Chapter 11. Aggregate Demand I: Building the IS-LM Model 1

IN THIS CHAPTER, YOU WILL LEARN: the IScurve and its relation to: the Keynesian cross the loanable funds model the LMcurve and its relation to: the theory of liquidity preference how the IS-LMmodel determines income and the interest rate in the short run when Pis fixed 2

Context Chapter 10 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 3

Context This chapter develops the IS-LMmodel, the basis of the aggregate demand curve. We focus on the short run and assume the price level is fixed (so the SRAScurve is horizontal). Chapters 11 and 12 focus on the closed-economy case. Chapter 13 presents the open-economy case. 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 PE= C + I + G= planned expenditure Y= real GDP = actual expenditure Difference between actual & planned expenditure = unplanned inventory investment 5

Elements of the Keynesian cross ()CC YT=II=,GGTT==−++()PEC YTIG=YPEconsumption function: for now, planned investment is exogenous: planned expenditure: equilibrium condition: govt policy variables: actual expenditure = planned expenditure 6

Graphing planned expenditure income, output,YPEplanned expenditure PE=C +I +GMPC 1 7

Graphing the equilibrium condition income, output,YPEplanned expenditure PE=Y45º8

The equilibrium value of income income, output,YPE=YPE=C +I +GEquilibrium income PEplanned expenditure 9

An increase in government purchases YPEPE=C +I +G1PE1= Y1 PE=C +I +G2PE2= Y2 ΔY At Y1, there is now an unplanned drop in inventory… …so firms increase output, and income rises toward a new equilibrium. ΔG 10

Solving for ΔY YCIG=++YCIG∆=∆+ ∆+ ∆MPC=× ∆YGCG=∆+∆(1MPC)−×∆= ∆YG11MPC∆=× ∆−YGequilibrium condition in changes because Iexogenous because ΔC=MPCΔY Collect terms with ΔYon the left side of the equals sign: Solve for ΔY: 11

The government purchases multiplier Example: If MPC= 0.8, then Definition: the increase in income resulting from a $1 increase in G. In this model, the govt purchases multiplier equals 11MPC∆=∆−YG1510.8∆=∆−YGAn increase in G causes income to increase 5 times as much! 12

Why the multiplier is greater than 1 Initially, the increase in Gcauses an equal increase in Y:ΔY= ΔG. But YC further Yfurther C further YSo the final impact on income is much bigger than the initial ΔG. 13