Chapte 10 Aggegate Demand I CHAPTER 10 0 CHAPTER 10 1 Leaning Objectives Chapte 9 intoduced the model of aggegate demand and aggegate supply. Long un (Classical Theoy) pices flexible output detemined by factos of poduction & technology unemployment equals its natual ate Shot un (Keynes) pices fixed output detemined by aggegate demand unemployment is negatively elated to output CHAPTER 10 2 1
Leaning Objectives This chapte develops the IS-LM model (Hicks), the theoy that yields the aggegate demand cuve. We focus on the shot un and assume the pice level is fixed. CHAPTER 10 3 The Big Pictue Keynesian Coss Theoy of Liquidity Pefeence IS cuve LM cuve IS-LM model Explanation of shot-un fluctuations Agg. demand cuve Agg. supply cuve Model of Agg. Demand and Agg. Supply CHAPTER 10 4 1. The IS Cuve 1.1 The Keynesian Coss A simple closed economy model in which income is detemined by expenditue. (due to Keynes) Notation: E = C + I + G = planned expenditue = eal GDP = actual expenditue Diffeence between actual & planned expenditue: unplanned inventoy investment CHAPTER 10 5 2
1.1 The Keynesian Coss consumption function: govt policy vaiables: fo now, investment is exogenous: planned expenditue: C = C ( T ) G = G, T = T I = I E = C ( T ) + I + G Equilibium condition: Actual expenditue = = Planned expenditue E CHAPTER 10 6 1.1 The Keynesian Coss Planned Expenditue E planned expenditue E =C +I +G 1 MPC income, output, CHAPTER 10 7 1.1 The Keynesian Coss Equilibium Condition E planned E = expenditue 45º income, output, CHAPTER 10 8 3
1.1 The Keynesian Coss E planned expenditue E = E =C +I +G Equilibium income income, output, CHAPTER 10 9 1.1 The Keynesian Coss An incease in govenment puchases At 1, thee is now an unplanned dop in inventoy G E E = E =C +I +G 2 E =C +I +G 1 so fims incease output, and income ises towad a new equilibium E 1 = 1 E 2 = 2 CHAPTER 10 10 1.1 The Keynesian Coss An incease in govenment puchases = C + I + G = C + I + G = C + G = MPC + G equilibium condition in changes because I exogenous b.c. C = MPC ( - T) Collect tems with on the left side of the equals sign: (1 MPC) = G Finally, solve fo : 1 = G 1 MPC CHAPTER 10 11 4
1.1 The Keynesian Coss The govenment puchases multiplie Definition: the incease in income esulting fom a 1unit incease in G. In this model, the G multiplie equals G = 1 1 MPC CHAPTER 10 12 1.1 The Keynesian Coss The govenment puchases multiplie Example: MPC = 0.8 1 = G 1 MPC 1 1 = G = G = 5 G 1 0. 8 0. 2 The incease in G causes income to incease by 5 times as much! G 1 = = 1 0. 8 CHAPTER 10 13 5 1.1 The Keynesian Coss The govenment puchases multiplie Why is the multiplie geate than 1? Initially, the incease in G causes an equal incease in : = G. But C futhe futhe C futhe So the final impact on income is much bigge than the initial G. CHAPTER 10 14 5
1.1 The Keynesian Coss An incease in taxes Initially, the tax incease educes consumption, and theefoe E: E E = E =C 1 +I +G E =C 2 +I +G C = MPC T so fims educe output, and income falls towad a new equilibium E 2 = 2 At 1, thee is now an unplanned inventoy buildup E 1 = 1 CHAPTER 10 15 1.1 The Keynesian Coss An incease in taxes = C + I + G = C = MPC ( T ) Solving fo : eq m condition in changes I and G exogenous (1 MPC) = MPC T Final esult: MPC = T 1 MPC CHAPTER 10 16 1.1 The Keynesian Coss The tax multiplie Definition: the change in income esulting fom a 1unit incease in T : T MPC = 1 MPC If MPC = 0.8, then the tax multiplie equals 0. 8 0. 8 = = = 4 T 1 0. 8 0. 2 CHAPTER 10 17 6
1.1 The Keynesian Coss The tax multiplie is negative: An incease in taxes educes consume spending, which educes equilibium income. is geate than one (in absolute value): A change in taxes has a multiplie effect on income. is smalle than the govt spending multiplie: Consumes save the faction (1-MPC) of a tax cut, so the initial boost in spending fom a tax cut is smalle than fom an equal incease in G. CHAPTER 10 18 1.2 Defining and Deiving the IS Cuve 1.2.1 Using Keynesian Coss and Investment Function Definition: a gaph of all combinations of and that esult in goods maket equilibium, i.e. actual expenditue (output) = planned expenditue The equation fo the IS cuve is: = C ( T ) + I ( ) + G CHAPTER 10 19 1.2 Defining and Deiving the IS Cuve 1.2.1 Using Keynesian Coss and Investment Function E E = E =C +I( 2 )+G I E =C +I( 1 )+G E I 1 2 1 2 1 2 IS CHAPTER 10 20 7
1.2 Defining and Deiving the IS Cuve 1.2.2 Using Loanable Funds Appoach (a) The L.F. model S 2 S 1 (b) The IS cuve 2 2 1 I( ) S, I 1 2 1 IS CHAPTER 10 21 1.2 Defining and Deiving the IS Cuve The IS cuve is negatively sloped. Intuition: A fall in the inteest ate motivates fims to incease investment spending, which dives up total planned spending (E ). To estoe equilibium in the goods maket, output (a.k.a. actual expenditue, ) must incease. CHAPTER 10 22 1.3 Fiscal Policy and the IS Cuve We can use the IS-LM model to see how fiscal policy (G and T ) can affect aggegate demand and output. Let s stat by using the Keynesian Coss to see how fiscal policy shifts the IS cuve CHAPTER 10 23 8
1.3 Fiscal Policy and the IS Cuve At any value of, G E so the IS cuve shifts to the ight. The hoizontal distance of the IS shift equals 1 = G 1 MPC E 1 1 1 E = E =C +I( 1 )+G 2 2 2 IS 1 E =C +I( 1 )+G 1 CHAPTER 10 24 IS 2 2. The LM Cuve 2.1 The Theoy of Liquidity Pefeence A simple theoy in which the inteest ate is detemined by money supply and money demand. (due to Keynes again) CHAPTER 10 25 2.1 The Theoy of Liquidity Pefeence The supply of eal money balances is fixed: ( M P ) s = M P inteest ate ( M P ) s M P M/P eal money balances CHAPTER 10 26 9
2.1 The Theoy of Liquidity Pefeence Demand fo eal money balances: d ( M P ) = L( ) inteest ate ( M P ) s L() M P M/P eal money balances CHAPTER 10 27 2.1 The Theoy of Liquidity Pefeence The inteest ate adjusts to equate the supply and demand fo money: M P L( ) inteest ate 1 ( M P ) s = L() M P M/P eal money balances CHAPTER 10 28 2.1 The Theoy of Liquidity Pefeence A change in money supply To incease, Fed educes M inteest ate 2 1 L() M 2 P M 1 P M/P eal money balances CHAPTER 10 29 10
2.2 Defining and Deiving the LM Cuve 2.2.1 Using Theoy of Liquidity Pefeence Now let s put back into the money demand function: = L(, ) ( M P ) d The LM cuve is a gaph of all combinations of and that equate the supply and demand fo eal money balances. The equation fo the LM cuve is: M P = L(, ) CHAPTER 10 30 2.2 Defining and Deiving the LM Cuve 2.2.1 Using Theoy of Liquidity Pefeence (a) The maket fo (b) The LM cuve eal money balances LM 2 1 M 1 P L(, 2 ) L(, 1 ) M/P 2 1 1 2 CHAPTER 10 31 2.2 Defining and Deiving the LM Cuve 2.2.2 Using Quantity Equation Quantity Equation MV=P Quantity Theoy of money assumes constant velocity vetical LM cuve If we adjust it so that V=V() then we get the upwad sloping LM cuve again. CHAPTER 10 32 11
2.2 Defining and Deiving the LM Cuve The LM cuve is positively sloped. Intuition: An incease in income aises money demand. Since the supply of eal balances is fixed, thee is now excess demand in the money maket at the initial inteest ate. The inteest ate must ise to estoe equilibium in the money maket. CHAPTER 10 33 2.3 Monetay Policy and the LM Cuve (a) The maket fo eal money balances (b) The LM cuve LM 2 2 2 LM 1 1 L(, 1 ) 1 M 2 P M 1 P M/P 1 CHAPTER 10 34 3. The shot-un equilibium The shot-un equilibium is the combination of and that simultaneously satisfies the equilibium conditions in the goods & money makets: = C ( T ) + I ( ) + G M P = L(, ) Equilibium inteest ate LM IS Equilibium level of income CHAPTER 10 35 12
Chapte summay 1. Keynesian Coss basic model of income detemination takes fiscal policy & investment as exogenous fiscal policy has a multiplied impact on income. 2. IS cuve comes fom Keynesian Coss when planned investment depends negatively on inteest ate shows all combinations of and that equate planned expenditue with actual expenditue on goods & sevices CHAPTER 10 36 Chapte summay 3. Theoy of Liquidity Pefeence basic model of inteest ate detemination takes money supply & pice level as exogenous an incease in the money supply lowes the inteest ate 4. LM cuve comes fom Liquidity Pefeence Theoy when money demand depends positively on income shows all combinations of and that equate demand fo eal money balances with supply CHAPTER 10 37 Chapte summay 5. IS-LM model Intesection of IS and LM cuves shows the unique point (, ) that satisfies equilibium in both the goods and money makets. CHAPTER 10 38 13
Peview of Chapte 11 In Chapte 11, we will use the IS-LM model to analyze the impact of policies and shocks lean how the aggegate demand cuve comes fom IS-LM use the IS-LM and AD-AS models togethe to analyze the shot-un and longun effects of shocks lean about the Geat Depession using ou models CHAPTER 10 39 14