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