# Lecture 10 - 11/18/2009 LECTURE10 EC205.01 FALL2009 ALPER 1...

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11/18/2009 1 LECTURE LECTURE 10 EC205.01 FALL 2009 ALPER 1 Outline y Aggregate Demand: The IS LM Model y The IS Curve y The Keynesian Cross y The Loanabl Funds Model and the IS Curve The Loanable Funds Model and the IS Curve y The LM Curve y The Theory of Liquidity Preference y Short run determination of interest rates and income when price level is fixed EC205.01 FALL 2009 ALPER 2 Recall y Short Run y Price level is fixed. (Horizontal SRAS Curve) y Output is demand determined. y Unemployment and output are inversely related. EC205.01 FALL 2009 ALPER 3

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11/18/2009 2 The Keynesian Cross y Due to J.M. Keynes y A simple model of the economy where income is determined by expenditure Cl d y Closed economy y Notation: E – planned expenditure Y –actual expenditure (real GDP) I – planned investment y E = C + I + G EC205.01 FALL 2009 ALPER 4 Basic Idea y Idea : Any difference between planned expenditure and actual expenditure is due to unplanned investment ( changes in inventories ) y Equilibrium : Y = E y If Y > E then Δ inventories > 0 y Reduce production: Y declines y If Y < E then Δ inventories < 0 y Increase production: Y increases y No unplanned investment in equilibrium! EC205.01 FALL 2009 ALPER 5 Structural Equations of the Keynesian Cross =+ () CCbYT II = , GG TT == consumption function: for now, planned investment is exogenous: government policy variables: EC205.01 FALL 2009 ALPER 6 = +− + + ECbYT IG = Y E planned expenditure: equilibrium condition: actual expenditure = planned expenditure
11/18/2009 3 Graphing planned expenditure E planned expenditure = C + I + G MPC EC205.01 FALL 2009 ALPER 7 income, output, Y 1 Graphing the equilibrium condition planned expenditure = EC205.01 FALL 2009 ALPER 8 income, output, 45º The equilibrium value of income planned expenditure = = + + EC205.01 FALL 2009 ALPER 9 income, output, Equilibrium income CIGb T ++−

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11/18/2009 4 An increase in government purchases E = C + I + G 1 = + + 2 At Y 1 , there is now an unplanned drop in inventory… 2 CIG b T ++ − EC205.01 FALL 2009 ALPER 10 1 = 1 2 = 2 Δ …so firms increase output, and income rises toward a new equilibrium. Δ 1 T Solving for Δ Y CIG =++ Δ= Δ+ Δ Δ YG b CG =Δ + Δ equilibrium condition in changes because and are fixed C I EC205.01 FALL 2009 ALPER 11 −× Δ (1 b) ⎛⎞ × Δ ⎜⎟ ⎝⎠ 1 1b because Δ C = MPC Δ Y Collect terms with Δ on the left side of the equals sign: Solve for Δ : The government purchases multiplier Definition: the increase in income resulting from a one unit increase in G .
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## This note was uploaded on 12/27/2009 for the course ECONOMICS ec 205.1 taught by Professor Emrealper during the Spring '09 term at Boğaziçi University.

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Lecture 10 - 11/18/2009 LECTURE10 EC205.01 FALL2009 ALPER 1...

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