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Keynesian CrossThe IS-CurveThe LM-CurveIS-LM ModelClass 14, Business Cycle: the ISLM modelABC chapter 9 (mostly) and/or Williamsonchapter 13Julieta CaunedoCORNELL UNIVERSITY
Keynesian CrossThe IS-CurveThe LM-CurveIS-LM ModelThe IS-LM ModelTheKeynesian CrossTheIS Curve: Equilibrium in the Goods MarketTheLM Curve: Asset Market EquilibriumEquilibrium in the Complete IS-LM ModelIS-LM is the basis of the aggregate demand curve.We assume theprice level is fixed.We also assume aclosed economy.
Keynesian CrossThe IS-CurveThe LM-CurveIS-LM ModelShort-Run vs. Long-Run AnalysisLong run:Prices P flexibleOutput determined by factors of production & technologyUnemployment equals its natural rateShort run:Prices P fixedOutput determined by aggregate demandUnemployment negatively related to outputIS-LM model determines incomeYand the interest raterwhen Pis fixedIS-LM therefore focuses onshort-runanalysis.
Keynesian CrossThe IS-CurveThe LM-CurveIS-LM ModelKeynesian CrossA simple closed economy model in which income isdetermined by expenditure. (due to J.M. Keynes)Notation:I=planned investmentE=C+I+G=planned expenditureY=real GDP = actual expenditureDifference between actual and planned expenditure =unplanned inventory investment
Keynesian CrossThe IS-CurveThe LM-CurveIS-LM ModelElements of The Keynesian CrossConsumption Function:C=Ca+MPC×(Y-T),0<MPC<1Investment: exogenous for nowI=¯IGovernment: exogenousG=¯G,T=¯TSo planned expenditureE=Ca+MPC×(Y-¯T) +¯I+¯GGoods Market Equilibrium Condition:actual expenditure = planned expenditureY=ENote: this is the same as saying that savings must equal plannedinvestment:(Y-¯T-C) + (¯T-¯G) =¯I
An Increase in Government Spending
Keynesian CrossThe IS-CurveThe LM-CurveIS-LM ModelSolving for ΔYY=C+I+G(equilibrium condition)ΔY=ΔC+ ΔI+ ΔG(in changes)=ΔC+ ΔG(I is exogenous)=MPC×ΔY+ ΔG(using consumption function)After solving for ΔY:ΔY=ΔG1-MPC
Keynesian CrossThe IS-CurveThe LM-CurveIS-LM ModelSolving for ΔYΔY=ΔG1-MPCSupposeMPC= 0.8 then a 1$ increase inGleads to a11-0.8= 5$increase in income!ΔYΔG=11-MPCis thegovernment spending multiplier.