302-10 - CHAPTER AggregateDemandI BuildingtheIS LMModel...

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C H A P T E R Aggregate Demand I: Building the  IS   - LM    Model University of Wisconsin Charles Engel 10
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CHAPTER 10.01 slide 2 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
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CHAPTER 10.01 slide 3 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
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CHAPTER 10.01 slide 4 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.
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CHAPTER 10.01 slide 5 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 =  +   +  G = planned expenditure Y = real GDP = actual expenditure Difference between actual & planned expenditure = unplanned inventory investment
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CHAPTER 10.01 slide 6 Elements of the Keynesian Cross ( ) C C Y T = - I I = , G G T T = = ( ) E C Y T I G = - + + = Y E consumption function: for now, planned investment is exogenous: planned expenditure: equilibrium condition: govt policy variables: actual expenditure = planned expenditure
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CHAPTER 10.01 slide 7 Graphing planned expenditure income, output, Y E planned expenditure E  = + + G MPC 1
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CHAPTER 10.01 slide 8 Graphing the equilibrium condition income, output, Y E planned expenditure E  = Y 45 º
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CHAPTER 10.01 slide 9 The equilibrium value of income income, output, Y E planned expenditure E  = Y E  = + + G Equilibrium income
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CHAPTER 10.01 slide 10 An increase in government purchases Y E E  = Y E  = + + G 1 E 1  =  Y 1 E  = + + G 2 E 2  =  Y 2 Y At Y 1 , there is now an unplanned drop in inventory… …so firms increase output, and income rises toward a new equilibrium.
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