Chapter Three

Aggregate Demand in a Closed Economy

slide 1
 Introduction
 The primary objective of this section of the course is:
 To develop a theoretical model which will improve our
understanding of the economy in the short-run, especially short-
run fluctuations, or business cycles and which we can use for a
short run analysis of changes that affect the aggregate economy.
Economists want to understand various things such as
 What could cause business cycles,
 How business cycles work,
 What are the economic effects of business cycles,
 What are the impact of government policies on the aggregate
economy, and
 How do changes in the private sector affect the aggregate
economy. slide 2
  This macroeconomic model will use the three distinct types of
markets:
• Goods markets,
• Factor markets, and
• Asset markets.
 The first step to developing our macroeconomic model involves
modeling aggregate demand,
 AD is the total demand for all goods and services produced in an
economy.
AD = C+ I + G + NX
 In the case of closed economy, NIA identity is:
AD = C+ I + G
slide 3
 AD….
 Aggregate demand refers to the total demand for goods
and service in the economy.
 Aggregate demand is measured by total expenditure of
the economy’s demand of goods and services.
 Aggregate demand is the amount of money which all
sector, house hold, firm, and government are ready to
spend on the purchase of goods and services in an
economy during a given period of time.
 In general the quantity of goods demanded, depends
on the level of income in the economy.

slide 4
 CONT….
 Aggregate demand is down ward sloping that
indicates output which will be demanded in the
economy at various general price level.
 Determinants of aggregated demand in a given
economy
 Monetary and fiscal policy of the government.
 General level of income of the people.
 Level of economic activities in the economy
itself.
 Availability of credit.
slide 5
 3.1 Foundations of Theory of Aggregate Demand
 The Great Depression of 1930s caused many economists to
question the validity of classical economic theory.
 During this time, many countries experienced massive
unemployment and greatly reduced incomes.
 Classical theory seemed incapable of explaining the Depression.
 According to that theory, national income depends on factor
supplies and the available technology, neither of which changed
substantially from 1929 to 1933 (during the Great Depression).
 After the onset of the Depression, many economists believed they
needed a new model to explain such a pervasive economic
downturn and to suggest that government policies might ease some
of the economic hardship that society was experiencing.
 Keynesian economics is the view.
slide 6
  In 1936, John Maynard Keynes wrote his book “The General
Theory of Employment, Interest and Money”.
 The theory formed the basis of Keynesian economics
 In it, he proposed a new way to analyze the economy, which he
presented as an alternative to the classical theory.
 Keynes contrasted his approach to the aggregate supply-focused
'classical' economics.
 He proposed that low aggregate demand is responsible for the low
income and high unemployment that characterize economic
downturns (depression).
 He criticized the notion that aggregate supply alone determines
national income.
 As to Keynes, an economy’s total income is, in the short run,
determined largely by the desire to spend by HHs, firms, &gov’t.
 The more people want to spend, the more goods and services firms
can sell.
slide 7
 The more firms can sell, the more output they will
choose to produce and the more workers they will choose
to hire.
Thus, the problem during recessions and depressions,
according to Keynes, was inadequate spending.
 Keynesians, therefore, advocate an active stabilization policy to
reduce the amplitude of the business cycle.
 According to the theory, government spending can be used to
increase aggregate demand, thus increasing economic activity,
reducing unemployment and inflation.
This is the foundations for the theory of aggregate demand.
 Policymakers around the world debated how best to increase
aggregate demand and put their economies on the road to
recovery.

slide 8
  Economists today reconcile these two views with the model
of aggregate demand and aggregate supply.
 In the long run, prices are flexible, and aggregate supply
determines income.
 But in the short run, prices are sticky, so changes in aggregate
demand influence national income.
 This chapter focus on the closed-economy case and we focus on
the short run and assume the price level is fixed.
 In this chapter and the next, we continue our study of economic
fluctuations by looking more closely at aggregate demand.
 Our goal is to identify the variables that shift the aggregate
demand curve, causing fluctuations in national income.
 We also examine more fully the tools policymakers can use to
influence aggregate demand.
slide 9
  The model of AD going to be developed in this chapter is
called the IS–LM model
 It is the leading interpretation of Keynes’s theory.
 The aims of the model, which is a model of AD, are
To show what causes income to change in the short run
when the price level is fixed, and
To show what causes the AD curve to shift.
 The two parts of the IS–LM model are the IS curve and the
LM curve.
IS stands for “investment’’ and “saving”
It represents what’s going on in the market for goods and
services.
slide 10
  LM stands for “liquidity” and “money”
 It represents what’s happening to the supply and demand for
money.
 Interest rate links the two halves of the IS–LM model.
 B/c: it influences both investment and money demand
 The model shows:
 how interactions between the goods and money markets
determine the position and slope of the aggregate demand
curve and, thus, the level of national income in the short run.

slide 11
 3.2 The Goods Market and the IS Curve
 The IS curve plots the relationship between the interest rate and the
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, &
 It is a building block for the more complex and realistic IS–LM
model.

slide 12
 The Keynesian Cross
 In The General Theory, Keynes believed that the problem
during recessions and depressions was inadequate spending.
 The Keynesian cross is an attempt to model this insight.
 The derivation of the Keynesian cross begins by distinguishing
b/n actual and planned expenditure.
 Actual expenditure (AE) is the amount hhs, firms and the gov’t
spend on goods and services
 It equals the economy’s gross domestic product (income, Y).
AE = Y

slide 13
 Graphically,
AE AE = Y

Y
For instance, an AE of, say, 10 bln Birr is translated to a 10 bln
Birr value for GDP, giving rise to a 45 degree line relating AE &
GDP.
Actual Expenditure (AE) = C (Y – T)+ I + ∆inv + G

slide 14
  Planned expenditure is the amount households, firms, and
the government would like to spend on goods and services.
 It excludes the unexpected (undesired) changes in
inventories.
 Assuming that the economy is closed, so that net exports are
zero, we write planned expenditure PE as:
PE = C + I + G.

slide 15
Aggregate Consumption C = C(Y- T)
function:
Gov’t policy variables: G = G, T = T
For now, planned
investment is exogenous:
I=I
Planned expenditure: E = C(Y- T )+ I + G

slide 16
Graphing planned expenditure

planned E = C +I +G
expenditure
MPC
1

income, output, Y

slide 17
  This equation shows that PE is a function of income Y, the
level of planned investment I, and the fiscal policy variables
G and T.
 PE depends on income because higher income leads to higher
consumption.
 The PE line slopes upward because higher income leads to
higher consumption and thus higher planned expenditure.
 The slope of this planned-expenditure function relating PE and
Y is the MPC.
 it shows how much PE increases when income rises by $1.
 This planned expenditure function is the first piece of the model
called the Keynesian cross.

slide 18
 Why would AE ever differ from PE?
The answer is that firms might engage in unplanned
inventory investment because their sales do not meet their
expectations.
 When firms sell less of their product than they planned, their
stock of inventories automatically rises;
 conversely, when firms sell more than planned, their stock of
inventories falls.
 Because these unplanned changes in inventory are counted as
investment spending by firms, AE can be either above or below
PE.
 AE > PE whenever ∆inv > 0; AE < PE whenever ∆inv < 0; and,
when ∆inv = 0, AE = PE – the economy is in equilibrium.

slide 19
  The second piece of the Keynesian cross is the assumption
that the economy is in equilibrium when AE = PE
 Recalling that Y as GDP equals not only total income but also
total AE on goods and services, we can write this equilibrium
condition as : Y = PE.
 Graphically,

slide 20
  How does the economy get to the equilibrium?
 In this model, inventories play an important role in the
adjustment process.
 Whenever the economy is not in equilibrium, firms experience
unplanned changes in inventories,
 this induces them to change production levels.
Changes in production, in turn, influence total income and
expenditure, moving the economy toward equilibrium.
 Equilibrium occurs along this line because there is no tendency
for inventories to be built up or to be run down
 The following diagram shows how this works:

slide 21
slide 22
 Summary:
the Keynesian cross shows how income Y is determined for
given levels of planned investment (I) and fiscal policy, G and T.
We can use this model to show how income changes when one
of these exogenous variables changes.

slide 23
 Fiscal Policy and the Multiplier:
An increase in government purchases
E Y

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

G

…so firms
increase output,
and income Y
rises toward a
new equilibrium. E1 = Y 1 Y E2 = Y 2

slide 24
 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 

slide 25
 The government purchases multiplier
Definition: the increase in income resulting from a
$1 increase in G.
In this model, the gov’t 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!

slide 26
 Why the multiplier is greater than 1?
 Initially, the increase in G causes an equal increase in Y:
Y = G.
 But Y  C by MPC x G
 further Y by MPC x G
 further C by MPC2 x G
 further Y by MPC2 x G ……..
 Overall impact can be calculated by adding up all the terms.
 Thus, ΔY = (1+MPC +MPC2 +MPC3 + . . .)ΔG
 This sum is a simple infinite geometric series and so we can use
the appropriate mathematical formula
 Doing this gives us:
 So, the final impact on income is much bigger than the initial
G. That is, Y > G.
 Thus, fiscal policy has a multiplied effect on income slide 27
 Fiscal Policy and the Multiplier:
An increase in taxes
E Y

=
Initially, the tax E E = C1 +I +G
increase reduces
consumption, and E = C2 +I +G
therefore E:

C = MPC T At Y1, there is now

an unplanned
…so firms inventory buildup…
reduce output,
and income falls Y
toward a new E2 = Y 2 Y E1 = Y 1
equilibrium

slide 28
 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 

slide 29
 The tax multiplier

def: the change in income resulting from $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

slide 30
 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
multiplied effect on income.
…is smaller than the gov’t 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.
slide 31
 The Interest Rate, Investment, and the IS
Curve
 The Keynesian cross is useful because it shows how the
spending plans of households, firms, and the government
determine the economy’s income.
 Yet, it makes the simplifying assumption that the level of
planned investment, I, is fixed.
 It is very unrealistic, however, to assume that planned
investment is exogenous as it will depend on economic
variables,
 An important macroeconomic relationship is that planned
investment depends on the interest rate, r.
 The next step is to relax the assumption of fixed planned
investment and include it in the income-expenditure model.
slide 32
  To add this relationship between the r and investment to our
model, we write the level of planned investment as I = I(r).
 Because the r is the cost of borrowing to finance investment
projects, an increase in the interest rate reduces planned
investment.
 As a result, the investment function slopes downward.
 To determine how Y changes when the r changes, we can combine the
investment function with the Keynesian-cross diagram.
 A decrease in the interest rate from r1 to r2 raises the quantity of investment
from I(r1) to I(r2).
 A decrease in the interest rate lowers income through PE and I.
 Then, IS can be derived by combining the interaction between r and I
expressed by the investment function and the interaction between I and Y
demonstrated by the Keynesian cross.
 Because a an increase in r causes planned investment to fall, which in turn
causes income to fall, the IS curve slopes downward.
slide 33
 The IS curve
 Summarizes the relationship between the interest rate and the level
of income
 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

slide 34
 Deriving the IS curve
E E =Y
E =C +I (r2 )+G
r  I E =C +I (r1 )+G

 E I

 Y Y1 Y2 Y
r
r1

r2
IS
Y1 Y2 Y

slide 35
Cont…

slide 36
 Why the IS curve is negatively
sloped
 A fall in the r motivates firms to increase investment spending,
which drives up total planned spending (E ).
 To restore equilibrium in the goods market, output (actual
expenditure, Y ) must increase.

slide 37
 The IS curve and the loanable
funds model
 Firms borrow to finance their investment payments
 At equilibrium, Y=E, implies
Y =C+I+G
Y- C- G = I
Add and subtract T on the LHS
(Y- C- T) + (T- G) = I
Private saving + Gov't saving = Investment

 Supply of loanable funds equal with demand for loanable funds

 Saving is now a function of income and at equilibrium S[Y] = I[r]

slide 38
Graphically,

slide 39
 Algebra of the IS curve
 We have derived the IS curve graphically, but we can also
derive it algebraically.
 We know that the IS curve is just pairs of r and Y such that
income (Y) equals planned expenditure (E),
Y = C + I + G.
Let C = a + b(Y − T) , I = c − dr
 Substituting in for C and I, we get:
Y = a + b(Y − T) + c − dr + G.
 Grouping the Y’s together and rearranging and solving for Y, we
get:

 This is the IS curve in algebraic form.

slide 40
 Points to Note about the IS Curve:
1) The IS curve is downward sloping because the
coefficient on r is negative (i.e. increases in r imply that
a lower value of Y).
2) The slope of the IS curve is determined by the
coefficient on r.
 If d is large (I is sensitive to r) or b is large (the MPC
is large), then the IS curve is flat.
3) Changes in autonomous expenditure from G, T, a, or c
will shift the IS curve in or out.
 The larger b (the MPC) then the larger the multipliers,
and the larger the shift in the IS curve.
4) The government expenditure multiplier is bigger than the
taxation multiplier. i.e.,

slide 41
 E Example: Given C=100+0.80Yd , I=50-25i

and G=T=50 Then estimate the IS equation?

 Y=C+I+G
 Y=100+0.8Yd+50-25i+50
 Y=100+0.80(Y-T)-25i+50 then, Y=100+0.80(Y-
50)-25i+50
 Y=200+0.80Y-25i this implies Y-0.80Y=200-25i
 0.20Y=200-25i. There for the general IS curve
equation will be Y=800-125i
slide 42
 Exercise
 The following equations describe an economy:
C=200+0.5(Y-T)
I=200–1000r
G = 250 and T = 200. Then,

a) Derive the equation of the IS curve

b) Draw the graph of the IS-curve

slide 43
 How Fiscal Policy Shifts the IS Curve
 We can use the IS 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…
 From Keynesian cross we learned that the equilibrium level of
income also depends on government spending, G and taxes, T.
 The IS curve is drawn for a given fiscal policy; that is, when we
construct the IS curve, we hold G and T fixed.
 When fiscal policy changes, the IS curve shifts.
 The following figure uses the Keynesian cross to show how an
increase in government purchases ΔG shifts the IS curve.

slide 44
 Shifting the IS curve: G
E E =Y E =C +I (r )+G
At any value of r, 1 2

G  E  Y E =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
Y  G IS2
1 MPC IS1
Y1 Y2 Y

slide 45
 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.

slide 46
 3.3 LM
 The Thecurve
Money Market
plots the andbetween
relationship the LM Curve
the r and the
level of Y that arises in the market for money balances.
 To understand this relationship, we begin by looking at a theory
of the interest rate, called the theory of liquidity preference.
The Theory of Liquidity Preference

 Due to John Maynard Keynes, the theory of liquidity preference is a

theory in which the interest rate is determined by money supply and
money demand.
 It posits that the interest rate adjusts to balance the supply and
demand for the economy’s most liquid asset—money
 It is a building block for the LM curve, as the Keynesian cross is for
the IS curve
slide 47
 The supply of real money balances (M/P)
The supply of real money r
M P
s

balances is fixed: does not

depend on the interest rate
M P M P
s

The theory of Liquidity

preference takes money supply M/P
& price level as exogenous. M P
real
Money supply is an exogenous money
policy variable chose by a balances
central bank and Price is
assumed to be fixed in the short-
run – thus, vertical SS curve slide 48
 The demand for real money balances

Demand for real money r

balances:

M P
d
 L (r )

The theory of liquidity preference

suggests that a higher interest L (r )
rate lowers the quantity of real
balances demanded, because r is M/P
the opportunity cost of holding real money
money. balances

slide 49
 Equilibrium in the Money Market
 It occurs when the
quantity of real money r M P
s

balances demanded
equals their supply.
 At that point, interest
rate prevails in the
economy determined. r
1

 The interest rate L (r )

adjusts to equate the
supply and demand for M/P
money: M P
real money
balances
M P  L (r )
slide 50
 How r responds to changes in M?

 According to the r
theory of liquidity
preference, a decrease
in the M raises r, and
an increase in the M r2
lowers r.
r1
 For instance, suppose
L (r )
that the central bank
suddenly decreases M. M/P
M2 M1
real money
P P balances

slide 51
 Income, Money Demand, and the LM Curve
 The demand for real money balances is not only a function of interest rate; it is also a function of
income.
 The level of income affects the demand for money (through transaction and precautionary motives).
 The greater income implies greater money demand
 Now let’s put Y back into the money demand function:

M P
d
 L (r ,Y )
It is negatively related to the r and positively related to income (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 )
slide 52
 Deriving the LM curve
(a)The market for
real money balances
 Suppose that Y increases. (b) The LM curve
r r
LM

r2 r2

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

M1 M/P Y1 Y2 Y
P

slide 53
 Why the LM curve is upward sloping

 An increase in income raises the real 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.

slide 54
 Algebra of the LM curve
 Let the money demand function is given by:
( M / P )d  L(r , Y )  eY  fr
 The LM curve (equilibrium of the money market):
M
( ) = eY - fr
P
e 1 M
r= Y - ( ),
f f P
This is the LM curve in algebraic form
 The LM curve is upward sloping b/c coefficient on Y is +ve.
 It is relatively steeper if the coefficient e is large.
 It is relatively flat if the coefficient f is large
 If f is large then an increase in M or decrease in P will cause a
small downward shift in the LM curve. slide 55
 How Monetary Policy Shifts the LM Curve
Suppose the central bank reduces money supply (M).
(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

slide 56
 Exercise
1. Suppose that the money demand function is:
(M/P)d = 1000 – 100r, where r is the interest
rate (in %).
The money supply M is 1000, and the price level is 2.
a. Graph the supply and demand for real money balances.
b. What is the equilibrium interest rate?

slide 57
 Equilibrium in the Short-run (IS-LM)
Equilibrium
The IS curve represents r
Interest rate
equilibrium in the goods LM
market.
Y  C (Y  T )  I (r )  G
r1
The LM curve represents
money market equilibrium.
IS
M P  L (r ,Y )
Y
Y1
The intersection determines
the unique combination of Y and r Equilibrium
that satisfies equilibrium in both markets. level of income

slide 58
 Policy analysis with the IS -LM model
(Explaining Fluctuations with the IS–LM Model)
Y  C (Y  T )  I (r )  G r
LM
M P  L (r ,Y )

We can use the IS-LM

model to analyze the r1
effects of
• fiscal policy: G and/or T IS
• monetary policy: M Y1
Y

slide 59
 1. Changes in fiscal policy
An increase in government purchases (G)

1. IS curve shifts right r

1 LM
by G
1 MPC
causing output & r2
income to rise. 2.
r1
2. This raises money 1 IS2
demand, causing the .
interest rate to rise… IS1
Y
3. …which reduces investment, Y1 Y2
so the final increase in Y 3.
1
is smaller than G
1 MPC G  Y   Md   r  I
slide 60
 A tax cut

Consumers save r
(1MPC) of the tax cut, LM
so the initial boost in
spending is smaller for T r2
than for an equal G… 3.
r1
and the IS curve shifts by
1. IS2
MPC
1. T IS1
1 MPC
Y
Thus, raises both Y and r. Y1 Y2
2.
…so the effects on r
2.
and Y are smaller for T than for an equal G.
Once again, increase in Y is smaller in the IS–LM modelslide 61
  Thus, the increase in Y in response to a fiscal expansion is smaller
in the IS–LM model than it is in the Keynesian cross (where
investment is assumed to be fixed) because:
 The increase in G or reduce in T has caused the “crowding out” of
planned investment due to a higher r.
 Fiscal policy is more effective at influencing national Y if:
o The LM curve is flatter – less sensitive demand for real
money balances to change in income, and
o The IS curve is steeper _ the MPC and the shift in the IS
curve are larger & the less sensitive I to change in r.

slide 62
 Changes in Monetary policy:
An increase in M
r
LM1
1. M > 0 shifts
the LM curve down LM2
(or to the right) r1
2. …causing the interest r2
rate to fall
IS
3. …which increases investment,
Y
causing output & income to rise. Y1 Y2
s
M  r  I  Y  Md 
 When the supply of money increases, people have more money than they want to
hold at the prevailing interest rate.

 As a result, they start depositing this extra money in banks or use it to buy bonds.
 The r then falls until people are willing to hold all the extra money that the
Central Bank has created.

 This in turn increases investment and income in the goods market. slide 63
 The IS–LM model shows that an increase in the M lowers the r,
which stimulates investment and thereby expands the demand
for goods and services
- a process called the monetary transmission mechanism.
 Monetary policy is more effective at influencing national Y if:
o The IS curve is flatter –the larger the MPC & more sensitive
investment to change in interest rate,
o The LM curve is steeper – less sensitive demand for real
money balances to change in interest rate .

slide 64
 Interaction between monetary & fiscal policy

 Model:
Monetary & fiscal policy variables
(M, G, and T ) are exogenous.
 Real world:
Monetary policymakers may adjust M
in response to changes in fiscal policy,
or vice versa.
 A change in one policy, therefore, may influence the other, and
this interdependence may alter the impact of the original policy
change.

slide 65
 Suppose Government raise G
The Central Bank’s response to G (G > 0)

 Suppose Parliament increases G.

 Possible Central Bank’s responses:
1. hold M constant
2. hold r constant
3. hold Y constant
 In each case, the effects of the G are different:

slide 66
 Response 1: Hold M constant

If raises G, the IS curve r

shifts right. LM1

If central bank holds M

r2
constant, then LM curve r1
doesn’t shift.
IS2
Results: IS1
Y  Y 2  Y 1 Y
Y1 Y2
r  r 2  r1

slide 67
 Response 2: Hold r constant

If raises G, the IS curve r

shifts right. LM1
LM2
To keep r constant,
r2
central bank increases M
r1
to shift LM curve right.
IS2
Results: IS1
Y  Y 3  Y1 Y
Y1 Y2 Y3

r  0

slide 68
 Response 3: Hold Y constant

If parliament raises G, r LM2

the IS curve shifts right. LM1

r3
To keep Y constant,
r2
central bank reduces M r1
to shift LM curve left.
IS2
Results: IS1
Y  0 Y
Y1 Y2
r  r3  r1

slide 69
 Exercise
Goods Market: C=200+0.5(Y-T); I=200–1000r; G=250; T=200
Money Market: M = 3000; P = 2; L(r,Y)= 2Y – 10000r
a. Derive the IS equation.
b. Derive the LM equation.
c. Solve for equilibrium real GDP (Y) and interest rate (r).
d. Solve for the equilibrium values of C, and I.
e. Verify that you get Y by adding up C+I+G.

slide 70
 3.5 From the IS–LM Model to the AD Curve
 So far, we’ve been using the IS-LM model to analyze Y
in the short run, when the price level is assumed fixed.

 To see how the IS–LM model fits into the model of AS and
AD, we now examine what happens in the IS–LM model if the
P level is allowed to change.

 A change in P would shift LM and therefore affect Y.

 The AD curve captures this relationship between P and Y.
 The IS–LM model provides a theory to explain the position and
slope of the AD curve.

slide 71
 We use the IS–LM model to show why Y falls as the P rises.
 Here:
We examine why the AD curve is downward sloping.
We also examine what causes the AD curve to shift.
 To explain why the AD curve slopes downward, we
examine what happens in the IS–LM model when the price
changes.

slide 72
 Deriving the AD curve
r LM(P2)
Intuition for slope LM(P1)
r2
of AD curve:
r1
P  (M/P )
IS
 LM shifts left (up) Y1 Y
Y2
P
 r
P2
 I
P1
 Y
AD
Y2 Y1 Y

slide 73
  For any given M, a higher P reduces the supply of real
money balances M/P.
 A lower supply of real money balances shifts the LM curve
upward.
This raises the equilibrium r and lowers the equilibrium Y.

 Here P level rises from P1 to P2, and income falls from Y1 to Y2.
 The AD plots this negative relationship between Y and P.
OR
 The AD curve shows the set of equilibrium points that arise in
the IS–LM model as we vary P level and see what happens to Y.

slide 74
 What causes the AD curve to shift?
 Because the AD curve is only a summary of results from the IS–
LM model, events that shift the IS curve or the LM curve (for a
given price level) cause the AD curve to shift.
 For instance, an increase in the M raises income in the IS–LM
model for any given price level;
 It, thus, shifts the AD curve to the right, as shown in panel (a) of
the figure that follows.

slide 75
 Monetary policy and the AD curve:
(Assume increase Money supply, M)
r LM(M1/P1)
The central bank can increase
r1 LM(M2/P1)
AD by increasing M:
r2
M  LM shifts right
IS
 r
Y1 Y2 Y
P
 I
 Y at each P1
value of P
AD2
AD1
Y1 Y2 Y

slide 76
 Fiscal policy and the AD curve:
(Assume decrease in T)
r LM
Expansionary fiscal policy
(G &/or T ) increases AD: r2
r1 IS2
T  C
IS1
 IS shifts right
Y1 Y2 Y
 Y at each P

value of P. P1

AD2
AD1
Y1 Y2 Y

slide 77
 Summary

 A change in income in the IS–LM model resulting from a change

in the price level represents a movement along the AD curve.

 A change in income in the IS–LM model for a fixed price level

represents a shift in the aggregate demand curve.

The End
slide 78
 Optional
Algebra of the AD Curve
Use the goods market equilibrium condition
Y=C+I+G
Y  C  b (Y  T )  I  dr  G
Solve for Y:
Y  bY  C  bT  I  dr  G
(1  b )Y  C  I  G  bT  I  dr
C  I   1   b   d 
IS:Y       G  T   r
 1  b  1  b  1  b  1  b 
 A line relating Y to r with slope –d/(1-b)
Can see multipliers here: rise in Y taking r as given.
But r is an endogenous variable and it will change…
slide 79
 Algebra of the AD Curve

Use the money market to find a value for r:

As done for the LM curve previously,
suppose the money market is characterized by:
   eY  fr
d
M / P e  0, f  0
M /P   M /P
s

Equilibrium in money market requires:

M /P   M /P 
s d

So LM: M /P  eY  fr
e   1 M
or write as: r   Y   
f  f  P
Line with slope = e/f

slide 80
 Algebra of the AD Curve
Suppose the expenditure side of the economy is
characterized by:

C  C  b (Y  T ) 0 b 1
I  I  dr d 0
G  G , T T

where: b & d are some numbers,

C is the 'autonomous part of consumption'
and I is 'autonomous investment'

slide 81
 Algebra of the AD Curve
Now combine the two, substituting in for r:
C  I   1   b   d 
IS: Y   
   G   T    r
 1  b  1  b  1  b  1  b 
e   1 M
LM: r   Y   
f  f  P
C  I   G   bT   d   e   1 M 
Y               f Y   f  P 
 1b  1  b  1  b  1  b      
Solve for Y. For convenience, define a term:
z  f /[f  de /(1  b )], so 0  z  1
C  I   z   zb   d M
Y  z  
   G  1  b T   
 1b   1  b     f 1  b   de P

slide 82
 Algebra of the AD Curve
C  I   z   zb   d M
Y  z     G   1  b T   f 1  b  de 
 1b  1  b       P
where z  f /[f  de /(1  b )], 0  z 1
The AD slopes downward because when P↑, Real money supply↓,
Interest rate↑ (to equilibrate the money market), planned investment↓,
firms will reduce production to reduce inventories Y ↓
AD is steeper when
1. b (MPC) is small, steeper IS
2. d (the interest sensitivity of planned I) is small, steeper IS
3. e (the income sensitivity of the demand for real money balances)
is large, 4. f (the interest sensitivity of the demand for real money
balances) is large.
This math of AD can help reveal under what conditions
monetary and fiscal policies will be most effective…
slide 83
 Policy Effectiveness
Fiscal policy is effective (Y will rise much) when:
LM flatter (f large or e small, so z near 1)
IS1 IS2 LM As the rise in G raises Y,
r
the increase in money demand
2
2’ LM’ does not raise r much: -
1
small e:Md not responsive to Y -
large f: Md is responsive to r
so investment is not crowded out
Y1 Y2 Y2’ as much.
C  I   z   zb   d M
Y  z      G  T  
 f 1  b   de
 1  b  1  b  1  b   P
where z  f /[f  de /(1  b )], 0  z 1
slide 84
 Policy Effectiveness
Monetary policy is effective (Y will rise much) when:
IS flatter (d large: Investment is responsive to r)

r As a rise in M lowers the

IS LM1 LM2 interest rate (r),
1 investment rises more in
2’
response to the fall in r,
2
IS’
so output rises more.
Y1 Y2 Y2’

C  I   z   zb   d M
Y  z      G  T  
 f 1  b   de
 1  b  1  b  1  b   P
where z  f /[f  de /(1  b )], 0  z 1
slide 85
 IS-LM and AD-AS
in the short run & long run
The force that moves the economy from the short run
to the long run is the gradual adjustment of prices.

In the short-run then over time, the

equilibrium, if price level will
Y Y rise
Y Y fall

Y Y remain constant

slide 86
 The SR and LR effects of an IS shock
r LRAS LM(P1)
A negative IS shock
shifts IS and AD left,
causing Y to fall. IS1
IS2
Y Y
P LRAS

P1 SRAS1

AD1
AD2
Y Y
slide 87
 The SR and LR effects of an IS shock
r LRAS LM(P1)

In the new short-run

equilibrium, Y  Y IS1
IS2
Y Y
P LRAS

P1 SRAS1

AD1
AD2
Y Y
slide 88
 The SR and LR effects of an IS shock
r LRAS LM(P1)

In the new short-run

equilibrium, Y  Y IS1
IS2
Y Y
Over time, P gradually
falls, which causes P LRAS

• SRAS to move down. P1 SRAS1

• M/P to increase,
which causes LM AD1
to move down. AD2
Y Y
slide 89
 The SR and LR effects of an IS shock
r LRAS LM(P1)
LM(P2)

IS1
IS2
Y Y
Over time, P gradually
falls, which causes P LRAS

• SRAS to move down. P1 SRAS1

• M/P to increase, P2 SRAS2

which causes LM AD1
to move down. AD2
Y Y
slide 90
 The SR and LR effects of an IS shock
r LRAS LM(P1)
LM(P2)

This process continues IS1

until economy reaches a IS2
long-run equilibrium with Y Y
Y Y P LRAS

P1 SRAS1

P2 SRAS2
AD1
AD2
Y Y
slide 91
 EXERCISE:
Analyze SR & LR effects of M
a. Draw the IS-LM and AD-AS r LRAS LM(M1/P1)
diagrams as shown here.
b. Suppose Fed increases M.
Show the short-run effects
IS
on your graphs.
c. Show what happens in the Y
Y
transition from the short run
to the long run. P LRAS

d. How do the new long-run

P1 SRAS1
equilibrium values of the
endogenous variables
compare to their initial AD1
values? Y Y
slide 92
 The Great Depression
240 30
Unemployment
220 (right scale) 25
billions of 1958 dollars

percent of labor force

200 20

180 15

160 10

140 Real GNP 5

(left scale)
120 0
1929 1931 1933 1935 1937 1939

slide 93
 THE SPENDING HYPOTHESIS:
Shocks to the IS curve
 asserts that the Depression was largely due to
an exogenous fall in the demand for goods &
services – a leftward shift of the IS curve.
 evidence:
output and interest rates both fell, which is what
a leftward IS shift would cause.

slide 94
 THE SPENDING HYPOTHESIS:
Reasons for the IS shift
 Stock market crash  exogenous C
 Oct-Dec 1929: S&P 500 fell 17%
 Oct 1929-Dec 1933: S&P 500 fell 71%
 Drop in investment
 “correction” after overbuilding in the 1920s
 widespread bank failures made it harder to obtain
financing for investment
 Contractionary fiscal policy
 Politicians raised tax rates and cut spending to
combat increasing deficits.
slide 95
 THE MONEY HYPOTHESIS:
A shock to the LM curve
 asserts that the Depression was largely due to
huge fall in the money supply.
 evidence:
M1 fell 25% during 1929-33.
 But, two problems with this hypothesis:
 P fell even more, so M/P actually rose slightly
during 1929-31.
 nominal interest rates fell, which is the opposite
of what a leftward LM shift would cause.

slide 96
 THE MONEY HYPOTHESIS AGAIN:
The effects of falling prices
 asserts that the severity of the Depression was
due to a huge deflation:
P fell 25% during 1929-33.
 This deflation was probably caused by the fall in
M, so perhaps money played an important role
after all.
 In what ways does a deflation affect the
economy?

slide 97
 THE MONEY HYPOTHESIS AGAIN:
The effects of falling prices
 The stabilizing effects of deflation:
 P  (M/P )  LM shifts right  Y
 Pigou effect:
P  (M/P )
 consumers’ wealth 
 C
 IS shifts right
 Y
slide 98
 THE MONEY HYPOTHESIS AGAIN:
The effects of falling prices
 The destabilizing effects of expected deflation:
 e
 r  for each value of i
 I  because I = I (r )
 planned expenditure & agg. demand 
 income & output 

slide 99
 THE MONEY HYPOTHESIS AGAIN:
The effects of falling prices
 The destabilizing effects of unexpected deflation:
debt-deflation theory
P (if unexpected)
 transfers purchasing power from borrowers to
lenders
 borrowers spend less,
lenders spend more
 if borrowers’ propensity to spend is larger than
lenders’, then aggregate spending falls,
the IS curve shifts left, and Y falls
slide 100