Injibara University
Department of Economics
Macroeconomics Lecture notes
By; Negussie Gebru (MSc)
Injibara, Ethiopia, 2012 E.C
CHAPTER THREE
AGGREGATE DEMAND
Lecture notes: By Negussie G. @ Injibara University, 2012 E.C
Monday, February 6, 2023
CHAPTER THREE
AGGREGATE DEMAND
3.1 Aggregate Demand
3.1.1 Quantity-Adjustment vs Price-Adjustment
3.1.2 The IS-LM Model
3.1.2.1 The Goods Market and the IS Curve
3.1.2.2 The Money Market and the LM Curve
3.1.2.3 Equilibrium in Goods & Money Markets
3.1.2.4 Explaining Fluctuations with IS-LM Model
3.1.2.5 Interaction b/n Monetary & Fiscal Policies
3.1.3 Deriving the Aggregate Demand Curve
3.1.1 Quantity-Adjustment vs Price-Adjustment
 The principal theme of classical price
theory is:
if there is an imbalance between supply &
demand in a competitive market, then prices
change to clear the market or establish eqlm.
 Real wage flexibility equilibrates the labor
sector & the real interest rate balances
output allocation b/n I & C goods.
 Together, the eqlm labor supply & capital
stock determine the eqlm output level.
 The Keynesian real sector model takes a
different approach.
3.1.1 Quantity-Adjustment vs Price-Adjustment
The simplest Keynesian model abstracts
entirely from price changes.
The Keynesian model explains interactions
b/n demand for goods & services, and the
financial sector.
The basic theme of the approach is that, in
the short-run, quantity adjustments occur
if there is imbalance b/n supply & demand.
The Keynesian model is an application of
the quantity adjustment paradigm:
if there is imbalance b/n supply & demand, then
producers will change the quantity of output
produced.
3.1.1 Quantity-Adjustment vs Price-Adjustment
 Clearly, both price & quantity adjustments
take place in reality.
 In the short run, a change in price is often
a costly & unreliable means of balancing
sales & production, esp. with a temporary
imbalance & a desire for rapid response.
 Thus, quantity adjustment is the primary
adjustment mechanism used to maintain
sales-production eqlm in the short run.
 In a modern economy with less emphasis
on manufacturing & greater emphasis on
services and with very rapid information
flows price changes do occur.
3.1.1 Quantity-Adjustment vs Price-Adjustment
 Price changes are often made infrequently
& therefore the principal adjustments to
supply & demand imbalances in the short
run are quantity changes.
 The above conclusion relies upon two
characteristics of the product market:
1. it is presumed that goods can be held in
inventory (true for manufactured goods).
2. some degree of product differentiation.
3.1.2 The IS-LM Model
In the short run when P is fixed, shifts in
AD lead to changes in national income.
The IS–LM model, a model of AD, aims at
showing what determines NI for any given
price level or what causes shifts in AD.
The 2 parts of the model are IS & LM.
IS stands for “Investment” & “Saving”, &
the IS curve represents what’s going on in
the market for goods & services.
LM stands for “Liquidity” (demand for
money) & “Money” (supply of money), &
the LM curve represents what’s happening
to the supply of & demand for money.
3.1.2 The IS-LM Model
The interest rate links the two halves of
the IS–LM model since it influences both
investment & money demand.
The IS–LM model shows how interactions
b/n these markets determine the position
& slope of the AD curve.
3.1.2.1 The Goods Market and the IS Curve
The IS curve plots the relationship b/n
interest rate & income level that arises in
the market for goods & services.
As to Keynes, an economy’s total income
in the short run is determined largely by
the desire to spend by hhs, firms & gov’t.
The more people want to spend, the more
goods & services firms can sell; the more
firms can sell, the more output they
choose to produce & the more resources
they choose to hire.
The Keynesian Cross & Income Determination
To develop the IS curve we start with a
basic model called the Keynesian cross.
3.1.2.1 The Goods Market and the IS Curve
This model is the simplest interpretation
of Keynes’s theory of NI & is a building
block for the more realistic IS–LM model.
The Keynesian cross begins by distinguishing b/n actual & planned expenditure.
AE is the amount hhs, firms & the gov’t
spend on goods & services, & equals GDP.
An AE of say 10 billion Birr is translated to
a 10 billion Birr value for GDP, giving rise
to a 450 line relating AE & GDP.
AE
90
10
0
45
10
90 Y (= output, GDP)
3.1.2.1 The Goods Market and the IS Curve
PE is the amount hhs, firms & the gov’t
would like to spend on goods & services.
For a closed economy (NX = 0), PE is the
sum of consumption, planned investment I
& gov’t purchases:
PE = C + I + G.
To this equation, we add the following:
 The consumption function: C = C(Y − T);
 Assumption of fixed G & T (fiscal policy); &
 A simplifying assumption of exogenously
fixed planned investment.
Combining these, we get: PE  C(Y T )  I G
PE is a function of income Y, planned
investment & fiscal policy variables.
PE
PE  C(Y T )  I  G
1
MPC
Y
3.1.2.1 The Goods Market and the IS Curve
Why would AE ever differ from PE?
Answer: firms might engage in unplanned
inventory investment when their sales do
not meet their expectations.
When firms sell less of their product than
they planned, their stock of inventories
automatically rises, and vice versa.
Since unplanned changes in inventory are
counted as investment spending by firms,
AE can be > or < PE.
AE = C(Y–T) + I + ∆inv + G while PE = C(Y–
T) + I + G.
AE > PE when ∆inv > 0; AE < PE when ∆inv
< 0; and,AE = PE when ∆inv = 0.
3.1.2.1 The Goods Market and the IS Curve
Some NI Identities of the Closed Economy
1. Consumption and Saving Functions
C  C  cY d
S Y C
Thus, the consumption function C  C  cY d
corresponds to the saving function S  Y d  C
which simplifies to S  C (1  c)Y d
2. Planned versus Actual Investment
PE = C(Y–T)+I+G & AE = C(Y–T)+I+∆inv+G;
where I is planned investment (IPLANNED) &
I + ∆inv is actual investment (IACTUAL).
PE = AE is thus equivalent to planned
investment = actual investment.
d
3.1.2.1 The Goods Market and the IS Curve
Thus, it always holds that IACTUAL = IPLANNED
+ undesired changes in inventories (∆inv).
At equilibrium, IACTUAL = IPLANNED. This
requires that there is no undesired or
unplanned change in inventories (∆inv = 0).
Thus, the eqlm condition PE = AE could be
stated as IACTUAL = IPLANNED or as ∆inv = 0.
3. Saving–Investment Identities
The condition PE = AE = Y is the same as
saying that Y = C + I + G, which could be
rewritten in a number of ways.
Subtracting taxes from both sides:
Y – T = C + I + G – T.
3.1.2.1 The Goods Market and the IS Curve
Y–T is disposable income, which is either
consumed or saved. So,Yd = C + I + (G –T).
For a hypothetical economy with no gov’t
(G = T = 0), it follows that:Yd = C + I.
Subtracting C from both sides yields:
Yd – C = C + I – C.
The LHS of this identity is saving & the
RHS is planned investment.Thus, we have:
S=I
For the case with gov’t, subtracting C
from both sides of Yd = C + I + (G – T):
Yd – C = I + (G – T).
Moving (G – T) to the left we will have:
Yd – C + (T – G) = I.
3.1.2.1 The Goods Market and the IS Curve
Yd – C on the left is saving by the private
sector of the economy, SP.
T – G is the difference between what gov’t
collects as taxes (net) & gov’t purchases. It
is saving by the public sector, SG.
Thus, Yd–C+(T–G) = I reduces to SP+SG = I.
S (= SG + SP) = I.
In sum, S = I is merely another way of
stating the basic equilibrium condition.
4.The Injection – Leakage Identity
Another way of stating the eqlm condition
The NI identity Y = C + I + G gives the
sources of national income.
3.1.2.1 The Goods Market and the IS Curve
Viewed from the income allocation side,
the income earned is shared among tax
payments, consumption & saving:
Y = T + C + S.
Bringing the two sides together:
C + I + G = Y = T + C + S.
In relation to the circular flow diagram, C,
I & G are injections/additions into the flow
while C, S & T are leakages/withdrawals
from the circle.
Thus, injections = withdrawals at eqlm.
C + I + G = T + C + S (or I + G = S + T) is
another way of representing the eqlm
condition.
3.1.2.1 The Goods Market and the IS Curve
The Multiplier
The Keynesian cross shows how income Y
is determined for given levels of planned
investment I & fiscal policy variables G & T.
Now, we use it to show how Y changes
when an exogenous variable changes.
More specifically, we will consider how
output (or GDP) responds to changes in:
government purchases,
autonomous taxes,
autonomous spending (on C or I),
G & T by the same amount (the balanced
budget multiplier), and
the tax rate.
3.1.2.1 The Goods Market and the IS Curve
The Government Purchases Multiplier (Y/G)
It tells us how much income rises in
response to a 1 Birr change in G.
Raising G by G (from G1 to G2) causes PE
to shift upward from PE1 to PE2 (by G).
3.1.2.1 The Goods Market and the IS Curve
Consequently, eqlm moves from A to B.
An increase in G leads to an even greater
increase in Y, i.e., Y > G.
For the movement from A to B caused by
G, the Y is shown by arrows from Y1 to
Y2 both on the horizontal & vertical axes.
The vertical distance b/n Y1 to Y2 is the
same as the distance from Point B to C.
The resulting Y > the distance b/n the
two PE expenditure curves.
The government-purchases multiplier > 1.
Why does fiscal policy have a multiplied
effect on income?

3.1.2.1 The Goods Market and the IS Curve
The reason is that, according to the
consumption function C = C(Y − T), higher
Y causes higher C.
When an increase in G raises Y, it also
raises C, which further raises Y, which
further raises C, and so on.
Therefore, in this model, an increase in G
causes a greater increase in Y.
How big is the multiplier?
To answer this question, we trace through
each step of the change in income.

3.1.2.1 The Goods Market and the IS Curve
The Effect of G
Round
on Consumption
on Income
G
1
2
MPC x G
MPC x G
3
MPC2 x G
MPC2 x G
4
MPC3 x G
MPC3 x G
…
…
C = (MPC + MPC2 +
Y = (1 + MPC + MPC2 +
MPC3 +…) x G
MPC3 +…) x G
SUM
Y/G = 1 + MPC + MPC2 + MPC3 +…
Y/G = 1/(1 – MPC)
The larger MPC, the larger the multiplier.

3.1.2.1 The Goods Market and the IS Curve
With MPC = 0.8, the multiplier is 5;
For MPC = 0.9, the multiplier is 10.
Higher MPC implies that a larger fraction
of additional income is consumed, thereby
causing a larger induced increase in dd.
Mathematically,
Substituting the consumption function
C  Ca  c(Y  T ) into the eqlm condition
Y  C  I  G and rearranging:
1
[Ca  cT  I  G ]
Y  Ca  cY  cT  I  G  Y 
1 c
Taking derivatives:
1
dY 
[dCa  cdT  dI  dG ]
1 c

3.1.2.1 The Goods Market and the IS Curve
From the final equation dY  1 [dCa  cdT  dI  dG ]:
1 c
dY
1

dG 1  c
dY
c

dT 1  c
dY
dY
dY
1

dC a 1  c
dY
dG
dG dT
dY
1

dI 1  c
?
dG  dT
1

[dCa  cdG  dI  dG ]
1 c
dG  dT
1

[dCa  (1  c)dG  dI ]
1 c
dY
dG
dG  dT
1 c

1
1 c

3.1.2.1 The Goods Market and the IS Curve
If tax is a (linear) function of income (T = tY):
Y  Ca  c(Y  tY )  I  G
dY  dCa  c[dY  d (tY )]  dI  dG
 dY  dCa  c[dY  (tdY  Ydt )]  dI  dG
 dY  dCa  cdY  ctdY  cYdt  dI  dG
 dY  cdY  ctdY  dCa  cYdt  dI  dG
 (1  c  ct )dY  dCa  cYdt  dI  dG
1
 dY 
[dCa  cYdt  dI  dG]
(1  c  ct )

3.1.2.1 The Goods Market and the IS Curve
If tax is a (linear) function of income (T = tY):
1
dY 
[dCa  cYdt  dI  dG]
(1  c  ct )
dY
dY dY
1



dCa dI dG 1  c  ct
The tax rate multiplier:
dY
 cY

dt 1  c  ct

3.1.2.1 The Goods Market and the IS Curve
Interest Rate, Investment and the IS Curve
The Keynesian cross makes a simplifying
assumption that planned investment is
fixed.
But, planned investment depends on the
interest rate, r – i.e., I = I(r).
Since r is the cost of borrowing to finance
investment projects, a rise in r reduces I:
the investment function slopes downward.
To determine how income changes when
interest rate changes, we combine the
investment function with Keynesian-cross.


3.1.2.1 The Goods Market and the IS Curve
Using C = Ca+c(Y–T) & a linear investment
function (I = Ia–br) together with the eqlm
condition Y = C + I + G,
Y  Ca  c(Y  T )  I a  br  G
1
 r  [(1  c)Y  Ca  cT  I a  G ]
b
A higher r is associated with a lower level
of equilibrium Y, given the other variables.
The slope of the IS curve: dr  (1  c)
dY

b
The slope of the IS curve depends on the
sensitivity of investment to changes in r (b)
& on MPC (c) or the multiplier.

3.1.2.1 The Goods Market and the IS Curve
If I is very sensitive to r, so that b is large, a
given  in r produces a large  in PE & thus
shifts PE curve up by a large amount.
A large shift in PE schedule produces a
correspondingly large  in eqlm income (Y).
If a given  in r produces a large  in Y, the IS
curve is very flat.
With b small & I not very sensitive to r, the IS
curve is relatively steep.
The larger MPC & the larger the multiplier,
the flatter the IS curve.
Larger multiplier: larger Y produced by a
given r, or smaller r needed for a given Y.
Points above & to the right of the IS curve
signify excess supply of goods, & vice versa.

3.1.2.1 The Goods Market and the IS Curve
In summary,
IS shows combinations of r & Y consistent with
eqlm in market for goods & services.
The IS curve is negatively sloped as a rise in r
reduces I & PE, thereby reducing eqlm Y.
To the right of the IS curve, there is excess
supply in the goods market, & vice versa.
The smaller the multiplier (MPC) & the less
sensitive I is to  in r, the steeper the IS curve.
The IS curve is drawn for a given fiscal policy.
s in fiscal policy that raise (reduce) demand
for goods shift IS curve to right (left).
IS curve is also shifted by s in autonomous
spending of private economic agents (Ca & Ia) .

3.1.2.2 The Money Market and the LM Curve
The money market is just one component of
the broader concept of asset markets.
Asset markets are markets where money,
bonds, stocks, houses & other forms of wealth
are traded.
We simplify matters by grouping assets into
two: money & interest-bearing assets.
At a given time, an individual has to decide
how to allocate his/her financial wealth b/n
two alternatives – money & bond.
The more bonds held, the more interest
received; the more money held, the more
likely the individual is to have money available
for making a purchase.
Such decisions on the form in which to hold
assets are portfolio decisions.

3.1.2.2 The Money Market and the LM Curve
The portfolio decisions on how much money
& on how many bonds to hold are really the
same decision.
The LM curve plots the relationship b/n r & Y
that arises in the money market.
The theory of liquidity preference is the
building block for this relationship.
The Theory of Liquidity Preference
The theory explains how r is determined in
the short run; it posits that r adjusts to
balance supply of & demand for the
economy’s most liquid asset – money.
A.The supply of real money balances
If M stands for money stock & P for the price
level, M/P = supply of real money balances.

3.1.2.2 The Money Market and the LM Curve
The theory of liquidity preference assumes a
fixed supply of real money balances: M S M
(
P
) 
P
M is an exogenous policy variable chosen by a
central bank (NBE in our case).
P is an exogenous variable in this model: we
take P as given (IS–LM explains the SR).
These imply that supply of real money
balances is fixed & does not depend on r.
B.The demand for real money balances
Demand for money is demand for real
balances: we hold money for what it can buy.
The higher P, the more nominal balances a
person has to hold to be able to purchase a
given quantity of goods.

3.1.2.2 The Money Market and the LM Curve
If P doubles, one has to hold twice as many
nominal balances to be able to buy the same
amount of goods.
The demand for real balances depends on
real income (Y) & the interest rate (r).
It depends on Y as people hold money to pay
for purchases, which depend on their Y.
r is one determinant of how much money
people choose to hold as it is the opportunity
cost of holding money: it is what you forgo by
holding money instead of interest-bearing
assets like bonds.
When r rises, people want to hold less of
their wealth in the form of money.

3.1.2.2 The Money Market and the LM Curve
On these grounds, the demand for real
balances rises with Y & decreases with r:
M d
( )  kY  hr
P
For a given level of Y, the quantity demanded
of M/P is a decreasing function of r.
Higher Y means larger demand for M/P, &
therefore shifts the (M/P)d curve to the right.
(M/P)S & (M/P)d determine what r prevails in
the economy (what r equilibrates the money
market).

3.1.2.2 The Money Market and the LM Curve
Income, Money Demand, and the LM Curve
When Y is high, expenditure is high, so people
engage in more transactions that require the
use of money.
The higher Y, the higher (M/P)d will be, and
the higher the equilibrium r.
Therefore, a higher Y leads to a higher r.
The LM curve plots this positive relationship
b/n Y & r.

3.1.2.2 The Money Market and the LM Curve
For the money market to be in eqlm, demand
has to equal supply: M
 kY  hr
P
1
M
Solving for the interest rate: r  (kY  )
h
P
Slope of the LM curve is given by: dr  k
dY
h
The LM curve is steep if (M/P)d is very
responsive to Y & less responsive to r.
A point to the right of the LM curve is a point
of excess (M/P)d: r is too low &/or Y too high.
A point to the left of the LM curve is a point
of excess (M/P)S: r is too high &/or Y too low.
The LM curve is drawn for a given (M/P)S: If
(M/P)S changes the LM curve shifts.

3.1.2.2 The Money Market and the LM Curve
In summary,
The LM curve shows combinations of r & Y
consistent with eqlm in the money market.
The LM curve is positively sloped: given MS, a
rise in Y raises the quantity of M demanded, &
has to be accompanied by an increase in r.
The greater the responsiveness of (M/P)d to Y
& the lower the responsiveness of (M/P)d to r,
the steeper the LM curve will be.
To the right of the LM curve, there is an excess
(M/P)d & to its left, there is an excess (M/P)S.
The LM curve is drawn for a given (M/P)S:
decreases in (M/P)S shift the LM curve upward;
increases in (M/P)S shift it downward.

3.1.2.3 Equilibrium in Goods & Money Markets
IS & LM together determine economy’s eqlm.
The model takes G,T, M & P as exogenous.
Given these variables, IS gives combinations
of r & Y that satisfy Y=C(Y–T)+I(r)+G, & LM
combinations of r & Y that satisfy M/P=L(r,Y).
The eqlm of the economy is the point at
which the IS curve & the LM curve cross.
At this point, AE = PE & (M/P)d = (M/P)S .

3.1.2.3 Equilibrium in Goods & Money Markets
To find eqlm r & eqlm Y algebraically, solve
the IS & the LM equations simultaneously.
1
IS : r  [(1  c)Y  Ca  cT  I a  G ].........(1)
b
1
M
LM : r  (kY  ) or Y  1 (hr  M ).........(2)
h
P
k
P
 1 (1  c)
M
r [
(hr  )  Ca  cT  I a  G ]
b
k
P
k
(1  c) M
r
[Ca  I a  G 
 cT ]
bk  (1  c)h
k P

3.1.2.3 Equilibrium in Goods & Money Markets
1
M
Y  {hr  }
k
P
1
hk
(1  c) M
M
Y {
[Ca  I a  G 
 cT ]  }
k [bk  (1  c)h]
k P
P
1
hk
bk
M
Y {
[Ca  I a  G  cT ] 
( )}
k [bk  (1  c)h]
[bk  (1  c)h] P
h
b M
Y
[Ca  I a  G  cT  ( )]
bk  (1  c)h
h P

3.1.2.4 Explaining Fluctuations with IS-LM Model
The intersection of the IS & the LM curves
determines level of national income (Y).
When one of these curves shifts, the shortrun eqlm changes & Y fluctuates.
Changes in Fiscal Policy
s in G or T influence PE & thereby shift the
IS curve.
Consider an increase in G.
Goods Market
Money Market
G  PE 
Production & Y 
Md  r 
I  PE  Y

3.1.2.4 Explaining Fluctuations with IS-LM Model
The effect of fiscal policy (say, G) on Y in the
IS-LM model is weaker than the effect of the
same policy in the Keynesian Cross.
This is because of the crowding out effect.
Changes in Monetary Policy
 in MS influences (M/P)S & thereby shifts the
LM curve.
Consider an increase in MS.
Money Market
MS
 r 
MD  r
Goods Market
I  PE 
Production & Y 

3.1.2.4 Explaining Fluctuations with IS-LM Model
k
(1  c) M
From r 
[Ca  I a  G 
 cT ] ,
bk  (1  c)h
k P
k
(1  c) dM MdP
dr 
[dCa  dI a  dG  cdT 
[
 2 ]
bk  (1  c)h
k
P
P
dr
dr dr
k



0
dCa dI a dG bk  (1  c)h
dr
 ck

0
dT bk  (1  c)h
dr  (1  c) P 1

0
dM bk  (1  c)h

3.1.2.4 Explaining Fluctuations with IS-LM Model
From Y 
h
b M
[Ca  I a  G  cT  ( )] ,
bk  (1  c)h
h P
h
b dM MdP
dY 
[dCa  dI a  dG  cdT  (
 2 )]
(1  c)h  bk
h P
P
dY
dY dY
h



0
dCa dI a dG (1  c)h  bk
dY
 ch

0
dT (1  c)h  bk
dY
bP 1

0
dM (1  c)h  bk

3.1.2.4 Explaining Fluctuations with IS-LM Model
Fiscal policy is more effective at influencing Y:
the flatter the LM curve – (M/P)d less
sensitive to Y &/or more sensitive to r, &
the larger the MPC (larger right- or leftward shift in IS curve) & the less sensitive I
to r (smaller crowding out effect).
Monetary policy is more effective at
influencing Y:
the flatter the IS curve – the larger the
MPC & the more sensitive I to r, &
the less sensitive (M/P)d to r (larger downor up-ward shift in LM curve) &/or the less
sensitive (M/P)d to Y.

3.1.2.5 Interaction b/n Monetary & Fiscal Policies
A change in monetary/fiscal policy may
influence the other, & the interdependence
may alter the impact of a policy change.
For example, suppose gov’t raises taxes.
The effect of this policy depends on how the
central bank responds to the tax raise.
The figure below shows three of the many
possible outcomes.

3.1.3 Deriving the Aggregate Demand Curve
r
LM(P2)
LM(P1)
IS1
P
Y2
Y1
Y
P2
P1
AD
Y2
Y1
Y

3.1.3 Deriving the Aggregate Demand Curve
AD curve is drawn for given values of G, T, M
& P (exogenous variables in IS-LM model).
Events that shift the IS or LM curves (for a
given P) cause AD curve to shift.
A change in G, T, or MS will affect the eqlm Y
for every P & hence the position of AD curve.
Solving IS & LM equations simultaneously:
b
-1 h
Y
{MP  [Ca  cT  I a  G]}
bk  h(1  c)
b
The slope of AD is:
Y
b
M

[ 2]
P
bk  h(1  c) P
P
bk  h(1  c) P

[ ]  0
Y
b
M
2
THE END OF CHAPTER THREE!!!
THANK YOU FOR YOUR ATTENTION
@ BEING COMMITTED!!!