UNB ECON 3023 Textbook: MACROECONOMICS Sixth Edition, by Mankiw, Scarth and

Lam

UNIVERSITY OF NEW BRUNSWICK

FALL 2020

ECON 3023 FR01A

INTERMEDIATE MACROECONOMICS

INSTRUCTOR: DR. RAJENDRA CHAINI

TEXTBOOK : MACROECONOMICS CANADIAN EDITION (SIXTH EDITION)

AUTHORS : MANKIW, SCARTH AND LAM
ALTERNATE TEXTBOOK : MACROECONOMICS CANADIAN EDITION (FIFTH EDITION)
AUTHORS : N. GREGORY MANKIW AND WILLIAM M.. SCARTH
UNB ECON 3023 Textbook: MACROECONOMICS Sixth Edition, by Mankiw, Scarth and Lam

CHAPTER 11

AGGREGATE DEMAND I
BUILDING THE IS-LM MODEL
 UNB ECON 3023 Textbook: MACROECONOMICS Sixth Edition, by Mankiw, Scarth and Lam

THE GENERAL THEORY AND

AGGREGATE DEMAND
• The classical theory we learned could not explain the onset of the great Depression of 1930s. The
need for a new theory was realised that may explain the reasons leading to the event and that may
help identify appropriate policies to bring the economy back on track.
• In 1936, John Maynard Keynes proposed The General Theory of Employment, Interest, and Money
• Keynes proposed that low aggregate demand is responsible to low income and high
unemployment, contrast to relying on the classical theory that proposes aggregate supply alone, i.e.
supply of capital, labour and technology determines the national income.
 UNB ECON 3023 Textbook: MACROECONOMICS Sixth Edition, by Mankiw, Scarth and Lam

SALIENT FEATURES OF CHAPTER 11

 Using the Keynesian General Theory, try to understand the economic fluctuations from the
perspectives of Aggregate Demand
 Identify the variables that shift the AD curve leading to fluctuation in national income
 Examine the tools policy makers can use to address the economic fluctuation by influencing the
AD curve.
 Ch. 10 presented the AD derived from the quantity theory of money, and shifting the AD curve
by changing the money supply
 Chapter 11 shows how the AD curve can be influenced by both monetary and fiscal policies.
 UNB ECON 3023 Textbook: MACROECONOMICS Sixth Edition, by Mankiw, Scarth and Lam

SHIFT IN AGGREGATE DEMAND AND IS-LM MODEL

 For a given price level, the national income Price Level, P Shift in Aggregate Demand
changes |(fluctuates) because of change in 2826
24
Aggregate Demand 22
20

 The IS-LM model takes the price level as 18

16

given and shows what causes the change in

14
12
10 AD3
Income, Y 8
6 AD2
4 AD1
2
Output, Income, Y
0 Y1 Y2 Y3
0 2 4 6 8 10 12 14 16
 UNB ECON 3023 Textbook: MACROECONOMICS Sixth Edition, by Mankiw, Scarth and Lam

THE IS – LM MODEL
• The IS – LM Model uses
• The IS Curve known as the Investment and Savings Curve that represents the activities in the
market for goods and services
• The LM Curve, known as the Liquidity and Money Curve that represents what happens to the
supply and demand of money
• The interest rate, r as the link between the IS and LM curve as Interest Rate, r influences both
investment and money demand
 UNB ECON 3023 Textbook: MACROECONOMICS Sixth Edition, by Mankiw, Scarth and Lam

THE GOODS MARKET AND THE IS CURVE

• The IS curve presents the relationship between the level of income generated by the market
for goods and services, Y and the interest rate, r
• The model development starts from the Keynesian Cross
• The Keynesian Theory presents a strong relationship between the National Income and the
planned spending by the households C, by the governments G, and by the businesses I in
short run,
• Higher spending represents higher level of sale of Goods and Services or higher level of
Output and higher level of employment.
 UNB ECON 3023 Textbook: MACROECONOMICS Sixth Edition, by Mankiw, Scarth and Lam

THE GOODS MARKET AND THE IS CURVE

THE KEYNESIAN CROSS
Planned Expenditure as a Function of Incoe
3
•  Planned Expenditure Expenditure
2.5

PE = C+G+I
2

Keeping the Tax, Investment , and 1.5

Government Spending as Constant, 1

We have, 0.5
45o
Income
0
PE = C(Y-)+ + 0 0.5 1 1.5 2 2.5 3
 UNB ECON 3023 Textbook: MACROECONOMICS Sixth Edition, by Mankiw, Scarth and Lam

THE ECONOMY IN EQUILIBRIUM: THE KEYNESIAN CROSS

Planned Expenditure as a Function of Income Planned Expenditure as a Function of Income
3 3
PE
Expenditure MPC = 1 Expenditure
2.5 2.5 MPC = 1.2/2 = 0.6
MPC
2 2 slope = MPC

1.5
$1
1.5

1 1

0.5
0.5
Income Income
0
0
0 0.5 1 1.5 2 2.5 3
0 0.5 1 1.5 2 2.5 3
Planned Expenditure = Actual Expenditure at all Income Planned Expenditure = Actual Expenditure at only, Income level 2
UNB ECON 3023 Textbook: MACROECONOMICS Sixth Edition, by Mankiw, Scarth and Lam

FISCAL POLICY AND THE MULTIPLIER

GOVERNMENT EXPENDITURE MULTIPLIER
Shift in Output Due to Increase in Giovernment
 • For a change in government expenditure, ΔG, the change in the
Output, Y will by (1/(1-mpc), i.e. ΔY = ΔG × {1/(1-mpc)} 3 Expenditure
2.5
For, ΔG = 0.2, ΔY = 0.2 × {1/(1-0.6)} 2.5 MPC = slope of the PE curve = 0.6
Or, ΔY = 0.2 ×1/0.4) = 0.2 ×2.5 = 0.5 2

mpc is the marginal propensity to consume 2

1.5
For, an initial consumption, = 0.8 (autonomous consumption),
output, 1
ΔG PE1 = Y1 PE2 = Y2
0.8
Y = 0.8 /0.4 = 0.8 ×2.5 = 2.0 and 0.5 ΔY=0.5
for = 1, Y = 1/0.4 = 2.5 , 0
0 0.5 1 1.5 2 2.5 3
thus ΔY for ΔG ( = 0.2, ΔY = 0.5
 UNB ECON 3023 Textbook: MACROECONOMICS Sixth Edition, by Mankiw, Scarth and Lam

FISCAL POLICY AND THE MULTIPLIER: TAX MULTIPLIER

• For a change in government taxes, ΔT, the change in the Shift in Output Due to Increase in Giovernment
Output, Y will by 3 Expenditure
2.5
- mpc / (1-mpc)
2.5 MPC = slope of the PE curve = 0.6
i.e. ΔY = ΔT × {-mpc /(1-mpc)}
2
When tax increases, ΔT is positive, and thus, ΔY decreases 2
1.5
When tax decreases, ΔT is –ve and thus, ΔY increases
3( < PE2 = Y2
For the same change in Income, ΔY , mpc×-ΔT
1

0.8
-mpc×ΔT need the be same as ΔG. Thus, for 0.5 change in 0.5 ΔY=0.5
Income,
0
0 0.5 1 1.5 2 2.5 3
tax cut need to be 0.333 (i.e. ΔT = 0.333)
 UNB ECON 3023 Textbook: MACROECONOMICS Sixth Edition, by Mankiw, Scarth and Lam

THE INTEREST RATE , INVESTMENT The Keyenesian Cross

AND THE IS CURVE

3
2.5
2.5

2
2
1.5

0.8

Saving and Investment in a small economy

0.5
ΔI = - 0.2
0
Real 0 0.5 1 1.5 2 2.5 3

Interest I
Rate, r 3 Real Interest The IS Curve
2.5 Rate, r
2

1.5

1
Interest Rate, r2
0.5
I ( r)
Interest Rate , ΔI = - 0.2 Y2 Y
r1
0
0 0.5 1 1.5 2 Income,
1 Y
2.5 3

0 2 4 6 8 10
UNB ECON 3023 Textbook: MACROECONOMICS Sixth Edition, by Mankiw, Scarth and Lam

SHIFT OF IS CURVE DUE TO 3

Shift in Output Due to Increase in Giovernment
Expenditure

FISCAL POLICY 2.5

• An increase in the government expenditure, ΔG will 1.5

2

shift the PE curve upwards and increases the 1

0.8
0.5
equilibrium income level. As a result, the IS curve 0

shifts rightwards maintaining the same interst 0 0.5 1 1.5 2 2.5 3

rate 3

• A decrease in the government expenditure, ΔG will

2.5

shift the PE curve downwards and decreases the 1.5

equilibrium income level. As a result, the IS curve 1

shifts leftwards maintaining the same inters rate 0.5

0
0 0.5 1 1.5 2 2.5 3