Chapter 10
Aggregate Demand I:
Building the IS-LM Model

Can We Ignore Short Run?
 In 1933, unemployment rate was 25% and
GDP was one-third below its 1929 level.
 Classics: supply creates its own demand.
 Keynes: aggregate demand fluctuates independent of the supply.
 Classics: prices adjust fast.
 Keynes: prices are sticky.
2

Expenditures
PE = C + I + G + NX Leave NX for Ch. 12; NX=0
C = c(Y-T) Consumption is determined by MPC times disposable income.
T, I, G are exogenous: values given outside of the model.
3

Keynesian Cross
For the economy to be in equilibrium
(the circular flow to have top and bottom flows matched) the horizontal distance has to equal to the vertical distance.
The 45-degree line represents Y=PE.
4

Equilibrium in Keynesian Cross
Firms Households
Review your circular flow diagram: Ch. 2, slide #5
5

Multiplier: Response of Y to a
Change in Expenditure



Y
Y
Y
1




G

( MPC )

Y

G

Y

MPC
MPC


G

Y

Y

G

1

1
MPC
If ΔG=700 and MPC=0.33, what is ΔY?

Y
 
G
 
G ( MPC )
 
G ( MPC )( MPC )
 
G ( MPC )
3 
...
 
G ( MPC ) n
6

Multiplier for a Tax Cut

Y

( MPC )

T

( MPC
1

Y

Y


Y

T


T
MPC
( MPC


Y

T
)

MPC
( MPC )

Y

1
MPC

MPC
)

Y
Which fiscal policy gives more bang for the buck?
Increasing government expenditures or reducing taxes?
7

Derivation of IS Curve
PE
C

 c (
C
Y

I


T )
G
I
Y

I ( r )

PE
G,T, and r are exogenous.
8

Shifts in IS
What shifts Keynesian PE curve?
Any increase in the components of PE:
C, I, G.
Any decrease in taxes.
If real interest rate drops and PE shifts up, what will happen to IS?
Movement along the IS!
9

Monetary Sector and
Nominal Interest Rate
How does the sector move from the first equilibrium to the second?
10

Derivation of the LM Curve
M
P d

L ( r , Y )
Demand for money (liquidity preference) increases with real income but decreases with higher interest rates.
11

Shifts in LM
Money supply increases will shift LM right; money supply decreases will shift it to the left.
12

Equilibrium: r* and Y*
John Hicks
C
IS:
PE

C
 c ( Y

I

G

T )
I
Y

I ( r )

PE
LM: d
M

L ( r , Y )
P
M s 
M d
13

Theory of Short Run Fluctuations
Y=C+I+G
M/P=L(r,Y)
Y=f(r)
Y=f(r,M/P)
Equate Ys solve for r
Equate rs solve for Y
Y=f(P)
LR: Y=f(K,L)
SR: Y=f(AD)
14

Contradiction?
 IS-LM Model says if the Central Bank increases the money supply, interest rates will fall.
 Fisher effect said that if inflation rises, interest rates will rise.
 Money supply increases trigger inflation.
 What is going on?
15

r
Ms
Contradiction?
r
LM
IS
M/P
Y
Fisher effect: Nominal interest rate = real interest rate + inflation
16