Context Chapter 9 introduced the model of aggregate demand and aggregate supply.

Chapter 10: Aggregate Demand I

Long run prices flexible output determined by factors of production & technology

unemployment equals its natural rate

Short run prices fixed output determined by aggregate demand unemployment negatively related to output CHAPTER 10

Aggregate Demand I

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CHAPTER 10

Aggregate Demand I

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Context

The Keynesian Cross

This chapter develops the IS-LM model,

A simple closed economy model in which income is determined by expenditure. (due to J.M. Keynes)

the basis of the aggregate demand curve.

We focus on the short run and assume the price

Notation:

level is fixed (so, (so SRAS curve is horizontal). horizontal)

I = planned investment PE = C + I + G = planned expenditure Y = real GDP = actual expenditure

This chapter (and chapter 11) focus on the closed-economy case. Chapter 12 presents the open-economy case.

Difference between actual & planned expenditure = unplanned inventory investment

CHAPTER 10

Aggregate Demand I

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Elements of the Keynesian Cross

for now, planned investment is exogenous:

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PE planned expenditure

G G , T T

govt policy variables:

Aggregate Demand I

Graphing planned expenditure

C C (Y T )

consumption function:

planned expenditure:

CHAPTER 10

PE =C +I +G

I I

MPC 1

PE C (Y T ) I G

equilibrium condition:

income, output, Y

actual expenditure = planned expenditure

Y PE CHAPTER 10

Aggregate Demand I

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CHAPTER 10

Aggregate Demand I

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The equilibrium value of income

Graphing the equilibrium condition PE

PE PE =Y

planned expenditure

PE =Y

planned expenditure

PE =C +I +G

45º income, output, Y

income, output, Y

Equilibrium income CHAPTER 10

Aggregate Demand I

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PE PE =C +I +G2 PE =C +I +G1

equilibrium condition

Y C I G

in changes

CHAPTER 10

C

G

MPC Y G Collect terms with Y on the left side of the equals sign:

Y PE1 = Y1

Y

(1 MPC) Y G

PE2 = Y2

Aggregate Demand I

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The government purchases multiplier

CHAPTER 10

because I exogenous b because C = MPC Y Solve for Y :

1 Y G 1 MPC

Aggregate Demand I

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Why the multiplier is greater than 1 Initially, the increase in G causes an equal increase

Definition: the increase in income resulting from a $1 increase in G. In this model, the govt purchases multiplier equals

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Y C I G

G …so firms increase output, and income rises toward a new equilibrium.

Aggregate Demand I

Solving for Y

An increase in government purchases At Y1, there is now an unplanned drop in inventory…

CHAPTER 10

in Y:

Y = G.

But Y C

Y 1 G 1 MPC

further Y further C

Example: If MPC = 0.8, then

Y 1 5 G 1 0.8

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Aggregate Demand I

further Y

An increase in G causes income to increase 5 times as much!

So the final impact on income is much bigger than the initial G.

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Solving for Y

An increase in taxes PE Initially, the tax increase reduces consumption, and therefore PE:

PE =C1 +I +G

C = MPC T …so firms reduce output, and income falls toward a new equilibrium CHAPTER 10

Y PE2 = Y2

Y

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CHAPTER 10

(1 MPC) Y MPC T

MPC Y T 1 MPC

Aggregate Demand I

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…is negative: A tax increase reduces C, which reduces income.

MPC 1 MPC

…is greater than one (in absolute value): A change in taxes has a multiplier effect on income.

If MPC = 0.8, then the tax multiplier equals

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The tax multiplier

def: the change in income resulting from a $1 increase in T :

Y T

Solving for Y :

Final result:

The tax multiplier

MPC Y T

PE1 = Y1

Aggregate Demand I

Y T

I and G exogenous

C

PE =C2 +I +G At Y1, there is now an unplanned inventory buildup…

eq’m condition in changes

Y C I G

…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.

0.8 0.8 4 1 0.8 0.2

Aggregate Demand I

NOW YOU TRY:

Practice with the Keynesian Cross Use a graph of the Keynesian cross to show the effects of an increase in planned investment on the equilibrium level of income/output.

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CHAPTER 10

Aggregate Demand I

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The IS curve def: a graph of all combinations of r and Y that result in goods market equilibrium i.e. actual expenditure (output) planned expenditure p =p

The equation for the IS curve is:

Y C (Y T ) I (r ) G

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Deriving the IS curve PE =Y PE =C +I (r )+G 2

PE

r

Why the IS curve is negatively sloped

A fall in the interest rate motivates firms to increase investment spending, which drives up total planned spending (PE ).

PE =C +I (r1 )+G

I PE

I

Y

To restore equilibrium in the goods market, r

Y1

Y2

Y1

Y2

output (a (a.k.a. k a actual expenditure expenditure, Y ) must increase.

Y

r1 r2

CHAPTER 10

IS

Y

Aggregate Demand I

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r

S2

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We can use the IS-LM model to see

(b) The IS curve

how fiscal policy (G and T ) affects aggregate demand and output.

r

S1

Aggregate Demand I

Fiscal Policy and the IS curve

The IS curve and the loanable funds model (a) The L.F. model

CHAPTER 10

Let’s start by using the Keynesian cross to see how fiscal policy shifts the IS curve… curve

r2

r2 r1

r1

I (r )

IS

S, I

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Y2

Y1

Y

Aggregate Demand I

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PE =Y PE =C +I (r )+G 1 2

PE

PE =C +I (r1 )+G1

G PE Y

Y

r

Y1

Shifting the IS curve: T

Use the diagram of the Keynesian cross or

Y

Y2

r1

1 G 1 MPC

Y

Y1 CHAPTER 10

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loanable funds model to show how an increase in taxes shifts the IS curve.

…so the IS curve shifts to the right. The horizontal distance of the IS shift equals

Aggregate Demand I

NOW YOU TRY:

Shifting the IS curve: G At any value of r,

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Aggregate Demand I

IS1

Y2

IS2 Y 22

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The Theory of Liquidity Preference

Money supply

Due to John Maynard Keynes. A simple theory in which the interest rate

r

The supply of real money balances is fixed:

is determined by money supply and money demand.

M

interest rate

M

P

s

P M P s

M/P

M P

CHAPTER 10

Aggregate Demand I

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Money demand

M

P

d

M

interest rate

P

s

The interest rate adjusts to equate the supply and d demand d ffor money:

L (r )

L (r ) M P

CHAPTER 10

M

P

s

r1

M/P

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L (r ) M P

CHAPTER 10

M/P real money balances

Aggregate Demand I

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CASE STUDY:

Monetary Tightening & Interest Rates

r

Late 1970s: > 10% Oct 1979: Fed Chairman Paul Volcker

interest rate

announces that monetary policy would aim to reduce inflation

r2

Aug 1979-April 1980:

r1

Fed reduces M/P 8.0%

L (r ) M2 P Aggregate Demand I

r interest rate

M P L (r )

How the Fed raises the interest rate

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real money balances

Aggregate Demand I

To increase r, Fed reduces M

Aggregate Demand I

Equilibrium r

Demand for real money balances:

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real money balances

M1 P

M/P

Jan 1983: = 3.7% How do you think this policy change would affect nominal interest rates?

real money balances 28

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Aggregate Demand I

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Monetary Tightening & Interest Rates, cont.

The LM curve

The effects of a monetary tightening on nominal interest rates

model

Now let’s put Y back into the money demand function: d

short run

long run

Liquidity preference

Quantity theory, Fisher effect

M

P

L (r ,Y )

prices

sticky

flexible

The LM curve is a graph of all combinations of r and Y that equate the supply and demand for real money balances.

prediction

i > 0

i < 0

The equation for the LM curve is:

actual outcome

8/1979: i = 10.4% 4/1980: i = 15.8%

8/1979: i = 10.4% 1/1983: i = 8.2%

(K (Keynesian) i )

(Classical)

M P L (r ,Y ) CHAPTER 10

Deriving the LM curve

r

An increase in income raises money demand. Since the supply of real balances is fixed, there

(b) The LM curve

r

is now excess demand in the money market at the initial interest rate.

LM r2

r2 L (r , Y2 )

r1

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Why the LM curve is upward sloping

(a) The market for

real money balances

Aggregate Demand I

The interest rate must rise to restore equilibrium in the money market.

r1

L (r , Y1 ) M/P

M1 P CHAPTER 10

Y1

Y

Y2

Aggregate Demand I

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r

real money balances

Suppose a wave of credit card fraud causes consumers to use cash more frequently in transactions.

LM2 LM1

r1

L (r , Y1 ) M2 P

CHAPTER 10

Use the liquidity preference model

r2

r2

M1 P

M/P

Aggregate Demand I

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Shifting the LM curve

(b) The LM curve

r

Aggregate Demand I

NOW YOU TRY:

How M shifts the LM curve (a) The market for

CHAPTER 10

to show how these events shift the LM curve.

r1 Y1

Y

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The Big Picture

The short-run equilibrium The short-run equilibrium is the combination of r and Y that simultaneously satisfies the equilibrium conditions in the g goods & money y markets:

r

Y C (Y T ) I (r ) G

LM

IS curve

Theory of Liquidity Preference

LM curve

Y Equilibrium interest rate

Agg. supply curve

Equilibrium level of income

Aggregate Demand I

Chapter Summary 3. Theory of Liquidity Preference

basic model of interest rate determination takes money supply & price level as exogenous an increase in the money supply lowers the interest rate

Model of Agg. Demand and Agg. Supply

Chapter Summary

In Chapter 11, we will use the IS-LM model to analyze the impact of policies and shocks. learn how the aggregate demand curve comes from IS IS-LM LM. use the IS-LM and AD-AS models together to analyze the short-run and long-run effects of shocks. use our models to learn about the Great Depression. Aggregate Demand I

Explanation of short-run fluctuations

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Preview of Chapter 11

CHAPTER 10

IS-LM model

Agg. demand curve

IS

M P L (r ,Y )

CHAPTER 10

Keynesian Cross

1. Keynesian cross

basic model of income determination takes fiscal policy & investment as exogenous fiscal policy has a multiplier effect on income 2 IS curve 2.

comes from Keynesian cross when planned investment depends negatively on interest rate shows all combinations of r and Y that equate planned expenditure with actual expenditure on goods & services

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Chapter Summary 5. IS-LM model Intersection of IS and LM curves shows the unique point (Y, r ) that satisfies equilibrium in both the goods and money markets.

4. 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

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