cross
• basic model of income determination
• takes fiscal policy & investment as exogenous
• fiscal policy has a multiplier effect on income
2. IS curve
• comes from Keynesian cross when planned
investment depends negatively on interest rate
• shows all combinations of r and Y
that equate planned expenditure with
actual expenditure on goods & services

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 CHAPTER SUMMARY

3. Theory of liquidity preference

• basic model of interest rate determination
• takes money supply & price level as exogenous
• an increase in the money supply lowers the interest
rate
4. LM curve
• comes from liquidity preference theory when
money demand depends positively on income
• shows all combinations of r and Y that equate
demand for real money balances with supply

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 CHAPTER SUMMARY

5. IS-LM model
• Intersection of IS and LM curves shows the unique
point (Y, r ) that satisfies equilibrium in both the
goods and money markets.

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