Intermediate macroeconomics chapt10

The IS-LM ModelA short-run macroeconomic model which takes the price level constant and shows how changes in the level of Aggregate Demand cause changes in income.. Effect of Stabilizati

Chapter 10: Aggregate Demand I

The IS-LM Model

A short-run macroeconomic model which takes the price level constant and shows how changes in the level of Aggregate Demand cause changes in income

The IS curve: The Keynesian Cross Theory

The LM curve: The Liquidity Preference Theory

Shift in Aggregate Demand

The Keynesian Cross

Equilibrium in the product market:

Planned Expenditures: E = C(Y-T) + I + G

Actual Expenditures: Y

Aggregate Equilibrium: Y = C(Y-T) + I + G

Total income = Total planned expenditures

Adjustment to Equilibrium

Y1> Y indicates an excess supply of goods in the market

So, businesses accumulate inventories to reduce Y1 to Y

Y2<Y indicates an excess demand for goods in the market

So, businesses reduce inventories to increase Y2 to Y

Effect of Stabilization Policy

A government policy of changing planned expenditure, C,

I, or G, would shift the Planned Expenditure line to

increase the level of income

The increase in income is subject to a multiplier effect as spending by consumers receiving the new income, creates income for other consumers

Effect of Government Spending Policy

Government Spending Multiplier

ΔG = Increase in government purchases

ΔY = Increase in income

Multiplier effect: ΔY / ΔG = 1 / (1 – MPC)

Example, MPC = 0.6, Spending Multiplier = 2.50; Any $1

increase in G creates an additional $2.50 of income

Effect of Government Tax Policy

Government Tax Multiplier

ΔT = Decrease in income taxes

ΔC = Increase in consumption = -MPC * ΔT

ΔY = Increase in income

Multiplier effect: ΔY / ΔT = -MPC / (1 – MPC)

Example, MPC = 0.6, Tax Multiplier = -1.50; Any $1 decrease in T creates an additional $1.50 of income

Derivation of IS Curve

IS shows level of income and interest rate that bring about equilibrium to the product market

Assume an initial income level and interest rate An

increases in interest rate reduces planned investment

Then, the Planned Expenditure line shifts down, causing income to decline

IS shows pairs of income and interest rate such as (Y 1 , r 1 ) and (Y 2 , r 2 ) that bring about equilibrium in the product market The higher the interest rate, the lower the level of income.

IS 1

IS 2

Theory of Liquidity Preference

Equilibrium in the money market

Demand for money: (M/P)d = L(r,Y)

Money supply: (M/P)s = M/P

Equilibrium: M/P = L(r, Y)

Money Market Equilibrium

r

M/P

L(r, Y)

_ M/P

r1

Derivation of LM Curve

An increase in the level of income causes the demand for money to increase As a result of a higher demand for money, the interest rate goes up

The higher the level of income, the higher is the rate of interest

Aggregate Equilibrium

Aggregate equilibrium is achieved when IS = LM

IS: Y = C(Y - T) + I(r) + G

LM: M/P = L(r, Y)

Theory of Short-Run Fluctuations

AD Curve

AS Curve

AD-AS Model

Short-run Fluctuations: Income Interest Rate