CHAPTER 3
Aggregate Demand in
the closed Economy
CHAPTER 10
Aggregate Demand I
slide 0
Context
 This chapter develops the IS-LM model,
the theory that yields the aggregate demand
curve.
 We focus on the short run and assume the
price level is fixed.
 This chapter focus on the closed-economy
case. The next chapter presents the openeconomy case.
CHAPTER 10
Aggregate Demand I
slide 2
Introduction
 In the worst year, 1933, one-fourth of the U.S. labor force was
unemployed, and real GDP was 30 percent below its 1929 level.
 Classical theory (national income depends on factor supplies and the
available technology)seemed incapable of explaining the Depression.
–
Neither of which changed substantially from 1929 to 1933.
 In 1936 the British economist John Maynard Keynes revolutionized
economics with his book The General Theory of Employment,
Interest, and Money.
 Keynes: low aggregate demand is responsible for the economic
downturns
 Economists reconcile:
In the long run, prices are flexible, and aggregate supply determines
income.
– But in the short run, prices are sticky, so changes in aggregate demand
influence income.
–
CHAPTER 10
Aggregate Demand I
slide 3
The Goods Market and the IS Curve
 The model of aggregate demand
developed in this chapter, called the IS–
LM model, is the leading interpretation
of Keynes’s theory.The goal of the model
is to show what determines national
income for any given price level.
 The IS curve plots the relationship
between the interest rate and the level of
income that arises in the market for
goods and services.
CHAPTER 10
Aggregate Demand I
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
CHAPTER 10
Aggregate Demand I
slide 5
Elements of the Keynesian Cross
consumption function:
C  C (Y T )
govt policy variables:
G  G , T T
for now, planned
investment is exogenous:
planned expenditure:
I I
E  C (Y  T )  I  G
Equilibrium condition:
Actual expenditure  Planned expenditure
Y  E
CHAPTER 10
Aggregate Demand I
slide 6
Graphing planned expenditure
E
planned
expenditure
E =C +I + G
MPC
1
income, output, Y
CHAPTER 10
Aggregate Demand I
slide 7
Graphing the equilibrium condition
E
E =Y
planned
expenditure
45º
income, output, Y
CHAPTER 10
Aggregate Demand I
slide 8
The equilibrium value of income
E
E =Y
planned
expenditure
E =C +I + G
income, output, Y
Equilibrium
income
CHAPTER 10
Aggregate Demand I
slide 9
An increase in government purchases
E
At Y1,
there is now an
unplanned drop
in inventory…
E = C + I + G2
E = C + I + G1
G
…so firms
increase output,
and income
rises toward a
new equilibrium
CHAPTER 10
Y
E1 = Y 1
Y
Aggregate Demand I
E2 = Y2
slide 10
Solving for Y
Y  C  I  G
equilibrium condition
Y  C  I  G
in changes

C
 G
 MPC  Y  G
Collect terms with Y
on the left side of the
equals sign:
(1  MPC) Y  G
CHAPTER 10
because I exogenous
because C = MPC Y
Finally, solve for Y :


1
Y  
  G
 1  MPC 
Aggregate Demand I
slide 11
The government purchases multiplier
Definition: the increase in income resulting
from a $1 increase in G.
In this model, the govt purchases
multiplier equals Y
1

G
1  MPC
Example: If MPC = 0.8, then
An increase in G
Y
1

 5
causes income to
G
1  0.8
increase by 5 times
as much!
CHAPTER 10
Aggregate Demand I
slide 12
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
slide 13
An increase in taxes
E
Initially, the tax
increase reduces
consumption, and
therefore E:
E =C1 +I +G
E =C2 +I +G
At Y1, there is now
an unplanned
inventory buildup…
C = MPC T
…so firms
reduce output,
and income falls
toward a new
equilibrium
CHAPTER 10
Y
E2 = Y 2
Y
Aggregate Demand I
E1 = Y1
slide 14
Solving for Y
eq’m condition in
changes
Y  C  I  G
 C
I and G exogenous
 MPC   Y  T
Solving for Y :
Final result:
CHAPTER 10

(1  MPC) Y   MPC  T
  MPC 
Y  
  T
 1  MPC 
Aggregate Demand I
slide 15
The Tax Multiplier
def: the change in income resulting from
a $1 increase in T :
Y
T
 MPC

1  MPC
If MPC = 0.8, then the tax multiplier equals
Y
T
CHAPTER 10
 0.8
 0.8


 4
1  0.8
0.2
Aggregate Demand I
slide 16
The Tax Multiplier
…is negative:
A tax hike reduces
consumer spending,
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
slide 17
Exercise:
 Use a graph of the Keynesian Cross
to show the impact of an increase in
planned investment on the equilibrium
level of income/output.
CHAPTER 10
Aggregate Demand I
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
CHAPTER 10
Aggregate Demand I
slide 19
Deriving the IS curve
CHAPTER 10
Aggregate Demand I
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.
CHAPTER 10
Aggregate Demand I
slide 21
The IS curve and the Loanable Funds model
(b) The IS curve
(a) The L.F. model
r
S2
r
S1
r2
r2
r1
r1
I (r )
S, I
CHAPTER 10
Aggregate Demand I
IS
Y2
Y1
Y
slide 22
Fiscal Policy and the IS curve
 We can use the IS-LM model to see
how fiscal policy (G and T ) can affect
aggregate demand and output.
 Let’s start by using the Keynesian Cross
to see how fiscal policy shifts the IS
curve…
CHAPTER 10
Aggregate Demand I
slide 23
Shifting the IS curve: G
At any value of r,
G  E   Y
…so the IS curve
shifts to the right.
The horizontal
distance of the
IS shift equals
E =Y E =C +I (r )+G
1
2
E
E =C +I (r1 )+G1
r
Y1
r1
1
Y 
G
1  MPC
Y
Y1
CHAPTER 10
Y
Y2
IS1
Y2
Aggregate Demand I
IS2
Y
slide 24
Exercise: Shifting the IS curve
 Use the diagram of the Keynesian Cross
or Loanable Funds model to show how
an increase in taxes shifts the IS curve.
CHAPTER 10
Aggregate Demand I
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.
CHAPTER 10
Aggregate Demand I
slide 26
Money Supply
The supply of
real money
balances
is fixed:
M
r
interest
rate
M
P
s
P M P
s
M P
CHAPTER 10
Aggregate Demand I
M/P
real money
balances
slide 27
Money Demand
r
Demand for
real money
balances:
M
P
d
interest
rate
M
P
s
 L (r )
L (r )
M P
CHAPTER 10
Aggregate Demand I
M/P
real money
balances
slide 28
Equilibrium
The interest
rate adjusts
to equate the
supply and
demand for
money:
M P  L (r )
r
interest
rate
M
P
r1
L (r )
M P
CHAPTER 10
s
Aggregate Demand I
M/P
real money
balances
slide 29
How the Fed raises the interest rate
r
interest
rate
To increase r,
Fed reduces M
r2
r1
L (r )
M2
P
CHAPTER 10
Aggregate Demand I
M1
P
M/P
real money
balances
slide 30
CASE STUDY
Volcker’s Monetary Tightening
 Late 1970s:  > 10%
 Oct 1979: Fed Chairman Paul Volcker
announced that monetary policy
would aim to reduce inflation.
 Aug 1979-April 1980:
Fed reduces M/P 8.0%
 Jan 1983:  = 3.7%
How do you think this policy change
would affect interest rates?
CHAPTER 10
Aggregate Demand I
slide 31
Volcker’s Monetary Tightening, cont.
The effects of a monetary tightening
on nominal interest rates
model
short run
long run
Liquidity Preference
Quantity Theory,
Fisher Effect
(Keynesian)
(Classical)
prices
sticky
flexible
prediction
i > 0
i < 0
actual
outcome
8/1979: i = 10.4%
4/1980: i = 15.8%
1/1983: i = 8.2%
CHAPTER 10
Aggregate Demand I
slide 32
The LM curve
Now let’s put Y back into the money demand
function:
d
M
P
 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
slide 33
Deriving the LM curve
(a) The market for
r
real money balances
(b) The LM curve
r
LM
r2
r2
L (r , Y2 )
r1
r1
L (r , Y1 )
M1
P
CHAPTER 10
M/P
Aggregate Demand I
Y1
Y2
Y
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.
CHAPTER 10
Aggregate Demand I
slide 35
How M shifts the LM curve
(a) The market for
r
real money balances
(b) The LM curve
r
LM2
LM1
r2
r2
r1
r1
L ( r , Y1 )
M2
P
CHAPTER 10
M1
P
M/P
Aggregate Demand I
Y1
Y
slide 36
Exercise: Shifting the LM curve
 Suppose a wave of credit card fraud
causes consumers to use cash more
frequently in transactions.
 Use the Liquidity Preference model
to show how these events shift the
LM curve.
CHAPTER 10
Aggregate Demand I
slide 37
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:
r
Y  C (Y  T )  I (r )  G
LM
IS
Y
M P  L (r ,Y )
Equilibrium
interest
rate
CHAPTER 10
Aggregate Demand I
Equilibrium
level of
income
slide 38
The Big Picture
Keynesian
Cross
Theory of
Liquidity
Preference
IS
curve
LM
curve
IS-LM
model
Agg.
demand
curve
Agg.
supply
curve
CHAPTER 10
Aggregate Demand I
Explanation
of short-run
fluctuations
Model of
Agg.
Demand
and Agg.
Supply
slide 39
Chapter summary
1. Keynesian Cross
 basic model of income determination
 takes fiscal policy & investment as exogenous
 fiscal policy has a multiplier effect on income.
2. IS curve
 comes from Keynesian Cross when planned
investment depends negatively on interest rate
 shows all combinations of r and Y
that equate planned expenditure with
actual expenditure on goods & services
CHAPTER 10
Aggregate Demand I
slide 40
Chapter summary
3. Theory of Liquidity Preference
 basic model of interest rate determination
 takes money supply & price level as exogenous
 an increase in the money supply lowers the
interest rate
4. LM curve
 comes from Liquidity Preference Theory when
money demand depends positively on income
 shows all combinations of r andY that equate
demand for real money balances with supply
CHAPTER 10
Aggregate Demand I
slide 41
Chapter summary
5. IS-LM model
 Intersection of IS and LM curves shows the
unique point (Y, r ) that satisfies equilibrium
in both the goods and money markets.
CHAPTER 10
Aggregate Demand I
slide 42
Preview of Chapter 3
In Chapter 3, we will
 use the IS-LM model to analyze the impact
of policies and shocks
 learn how the aggregate demand curve
comes from IS-LM
 use the IS-LM and AD-AS models together
to analyze the short-run and long-run
effects of shocks
 use our models to learn about
the Great Depression
CHAPTER 10
Aggregate Demand I
slide 43
Context
 In the next section, we will use the IS-LM
model to
– see how policies and shocks affect income
and the interest rate in the short run when
prices are fixed
– derive the aggregate demand curve
– explore various explanations for the
Great Depression
CHAPTER 10
Aggregate Demand I
slide 44
Equilibrium in the IS-LM Model
The IS curve represents
equilibrium in the goods
market.
Y  C (Y  T )  I (r )  G
r
LM
The LM curve represents r1
money market equilibrium.
IS
M P  L (r ,Y )
Y1
The intersection determines
the unique combination of Y and r
that satisfies equilibrium in both markets.
CHAPTER 10
Aggregate Demand I
Y
slide 45
Policy analysis with the IS-LM Model
Y  C (Y  T )  I (r )  G
r
LM
M P  L (r ,Y )
Policymakers can affect
macroeconomic variables
r1
with
• fiscal policy: G and/or T
• monetary policy: M
We can use the IS-LM
model to analyze the
effects of these policies.
CHAPTER 10
Aggregate Demand I
IS
Y1
Y
slide 46
An increase in government purchases
r
1. IS curve shifts right
1
by
G
1  MPC
causing output &
income to rise.
2. This raises money
2.
LM
r2
r1
3. …which reduces investment,
so the final increase in Y
1
is smaller than
G
1  MPC
CHAPTER 10
Aggregate Demand I
IS2
1.
demand, causing the
interest rate to rise…
IS1
Y1 Y2
Y
3.
slide 47
A tax cut
Because consumers save
(1MPC) of the tax cut,
the initial boost in
spending is smaller for T
than for an equal G…
and the IS curve
shifts by
MPC
1.
T
1  MPC
r
r2
2.
r1
2. …so the effects on r and Y
are smaller for a T than
for an equal G.
CHAPTER 10
LM
Aggregate Demand I
1.
IS2
IS1
Y1 Y2
Y
2.
slide 48
Monetary Policy: an increase in M
1. M > 0 shifts
the LM curve down
(or to the right)
2. …causing the
interest rate to fall
r
LM2
r1
r2
3. …which increases
investment, causing
output & income to
rise.
CHAPTER 10
LM1
Aggregate Demand I
IS
Y1 Y2
Y
slide 49
Interaction between
monetary & fiscal policy
 Model:
monetary & fiscal policy variables
(M, G and T ) are exogenous
 Real world:
Monetary policymakers may adjust M
in response to changes in fiscal policy,
or vice versa.
 Such interaction may alter the impact of
the original policy change.
CHAPTER 10
Aggregate Demand I
slide 50
The Fed’s response to G > 0
 Suppose Congress increases G.
 Possible Fed responses:
1. hold M constant
2. hold r constant
3. hold Y constant
 In each case, the effects of the G
are different:
CHAPTER 10
Aggregate Demand I
slide 51
Response 1: hold M constant
If Congress raises G,
the IS curve shifts
right
If Fed holds M
constant, then LM
curve doesn’t shift.
r
LM1
r2
r1
IS2
IS1
Results:
Y  Y 2  Y1
Y1 Y2
Y
r  r2  r1
CHAPTER 10
Aggregate Demand I
slide 52
Response 2: hold r constant
If Congress raises G,
the IS curve shifts
right
r
To keep r constant,
Fed increases M to
shift LM curve right.
r2
r1
LM1
IS2
IS1
Results:
Y  Y 3  Y1
LM2
Y1 Y2 Y3
Y
r  0
CHAPTER 10
Aggregate Demand I
slide 53
Response 3: hold Y constant
If Congress raises G,
the IS curve shifts
right
To keep Y constant,
Fed reduces M to
shift LM curve left.
LM2
LM1
r
r3
r2
r1
IS2
IS1
Results:
Y  0
Y1 Y2
Y
r  r3  r1
CHAPTER 10
Aggregate Demand I
slide 54
Estimates of fiscal policy multipliers
from the DRI macroeconometric model
Estimated
value of
Y / G
Estimated
value of
Y / T
Fed holds money
supply constant
0.60
0.26
Fed holds nominal
interest rate constant
1.93
1.19
Assumption about
monetary policy
CHAPTER 10
Aggregate Demand I
slide 55
Shocks in the IS-LM Model
IS shocks: exogenous changes in the
demand for goods & services.
Examples:
• stock market boom or crash
 change in households’ wealth
 C
• change in business or consumer
confidence or expectations
 I and/or C
CHAPTER 10
Aggregate Demand I
slide 56
Shocks in the IS-LM Model
LM shocks: exogenous changes in the
demand for money.
Examples:
• a wave of credit card fraud increases
demand for money
• more ATMs or the Internet reduce money
demand
CHAPTER 10
Aggregate Demand I
slide 57
EXERCISE:
Analyze shocks with the IS-LM model
Use the IS-LM model to analyze the effects of
1. A boom in the stock market makes
consumers wealthier.
2. After a wave of credit card fraud, consumers
use cash more frequently in transactions.
For each shock,
a. use the IS-LM diagram to show the effects
of the shock on Y and r .
b. determine what happens to C, I, and the
unemployment rate.
CHAPTER 10
Aggregate Demand I
slide 58
IS-LM and Aggregate Demand
 So far, we’ve been using the IS-LM model
to analyze the short run, when the price
level is assumed fixed.
 However, a change in P would shift the LM
curve and therefore affect Y.
 The aggregate demand curve
(introduced in chap. 9 ) captures this
relationship between P and Y
CHAPTER 10
Aggregate Demand I
slide 59
Deriving the AD curve
Intuition for slope
of AD curve:
P  (M/P )
 LM shifts left
 r
 I
 Y
r
LM(P2)
LM(P1)
r2
r1
IS
P
Y2
Y
P2
P1
AD
Y2
CHAPTER 10
Y1
Aggregate Demand I
Y1
Y
slide 60
Monetary policy and the AD curve
The Fed can increase
aggregate demand:
M  LM shifts right
r
LM(M1/P1)
LM(M2/P1)
r1
r2
IS
 r
 I
P
 Y at each
value of P
P1
Y1
Y1
CHAPTER 10
Aggregate Demand I
Y2
Y2
Y
AD2
AD1
Y
slide 61
Fiscal policy and the AD curve
Expansionary fiscal policy
(G and/or T )
increases agg. demand:
r
LM
r2
r1
IS2
T  C
IS1
 IS shifts right
P
Y1
Y2
Y
 Y at each
value
P1
of P
Y1
CHAPTER 10
Aggregate Demand I
Y2
AD2
AD1
Y
slide 62
IS-LM and AD-AS
in the short run & long run
Recall :
The force that moves the economy
from the short run to the long run
is the gradual adjustment of prices.
In the short-run
equilibrium, if
then over time,
the price level will
Y Y
rise
Y Y
fall
Y Y
remain constant
CHAPTER 10
Aggregate Demand I
slide 63
The SR and LR effects of an IS shock
r
A negative IS shock
shifts IS and AD left,
causing Y to fall.
LRAS LM(P )
1
IS2
Y
P
SRAS1
Y
Aggregate Demand I
Y
LRAS
P1
CHAPTER 10
IS1
AD1
AD2
Y
slide 64
The SR and LR effects of an IS shock
r
LRAS LM(P )
1
In the new short-run
equilibrium, Y  Y
IS2
Y
P
SRAS1
Y
Aggregate Demand I
Y
LRAS
P1
CHAPTER 10
IS1
AD1
AD2
Y
slide 65
The SR and LR effects of an IS shock
r
LRAS LM(P )
1
In the new short-run
equilibrium, Y  Y
IS2
Over time,
P gradually falls,
which causes
• SRAS to move down
• M/P to increase,
which causes LM
to move down
CHAPTER 10
Y
P
Y
LRAS
P1
Aggregate Demand I
IS1
SRAS1
Y
AD1
AD2
Y
slide 66
The SR and LR effects of an IS shock
r
LRAS LM(P )
1
LM(P2)
IS2
Over time,
P gradually falls,
which causes
• SRAS to move down
• M/P to increase,
which causes LM
to move down
CHAPTER 10
Y
P
IS1
Y
LRAS
P1
SRAS1
P2
SRAS2
Aggregate Demand I
Y
AD1
AD2
Y
slide 67
The SR and LR effects of an IS shock
r
LRAS LM(P )
1
LM(P2)
This process continues
until economy reaches
a long-run equilibrium
with
Y Y
IS2
Y
P
Y
LRAS
P1
SRAS1
P2
SRAS2
Y
CHAPTER 10
IS1
Aggregate Demand I
AD1
AD2
Y
slide 68
EXERCISE:
Analyze SR & LR effects of M
a. Draw the IS-LM and AD-AS r
diagrams as shown here.
b. Suppose Fed increases M.
Show the short-run effects
on your graphs.
c. Show what happens in the
transition from the short
P
run to the long run.
d. How do the new long-run
P1
equilibrium values of the
endogenous variables
compare to their initial
values?
CHAPTER 10
Aggregate Demand I
LRAS LM(M /P )
1
1
IS
Y
Y
LRAS
SRAS1
AD1
Y
Y
slide 69
240
30
220
Unemployment
25
(right scale)
200
20
180
15
160
10
140
5
120
1929
0
1931
1933
1935
1937
percent of labor force
billions of 1958 dollars
The Great Depression
1939
Real GNP
(left scale)
CHAPTER 10
Aggregate Demand I
slide 70
The Spending Hypothesis:
Shocks to the IS Curve
 asserts that the Depression was largely due
to an exogenous fall in the demand for
goods & services -- a leftward shift of the IS
curve
 evidence:
output and interest rates both fell, which is
what a leftward IS shift would cause
CHAPTER 10
Aggregate Demand I
slide 71
The Spending Hypothesis:
Reasons for the IS shift
1. Stock market crash  exogenous C
 Oct-Dec 1929: S&P 500 fell 17%
 Oct 1929-Dec 1933: S&P 500 fell 71%
2. Drop in investment
 “correction” after overbuilding in the 1920s
 widespread bank failures made it harder to
obtain financing for investment
3. Contractionary fiscal policy
 in the face of falling tax revenues and
increasing deficits, politicians raised tax rates
and cut spending
CHAPTER 10
Aggregate Demand I
slide 72
The Money Hypothesis:
A Shock to the LM Curve
 asserts that the Depression was largely due
to huge fall in the money supply
 evidence:
M1 fell 25% during 1929-33.
But, two problems with this hypothesis:
1. P fell even more, so M/P actually rose
slightly during 1929-31.
2. nominal interest rates fell, which is the
opposite of what would result from a
leftward LM shift.
CHAPTER 10
Aggregate Demand I
slide 73
The Money Hypothesis Again:
The Effects of Falling Prices
 asserts that the severity of the Depression
was due to a huge deflation:
P fell 25% during 1929-33.
 This deflation was probably caused by
the fall in M, so perhaps money played
an important role after all.
 In what ways does a deflation affect the
economy?
CHAPTER 10
Aggregate Demand I
slide 74
The Money Hypothesis Again:
The Effects of Falling Prices
The stabilizing effects of deflation:
 P  (M/P )  LM shifts right  Y
 Pigou effect:
P  (M/P )
 consumers’ wealth 
 C
 IS shifts right
 Y
CHAPTER 10
Aggregate Demand I
slide 75
The Money Hypothesis Again:
The Effects of Falling Prices
The destabilizing effects of unexpected deflation:
debt-deflation theory
P (if unexpected)
 transfers purchasing power from borrowers
to lenders
 borrowers spend less,
lenders spend more
 if borrowers’ propensity to spend is larger
than lenders, then aggregate spending falls,
the IS curve shifts left, and Y falls
CHAPTER 10
Aggregate Demand I
slide 76
The Money Hypothesis Again:
The Effects of Falling Prices
The destabilizing effects of expected deflation:
e




r  for each value of i
I  because I = I (r )
planned expenditure & agg. demand 
income & output 
CHAPTER 10
Aggregate Demand I
slide 77
Why another Depression is unlikely
 Policymakers (or their advisors) now know
much more about macroeconomics:
 The Fed knows better than to let M fall
so much, especially during a contraction.
 Fiscal policymakers know better than to raise
taxes or cut spending during a contraction.
 Federal deposit insurance makes widespread
bank failures very unlikely.
 Automatic stabilizers make fiscal policy
expansionary during an economic downturn.
CHAPTER 10
Aggregate Demand I
slide 78
Chapter summary
1. IS-LM model
 a theory of aggregate demand
 exogenous: M, G, T,
P exogenous in short run, Y in long run
 endogenous: r,
Y endogenous in short run, P in long run
 IS curve: goods market equilibrium
 LM curve: money market equilibrium
CHAPTER 10
Aggregate Demand I
slide 79
Chapter summary
2. AD curve
 shows relation between P and the IS-LM
model’s equilibrium Y.
 negative slope because
P  (M/P )  r  I  Y
 expansionary fiscal policy shifts IS curve right,
raises income, and shifts AD curve right
 expansionary monetary policy shifts LM curve
right, raises income, and shifts AD curve right
 IS or LM shocks shift the AD curve
CHAPTER 10
Aggregate Demand I
slide 80