In this chapter, you will learn…

10
CHAPTER
 the IS curve, and its relation to
Aggregate Demand I:  the Keynesian cross
Building the IS -LM Model  the LM curve, and its relation to
 the theory of liquidity preference
 how the IS-LM model determines income and
MACROECONOMICS SIXTH EDITION
the interest rate in the short run when P is fixed

N. GREGORY MANKIW
PowerPoint® Slides by Ron Cronovich
© 2007 Worth Publishers, all rights reserved CHAPTER 10 Aggregate Demand I slide 1

Context Context
 Chapter 9 introduced the model of aggregate
demand and aggregate supply.  This chapter develops the IS-LM model,
the basis of the aggregate demand curve.
 Long run
 prices flexible  We focus on the short run and assume the price
 output determined by factors of production & level is fixed (so, SRAS curve is horizontal).
technology
 unemployment equals its natural rate
 This chapter (and chapter 11) focus on the
closed-economy case.
 Short run Chapter 12 presents the open-economy case.
 prices fixed
 output determined by aggregate demand
 unemployment negatively related to output
CHAPTER 10 Aggregate Demand I slide 2 CHAPTER 10 Aggregate Demand I slide 3

The Keynesian Cross Elements of the Keynesian Cross

 A simple closed economy model in which income consumption function: C = C (Y ! T )
is determined by expenditure. govt policy variables: G = G , T =T
(due to J.M. Keynes)
for now, planned
 Notation: investment is exogenous: I =I
I = planned investment
E = C + I + G = planned expenditure planned expenditure: E = C (Y ! T ) + I + G
Y = real GDP = actual expenditure
equilibrium condition:
 Difference between actual & planned expenditure actual expenditure = planned expenditure
= unplanned inventory investment
Y = E
CHAPTER 10 Aggregate Demand I slide 4 CHAPTER 10 Aggregate Demand I slide 5

1
 Graphing planned expenditure Graphing the equilibrium condition

E E E =Y

planned E =C +I + G planned

expenditure expenditure
MPC
1

45º

income, output, Y income, output, Y

CHAPTER 10 Aggregate Demand I slide 6 CHAPTER 10 Aggregate Demand I slide 7

The equilibrium value of income An increase in government purchases

E Y
E E =Y

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

…so firms
increase output,
income, output, Y and income Y
rises toward a
Equilibrium new equilibrium. E1 = Y 1 ΔY E2 = Y 2
income
CHAPTER 10 Aggregate Demand I slide 8 CHAPTER 10 Aggregate Demand I slide 9

Solving for Δ Y The government purchases multiplier

Y = C + I + G equilibrium condition Definition: the increase in income resulting from a
$1 increase in G.
!Y = !C + !I + !G in changes
In this model, the govt !Y 1
= !C + !G because I exogenous =
purchases multiplier equals !G 1 " MPC
= MPC ! "Y + "G because ΔC = MPC ΔY
Example: If MPC = 0.8, then
Collect terms with ΔY Solve for ΔY : An increase in G
on the left side of the !Y 1
equals sign: ! 1 " = = 5 causes income to
#Y = % !G 1 " 0.8
& $ #G increase 5 times
(1 ! MPC) " #Y = #G ( 1 ' MPC ) as much!

CHAPTER 10 Aggregate Demand I slide 10 CHAPTER 10 Aggregate Demand I slide 11

2
 Why the multiplier is greater than 1 An increase in taxes
E Y
 Initially, the increase in G causes an equal increase

=
Initially, the tax E
increase reduces E =C1 +I + G
in Y: ΔY = ΔG.
consumption, and E =C2 +I + G
 But ↑Y ⇒ ↑C therefore E:

⇒ further ↑Y At Y1, there is now

ΔC = −MPC ΔT
⇒ further ↑C an unplanned
inventory buildup…
…so firms
⇒ further ↑Y reduce output,
 So the final impact on income is much bigger than and income Y
the initial ΔG.
falls toward a
E2 = Y 2 ΔY E1 = Y 1
new equilibrium

CHAPTER 10 Aggregate Demand I slide 12 CHAPTER 10 Aggregate Demand I slide 13

Solving for Δ Y The tax multiplier

eq’m condition in
!Y = !C + !I + !G def: the change in income resulting from
changes
a $1 increase in T :
= !C I and G exogenous
!Y " MPC
=
= MPC ! ("Y # "T ) !T 1 " MPC

Solving for ΔY : (1 ! MPC) " #Y = ! MPC " #T If MPC = 0.8, then the tax multiplier equals

!Y " 0.8 " 0.8

Final result: ! # MPC " = = = "4
$Y = & ' % $T !T 1 " 0.8 0.2
( 1 # MPC )

CHAPTER 10 Aggregate Demand I slide 14 CHAPTER 10 Aggregate Demand I slide 15

The tax multiplier Exercise:

…is negative:
A tax increase reduces C,  Use a graph of the Keynesian cross
which reduces income. to show the effects of an increase in planned
investment on the equilibrium level of
…is greater than one
(in absolute value):
income/output.
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 10 Aggregate Demand I slide 16 CHAPTER 10 Aggregate Demand I slide 17

3
 The IS curve Deriving the IS curve
E E =Y E = C +I (r )+G
2
def: a graph of all combinations of r and Y that
↓r ⇒ ↑I E = C +I (r1 )+G
result in goods market equilibrium
i.e. actual expenditure (output) ⇒ ↑E ΔI
= planned expenditure
⇒ ↑Y Y1 Y2 Y
r
The equation for the IS curve is:
r1

Y = C(Y " T ) + I(r) + G r2

IS
Y1 Y2 Y

CHAPTER 10 Aggregate Demand I slide 18 CHAPTER 10 Aggregate Demand I slide 19

!

Fiscal Policy and the IS curve Shifting the IS curve: ΔG

E E =Y E = C +I (r )+G
At any value of r, ↑ 1 2
 We can use the IS-LM model to see G ⇒ ↑E ⇒ ↑Y E = C +I (r1 )+G1
how fiscal policy (G and T ) affects
…so the IS curve
aggregate demand and output.
shifts to the right.
 Let’s start by using the Keynesian cross Y1 Y2 Y
The horizontal r
to see how fiscal policy shifts the IS curve…
distance of the
r1
IS shift equals
1 ΔY
!Y = !G IS2
1" MPC IS1
Y1 Y2 Y

CHAPTER 10 Aggregate Demand I slide 22 CHAPTER 10 Aggregate Demand I slide 23

The Theory of Liquidity Preference Money supply

r
 Due to John Maynard Keynes. The supply of interest (M P)
s

real money rate

 A simple theory in which the interest rate
balances
is determined by money supply and
is fixed:
money demand.

( M P )s = M P

M/P
M P real money
balances

CHAPTER 10 Aggregate Demand I

! CHAPTER 10 Aggregate Demand I
slide 25 slide 26

4
 Money demand Equilibrium
r r
s s
Demand for interest (M P) The interest interest (M P)
real money rate rate adjusts rate
balances: to equate the
supply and
demand for
money: r1
( M )d = L(r)
P L (r ) M P = L (r ) L (r )

M/P M/P
M P real money
M P real money
balances balances
! CHAPTER 10 Aggregate Demand I CHAPTER 10 Aggregate Demand I
slide 27 slide 28

CASE STUDY:
How the Fed raises the interest rate Monetary Tightening & Interest Rates
r  Late 1970s: π > 10%
interest
To increase r, rate  Oct 1979: Fed Chairman Paul Volcker
Fed reduces M
announces that monetary policy
r2 would aim to reduce inflation
r1  Aug 1979-April 1980:
Fed reduces M/P 8.0%
L (r )
 Jan 1983: π = 3.7%
M/P
M2 M1 real money How do you think this policy change
P P balances
would affect nominal interest rates?
CHAPTER 10 Aggregate Demand I slide 29 CHAPTER 10 Aggregate Demand I slide 30

Monetary Tightening & Rates, cont.

The LM curve
The effects of a monetary tightening
on nominal interest rates
Now let’s put Y back into the money demand
short run long run function:
( M P ) = L(r,Y )
d
Quantity theory,
Liquidity preference
model Fisher effect
(Keynesian)
(Classical)
The LM curve is a graph of all combinations of
r and Y that equate the supply and demand for
prices sticky flexible real money balances.
prediction Δi > 0 Δi < 0
! equation for the LM curve is:
The
M
actual
outcome
8/1979: i = 10.4% 8/1979: i = 10.4%
P = L(r,Y )
4/1980: i = 15.8% 1/1983: i = 8.2%
CHAPTER 10 Aggregate Demand I slide 32

5
 Deriving the LM curve Why the LM curve is upward sloping
(a) The market for
(b) The LM curve
real money balances  An increase in income raises money demand.
r r
 Since the supply of real balances is fixed, there
LM
is now excess demand in the money market at
r2 r2 the initial interest rate.

L (r , Y2 )  The interest rate must rise to restore equilibrium

r1 r1 in the money market.
L (r , Y1 )

M1 M/P Y1 Y2 Y
P
CHAPTER 10 Aggregate Demand I slide 33 CHAPTER 10 Aggregate Demand I slide 34

How ΔM shifts the LM curve Exercise: Shifting the LM curve

(a) The market for
(b) The LM curve
real money balances  Suppose a wave of credit card fraud causes
r r LM2 consumers to use cash more frequently in
transactions.
LM1
 Use the liquidity preference model
r2 r2
to show how these events shift the
LM curve.
r1 r1
L (r , Y1 )

M2 M1 M/P Y1 Y
P P
CHAPTER 10 Aggregate Demand I slide 35 CHAPTER 10 Aggregate Demand I slide 36

The short-run equilibrium The Big Picture

The short-run equilibrium is r Keynesian IS
the combination of r and Y Cross curve
LM
that simultaneously satisfies IS-LM
model Explanation
the equilibrium conditions in Theory of LM of short-run
Liquidity curve fluctuations
the goods & money markets: Preference
Agg.
Y = C(Y " T ) + I(r) + G IS demand
curve Model of
Y
M Agg.
P = L(r,Y ) Equilibrium
interest Equilibrium Agg.
Demand
and Agg.
level of supply
rate Supply
income curve
!
CHAPTER 10 Aggregate Demand I slide 37 CHAPTER 10 Aggregate Demand I slide 38

6
 Preview of Chapter 11 Chapter Summary

In Chapter 11, we will Keynesian cross

 use the IS-LM model to analyze the impact of  basic model of income determination
policies and shocks.  takes fiscal policy & investment as exogenous
 learn how the aggregate demand curve comes  fiscal policy has a multiplier effect on income.
from IS-LM. IS curve
 use the IS-LM and AD-AS models together to  comes from Keynesian cross when planned
analyze the short-run and long-run effects of investment depends negatively on interest rate
shocks.  shows all combinations of r and Y
 use our models to learn about the that equate planned expenditure with
actual expenditure on goods & services
Great Depression.
CHAPTER 10 Aggregate Demand I slide 39 CHAPTER 10 Aggregate Demand I slide 40

Chapter Summary Chapter Summary

Theory of Liquidity Preference IS-LM model

 basic model of interest rate determination  Intersection of IS and LM curves shows the unique
 takes money supply & price level as exogenous point (Y, r ) that satisfies equilibrium in both the
 an increase in the money supply lowers the interest goods and money markets.
rate
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

CHAPTER 10 Aggregate Demand I slide 41 CHAPTER 10 Aggregate Demand I slide 42