Economics Notes

ECO 2214
MACROECONOMICS
AY 23/24
TOPIC 3:
National Income Determination: The
Static Equilibrium Model
Outline
• Income determination: the static equilibrium
model
– Demand side equilibrium: Income & the interest
rate
• Equilibrium income and the interest rate in the
products/ goods market (IS curve)
• Equilibrium income and the interest rate in the money/
assets market (LM curve)
• Equilibrium in the product and money markets (IS – LM
framework)
• Income and price level on the demand side
3/11/2024 2
Outline
– Introduction to monetary and fiscal policy
• Fiscal policy effect on demand
• Monetary policy effects on demand
• Interaction of monetary and fiscal policies
– Equilibrium output and the price level: the
classical case
– Supply side equilibrium: Output and price level
• Labor supply and the money wage
• Unemployment and wage rigidity
– Equilibrium in the basic static model
3/11/2024 3
References
Gregory Mankiw: Macroeconomics, 7th Edition
O. Blanchard & D. Johnson: Macroeconomics
(4th Edition)
William H. Branson: Macroeconomic Theory
and Policy
Dornbusch & Fischer: Macroeconomics, 6th
Edition
J. Sachs & Larrain: Macroeconomics in the
global economy
National Income determination: the basic
equilibrium model
• Recall the definition of GDP as the measure of
aggregate output produced in a country.
• Recall further that GDP can be considered from either
the output side or income side.
• The components of which are:
– Consumption expenditure (C)
– Investment expenditure (I)
– Government expenditure (G)
– Net exports/ trade balance (X-M)
• …and summarized as the national income identity:
GDP = Y = C + I + G + (X-M)  open economy
GDP = Y = C + I + G  closed economy
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equilibrium model
• GDP is thus a major macroeconomic variable, as it is an
indicator of how the economy is performing.
– Others being;
• Unemployment
• Inflation
What then determines the level of aggregate output?
• In the short run, the level of output is determined by
the aggregate demand
• Changes in demand lead to changes in production
• Changes in production lead to changes in income
• Changes in income lead to changes in demand
[High consumer spending  higher sales  higher output 
higher employment]
3/11/2024 6
equilibrium model
• This basic model of income determination is based
on Keynes’ theory of determination of income and
employment.
– Explained the short run behavior of the economy when
prices are fixed;
– Classical theory posited that national income depends
on factor supplies and available production
technology (Aggregate supply)
• Keynes proposed that the level of national income
and employment depends on the level of aggregate
demand in the economy.
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equilibrium model
• Aggregate demand (Z) being the total demand for
goods in the economy, i.e.:
– Consumption (C), where C = c0 + c1Yd
where Yd = (Y – T)
– Investment (I)
– Government spending (G)
– Net exports (X-M)
i.e. Z = c0 + c1(Y – T) + I + G + (X-M)
• If in this product (goods) market, all that is
produced is demanded/ used (i.e. AS = AD), the
equilibrium condition will thus be:
GDP = Y = Z  Y = c0 + c1(Y – T) + I + G + (X-M)
• T, I and G are taken as given (i.e. fixed).
3/11/2024 8
Equilibrium in the goods market: the basic model
The basic equilibrium model is represented by a tool
called the Keynesian Cross.
3/11/2024 9
equilibrium model
• Consider the effect of an increase in G on the equilibrium
income:
• Consider the individual effects of an increase in T or reduction in I

3/11/2024 10
National Income determination: the static
equilibrium model
• Aggregate demand is determined by many factors, e.g.:
– Consumer confidence (how?)
– Fiscal policy (how?)
– Monetary policy (how?)
• The main interpretation of Keynes’ theory is the IS –
LM model, a major tool used in macroeconomic
analysis.
• An extension of the basic model, the IS – LM model
shows how the interactions between the goods market
and financial market determine level of national
income in the SR.
• The model therefore shows what causes AD to shift in
the short run.
3/11/2024 11
National Income determination: the static
equilibrium model
• In our analysis of the demand side equilibrium, we make
some underlying assumptions:
– The economy is closed (i.e. no foreign sector)
– Prices are fixed (i.e. the period of analysis is the short run)
• In the basic model, by taking investment (I) as fixed, the
assumption was that interest rates do not affect the
demand for goods.
• This assumption is relaxed and we go ahead to construct
the equilibrium conditions in the 2 markets, i.e.
The IS relation representing the goods market
equilibrium
The LM relation representing the financial market
equilibrium
3/11/2024 12
Equilibrium in the Goods Market: the IS
relation
Deriving the IS curve
• In the basic model, investment I was taken as given/
exogenously fixed.
• However, investment does in fact depend on the
interest rate among other factors. (How do we
characterize this relationship?)
I = I(r, Y, …)
where I’(r) < 0; I’(Y) > 0
– The interest rate measures the cost of the funds used to
finance investments.
• An ↑se in r will reduce planned investment, I, which in
turn lowers the equilibrium level of income.
3/11/2024 13
curve
• The IS curve plots the relationship between the
interest rate (r) and the level of income (Y) that
arises in the market for goods & services.
• The IS curve expression is thus: Y = Z  Y = c0 + c1(Y
– T) + I(r) + G
• Each point on the IS curve represents equilibrium in
the goods market; illustrating how the equilibrium
level of income depends on the interest rate
• Because an ↑se in the interest rate causes planned
investment to fall which in turn causes the eqbm
income to fall, the IS curve will be downward sloping.
3/11/2024 14
curve
3/11/2024 15
Equilibrium in the Money Market: the LM
curve
The money market:
• Thinking of the money market, what do we
expect is:
– The commodity being “traded”/ demanded?
– The “price” being paid for said commodity?
– The nature of the demand relationship?
– The source of supply of the said commodity?
– How is equilibrium being attained in this market?
• Illustrate the market equilibrium.
3/11/2024 16
curve
• People hold money for its purchasing power, i.e. what it will
buy (transactions theory of money demand).
– the demand for money = the demand for real money balances
– The higher the prices, the higher the nominal money balances
one will need to hold.
• The interest rate is the opportunity cost (“the price”) of holding
money instead of other interest bearing assets e.g. bonds, bank
deposits etc. (How do we characterize this relationship?)
• On the demand side, therefore, the interest rate is one
determinant of how much money people choose to hold.
• Another key determinant will be the income (How do we
characterize this relationship?).
3/11/2024 17
curve
• The demand for real money balances is thus

given by;
(𝑴Τ𝑷)𝒅 = L(r, Y)
Where L’(r) < 0; L’(Y) > 0
• When the interest rate rises, people will want to
hold less of their wealth in form of money.
• The money demand curve therefore slopes
downwards.
3/11/2024 18
curve
• On the supply side, money supply refers to the nominal
money stock in the economy.
• Taken as an exogenous policy variable set and thus
controlled by the Central Bank.
ഥ
𝑴𝒔 = 𝑴
• Recall that, in the short run, the general price level, P, is
fixed and therefore also an exogenous variable.
• The supply of real money balances therefore doesn’t
depend on the interest rate. (How then would this
relationship be represented?)
ഥ 𝑷
(𝑴Τ𝑷)𝒔 = 𝑴/ ഥ
3/11/2024 19
curve
• At the equilibrium interest rate, the quantity of real money
balances demanded equals the quantity supplied
Equilibrium in the money market:
3/11/2024 20
curve
Effects of a change in the money supply:
Recall that money supply is a policy variable.
• Consider a fall/ reduction in the money supply
3/11/2024 21
curve
Effects of a change in the money supply:
– A fall/ reduction in the money supply reduces the
supply of real money balances, shifting the money
supply curve to the left.
– Equilibrium interest rises from r1 to r2.
– With the higher interest rate, the demand for real
money balances is lowered.
– What happens when the money supply is
increased?
• An ↑se in Ms, … r and ↓se in Ms, … r.
3/11/2024 22
curve
Check your understanding:
• Suppose that the money demand function is:
(M/P)d = 800 – 50r
where r is the interest rate in percent. The money
supply M is 2,000 and the price level P is fixed at 5.
• What is the equilibrium interest rate?
• What happens to the equilibrium interest rate if
the supply of money is reduced from 2,000 to
1,500?
• What money supply level should the central bank
set if it wants the interest rate to be 4%?
3/11/2024 23
curve
• Having seen how the equilibrium interest rate is
determined in the money market,
• We also need to see how the level of income
affects the market for real money balances.
• This relationship will allow us to derive the LM
curve.
• The LM curve plots the relationship between the
equilibrium interest rate and the level of income
that arises in the market for money balances.
3/11/2024 24
curve
• A higher level of income implies a greater demand for money.
Why?
3/11/2024 25
curve
• An increase in the level of income shifts the
money demand curve to the right
• With a fixed money supply, the interest rate must
rise to equilibrate the demand and supply for real
money balances.
• Plotting the equilibrium interest rate against the
level of income thus produces the LM curve.
• Each point on the LM curve represents
equilibrium in the money market; illustrating how
the equilibrium interest rate depends on the level
of income.
3/11/2024 26
curve
• The LM curve slopes upwards. Why?
• Explain this statement: “Higher economic activity puts
pressure on interest rates”
3/11/2024 27
Demand side equilibrium: the IS – LM model
The short-run equilibrium – the IS – LM model:

• The 2 parts of the model are thus given by;
Y = C(Y – T) + I(r) + G IS relation
M/P = L(r, Y) LM relation
• The fiscal policy (G and T), monetary policy (M)
and the price level, P are taken as exogenous.
• The equilibrium in the economy will occur at the
point where the IS and LM curves intersect.
• At this point, there is a simultaneous equilibrium
in both the goods and financial markets.
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Demand side equilibrium: income and the
interest rate – the IS – LM model
• The equilibrium point gives the interest rate, r and level
of income, Y that satisfy the conditions for equilibrium in
the goods and money markets.
3/11/2024 29
• The equilibrium point gives the interest rate, r and level
of income, Y that satisfy the conditions for equilibrium in
the goods and money markets.
• The IS – LM model allows us to study what happens to
the output and interest rate when say the Central Bank
increases/ decreases the money stock or when
government decides to increase taxes, etc.
– i.e. how do policy actions affect the real variables, i.e. output
and interest rate?
– The effects are characterized by the shifts in the IS and LM
curves and how these shifts affect the equilibrium point
– Can be shown both analytically and graphically
3/11/2024 30
Work it out:
1. The following equations describe an economy.
Y = C + I + G; C = 50 + 0.75 (Y – T); I = 150 – 10r;
(M/P)d = Y – 50r; G = 250; T = 200; M = 3,000; P = 4
a) Use the relevant set of equations to derive the IS
curve. Graph it
b) Use the relevant set of equations to derive the LM
curve. Plot it on the same graph in a) above.
c) What is the equilibrium level of income and
equilibrium interest rate?
3/11/2024 31
Work it out:
2. Consider a closed economy where;.
C = 360 + 0.8Yd; I = 640 – 60r; (M/P)d = 0.2Y – 40r;
G = 160; T = 200; M = 2,400; P = 6
a) Use the relevant set of equations to establish the
IS and LM curves
b) What is the equilibrium level of income and
equilibrium interest rate?
c) Given that gov’t spending increases by 200,
determine its impact on the equilibrium r and Y
3/11/2024 32
Work it out:
3. Consider a closed economy where;.
C = 200 + 0.25Yd; I = 150 + 0.25Y – 1000r; (M/P)d =
2Y – 8000r; G = 250; T = 200; (Ms/P) = 1600
a) Derive the IS and LM equations
b) Determine the equilibrium level of income and
interest rate?
c) Given that gov’t spending increases by 100
percent, determine its impact on the equilibrium
r and Y
3/11/2024 33
Work it out:
4. Using a diagram, explain how the IS curve is
derived
a) Given the IS – LM model for the economy as;
C = 100 + 0.8Yd ; I = 50 – 25i; G = T = 50; (Ms/P) = 200;
(Md/P) = Y – 25i
i. Calculate the equilibrium interest rate and income
ii. Suppose that real money supply decreases to 150,
determine the new level of output and interest
rates.
3/11/2024 34
Demand side equilibrium: Shifts in the IS –
LM framework
• In the previous section, we have seen how the equilibrium
interest rate and income level are determined when the
price level is fixed.
• Now we move on to examine how changes in the
exogenous variables affect the endogenous variables for a
given price level.
• What are the exogenous variables of the IS – LM model?
• The endogenous variables are … and ….
• Before considering the shifts in the IS – LM model, we’ll
first consider the policy effects in each market, i.e.
– Shifts in the IS curve
– Shifts in the LM curve
3/11/2024 35
Demand side equilibrium: Shifts in the IS
curve
• The IS curve shows, for any given interest rate, the
level of income that brings the goods market in
equilibrium.
• Recall, Y = C(Y – T) + I + G. So the equilibrium level of
income also depends on gov’t spending & taxes,
which are the fiscal policy tools as seen in the basic
model.
• The IS curve is drawn for a given level of G and T.
• Changes in fiscal policy will shift the IS curve.
• Consider the effect of an increase in government
spending:
3/11/2024 36
curve
Increase in Government spending
– At a given interest rate r, an increase in government
spending (through e.g. …?) will increase the aggregate
demand,
– and through the multiplier increases the level of
income/ output,
– Causing an outward shift of the IS curve.
• i.e. at any level of the interest rate, the
equilibrium level of output is higher than before
the policy application.
3/11/2024 37
3/11/2024 38
curve
• A fiscal contraction or tightening will have the
opposite effect.
• In summary, any changes in the factors that
decrease or increase the demand for goods given the
interest rate will shift the IS curve to the left or right.
• Examine/ illustrate what happens with;
– A decrease in taxes
– A decrease in government purchases
– An increase in taxes
– An increase in the desire to save
– An increase in consumer confidence
3/11/2024 39
Demand side equilibrium: Shifts in the LM
curve
• The LM curve indicates the interest rate that
equilibrates the money market for any level of
income.
• The LM curve is drawn for a given level of money
supply, which is a key monetary policy tool.
• The interest rate also depends on the supply of
real money balances, M/P.
• A change in the money supply will shift the LM
curve.
• Consider a decrease in money supply;
3/11/2024 40
curve
– A reduction in the nominal money balances, at fixed
prices, results in a reduction in the supply of real
money balances shifting the supply curve to the left,
– At a given level of income (and thus constant demand
for real money balances), the reduction in money
supply leads to an increase in the equilibrium interest
rate.
– This causes the LM curve to shift upwards.
• Illustrate/ examine what happens with an
expansionary monetary policy.
3/11/2024 41
curve
• What happens with a decrease in money supply?
3/11/2024 42
Demand side equilibrium: Shifts in the IS –
LM framework
Changes in fiscal policy: government spending:
• Recall that changes in fiscal policy influence the level of
aggregate demand and income and thereby shift the IS
curve.
• Whereas changes in monetary policy influence the
interest rate and thereby shift the LM curve.
• How then do the policy changes affect the short-run
equilibrium?
• Consider an increase in government spending G.
– Through the multiplier concept, increase in G increases AD
and the equilibrium level of income causing the IS curve to
shift … .
– What happens to the LM curve?
3/11/2024 43
Shifts in the IS –LM framework: changes
in fiscal policy
An increase in government spending:
– In the goods market, the ↑se in gov’t purchases raises the
aggregate demand (AD),
– The ↑se in AD stimulates the production of goods & services
and through the multiplier, causing the Y to rise shifting the IS
curve outwards.
– In the money market, the ↑se in Y, ↑ses the quantity of money
demanded at every interest rate.
– However, with a fixed Ms, the higher money demand causes the
equilibrium interest rate r to rise;
– The higher r arising in the money market causes firms to cut
back on their investment plans/ spending causing a reduction in
the income (from the increase generated by the initial increase in G).
– The new equilibrium will be established at point B at the
intersection between the LM curve and new IS curve.
3/11/2024 44
in fiscal policy
Increase in government spending:
3/11/2024 45
in fiscal policy
An increase in government spending:
– The increase in G leads to an increase in the equilibrium
level of income Y and interest rate r.
– The increase in income in response to an expansionary
fiscal policy is smaller in the IS – LM model than it is in the
Keynesian cross model. Why is that the case?
• The expansionary effect of the increase in G is partially offset by
the fall in investment due to rising interest rates.
• Another way to look at it is, the increase in gov’t borrowing to fund
the ↑se in gov’t purchases. Why/ what happens in this case?
• This effect of the expansionary fiscal policy is called the
crowding out of private investment/ crowding out
effect.
3/11/2024 46
in fiscal policy
Changes in taxes:
• What would happen in the case of an increase
in taxes?
• A change in taxes will affect the expenditure
through … (which component of demand?)
• Consider a decrease in taxes;
• By the tax multiplier concept, the level of
incomes rises and shifts the IS curve ….
• The tax cut ... both income and interest rates.
3/11/2024 47
in fiscal policy
A decrease in taxes:
3/11/2024 48
in fiscal policy
A decrease in taxes:
– The tax cut, through an ↑se in disposable incomes raises
consumption demand and thus the aggregate demand.
– The ↑se in aggregate demand stimulates the production
of goods & services, causing total Y to rise, shifting the IS
curve outwards.
– The ↑se in total Y, ↑ses the demand for money balances
at every interest rate.
– However, with a fixed Ms, the higher money demand
causes the equilibrium interest rate r to rise.
– The higher r arising in the money market causes firms to
cut back on their investment plans.
– This fall in investment therefore partially offsets the
expansionary effect of the tax cut.
3/11/2024 49
Shifts in the IS – LM framework: changes
in monetary policy
Changes in the money supply:
• Recall that a change in money supply alters the
interest rate that equilibrates the money market for
any given level of income, and thereby shifts the LM
curve.
• Consider an ↑se in the money supply, M.
• The ↑se in M leads to an increase in the real money
balances, M/P.
• For a given level of income, the increase in real
money supply leads to a lower interest rate, r,
shifting the LM curve downwards.
• What happens to the IS curve?
3/11/2024 50
in monetary policy
An increase in the money supply:
• Suppose the Central Bank increases nominal money
through an open market operation;
– With fixed prices, the increase in nominal money leads to
an increase in real money,
– At a given level of income, the monetary expansion leads
to a decrease in the interest rate,
– Shifting the LM curve downwards.
– In the goods market, the lower interest rate stimulates
investment demand, increasing production and output and
total income Y.
– The new equilibrium will be established at point B with a 51
lower interest r, and higher equilibrium income Y.
3/11/2024
Shifts in the IS – LM framework: changes
in monetary policy
An increase in the money supply:
3/11/2024 52
in monetary policy
Changes in the money supply:
• The IS – LM model shows that monetary policy
influences income by changing the interest rate.
• When prices are fixed, a monetary expansion
induces greater spending on goods and services
through a process called the monetary
transmission mechanism.
– With higher incomes, consumption goes up
– With higher sales and low interest rates, investment
also goes up
3/11/2024 53
Shifts in the IS –LM framework: interactions
between monetary and fiscal policy
• So far, the policy changes have been considered in isolation
• Keep in mind, however, that a change in one policy will
likely influence the other.
• This interdependence may therefore alter the impact of a
policy change.
• Moreover, in practice, the two policies are often used
together.
• This policy combination is called a policy mix.
• Consider MoFPED announces an ↑se in taxes (to raise
gov’t revenue), what effect will this policy have on the
economy?
• According to the IS – LM model, the answer depends on
how the Central bank responds to this policy position.
3/11/2024 54
Central bank responds by keeping Ms fixed:

o The tax ↑se shifts the IS curve to the left. Why?
o Money supply is held constant, therefore no shift
occurs in the LM curve.
o Level of income Y falls, and the interest rate r
falls. Why?
o The fall in income therefore indicates that the tax
hike causes a recession.
3/11/2024 55
Central bank responds by keeping Ms fixed:
3/11/2024 56
 Central bank wants to hold r constant:

o The tax ↑se shifts the IS curve to the left.
o To keep the interest rate at its original level, the CB
must ↓se the money supply.
o The fall in Ms therefore shifts the LM curve upwards.
o While the interest rate r is maintained at its original
level, the level of income Y falls.
o This fall in income is even more than when the
money supply was held constant. Why is this so?
o The fall in income amidst high interest rate, further
deepens the recession.
3/11/2024 57
Central bank wants to hold r constant:
3/11/2024 58
 Central bank wants to hold the income constant:
o The tax ↑se shifts the IS curve to the left.
o To prevent the fall in income due to the tax hike, the CB
must ↑se the money supply which shifts the LM curve
downward enough to offset the IS curve shift.
o In this case, the tax hike doesn’t cause a recession but it
causes a large fall in the interest rate.
o The combination of a tax increase and monetary
expansion, however, changes the allocation of the
economy’s resources.
o The higher taxes depress consumption, while the lower
interest rate stimulates investment.
o The balance of these 2 effects leaves income unchanged.
3/11/2024 59
 Central bank wants to hold the income constant:
3/11/2024 60
Income and price level on the demand
side: the aggregate demand (AD) curve
• The preceding exposition of national income has
considered the price level as fixed.
• We now examine what happens in the IS – LM
model when the price level is allowed to change.
• By examining the effects of changing the price
level, we can derive the economy’s aggregate
demand curve.
• The AD curve describes the relationship between
the price level and the level of national income.
3/11/2024 61
• For any given level of money supply, a rise in
prices reduces the supply of real money balances,
M/P.
• A lower supply of M/P, shifts the LM curve
upwards, raising the equilibrium interest rate.
• The higher r dampens investment and lowers the
equilibrium level of income.
• Plotting the price against income shows that the
increase in prices causes income to fall  the
downward sloping AD curve
3/11/2024 62
3/11/2024 63
Income and price level on the demand side:
the aggregate demand (AD) curve
• An alternative illustration:
3/11/2024 64

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ECO 2214

• Consider the individual effects of an increase in T or reduction in I

• The demand for real money balances is thus

The short-run equilibrium – the IS – LM model:

Central bank responds by keeping Ms fixed:

 Central bank wants to hold r constant:

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