Facts about the business cycle

GDP growth averages 6-7 percent per year over

the last decade with large fluctuations in the
short run.
Consumption and investment fluctuate with
GDP, but consumption tends to be less volatile
and investment more volatile than GDP.
Unemployment rises during recessions and falls
during expansions.

CHAPTER 10 Aggregate Demand I 1

 Index of Leading Economic
Indicators

Aims to forecast changes in economic activity

6-9 months into the future.
Used in planning by businesses and govt,
despite not being a perfect predictor.

CHAPTER 10 Aggregate Demand I 2

 Leading and Lagging Variables

CHAPTER 10 Aggregate Demand I 3

CHAPTER 10 Aggregate Demand I 4
CHAPTER 10 Aggregate Demand I 5
 Time horizons in macroeconomics
Long run
Prices are flexible, respond to changes in supply
or demand.
Short run
Many prices are sticky at a predetermined
level.

The economy behaves much

differently when prices are sticky.

CHAPTER 10 Aggregate Demand I 6

 Recap of classical macro theory

Output is determined by the supply side:

supplies of capital, labor
technology
Changes in demand for goods & services
(C, I, G ) only affect prices, not quantities.
Assumes complete price flexibility.
Applies to the long run.

CHAPTER 10 Aggregate Demand I 7

 When prices are sticky
output and employment also depend on
demand, which is affected by:
fiscal policy (G and T )
monetary policy (M )
other factors, like exogenous changes in
C or I

CHAPTER 10 Aggregate Demand I 8

 The model of
aggregate demand and supply
The paradigm most mainstream economists
and policymakers use to think about economic
fluctuations and policies to stabilize the economy
Shows how the price level and aggregate output
are determined
Shows how the economys behavior is different
in the short run and long run

CHAPTER 10 Aggregate Demand I 9

 Aggregate demand
The aggregate demand curve shows the
relationship between the price level and the
quantity of output demanded.
For this chapters intro to the AD/AS model,
we use a simple theory of aggregate demand
based on the quantity theory of money.
Chapters 10-12 develop the theory of aggregate
demand in more detail.

CHAPTER 10 Aggregate Demand I 10

 The Quantity Equation as
Aggregate Demand
The quantity equation
MV = PY
For given values of M and V,
this equation implies an inverse relationship
between P and Y

CHAPTER 10 Aggregate Demand I 11

 The downward-sloping AD curve

P
An
An increase
increase in in the
the
price
price level
level causes
causes
aa fall
fall in
in real
real money
money
balances
balances (M/P (M/P),),
causing
causing aa
decrease
decrease in in the
the
demand
demand for for goods
goods
AD
&& services.
services.
Y

CHAPTER 10 Aggregate Demand I 12

 Shifting the AD curve

An
An increase
increase in in
the
the money
money supply
supply
shifts
shifts the
the AD
AD
curve
curve toto the
the right.
right.

AD
AD 2

1
Y

CHAPTER 10 Aggregate Demand I 13

 Aggregate supply in the long run

Recall
In the long run, output is determined by
factor supplies and technology
Y F (K , L)

Y is the full-employment or natural level of

output, at which the economys resources are
fully employed.
Full employment means that
unemployment equals its natural rate (not zero).
CHAPTER 10 Aggregate Demand I 14
 The long-run aggregate supply curve

P LRAS
Y does
does not
not
depend
depend on on P,
P,
so
so LRAS
LRAS is is
vertical.
vertical.

Y
Y
F (K , L)
CHAPTER 10 Aggregate Demand I 15
 Long-run effects of an increase in M

P LRAS
An increase
in M shifts
AD to the
right.
In the long run, P2
this raises the
price level P1 AD
AD 2

1
but leaves Y
Y
output the same.

CHAPTER 10 Aggregate Demand I 16

 Aggregate supply in the short run

Many prices are sticky in the short run.

For now , we assume
all prices are stuck at a predetermined level in
the short run.
firms are willing to sell as much at that price
level as their customers are willing to buy.
Therefore, the short-run aggregate supply
(SRAS) curve is horizontal:

CHAPTER 10 Aggregate Demand I 17

 The short-run aggregate supply
curve
P
The
The SRAS
SRAS
curve
curve is is
horizontal:
horizontal:
The
The price
price level
level
is
is fixed
fixed at
at aa
predetermined SRAS
predetermined P
level,
level, and
and firms
firms
sell
sell asas much
much as as
buyers
buyers demand.
demand.
Y

CHAPTER 10 Aggregate Demand I 18

 Short-run effects of an increase in
M
In the short run P
an increase
when prices are in aggregate
sticky, demand

SRAS
P
AD
AD2
1
Y
causes Y1 Y2
output to rise.
CHAPTER 10 Aggregate Demand I 19
 Supply shocks
A supply shock alters production costs, affects the
prices that firms charge. (also called price shocks)
Examples of adverse supply shocks:
Bad weather reduces crop yields, pushing up
food prices.
Workers unionize, negotiate wage increases.
New environmental regulations require firms to
reduce emissions. Firms charge higher prices to
help cover the costs of compliance.
Favorable supply shocks lower costs and prices.

CHAPTER 10 Aggregate Demand I 20

 CASE STUDY:
The 1970s oil shocks
The
The oil
oil price
price shock
shock P LRAS
shifts
shifts SRAS
SRAS up, up,
causing
causing output
output and
and
employment
employment to to fall.
fall.
B SRAS2
P2
In
In absence
absence ofof
further A SRAS1
further price
price P1
shocks,
shocks, prices
prices will
will AD
fall
fall over
over time
time and
and
economy
economy movesmoves Y
back
back toward
toward full
full Y2 Y
employment.
employment.
CHAPTER 10 Aggregate Demand I 21
 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).

CHAPTER 10 Aggregate Demand I 22

 The Keynesian Cross

A simple closed economy model in which income

is determined by expenditure.
(due to J.M. Keynes)
Notation:
I = planned investment
PE = C + I + G = planned expenditure
Y = real GDP = actual expenditure
Difference between actual & planned expenditure
= unplanned inventory investment

CHAPTER 10 Aggregate Demand I 23

 Elements of the Keynesian Cross
consumption function: C C (Y T )

govt policy variables: G G , T T

for now, planned
investment is exogenous: I I

planned expenditure: PE C (Y T ) I G

equilibrium condition:
actual expenditure = planned expenditure
Y PE
CHAPTER 10 Aggregate Demand I 24
 Graphing planned expenditure

PE

planned PE =C +I
+G
expenditure
MPC
1

income, output, Y

CHAPTER 10 Aggregate Demand I 25

 Graphing the equilibrium condition

PE PE
=Y
planned

expenditure

45

income, output, Y

CHAPTER 10 Aggregate Demand I 26

 The equilibrium value of income

PE AE
=Y
planned PE =C +I
+G
expenditure

income, output, Y
Equilibrium
income
CHAPTER 10 Aggregate Demand I 27
 An increase in government purchases
PE

Y
=
E
At Y1,

A
PE =C +I
there is now an +G2
unplanned drop PE =C +I
in inventory +G1

G
so firms
increase output,
and income Y
rises toward a
new equilibrium. PE1 = Y PE2 =
Y1 Y2
CHAPTER 10 Aggregate Demand I 28
 Solving for Y
Y C I G equilibrium condition

Y C I G in changes

C G because I exogenous

MPC Y G because C = MPC

Y
Collect terms with Y Solve for Y :
on the left side of the
equals sign: 1
Y G
(1 MPC) Y G 1 MPC

CHAPTER 10 Aggregate Demand I 29

 The government purchases multiplier

Definition: the increase in income resulting from a

$1 increase in G.
In this model, the govt Y 1
purchases multiplier equals
G 1 MPC

Example: If MPC = 0.8, then

An
An increase
increase in
in G
G
Y 1
5 causes
causes income
income to to
G 1 0.8
increase
increase 55 times
times
as
as much!
much!
CHAPTER 10 Aggregate Demand I 30
 Why the multiplier is greater than 1
Initially, the increase in G causes an equal increase
in Y: Y = G.
But Y C
further Y
further C
further Y
So the final impact on income is much bigger than
the initial G.

CHAPTER 10 Aggregate Demand I 31

 An increase in taxes
PE
Initially, the tax

= E
P
PE =C1 +I

Y
increase reduces
consumption, and +G
PE =C2 +I
therefore PE: +G

C = MPC At Y1, there is now

T an unplanned
so firms inventory buildup
reduce output,
and income falls Y
toward a new PE2 = Y PE1 =
equilibrium
Y2 Y1
CHAPTER 10 Aggregate Demand I 32
 Solving for Y
eqm condition in
Y C I G
changes
C I and G exogenous

MPC Y T

Solving for Y : (1 MPC) Y MPC T

MPC
Final result: Y T
1 MPC

CHAPTER 10 Aggregate Demand I 33

 The tax multiplier

def: the change in income resulting from

a $1 increase in T :
Y MPC

T 1 MPC

If MPC = 0.8, then the tax multiplier equals

Y 0.8 0.8
4
T 1 0.8 0.2

CHAPTER 10 Aggregate Demand I 34

 The tax multiplier
is negative:
A tax increase reduces C,
which reduces income.
is greater than one
(in absolute value):
A change in taxes has a
multiplier effect on income.
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.

CHAPTER 10 Aggregate Demand I 35

 Deriving the IS curve
P PE =Y
PE =C +I (r2 )
E +G
r I PE =C +I (r1 )
+G
PE I

Y Y1 Y2 Y
r
r1

r2
IS
Y1 Y2 Y

CHAPTER 10 Aggregate Demand I 36

 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 ).
To restore equilibrium in the goods market,
output (a.k.a. actual expenditure, Y )
must increase.

CHAPTER 10 Aggregate Demand I 37

 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

CHAPTER 10 Aggregate Demand I 39

 Shifting the IS curve: G

PE PE PE =C +I (r1 )
At any value of r, =Y
G PE Y +G2=C +I (r )
PE 1

so the IS curve +G1

shifts to the right.

The horizontal Y1 Y2 Y
r
distance of the
r1
IS shift equals
1
Y G Y
1 MPC IS1 IS2
Y1 Y2 Y

CHAPTER 10 Aggregate Demand I 40

 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.

CHAPTER 10 Aggregate Demand I 41

 Money supply

r
M P
s
The supply of interest
real money rate
balances
is fixed:

M P M P
s

M/P
M P
real money
balances

CHAPTER 10 Aggregate Demand I 42

 Money demand

r
M P
s
Demand for interest
real money rate
balances:

M P
d
L(r )

L (r )

M/P
M P
real money
balances

CHAPTER 10 Aggregate Demand I 43

 Equilibrium

r
The interest M P
s
interest
rate adjusts rate
to equate the
supply and
demand for
money: r1

M P L(r ) L (r )

M/P
M P
real money
balances

CHAPTER 10 Aggregate Demand I 44

 How the Central Bank raises the
interest rate
r
interest
To increase r, rate
Fed reduces M
r2

r1
L (r )

M/P
M2 M1
real money
P P balances

CHAPTER 10 Aggregate Demand I 45

 Monetary Tightening & Interest Rates,
cont.
The effects of a monetary tightening
on nominal interest rates

short run long run

Quantity theory,
Liquidity preference
model Fisher effect
(Keynesian)
(Classical)

prices sticky flexible

prediction i > 0 i < 0

actual 8/1979: i = 10.4% 8/1979: i = 10.4%

outcome 4/1980: i = 15.8% 1/1983: i = 8.2%
CHAPTER 10 Aggregate Demand I 46
 The LM curve

Now lets put Y back into the money demand

function:
M P
d
L(r ,Y )

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 L(r ,Y )

CHAPTER 10 Aggregate Demand I 47

 Deriving the LM curve

(a) The market for

(b) The LM curve
real money balances
r r
LM

r2 r
2
L (r ,
r1 Y2 ) r
L (r , 1

Y1 )
M1 M/P Y1 Y2 Y
P

CHAPTER 10 Aggregate Demand I 48

 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.

CHAPTER 10 Aggregate Demand I 49

 How M shifts the LM curve
(a) The market for
(b) The LM curve
real money balances
r r
LM
2
LM1
r2 r2

r1 r1
L (r , Y1 )

M2 M1 M/P Y1 Y
P P

CHAPTER 10 Aggregate Demand I 50

 The Big Picture

Keynesian
Keynesian IS
IS
Cross
Cross curve
curve
IS-LM
IS-LM
model Explanation
Explanation
Theory
Theory ofof model
LM
LM of
of short-run
short-run
Liquidity
Liquidity curve fluctuations
curve fluctuations
Preference
Preference
Agg.
Agg.
demand
demand
curve
curve Model
Model of
of
Agg.
Agg.
Demand
Demand
Agg.
Agg. and
and Agg.
Agg.
supply
supply Supply
Supply
curve
curve

CHAPTER 10 Aggregate Demand I 51