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CHAPTER TENAggregate Demand I

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The Great Depression caused many economists to question the validity of classical economic theory (from Chapters 3-6). They 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.

In 1936, John Maynard Keynes wrote The General Theory ofEmployment, Interest and Money. In it, he proposed a new way to analyze the economy, which he presented as an alternative to the classical theory.

Keynes proposed that low aggregate demand is responsible for the low income and high unemployment that characterize economic downturns.He criticized the notion that aggregate supply alone determines national income.

The Great Depression caused many economists to question the validity of classical economic theory (from Chapters 3-6). They 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.

In 1936, John Maynard Keynes wrote The General Theory ofEmployment, Interest and Money. In it, he proposed a new way to analyze the economy, which he presented as an alternative to the classical theory.

Keynes proposed that low aggregate demand is responsible for the low income and high unemployment that characterize economic downturns.He criticized the notion that aggregate supply alone determines national income.

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This chapter: Aggregate Demand

1. The goods market and the IS curve

2. The money market and the LM curve

3. The short-run equilibrium

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The basic textbook Keynesian model: an elaboration and extension of the ‘classical theory’.

Its variables velocity of money and ‘sticky’ prices reflects Keynes’ belief that the Classical model’s shortcomings arose from its overly-strict assumptions of constant velocity and highly flexible wages and prices.

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Price Level, P

Income, Output, Y

SRAS

AD

Y*Y*'

AD'AD''

Y*''

In the short run, when the price level is fixed, shifts in the aggregate demand curve lead to changes in national income, Y.

The IS-LM model = the leading interpretation of Keynes’ work.

The goal of the model: to show what determines national income for any given price level.

The Keynesian model - shows what causes the aggregate demand curve to shift.

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The model of aggregate demand (AD) can be split into two parts: - IS (“investment” and “saving”)model of the ‘goods market’

- LM (“liquidity” and “money”) model of the ‘money market’.

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The IS curve (which stands for investment and saving) plots the relationship between the interest rate and the level of income that arises in the market for goods and services.

The LM curve (which stands for liquidity and money) plots the relationship between the interest rate and the level of income that arises in the money market.

The variable that links the two parts of the IS-LM model: the interest rate (it influences both investment and money demand).

The variable that links the two parts of the IS-LM model: the interest rate (it influences both investment and money demand).

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In the General Theory of Money, Interest and Employment (1936), Keynes proposed: an economy’s total income was, in the short run, determined largely by the desire to spend by households, firms and the government.

Thus, the problem during recessions and depressions, according to Keynes, was inadequate spending.

How to model this insight? - The Keynesian Cross

In the General Theory of Money, Interest and Employment (1936), Keynes proposed: an economy’s total income was, in the short run, determined largely by the desire to spend by households, firms and the government.

Thus, the problem during recessions and depressions, according to Keynes, was inadequate spending.

How to model this insight? - The Keynesian Cross

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Actual expenditure = the amount households, firms and the government spend on goods and services (GDP). Planned expenditure = the amount households, firms and the governmentwould like to spend on goods and services.

The economy is in equilibrium when: Actual Expenditure = Planned Expenditure or Y=E

Expenditure, E

Income, Output, Y

Actual Expenditure, Y=E

Planned Expenditure,E = C + I + G

Y2 Y1Y*

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Expenditure, E

Income, Output, Y

Actual Expenditure, Y=E

Planned Expenditure,E = C + I + G

Y2 Y1Y*

Question: How does the economy get to this equilibrium?

- Inventories play an important role in the adjustment process.

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Let’s see how changes in government purchases affect the economy.

Expenditure, E

Income, Output, Y

Actual Expenditure, Y=E

Planned Expenditure,E = C + I + G

Y1Y*

G

An increase in government purchases of ΔG raises planned expenditure by that amount for any given level of income. The equilibrium moves from A to B and income rises. Note: the increase in income Y exceeds the increase in government purchases ΔG. Thus, fiscal policy has a multiplied effect on income.

A

B

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If government spending were to increase by $1, then you might expect equilibrium output (Y) to also rise by $1. But it doesn’t! The multiplier shows that the change in demand for output (Y) will be larger than the initial change in spending. Here’s why:When there is an increase in government spending (G), income rises by G as well. The increase in income will raise consumption by MPC G, where MPC is the marginal propensity to consume. The increase in consumption raises expenditure and income again. The second increase in income of MPC G again raises consumption, this time by MPC (MPC G), which again raises income and so on.So, the multiplier process helps explain fluctuations in the demand for output. For example, if something in the economy decreases investment spending, then people whose incomes have decreased will spend less, thereby driving equilibrium demand down even further.

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The government-purchases multiplier: Y/G = 1 + MPC + MPC2 + MPC3 + …

Y/G = 1 / 1 - MPC

The government-purchases multiplier: Y/G = 1 + MPC + MPC2 + MPC3 + …

Y/G = 1 / 1 - MPC

The tax multiplier: Y/T = - MPC / (1 - MPC)

The tax multiplier: Y/T = - MPC / (1 - MPC)

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Let’s now relax the assumption that the level of planned investment is fixed. - We write the level of planned investment as: I = I (r).

The investment function - downward-sloping (it shows the inverse relationship between investment and the interest rate)

The IS curve summarizes the relationship between the interest rate and the level of income. It is downward-sloping.

The IS curve combines:•the interaction between I and r expressed by the investment function•the interaction between I and Y demonstrated by the Keynesian cross.

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E

Income, Output, Y

Y=EPlanned Expenditure,E = C + I + G

r

Income, Output, Y

r

Investment, I

I(r) IS

An increase in the interest rate (in graph a), lowers planned investment, which shifts planned expenditure downward (ingraph b) and lowers income (in graph c).(a)

(b)

(c)

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E

Income, Output, Y

Y=EPlanned Expenditure,E = C + I + G

r

Income, Output, YIS1

An increase in government purchases or a decrease in taxes - IS curve shifts outward.

A decrease in government purchases or an increase in taxes - IS curve shifts inward.

IS2

An increase in government purchases

How fiscal policy shifts the IS curve?

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Summary

•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.

Summary

•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.

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r

M/PM/P

Supply

LM curve = the relationship between the interest rate and the level of income that arises in the market for money balances

The theory of liquidity preference- how the interest rate is determined in the short run

The supply of real money balances - vertical The demand for real money balances - downward sloping

Demand, L (r)

The supply and demand for real money balances determine the equilibrium interest rate.

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Money DemandMoney Demand equalsequals Real Money BalancesReal Money Balances

L(r) = M/PL(r) = M/P

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r

M/PM/P

Supply

Demand, L (r,Y)

Since the price level is fixed, a reduction in the money supply reduces the supply of real balances. Notice the equilibrium interest rate rose.

A Reduction in the Money Supply: -M/PA Reduction in the Money Supply: -M/P

Supply'

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(M/P)d = L (r,Y) (M/P)d = L (r,Y)

The quantity of real money balances demanded is negatively related to the interest rate (because r is the opportunity cost of holding money) and positively related to income (because of transactions demand).

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r

M/PM/P

Supply

L (r,Y)'L (r,Y)

r1

r2

r

Y

LM

An increase in income raises money demand, which increases the interest rate; this is called an increase in transactions demand for money. The LM curve summarizes these changes in the money market equilibrium.

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r

M/P

L (r,Y)

r

Y

LM

M/P

Supply

A contraction in the money supply raises the interest rate that equilibrates the money market. Why? Because a higher interest rate is needed to convince people to hold a smaller quantity of real balances.As a result of the decrease in the money supply, the LM shifts upward.

r1 r1

M´/P

Supply'

LM'

r2 r2

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Summary

•The LM curve shows the combinations of the interest rate and the level of income that are consistent with equilibrium in the market for real money balances.

•The LM curve is drawn for a given supply of real money balances

•Decreases in the supply of real money balances shift the LM curve upward

•Increases in the supply of real money balances shift the LM curve downward

Summary

•The LM curve shows the combinations of the interest rate and the level of income that are consistent with equilibrium in the market for real money balances.

•The LM curve is drawn for a given supply of real money balances

•Decreases in the supply of real money balances shift the LM curve upward

•Increases in the supply of real money balances shift the LM curve downward

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r

Y

LM(P0)IS

r0

Y0

The IS curve/equation Y= C (Y-T) + I(r) + G The LM curve/equation M/P = L(r, Y) The intersection of the IS and LM curves represents simultaneous equilibrium in the market for goods and services and in the market for real money balances for given values of government spending, taxes, the money supply, and the price level.

The IS curve/equation Y= C (Y-T) + I(r) + G The LM curve/equation M/P = L(r, Y) The intersection of the IS and LM curves represents simultaneous equilibrium in the market for goods and services and in the market for real money balances for given values of government spending, taxes, the money supply, and the price level.

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IS-LM ModelIS CurveLM CurveKeynesian crossGovernment-purchases multiplierTax multiplierTheory of liquidity preference

IS-LM ModelIS CurveLM CurveKeynesian crossGovernment-purchases multiplierTax multiplierTheory of liquidity preference