Chapter 2

Aggregate Demand:
Building the IS-LM Model
 In this chapter, you will learn:
 The IS curve (Goods market equilibrium), and
its relation to:
 The Keynesian cross
 The LM curve (Money market equilibrium),
and its relation to:
 The theory of liquidity preference
 How the IS-LM model determines income and
the interest rate in the short run when P is fixed
 Aggregate demand
 The Big Picture

Keynesian IS
Cross curve
IS-LM
Explanation
Theory of model
LM of short-run
Liquidity curve fluctuations
Preference
Agg.
demand
curve Model of
Agg.
Agg. Demand
supply and Agg.
curve Supply
The Keynesian Cross

 A simple closed economy model in which income is

determined by expenditure. (due to J.M. Keynes)
 Notation:
I = Planned investment
PE = C + I + G = Planned expenditure
Y = real GDP = actual expenditure
 Difference between Actual & Planned Expenditure =
Unplanned Inventory Investment
Elements of the Keynesian Cross
Consumption Function: C  C (Y  T )
gov’t policy variables: G  G , T T
for now, planned
investment is exogenous: I I

Planned Expenditure: PE  C (Y  T )  I  G

Equilibrium Condition:
Actual Expenditure = Planned Expenditure
Y  PE
Graphing planned expenditure

PE

planned PE =C +I +G
expenditure
MPC
1

income, output, Y
Graphing the equilibrium condition

PE PE =Y

planned

expenditure

45º

income, output, Y
The equilibrium value of income

PE PE =Y

planned PE =C +I +G

expenditure

Income, output, Y
Equilibrium
income
Comparative statics: what happens if G, T, I change?
An increase in government purchases
PE

=Y
PE
At Y1, PE =C +I +G2
there is now an
unplanned drop PE =C +I +G1
in inventory…

G

…so firms
increase output,
and income rises Y
toward a new
equilibrium. PE1 = Y1 Y PE2 = Y2
Solving for Y
Y  C  I  G Equilibrium condition

Y  C  I  G in changes

 C  G because I exogenous

 MPC  Y  G because C = MPC Y

Collect terms with Y on Solve for Y :

the left side of the equals
sign:  1 
Y     G
(1  MPC)  Y  G  1  MPC 
The government purchases multiplier

Definition: the increase in income resulting from a $1

increase in G.
In this model, the govt Y 1

purchases multiplier equals G 1  MPC

Example: If MPC = 0.8, then

Y 1 An increase in G
  5 causes income to
G 1  0.8
increase 5 times
as much!
Why the multiplier is greater than 1?
 Initially, the increase in G causes an equal increase in Y:
Y = G.
 But Y  C
 further Y
 further C
 further Y
 So the final impact on income is much bigger than the
initial G.
An increase in taxes
PE

=Y
Initially, the tax

PE
PE =C1 +I +G
increase reduces
consumption, and PE =C2 +I +G
therefore PE:

C = MPC T At Y1, there is now an

unplanned
…so firms reduce inventory buildup…
output, and
income falls Y
toward a new PE2 = Y2 Y PE1 = Y1
equilibrium
Solving for Y
eq’m condition in
Y  C  I  G
changes
 C I and G exogenous

 MPC   Y  T 
Solving for Y : (1  MPC)  Y   MPC  T

Final result:
  MPC 
Y     T
 1  MPC 
The Tax multiplier

Def: the change in income resulting from a $1 increase

in T :
Y  MPC

T 1  MPC

If MPC = 0.8, then the tax multiplier equals

Y  0.8  0.8
   4
T 1  0.8 0.2
The Tax Multiplier
…is negative:
A tax increase reduces C,
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.
Increase in Planned Investment
PE

=Y
PE
At Y1, PE =C +I2 +G
there is now an PE =C +I1 +G
unplanned drop
in inventory…
I

…so firms
increase output,
and income rises Y
toward a new PE1 = Y1 Y PE2 = Y2
equilibrium.
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
PE PE =Y
PE =C +I (r2 )+G
r  I PE =C +I (r1 )+G

 PE I

 Y Y1 Y2 Y
r
r1

r2
IS
Y1 Y2 Y
Why the IS curve is negatively sloped

 A fall in the interest rate motivates firms to increase

investment spending, which drives up total planned
spending (PE ).
 To restore equilibrium in the goods market, output
(a.k.a. actual expenditure, Y )
must increase.
Fiscal Policy and the IS curve
 We can use the IS-LM model to see
how fiscal policy (G and T ) affects
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: G

PE PE =Y PE =C +I (r )+G
At any value of r, G 1 2

 PE  Y PE =C +I (r1 )+G1

…so the IS curve
shifts to the right.

The horizontal Y1 Y2 Y
r
distance of the
r1
IS shift equals
1
Y  G Y
1 MPC IS1 IS2
Y1 Y2 Y
NOW YOU TRY:
Shifting the IS curve: T
 Use the diagram of the Keynesian cross to
show how an increase in taxes shifts the IS
curve.
 If you can, determine the size of the shift.
ANSWERS:
Shifting the IS curve: T
PE PE =Y PE =C +I (r )+G
At any value of r, 1 1

T  C  PE PE =C2 +I (r1 )+G

…so the IS curve
shifts to the left.

Y2 Y1 Y
The horizontal r
distance of the r1
IS shift equals
MPC Y
Y  T
1 MPC IS2 IS1
Y2 Y1 Y
The Theory of Liquidity Preference

 Due to John Maynard Keynes.

 A simple theory in which the interest rate
is determined by money supply and
money demand.
Money Supply

r
M P
s
The supply of Interest
real money rate
balances
is fixed:

M P M P
s

M/P
M P
Real Money
Balances
Money Demand: (M/P)d=L(r,Y)

Demand for r
M P
s

real money Interest

balances: rate

M P
d
 L (r )

L (r,)

M P M/P
real money
balances
Equilibrium

r
M P
s
The interest rate interest
adjusts rate
to equate the
supply and
demand for
money: r1

M P  L (r ) L (r )

M/P
M P
real money
balances
How the NBE raises the Interest Rate

r
Interest
To increase r,
Rate
NBE reduces M
r2

r1
L (r )

M2 M1 M/P
Real
P P
Money
Balances
The LM curve

Now let’s put Y back into the money demand function:

M P
d
 L (r ,Y )

The LM curve is a graph of all combinations of r

and Y that equate the supply and demand for real
money balances.
The equation for the LM curve is:
M P  L (r ,Y )
Deriving the LM Curve

(a) The market for

(b) The LM curve
real money balances
r r
LM

r2 r2

L (r , Y2 )
r1 r1
L (r , Y1 )

M1 M/P Y1 Y2 Y
P
Why the LM curve is upward sloping

 An increase in income raises money demand.

 Since the supply of real balances is fixed, there is
now excess demand in the money market at the initial
interest rate.

 The interest rate must rise to restore equilibrium in

the money market.
 Comparative statics
How M shifts the LM curve
(a) The market for
(b) The LM curve
real money balances
r r
LM2

LM1
r2 r2

r1 r1
L (r , Y1 )

M2 M1 M/P Y1 Y
P P
The short-run equilibrium
The short-run equilibrium is r
the combination of r and Y LM
that simultaneously satisfies
the equilibrium conditions in
the goods & money markets:
Y  C (Y  T )  I (r )  G IS
M P  L (r ,Y ) Y
Equilibrium
Equilibrium
interest
level of
rate
income
 Basic IS-LM Summary
1. Keynesian cross
 Basic model of income determination
 Takes fiscal policy & investment as exogenous
 Fiscal policy has a multiplier effect on income
2. 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
 Basic IS-LM Summary
3. Theory of Liquidity Preference
 Basic model of interest rate determination
 Takes money supply & price level as exogenous
 An increase in the money supply lowers the
interest rate
4. LM curve
 Comes from liquidity preference theory when
money demand depends positively on income
 Shows all combinations of r and Y that equate
demand for real money balances with supply
 Basic IS-LM Summary
5. IS-LM model
 Intersection of IS and LM curves shows the
unique point (Y, r ) that satisfies equilibrium in
both the goods and money markets.