CHAPTERTHREE

AGGREGATEDEMANDINTHECLOSEDECONOMY
Thepr imar yobjectiv
eoft hissect i
onoft hecour seistodev elopat heoreti
calmodelwhi chwi l
l
i
mpr ov
eourunder standi
ngoft heeconomyi nt heshort-
run,especi all
yshort-
runfluct
uat ions,
orbusi nesscy cles( whichi soneoft womaj orar easofst udyinmacr oeconomicswi tht he
otherbei ngeconomi cgrowt h),andwhi chwecanusef orashor trunanal ysi
sofchangest hat
affecttheaggr egat eeconomy .Economi st
swantt ounderstandv ariousthingssuchaswhat
couldcausebusi nesscy cl
es,how busi nesscy cleswork,whatar et heeconomi ceffect sof
businesscy cl
es,whatar et hei mpactofgov ernmentpolici
esont heaggr egateeconomy ,and
how dochangesi nt heprivatesect oraf f
ectt heaggregateeconomy .Thismacroeconomi c
modelwi llusethet hreedistinctt ypesofmar kets:Goodsmar ket
s,Fact ormarketsandAsset
mar kets.Thef i
rstst eptodev el opi
ngourmacr oeconomicmodeli nv olvesmodelingaggr egat e
demand, orthetot aldemandf orallgoodsandser v i
cesproducedinaneconomy .

Aggregatedemand( AD)isther el
ationshi
pbetweent hequant it
yofout putdemandedandt he
aggregatepricelevel
.Inot herwor ds,theaggregat edemandcur vet el
lsust hequantit
yof
goodsandser vi
cespeoplewantt obuyatanygi venl evelofpr i
ces.I tisthet otalamountof
goodsdemandedi nt heeconomy .Thecomponent sofaggr egatedemandar eConsumpt ion
(C)
,Investment(I)
,Governmentexpendi tur
e(G)andNetexpor ts(NX) .Thus, AD=C+I+G+NX.
ThisADcanbedet erminedbymonet ar
yandf i
scalpol i
cyoft hegover nment ,thegenerall
evel
ofincomeoft hepeople,l
evelofeconomi cactivi
tiesi ntheot hercount ry,levelofeconomi c
acti
vit
iesintheeconomyi tsel
f,andt heavai
labi
li
tyofcr edi
t.Sincewear econsi deri
ngthecase
ofclosedeconomy–aneconomywhi chisnott radingwi thot hercount ries–t henat i
onal
i
ncomeaccount i
ngidenti
tyforclosedeconomyi sr epresentedasAD=C+I+G.

3.
1Foundat
ionsofTheor
yofAggr
egat
eDemand
Ofalltheeconomi cfluctuati
onsinwor l
dhistory,t
heonet hatst
andsoutaspar ticularl
ylarge,
painf
ul,andi ntel
lectuall
ysignif
icantistheGr eatDepressionoft he1930s.Dur ingt hi
st i
me,
manycount ri
es exper i
enced massi ve unemploymentand gr eat lyr educed incomes.Thi s
devastat
ingepi sodecausedmanyeconomi st
st oquest ionthev alidi
tyofcl assicaleconomi c
theor
y.Cl assicaltheoryseemedi ncapableofexpl ai
ningt heDepr ession.Accor dingt othat
theor
y,nat i
onalincomedependsonf actorsuppliesandt heav ailablet echnol
ogy ,neitherof
whichchangedsubst antial
lyfr
om 1929t o1933( duri
ngt heGreatDepr ession).

Aftert heonsetoft heDepr ession,manyeconomi stsbel i

evedt hatanewmodelwasneededt o
expl ainsuchal ar
geandsuddeneconomi cdownt ur
nandt osuggestgov ernmentpol i
ciesthat
mightr educet heeconomi char dshipsomanypeopl ef aced.Key nesianeconomi csisthev i
ew,
and t hev ar
ioust heor i
esaboutwhy ,i
nt heshor tr un (and especiall
ydur ing r
ecessions)
economi cout putisst r
onglyinfluencedbyaggr egatedemand( t
otalspendingintheeconomy ).
Int heKey nesianv iew,aggr egatedemanddoesnotnecessar i
lyequalthepr oducti
vecapaci t
y
oft heeconomy ;instead,i tisi nfl
uenced bya hostoff actor
sand somet i
mesbehav es
erratically,affecti
ngpr oduct i
on,empl oyment,andi nflati
on.Thet heori
esf or
mi ngthebasi sof
Key nesi aneconomi csweref ir
stpr esent
edbyt heBr i
tisheconomi stJohnMay nardKey nesin
hisbook,“ TheGener alTheoryofEmpl oyment,InterestandMoney ”,publ
ishedi n1936,dur i
ng
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he GreatDepressi
on.Keynes cont
rast
ed hi
sappr
oach t
othe aggr
egat
e suppl
y-
focused
'
cl
assi
cal'
economicsthatpr
ecededhi
sbook.

Key nesr ev oluti

oni zedeconomi cswi thhi sbook“ TheGener alTheor yofEmpl oy ment ,Int
erest,
andMoney ”
.Hepr oposedanew wayt oanal yzet heeconomy ,whi chhepr esent edasan
alt
er nativet ocl assicaltheor y.Hi sv isionofhowt heeconomywor ksqui cklybecameacent er
ofcont rov ersy.Yet ,aseconomi stsdebat edTheGener alTheor y,anew under standingof
economi cf l
uctuat i
onsgr adual lydev eloped.Key nespr oposedt hatl ow aggr egat edemandi s
responsi bl ef ort helowi ncomeandhi ghunempl oy mentthatchar acteri
zeeconomi cdownt urns.
Hecr i
ti
cizedcl assicalt heoryf orassumi ngt hataggregat esuppl yal one—capi t
al,labor ,and
technol ogy —det ermi nesnat i
onali ncome.Ast oKey nes,aneconomy ’
st otali ncomei s,inthe
shor trun, determi nedl argelybyt hedesi retospendbyhousehol ds, f
irms, andt hegov ernment .
Themor epeopl ewantt ospend,t hemor egoodsandser vicesf i
rmscansel l.Themor efir
ms
cansel l
, themor eout putt heywi l
lchooset oproduceandt hemor ewor ker st heywi llchooset o
hire.Thus,t he pr oblem dur ing r ecessi ons and depr essions,accor ding t o Key nes,was
i
nadequat espendi ng.Key nesians,t her efore,advocateanact iv
est abilizationpol i
cyt or educe
theampl itudeoft hebusi nesscy cle,whi chtheyr ankamongt hemostser i
ousofeconomi c
probl ems.Accor dingt ot het heor y,gov ernmentspendi ngcanbeusedt oi ncr easeaggr egate
demand,t husi ncreasi ngeconomi cact ivi
ty,reducingunempl oymentandi nflation.Thi sisthe
foundat ionsf orthet heor yofaggr egat edemand.Pol i
cymaker sar oundt hewor lddebat edhow
bestt oi ncr easeaggr egatedemandandputt heireconomi esont her oadt or ecov ery.

Economi ststodayr econcil

et hese t wo v i
ewswi t
ht he modelofaggr egate demand and
aggregatesupply.Inthelongrun, pr
icesar eflexi
ble,andaggr egat
esupplydeterminesi
ncome.
Butintheshor trun,pri
cesaresticky, sochangesi naggregatedemandi nfl
uenceincome.Over
l
ongper iodsoft i
me,pr i
cesareflexible,t heaggregat esupplycurveisvert
ical
,andchangesin
aggregatedemandaf fectt
hepr i
cel ev elbutnotout put.Ov ershortperi
odsoftime,pri
cesare
sti
cky,theaggr egatesupplycur vei sf lat,andchangesi naggr egat
edemanddoaf f
ectthe
economy ’soutputofgoodsandser vices.

Inthischapt
erandt henext
,weconti
nueourstudyofeconomi cfl
uctuat
ionsbylooki
ngmore
closel
yataggr egatedemand.Ourgoalistoidenti
fyt hevari
abl
esthatshif
ttheaggregat
e
demandcur ve,causi
ngfl
uctuat
ionsi
nnati
onalincome.Weal soexaminemor ef
ullyt
hetool
s
policy
makerscanuset oinfl
uenceaggr
egatedemand.Wecanseet hatt hegover
nmentcan
i
nf l
uenceaggregatedemandwit
hbothmonetaryandfiscalpol
i
cy.

Themodelofaggr egat
edemandgoi ngtobedev elopedinthi
schapt er,call
edtheI S–LM
model ,
istheleadi
ngi nt
erpr
etat
ionofKeynes’
st heory
.Theaim ofthemodel ,t
heI S-
LM model,
whichisamodelofAD,i stoshowwhatdet ermi nesnati
onali
ncomef oragi v
enpr i
celevelor
equival
entlyatshowingwhatcausest heaggregatedemandcur v
et oshift
.Thus,wecanv i
ew
theIS–LM modelasshowi ngwhatcausesincomet ochangeintheshor trunwhent heprice
l
evelisfixedbecauseallpri
cesaresti
cky.Or,
wecanv i
ewthemodelasshowi ngwhatcauses
theaggregatedemandcur vetoshif
t.

The t
wo par
ts oft
he I
S–LM modelar
ethe I
S cur
ve and t
he LM cur
ve.I
S st
ands f
or
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nvestment’
’ and“savi
ng,
’’
andtheIScur verepr
esent swhat’
sgoi ngoni nthemar ketforgoods
andser vi
ces.LM st andsfor“li
quidi
ty’
’and“ money ,’
’andt heLM cur ver epresentswhat ’
s
happeningtot hesupplyanddemandf ormoney .Becauset hei nter
estratei nfluencesboth
i
nvestmentandmoneydemand, i
tisthev ar
iabl
et hatli
nksthetwohal vesoft heI S–LM model.
Themodelshowshow i nter
acti
onsbet weent hegoodsandmoneymar ketsdet erminethe
posit
ionandsl opeoftheaggregatedemandcur v
eand, theref
ore, t
helevelofnat ionalincome
i
nt heshortrun.

3.
2TheGoodsMar
ketandt
heI
SCur
ve

TheIScurveplotsther
elati
onshi
pbet weent
hei nt
erestrateandthel
evelofincomet hatar
ises
i
nt hemarketforgoodsandser v
ices.Todevel
opt hi
srelati
onshi
p,westartwithabasicmodel
call
edtheKeynesiancr
oss.Thismodel i
sthesimplestinter
pret
ati
onofKey nes’
stheoryofhow
nati
onalincomei sdeterminedandi sabui l
dingblockf orthemorecompl exandr eal
isti
c
IS–LM model.

TheKey nesianCross
InTheGener alTheoryKey nespr oposedt hataneconomy ’
stotalincomewas, intheshor trun,
determinedlargel
ybyt hespendi ngplansofhousehol ds,businesses,andgov ernment .The
mor epeoplewantt ospend,t hemor egoodsandser vi
cesf i
rmscansel l.Themor ef i
rmscan
sel
l,themoreout puttheywillchooset oproduceandt hemor ewor kerstheywil
lchooset ohi r
e.
Keynes believed thatt he problem dur ing recessi
ons and depr essi
ons was i nadequate
spending.TheKey nesi
ancr ossi sanat temptt omodelt hisinsight.Theder i
vationoft he
Keynesiancr ossbeginsbydr awi ngadi stincti
onbetweenact ualandpl annedexpenditure.It
rel
atesplannedexpendi t
uretoact ualexpendi t
ure.

Act
ualexpendi
tur
eist
heamounthousehol
ds,f
ir
msandt
hegov
ernmentspendongoodsand
ser
vicesandi
tequal
stheeconomy
’sgr
ossdomest
icpr
oduct(
income,
Y).
ActualExpendi
ture(
AE)=C( Y–T)+I+Δinv+G;
Wher eYi sincome( GDP),C i
sconsumpti
on,Ii
splannedinvest
ment ,Δi
nvi
sunexpect
ed
(undesir
ed)changesi
ninvent
ori
es,
TistaxesandGi
sgovernmentpurchase.
Graphical
ly,
AE=Y

450
Y

Pl
annedexpendi
tur
eist
heamounthousehol
ds,
fir
ms,
andt
hegov
ernmentwoul
dli
ket
ospend
on goods and ser
vices.Itexcludes t
he unexpect
ed (undesi
red)changes i
ni nventor
ies.
Assuming thatthe economyi s cl
osed,so thatnetexports are zer
o,we writ
e planned
expendi
tur
e PE as t he sum ofconsumpt i
on C,planned invest
mentI ,and government
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PE=C+I+G.
Nextwe wi l
lassume t
hataggr
egat
e consumpti
on i
saf unct
ion ofdi
sposableincome.
Disposablei
ncomeequal
stot
ali
ncome(Y)lesst
axes(
T)andtheconsumpt
ionfunct
ionwoul
d
bewr i
ttenas:
C=C( Y−T)
Tokeepthi
ngssi
mple,
fornowwetakepl
annedinvest
mentasexogenousl
yfixed:
Fi
nal
ly,
weassumethatfi
scal
pol
i
cy—thel
evelsofgovernmentpur
chasesandtaxes—ar
efi
xed:
G= , T=T.
Combi
ningt
heseequat
ions,
weobt
ainaggr
egat
epl
annedexpendi
tur
ecur
ve
PE=C( Y−T)+I+ .
Thisequati
onshowst hatplannedexpendi
tur
eisaf
unct
ionofi
ncomeY,t
hel
evelofpl
anned
i
nvestmentI,andthefi
scalpoli
cyvar
iabl
esGandT.
Graphi
call
ythisr
elat
ionshi
plooksli
ke,

PE
PE=C(
Y−T)+I+G.

MPC MPC=dC/
d(Y–T)
$1

Y
Pl
annedExpendi
tur
easaFunct
ionofI
ncome
Plannedexpendi t
uredependsoni ncomebecausehi gherincomeleadstohi
gherconsumpt ion,
whichi spartofplannedexpendit
ure.ThePEl i
neslopesupwar dbecausehi
gherincomel eads
to higherconsumpt ion and t
hushi gherplanned expendit
ure.Theslopeoft hisplanned-
expenditur
ef unct
ionr el
ati
ngPEandYi sthemar ginalpr
opensit
ytoconsume,MPC:i tshows
howmuchpl annedexpendi t
urei
ncreaseswheni ncomer i
sesby$1.

 Thi
splannedexpendi
tur
efunct
ioni
sthef
ir
stpi
eceoft
hemodelcal
l
edt
heKey
nesi
an
cr
oss.

Whywoul dactualexpendi t
ureeverdif
ferfrom plannedexpenditur
e?Theansweri st hatf ir
ms
mightengagei n unplanned i
nventor
yi nvestmentbecauset hei
rsal esdo notmeett heir
expectati
ons.Whenf i
rmssel ll
essofthei
rpr oductthantheyplanned,t
hei rstockofinvent ories
automat i
call
yrises;conv er
sely
,whenf i
rmssel lmor ethanplanned,theirst ockofinvent ories
fal
ls.Becauset heseunpl annedchangesi ninventoryarecountedasi nvest mentspendi ngby
fi
rms,act ualexpenditurecanbeei t
herabov eorbel owplannedexpendi ture.Youshouldnot e
thatactualexpenditureequalsincome(Y),becauseanyunsol dgoodsar edef i
nedasi nvent ory
i
nv est
ment ,butpl anned expendit
ure may notequali ncome.Forexampl e,f i
rms and
householdsmaypur chasemor egoodsandser vicesthanar eproducedi nay ear,sot hat
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nvent
ori
esarer
undown.I
nthi
scase,PE>Y.AE>PEwhenev erΔinv
>0;AE<PEwhenev
er
Δi
nv<0;and,
whenΔi
nv=0,AE=PE–t heeconomyi
sinequi
l
ibr
ium.

ThesecondpieceoftheKey
nesiancrossist
heassumpt i
onthattheeconomyisi
nequil
i
bri
um
whenactualexpendi
tur
eequalsplannedexpendit
ure.Thi
sassumptionisbasedontheidea
thatwhenpeople’
splanshavebeenr eal
i
zed,theyhavenor easontochangewhattheyare
doing.

Recal
li
ngthatYasGDPequalsnotonlytot
ali
ncomebutal sot
otalact
ualexpendi
tur
eon
goodsandserv
ices,
wecanwr
it
ethi
sequi
li
bri
um condi
ti
onas

Act
ual
Expendi
tur
e=Pl
annedExpendi
tur
e

Y=PE.

The45- degreeli
neinthefi
gurebelow plot
sthepoi nt
swher ethi
sconditi
onholds.Withthe
additi
onoft hepl
anned-
expendi
tur
ef unct
ion,t
hisdiagram becomest heKeynesi
ancross.The
equil
ibri
um ofthi
seconomyisatpointA,wher etheplanned-expendi
tur
efuncti
oncrossesthe
45-degreeli
ne.

Howdoest heeconomygett otheequi l

ibr i
um?Inthi
smodel ,
invent
ori
espl ayanimportantrol
e
i
nt headj ust
mentpr ocess.Whenev ert heeconomyi snoti nequil
ibr
ium,f i
rmsexper i
ence
unplannedchangesi ninventor
ies,andt hisinducest
hem tochangeproduct i
onlev
els.Changes
i
npr oductioninturni nfl
uencet otalincomeandexpendi t
ure,mov i
ngt heeconomyt oward
equil
ibri
um.Equil
ibr
ium occur salongt hisl i
nebecausether
ei snotendencyf ori
nventori
esto
bebui l
tuportober undownandt hef ollowingdiagr
am showshowt hi
swor ks:
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 TheAdj
ust
mentt
oEqui
l
ibr
ium i
ntheKey
nesi
anCr
oss

Forexampl e, supposet heeconomyf indsi tselfwi t

hGDPatal ev elgr
eatert hant heequi l
ibr i
um
l
ev el,suchast hel evelY1 intheabov ef i
gur e.Iffir
mswer epr oducingatl evelY1,t henpl anned
expendi tureE1 woul df allshortofpr oduct i
onandf irmswoul daccumul atei nventories( fir
ms
aresel li
ngl esst hant heyar epr oduci ng) .Firmsaddt heunsol dgoodst ot heirst ockof
i
nv ent ories.Thi sinventoryaccumul ation( unplannedr iseininv entori
es)woul dinducef i
rmst o
l
ayof fwor ker sandr educepr oduction;t heseact ionsi nt urnr educeGDP.Thi spr ocessof
unintendedi nventoryaccumul ati
onandf al li
ngi ncomecont inuesunt i
lincomeYf allst ot he
equilibrium l evel.Simil
ar l
y,supposeGDPi satal ev ellowert hant heequi l
ibri
um l evel,suchas
thel ev elY2. Iffir
mswer eproduci ngatl ev elY2,t henpl annedexpendi tur eE2 woul dexceed
product i
on( Y2),andf i
rmswoul dr undownt heirinv entor
ies.i .
e.,fi
rmsmeett hehi ghl ev elof
salesbydr awingdownt hei
rinv entories.Thi sf allini nv
ent orieswouldi nducef ir
mst ohi re
mor ewor kersandr ai
sepr oduction,andt husGDPr i
ses.Inbot hcases,t hef irms’deci sions
dri
v et heeconomyt owar dequil
ibrium.

Insummar y,t
heKeynesiancrossshowshow incomeYi sdeter
minedforgi
venlevel
sof
plannedi
nvest
ment(
I)andf i
scalpol
icy
,GandT.Wecanuset hismodeltoshowhowincome
changeswhenoneoftheseexogenousvar
iabl
eschanges.

TheMult
ipli
er
Now,wewillconsi
derhow out
put(
orGDP)respondst
ochangesi
n:gov
ernmentpur
chases,
aut
onomoustaxesandaut
onomousspendi
ng(I
).

Fi
scalPol
icyandtheMulti
pli
er:Gov
ernmentPurchases
Consi
der how changes in gover
nmentpur chases aff
ectt he economy .Suppose t
hat
gover
nmentpurchaseofgoodsandserv
icesi
ncreased(expansi
onar
yf i
scalpol
icy
).

Thef
oll
owi
nggr
aphshowswhathappens:

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 AnI
ncr
easei
nGov
ernmentPur
chasesi
ntheKey
nesi
anCr
oss

Becausegov ernmentpur chasesar eonecomponentofexpendi ture,anincreasei ngovernment

purchasesofΔGr aisespl annedexpendi turebyt hatamountf oranygi venl evelofincome.I f
gov ernmentpur chasesr sebyΔG,
i thent hepl anned-expendit
ureschedul eshift
supwar dbyΔG,
asi nabov efigure.Theequi li
bri
um oft heeconomymov esf r
om poi ntAt opointBandi ncome
ri
sesf r
om Y1 toY2.Not et hatthei ncreasei nincomeΔYexceedst heincreasei ngovernment
purchasesΔG.i .e.
, ΔYi slargerthanΔG.Thei nit
iali
ncreaseingov ernmentexpendi t
urecauses
anev engr eaterincreasei nactual (
andpl anned)expendi t
ure,ori ncome, thanisf i
rsti
mpliedby
j
ustl ookingatt hei ncreasei ngov ernmentexpendi t
urealone.Thef inaleffectoft hechangein
anexogenousv ariableisamul tipleoft hei ni
ti
alchange.Thi spar t
icul
armul ti
plei scal
ledthe
gover nmentpur chasesmul ti
pli
er ,i
.e.,ther atoofΔY/ΔG;
i ittell
sushowmuchi ncomer i
sesin
responset oa$1i ncr easei ngov ernmentpur chases.Ani mplicat i
onoft heKey nesiancrossis
thatthegov ernment -purchasesmul t
ipl
ieri slargerthan1.Thus,f i
scalpol i
cyhasamul t
ipl
i
er
effectoni ncome.

I
fweconsi derachangei nGofsi zeΔG, t
henthefol
lowingsequenceofev entsoccur
s:
STEP1: I
niti
all
yEchangesbyt hechangei nG
STEP2: Next,thechangeinYcausesachangei nC—i .e.byMPC×ΔG.
STEP3: Thechangei nCcausesEandYt ochangeagainbyMPC( MPC×ΔG) .
STEP4:Theext rachangeinYcausesaf urt
herchangei nC— i .e.Cchangesbyaf urther
:
2
MPC×( MPC ×ΔG) .
STEP5: Andsoon, withthechangesinCandYget ti
ngsmal l
erwitheachst ep.
Thisprocesscont i
nuesbutt hedecreasesinconsumpt ionandthusexpendi t
ureandincome
becomesmal l
erwi t
heachr ound.Theov eral
limpactcanbecal culat
edbyaddi ngupal lthe
terms,t
hatis,
ΔY=( 1+MPC+MPC2+MPC3+... )ΔG.
Thewayt owor kthisoutistoreali
zethatthi
ssum isasi mpleinf
initegeomet r
icser
iesandso
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wecanuset
heappr
opr
iat
emat
hemat
ical
for
mul
a.Doi
ngt
hisgi
vesus:

Si
ncewehav
easi
mpl
einf
ini
tegeomet
ri
cser
iest
oadd,
andcanuset
her
elev
antmat
hemat
ical

f
ormul
a.Thet
erm, i
scal
l
edt
hegov
ernmentexpendi
tur
emul
ti
pli
erandi
tisgr
eat
er

thanonebecause0<MPC<1.
Forexample,i
fthemar
ginalpropensi
tytoconsumeis0.6,t
hemult
ipli
eris
ΔY/ΔG=1+0. 6+0. 62+0.63+...=1/( 1−0.6)=2.5.
I
nt hi
scase,aBr1.00i
ncreaseingovernmentpur
chasesrai
sesequil
i
brium i
ncomebyBr2.
50.

Fi
scalPol i
cyandt heMulti
pli
er:Taxes
Considernow how changesi ntaxesaf fectequi
li
bri
um income.Adecr easeintaxesofΔT
i
mmedi at
elyrai
sesdisposabl
ei ncome( Y–T)byΔTand,t herefor
e,incr
easesconsumpt i
onby
MPC×ΔT.Foranygi v
enlevelofi ncomeY,pl annedexpendit
ureisnowhi gher
.Asthef i
gure
bel
owshows,t heplannedexpendi tur
escheduleshift
supwar dbyMPC×ΔT.Theequi l
ibri
um
oftheeconomymov esfrom pointAt opointB.
Justasani ncr
easeingov ernmentpur chaseshasamul ti
pli
edeffectoni ncome,sodoesa
decreaseintaxes.Asbefore,theiniti
alchangeinexpendi
ture,nowMPC×ΔT, i
smulti
pli
edby
1/(1−MPC) .

Theoveralleffectonincomeoft hechangei ntaxesis

ΔY/ΔT=−MPC/( 1−MPC) .
Thi
sexpr essioni st
het axmul t
ipli
er,theamounti ncomechangesi nresponsetoa$1change
i
ntaxes.(Thenegat ivesignindicatesthatincomemov esi
nt heopposit
edir
ecti
onfrom t
axes)
.
Forexampl e,i
fthemar ginalpr
opensi tytoconsumei s0.6,t
henthetaxmulti
pli
eris
ΔY/ΔT=−0. 6/(1−0. 6)=−1.5.
I
nthisexampl e, a$1.
00cuti ntaxesr aisesequil
ibr
ium i
ncomeby$1. 50.

TheI
nter
estRat
e,I
nvest
ment
,andt
heI
SCur
ve

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Thei ncome- expendi turer elationshi p( Key nesiancr oss)i st hef i
rststepi nbui ldi
ngourmacr o
model .TheKey nesiancr ossi susef ul becausei tshowshowt hespendi ngpl ansofhousehol ds,
fi
rms,andt hegov ernmentdet ermi net heeconomy ’
si ncome.Yet ,itmakest hesi mplifying
assumpt i
ont hatt hel ev elofpl annedi nv est ment ,I,i sf ixed.I tisv eryunr eal i
sti
c,howev er,to
assumet hatpl annedi nv est menti sexogenousasi twi lldependoneconomi cv ar i
ables,t he
valuesofwhi char edet er mi ned byt heact ionsofpeopl e.Ani mpor tantmacr oeconomi c
relati
onshi pi st hatpl annedi nv estmentdependsont hei nt erestr ate,r.Thenextst epi stor elax
theassumpt ionoff ixedpl annedi nv est mentandi ncl udei ti nt heincome- expendi turemodel .
Toaddt hisr elationshi pbet weent hei nterestr ateandi nv estmentt oourmodel ,wewr i
tet he
l
ev elofpl annedi nv estmentasI=I (r).Becauset hei nter estr at eist hecostofbor rowingt o
fi
nancei nv est mentpr oject s, ani ncr easei nt hei nt
er estr at er educespl annedi nvest ment .Asa
result,thei nv estmentf unct ionsl opesdownwar d.
Todet erminehow i ncomechangeswhent hei nt erestr atechanges,wecancombi net he
i
nv est mentf unction wi tht he Key nesi an- cross di agr am.Because i nvestmenti si nversel y
relatedt ot hei nterestr at e, ani ncr easei nt hei nterestr atef rom r 1tor2r educest hequant it
yof
i
nv est mentf rom I (r
1)t oI (r2).Ther educt ioni npl annedi nv est ment ,int urn,shiftsthepl anned-
expendi t
uref unctiondownwar d,asi npanel( b)oft hef igur ebel ow.Theshi ftint hepl anned-
expendi t
uref unct ioncausest hel ev elofi ncomet of al lfrom Y1t oY2.Hence, anincr easei nt he
i
nt erestr atel ower si ncome.TheI Scur ve,showni npanel( c)oft hef igure,summar izest his
relati
onshi pbet weent hei nter estr ateandt hel ev elofi ncome.I nessence,t heI S cur ve
combi nest hei nter actionbet weenrandIexpr essedbyt hei nvest mentf unctionandt he
i
nt eract i
onbet weenIandYdemonst ratedbyt heKey nesi ancr oss.Eachpoi ntont heI Scur ve
represent sequi li
brium i nt hegoodsmar ket ,andt hecur vei ll
ust r
ateshowt heequi libri
um l ev el
ofi ncomedependsont hei nterestr ate.Becauseani ncr easei nt hei nterestr atecauses
plannedi nvest mentt of all,whi chi n- turncausesi ncomet of all
,theI Scur vesl opesdownwar d.

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 ALoanabl eFundsI nterpret
ati
onoft heISCur v
e
Wehav edevelopedt heI Scurveusingi ncomeandexpendi tureast hekeyconcept s,butit
hi
des some i mpor tanteconomi cs i
nt hinki
ng aboutt he meani ng ofthe goods mar ket
equili
bri
um whichwewi l
lnowhi ghl
i
ght.Inpar ti
cular
,ithidesthefactthatfir
mswhoar ebuy ing
i
nv estmentgoodshav etobor r
owt ofi
nancepay mentf orthem, ei
therfrom t
hemselvesorfrom
othereconomicact orssuchasbanks.Wewi l
lnowshowt hisexplici
tl
y.Inderi
vi
ngtheI Scurve
wer equi
redthatincomeequal sexpenditure,or,
Y=E
Y=C+I+ , subst
it
utingint
heter
msofexpendi
tur
e.
Now,
rear
ranget
hisbysubtr
actingCandGfr
om bot
hsides,whi
chgi
vesus,

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 Y−C− =I
.
Next
,addandsubt
ractTont
hel
efthandsi
deoft
hisexpr
essi
onwhi
chgi
vesus,
(Y−T−C)+( T− )=I .
Thet erm(Y−T–C)i ssimpl ypri
vatesavingswhilethet er
m( T–G) i
sgov er
nmentsav i
ngs.
Whatt hissaysist hatequil
ibri
um inthegoodsmar ketrequi
respai
rsofrandYt hatresultin
thesupplyofl oanabl efundsthroughsavingt oequalthedemandf orloanablefundst obuy
i
nv estmentgoods.I nt heIS-LM modelthesav i
ngsar ewhatislef
tov erfr
om consumpt i
on,
whi chisaffectedbyi ncome Y,soaggr egat esav i
ngsar efunct
ionofY.Theamountof
i
nv estmentisaf unctonofr
i .Thismeansthati nequil
ibrum Yandrneedt
i otakeonv aluesso
thatS[Y]=I [
r](thisiswher ethe‘I’andthe‘ S’comef r
om tomakeI S).Thisrel
ati
onshipi s
showni nthefoll
owi nggraph:

ALoanabl e-
FundsInterpret
ationoftheI SCurve:
Panel(a)showst hatanincr
easeini ncome
fr
om Y1 t
oY2 raisessavingandt huslowerstheinter
estratethatequil
i
brat
est hesupplyand
demandf orloanablefunds.TheI Scur veinpanel( b)expressesthi
snegativerelat
ionshi
p
betweenincomeandt heinterestr
ate.
Thi
sshouldnotsurpri
seus.I
fpeoplewanttoinv
estfort
hefut
ure,t
hent
heyhav
etof
orgo
cur
rentconsumpt
ionandequi
l
ibr
ium r
equi
rest
hetwotobeequal
.

HowFi scal Pol

icyShi f
tstheISCur ve
TheI Scurveshowsus,f oranygi v
eni nterestrate,thelevelofincomet hatbringsthegoods
marketint oequilibr
ium.Aswel earnedf rom t heKey nesiancross,t heequi li
bri
um lev
elof
i
ncomeal sodependsongov ernmentspendi ng,Gandt axes,T.TheI Scur v
ei sdrawnfora
gi
venf i
scalpolicy;thatis,whenweconst r
ucttheI Scurve,wehol dGandTf ixed.Whenf i
scal
pol
icychanges, theIScur veshif
ts.Thef oll
owingf igureusest heKeynesiancrosst oshowhow
anincreasei ngov ernmentpurchasesΔGshi ft
st heI Scurve.Thisfigureisdr awnf oragiv
en
i
nterestrateandt husforagi v
enl evelofplannedi nvestment .
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TheKey nesiancr ossi npanel( a)showst hatthi
schangei nfiscalpol i
cyraisespl anned
expendi
turet herebyincreasesequil
ibri
um incomef r
om Y1 toY2.Ther efore,i
npanel( b)
,the
i
ncreaseingov er
nmentpur chasesshif
tstheIScurveoutward.
Wecanuset heKey nesi
ancr osstoseehowot herchangesinf i
scalpol i
cyshifttheIScur ve.
Becauseadecr easei nt
axesal soexpandsexpendit
ureandi ncome,i t
,too,shif
tst heIScurve
outward(tother i
ght).Adecreaseingov er
nmentpur chasesorani ncreaseintaxesr educes
i
ncome; ther
ef ore,suchachangei nfi
scalpoli
cyshif
tstheIScurvi
ngi nwar d(t
othel eft
).

I
nsummar y,
1.TheI Scur veshowst hecombi nat
ionsoft hei nt
erestrateandt helevelofi ncomet hat
areconsist entwit
hequil
ibri
um i nthemar ketf orgoodsandser vices.
2.TheI Scur vei sdrawnforagi venfiscalpol i
cy.Changesi nf i
scalpolicyt hatraisethe
demandf orgoodsandser vicesshifttheI Scur vet otheri
ght.Changesi nfiscalpol
icy
thatreducet hedemandf orgoodsandser vicesshifttheIScurvet ot
hel eft
.
3.TheI Scurvedoesnotdet ermineei t
herincomeort heint
erestrate.I
nstead,t heIScurve
i
sar el
ati
onshi pbetweenYandrar isinginthemar ketforgoodsandser vices.
Thef ocusofattent
ionoftheI Scurveisthemar ketf orgoods:consumpti
on,investment,and
gov er
nmentpurchases.I
tisalsowor thnoti
ngthatt heI Scurv
edependsont hef
iscalpositi
on
oft hegover
nment ,
wherefiscalrel
atestogovernmentspendi ngandt axat
ion.Fi
nall
y,ifCwas
affectedbyrthenitwouldjustaddandt heref
orer einforcet
heimpactofronIwi ththebasic
resultsoft
hemodel notchanging.

3.3TheMoneyMarketandtheLM Cur
ve
TheLM cur
vepl
otsther
elati
onshi
pbetweenthei
nter
estr
ateandt
hel
evelofi
ncomet
hat

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ari
sesinthemarketformoneybalances.Tounder
standthi
srelat
ionshi
p,webegi
nbyl
ooki
ng
atatheor
yoftheint
erestr
ate,
cal
ledt hetheor
yofl
iqui
dit
ypref
erence.

TheTheor yofLi qui

dityPreference
Inhiscl assicwor k,TheGener alTheor y,Keynesof f
eredhi sview ofhow theinter
estratei s
determinedi nt heshor trun.Thatexpl anati
oni scal l
edt het heor
yofl iqui
dit
ypr ef
erence
becausei tposi tsthatt heinterestrateadjuststobal ancethesuppl yanddemandf orthe
economy ’
smostl i
quidasset—money .JustastheKey nesiancrossisabuil
dingblockfortheI S
curve,thet heoryofl i
quidi
typr efer
encei sabuildi
ngbl ockfort heLM cur
v e.Todev el
opt his
theory,
webegi nwi ththesupplyofr ealmoneybal ancesandt henweconsi derthedemandf or
realmoneybal ances.

Thesuppl
yofrealmoneybal
ances:I
fM st
andsfort
hesupplyofmoneyandPstandsforthe
pri
cel
evel
,thenM/Pisthesuppl
yofrealmoneybal
ances.Thetheor
yofli
qui
dit
ypref
erence

assumest
her
eisaf
ixedsuppl
yofr
eal
moneybal
ances.Thati
s, =

Themoneysuppl yM isanexogenouspol icyv ari

ablechosenbyacent ralbank( Nat
ionalBankof
Ethiopiainourcase) .Theamountofcur r
encyanddemanddeposi tthatconst i
tut
est hemoneysuppl y
oft heeconomyi sexogenousl ydet
erminedbyt hecent r
albank’spolicies.Thepr icelevelPisalsoan
exogenousv ar
iableinthismodel.Wet akethepr i
celevelasgivenbecauset heI S–LM model–our
ult
imat egoalint hischapter
–expl
ainstheshortr unwhent hepricelev elisfixed.Theseassumpt i
ons
i
mpl ythatt
hesuppl yofrealmoneybalancesisfixedand, i
nparti
cular,doesnotdependont heinterest
rate.Thus,whenwepl otthesuppl
yofrealmoneybal ancesagainsttheint er
estr at
eweobt ai
nav ert
ical
suppl ycurv
e.

Thedemandf orrealmoneybal
ances:Thedemandforhol
dingmoneyrel
iesonthr
eemotives:
tr
ansact
ion,pr
ecautionar
yandspecul
ati
vemoti
ves.Thetheoryofl
iqui
ditypr
efer
enceposit
s
thattheinter
estr ateisonedet erminantofhow muchmoneypeopl echooset ohol d.The
reasonisthattheinterestr
ateist heoppor t
unit
ycostofhol dingmoney:itiswhaty ouforgoby
holdi
ngsomeofy ourassetssuchasmoney ,whi chdoesnotbeari nterest,insteadofas
i
nterest
-beari
ngbankdeposi tsorbonds( speculat
ivemot iv
e).Whent hei nterestr at
er i
ses,
peoplewantt ohol dlessoftheirweal t
hi nthef orm ofmoney .Wecanwr itethedemandf or
d
realmoneybal ancesas( M/P) =L( r),wheret hef uncti
onL( r
)showst hatt hequant it
yof
moneydemandeddependsont heinterestrate.Thus,t hedemandcur vesl opesdownwar d
becausehigherint
er estrat
esreducet hequant i
tyofreal moneybal
ancesdemanded.

Equili
bri
um intheMoneyMar ket:Equili
brium inthemoneymar ketoccur
swhent hequanti
tyof
realmoneybal ancesdemanded equal st hei
rsupply.Accordi
ng tothet heor
yofl i
quidit
y
pref
erence,thesuppl yanddemandf orr ealmoneybal ancesdetermi
newhati nter
estr at
e
prevai
lsintheeconomy .Thatis,theinterestrateadj
uststoequil
ibr
atethemoneymar ket.As
the fi
gure shows,att he equil
ibri
um i nterestrat
e,the quanti
tyofr ealmoneybal ances
demandedequal sthequanti
tysupplied.

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The Theory ofLi qui
dity Preference The suppl
y and demand f orrealmoney bal ances
determinetheint
erestrate.Thesuppl ycurveforr
ealmoneybal ancesisvert
icalbecausethe
supplydoesnotdependont hei nter
estrat
e.Thedemandcur veisdownwar dslopingbecause
ahigherint
erestr
ateraisesthecostofhol dingmoneyandthuslower st
hequant i
tydemanded.
Att heequil
ibr
ium int
erestrate,thequant i
tyofrealmoneybal ancesdemandedequal sthe
quantit
ysuppli
ed

 Howdoest heinter estrategett ot hi

sequi l
ibri
um ofmoneysuppl yandmoneydemand?
Theadj ust mentoccur sbecausewhenev erthemoneymar ketisnoti nequi li
bri
um, peopletryto
adjustthei rportf
ol i
osofasset sand,i nthepr ocess,altert hei nterestrate.Forinstance,ifthe
i
nterestr at eisabov et heequi li
brium l evel
,thequant ityofr ealmoneybal ancessuppl i
ed
exceedst hequant it
ydemanded.I ndivi
dualshol dingtheexcesssuppl yofmoneyt r ytoconv ert
someoft heirnon-interest -
bearingmoneyi nt
oi nter
est-bear i
ngbankdeposi tsorbonds.Banks
andbondi ssuers,whopr efertopayl oweri nterestrates,r espondt ot hisexcesssuppl yof
moneybyl oweri
ngt hei nterestratest heyof fer.Conv ersely,ift heinterestrateisbel ow the
equil
ibrium l evel
,sot hatt hequant i
tyofmoneydemandedexceedst hequant it
ysuppl ied,
i
ndividualst r
ytoobt ainmoneybysel l
ingbondsormaki ngbankwi thdrawals.Toat tr
actnow-
scarcerf unds,banksandbondi ssuersr espondbyi ncreasi ngt hei nterestrat
est heyof fer.
Eventual l
y,theinterestr ater eachest heequi l
i
brium level,atwhi chpeopl ear econtentwi ththeir
portf
oliosofmonet aryandnon- monet aryassets.

Havingseenhowt heint erestrat

ei sdetermined,wecanuset hetheoryofl i
quidi
typr eference
toshow how t hei nt
erestr at
er espondst ochangesi nthesupplyofmoney .Suppose,f or
i
nstance,thatthecent ralbanksuddenl ydecreasesthemoneysupply.Af alli
nM r educesM/ P,
becausePi sf i
xedi nt hemodel .Thesuppl yofr ealmoneybalancesshi ft
st ot hel eft.The
equil
ibr
ium interestrater i
sesandt hehigherinter
estrat
emakepeopl esatisfi
edt ohol dthe
smallerquant i
tyofr ealmoneybal ances.(SeeManki w,fi
gure10.10).Theopposi tewoul d
occurifthemoneysuppl yisincr
eased.Thus, accordi
ngtothetheoryofliquidi
typr ef
er ence,a
decreaseint hemoneysuppl yraisesthei nt
erestrat
e,andani ncr
easei nt hemoneysuppl y
l
ower stheinterestrate.

I
ncome,
MoneyDemand,
andt
heLM Cur
ve

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Thedemandf orr
ealmoneybal ancesisnotonlyaf unct
ionofinterestrate;i
tisalsoaf unct
ion
ofincome.Thel evelofincomeaf fect
st hedemandf ormoney( t
hrought r
ansactionand
precauti
onar ymot i
ves)
.Wheni ncomei shigh,expendit
ureishigh,sopeopl eengagei nmor e
tr
ansactionst hatrequir
et heuseofmoney .Thus,gr eat
erincomei mpli
esgr eatermoney
demand.Wecanexpr esstheseideasbywriti
ngthemoneydemandf uncti
onas:
d
(M/P) =L( r,Y).
Thequant ityofrealmoneybal ancesdemandedi snegativ
elyrelatedt otheint
er estrat
eand
posit
ivel
yr el
atedtoincome.

Usingt het heoryofl i

quiditypr eference,wecanf i
gureoutwhathappenst otheequi l
ibr
ium
i
nterestr atewhent helev elofi ncomechanges.Forexampl e,considerwhathappensi nt he
fol
lowi ngfigurewheni ncomei ncr easesfrom Y1t oY2.Ani ncreasei nincomeshi f
tsthemoney
demandcur vet otheri
ght .Wi t
ht hesuppl yofr ealmoneybal ancesunchanged, theinterestrate
mustr i
sef rom r 1tor2toequi li
br atet hemoneymar ket.Ther efore,accordi
ngt othet heoryof
l
iquiditypr eference,higheri ncomel eadst oahi gherinterestr ate.TheLM cur v
epl otst hi s
rel
ationshipbet weenthel ev elofi ncomeandt heinterestrate.Thehi gherthelevelofi ncome,
thehi ghert hedemandf orr ealmoneybal ances,andt hehighert heequili
bri
um interestrat e.
Forthisr eason, theLM cur veslopesupwar d,asshowni npanel (b).

Der i
vi
ngtheLM Curve:Panel(a)showsthemar ketforrealmoneybal ances:anincreasein
i
ncomef r
om Y1toY2rai
sest hedemandformoneyandt husr aisestheint
erestratefr
om r1to
r2.Panel(
b)showstheLM cur vesummarizi
ngthisrelat
ionshipbet weentheinterestr
ateand
i
ncome:t hehighert
helevelofincome,
thehighertheinterestrate.

HowMonet aryPolicyShiftstheLM Curve

TheLM cur vetel
lsust hei nt
erestrat
et hatequili
bratest hemoneymar ketatanyl ev
elof
i
ncome.Yet ,
aswesawear l
i
er,theequi
li
brium i
nterestrateal sodependsont hesupplyofreal
moneybalancesM/ P.Thismeanst hattheLM cur v
ei sdr awnf oragivensupplyofrealmoney
bal
ances.Ifrealmoneybal anceschange—f orexampl e,ift hecentralbankalter
sthemoney
suppl
y—theLM cur veshifts.Wecanuset hetheoryofl iquidit
ypreferencetounderst
andhow
monetar
ypol icyshift
st heLM cur ve.Supposet hatt hecent r
albankdecr easesthemoney

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suppl
yfrom M1toM2,whichcausest
hesuppl
yofr ealmoneybal
ancest
ofal
lfr
om M1/
Pto
M2/P.Thefi
gur
ethatf
oll
owsshowswhathappens.

AReduct i
oni ntheMoneySuppl yShi
ftstheLM CurveUpwar d:Hol di
ngconstanttheamount
ofincomeandt husthedemandcur veforrealmoneybalances,weseet hatar educt
ioni
nthe
supplyofrealmoneybal ancesi
npanel(a)rai
sestheint
erestratethatequi
li
bratesthemoney
mar ket
.Hence,adecreaseinthemoneysupplyinpanel(
b)shiftstheLM cur
veupwar d.

I
nsummar y,
1.TheLM cur veshowst hecombi nat
ionsoft heinter
estrateandt hel evelofi ncomet hati
s
consistentwithequili
bri
um int hemar ketf orrealmoneybal ances.
2.TheLM cur veisdr awnforagi vensuppl yofrealmoneybal ances.Decr easesint hesuppl
y
ofrealmoneybal ancesshifttheLM cur veupwar d.Incr
easesi nt hesuppl yofr ealmoney
balancesshifttheLM curvedownwar d.
3.TheLM cur vebyi t
sel
fdoesnotdet er mineei t
herincomeort hei nterestratethatwill
prevailint
heeconomy.Li ketheI Scur ve,theLM curveshowsonl yar elati
onshipbetween
theset woendogenousvar i
ables.
4.TheI SandLM cur vestogetherdet ermi netheeconomy’ sequi l
i
brium.

3.4TheShor t-
runEquili
brium
Wenowhav eallthepiecesoftheI S–LM model .Thetwoequat ionsoft hi
smodelare;
Y=C( Y−T)+I (r
)+G……………………………I S,
M/ P=L( r,
Y) ………………………………………. .LM.
Themodelt akesf i
scalpoli
cy,GandT,monet arypolcyM,
i andt hepricel
evelPasexogenous.
Giventheseexogenousv ari
ables,theIScurv eprovi
dest hecombi nat
ionsofrandYt hatsat
isf
y
theequationr epr
esentingthegoodsmar ket[Y=C( Y–T)+I+G] ,andtheLM curveprovi
desthe
combinationsofrandYt hatsatisfytheequat ionrepresent
ingt hemoneymar ket[M/P=L( r,
Y)]
.Theset wocur v
esar eshownt ogetherinthef ol
l
owingf i
gure.

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Theequili
bri
um oftheeconomyi sthepointatwhicht
heI Scur
v eandtheLM curvecross.Thi
s
pointgiv
estheinterestr at
eandt helevelofincomethatsati
sfycondit
ionsforequil
ibr
ium i
n
boththegoodsmar ketandt hemoneymar ket.Inotherwords,atthisint
ersect
ion,actual
expendit
ureequal
spl annedexpendit
ure,andthedemandf orrealmoneybalancesequal st
he
supply.

Ourultimategoali ndev el
opingt heIS–LM modelist o anal
yzeshort
-r
unf l
uctuat
ionsin
economicact i
vi
ty.Int hischapter,
wedev el
opedtheKeynesi
ancrossandthetheoryofl
iquidi
ty
pref
erenceasbui ldingbl ocksf ortheIS–LM model.Asweseel at
ermor eful
ly
,theI S–LM
modelhel psexplaint heposi t
ionandsl opeoftheaggregatedemandcurve.Theaggr egate
demandcur v
e,intur n,isapi eceoft hemodelofaggregatesupplyandaggregatedemand,
whicheconomi st
suset oexplaintheshort-
runeff
ect
sofpol i
cychangesandothereventson
nati
onalincome.(
Seef igure10.14onManki w).

ExplainingFluctuationswi t
ht heIS–LM Model
Thei ntersect
ionoft heI Scur v
eandt heLM cur v
edet er
minest helevelofnat ionalincome.
Whenoneoft hesecur v esshi ft
s,theshor t
-r
unequi li
bri
um oft heeconomychangesand
nati
onali ncomef luctuates.Int hissect
ionweexami nehowchangesi npol i
cycancauset hese
curvest oshiftt
her ebyaffectYandr .
1.Changesi nFiscalPol icy:Webegi nbyexami ni
nghowchangesi nfiscalpolicy(government
purchasesandt axes)al tert heeconomy ’
sshor t-
runequili
bri
um.Thesei nfl
uencepl anned
expenditureandt her ebyshi fttheIScurve.Thef oll
owingfi
gureill
ust
ratest hisusingthecase
ofani ncreaseinGbyΔG.

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Thegov ernment -pur chasesmul t
ipl
ierint heKey nesi ancrosst ell
sust hat ,atanygi veni nterest
rat
e,t hischangei nf iscalpol icyr aisest helevelofi ncomebyΔG/ (1−MPC) .Ther eforet heI S
curveshi ft
st other ightbyt hisamount .Theequi librium oftheeconomymov esf rom poi ntAt o
pointB.Thei ncreasei ngov ernmentpur chasesr ai sesbot hincomeandt hei nterestr ate.When
the gov ernmenti ncreasesi t
spur chasesofgoodsand ser vices,t he economy ’spl anned
expendi turer i
ses.Thei ncreasei nplannedexpendi turestimulatest hepr oduct i
onofgoodsand
services,whi chcausest otali ncomeYt or i
se.Theseef fectsshoul dbef ami liarf rom t he
Keynesi ancr oss.
Now,consi dert hemoneymar ket,asdescr i
bedbyt hetheor yofl i
quiditypr ef erence.Because
theeconomy ’
sdemandf ormoneydependsoni ncome,t herisei ntotali ncomei ncreasest he
quant it
yofmoneydemandedatev eryinter
estr ate.Thesuppl yofmoney ,howev er,hasnot
changedsohi ghermoneydemandcausest heequi l
ibr
ium interestr atert or ise.Thehi gher
i
nter estratear isingi nthemoneymar ket,inturn,hasconsequencesbacki nt hegoodsmar ket
.
Whent hei nterestr ater i
ses,f i
rmscutbackont hei ri
nvestmentpl ans.Thi sf allininv estment
partiall
yof fsetst heexpansi onaryef f
ectoft hei ncr easei ngov ernmentpur chases.Thus,t he
i
ncr easei nincomei nr esponset oaf i
scalexpansi onissmal lerintheI S–LM modelt hani tisin
theKey nesiancr oss( wher einv estmenti sassumedt obef ixed)becauset hei ncreasei nGhas
causedt he“ crowdi ngout ”ofsomepl annedinv est mentduet oahi gheri nterestr ate.

Int heIS–LM model ,changesi ntaxesaf fectt heeconomymucht hesameaschangesi n

gov er
nmentpur chases do,exceptt hatt axes af fectexpendi t
uret hrough consumpt i
on.
Consider,forinstance, adecr easeintaxesofΔT.Thet axcutencour agesconsumer stospend
mor eand,t herefore,increasesplannedexpendi tur
e.Thet axmul ti
pli
erintheKey nesi
ancr oss
tell
sust hat,atanygi veni nt
erestrate,thischangei npol i
cyraisesthelev elofincomebyΔT
×MPC/ (
1-MPC) .
Ther efore,theIScur veshift
st ot her ightbythisamount .Thet axcutr ai
ses
bothi ncomeandt hei nterestrate.Onceagai n,becauset hehi gherinterestratedepr esses
i
nv estment,thei ncreasei nincomei ssmal l
erint heI S–LM modelt haniti sintheKey nesian
cross.(Forthis,seeonManki w,fi
gure11. 2).
Fiscalpoli
cyismor eef fecti
veatinfl
uenci ngnationalincomei f
:
o TheLM cur veisf latt
er–l esssensi ti
vedemandf orrealmoneybal ancest ochangei n
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 i
ncome, and
o TheIScur vei
sst eeper_ t
heMPC andt
heshi
fti
ntheI
Scur
vear
elar
ger
&thel
ess
sensi
ti
veItochangeinr.

2.Changesi nMonet aryPol icy :Wenowexami net heef fect sofmonet arypoli
cy.Achangei n
themoneysuppl yalterst hei nter estr atet hatequi l
ibratest hemoneymar ketforanygi venl ev el
ofincomeand,t hereby ,shiftst heLM cur ve.TheI S–LM modelshowshow ashi ftint heLM
curveaffect sincomeandt hei nter estr at e.Let ’sconsi derani ncreasei nmoneysuppl y.An
i
ncreasei nM l eadst oani ncr easei nr ealmoneybal ancesM/ P,becauset hepricel ev elPi s
fi
xedi nt heshor trun.Thet heor yofl iqui di
typr eferenceshowst hatf oranygi venl evelof
i
ncome,ani ncreasei nr ealmoneybal ancesl eadst oal oweri nter
estr ate.Therefore,t heLM
curveshiftsdownwar dasdepi ct edi nManki w( figure11. 3) .Theequi l
i
brium mov esf r
om poi nt
At opointB.Thei ncreasei nt hemoneysuppl ylower sthei nterestr ateandr ai
sest hel ev elof
i
ncome.Whent hecent ralbanki ncr easest hesuppl yofmoney ,peopl ehav emor emoneyt han
theywantt ohol datt hepr ev ail
ingi nter estr ate.Asar esul t,theyst artdepositi
ngt hisext ra
moneyi nbanksorusei ttobuybonds.Thei nt erestr atert henf all
sunt i
lpeoplearewi lli
ngt o
holdalltheext ramoneyt hatt hecent ralbankhascr eated;t hisbr i
ngst hemoneymar kett oa
new equilibri
um.Thel oweri nt erestr ate,i ntur n,hasr ami fi
cat i
onsf orthegoodsmar ket .A
l
oweri nter estr ate stimul ates pl anned i nvest ment ,whi ch i ncreases pl anned expendi ture,
producti
on, andi ncome.TheI S–LM modelshowst hatani ncr easei nt hemoneysuppl yl ower s
theint
erestr ate,whi chst imul atesi nvest mentandt herebyexpandst hedemandf orgoodsand
servi
ces-apr ocesscal l
edt hemonet aryt ransmi ssionmechani sm.

Monet arypol icyi smor eeffect iveati nf l

uenci ngnat ional i
ncomei f:
o TheI Scur vei sf l
atter–t hel argert heMPC&mor esensi tiveinv estmentt ochangei n
i
nterestr ate,
o TheLM cur vei ssteeper–l esssensi tivedemandf orr ealmoneybal ancest ochangei n
i
nterestr ate.
TheI nteract i
onbet weenMonet aryandFi scal Policies
Whenanal yzi
nganychangei nmonet ar yorf iscalpol i
cy ,i
ti si mpor tanttokeepi nmi ndthatthe
poli
cy maker swhocont rolt hesepol icyt ool sar eawar eofwhatt heot herpol i
cymaker sar e
doing.Achangei nonepol i
cy ,theref ore,mayi nfluencet heot her ,andt hisinterdependence
mayal tert hei mpactofapol icychange.Forexampl e,supposegov ernmentwer etor ai
set axes.
Whatef fectshoul dt hispol icyhav eont heeconomy ?Accor di ngt ot heI S–LM model ,the
answerdependsonhow t hecent ralbankr espondst ot het axi ncrease.Thef igurebel ow
showst hreeoft hemanypossi bl eout comes.
 I npanel( a),thecent ralbankhol dst hemoneysuppl yconst ant.Thet axi ncreaseshi ft
s
theI Scur vetot helef t.Incomef all
s( becausehi ghert axesr educeconsumerspendi ng),
andt hei nterestratef alls( becausel oweri ncomer educest hedemandf ormoney ).The
fallini ncomei ndi
cat est hatt het axhi kecausesar ecessi on.
 I npanel( b) ,t
hecent r albankwant st ohol dt hei nterestr ateconst ant.Inthiscase, when
thet axi ncreaseshi ftst heI S cur vet ot hel eft,thecent ralbankmustdecr easet he
moneysuppl yt okeept hei nterestr ateati t
sor igi
nall evel .Thisf allinthemoneysuppl y
shi ftstheLM cur veupwar d( tot helef t)
.Thei nterestr atedoesnotf al
l,butincomef all
s
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 byal argeramountt hani ft hecent ralbankhadhel dthemoneysuppl yconst ant .
Wher easi npanel( a)thel oweri nterestr atest i
mulatedi nvestmentandpar ti
all
yof fset
theCont racti
onaryef f
ectoft het axhi ke,inpanel( b)t hecent r
albankdeepenst he
recessionbykeepi ngt heinterestrat ehigh.
 Inpanel( c),
thecent ralbankwant st opr ev entthetaxincreasef rom lower
ingincome.I t
must ,theref
or e,r
aiset hemoneysuppl yandshi f
ttheLM cur vedownwar denought o
offsettheshiftintheI Scur ve.Inthiscase, thetaxincreasedoesnotcausear ecession,
buti tdoescauseal argef allinthei nt erestrate.Althought hel evelofi
ncomei snot
changed, thecombi nationofat axi ncreaseandamonet aryexpansi ondoeschanget he
all
ocationoft heeconomy ’sr esources.Thehi ghertaxesdepr essconsumption,whi l
e
theloweri nt
erestratest i
mul atesinv estment .I
ncomei snotaf fectedbecausetheset wo
effectsexactlybalance.

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From thisexample,wecanseet hattheimpactofachangei nf i
scalpoli
cydependsont he
policythecentr
albankpursues–t hati
s,onwhetherithol
dst hemoneysuppl y,t
heinter
est
rate,orthelevelofincomeconstant.Moregeneral
ly
,whenev eranalyzi
ngachangei none
policy,
wemustmakeanassumpt i
onaboutitsef
fectontheotherpoli
cy.Themostappropri
ate
assumpt i
ondependsont hecaseathandandthemanypol i
ti
calconsiderat
ionst
hatli
ebehind
economi cpol
icymaki
ng.

3.5From theIS–LM Modelt ot heAggr egateDemandCur ve

Wehav ebeenusi ngtheI S–LM modelt oexplainnationali ncomei ntheshor trunwhent he
pri
celevelisfixed.Toseehowt heI S–LM modelf i
tsintot hemodelofaggr egatesupplyand
aggregatedemand,wenow exami newhathappensi nt heI S–LM modeli ft hepr i
celevelis
all
owedt ochange.Aswaspr omi sedwhenwebeganourst udyoft hismodel, theIS–LM model
provi
desat heorytoexplai
nt heposi t
ionandsl opeoft heaggr egatedemandcur ve.
Theaggr egat
edemandcur v
edescr ibesar elati
onshipbet weent hepr i
celevelandt helevelof
nati
onalincome.Weuset heI S–LM modelt oshowwhynat ionalincomef all
sast hepri
celev el
ri
ses–t hatis,whyt heaggregatedemandcur v eisdownwar dsl oping.Weal soexami newhat
causestheaggr egatedemandcur vetoshi f
t.
Toexplainwhyt heaggregatedemandcur vesl opesdownwar d,weexami newhathappensi n
theIS–LM modelwhent hepr i
celevel changes.Thisisdonei nt hefoll
owingfigure.

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Foranygi venmoneysuppl yM,ahi gherpr i
cel evelP reducest hesuppl yofr ealmoney
balancesM/ P.A l owersuppl yofr ealmoneybal ancesshi f
tst heLM cur veupwar d,whi ch
rai
sest heequi l
i
brium interestr ateandl owerstheequi li
bri
um lev elofincome,asshowni n
panel( a).Her ethepr i
cel evelr i
sesf om P1t
r oP2,andi ncomef all
sf rom Y1toY2.Theaggr egate
demandcur veinpanel( b)pl otst hi
snegat i
verelati
onshipbet weennat i
onalincomeandt he
pri
cel ev el.Inotherwor ds,t heaggr egatedemandcur veshowst hesetofequi libri
um poi nts
thatarisei nt heIS–LM modelaswevar ythepri
cel evelandseewhathappenst oi ncome.
Whatcausest heaggr egat edemandcur v
etoshift?Becauset heaggr egatedemandcur veis
mer elyasummar yofr esultsf rom theI S–LM model ,eventsthatshi f
ttheIScur veort heLM
curve( foragi venpr i
cel evel)causet heaggregatedemandcur v etoshift.Fori nstance,an
i
ncr easei nt hemoneysuppl yr aisesincomei ntheI S–LM modelf oranygi v
enpr i
cel evel;i
t
thusshi ftst heaggr egatedemandcur vet otheri
ght ,asshowni npanel( a)oft hef i
gur ethat
foll
ows. (i.
e.M  LM shiftsrightrIYateachval ueofP).

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Simi
lar
ly,anincr
easei ngovernmentpur chasesoradecr easeint
axesr ai
sesincomei nt heIS-
LM modelf oragivenpr i
celev el
;ital
soshi ft
stheaggr egatedemandcur vet other i
ght ,as
showninpanel(b).(Fori
nstance,TCI Sshi
ft
storightYateachvalueofP).Conversely,a
decr
easei nthemoneysuppl y ,adecreasei ngover
nmentpur chases,oranincreasei nt axes
l
owersincomei ntheIS–LM modelandshi ft
stheaggregatedemandcur vetotheleft
.

Wecansummar
izet
heser
esul
tsasf
olows:Achangei
l nincomei
ntheI
S–LM modelr
esul
ti
ng
fr
om achangeint
hepri
celevelr
epr
esentsamovementalongtheaggregat
edemandcurve.A
changei
nincomeint
heIS–LM modelforafi
xedpr
icel
evelrepr
esent
sashifti
ntheaggr
egate
demandcurve.

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