chapter 10: aggregate demand i. the is-lm model a short-run macroeconomic model which takes the...
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Chapter 10: Aggregate Demand IChapter 10: Aggregate Demand I
The IS-LM Model
A short-run macroeconomic model which takes the price level constant and shows how changes in the level of Aggregate Demand cause changes in income.
The IS curve: The Keynesian Cross TheoryThe LM curve: The Liquidity Preference Theory
Shift in Aggregate Demand
Output, Income
Price level
AD2
An increase in the level AD increases the level of income, given the price level.
SRASP
AD1
AD3
Y1 Y2 Y3
The Keynesian Cross
Equilibrium in the product market:
Planned Expenditures: E = C(Y-T) + I + GActual Expenditures: Y Aggregate Equilibrium: Y = C(Y-T) + I + G
Total income = Total planned expenditures
Aggregate Equilibrium
E
Y
Actual Expenditure: Y = E
Keynesian Cross
Y
Planned Expenditure:E = C + I + G
Y2 Y1
Reduce inventoriesIncrease inventories
Adjustment to Equilibrium
Y1> Y indicates an excess supply of goods in the market. So, businesses accumulate inventories to reduce Y1 to Y
Y2<Y indicates an excess demand for goods in the market. So, businesses reduce inventories to increase Y2 to Y
Effect of Stabilization Policy
A government policy of changing planned expenditure, C, I, or G, would shift the Planned Expenditure line to increase the level of income.
The increase in income is subject to a multiplier effect as spending by consumers receiving the new income, creates income for other consumers
Effect of Government Spending Policy
E
Y
Y = E
A
Y1
E = C + I + G1
Y2
E = C + I + G2
ΔGB
ΔY
Government Spending Multiplier
ΔG = Increase in government purchasesΔY = Increase in income
Multiplier effect: ΔY / ΔG = 1 / (1 – MPC)
Example, MPC = 0.6, Spending Multiplier = 2.50; Any $1 increase in G creates an additional $2.50 of income
Effect of Government Tax Policy
E
Y
Y = E
A
Y1
E = C 1+ I + G
Y2
E = C2 + I + G
ΔCB
ΔY
Government Tax Multiplier
ΔT = Decrease in income taxesΔC = Increase in consumption = -MPC * ΔTΔY = Increase in incomeMultiplier effect: ΔY / ΔT = -MPC / (1 – MPC)Example, MPC = 0.6, Tax Multiplier = -1.50; Any $1 decrease in T creates an additional $1.50 of income
Derivation of IS Curve
IS shows level of income and interest rate that bring about equilibrium to the product market
Assume an initial income level and interest rate. An increases in interest rate reduces planned investment. Then, the Planned Expenditure line shifts down, causing income to decline.
IS Curve
Income
Interest rate
Y1Y2
r1
r2
A
B
IS shows pairs of income and interest ratesuch as (Y1, r1) and (Y2, r2) that bring about equilibrium in the product market. The higher the interest rate, the lower the level of income.
Shift of IS Curve
Income
Interest rate
Y2Y1
An increase in planned expenditure (C, I, or G)causes the IS to increase, hence increasing the level of income through the multiplier effect.
IS1
IS2
Theory of Liquidity Preference
Equilibrium in the money market
Demand for money: (M/P)d = L(r,Y)
Money supply: (M/P)s = M/P
Equilibrium: M/P = L(r, Y)
Money Market Equilibrium
r
M/P
L(r, Y)
_M/P
r1
Derivation of LM Curve
An increase in the level of income causes the demand for money to increase. As a result of a higher demand for money, the interest rate goes up
The higher the level of income, the higher is the rate of interest
Derivation of LM Curve
r
r2
r1
M/P
r2
Y1 Y2
r1
L(r, Y1)
L(r, Y2)
_M/P LM
LM shows pairs of income and interest rate such as(Y1, r1) and (Y2, r2) that bring bout equilibrium in the money market.
Shift in LM Curve
r
r2
r1
M/P
r2
Y
r1
L(r, Y)
LM1
LM2
M1/P M2/P
An increase in the money supply, lowers the interest rate, making the LM curve to increase.
Aggregate Equilibrium
Aggregate equilibrium is achieved when IS = LM
IS: Y = C(Y - T) + I(r) + GLM: M/P = L(r, Y)
Aggregate Equilibrium
Income
Interest rate
Y
r
IS
LM
Theory of Short-Run Fluctuations
KeynesianCross
Theory of Liquidity
Preference
IS Curve
LM Curve
IS-LM Model
AD Curve
AS Curve
AD-AS Model
Short-run Fluctuations:
Income Interest
Rate