demand building islm model

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Aggregate Demand I: Building the IS–LM Model

Classical theory seemed incapable of explaining the Depression. According to the theory,national income depends on factor supplies and the available technology, neither of which

changed substantially from 1929 to 19.!n 19" the #ritish economist $ohn %aynard &eynes revolutioni'ed economics with his boo(

The General Theory of Employment, Interest, and Money . &eynes proposed a new way toanaly'e the economy, which he presented as an alternative to classical theory. &eynes

proposed that low aggregate demand is responsible for the low income and highunemployment that characteri'e economic downturns. )e critici'ed classical theory for

assuming that aggregate supply alone*capital, labor, and technology*determines nationalincome. +conomists today reconcile these two views with the model of aggregate demand

and aggregate supply introduced in Chapter 9. !n the long run, prices are flexible, andaggregate supply determines income. #ut in the short run, prices are stic(y, so changes in

aggregate demand influence income.he model of aggregate demand developed in this chapter, called the IS–LM model, is the

leading interpretation of &eynes-s theory. he two parts of the !/0% model are, notsurprisingly, the ! curve and the 0% curve. ! stands for investment-- and saving,-- and the

! curve represents what-s going on in the mar(et for goods and services. 0% stands for liuidity-- and money,-- and the 0% curve represents what-s happening to the supply and

demand for money. #ecause the interest rate influences both investment and moneydemand, it is the variable that lin(s the two halves of the !/0% model.

The Goods Market and the IS Curve

!n he 3eneral heory &eynes proposed that an economy-s total income was, in the short

run, determined largely by the spending plans of households, businesses, and government.he more people want to spend, the more goods and services firms can sell. he more firms

can sell, the more output they will choose to produce and the more wor(ers they will chooseto hire. &eynes believed that the problem during recessions and depressions was inadeuate

spending.An increase in government purchases leads to an even greater increase in income. hat

is, 45 is larger than 43. he ratio 45643 is called the government7purchases multiplier8 ittells us how much income rises in response to a 1 increase in government purchases. :hy

does fiscal policy have a multiplied effect on income; he reason is that, according to theconsumption function C < C=5 > ?, higher income causes higher consumption. :hen an

increase in government purchases raises income, it also raises consumption, which furtherraises income, which further raises consumption, and so on. :hen @resident #arac( bama

too( office in $anuary 2BB9, the economy was suffering from a significant recession. hepresident and his advisers proposed a si'able stimulus pac(age to increase aggregate

demand. %uch of it was made up of increases in government purchases of goods andservices.

A decrease in taes of 4 immediately raises disposable income 5 > by 4 and,therefore, increases consumption by %@C 4. :hen $ohn . &ennedy became president of

the Enited tates in 19"1, one of the first proposals was to expand national income byreducing taxes. he tax cut was intended to stimulate expenditure on consumption and

investment and lead to higher levels of income and employment. As &ennedy-s economic

advisers predicted, the passage of the tax cut was followed by an economic boom.

The Interest !ate" Investment" and the IS Curve

o add the relationship between the interest rate and investment to our model, we write the

level of planned investment as ! < !=r?.#ecause the interest rate is the cost of borrowing to finance investment proFects, an increase

in the interest rate reduces planned investment. As a result, the investment function slopesdownward.

#ecause investment is inversely related to the interest rate, an increase in the interest ratefrom r1 to r2 reduces the uantity of investment from !=r1? to !=r2?. he reduction in

planned investment, in turn, causes the level of income to fall from 51 to 52. )ence, anincrease in the interest rate lowers income.



!n summary, the ! curve shows the combinations of the interest rate and the level of income that are consistent with euilibrium in the mar(et for goods and services. he !

curve is drawn for a given fiscal policy. Changes in fiscal policy that raise the demand forgoods and services shift the ! curve to the right. Changes in fiscal policy that reduce the

demand for goods and services shift the ! curve to the left.

The Mone# Market and the LM Curve

he 0% curve plots the relationship between the interest rate and the level of income thatarises in the mar(et for money balances. o understand this relationship, we begin by

loo(ing at a theory of the interest rate, called the theory of liuidity preference. he theoryposits that the interest rate adFusts to balance the supply and demand for the economy-s

most liuid asset*money.he theory of liuidity preference assumes there is a fixed supply of real money balances.

hat is, =%6@?s < % [email protected] money supply % is an exogenous policy variable chosen by a central ban(. he price

level @ is also fixed as we are explaining the short run. hese assumptions imply that thesupply of real money balances is fixed and, in particular, does not depend on the interest

rate.

Gext, consider thedemand for real money

balances. he theory of liuidity preference

posits that the interestrate is one determinant

of how much moneypeople choose to hold.

he underlying reasonis that the interest rate

is the opportunity costof holding moneyH it is

what you forgo byholding some of your

assets as money, whichdoes not bear interest,

instead of as interest7bearing ban( deposits

or bonds. :hen the interest rate rises, people want to hold less of their wealth in the form of money. :e can write the demand for real money balances as =%6@?d < 0=r?,

)ow does the interest rate get to this euilibrium of money supply and money demand; he

adFustment occurs because whenever the money mar(et is not in euilibrium, people try toadFust their portfolios of assets and, in the process, alter the interest rate. or instance, if

the interest rate is above the euilibrium level, the uantity of real money balances supplied

exceeds the uantity demanded. !ndividuals holding the excess supply of money try toconvert some of their non7interest7bearing money into interest7bearing ban( deposits orbonds. #an(s and bond issuers, who prefer to pay lower interest rates, respond to this



excess supply of money by lowering the interest rates they offer. Conversely, if the interestrate is below the euilibrium level, so that the uantity of money demanded exceeds theuantity supplied, individuals try to obtain money by selling bonds or ma(ing ban(withdrawals. o attract now7scarcer funds, ban(s and bond issuers respond by increasing theinterest rates they offer.

!f the price level is fixed, a reduction in the mone# suppl# from %1 to %2 reduces thesupply of real money balances. he euilibrium interest rate therefore rises from r1 to r2.he opposite would occur if the ed had suddenly increased the money supply.ur analysis of the isher effect in Chapter I suggests that, in the long run when prices areflexible, a reduction in money growth would lower inflation, and this in turn would lead tolower nominal in terest rates. 5et the theory of liuidity preference predicts that, in the shortrun when prices are stic(y, anti7inflationary monetary policy would lead to falling real moneybalances and higher interest rates. #oth conclusions are consistent with experience.

Income" Mone# Demand" and the LM Curve

)aving developed the theory of liuidity preference as an explanation for how the interestrate is determined, we can now use the theory to derive the 0% curve. :hen income is high,expenditure is high, so people engage in more transactions that reuire the use of money.

hus, greater income implies greater money demand. :e can write the money demandfunction as, =%6@?d < 0=r,5?. he uantity of real money balances demanded is negativelyrelated to the interest rate and positively related to income.

Esing the theory of liuidity preference, we can figure out what happens to the euilibriuminterest rate when the level of income changes. or example, an increase in income shifts themoney demand curve to the right. :ith the supply of real money balances unchanged, theinterest rate must rise from r1 to r2 to euilibrate the money mar(et. herefore, according tothe theory of liuidity preference, higher income leads to a higher interest rate. he 0% curvesummari'es this relationship between the level of income and the interest rate. +ach point onthe 0% curve represents euilibrium in the money mar(et.

he 0% curve is drawn for a given supply of real money balances. !f real money balances

change*for example, if the ed alters the money supply*the 0% curve shifts.

!n summary, the 0% curve shows the combinations of the interest rate and the level of income that are consistent with euilibrium in the mar(et for real money balances. he 0%

curve is drawn for a given supply of real money balances. Decreases in the supply of realmoney balances shift the 0% curve upward. !ncreases in the supply of real money balances

shift the 0% curve downward.



Conclusion: The Short$!un %&uili'rium

:e now have all the pieces of the !/0% model. he two euations of this model areHIS: ( ) C*( + T, - I*r, - G

LM: M./ ) L*r" ( ,

he model ta(es fiscalpolicy 3 and , monetarypolicy %, and the price level@ as exogenous. 3iventhese exogenous variables,the ! curve provides thecombinations of r and 5that satisfy the euationrepresenting the goodsmar(et, and the 0% curve

provides the combinationsof r and 5 that satisfy theeuation representing themoney mar(et.he euilibrium of theeconomy is the point atwhich the ! curve and the0% curve cross. his pointgives the interest rate r andthe level of income 5 thatsatisfy conditions for

euilibrium in both the goods mar(et and the money mar(et. !n other words, at thisintersection, actual expenditure euals planned expenditure, and the demand for real moneybalances euals the supply.

demand building islm model

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