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This chapter sets up the IS-LM model, which chapter 11 then uses extensively to analyze the effects of policies and economic shocks. This chapter also introduces students to the Keynesian Cross and Liquidity Preference models, which underlie the IS curve and LM curve, respectively. If you would like to spend less time on this chapter, you might consider omitting the Keynesian Cross, instead using the loanable funds model from Chapter 3 to derive the IS curve.
Review of the previous lecture Long run: prices are flexible, output and employment are always at their natural rates, and the classical theory applies Short run: prices are sticky, shocks can push output and employment away from their natural rates Aggregate demand and supply: a framework to analyze economic fluctuations The aggregate demand curve slopes downward The long-run aggregate supply curve is vertical, because output depends on technology and factor supplies, but not prices The short-run aggregate supply curve is horizontal, because prices are sticky at predetermined levels Review of the previous lecture Shocks to aggregate demand and supply cause fluctuations in GDP and employment in the short run The Fed can attempt to stabilize the economy with monetary policy Lecture 15 Aggregate demand – I Instructor: Prof Dr Qaisar Abbas Lecture Contents • the IS curve, and its relation to – the Keynesian Cross – the Loanable Funds model 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 = C + I + G = planned expenditure Y = real GDP = actual expenditure • Difference between actual & planned expenditure: unplanned inventory investment Elements of the Keynesian Cross C = C (Y − T ) consumption function: G = G , T =T govt policy variables: for now, investment is exogenous: planned expenditure: I =I E = C (Y − T ) + I + G Equilibrium condition: Actual expenditure = Planned expenditure Y = E Graphing planned expenditure E planned E =C +I +G expenditure MPC income, output, Y Graphing the equilibrium condition E E =Y planned expenditure 45º income, output, Y The equilibrium value of income E E =Y planned E =C +I +G expenditure income, output, Y Equilibrium income An increase in government purchases E =Y E At Y1, there is now an unplanned drop in inventory… E =C +I +G2 E =C +I +G1 G …so firms increase output, and income rises toward a new equilibrium Y E1 = Y1 Y E2 = Y2 Why the multiplier is greater than • Initially, the increase in G causes an equal increase in Y: • But Y Y= C further Y further C further Y • So the final impact on income is much bigger than the initial G G E =Y An increase in taxes E Initially, the tax increase reduces consumption, and therefore E: E =C1 +I +G E =C2 +I +G At Y1, there is now an unplanned inventory buildup… C = MPC T …so firms reduce output, and income falls toward a new equilibrium Y E2 = Y2 Y E1 = Y1 Solving for eq’m condition in changes ∆Y = ∆C + ∆I + ∆G = ∆C = MPC I and G exogenous ( ∆Y Solving for Y : Final result: Y − ∆T ) (1 − MPC) ∆Y = − MPC ∆T �− MPC � ∆Y = � � ∆T − MPC � � The Tax Multiplier def: the change in income resulting from a $1 increase in T : ∆Y ∆T − MPC = − MPC If MPC = 0.8, then the tax multiplier equals ∆Y ∆T − − = = = −4 − The Tax Multiplier …is negative: A tax hike reduces consumer spending, which reduces income …is greater than one (in absolute value): A change in taxes has a multiplier effect on income …is smaller than the govt spending multiplier: Consumers save the fraction (1-MPC) of a tax cut, so the initial boost in spending from a tax cut is smaller than from an equal increase in G The Tax Multiplier …is negative: An increase in taxes reduces consumer spending, which reduces equilibrium income …is greater than one (in absolute value): A change in taxes has a multiplier effect on income …is smaller than the govt spending multiplier: Consumers save the fraction (1-MPC) of a tax cut, so the initial boost in spending from a tax cut is smaller than from an equal increase in G Exercise: • Use a graph of the Keynesian Cross to show the impact of an increase in investment on the equilibrium level of income/output The IS curve def: a graph of all combinations of r and Y that result in goods market equilibrium, i.e actual expenditure (output) = planned expenditure The equation for the IS curve is: Y = C (Y − T ) + I ( r ) + G Deriving the IS curve E =Y E r E =C +I (r1 )+G I E Y E =C +I (r2 )+G I r Y1 Y Y2 r1 r2 IS Y1 Y2 Y Understanding the IS curve’s slope • • The IS curve is negatively sloped Intuition: A fall in the interest rate motivates firms to increase investment spending, which drives up total planned spending (E ) To restore equilibrium in the goods market, output (a.k.a actual expenditure, Y ) must increase The IS curve and the Loanable Funds model The L.F. model (a) r S2 r S1 r2 r2 r1 (b) The IS curve I (r ) r1 IS S, I Y2 Y1 Y Fiscal Policy and the IS curve • • We can use the IS-LM model to see how fiscal policy (G and T ) can affect aggregate demand and output Let’s start by using the Keynesian Cross to see how fiscal policy shifts the IS curve… Shifting the IS curve: At any value of r, G Y E G E =Y E E =C +I (r1 )+G2 E =C +I (r1 )+G1 …so the IS curve shifts to the right The horizontal distance of the IS shift equals ∆Y = ∆G − MPC r Y1 Y Y2 r1 Y Y1 IS1 Y2 IS2 Y Exercise: Shifting the IS curve • Use the diagram of the Keynesian Cross or Loanable Funds model to show how an increase in taxes shifts the IS curve Summary Keynesian Cross § basic model of income determination § takes fiscal policy & investment as exogenous § fiscal policy has a multiplied impact on income IS curve § comes from Keynesian Cross when planned investment depends negatively on interest rate § shows all combinations of r and Y that equate planned expenditure with actual expenditure on goods & services ... previous lecture Shocks to aggregate demand and supply cause fluctuations in GDP and employment in the short run The Fed can attempt to stabilize the economy with monetary policy Lecture 15 Aggregate... the economy with monetary policy Lecture 15 Aggregate demand – I Instructor: Prof Dr Qaisar Abbas Lecture Contents • the IS curve, and its relation to – the Keynesian Cross – the Loanable Funds... multiplier effect on income …is smaller than the govt spending multiplier: Consumers save the fraction (1-MPC) of a tax cut, so the initial boost in spending from a tax cut is smaller than from an equal