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ISLM

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Aggregate Demand I:

Building the IS -LM Model

10

slide 1

In this chapter, you will learn

the IS curve, and its relation to

the Keynesian cross

the loanable funds model

the LM curve, and its relation to

the theory of liquidity preference

how the IS-LM model determines income and

the interest rate in the short run when P is fixed

slide 2

Context

Chapter 9 introduced the model of aggregate

demand and aggregate supply.

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

slide 3

Context

This chapter develops the IS-LM model,

the basis of the aggregate demand curve.

We focus on the short run and assume the price

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

This chapter (and chapter 11) focus on the

closed-economy case.

Chapter 12 presents the open-economy case.

slide 4

The Keynesian Cross

A simple closed economy model in which income

is determined by expenditure.

(due to J.M. Keynes)

Notation:

I = planned investment

E = C + I + G = planned expenditure

Y = real GDP = actual expenditure

Difference between actual & planned expenditure

= unplanned inventory investment

slide 5

Elements of the Keynesian Cross

( ) C C Y T =

I I =

, G G T T = =

( ) E C Y T I G = + +

= Y E

consumption function:

for now, planned

investment is exogenous:

planned expenditure:

equilibrium condition:

govt policy variables:

actual expenditure = planned expenditure

slide 6

Graphing planned expenditure

income, output, Y

E

planned

expenditure

E =C +I +G

MPC

1

slide 7

Graphing the equilibrium condition

income, output, Y

E

planned

expenditure

E =Y

45

slide 8

The equilibrium value of income

income, output, Y

E

planned

expenditure

E =Y

E =C +I +G

Equilibrium

income

slide 18

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

The equation for the IS curve is:

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

slide 19

Y

2

Y

1

Y

2

Y

1

Deriving the IS curve

+r |I

Y

E

r

Y

E =C +I (r

1

)+G

E =C +I (r

2

)+G

r

1

r

2

E =Y

IS

AI

|E

|Y

slide 20

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 (E ).

To restore equilibrium in the goods market,

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

must increase.

slide 21

The IS curve and the loanable funds

model

S, I

r

I (r )

r

1

r

2

r

Y

Y

1

r

1

r

2

(a) The L.F. model (b) The IS curve

Y

2

S

1

S

2

IS

slide 22

Fiscal Policy and the IS curve

We can use the IS-LM model to see

how fiscal policy (G and T ) affects

aggregate demand and output.

Lets start by using the Keynesian cross

to see how fiscal policy shifts the IS curve

slide 23

Y

2

Y

1

Y

2

Y

1

Shifting the IS curve: AG

At any value of r,

|G |E |Y

Y

E

r

Y

E =C +I (r

1

)+G

1

E =C +I (r

1

)+G

2

r

1

E =Y

IS

1

The horizontal

distance of the

IS shift equals

IS

2

so the IS curve

shifts to the right.

1

1 MPC

A = A

Y G

AY

slide 25

The Theory of Liquidity Preference

Due to John Maynard Keynes.

A simple theory in which the interest rate

is determined by money supply and

money demand.

slide 26

Money supply

The supply of

real money

balances

is fixed:

M/P

real money

balances

r

interest

rate

( )

s

M P

M P

M P

( )

s

= M P

slide 27

Money demand

Demand for

real money

balances:

M/P

real money

balances

r

interest

rate

( )

s

M P

M P

L (r )

M P

( )

d

= L(r )

slide 28

Equilibrium

The interest

rate adjusts

to equate the

supply and

demand for

money:

M/P

real money

balances

r

interest

rate

( )

s

M P

M P

( ) M P L r =

L (r )

r

1

slide 29

How the NRB raises the interest

rate

To increase r,

NRB reduces M

M/P

real money

balances

r

interest

rate

1

M

P

L (r )

r

1

r

2

2

M

P

slide 30

CASE STUDY:

Monetary Tightening & Interest Rates

Late 1970s: t > 10%

Oct 1979: Fed Chairman Paul Volcker

announces that monetary policy

would aim to reduce inflation

Aug 1979-April 1980:

Fed reduces M/P 8.0%

Jan 1983: t = 3.7%

How do you think this policy change

would affect nominal interest rates?

Monetary Tightening & Rates, cont.

Ai < 0 Ai > 0

8/1979: i = 10.4%

1/1983: i = 8.2%

8/1979: i = 10.4%

4/1980: i = 15.8%

flexible sticky

Quantity theory,

Fisher effect

(Classical)

Liquidity preference

(Keynesian)

prediction

actual

outcome

The effects of a monetary tightening

on nominal interest rates

prices

model

long run short run

slide 32

The LM curve

Now lets put Y back into the money demand

function:

The LM curve is a graph of all combinations of

r and Y that equate the supply and demand for

real money balances.

The equation for the LM curve is:

M P

( )

d

= L(r ,Y)

M P = L(r ,Y)

slide 33

Deriving the LM curve

M/P

r

1

M

P

L (r , Y

1

)

r

1

r

2

r

Y

Y

1

r

1

L (r , Y

2

)

r

2

Y

2

LM

(a) The market for

real money balances

(b) The LM curve

slide 34

Why the LM curve is upward sloping

An increase in income raises money demand.

Since the supply of real balances is fixed, there

is now excess demand in the money market at

the initial interest rate.

The interest rate must rise to restore equilibrium

in the money market.

slide 35

How AM shifts the LM curve

M/P

r

1

M

P

L (r , Y

1

)

r

1

r

2

r

Y

Y

1

r

1

r

2

LM

1

(a) The market for

real money balances

(b) The LM curve

2

M

P

LM

2

slide 37

CHAPTER 10 Aggregate Demand I

The short-run equilibrium

The short-run equilibrium is

the combination of r and Y

that simultaneously satisfies

the equilibrium conditions in

the goods & money markets:

Y

r

IS

LM

Equilibrium

interest

rate

Equilibrium

level of

income

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

M P = L(r ,Y)

slide 38

The Big Picture

Keynesian

Cross

Theory of

Liquidity

Preference

IS

curve

LM

curve

IS-LM

model

Agg.

demand

curve

Agg.

supply

curve

Model of

Agg.

Demand

and Agg.

Supply

Explanation

of short-run

fluctuations

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