ECON 2000 Chapter 10 – Aggregate Demand 1: building the IS-LM Model Notes •Classic theory is not sufficient to explain economy in short-run and short-run fluctuations. oKeynes proposed that low aggregate demand is responsible for the low income and high unemployment that characterize economic downturns. Classical theory assumes that capital, labour and technology alone (i.e. aggregate supply) determines national income. •Goal in this chapter is to identify the variables that shift the aggregated demand curve, causing fluctuations in national income. •Model of aggregate demand is called IS-LM modeloWhat causes income to change in short runoWhat causes aggregate demand to curve to shift. oIS curveStands for Investment and saving Represents what’s going on int the market for goods and servicesoLM curveStands for liquidity and moneyRepresents what’s happening to the supply and demand for money. oThe interest rate, which influences both investment and money demand, is the variable that links the two halves of the IS-LM model. Model shows how interactions between these two markets determine the position and slope of the aggregate demand curve, and therefore, the level of national income in the short run. The Goods Markets and the IS Curve •IS curve plots the relationship between the interest rate and the level of income that arises in the market for goods and services. oKeynesian crossis the simplest interpretation of Keynes’s theory of national income and Is a building block of the IS-LM model. •The Keynesian CrossoKeynes proposed that an economy’s total income was, in the short run, determined largely by the desire to spend by households, firms, and the government. The problem during recessions and depressions, according to Keynes, was inadequate spending. oPlanned Expenditure Actual expenditureis the amount households, firms, and the government spend on goods and services•Equals economy’s GDP.Planned expenditureis the amount households, firms, and the government would like to spend on goods and services.
AE and PE differ because firms might engage in unplanned inventory investment because their sales do not meet their expectations. •When firms sell less of their product than they planned, their stock of inventories automatically rises; and vice versa. oBecause these unplanned changes in inventory are counted as investment spending by firms, actual expenditure can be either above or below planned expenditure. E = C + I + G•E = planned expenditure•C = consumption•I = planned investment •G = government purchases E = C(Y-T-bar) + I-bar + G-bar •This equation shows that planned expenditure is a function of income Y, the level of planned investment I-bar, and the fiscal policy variables G-bar and T-bar.