Chapter 10
Aggregate Demand I
Building the IS-LM Model

Goods Market IS Curve

Money Market LM Curve

Short Run Equilibrium

IS stands for investment and saving

LM stands for liquidity and money

Keynesian Cross

IS-LM Model determines income (Y) and interest rate (r) in short run when price (P) is fixed

Long run

Prices flexible

Output determined by factors of production and technology

Unemployment equals its natural rate

Short run

Prices fixed

Output determined by aggregate demand

Unemployment negatively related to output

Closed economy

Definition

PE = C( Y - T ) + I + G
PE = planned expenditure
C = MPC
Y = income
T = taxes (exogenous)
I = planned investment (exogenous)
G = government spending (exogenous)

Y = PE in equilibrium

Slope of PE is MPC since values other than Y are exogenous.

Keynesian cross is model in which income (Y) is determined by expenditure (PE)

Fiscal Policy

Government purchases multiplier: ∆Y = 1/(1-MPC) x ∆G

Tax multiplier: ∆Y = -MPC/(1-MPC) x ∆T

Tax multiplier is smaller than Government purchases multiplier

Planned expenditure changes

PE reduction means unplanned inventory buildup, production will decrease to bring it back to a constant level, ∆Y decreases

PE increase mean unplanned inventory drop, production will increase to bring it back to a constant level, and ∆Y will increase

Deriving the IS curve

Negatively sloped because decrease in r means firms want to invest more (increase in I), which drives up output (increase in Y)

IS curve changes

IS curve shows the inverse relationship between interest rate and income in the market for goods and services

Change in G and T is a shift in the IS curve

Change in I and r is a movement along the IS curve

Theory of Liquidity Preference

Money Supply

Money Demand

is influenced by two things

quantity or price of G&S: when either increase, people need to hold more money

Money depends negatively on nominal interest rate. Interest rate adjusts to balance the money supply and demand in the market.

(M/P)s = M(bar)/P(bar)

is determined by BoC

interest rate: the higher the interest rate, the higher the opportunity cost of holding money as opposed to investing it, thus people hold less money

(M/P)d = L(r)

Deriving the LM curve

Positively sloped because increase in Y raises money demand, and as M is fixed, r must increase to restore equilibrium in the money market. Or increase in r decreases money demand, and Y must increase to balance the equation and keep money supply constant

LM curve changes

LM is the positive relationship between interest rate and level of income in the market for money balances

MV(r) = PY, when interest rate increase, people invest their money, and velocity of money (V) increases because each dollar must be used in more transactions

Change in M or L() is a shift in the LM curve

Change in Y is a movement along the LM curve

IS: Y = C(Y - T) + I(r) + G

LM: M/P = L(r, Y)

Curve changes

IS: r and I is movement along curve
LM: Y is movement along curve

IS: T and G are shifts in the curve
LM: M and L() are shifts in the curve

Combination of r and Y that simultaneously satisfies equilibrium conditions in the goods and money markets