Lect Two Ad (Is LM BP)

Type author names here
LECT TWO
AD:IS-LM-BP
© Wendy Carlin and David Soskice, 2015. All rights reserved.

The basic building blocks of aggregate demand: aggregate
demand for a closed economy
• In a closed economy aggregate demand is the
sum of 3 economic agents i.e. the households,
the business firms and the government (including
the local government).
• Areas like exchange rate, import, export, and
financial outflow are excluded in considering the
closed economy
Carlin & Soskice: Macroeconomics: Institutions, Instability, and the Financial System
• Where C is consumption at the household level, I is
investment by the business firms and G is government
expenditure.
Behavior of each of the variables in the AD Model
 Consumption: consumption depends on after tax income,
also known as disposable income.
…… (1)
 Investment: it depends on the interest rate as shown in

equation 2 or on the accelerator effect as shown by
equation 3
………………….. (2)
………………….. (3)
 Government expenditure is taken as exogenous
With …………………. (4)

•In total,
•Differentiating each function with respect to

Y;
– where Cy is the marginal propensity to consume and
hence .
– Ty is the marginal propensity to tax which is . This is

because government does not tax all additional income
or there will be no incentive to work for extra hours.
– Also , therefore < Cy (1- Ty)<1, and that is the Keynesian

stability condition, also known as the slope of the AD
– Expanding, you will get,
– Therefore, hence a positive function.

•Given
 Differentiating with respect to R,
• This shows the negative relationship between
investment and interest rate.
 Differentiating with respect to Y,
• This shows the positive relationship between

income and investment.
The product market equilibrium
• Deriving the investment-saving equation (IS)
• From
– This is Equilibrium in goods and services (product) market

which is also known as the IS (investment=savings) curve
– In simple terms,
The slope of the IS
•In deriving the slope of the IS curve. Suppose
– Writing the consumption function explicitly,
– Writing the investment function explicitly,
– Therefore,
•Taking a total derivative of equation 4,
– Making dY the subject:

– where is the multiplier
– Since change in a constant is zero,
– Hence:
– Divide both sides by to get:
– Turning equation upside down gives you
– Where and hence equation (7) which is the slope of the IS

curve is negative.
• The slope of the IS is negative and downward sloping. Why?
– A lower is associated with a higher income and a higher
is associated with a lower income.
•At a higher investment is low and since investment is a
component of AD, it brings about a lower demand for income
and AD becomes low eventually.
•Inversely, a lower , investment is high and hence demand for
income rises making AD higher. This makes the IS curve slope
downwards from left to right (i.e. have a negative relation
between income and interest rate)
What are the factors that cause the IS curve to shift over time
•These factors are going to be referred from the model
under consideration and they are;
 Autonomous investment (Io)

 Autonomous consumption (Co)
 Autonomous government expenditure (Go)
•All these form the autonomous expenditure or spending.
•The IS shifts when there is a change in any of the

autonomous expenditure
Explaining the shape of the slope of the IS curve
 Keynesians have a very steep IS curve on the assumption
that the sensitivity of investment to changes in the interest
rate is zero i.e. Ir = 0. This means investment does not
respond to changes in the interest rate. The slope of the IS
curve in this case is infinite. If the magnitude of investment
is less sensitive to interest rate, the slope of the IS
approaches infinite (i.e. has a steep slope).
 In the extreme case of a vertical IS, a change in interest

rate has no effect on investment. That is according to
the Keynesian school.
 When the IS curve is flatter, it means a small
change in interest rate has a high effect on
investment (classical and monetary schools)
 A horizontal IS curve shows that investment is
perfectly elastic to changes in interest rate. And
this is according to classical school.
Issues of the multiplier: deriving the multiplier
•Rewriting the model under consideration,
– The multiplier tells us by how much equilibrium national

income will change when there is a change in autonomous
expenditure by 1 unit. The multiplier is in terms of the change
in autonomous expenditure (i.e. )
–Therefore,
 In interpreting why the multiplier is greater 1, when autonomous
spending increases by 1 cedi equilibrium national income increases
by more than 1 cedi, holding interest rate and all other policies
constant.
 A higher or increase in the MPC, given the marginal tax rate, makes
the multiplier increase or become high.
 Therefore a bigger multiplier is as a result of higher MPC and a
smaller MTR
 A higher MTR decreases the multiplier because taxes are leakages.
 The larger the multiplier the flatter the IS and hence a small change
in the interest rate will have a large effect on output.
The money market equilibrium
•Generally, equilibrium in the money market is
established when the real money demand is the same as
the real money supply;
•Where M is nominal money stock, P is the general price

level, and is the real money balances (supply). is the real
money demand.
•In explicit form,
 Differentiating equation (3),
 This shows that MD is positively related to income and

negatively related to interest rate.
 Depending on the expected rates of interest consumers will
choose the amount of idle funds to hold.
Deriving the slope of LM
•Taking total derivative;
•At the equilibrium, is fixed and hence a change in a constant is zero
Therefore,
This implies that :
Making the subject;
•Divide both sides by to obtain the slope of the LM
curve
Determining the sign of the slope of the LM
 Evaluate the numerator and denominator by going back to

the MD theory.
 From the theory, i.e. there is a positive relationship between
MD and income
 Also, to show the negative relation between MD and interest
rate
 But due to the negative sign the entire slope becomes
positive.
 That is,
What determines the steepness or flatness of the LM curve
 There are two schools of macroeconomic thought to be considered.

 The classical/monetarist economist does not view interest rate as an
important determinant of MD since there is no interest rate in their
model. A typical classical economist draws the LM almost vertically ()
 Keynesians draw a downward sloping MD curve. The liquidity trap
(the horizontal part of the MD curve) is perfectly elastic to changes in
interest rate therefore . They argue the economy is trapped in the
liquidity trap where MD is perfectly elastic to changes in interest
rates. Monetary policy according to them does not work so the LM
curve according to Keynesians is an almost horizontal line.
 Thus, the slope of the LM curve (whether steep or flat) depends
on the sensitivity of MD to changes in income () and interest
rate (). Changes in the slope caused changes in and . When
these factors change the slope of the LM also changes
The diagram
show a floor to
interest rate and
a ceiling on the
velocity of
money
• Keynes’s theory becomes relevant if, because of a
weak inducement to invest or a high propensity to save,
equilibrium lies on the left of the LL curve, since, on the
one hand, the rate of interest is not influenced by real
factors, and, on the other, income is not affected by
changes in money supply.
• An increase in money supply cannot bring the interest
rate down any further—the LL curve shifts to the right,
but “the horizontal parts are almost the same.
Therefore Keynes’s theory is the “Economics of
Depression or a recession
What are the factors that cause a shift in the LM CURVE?
 In deriving the LM, was assumed constant

 Holding constant a change in either the nominal money supply
(M) or general price levels (P) are the factors that cause
changes in the real money supply, shifting the LM curve.
 A change in price levels holding nominal money supply
constant changes the real money supply and hence shifting
the LM curve while a change in nominal MS holding the
general price level constant changes the real money supply
and hence shifting the LM curve
Combining the IS and LM:AD
• Combine the IS and LM curves to obtain a relationship
between output and the price level.
• Given the fixed money supply a higher price level
reduces real money balances.
• Thus, for a given level of income, the interest rate at
which the quantity of money demanded equals the
supply rises.
• The LM curve therefore shifts up, and the IS and LM
curves intersect at a lower level of output than before.
This inverse relationship between the price level and
output is known as the aggregate demand curve
•Goods market equilibrium condition is given as:
•Money market equilibrium condition is given as:
•Taking a total differentiation of equation (1);
•Simplifying;
•Where,
•Therefore,
•Taking a total differentiation of equation (2);

•Simplify and make the subject;
•Substitute equation (4) into equation (3)
•Expanding;
•Grouping like terms,
•Simplifying to make the subject;
•Therefore;
•Equation (5) is the aggregate demand equation.
 The AD multiplier is the with as the crowding out effect or feedback

from the money market.
 The crowding out effect is the difference between the IS multiplier
and AD multiplier
 The crowding out term is positive since and
 The crowding out term appears in the denominator which makes the
whole denominator larger so the multiplier for the AD is smaller than
the multiplier for the IS
 There would be complete crowding out if . This makes the
multiplier expression to be equal to zero. This is according to
the monetarists.
 When there is a complete crowding out fiscal policy becomes
ineffective and hence change in government expenditure has
no effect on output.
 When is neither equal to zero nor infinity, there is still a
crowding out but not a complete crowding out.
 When and , there is said to be no crowding out. And this is
according to the Keynes
Deriving the slope of the AD function
•From equation (5);
•At equilibrium change in money supply is zero just as a change in

autonomous variables hence
•Substituting equation (6) into equation (5) and dividing both
sides by ;
•Therefore the slope will be;

(7)
Business-Cycle Fluctuation
• A shift in either the IS curve or the LM curve can
cause a business-cycle fluctuation.
• Different economic forces shift the IS and LM
curves, so the curves shift independently.
• A change in aggregate demand shifts the IS
curve but not the LM curve
• A change in the demand or supply of money or
bonds shifts the LM curve but not the IS curve.
Monetary Policy
• Policy Monetary policy is exogenous.
• With the price level taken as exogenous, the money supply sets
the position of the LM curve.
• Monetary policy has no effect on the IS curve.
• Expansionary monetary policy shifts the LM curve down.
• The money supply increases, and the interest rate falls.
• The economy moves down along the IS curve: the fall in the
interest rate raises investment demand, which has a multiplier
effect on consumption.
Fiscal Policy Fiscal
• Fiscal Policy Fiscal policy is exogenous.

• The level of government expenditure and taxation and the tax
code set the position of the IS curve.
• Fiscal policy has no direct effect on the LM curve.
• Increased government spending or a tax cut is assumed to be
financed by borrowing. The money supply does not change, so
the LM curve does not change
• Expansionary fiscal policy shifts the IS curve to the right. The
multiplier effect on consumption raises the national income and
product. The increase in the interest rate partially offsets the
expansionary effect.

Lect Two Ad (Is LM BP)

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Type author names here

© Wendy Carlin and David Soskice, 2015. All rights reserved.

 Investment: it depends on the interest rate as shown in

With …………………. (4)

•Differentiating each function with respect to

– Ty is the marginal propensity to tax which is . This is

– Also , therefore < Cy (1- Ty)<1, and that is the Keynesian

– Therefore, hence a positive function.

 Differentiating with respect to R,

 Differentiating with respect to Y,

• This shows the positive relationship between

– This is Equilibrium in goods and services (product) market

– Writing the investment function explicitly,

– Making dY the subject:

– Where and hence equation (7) which is the slope of the IS

 Autonomous investment (Io)

•The IS shifts when there is a change in any of the

 In the extreme case of a vertical IS, a change in interest

– The multiplier tells us by how much equilibrium national

•Where M is nominal money stock, P is the general price

 Differentiating equation (3),

 This shows that MD is positively related to income and

•Taking total derivative;

•At the equilibrium, is fixed and hence a change in a constant is zero

This implies that :

Making the subject;

 Evaluate the numerator and denominator by going back to

 There are two schools of macroeconomic thought to be considered.

 In deriving the LM, was assumed constant

•Money market equilibrium condition is given as:

•Taking a total differentiation of equation (1);

•Taking a total differentiation of equation (2);

•Simplifying to make the subject;

 The AD multiplier is the with as the crowding out effect or feedback

•At equilibrium change in money supply is zero just as a change in

•Therefore the slope will be;

• Fiscal Policy Fiscal policy is exogenous.

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