N. Gregory Mankiw

SEVENTH EDITION
MACROECONOMICS
N. Gregory Mankiw
PowerPoint® Slides by Ron Cronovich
CHAPTER 10
Aggregate Demand I:
Building the IS-LM Model
© 2010 Worth Publishers, all rights reserved

In this chapter, you will learn:
 the IS curve, and its relation to:
 the Keynesian cross
 the loanable funds model
 the LM curve, 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
Context
 Chapter 9 introduced the model of aggregate
demand and aggregate supply.
 Long run
 prices flexible
 output determined by factors of production &
technology
 unemployment equals its natural rate
 Short run
 prices fixed
 output determined by aggregate demand
 unemployment negatively related to output
CHAPTER 10 Aggregate Demand I 3
Context
 This chapter develops the IS-LM model,

the basis of the aggregate demand curve.
 We focus on the short run and assume the price
level is fixed (so, SRAS curve is horizontal).
 This chapter (and chapter 11) focus on the
closed-economy case.
Chapter 12 presents the open-economy case.

Context
 Two parts of IS-LM model are IS curve and LM curve.
 IS stands for “investment” and “saving” and IS curve represents
what’s going on in the market for goods and services (as in
chapter 3).
 LM stands for “liquidity” and “money” and the LM curve
represents what’s happening to the supply and demand for
money (as in chapter 4).
 Because the interest rate influences both investment and money
demand, it is the variable that links the two halves of the IS-LM
model.
 The model shows how interactions between the goods and
money markets determine the position and slope of the
aggregate demand curve and therefore, the level of national
income in the short run.

The Goods Market and the IS curve
 The IS curve plots the relationship between the
interest rate and trhe level of income that arises
in the market for goods and services.
 To develop this relationship, we start with a
basic model called the Keynesian cross.
 This model is the simplest interpretation of
Keynes’s theory of how national income is
determined and is building block for the more
complex and realistic IS-LM model.

The Keynesian Cross
 According to the Keynes (in The General
Theory) an economy’s total income was, in the
short run, determined by the spending plans of
households, businesses and government.
 Keynes believed that the problem during

recessions and depressions was inadequate
spending.

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

The Keynesian Cross: planned expenditure
 Actual expenditure is the amount households, firms and the
government spend on goods and services.
 Planned expenditure is the amount households, firms and the
government would like to spend on goods and services.
 Actual expenditure differ from planned expenditure: because
firms engage in unplanned expenditure. Because their sales
do not meet their expectations.
 When firms sell less of their product than they planned, their
stock of inventories automatically rises;
 When firms sell more than planned, their stock of inventories
falls.
 Because unplanned changes in inventory are counted as
investment spending by firms.
Elements of the Keynesian Cross
consumption function: C  C (Y  T )
govt 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 planned expenditure
 Planned expenditure is the function of income.
 This line slopes upward because higher income
leads to higher consumption and thus higher
planned expenditure.
 The slope of this line is the marginal propensity
to consume, MPC: it shows how much planned
expenditure increases when income rises by $1.

The economy in equilibrium
 The economy is in equilibrium when;
 actual expenditure = planned expenditure Y  PE
 Y as GDP equals not only total income but also total
actual expenditure on goods and services.
 The points on the 45 degree line is the where this
condition holds.

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
The equilibrium value of income
 The equilibirum in the Keynesian cross is the point at
which income (actual expenditure) equals planned
expenditure.
 How does the economy get to equilibrium?
 Inventories play an important role.
 Whenever an economy is not in equilibrium, firms
experience unplanned changes in inventories and this
induces them to change production levels.
 Changes in production influence total income and
expenditure, moving the economy toward equilibrium.

An increase in government purchases
How changes in government purchases affect the economy?
PE Y
=
At Y1, PE PE =C +I +G
2
there is now an
unplanned drop PE =C +I +G1
in inventory…
G
…so firms
increase output,
and income Y
rises 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 Solve for Y :

on 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. ΔY>ΔG
In this model, the govt Y 1

purchases multiplier equals G 1  MPC
Example: If MPC = 0.8, then

Y 1 An
An increase
increase inin G
G
  5 causes
causes income
income toto
G 1  0.8
increase
increase 55 times
times
as
as much!
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 =C +I +G
increase reduces 1
consumption, and PE =C2 +I +G

therefore PE:
C = MPC T At Y1, there is now

an unplanned
…so firms inventory buildup…
reduce 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
  MPC 
Final result: 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.

 Fiscal policy has a multiplier effect
(government purchase multiplier & tax
multiplier) on income.

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 (r )+G
2
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.

The IS curve
 Each point on the IS curve represents
equilibrium in the goods market.
 IS curve illustrates how the equilibrium level of
income depends on the interest rate.
 Because an increase in the interest rate causes
planned investment to fall which in turn causes
equilibrium income to fall, the IS curve slopes
downward.

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, 1 2
G  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

The IS curve
 The IS curve shows the combinations of the
interest rate and the level of income that are
consistent with equilibrium in the market for goods
and services.
 The IS curve is drawn for a given fiscal policy.
 Changes in fiscal policy that raise the demand for
goods and services shift the IS curve to the right.
 Changes in fiscal policy that reduce the demand
for goods and services shift the IS curve to the
left.
NOW YOU TRY:
Shifting the IS curve: T
 Use the diagram of the Keynesian cross or
loanable funds model to show how an
increase in taxes shifts the IS curve.
The Money market and the LM Curve
 The LM curve plots the relationship between the
interest rate and the level of income that arises in the
market for money balances.
 According to the Keynes’s theory of liquidity
preference the interest rate adjusts to balance the
supply and demand for the economy’s most liquid
asset-money.
 Keynesian cross is a building block for the IS curve,
 The theory of liquidity preference is a building block
for the LM curve.
CHAPTER 1 The Science of Macroeconomics 35
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
r
M P
s
Demand for interest
real money rate
balances:
M P
d
 L (r )
L (r )
M/P
M P
real money
balances

Equilibrium
r
M P
s
The interest interest
rate 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 Fed raises the interest rate
r
interest
To increase r, rate
Fed reduces M
r2
r1
L (r )
M/P
M2 M1
real money
P P balances

According to the theory of liquidity
preference
 A decrease in the money supply raises the

interest rate and an increase in the money
supply lowers the interest rate.

CASE STUDY:
Monetary Tightening & Interest Rates
 Late 1970s:  > 10%
 Oct 1979: Fed Chairman Paul Volcker
announces that monetary policy
would aim to reduce inflation
 Aug 1979-April 1980:
Fed reduces M/P 8.0%
 Jan 1983:  = 3.7%
How
How do
do you
you think
think this
this policy
policy change
change
would
would affect
affect nominal
nominal interest
interest rates?
rates?
Monetary Tightening & Interest Rates, cont.
The effects of a monetary tightening

on nominal interest rates
short run long run

Quantity theory,
Liquidity preference
model Fisher effect
(Keynesian)
(Classical)
prices sticky flexible
prediction i > 0 i < 0
actual 8/1979: i = 10.4% 8/1979: i = 10.4%

outcome 4/1980: i = 15.8% 1/1983: i = 8.2%
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.

The LM curve
 Each point on the LM curve represents
equilibrium in the money market.
 LM curve summarize the relationship between
the interest rate and income.
 The higher the level of income (the higher the
demand for real money balances) and the higher
the equilibrium interest rate.
 For this reason LM curve slopes upward.

How M shifts the LM curve
How monetary policy 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
NOW YOU TRY:
Shifting the LM curve
 Suppose a wave of credit card fraud causes
consumers to use cash more frequently in
transactions.
 Use the liquidity preference model
to show how these events shift the
LM curve.
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
interest Equilibrium
rate level of
income
The short-run equilibrium
 At the intersection both the goods market and
the money market is in the equilibrium.
 In other words,
 Actual expenditure = planned expenditure
 Demand for real money balances = money
supply

The Big Picture
Keynesian
Keynesian IS
IS
Cross
Cross curve
curve
IS-LM
IS-LM
model Explanation
Explanation
Theory
Theory ofof model
LM
LM of
of short-run
short-run
Liquidity
Liquidity curve fluctuations
curve fluctuations
Preference
Preference
Agg.
Agg.
demand
demand
curve
curve Model
Model of
of
Agg.
Agg.
Demand
Demand
Agg.
Agg. and
and Agg.
Agg.
supply
supply Supply
Supply
curve
curve
Preview of Chapter 11
In Chapter 11, we will
 use the IS-LM model to analyze the impact of
policies and shocks.
 learn how the aggregate demand curve comes
from IS-LM.
 use the IS-LM and AD-AS models together to
analyze the short-run and long-run effects of
shocks.
 use our models to learn about the
Great Depression.

Chapter 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
Chapter 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
Chapter 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.

N. Gregory Mankiw

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SEVENTH EDITION

© 2010 Worth Publishers, all rights reserved

 This chapter develops the IS-LM model,

CHAPTER 10 Aggregate Demand I 4

CHAPTER 10 Aggregate Demand I 5

CHAPTER 10 Aggregate Demand I 6

 Keynes believed that the problem during

CHAPTER 10 Aggregate Demand I 7

 A simple closed economy model in which income

CHAPTER 10 Aggregate Demand I 8

CHAPTER 10 Aggregate Demand I 11

CHAPTER 10 Aggregate Demand I 12

CHAPTER 10 Aggregate Demand I 13

CHAPTER 10 Aggregate Demand I 14

CHAPTER 10 Aggregate Demand I 16

CHAPTER 10 Aggregate Demand I 17

 MPC  Y  G because C = MPC Y

Collect terms with Y Solve for Y :

CHAPTER 10 Aggregate Demand I 18

Definition: the increase in income resulting from a

Example: If MPC = 0.8, then

CHAPTER 10 Aggregate Demand I 20

consumption, and PE =C2 +I +G

C = MPC T At Y1, there is now

CHAPTER 10 Aggregate Demand I 21

CHAPTER 10 Aggregate Demand I 22

def: the change in income resulting from

If MPC = 0.8, then the tax multiplier equals

CHAPTER 10 Aggregate Demand I 23

CHAPTER 10 Aggregate Demand I 24

CHAPTER 10 Aggregate Demand I 25

def: a graph of all combinations of r and Y that

The equation for the IS curve is:

CHAPTER 10 Aggregate Demand I 26

CHAPTER 10 Aggregate Demand I 27

 A fall in the interest rate motivates firms to

CHAPTER 10 Aggregate Demand I 28

CHAPTER 10 Aggregate Demand I 29

CHAPTER 10 Aggregate Demand I 31

G  PE  Y PE =C +I (r1 )+G1

CHAPTER 10 Aggregate Demand I 32

 Due to John Maynard Keynes.

CHAPTER 10 Aggregate Demand I 36

CHAPTER 10 Aggregate Demand I 37

CHAPTER 10 Aggregate Demand I 38

CHAPTER 10 Aggregate Demand I 39

CHAPTER 10 Aggregate Demand I 40

 A decrease in the money supply raises the

CHAPTER 10 Aggregate Demand I 41

The effects of a monetary tightening

short run long run

prices sticky flexible

prediction i > 0 i < 0

actual 8/1979: i = 10.4% 8/1979: i = 10.4%

Now let’s put Y back into the money demand

The LM curve is a graph of all combinations of

CHAPTER 10 Aggregate Demand I 44

(a) The market for

 An increase in income raises money demand.