MACROECONOMICSMACROECONOMICS

Chapter 10Chapter 10

Aggregate Demand I: Aggregate Demand I: Building the IS-LM ModelBuilding the IS-LM Model

22

Can We Ignore Short Run?Can We Ignore Short Run?

In 1933, unemployment rate was 25% and In 1933, unemployment rate was 25% and GDP was one-third below its 1929 level.GDP was one-third below its 1929 level.

Classics: supply creates its own demand.Classics: supply creates its own demand.Keynes: aggregate demand fluctuates Keynes: aggregate demand fluctuates

independent of the supply.independent of the supply.Classics: prices adjust fast.Classics: prices adjust fast.Keynes: prices are sticky.Keynes: prices are sticky.

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ExpendituresExpendituresPE = C + I + G + NX Leave NX for Ch. 12; NX=0C = c(Y-T) Consumption is determined by MPC times disposable income.T, I, G are exogenous: values given outside of the model.

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Keynesian CrossKeynesian Cross

For the economy to be in equilibrium (the circular flow to have top and bottom flows matched) the horizontal distance has to equal to the vertical distance.

The 45-degree line represents Y=PE.

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Equilibrium in Keynesian CrossEquilibrium in Keynesian Cross

Firms Households

Review your circular flow diagram: Ch. 2, slide #5

66

Multiplier: Response of Y to a Multiplier: Response of Y to a Change in ExpenditureChange in Expenditure

MPCG

YY

GMPC

MPCY

G

Y

Y

YMPCGY

1

1

1

)(

nMPCGMPCGMPCMPCGMPCGGY )(...)())(()( 3

If ΔG=700 and MPC=0.33, what is ΔY?

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Multiplier for a Tax CutMultiplier for a Tax Cut

MPC

MPC

T

YY

MPCTMPC

MPCY

MPCT

Y

Y

YMPCTMPCY

1

)(1

)(

)()(

Which fiscal policy gives more bang for the buck? Increasing government expenditures or reducing taxes?

88

Derivation of IS CurveDerivation of IS Curve

PEY

rII

TYcC

GICPE

)(

)(

G,T, and r are exogenous.

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Shifts in ISShifts in ISWhat shifts Keynesian PE curve?

Any increase in the components of PE: C, I, G.

Any decrease in taxes.

If real interest rate drops and PE shifts up, what will happen to IS?

Movement along the IS!

1010

Monetary Sector and Monetary Sector and Nominal Interest RateNominal Interest Rate

How does the sector move from the first equilibrium to the second?

1111

Derivation of the LM CurveDerivation of the LM Curve),( YrL

P

Md

Demand for money (liquidity preference) increases with real income

but decreases with higher interest rates.

1212

Shifts in LMShifts in LMMoney supply increases will shift LM right; money supply decreases will shift it to the left.

1313

Equilibrium: r* and Y*Equilibrium: r* and Y*

ds

d

MM

YrLP

M

),(

PEY

rII

TYcC

GICPE

)(

)(

IS:

LM:

John Hicks

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Theory of Short Run FluctuationsTheory of Short Run Fluctuations

Y=C+I+G

M/P=L(r,Y)

Y=f(r)

Y=f(r,M/P)

Equate Ys solve for r

Equate rs solve for Y Y=f(P)

LR: Y=f(K,L)

SR: Y=f(AD)

1515

Contradiction?Contradiction?

IS-LM Model says if the Central Bank IS-LM Model says if the Central Bank increases the money supply, interest rates increases the money supply, interest rates will fall.will fall.

Fisher effect said that if inflation rises, Fisher effect said that if inflation rises, interest rates will rise.interest rates will rise.Money supply increases trigger inflation.Money supply increases trigger inflation.

What is going on? What is going on?

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Contradiction?Contradiction?

M/P

rr

Ms LM

IS

Y

Fisher effect: Nominal interest rate = real interest rate + inflation