3.

1 Aggregate Demand
 3.1.1 Quantity-Adjustment vs Price-Adjustment
 The principal theme of classical price theory is:
if there is an imbalance between supply & demand in a
competitive market, then prices change to clear the
market or establish eqlm.
 Real wage flexibility equilibrates the labor sector
& the real interest rate balances output
allocation b/n I & C goods.
 Together, the eqlm labor supply & capital stock
determine the eqlm output level.
 The Keynesian real sector model takes a different
approach.
 3.1.1 Quantity-Adjustment vs Price-Adjustment
The simplest Keynesian model abstracts entirely
from price changes.
The Keynesian model explains interactions b/n
demand for goods & services, and the financial
sector.
The basic theme of the approach is that, in the
short-run, quantity adjustments occur if there is
imbalance b/n supply & demand.
The Keynesian model is an application of the
quantity adjustment paradigm:
if there is imbalance b/n supply & demand, then producers will change the quantity of output
produced.
 3.1.1 Quantity-Adjustment vs Price-Adjustment
 Clearly, both price & quantity adjustments take
place in reality.
 In the short run, a change in price is often a
costly & unreliable means of balancing sales &
production, esp. with a temporary imbalance &
a desire for rapid response.
 Thus, quantity adjustment is the primary
adjustment mechanism used to maintain sales-
production eqlm in the short run.
 In a modern economy with less emphasis on
manufacturing & greater emphasis on services
and with very rapid information flows price
changes do occur.
 3.1.1 Quantity-Adjustment vs Price-Adjustment
 Price changes are often made infrequently &
therefore the principal adjustments to supply
& demand imbalances in the short run are
quantity changes.
 The above conclusion relies upon two
characteristics of the product market:
1. it is presumed that goods can be held in inventory (true for manufactured goods).
2. some degree of product differentiation.
 Goods Market
• In the goods market we are going to look at the relationship
between the real interest rate and the level of income.
• This relationship is captured by the IS curve

CHAPTER 10
Aggregate Demand I
 Keynesian Cross
• In general theory propose that an economy total income was in
short run , determined largely by the desire to spend house
holds, firms and Gov’t.
• The more peoples want to spend ,the more goods and services
firms can sell . The more firms can sell the more output they
will choose to produce and the more worker to hire thus the
problem during recession and depression .

CHAPTER 10
Aggregate Demand I
• Keynesian cross model on the built from the concept of
planned and actual expenditure. So we have to define these
concepts before they are used to construct the model.
• Actual expenditure is the amount households, firms and
government spend on goods and services. It is equal to GDP
of an economy (Y).
• Planned expenditure is the amount households, firms and
government would like to spend on goods and services. This
implies planned expenditure is the same as aggregate demand
of closed economy.
• The income expenditure relationship (also called the
Keynesian cross model) is the first step to deriving the interest
rate/income relationship. It relates planned expenditure (E) to
actual expenditure.
• actual expenditure equals income (Y ), because any unsold
goods are defined as inventory investment, but planned
expenditure may not
 Con..
• For example, firms and households may purchase more goods
and services than are produced in a year, so that inventories
are run down.
• assume at the moment that the values of the other variables are
fixed for simplicity:

CHAPTER 10
Aggregate Demand I
Elements of the Keynesian
Cross
Consumption function: C=a+b(Y-T)

Government policy variables: G  G , T T

For now, planned
investment is exogenous: I I

Planned expenditure: E  C (Y  T )  I  G

Equilibrium condition:
actual expenditure = planned expenditure
Y  E
CHAPTER 3
Aggregate Demand I
CHAPTER 10
Aggregate Demand I
• To simplify the analysis let us assume planned investment is
exogenous (I= I ) and tax is also assumed to be fixed (T= T ).
Thus E= C(Y-T ) +I + G . Planned expenditure is a positive
function of income for a certain level of planned investment,
Government expenditure and tax. This can be represented by
upward sloping curve with MPC (marginal propensity to
consume) slope and intercept autonomous spending whereas
actual expenditure is represented by a 450 line from the origin.

CHAPTER 10
Aggregate Demand I
• Putting together planned expenditure and actual expenditure
curve we construct a Keynesian cross

CHAPTER 10
Aggregate Demand I
• In Keynesian cross model, the economy reach equilibrium
when actual expenditure equals planned expenditure (Y=AD).
It is a point when the idea of economic agents realizes. That is
where quantity demand equal to quantity of output produced.
• Any deviation from this equilibrium level causes change in
unplanned inventory investment or disinvestment (IU). It is
represents the difference between planned expenditure and
actual expenditure.
 Income-expenditure adjustment graph

CHAPTER 10
Aggregate Demand I
• If firms were producing at level Y1, then planned expenditure
E1 would fall short of production, and firms would accumulate
inventories. 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. This fall in inventories would induce
firms to raise production. In both cases, the firms’ decisions
drive the economy toward equilibrium.

CHAPTER 10
Aggregate Demand I
 The Multiplier
• What happens when an exogenous change occurs. For
example, say that government purchase of goods and services
increased (expansionary fiscal policy). The following graph
shows what happens:
 Con…
• An increase in government purchases of ΔG raises planned
expenditure by that amount for any given level of income. The
equilibrium moves from point A to point B, and income rises
from Y1 to Y2. Note that the increase in income ΔY exceeds the
increase in government purchases ΔG. Thus, fiscal policy has
a multiplied effect on income.

Aggregate
CHAPTER 10

Demand I
 Con….
•  

Aggregate
CHAPTER 10

Demand I
 multiplier is It
measures the amount of
change in income as a
result of a unit change
in government
expenditure.
G AD Y C AD Y…….

CHAPTER 10
Aggregate Demand I
 Mathematical derivation of tax and
government purchase multipliers.
• Given consumption function;
C=b(Y-T) , Where b-marginal propensity to consume Y-
income T- Tax revenue
• Y=b(Y-T) +I+G
• Totally differentiate the equilibrium condition will gives:
• Assume tax and investment spending are fixed
Rearranging ……government purchase multiplier
•  

CHAPTER 10
Aggregate Demand I
• Now assume G and I are fixed to derive tax multiplier (G and I
)
• Rearranging ……tax multiplier
• Considering the case when tax revenues are an increasing
function of income, let us drive investment and government
purchase multiplier.
-C\1-C

CHAPTER 10
Aggregate Demand I
 Y
Solving
 C  I  G
for Y
equilibrium condition

Y  C  I  G in changes

 C  G because I exogenous
because C = MPC Y
 MPC  Y  G MPC=marginal propensity to
consume.
Collect terms with Y
on the left side of the Solve for Y :
equals sign:
 1 
(1  MPC)  Y  G Y     G
 1  MPC 
CHAPTER 3 Aggregate
Demand I
 Example
• In the Keynesian cross, assume that the consumption function
is given by:
• C = 100 +0.75(Y – T). Planned investment is 200; government
purchases and taxes are both 200.
a. Graph planned expenditure as a function of
income.
b. What is the equilibrium level of income?
c. If government purchases increase to 125,
what is the new equilibrium income?
 An increase
E in taxes
Y

=
Initially, the tax E E =C1 +I +G
increase reduces
consumption, and E =C2 +I +G
therefore E:

C = MPC T At Y1, there is now

an unplanned
…so firms inventory buildup…
reduce output,
and income falls Y
toward a new E2 = Y 2 Y E1 = Y 1
equilibrium
CHAPTER 3 Aggregate
Demand I
 Solving for Y
eq’m condition in
Y  C  I  G
changes
 C I and G exogenous

 MPC   Y  T 
Solving for Y : (1  MPC)  Y   MPC  T

  MPC 
Final result: Y     T
 1  MPC 

CHAPTER 3 Aggregate
Demand I
 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

CHAPTER 3
Aggregate Demand I
 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.

CHAPTER 3
Aggregate Demand I
• IS curve that is used to represent the relationship between
interest rate and equilibrium level of output in the goods
market.
• investment spending (I) has been treated as exogenously
determined outside of the model. However investment
depends on interest rate for two main reasons. In order to
invest, firms must either borrow or use its own funds. In
either case, the cost of borrowing can be measured by interest
rate.

CHAPTER 10
Aggregate Demand I
• higher interest rate may result in lower profit by increasing
cost, and then firms willingness to borrow and to invest
decreases. Conversely, firms will borrow and invest more
when interest rate is lower.
• Thus, we can easily conclude that there is inverse relationship
between investment and interest rate.
• I=I(r), dI/dr = I’<0

CHAPTER 10
Aggregate Demand I
• I’- the slope of investment function representing the
responsiveness of investment to interest rate. If I’ is large,
then relatively small increase in interest rate general result in a
greater drop in investment spending.

CHAPTER 10
Aggregate Demand I
 How to derive IS
curve ?
• Let
  us starts by restating the aggregate demand function by
modifying investment function in such way that investment is
a function of interest rate.

CHAPTER 10
Aggregate Demand I
• Transferring the equilibrium level of income at different level
of interest rate to interest rate-–income plane gives IS
curve. IS curve is negatively sloped, reflecting the inverse
relationship between interest rate, and aggregate demand
(income).
• Its slope depends how sensitive investment to interest rate. If
investment is very sensitive to interest rate, a small change in
interest rate
•  

CHAPTER 10
Aggregate Demand I
• cause a large shift in aggregate demand and cause large
change in equilibrium income resulting in flat IS curve. If
investment is less sensitive to interest rate IS becomes
relatively steeper.

CHAPTER 10
Aggregate Demand I
 Y

E1

E2

r2

r1

IS

Y0 Y1 Out put/ income

Fig 3.10 Derivation IS curve from Keynesian cross model

CHAPTER 10
Aggregate Demand I
 Matmatical derivation of
• Y = C + I + G.
IS curve
• Substituting in for C and I we get,
• Y = a + b(Y − T) + c − dr + G.
• Grouping the Y s together and rearranging and solving for Y
we get:
Points to Note about the IS Curve:
• The IS curve is downward sloping because the coefficient on
r is negative (i.e. increases in r imply that a lower value of Y is
associated with being on the IS curve).
 Con…
• The slope of the IS curve is determined by the coefficient on r.
• If d is large (I is sensitive to r) or b is large (the MPC is large)
then the IS curve is flat.
• A large d means that an increase in r will lead to a large
decrease in I and hence a large decrease in Y. Similarly, if b is
large then an increase in expenditure will induce a large
increase in C consumption, and hence a large increase in Y .

Aggregate
CHAPTER 10

Demand I
 Fiscal policy and IS cure
• In which direction do increase in government spending or
decrease in tax cause shift in IS curve? One way of identifying
whether fiscal policy cause outward or inward shift in IS curve
is through understanding the impact of the policies on demand
using Keynesian cross model.

CHAPTER 10
Aggregate Demand I
• Suppose there is decrease in tax or increase in government
expenditure. Both changes result in increase in aggregate
demand causing upward shift in aggregate demand curve
which results in higher level of equilibrium output for fixed
level of interest rate Therefore, increase in government
purchase or decrease in tax results in outwards shift in IS
curve. On the other hand a decrease in government
expenditure or increase in tax reduces income by reducing
aggregate demand will cause IS curve to shift inward.

CHAPTER 10
Aggregate Demand I
• On the other hand a decrease in government expenditure or
increase in tax reduces income by reducing aggregate demand
will cause IS curve to shift inward.

CHAPTER 10
Aggregate Demand I
 AD

AD = C(Y-T)+I (r)+G2

AD = C(Y-T)+I(r) +G1

Interest rate

IS2

IS1

Y1 Y2 income/ Out put

Fig 3.12 shift in IS curve due to change in fiscal policy

CHAPTER 10
Aggregate Demand I
 A LOANABLE FUNDS INTERPRETATION OF THE IS
CURVE
• We have developed the IS curve using income and expenditure
as the key concepts, but it hides some important economics in
thinking about the meaning of the goods market equilibrium
which we will now highlight.
• In particular it hides the fact that firms who are buying
investment goods have to borrow to finance payment for them,
either from themselves or from other economic actors such as
banks. We will now show this explicitly. In deriving the IS
curve we required that income equals expenditure, or,
Y=E
Y=C+I+
• substituting in the terms of expenditure. Now rearrange this by
subtracting C and G from both sides, which gives us,
Y − C − = I.
• Next add and subtract T on the LHS of this expression which
Con..
• The term Y − T − C is simply private savings while the term T
− G is government savings.
• What this says is that equilibrium in the goods market requires
pairs of r an Y that result in the supply of loanable funds
through saving to equal the demand for loanable funds to buy
investment goods.
• In the IS-LM model the savings are what is left over from
consumption, which is affected by income Y, so aggregate
savings are function of Y. The amount of investment is a
function of r. This means that in equilibrium Y and r need to
take on values so that S[Y] = I[r] (this is where the ‘I’ and the
‘S’ come from to make IS).
• A Loanable-Funds Interpretation of the IS Curve Panel (a)
shows that an increase in income from Y1 to Y2 raises saving
and thus lowers the interest rate that equilibrates the supply
and demand for loanable funds. The IS curve in panel (b)
expresses this negative relationship between income and the
interest rate
 Money market and LM curve
• LM curve represent combination of interest rate, and income
associated with equilibrium in the money market.
• Equilibrium in the money market occurs where the demand
and supply of money are equal through the adjustment made
by interest rate.

CHAPTER 10
Aggregate Demand I
 Theory of liquidity
preference
• The theory of liquidity preference explains how the supply and
demand for real money balance interact to determine interest
rate prevailing in the economy.
• Demand for money
• Motives for holding money

CHAPTER 10
Aggregate Demand I
 dk ( y )
K' =  0.
dy

CHAPTER 10
Aggregate Demand I
• Secondly people hold cash as alternative form of asset by
comparing with the return obtain from the other alternative
forms. That is the demand for money depends on cost of
holding money. The cost of holding money is the interest rate
that is forgone by holding money rather than keeping in the
form of interest bearing asset such as bonds and bank deposits.

CHAPTER 10
Aggregate Demand I
 dL(r )
 L'  0
dr

CHAPTER 10
Aggregate Demand I
 Now summing up the two component of demand for money, we get the demand function for real
money balance with L’ <0 and K’>0

Md
M=  L( r)  k ( y )
P

In general functional form of demand for money might be written as:

M m m
 m  m( r, y ) Where  o, 0
p r y

CHAPTER 10
Aggregate Demand I
• demand for real balance against the interest rate for fixed level
of income. That is for fixed transaction demand, as r rises the
speculative demand falls and vice versa. Thus the demand for
money curve slope downward

CHAPTER 10
Aggregate Demand I
 Money supply

Interest rate

Figure 3.13 the theory of liquidity preference. Money demand

CHAPTER 10
Aggregate Demand I
 Real money balance
• To develop theory of liquidity preference, now consider the
supply of real money balance. If - Stand for the supply of
money and P stands for the price level then is the supply of
real money balances. The money supply is an exogenous
policy variable determined by central bank. The price level is
also exogenous or fixed since ISLM model is a short run
model.
• This implies supply of real money balance is fixed or at least
not interest rate dependent.

CHAPTER 10
Aggregate Demand I
 Equating the money demand function to exogenously fixed supply gives us the equilibrium
condition in money market which is also know as LM function.

Ms M

P P

M M
 m( r, y ) Or  L(r )  K ( y )
P P

CHAPTER 10
Aggregate Demand I
• According to theory of liquidity preference, money market
equilibrium attained through adjustment of portfolio of asset
holding. For instance, if there is excess money supply than
demanded, interest rate of the economy becomes higher than
the equilibrium level.

CHAPTER 10
Aggregate Demand I
• Hence, to adjust downward to equilibrium level, individuals
are converting excess money to interest bearing bonds and
bank deposit. On the other hand when the supply of real
balance is less than real money demand, the reverse
adjustment would happen to restore to equilibrium level.

CHAPTER 10
Aggregate Demand I
• Hence, to adjust downward to equilibrium level, individuals
are converting excess money to interest bearing bonds and
bank deposit. On the other hand when the supply of real
balance is less than real money demand, the reverse
adjustment would happen to restore to equilibrium level.

CHAPTER 10
Aggregate Demand I
 how to derive LM curve
• It is a curve which shows combination of interest rate and
income associated with money market equilibrium.
• As we have discussed before the demand for real balance is
negatively related to interest rate for fixed level of income.
The supply of real money balance is independent of interest
rate. In such set up what is the effect of increase in income
from Y1 to Y2 on equilibrium level of interest rate?

CHAPTER 10
Aggregate Demand I
 Ms

r LM

………… L( r , Y2 )

L( r , Y1 )

m
p

Income
Figure 3.14 derivation LM curve

CHAPTER 10
Aggregate Demand I
• When the income increases, expenditure of individuals also
increase since they are engage in more transaction that require
more money. Thus increase in income from Y1 to Y2 , increase
the demand for money from L(r,y1) to L(r,y2) as indicated by
outward shift in the demand .
• With the supply of real money balance remain constant, the
interest rate rise from r1 to r2 to equilibrate money market
when demand for money increases as result of increase in
income. This implies higher income resulted in higher
interest rate.

CHAPTER 10
Aggregate Demand I
• If we summarizes this relationship between interest rate and
equilibrium incomes in the money market give rise to LM
curves.

CHAPTER 10
Aggregate Demand I
 Quantity Equation and Interest
Rate
• quantity equation to derive positive relationship between
interest rate and income at money market equilibrium by
relaxing the assumption that velocity of money is constant.
• As we have seen before the demand for real money balances
depend on interest rate. That is higher interest rate raises cost
of holding money and reduces money demand.

CHAPTER 10
Aggregate Demand I
• When people respond to higher interest rate by holding less
money, each unit of money they do hold must be used often to
support a given volume of transaction. In other words the
velocity of money should increase to undertake the same
volume of transaction. This implies an increase in interest rate
result in increase in the velocity of money and therefore the
level of income.

CHAPTER 10
Aggregate Demand I
• Here like liquidity preference theory, using quantity equation
of money it is possible to establish positive relationship
between interest rate and income in money market for a given
level of money supply and price.

CHAPTER 10
Aggregate Demand I
M
=L(r) +k(y) ----LM curve
P

Differentiate money market equilibrium condition

M
0  Ldr
'
 k 'dy (Since money supply assumed to be fixed by policy d ( )  0
P
dr k '
Rearranging  '
dy L

' dr
Since K ' >0 and L < 0) > 0, that is LM curve upward sloping.
dy

CHAPTER 10
Aggregate Demand I
• LM curve would be steeper or flatter depending up on the
responsiveness of demand for money to income measured by
K’ and responsiveness of demand for money to interest rate
measured by L . That is if demand for money is highly
responsive to money ( K is large) and less responsive to
interest rate ( L is small) LM curve is steeper (K/Lhave larger /
)

CHAPTER 10
Aggregate Demand I
 Monetary policy and LM curve
• Suppose the central bank of a given country increase money
supply from M1 to M2. For constant level of income and price,
it will increase real balance causing shift in real balance curve
from Shown in figure 3.15. That is the excess supply of
money pushes the equilibrium interest rate down from r2 to r1.
Therefore, increase in money supply causes outward shift in
LM curve to the right from LM1 to LM2.

CHAPTER 10
Aggregate Demand I
 M1 M 2
LM1
P P

r LM2

r2

r1…………

Real money balance Income

Figure 3.15 Increase in money supply shift LM curve down ward to the left

CHAPTER 10
Aggregate Demand I
•  On the other hand, decrease in money supply for fixed level
of income and price, causes a reduction in real money balance
which in turn creates excess demand in money market. This
will cause interest rate to rise and clear the market. Hence
decrease in money supply causes LM curves to shift in ward to
the left.

CHAPTER 10
Aggregate Demand I
• LM curve shifted whenever there is change in money supply
for fixed level of price and income. An increase in money
supply shifts LM curve outward and a decrease in money
supply cause shift in LM curve upward to left.

CHAPTER 10
Aggregate Demand I
 The Keynesian Cross
• A simple closed economy model in which income is determined by
expenditure. ( J.M. Keynes)
• Notation:
I = planned investment
E = C + I + G = planned expenditure
Y = real GDP = actual expenditure
• Difference between actual & planned expenditure = unplanned
inventory investment

CHAPTER 3
Aggregate Demand I
 Short run equilibrium of goods and money market:
IS - LM Model

• IS curve is used to represents the equilibrium in the market for

goods and services while LM curve represent the equilibrium
in the market for real balance. Putting them together in the
same quadrant form ISLM model whose equilibrium satisfy
the equilibrium condition for the two market simultaneously
as shown in

CHAPTER 10
Aggregate Demand I
 LM
Interest

rate

IS

r Y1
Income /output

Figure 3.16 equilibrium in the ISLM model

CHAPTER 10
Aggregate Demand I
• In other words solving the two equation simultaneously we
can get a single pair of interest rate and income that satisfy
equilibrium of both money and goods market.
• When the economy is in disequilibrium, it moves toward
equilibrium through the interaction of both markets.

CHAPTER 10
Aggregate Demand I
• Once ISLM model is constructed, we use it next to see how
change in exogenous policy variables such as tax , government
spending and money supply influence equilibrium level of
output and interest rate in the short run (with the assumption
of fixed price level).

CHAPTER 10
Aggregate Demand I
 Aggregate demand and ISLM model

• Now we can derive the economy’s demand curve by varying P

and seeing what happens to the equilibrium real income level,
Y.
• Suppose there is an increase from P0 to P1, what is the impact
of such change on equilibrium level of income? The increase
in price cause real money supply to decrease from

CHAPTER 10
Aggregate Demand I
• As a result LM curve shifts to the left to new LM1 and the
equilibrium level of income and interest rate move to Y1 and r1
•  

CHAPTER 10
Aggregate Demand I
 Interest Interest Lm1
rate rate
r1

r0 r1

r2 L (r, Y)

IS

m m m
Y2 Y0 Y1 Income
p2 p0 p1
Interest
rate

AD
Figure 3.21: Derivation of demand curve form ISLM model
Income

CHAPTER 10
Aggregate Demand I
• When price level increases for whatever reasons, the real
money supply shrinks and excess demand in the money
market created. This excess demand raises interest rate,
reducing investment demand and then income.
• Thus, varying the price level produces opposite variations in
the equilibrium level of output demanded in the economy; as
price raises, Y falls and vice versa. This relationship gives the
economy’s demand curve.
•

CHAPTER 10
Aggregate Demand I
 dm mdp k ' dy
LM: dr =  
l' p2L l'

IS: dY = C’ (dY-dT) + dG+I’dr

Solving for equilibrium level of output in differential form

1  I' I 'm 
dy  c ' dT  dG  dm  2 dp 
I ' K '  L' p L' 
(1  c ') 
L'

dy dy
If we sign the expression of it has negative sign (  0 ) which Show the inverse relation
dp, dp
ship between price and income demanded.

CHAPTER 10
Aggregate Demand I
 Graphing Planned Expenditure
E

Planned E = C + I +G
expenditure
MPC
1

income, output, Y

CHAPTER 3 Aggregate
Demand I
 Graphing the equilibrium condition
E E =Y

planned

expenditure

45º

income, output, Y

CHAPTER 3 Aggregate
Demand I
The equilibrium value of
income
E E =Y

planned E = C + I +G
expenditure

income, output, Y
Equilibrium
income
CHAPTER 3 Aggregate
Demand I
 An increaseEin government purchases
Y

=
At Y1, E E =C +I +G2
there is now an
unplanned drop E =C +I +G1
in inventory…

G

…so firms
increase output,
and income Y
rises toward a
new equilibrium. E1 = Y 1 Y E2 = Y2

CHAPTER 3 Aggregate
Demand I
 Y
Solving
 C  I  G
for Y
equilibrium condition

Y  C  I  G in changes

 C  G because I exogenous
because C = MPC Y
 MPC  Y  G MPC=marginal propensity to
consume.
Collect terms with Y
on the left side of the Solve for Y :
equals sign:
 1 
(1  MPC)  Y  G Y     G
 1  MPC 
CHAPTER 3 Aggregate
Demand I
 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

Y 1 An
An increase
increase in
in G
G
  5 causes
causes income
income to
to
G 1  0.8
increase
increase 55 times
times
as
as much!
much!
CHAPTER 3
Aggregate Demand I
 Why the multiplier is greater than 1

• Initially, the increase in G causes an equal increase in Y:

Y = G.
• But Y  C
 further Y
 further C
 further Y
• So the final impact on income is much bigger than the
initial G.

CHAPTER 3 Aggregate
Demand I
 An increase
E in taxes
Y

=
Initially, the tax E E =C1 +I +G
increase reduces
consumption, and E =C2 +I +G
therefore E:

C = MPC T At Y1, there is now

an unplanned
…so firms inventory buildup…
reduce output,
and income falls Y
toward a new E2 = Y 2 Y E1 = Y 1
equilibrium
CHAPTER 3 Aggregate
Demand I
 Solving for Y
eq’m condition in
Y  C  I  G
changes
 C I and G exogenous

 MPC   Y  T 
Solving for Y : (1  MPC)  Y   MPC  T

  MPC 
Final result: Y     T
 1  MPC 

CHAPTER 3 Aggregate
Demand I
 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

CHAPTER 3
Aggregate Demand I
 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.

CHAPTER 3
Aggregate Demand I
 3.2 The goods market and
the IS curve
• The IS curve summarises the relationship between r, the level of
Y that results from the investment function and the income-
expenditure relationship.
• The IS curve displays the values of r and Y such that aggregate
planned expenditure is consistent with actual income, where
income is assumed to be derived from output produced (which is
taken as un-modelled so far).
• The curve shows the invers relation among interest are and
income in goods market.
 DerivingE the IS
E =Ycurve
E =C +I (r )+G 2

r  I E =C +I (r1 )+G

 E I

 Y Y1 Y2 Y
r
r1

r2
IS
Y1 Y2 Y

CHAPTER 3 Aggregate
Demand I
 ALGEBRA OF THE IS
•
CURVE
We know that the IS curve is just pairs of r and Y such that
income (Y ) equals planned expenditure (E), or that,
• Y = C + I + G.
• Substituting in for C and I we get,
• Y = a + b(Y − T) + c − dr + G.
• Grouping the Y s together and rearranging and solving for Y
we get:
• which is the IS curve in algebraic form.

Aggregate
CHAPTER 10

Demand I
1)  
 1   1   1   d 
Y   (a  c )   G   T   r
 1 b  1 b  1 b  1 b 

2) The IS curve is downward sloping because the coefficient on

r is negative
3) The slope of the IS curve is determined by the coefficient on
r. If d is large (I is sensitive to r) or b is large (the MPC is
large) then the IS curve is flat. A large d means that an
increase in r will lead to a large decrease in I and hence a
large decrease in Y. Similarly, if b is large then an increase in
expenditure will induce a large increase in C consumption,
and hence a large increase in Y .
• Changes in autonomous expenditure from G, T, a, or c
will shift the IS curve in or out. The sizes of these shifts
are determined by b through their impact on induced
consumption. The larger b (the MPC) then the larger the
multipliers, and the larger the shift in the IS curve.
• The government expenditure multiplier is bigger than the
taxation multiplier.
• This is because if G increases it directly increases planned
expenditure and then causes subsequent increases in C,
whereas if T decreases it only indirectly increases planned
expenditure by causing C to increase.

Aggregate
CHAPTER 10

Demand I
 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…

CHAPTER 10
Aggregate Demand I
 E =YE
ShiftingE the IS curve: G=C +I (r )+G
At any value of r, G 1 2

 E  Y E =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
Y  G IS2
1 MPC IS1
Y1 Y2 Y

CHAPTER 10
Aggregate Demand I
• This slide has two purposes. First, to show which way the IS curve
shifts when G changes. Second, to actually measure the distance of
the shift.
• We can measure either the horizontal or vertical distance of the
shift. The horizontal distance of the IS curve shift is the change in
Y required to restore goods market equilibrium AT THE INITIAL
INTEREST RATE when G is raised.

CHAPTER 3
Aggregate Demand I
• Since the interest rate is unchanged at r1, investment will also
be unchanged.
• This is why, in the upper panel, we write “I(r1)” in the E
equation for both expenditure curves – to remind us that
investment and the interest rate are not changing.

CHAPTER 10
Aggregate Demand I
 Exercise: Shifting the IS
curve
• Use the diagram of the Keynesian cross to show how an
increase in taxes shifts the IS curve.
• Use the diagram of the Keynesian cross to show how a
decrease in taxes shifts the IS curve
• Use the diagram of the Keynesian cross to show how a
decrease in government expenditure shifts the IS curve

CHAPTER 10
Aggregate Demand I
 3.3 The money market and the LM curve
• The Theory of Liquidity Preference
• A simple theory in which the interest rate
is determined by money supply and
money demand.

CHAPTER 3 Aggregate
Demand I
 Money supply
r
M P
s
The supply of interest
real money rate
balances
is fixed:

M P M P
s

We are assuming a fixed supply of real M/P

money balances because M P
real money
P is fixed by assumption (short-run), and balances
M is an exogenous policy variable.
CHAPTER 3
Aggregate Demand I
 Money demand
r
M P
s
Demand for interest
real money rate
balances:

M P
d
 L (r )

L (r )
The nominal interest rate is the
opportunity cost of holding money M/P
M P
(instead of bonds), so money demand real money
depends negatively on the nominal balances
interest rate. 3
CHAPTER
Aggregate Demand I
 Equilibrium
r
M P
s
The interest rate interest
adjusts rate
to equate the
supply and
demand for
money: r1

M P  L (r ) L (r )

M/P
M P
real money
balances
CHAPTER 10
Aggregate Demand I
 How the Fed raises the interest rate
r
interest
To increase r, Fed rate
reduces M
r2

r1
L (r )

M/P
M2 M1
real money
P P balances
CHAPTER 3
Aggregate Demand I
 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 )

CHAPTER 3
Aggregate Demand I
 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
CHAPTER 3 Aggregate
Demand I
 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.

CHAPTER 3
Aggregate Demand I
 How M shifts the LM
The market for
(a)
curve
(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
CHAPTER 10
Aggregate Demand I
• When the Fed reduces M, the vertical distance of the shift tells
us what happens to the equilibrium interest rate associated
with a given value of income.
• Or, we can think of the LM curve shifting horizontally:
• When the Fed reduces M, the horizontal distance of the shift
tells us what would have to happen to income to restore
money market equilibrium at the initial interest rate

CHAPTER 3 Aggregate
Demand I

3.1.2.2 The Money Market and the LM Curve
For the money market to be in eqlm, demand has
to equal supply: M
 kY  hr
P1 M
Solving for the interest rate: r  (kY  )
h P
dr k
Slope of the LM curve is given by: 
dY h
The LM curve is steep if (M/P)d is very responsive
to Y & less responsive to r.
The LM curve is drawn for a given (M/P)S: If
(M/P)S changes the LM curve shifts.
 Exercise: 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.

CHAPTER 10
Aggregate Demand I
 3.4 The short-run equilibrium
The short-run equilibrium is the
r
combination of r and Y that
simultaneously satisfies the equilibrium LM
conditions in the goods & money
markets:
Y  C (Y  T )  I (r )  G
Equilibrium
M P  L (r ,Y ) interest
rate IS
In other words, at this intersection,
Y
actual expenditure equals planned
expenditure, and the demand for Equilibrium
real money balances equals the level of
supply. income
CHAPTER 3
Aggregate Demand I
 Explaining Fluctuations With the IS–LM Model
•A.   How Fiscal Policy Shifts the IS Curve and Changes
the Short-Run Equilibrium

• This fall in investment partially offsets the expansionary effect

of the increase in government purchases. Thus, the increase
in income in response to a fiscal expansion is smaller in the
IS–LM model than it is in the Keynesian cross (where
investment is assumed to be fixed).
• The horizontal shift in the IS curve equals the rise in
equilibrium income in the Keynesian cross. This amount is
larger than the increase in equilibrium income here in the IS–
LM model. The difference is explained by the crowding out of
investment caused by a higher interest rate.
 Changes in Taxes In the IS–LM Model
•  
• higher interest rate depresses investment ,the increase in
income is smaller in the IS–LM model than it is in the
Keynesian cross
 How Monetary Policy Shifts the LM Curve and
Changes the Short-Run Equilibrium?
•  
 The Interaction Between Monetary and Fiscal
Policy
• When analysing any change in monetary or fiscal policy, it is
important to keep in mind that the policymakers who control
these policy tools are aware of what the other policymakers
are doing.
• A change in one policy, therefore, may influence the other, and
this interdependence may alter the impact of a policy change.
• For example, suppose house of people representative raise
taxes. What effect should this policy have on the economy?
According to the IS–LM model, the answer depends on how
the Fed responds to the tax increase.
 Case I : the NB holds the money
supply constant
•  I
• The fall in income indicates that the tax hike causes a
recession. However, the lower interest rate stimulated
investment and partially offset the contractionary effect of the
tax hik
 Case II: the Fed wants to hold the interest
rate constant.
•  
• The interest rate does not fall, but income falls by a larger
amount than if the Fed had held the money supply constant.
The national bank (NB) deepens the recession by keeping the
interest rate high.
 Case III: the NB wants to prevent the
tax increase from lowering income.
•  
• In this case, the tax increase does not cause a recession, but it
does cause a large fall in the interest rate. Although the level
of income is not changed, the combination of a tax increase
and a monetary expansion does change the allocation of the
economy’s resources.
• The higher taxes depress consumption, while the lower
interest rate stimulates investment. Income is not affected
because these two effects exactly balance.
 THE AGGREGATE DEMAND
CURVE
• The final step in constructing the AD curve is to relax the
price level which has so far been kept fixed in value in
deriving the LM curve.
• When we unfix the price level then the IS-LM model can be
used to derive the quantity of aggregate output demanded in an
economy. As an example, consider a decrease in the price level
from P1 to P2 which is shown in the following graph:
 Con…
•  
• The new equilibrium point results in a higher value of Y
and a lower value of r. Notice that the fall in r is not by
as much as you would think right at the beginning. This
is because the increase in Y partially offsets it.
• What this tells us is that lower (higher) values of P are
associated with higher (lower) values of Y, r that the AD
curve is downward sloping in P. In this case the value of
Y represents aggregate income, or the aggregate quantity
of goods and services demanded(Y d).
 A SHIFT OF THE AD CURVE
• Changes in P will cause a movement along the AD curve, as
outlined above. Changes in the exogenous variables (except P
— and we will let that vary eventually) cause shifts of the AD
curve.
• The following graph shows what happens if there is an
increase in the amount of government purchases of goods and
services (i.e. G increases).
•  
 The Big Picture
Keynesian
Keynesian IS
IS
Cross
Cross curve
curve
IS-LM
IS-LM
model Explanation
Explanation
Theory
Theory ofof model
LM
LM of
of short-run
short-run
Liquidity
Liquidity curve fluctuations
curve fluctuations
Preference
Preference
Agg.
Agg.
demand
demand
curve
curve Model
Model of
of
Agg.
Agg.
Demand
Demand
Agg.
Agg. and
and Agg.
Agg.
supply
supply Supply
Supply
curve
curve
CHAPTER 3 Aggregate
Demand I