CHAPTER
10
Aggregate Demand I:
Building the IS -LM Model
Adapted for EC 204 by
Prof. Bob Murphy
MACROECONOMICS
SIXTH EDITION
N. GREGORY MANKIW
PowerPoint® Slides by Ron Cronovich
© 2007 Worth Publishers, all rights reserved
In this chapter, you will learn…
 the IS curve, and its relation to
 the Keynesian cross
 the loanable funds model
 the LM curve, and its relation to
 the theory of liquidity preference
 how the IS-LM model determines income and
the interest rate in the short run when P is fixed
CHAPTER 10
Aggregate Demand I
slide 1
Context
 Chapter 9 introduced the model of aggregate
demand and aggregate supply.
 Long run
 prices flexible
 output determined by factors of production &
technology
 unemployment equals its natural rate
 Short run
 prices fixed
 output determined by aggregate demand
 unemployment negatively related to output
CHAPTER 10
Aggregate Demand I
slide 2
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).
 This chapter (and chapter 11) focus on the
closed-economy case.
Chapter 12 presents the open-economy case.
CHAPTER 10
Aggregate Demand I
slide 3
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 4
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 5
Graphing planned expenditure
E
planned
expenditure
E =C +I +G
MPC
1
income, output, Y
CHAPTER 10
Aggregate Demand I
slide 6
Graphing the equilibrium condition
E
E =Y
planned
expenditure
45º
income, output, Y
CHAPTER 10
Aggregate Demand I
slide 7
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 8
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 18
Deriving the IS curve
E =Y E =C +I (r )+G
2
E
r
E =C +I (r1 )+G
 I
 E
 Y
I
r
Y1
Y
Y2
r1
r2
IS
Y1
CHAPTER 10
Aggregate Demand I
Y2
Y
slide 19
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 20
The IS curve and the loanable funds
model
(a) The L.F. model
r
S2
(b) The IS curve
r
S1
r2
r2
r1
r1
I (r )
S, I
CHAPTER 10
Aggregate Demand I
IS
Y2
Y1
Y
slide 21
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.
 Let’s start by using the Keynesian cross
to see how fiscal policy shifts the IS curve…
CHAPTER 10
Aggregate Demand I
slide 22
Shifting the IS curve: G
At any value of r,
G  E  Y
E =Y E =C +I (r )+G
1
2
E
E =C +I (r1 )+G1
…so the IS curve
shifts to the right.
The horizontal
distance of the
IS shift equals
r
Y1
r1
Y
1
Y 
G
1 MPC
Y1
CHAPTER 10
Y
Y2
Aggregate Demand I
IS1
Y2
IS2
Y
slide 23
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 25
Money supply
r
The supply of
real money
balances
is fixed:
interest
rate
M
P
s
M P   M P
s
M P
CHAPTER 10
Aggregate Demand I
M/P
real money
balances
slide 26
Money demand
r
Demand for
real money
balances:
M P 
d
interest
rate
M
P
 L(r )
L (r )
M P
CHAPTER 10
Aggregate Demand I
s
M/P
real money
balances
slide 27
Equilibrium
The interest
rate adjusts
to equate the
supply and
demand for
money:
r
interest
rate
M
P
r1
L (r )
M P  L (r )
M P
CHAPTER 10
s
Aggregate Demand I
M/P
real money
balances
slide 28
How the Fed raises the interest rate
r
To increase r,
Fed reduces M
interest
rate
r2
r1
L (r )
M2
P
CHAPTER 10
Aggregate Demand I
M1
P
M/P
real money
balances
slide 29
CASE STUDY:
Monetary Tightening & Interest Rates
 Late 1970s:  > 10%
 Oct 1979: Fed Chairman Paul Volcker
announces 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 nominal interest rates?
CHAPTER 10
Aggregate Demand I
slide 30
Monetary Tightening & Rates, 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%
8/1979: i = 10.4%
4/1980: i = 15.8%
1/1983: i = 8.2%
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 32
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 33
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 34
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 35
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:
Y  C (Y  T )  I (r )  G
r
LM
IS
Y
M P  L(r ,Y )
CHAPTER 10
Equilibrium
interest
rate
Aggregate Demand I
Equilibrium
level of
income
slide 37
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 38