CHAPTER THREE

AGGREGATE DEMAND IN THE CLOSED ECONOMY

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
(which is one of two major areas of study in macroeconomics with the other being economic growth),
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. 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, or the total demand for all goods and services produced in an economy.

Aggregate demand (AD) is the relationship between the quantity of output demanded and the aggregate
price level. In other words, the aggregate demand curve tells us the quantity of goods and services
people want to buy at any given level of prices. It is the total amount of goods demanded in the
economy. The components of aggregate demand are Consumption (C), Investment (I), Government
expenditure (G) and Net exports (NX). Thus, AD = C+ I + G + NX. This AD can be determined by
monetary and fiscal policy of the government, the general level of income of the people, level of
economic activities in the other country, level of economic activities in the economy itself, and the
availability of credit. Since we are considering the case of closed economy – an economy which is not
trading with other countries – the national income accounting identity for closed economy is
represented as AD = C + I + G.

3.1 Foundations of Theory of Aggregate Demand

Of all the economic fluctuations in world history, the one that stands out as particularly large, painful,
and intellectually significant is the Great Depression of the 1930s. During this time, many countries
experienced massive unemployment and greatly reduced incomes. This devastating episode caused
many economists to question the validity of classical economic theory. 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 that a new model was needed to explain
such a large and sudden economic downturn and to suggest government policies that might reduce the
economic hardship so many people faced. Keynesian economics is the view, and the various theories
about why, in the short run (and especially during recessions) economic output is strongly influenced by
aggregate demand (total spending in the economy). In the Keynesian view, aggregate demand does not
necessarily equal the productive capacity of the economy; instead, it is influenced by a host of factors
and sometimes behaves erratically, affecting production, employment, and inflation. The theories
forming the basis of Keynesian economics were first presented by the British economist John Maynard
Keynes in his book, “The General Theory of Employment, Interest and Money”, published in 1936,
during the Great Depression. Keynes contrasted his approach to the aggregate supply-focused 'classical'
economics that preceded his book.

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Keynes revolutionized economics with his book “The General Theory of Employment, Interest, and
Money”. He proposed a new way to analyze the economy, which he presented as an alternative to
classical theory. His vision of how the economy works quickly became a center of controversy. Yet, as
economists debated The General Theory, a new understanding of economic fluctuations gradually
developed. Keynes proposed that low aggregate demand is responsible for the low income and high
unemployment that characterize economic downturns. He criticized classical theory for assuming that
aggregate supply alone—capital, labor, and technology—determines national income. As to Keynes, an
economy’s total income is, in the short run, determined largely by the desire to spend by households,
firms, and the government. The more people want to spend, the more goods and services firms can sell.
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, which they rank among the most serious of economic problems.
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.

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 income. Over long periods of time, prices are
flexible, the aggregate supply curve is vertical, and changes in aggregate demand affect the price level
but not output. Over short periods of time, prices are sticky, the aggregate supply curve is flat, and
changes in aggregate demand do affect the economy’s output of goods and services.

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. We can see that the government can influence aggregate demand with both monetary
and fiscal policy.

The model of aggregate demand going to be developed in this chapter, called the IS–LM model, is the
leading interpretation of Keynes’s theory. The aim of the model, the IS-LM model, which is a model of
AD, is to show what determines national income for a given price level or equivalently at showing what
causes the aggregate demand curve to shift. Thus, we can view the IS–LM model as showing what
causes income to change in the short run when the price level is fixed because all prices are sticky. Or,
we can view the model as showing what causes the aggregate demand 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,’’ and the IS curve represents what’s going on in the market for goods and services. LM stands
for “liquidity’’ and “money,’’ and the LM curve represents what’s happening to the supply and demand
for money. 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.

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 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 and is a building block for the more complex and realistic IS–LM model.

The Keynesian Cross

In The General Theory Keynes proposed that an economy’s total income was, in the short run,
determined largely by the spending plans of households, businesses, and government. The more people
want to spend, the more goods and services firms can sell. The more firms can sell, the more output they
will choose to produce and the more workers they will choose to hire. 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 drawing a distinction between actual and
planned expenditure. It relates planned expenditure to actual expenditure.

Actual expenditure is the amount households, firms and the government spend on goods and services
and it equals the economy’s gross domestic product (income, Y).
Actual Expenditure (AE) = C (Y – T)+ I + ∆inv + G;
Where Y is income (GDP), C is consumption, I is planned investment, ∆inv is unexpected (undesired)
changes in inventories, T is taxes and G is government purchase.
Graphically, AE = Y

450
Y

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 the sum of consumption C,
planned investment I, and government purchases G:
PE = C + I + G.
Next we will assume that aggregate consumption is a function of disposable income. Disposable income
equals total income (Y) less taxes (T) and the consumption function would be written as:
C = C(Y − T)
To keep things simple, for now we take planned investment as exogenously fixed: I = I
Finally, we assume that fiscal policy—the levels of government purchases and taxes—are fixed:
G = , T =T.
Combining these equations, we obtain aggregate planned expenditure curve
PE = C(Y − T) + I + .

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This equation shows that planned expenditure is a function of income Y, the level of planned investment
I, and the fiscal policy variables G and T.
Graphically this relationship looks like,

PE
PE = C(Y − T) + I + G.

MPC MPC = dC/d(Y–T)

$1

Y
Planned Expenditure as a Function of Income
Planned expenditure depends on income because higher income leads to higher consumption, which is
part of planned expenditure. 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 marginal propensity to consume, MPC: it shows how much planned expenditure
increases when income rises by $1.

 This planned expenditure function is the first piece of the model called the Keynesian cross.

Why would actual expenditure ever differ from planned expenditure? 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, actual expenditure can be either
above or below planned expenditure. You should note that actual expenditure equals income (Y),
because any unsold goods are defined as inventory investment, but planned expenditure may not equal
income. For example, firms and households may purchase more goods and services than are produced in
a year, so that inventories are run down. In this case, PE >Y. AE > PE whenever ∆inv> 0; AE < PE
whenever ∆inv< 0; and, when ∆inv = 0, AE = PE – the economy is in equilibrium.

The second piece of the Keynesian cross is the assumption that the economy is in equilibrium when
actual expenditure equals planned expenditure. This assumption is based on the idea that when people’s
plans have been realized, they have no reason to change what they are doing.

Recalling that Y as GDP equals not only total income but also total actual expenditure on goods and
services, we can write this equilibrium condition as

Actual Expenditure = Planned Expenditure

Y = PE.

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The 45-degree line in the figure below plots the points where this condition holds. With the addition of
the planned-expenditure function, this diagram becomes the Keynesian cross. The equilibrium of this
economy is at point A, where the planned-expenditure function crosses the 45-degree line.

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, and 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 and the
following diagram shows how this works:

The Adjustment to Equilibrium in the Keynesian Cross

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For example, suppose the economy finds itself with GDP at a level greater than the equilibrium level,
such as the level Y1 in the above figure. If firms were producing at level Y1, then planned expenditure E1
would fall short of production and firms would accumulate inventories (firms are selling less than they
are producing). Firms add the unsold goods to their stock of inventories. This inventory accumulation
(unplanned rise in inventories) would induce firms to lay off workers and reduce production; these
actions in turn reduce GDP. This process of unintended inventory accumulation and falling income
continues until income Y falls to the equilibrium level. Similarly, suppose GDP is at a level lower than
the equilibrium level, such as the level Y 2.If firms were producing at level Y 2, then planned expenditure
E2 would exceed production (Y2), and firms would run down their inventories. i.e., firms meet the high
level of sales by drawing down their inventories. This fall in inventories would induce firms to hire more
workers and raise production, and thus GDP rises. In both cases, the firms’ decisions drive the economy
toward equilibrium.

In 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.

The Multiplier
Now, we will consider how output (or GDP) responds to changes in: government purchases,
autonomous taxes and autonomous spending (I).

Fiscal Policy and the Multiplier: Government Purchases

Consider how changes in government purchases affect the economy. Suppose that government purchase
of goods and services increased (expansionary fiscal policy).

The following graph shows what happens:

An Increase in Government Purchases in the Keynesian Cross

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Because government purchases are one component of expenditure, an increase in government purchases
of ΔG raises planned expenditure by that amount for any given level of income. If government
purchases rise by ΔG, then the planned-expenditure schedule shifts upward by ΔG, as in above figure.
The equilibrium of the economy moves from point A to point B and income rises from Y 1 to Y2. Note
that the increase in income ΔY exceeds the increase in government purchases ΔG. i.e., ΔY is larger than
ΔG. The initial increase in government expenditure causes an even greater increase in actual (and
planned) expenditure, or income, than is first implied by just looking at the increase in government
expenditure alone. The final effect of the change in an exogenous variable is a multiple of the initial
change. This particular multiple is called the government purchases multiplier, i.e., the ratio of ΔY/
ΔG;it tells us how much income rises in response to a $1 increase in government purchases. An
implication of the Keynesian cross is that the government-purchases multiplier is larger than 1. Thus,
fiscal policy has a multiplier effect on income.

If we consider a change in G of size ΔG, then the following sequence of events occurs:
STEP 1: Initially E changes by the change in G
STEP 2: Next, the change in Y causes a change in C — i.e. by MPC × ΔG.
STEP 3: The change in C causes E and Y to change again by MPC (MPC × ΔG).
STEP 4: The extra change in Y causes a further change in C — i.e. C changes by a further: MPC ×
(MPC2 × ΔG).
STEP 5: And so on, with the changes in C and Y getting smaller with each step.
This process continues but the decreases in consumption and thus expenditure and income become
smaller with each round. The overall impact can be calculated by adding up all the terms, that is,
ΔY = (1+MPC +MPC2 +MPC3 + . . .) ΔG.
The way to work this out is to realize that this sum is a simple infinite geometric series and so we can
use the appropriate mathematical formula. Doing this gives us:
1
ΔY = ΔG
(1−MPC )
Since we have a simple infinite geometric series to add, and can use the relevant mathematical formula.

The term, is called the government expenditure multiplier and it is greater than one because
0<MPC < 1.
For example, if the marginal propensity to consume is 0.6, the multiplier is
ΔY/ ΔG= 1 + 0.6 + 0.62 + 0.63 + . . . = 1/ (1 − 0.6) = 2.5.
In this case, a Br 1.00 increase in government purchases raises equilibrium income by Br 2.50.

Fiscal Policy and the Multiplier: Taxes

Consider now how changes in taxes affect equilibrium income. A decrease in taxes of ΔT immediately
raises disposable income (Y – T) by ΔT and, therefore, increases consumption by MPC × ΔT. For any
given level of income Y, planned expenditure is now higher. As the figure below shows, the planned
expenditure schedule shifts upward by MPC × ΔT. The equilibrium of the economy moves from point A
to point B.
Just as an increase in government purchases has a multiplied effect on income, so does a decrease in
taxes. As before, the initial change in expenditure, now MPC × ΔT, is multiplied by 1/ (1 − MPC).

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The overall effect on income of the change in taxes is
ΔY/ΔT = −MPC/ (1 − MPC).
This expression is the tax multiplier, the amount income changes in response to a $1 change in taxes.
(The negative sign indicates that income moves in the opposite direction from taxes). For example, if the
marginal propensity to consume is 0.6, then the tax multiplier is
ΔY/ΔT = −0.6/ (1 − 0.6) = −1.5.
In this example, a $1.00 cut in taxes raises equilibrium income by $1.50.

The Interest Rate, Investment, and the IS Curve

The income-expenditure relationship (Keynesian cross) is the first step in building our macro model.
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, the values of which are determined by the actions of
people. 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. To add this relationship between the interest rate and investment to our model, we
write the level of planned investment as I = I(r). Because the interest rate 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 income changes when the interest rate changes, we can combine the investment
function with the Keynesian-cross diagram. Because investment is inversely related to the interest rate,
an increase in the interest rate from r 1 to r2 reduces the quantity of investment from I(r 1) to I(r2).The
reduction in planned investment, in turn, shifts the planned-expenditure function downward, as in panel
(b) of the figure below. The shift in the planned-expenditure function causes the level of income to fall
from Y1 to Y2. Hence, an increase in the interest rate lowers income. The IS curve, shown in panel (c) of
the figure, summarizes this relationship between the interest rate and the level of income. In essence, the
IS curve combines the interaction between r and I expressed by the investment function and the
interaction between I and Y demonstrated by the Keynesian cross. Each point on the IS curve represents
equilibrium in the goods market, and the 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 income to fall, the IS curve slopes downward.
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 A Loan able Funds Interpretation of the IS Curve
We have developed the IS curve using income and expenditure as the key concepts, but it hides some
important economics in thinking about the meaning of the goods market equilibrium which we will now
highlight. In particular, it hides the fact that firms who are buying investment goods have to borrow to
finance payment for them, either from themselves or from other economic actors such as banks. We will
now show this explicitly. In deriving the IS curve we required that income equals expenditure, or,
Y=E
Y=C+I+ , substituting in the terms of expenditure.
Now, rearrange this by subtracting C and G from both sides, which gives us,
Y−C− = I.

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Next, add and subtract T on the left hand side of this expression which gives us,
(Y − T − C) + (T − ) = I.
The term (Y − T – C) is simply private savings while the term (T – G)is government savings. What this
says is that equilibrium in the goods market requires pairs of r and Y that result in the supply of loan able
funds through saving to equal the demand for loan able funds to buy investment goods. In the IS-LM
model the savings are what is left over from consumption, which is affected by income Y, so aggregate
savings are function of Y. The amount of investment is a function of r. This means that in equilibrium Y
and r need to take on values so that S[Y] = I[r] (this is where the ‘I’ and the ‘S’ come from to make IS).
This relationship is shown in the following graph:

A Loanable-Funds Interpretation of the IS Curve:Panel (a) shows that an increase in income from Y 1
to Y2 raises saving and thus lowers the interest rate that equilibrates the supply and demand for
loanable funds. The IS curve in panel (b) expresses this negative relationship between income and the
interest rate.
This should not surprise us. If people want to invest for the future, then they have to forgo current
consumption and equilibrium requires the two to be equal.

Algebra of the IS Curve

We have derived the IS curve graphically, but we can also derive it algebraically. Doing so increases our
understanding of the goods market relationship and also is needed to understand some aspects of the
model which cannot be easily seen on the graph. We know that the IS curve is just pairs of r and Y such
that income (Y) equals planned expenditure (E), or that,
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:

, which is the IS curve in algebraic form.

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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 is associated with being on the IS curve).
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. A large d means that an increase in r will lead to a
large decrease in I and hence a large decrease in Y. Similarly, if b is large then an increase in expenditure
will induce a large increase in C consumption, and hence a large increase in Y.
3) Changes in autonomous expenditure from G, T, a, or c will shift the IS curve in or out. The sizes of
these shifts are determined by b through their impact on induced consumption. 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. That is,

>
This is because if G increases it directly increases planned expenditure and then causes subsequent
increases in C, whereas if T decreases it only indirectly increases planned expenditure by causing C to
increase.

How Fiscal Policy Shifts the IS Curve

The IS curve shows us, for any given interest rate, the level of income that brings the goods market into
equilibrium. As we learned from the Keynesian cross, 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. This figure is drawn for a given interest rate and thus for a given level of planned
investment.

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The Keynesian cross in panel (a) shows that this change in fiscal policy raises planned expenditure
thereby increases equilibrium income from Y1 to Y2. Therefore, in panel (b), the increase in government
purchases shifts the IS curve outward.
We can use the Keynesian cross to see how other changes in fiscal policy shift the IS curve. Because a
decrease in taxes also expands expenditure and income, it, too, shifts the IS curve outward (to the right).
A decrease in government purchases or an increase in taxes reduces income; therefore, such a change in
fiscal policy shifts the IS curving inward (to the left).

In summary,
1. 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.
2. 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.
3. The IS curve does not determine either income or the interest rate. Instead, the IS curve is a
relationship between Y and r arising in the market for goods and services.
The focus of attention of the IS curve is the market for goods: consumption, investment, and government
purchases. It is also worth noting that the IS curve depends on the fiscal position of the government,
where fiscal relates to government spending and taxation. Finally, if C was affected by r then it would
just add and therefore reinforce the impact of r on I with the basic results of the model not changing.

3.3 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. To understand this relationship, we begin by looking at a theory of the
interest rate, called the theory of liquidity preference.
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 The Theory of Liquidity Preference
In his classic work, The General Theory, Keynes offered his view of how the interest rate is determined
in the short run. That explanation is called the theory of liquidity preference because it posits that the
interest rate adjusts to balance the supply and demand for the economy’s most liquid asset—money. Just
as the Keynesian cross is a building block for the IS curve, the theory of liquidity preference is a
building block for the LM curve. To develop this theory, we begin with the supply of real money
balances and then we consider the demand for real money balances.

The supply of real money balances: If M stands for the supply of money and P stands for the price
level, then M/P is the supply of real money balances. The theory of liquidity preference assumes there is
M s M
) (
a fixed supply of real money balances. That is, P = P
The money supply M is an exogenous policy variable chosen by a central bank (National Bank of Ethiopia in our
case). The amount of currency and demand deposit that constitutes the money supply of the economy is
exogenously determined by the central bank’s policies. The price level P is also an exogenous variable in this
model. We take the price level as given because the IS–LM model – our ultimate goal in this chapter–explains the
short run when the price level is fixed. These assumptions imply that the supply of real money balances is fixed
and, in particular, does not depend on the interest rate. Thus, when we plot the supply of real money balances
against the interest rate we obtain a vertical supply curve.

The demand for real money balances: The demand for holding money relies on three motives:
transaction, precautionary and speculative motives. The theory of liquidity preference posits that the
interest rate is one determinant of how much money people choose to hold. The reason is that the
interest rate is the opportunity cost of holding money: it is what you forgo by holding some of your
assets such as money, which does not bear interest, instead of as interest-bearing bank deposits or bonds
(speculative motive). When the interest rate rises, people want to hold less of their wealth in the form of
money. We can write the demand for real money balances as (M/P) d = L(r), where the function L (r)
shows that the quantity of money demanded depends on the interest rate. Thus, the demand curve slopes
downward because higher interest rates reduce the quantity of real money balances demanded.

Equilibrium in the Money Market: Equilibrium in the money market occurs when the quantity of real
money balances demanded equals their supply. According to the theory of liquidity preference, the
supply and demand for real money balances determine what interest rate prevails in the economy. That
is, the interest rate adjusts to equilibrate the money market. As the figure shows, at the equilibrium
interest rate, the quantity of real money balances demanded equals the quantity supplied.

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The Theory of Liquidity Preference The supply and demand for real money balances determine the
interest rate. The supply curve for real money balances is vertical because the supply does not depend
on the interest rate. The demand curve is downward sloping because a higher interest rate raises the
cost of holding money and thus lowers the quantity demanded. At the equilibrium interest rate, the
quantity of real money balances demanded equals the quantity supplied

 How does the interest rate get to this equilibrium of money supply and money demand?
The adjustment occurs because whenever the money market is not in equilibrium, people try to adjust
their portfolios of assets and, in the process, alter the interest rate. For instance, if the interest rate is
above the equilibrium level, the quantity of real money balances supplied exceeds the quantity
demanded. Individuals holding the excess supply of money try to convert some of their non-interest-
bearing money into interest-bearing bank deposits or bonds. Banks 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 interest rate is below the equilibrium level, so that the quantity of money demanded
exceeds the quantity supplied, individuals try to obtain money by selling bonds or making bank
withdrawals. To attract now-scarcer funds, banks and bond issuers respond by increasing the interest
rates they offer. Eventually, the interest rate reaches the equilibrium level, at which people are content
with their portfolios of monetary and non-monetary assets.

Having seen how the interest rate is determined, we can use the theory of liquidity preference to show
how the interest rate responds to changes in the supply of money. Suppose, for instance, that the central
bank suddenly decreases the money supply. A fall in M reduces M/P, because P is fixed in the model.
The supply of real money balances shifts to the left. The equilibrium interest rate rises and the higher
interest rate make people satisfied to hold the smaller quantity of real money balances. (See Mankiw,
figure 10.10). The opposite would occur if the money supply is increased. Thus, 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.

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). When income is high, expenditure is high, so people engage in more transactions that require

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the use of money. Thus, greater income implies greater money demand. We can express these ideas by
writing the money demand function as:
(M/P) d = L(r, Y).
The quantity of real money balances demanded is negatively related to the interest rate and positively
related to income.

Using the theory of liquidity preference, we can figure out what happens to the equilibrium interest rate
when the level of income changes. For example, consider what happens in the following figure when
income increases from Y1 to Y2. An increase in income shifts the money demand curve to the right. With
the supply of real money balances unchanged, the interest rate must rise from r1 to r2 to equilibrate the
money market. Therefore, according to the theory of liquidity preference, higher income leads to a
higher interest rate. The LM curve plots this relationship between the level of income and the interest
rate. The higher the level of income, the higher the demand for real money balances, and the higher the
equilibrium interest rate. For this reason, the LM curve slopes upward, as shown in panel (b).

Deriving the LM Curve: Panel (a) shows the market for real money balances: an increase in income
from Y1 to Y2 raises the demand for money and thus raises the interest rate from r1 to r2. Panel (b) shows
the LM curve summarizing this relationship between the interest rate and income: the higher the level of
income, the higher the interest rate.

Algebra of the LM Curve

As with the IS curve, we will now derive the LM curve algebraically as doing so increases our
understanding of the money market relationship and also is needed to understand some aspects of the
model which cannot be easily seen on the graph. We also know that money market equilibrium requires

that, ( ) = (M/P) d
(M/P) d =L(r, Y) = e Y_ f r

Thus, ( ) = e Y -_ f r. And rearranging this expression, we get:

e 1
r = f Y − f ( ), which is the LM curve in algebraic form.

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Points to Note about the LM Curve:
1) The LM curve is upward sloping because the coefficient on Y is positive (i.e. if Increases then a
higher value of Y is associated with the money market being in equilibrium).
2) The slope of the LM curve is determined by the coefficient on Y. If e is large (changes in Y cause
large changes in the transactions demand for real money balances) then the LM curve is relatively
steep (i.e. a given increase in r will cause the demand for real money balances to fall, if e is large
then only a small increase in Y is required to produce an offsetting increase in the demand for real
money balances). If f is large (changes in r cause large changes in the quantity of real money
balances demanded) the LM curve is relatively flat (i.e. a given increase in Y will cause the demand
for real money balances to increase, if f is large then a small increase in r is required to produce an
offsetting decrease in the demand for real money balances).
3) Changes in or will shift the LM curve in or out. The sizes of these shifts depend upon the value
of f. If f is large then an increase in or decrease in will cause a small downward shift in the LM
curve (i.e. for a given Y and a given increase in or decrease in , then a large f implies a small fall
in r).

How Monetary Policy Shifts the LM Curve

The LM curve tells us the interest rate that equilibrates the money market at any level of income. Yet, as
we saw earlier, the equilibrium interest rate also depends on the supply of real money balances M/P.
This means that the LM curve is drawn for a given supply of real money balances. If real money
balances change—for example, if the central bank alters the money supply—the LM curve shifts. We
can use the theory of liquidity preference to understand how monetary policy shifts the LM curve.
Suppose that the central bank decreases the money supply from M1 to M2, which causes the supply of
real money balances to fall from M1/P to M2/P. The figure that follows shows what happens.

A Reduction in the Money Supply Shifts the LM Curve Upward: Holding constant the amount of
income and thus the demand curve for real money balances, we see that a reduction in the supply of real
money balances in panel (a) raises the interest rate that equilibrates the money market. Hence, a
decrease in the money supply in panel (b) shifts the LM curve upward.

In summary,

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 1. The LM curve shows the combinations of the interest rate and the level of income that is consistent
with equilibrium in the market for real money balances.
2. 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.
3. The LM curve by itself does not determine either income or the interest rate that will prevail in the
economy. Like the IS curve, the LM curve shows only a relationship between these two endogenous
variables.
4. The IS and LM curves together determine the economy’s equilibrium.

3.4 The Short-run Equilibrium

We now have all the pieces of the IS–LM model. The two equations of this model are;
Y = C(Y − T ) + I(r) + G …………………………… IS,
M/P = L(r, Y )………………………………………..LM.
The model takes fiscal policy, G and T, monetary policy M, and the price level P as exogenous. Given
these exogenous variables, the IS curve provides the combinations of r and Y that satisfy the equation
representing the goods market [Y = C(Y–T) + I + G], and the LM curve provides the combinations of r
and Y that satisfy the equation representing the money market [M/P = L(r, Y)]. These two curves are
shown together in the following figure.

The equilibrium of the economy is the point at which the IS curve and the LM curve cross. This point
gives the interest rate and the level of income that satisfy conditions for equilibrium in both the goods
market and the money market. In other words, at this intersection, actual expenditure equals planned
expenditure, and the demand for real money balances equals the supply.

Our ultimate goal in developing the IS–LM model is to analyze short-run fluctuations in economic
activity. In this chapter, we developed the Keynesian cross and the theory of liquidity preference as
building blocks for the IS–LM model. As we see later more fully, the IS–LM model helps explain the
position and slope of the aggregate demand curve. The aggregate demand curve, in turn, is a piece of the
model of aggregate supply and aggregate demand, which economists use to explain the short-run effects
of policy changes and other events on national income.(See figure 10.14 on Mankiw).

Explaining Fluctuations with the IS–LM Model

The intersection of the IS curve and the LM curve determines the level of national income. When one of
these curves shifts, the short-run equilibrium of the economy changes and national income fluctuates. In
this section we examine how changes in policy can cause these curves to shift thereby affect Y and r.
1. Changes in Fiscal Policy: We begin by examining how changes in fiscal policy (government
purchases and taxes) alter the economy’s short-run equilibrium. These influence planned expenditure
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and thereby shift the IS curve. The following figure illustrates this using the case of an increase in G by
∆G.

The government-purchases multiplier in the Keynesian cross tells us that, at any given interest rate, this
change in fiscal policy raises the level of income by ∆G/(1−MPC).Therefore the IS curve shifts to the
right by this amount. The equilibrium of the economy moves from point A to point B. The increase in
government purchases raises both income and the interest rate. When the government increases its
purchases of goods and services, the economy’s planned expenditure rises. The increase in planned
expenditure stimulates the production of goods and services, which causes total income Y to rise. These
effects should be familiar from the Keynesian cross.
Now, consider the money market, as described by the theory of liquidity preference. Because the
economy’s demand for money depends on income, the rise in total income increases the quantity of
money demanded at every interest rate. The supply of money, however, has not changed so higher
money demand causes the equilibrium interest rate r to rise. The higher interest rate arising in the money
market, in turn, has consequences back in the goods market. When the interest rate rises, firms cut back
on their investment plans. This fall in investment partially offsets the expansionary effect of the increase
in government purchases. Thus, the increase in income 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 has caused the “crowding out” of some planned investment due to a higher interest rate.

In the IS–LM model, changes in taxes affect the economy much the same as changes in government
purchases do, except that taxes affect expenditure through consumption. Consider, for instance, a
decrease in taxes of ∆T. The tax cut encourages consumers to spend more and, therefore, increases
planned expenditure. The tax multiplier in the Keynesian cross tells us that, at any given interest rate,
this change in policy raises the level of income by ∆T ×MPC/(1 - MPC).Therefore, the IS curve shifts to
the right by this amount. The tax cut raises both income and the interest rate. Once again, because the
higher interest rate depresses investment, the increase in income is smaller in the IS–LM model than it is
in the Keynesian cross. (For this, see on Mankiw, figure 11.2).
Fiscal policy is more effective at influencing national income if:
o The LM curve is flatter – less sensitive demand for real money balances to change in income, and

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 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.

2. Changes in Monetary Policy: We now examine the effects of monetary policy. A change in the
money supply alters the interest rate that equilibrates the money market for any given level of income
and, thereby, shifts the LM curve. The IS–LM model shows how a shift in the LM curve affects income
and the interest rate. Let’s consider an increase in money supply. An increase in M leads to an increase in
real money balances M/P, because the price level P is fixed in the short run. The theory of liquidity
preference shows that for any given level of income, an increase in real money balances leads to a lower
interest rate. Therefore, the LM curve shifts downward as depicted in Mankiw (figure 11.3). The
equilibrium moves from point A to point B. The increase in the money supply lowers the interest rate
and raises the level of income. When the central bank increases the supply of money, 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 interest rate r then falls until people are willing to hold all
the extra money that the central bank has created; this brings the money market to a new equilibrium.
The lower interest rate, in turn, has ramifications for the goods market. A lower interest rate stimulates
planned investment, which increases planned expenditure, production, and income. The IS–LM model
shows that an increase in the money supply lowers the interest rate, 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 income 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.
The Interaction between Monetary and Fiscal Policies
When analyzing any change in monetary or fiscal policy, it is important to keep in mind that the
policymakers who control these policy tools are aware of what the other policymakers are doing. A
change in one policy, therefore, may influence the other, and this interdependence may alter the impact
of a policy change. For example, suppose government were to raise taxes. What effect should this policy
have on the economy? According to the IS–LM model, the answer depends on how the central bank
responds to the tax increase. The figure below shows three of the many possible outcomes.
 In panel (a), the central bank holds the money supply constant. The tax increase shifts the IS
curve to the left. Income falls (because higher taxes reduce consumer spending), and the interest
rate falls (because lower income reduces the demand for money). The fall in income indicates
that the tax hike causes a recession.
 In panel (b), the central bank wants to hold the interest rate constant. In this case, when the tax
increase shifts the IS curve to the left, the central bank must decrease the money supply to keep
the interest rate at its original level. This fall in the money supply shifts the LM curve upward (to
the left). The interest rate does not fall, but income falls by a larger amount than if the central
bank had held the money supply constant. Whereas in panel (a) the lower interest rate stimulated
investment and partially offset the Contractionary effect of the tax hike, in panel (b) the central
bank deepens the recession by keeping the interest rate high.

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  In panel (c), the central bank wants to prevent the tax increase from lowering income. It must,
therefore, raise the money supply and shift the LM curve downward enough to offset the shift in
the IS curve. In this case, the tax increase does not cause a recession, but it does cause a large fall
in the interest rate. Although the level of income is not changed, the combination of a tax
increase and a monetary expansion does change the allocation of the economy’s resources. The
higher taxes depress consumption, while the lower interest rate stimulates investment. Income is
not affected because these two effects exactly balance.

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From this example, we can see that the impact of a change in fiscal policy depends on the policy the
central bank pursues – that is, on whether it holds the money supply, the interest rate, or the level of
income constant. More generally, whenever analyzing a change in one policy, we must make an
assumption about its effect on the other policy. The most appropriate assumption depends on the case at
hand and the many political considerations that lie behind economic policymaking.

3.5 From the IS–LM Model to the Aggregate Demand Curve

We have been using the IS–LM model to explain national income in the short run when the price level is
fixed. To see how the IS–LM model fits into the model of aggregate supply and aggregate demand, we
now examine what happens in the IS–LM model if the price level is allowed to change. As was promised
when we began our study of this model, the IS–LM model provides a theory to explain the position and
slope of the aggregate demand curve.
The aggregate demand curve describes a relationship between the price level and the level of national
income. We use the IS–LM model to show why national income falls as the price level rises – that is,
why the aggregate demand curve is downward sloping. We also examine what causes the aggregate
demand curve to shift.
To explain why the aggregate demand curve slopes downward, we examine what happens in the IS–LM
model when the price level changes. This is done in the following figure.

For any given money supply M, a higher price level P reduces the supply of real money balances M/P. A
lower supply of real money balances shifts the LM curve upward, which raises the equilibrium interest
rate and lowers the equilibrium level of income, as shown in panel (a). Here the price level rises from P1
to P2, and income falls from Y1 to Y2.The aggregate demand curve in panel (b) plots this negative
relationship between national income and the price level. In other words, the aggregate demand curve
shows the set of equilibrium points that arise in the IS–LM model as we vary the price level and see what
happens to income.
What causes the aggregate demand curve to shift? Because the aggregate demand curve is merely 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 aggregate demand curve to shift. For instance, an increase in the money supply
raises income in the IS–LM model for any given price level; it thus shifts the aggregate demand curve to

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the right, as shown in panel (a) of the figure that follows.(i .e.M Þ LM shifts right Þ¯r ÞI ÞY at each
value of P).

Similarly, an increase in government purchases or a decrease in taxes raises income in the IS-LM model
for a given price level; it also shifts the aggregate demand curve to the right, as shown in panel (b). (For
instance, ¯TÞCÞIS shifts to rightÞY at each value of P).Conversely, a decrease in the money supply, a
decrease in government purchases, or an increase in taxes lowers income in the IS–LM model and shifts
the aggregate demand curve to the left.

We can summarize these results as follows: A change in income in the IS–LM model resulting from a
change in the price level represents a movement along the aggregate demand curve. A change in
income in the IS–LM model for a fixed price level represents a shift in the aggregate demand curve.
Read- The IS–LM Model in the Short Run and Long Run (Mankiw, pp 324, 7th ed.).

Limitations of ISLM Model

Both the simple income-expenditure model and the quantity theory of money engage in drastic
aggregation. The quantity theory of money aggregates the economy into only two markets, the market
for money balances and the market for all other things. The simple income-expenditure model involves
an equally drastic but different aggregation, to a market for goods and services and a market for all other
things. Then each, by Walras' Law, ignores the second market and focuses on only one market. These
drastic aggregations make sense if the main source of problems in a market economy arise in only one
sector and the problems that are evident in other sectors are simply reflections of problems that originate
in that one sector. A year after the publication of the General Theory, John Hicks proposed ISLM as a
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less dramatic aggregation that he saw as a more general case of both the quantity theory and the simple
income-expenditure model. Part of its popularity this model, which has reigned as the standard
macroeconomic model for half a century, undoubtedly lies in its ability to present macroeconomics in
terms of a model with exactly the same structure and mechanics as the model of supply and demand.

Though the ISLM model is a fundamental model of macroeconomics, seldom do macroeconomists try to
estimate the parameters of the model and use it to predict the future course of GDP. There has been at
least one attempt to estimate the importance of fiscal and monetary policy with equations similar to the
equation one attains when one solves the model for equilibrium income. However, many economists
have argued that such an approach could not capture the subtleties of how the economy works and thus
do not give reliable estimates.

The fact that economists have not used the ISLM model in their attempts to numerically predict the
effects of policy suggests that ISLM has weaknesses. The first of these is the question of whether or not
ISLM is meant as a long-run or short-run model. If it is meant as a long-run model, then its prediction
that equilibrium can exist at any level of output is controversial. ISLM aggregates the economy into
three markets: goods, money, and all other. This aggregation makes sense if nothing interesting happens
in the "all-other" market, if it simply adjusts passively to changes in the goods and money market.
Included in the passively adjusting sector is the resource market, even though many economists point to
the labor market as a sector that does not readjust rapidly.

ISLM predicts the equilibrium can be at any level because it assumes, as does the simple income-
expenditure model, a passive supply. Sellers produce whatever is demanded, and all adjustment to
changes in demand are in the form of changes in output and none of the adjustment is in the form of
changes in prices. Adjustment cannot be in the form of price changes because the price level does not
enter the model. Since changes in prices are the primary way markets adjust in microeconomic theory,
the failure of ISLM to say anything about prices is a serious weakness.

If meant as a short-run model, the model is severely limited because it does not incorporate the rate of
inflation. Inflation creates a difference between real and nominal interest rates. The nominal rate is the
visible rate that people pay and receive, and the real interest rate is what is happening in terms of
purchasing power. Thus, if the rate of interest is 5% and the rate of inflation is 10%, a person who
borrows $100 and pays back $105 in a year will pay back less in terms of purchasing power than he
borrowed. He pays back 105 dollars, but each dollar can buy 10% less than it did a year earlier. Hence
his rate of interest in real terms is actually negative. The real interest rate is computed as the nominal
interest rate less the rate of inflation.
The distinction between real and nominal interest rates is important in ISLM because investment
spending should respond to the real interest rate and money demand to the nominal interest rate. To see
why investment depends on the real rate, consider a situation of zero inflation in which a person buys a
machine that will cost $100 and earn $105 one year later. This purchase will be worthwhile if the
interest rate is below 5%. Now suppose that inflation jumps from zero to 10%. The same machine will
produce the same output, but because of the increase in prices, the output will be 10% more valuable in
terms of the money it brings. Thus, the $100 machine will earn $115.05 (which is 10% more than 105)
in one year. The investment is now worthwhile at any nominal rate under 15% (which is a real rate

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under 5%.) Investment will remain constant if the real interest rate does not change; change in nominal
rates will not change investment if it does not change the real rate.

To keep the demand for money constant (which means that the velocity of circulation remains constant),
the nominal interest rate must remain constant. When people hold cash balances for transactions; they
are concerned with purchasing power. If all prices double, the amount of money people want to hold
will double, but the amount of purchasing power they want will remain constant. The interest rate is a
cost of holding purchasing power. If the rate of inflation increases, and the rate of interest with it,
holding money becomes more expensive and people will want to hold smaller amounts of purchasing
power. Thinking of the demand for money in terms of purchasing power lets us ignore price level and is
the key to seeing the effects of the rate of interest. It is the nominal rate, not the real rate that matters.
Further, the rate of inflation independently affects the demand for money by changing its desirability as
a store of wealth. In cases of very serious inflation, such as the German hyperinflation of 1923, people
try to spend money as quickly as possible because it is losing its value. As a result, the velocity of
money increases. To some extent estimates of how sensitive money demand is to interest rates may be
catching this sensitivity of money demand to inflation because rates of inflation and interest rates move
together.
One could graph the ISLM model assuming that the vertical axis measured the real rate. Then any time
the rate of inflation changed (and thus the nominal rate), one could shift the LM curve. A more rapid
inflation would shift the LM curve to the right, for example, reducing real interest rates and increasing
income. The problem with this solution, however, is that it leaves the rate of inflation as autonomous,
unrelated to what is happening to fiscal and monetary policy. Though there have been times when many
economists considered inflation autonomous ("cost-push" theories that were very popular in the 1950s
are an example--prices rise because costs rise), most economists believe that macroeconomic policy is
by far the most important determinant of rates of inflation.

Given these serious weaknesses, why has ISLM remained as a framework for so much macroeconomic
thinking? A major reason is that no other simple model gives as much insight. ISLM suggests that
economic disturbances can arise in either the money market or the goods market, a conclusion that
predates ISLM. Economists want a simple model that concludes this. Also, ISLM can be expanded and
made more complex in an effort to overcome its limitations.

IS-LM Model: An overview

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 *

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