Aggregate Demand I:

Building the IS-LM Model

Chapter 11 of
Macroeconomics, 8th edition,
by N. Gregory Mankiw
ECO62 Udayan Roy
THE GOODS MARKET IN
THE SHORT RUN
 Recap: Long-Run Theory of
Output
As
before, let Y denote total real GDP
Recall that, in the long run, total real GDP
is calculated as Y = F(K, L)
The economy produces as much as it can
Total real GDP in the long run is also called:
Natural GDP, or
Potential GDP
From now on, total long-run real GDP
will be denoted = F(K, L)
 Actual Output Potential
Output
In
the short run, total real GDP is not
necessarily equal to natural GDP, or
potential GDP
Y
We need a new theory of Y, because
the long-run theory = F(K, L)no
longer works
 Short-Run Theory of Output: its all
about demand
The short-run theory of total real GDP is
also called
Keynesian theory, after the economist John
Maynard Keynes, or
Aggregate Demand Theory
This theory assumes that, in the short
run, output is determined by
aggregate demand: the economy will
produce as much output as there is
demand for
The simplest theory of short-run equilibrium in the goods
market

THE KEYNESIAN CROSS

 Planned Expenditure
Assumption: The economy is a
closed economy
Planned Expenditure (PE) is the
total desired expenditure of the
three sectors of the economy:
Households (C)
Businesses (I) and
Government (G)
PE = C + I + G
 Consumption Expenditure
PE = C + I + G
What determines the planned
expenditure of households (C)?
We did this before in chapter 3
Consumption, C
Net Taxes = Tax Revenue Transfer Payments

Denoted T and always assumed exogenous:
Recall that GDP is defined as the market value of
all final goods and services produced in an
economy during a given period of time
But this is also actual total expenditure,
which is also actual total income
Therefore, Y also represents actual total income
Disposable income (or, after-tax income) is total
income minus total net taxes: Y T.
Assumption: planned consumption expenditure (C)
is directly related to disposable income (Y T)
Consumption, C
Assumption: Planned expenditure by
households is directly related to
disposable income
Consumption function: C = C (Y T )
Consumption Function:
algebra
Consumption function: C = C (Y T )
Specifically, C = Co + Cy(Y T)
Co represents all other exogenous
variables that affect consumption,
such as asset prices, consumer
optimism, etc.
Cy is the marginal propensity to
consume (MPC), the fraction of every
additional dollar of income that is
consumed
Consumption Function:
graph
C

C (Y T) = Co +
Cy(Y T)

The slope of the

MPC
consumption function
1 is the MPC.

Co
Y
Marginal propensity to consume (MPC)
is the increase in consumption (C) when
disposable income (Y T) increases by one
Consumption Function:
shifts
C C = Co2 +
Cy(Y T)
C = Co1 + Cy(Y
T)

Consumption shift factor:

higher consumer optimism,
higher asset prices (Co).

Y
Consumption Function:
shifts
C C = Co + Cy(Y
T 2)
C = Co + Cy(Y
T1)

The same shift can also be

caused by lower taxes. (T2 <
T1)

Y
 Consumption Function:
example
Suppose Y = 30.85 and T = 0.85.
Therefore, disposable income is Y T
= 30.
Now, suppose C = 2 + 0.8 (Y
Private Saving is
T). defined as
disposable income
Then, C = 2 + 0.8 30 = consumption,
26
which is Y T C =
30 26 = 4.
Y
C
C(Y T),
T
 Income and Private Saving
The marginal propensity to consume
is a positive fraction (0 < MPC < 1)
That is, when income (Y) increases,
consumption (C) also increases, but
by only a fraction of the increase in
income.
Therefore, Y C and Y C and
Y T C
Similarly, Y C and Y C and
Y T C
 Planned Investment
PE
=C+I+G
Assumption: Planned investment
spending by businesses (I) is
exogenous

This assumption is a big

simplification.
Recall that business investment was
assumed to be inversely related to
the real interest rate in Chapter 3.
 Government Spending
PE = C + I + G
Assumption: government spending
(G) is exogenous
Public Saving is defined as the net
tax revenue of the government
minus government spending, which
is T G
This is also called the budget surplus
 Planned Expenditure
PE = C + I + G
Therefore, PE = C(Y T) + I + G
Or, more specifically, PE = Co +
Cy(Y T) + I + G
 Equilibrium
Assumption: The goods market
will be in equilibrium. That is,
actual expenditure will be equal
to planned expenditure.
 Actual and planned
expenditure
Actual and planned expenditure do not
have to be equal in all circumstances
Actual expenditure = planned
expenditure + unplanned increase in
inventory
When unplanned increase in inventory >
0, more is bought than was intended.
When unplanned increase in inventory <
0, less is bought than was intended.
 Equilibrium
When unplanned increase in
inventory > 0, more is bought than
was intended.
So, actual expenditure > planned
expenditure
In this case, output will shrink
In other words, the current output
level cannot represent equilibrium
 Equilibrium
When unplanned increase in
inventory < 0, less is bought than
was intended.
So, actual expenditure < planned
expenditure
In this case, output will increase
In other words, the current output
level cannot represent equilibrium
 Equilibrium
For an economy to be in equilibrium,
unplanned increase in inventory must
be zero
Therefore, actual expenditure = planned
expenditure + unplanned increase in
inventory = planned expenditure
But recall that actual expenditure is actual
GDP or Y, and planned expenditure is C + I
+G
Therefore, in equilibrium, Y = C + I + G
 Short-Run GDP: calculation
We just saw that in equilibrium Y = C + I
+G
Therefore, Y = Co + Cy (Y T) + I + G
This is one equation with one unknown, Y
So, this equation can be used to solve for Y
Example: C = 2 + 0.8(Y T), T = 0.85, G =
3, and I = 1.85
Then, Y = 2 + 0.8(Y 0.85) + 1.85 + 3
Check that Y = 30.85
 Short-Run GDP: calculation
In equilibrium, Y = C + I + G

Y Co C y (Y T ) I G
Y Co C y Y C y T I G
Y C yY Co C yT I G
At this point, you
should be able to do
problems 2 and 4 on
(1 C y ) Y Co C yT I G pages 325-26 of the
textbook. Please try
them.
Co C y T I G Every variable on the right
Y hand-side of the equation is

1 Cy exogenous. So, this

equation tells us everything
we can say about Y in the
Short-Run GDP: predictions
Co C yT I G Predictions
Grid
Y
1 Cy
Y

C +
Every variable on the right o

hand-side of the equation is T

exogenous. So, this
I +
equation tells us everything
we can say about Y in the G +
Keynesian
Important: Cross model.
Note that there In other words, the
is absolutely no reason why Keynesian Cross model is
this short-run equilibrium able to explain why
GDP has to be equal to the recessions and booms
long-run equilibrium GDP (). happen.
 The Keynesian Cross
Equation
Co C yT I G 1 Cy
Y (Co I G ) T
1 Cy 1 Cy 1 Cy
 The Spending Multiplier
1 Cy
Y (Co I G ) T
1 Cy 1 Cy

Note that for every $1.00 increase in Co

+ I + G, Y increases by $1/(1 Cy).
As Cy is the marginal propensity to
consume, 1/(1 Cy) may be written as
1/(1 MPC).
This is called the spending multiplier.
 The Spending Multiplier
1 Cy
Y (Co I G ) T
1 Cy 1 Cy

As the marginal propensity to consume is

a positive fraction (0 < MPC < 1), 1 MPC
is also a positive fraction.
Therefore, 1/(1 MPC) > 1.
So, for every $1.00 increase in Co + I
+ G, Y increases by more than $1.00!
 The Spending Multiplier
1 Cy
Y (Co I G ) T
1 Cy 1 Cy
The spending multiplier is 1/(1 MPC).
Example: If MPC = 0.2, the spending multiplier = 1/(1
0.2) = 1.25. Therefore, if the government spends $3 billion
on a new highway, real GDP will increase by $3.75 billion
Example: If MPC = 0.8, the spending multiplier = 1/(1
0.8) = 5. Therefore, if the government spends $3 billion on
a new highway, real GDP will increase by $15 billion
The bigger MPC is, the bigger the spending
multiplier will be. Why???
 The Tax-Cut Multiplier
1 Cy
Y (Co I G ) T
1 Cy 1 Cy

Note that for every $1.00 decrease in

T, Y increases by $Cy/(1 Cy).
As Cy is the marginal propensity to
consume, Cy /(1 Cy) may be written
as MPC/(1 MPC).
This is the tax-cut multiplier.
 The Tax-Cut Multiplier
1 Cy
Y (Co I G ) T
1 Cy 1 Cy

As the marginal propensity to consume is

a positive fraction (0 < MPC <At1),
this point, you
MPC/(1 MPC) < 1/(1 MPC) should be able to
do problem 1 on
Tax-cut multiplier < spending multiplier
page 325 of the
textbook. Please
That is, a $1.00 tax cut provides
try it.a
smaller boost to the economy than a
$1.00 increase in government spending.
Why??
 The Tax-Cut Multiplier
1 Cy
Y (Co I G ) T
1 Cy 1 Cy
The tax-cut multiplier is MPC/(1 MPC).
Example: If MPC = 0.2, the tax-cut multiplier = 0.2/
(1 0.2) = 0.25 < 1. Therefore, if the government
cuts taxes by $3 billion, real GDP will increase by
$0.75 billion
Example: If MPC = 0.8, the tax-cut multiplier = 0.8/
(1 0.8) = 4. Therefore, if the government cuts taxes
by $3 billion, real GDP will increase by $12 billion
 Fiscal Policy
The practice of changing the levels of
government spending (G) and/or
taxes (T) in order to affect the
macroeconomic outcome is called
fiscal policy
Spending more (G) and/or cutting
taxes (T) is called expansionary fiscal
policy
Spending less (G) and/or raising taxes
(T) is called contractionary fiscal policy
 Fiscal Policy
The consequences of expansionary
and contractionary fiscal policy in the
Keynesian Cross model were
analyzed in previous slides
In any case, they can be easily seen
from the Keynesian Cross models
equation: 1 Cy
Y (Co I G ) T
1 Cy 1 Cy
K.C. K.C. Tax-
Spending cut
 Fiscal Policy: balanced budget
multiplier
Note that expansionary fiscal policy
(G and/or T) leads to lower public
saving (T G)
This could mean a rise in the budget
deficit or a fall in the budget surplus
Is there no way to stimulate an
economy in a recession while
keeping the budget balanced?
There is!
 Fiscal Policy: balanced budget
multiplier
What
happens if both G and T increase
by $1?
The $1 increase in G increases Y by 1/(1
MPC)
The $1 increase in T decreases Y by
MPC/(1 MPC)
Therefore, the total change in Y is

This is the balanced budget multiplier

 Fiscal Policy: balanced budget
multiplier
The balanced budget multiplier
shows that if both government
spending and taxes are increased by
the same amountthereby keeping
the budget balancedthen output
will increase by the same amount.
Graphing planned expenditure

PE

planned PE =C +I
+G
expenditure
MPC
1

income, output, Y
Graphing the equilibrium condition

PE PE
=Y
planned

expenditure

45

income, output, Y
The equilibrium value of
income
PE PE
=Y
planned PE =C +I
+G
expenditur
e

Output
gap

Y
Equilibriu ,
natural
m rate of
income output
 An increase in government purchases
PE

Y
=
E
At Y1,

P
PE =C +I
there is now an +G2
unplanned drop PE =C +I
in inventory +G1

G
so firms
increase output,
and income Y
rises toward a
new equilibrium. PE1 = Y PE2 =
Y1 Y2
 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
 The government purchases multiplier
Definition: the increase in income resulting
from a $1 increase in G.
In this model, the govt
Y 1
purchases multiplier equals
G 1 MPC

Example: If MPC = 0.8, then

An
An increase
increase in
in G
G
Y 1
5 causes
causes income
income toto
G 1 0.8
increase
increase 55 times
times
as
as much!
much!
 Why the multiplier is greater than 1

Initially, the increase in G causes an equal

increase in Y: Y = G.
But Y C
further Y
further C
further Y
So the final impact on income is much bigger
than the initial G.
 An increase in taxes
PE
Initially, the tax

= E
P
PE =C1 +I

Y
increase reduces
consumption, and +G
PE =C2 +I
therefore PE: +G

C = MPC At Y1, there is now

T an unplanned
so firms inventory buildup
reduce output,
and income falls Y
toward a new PE2 = Y PE1 =
equilibrium
Y2 Y1
 Solving for Y
eqm condition in
Y C I G
changes
C I and G exogenous

MPC Y T

Solving for Y : (1 MPC) Y MPC T

MPC
Final result: Y T
1 MPC
 The tax multiplier
def: the change in income resulting from
a $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
 The tax multiplier
is negative:
A tax increase reduces
C,
which reduces income.
is smaller than the
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 (or
NOW YOU TRY:
Practice with the Keynesian Cross
Use a graph of the Keynesian cross
to show the effects of an increase in
planned investment on the
equilibrium level of income/output.
 Tax Cuts: JFK
Kennedy cut personal and corporate income
taxes in 1964
An economic boom followed.
GDP grew 5.3% in 1964 and 6.0 in 1965.
Unemployment fell from 5.7% in 1963 to 5.2% in
1964 to 4.5% in 1965.
However, it is not easy to prove that the tax
cuts caused the boom
Even when they agree that the tax cuts caused
the boom, economists cant agree on the
reason
 Tax Cuts: JFK
Keynesians argued that the tax cuts
boosted demand, which led to higher
production and falling unemployment
Supply-siders argued that demand had
nothing to do with it. The tax cuts gave
people the incentive to work harder. So, L
increased. Therefore, Y = F(K, L) also
increased.
Personally, I feel this argument doesnt
explain why the unemployment rate fell
 Tax Cuts: GWB
Bush cut taxes in 2001 and 2003
After the second tax cut, a weak recovery from
the 2001 recession turned into a strong recovery
GDP grew 4.4% in 2004
Unemployment fell from its peak of 6.3% in June 2003
to 5.4% in December 2004
In justifying his tax cut, Bush used the Keynesian
explanation:
When people have more money, they can spend it
on goods and services. when they demand an
additional good or service, somebody will produce the
good or service.
 Spending Stimulus: Barack
Obama
When President Obama took office in
January 2009, the economy had suffered
the worst collapse since the Great
Depression
Obama helped enact an $800 billion (5%
of annual GDP) stimulus to be spent over a
two-year period
About 40% was tax cuts, and 60% was
additional government spending
White House economists had estimated the
spending multiplier to be 1.57 and the tax-cut
multiplier to be 0.99
 Spending Stimulus: Barack
Obama
Much of the new spending was on
infrastructure projects
These projects were fine for the long
run, but took a long time to be
implemented, and were therefore not
ideal as a short-run boost
Obama publicly justified his stimulus
bill using Keynesian demand-side
reasoning
A slightly more complex theory of short-run equilibrium in
the goods market

THE IS CURVE
 Planned Investment
The Keynesian Cross model assumed
that planned expenditure by
businesses (I) is exogenous
Recall that, in chapter 3, we had
assumed that investment spending is
inversely related to the real interest
rate
The IS Curve theory of the goods
market brings back the investment
function I = I(r)
 The Real Interest Rate
Recall from chapter 3 that, the real interest
rate is the inflation-adjusted interest
rate
To adjust the nominal interest rate for
inflation, you simply subtract the inflation
rate from the nominal interest rate
If the bank charges you 5% interest rate on a cash
loan, thats the nominal interest rate (i = 0.05).
If the inflation rate turns out to be 3% during the
loan period ( = 0.03), then you paid the real
interest rate of just 2% (r = i = 0.02)
 The Real Interest Rate
The problem is that when you are taking
out a loan you dont quite know what the
inflation rate will be over the loan period
So, economists distinguish between
the ex post real interest rate: r = i
and the ex ante real interest rate: r = i
E, where E is the expected inflation
rate over the loan period
We will use the ex ante interpretation of the
real interest rate
 Investment and the real interest
rate
Assumption: investment spending
is inversely related to the real
interest rate
Ir = I(r), such that r I

I (r
)
I
 Investment and the real interest
rate
Specifically, I = Io Irr
Here Ir is the effect of
r
r on I and
Io represents all
other factors that Io2
also affect business Irr
investment spending Io1
such as business Irr
optimism, technological I
progress, etc.
 Investment: example
Suppose I = 11.85 2r is the
investment function
Then, if r = 5 percent, we get I =
11.85 2r = 1.85.
 The IS Curve
Recall that the goods market is in
equilibrium when Y = C + I + G
The IS curve is a graph that shows
all combinations of r and Y for which
the goods market is in equilibrium
Therefore, the basic equation
underlying the IS curve is Y = C(Y
T) + I(r) + G
 Deriving the IS Curve:
algebra
Y C (Y T ) I (r ) G
Y Co C y (Y T ) I o I r r G
Y Co C y Y C y T I o I r r G
Y C y Y Co C y T I o I r r G
(1 C y ) Y Co C y T I o I r r G
1 Cy Ir
Y (Co I o G ) T r
1 Cy 1 Cy 1 Cy
K.C. K.C. Tax- IS
Spending cut Interest
 Deriving the IS Curve:
algebra
So, although the basic equation underlying the IS
curve is
Y C (Y T ) I (r ) G

for my specific consumption and investment

functions, the equation underlying the IS curve
can also be expressed as:
1 Cy Ir
Y (Co I o G ) T r
1 Cy 1 Cy 1 Cy
The two equations are equivalent forms of the IS
 Comparing the Equations of the
Keynesian Cross and the IS Curve

Keynesian
Cross
1 Cy
Y (Co I o G ) T
1 Cy 1 Cy
K.C. K.C. Tax-
This is the
Spending cut
only
multiplier multiplier
difference
IS
Curve 1 Cy Ir
Y (Co I o G ) T r
1 Cy 1 Cy 1 Cy
K.C. K.C. Tax- IS
Spending cut Interest
 The IS Curve
1 Cy Ir
Y (Co I o G ) T r
1 Cy 1 Cy 1 Cy
K.C. K.C. Tax- IS
Spending cut Interest
multiplier multiplier rate
r effect
Any change in the real interest
r1 rate will cause an opposite
change in real total GDP by a
multiple determined by the size
r r2 of the interest rate effect.
IS
This is why the IS curve is
Y1 Y2 Y negatively sloped.

 The IS Curve: effect of fiscal policy
1 Cy Ir
Y (Co I o G ) T r
1 Cy 1 Cy 1 Cy
K.C. K.C. Tax- IS
Spending cut Interest
multiplier multiplier rate
r effect
Any increase in Co + Io + G causes
the IS curve to shift right by the r1
amount of the increase
magnified by the Keynesian
Cross spending multiplier Y
That is, if the real interest rate is IS2
IS1
unchanged, the Keynesian Cross
model is the same as the IS curve Y1 Y2 Y
model.
 The IS Curve: effect of fiscal
policy
1 Cy Ir
Y (Co I o G ) T r
1 Cy 1 Cy 1 Cy
K.C. K.C. Tax- IS
Spending cut Interest
multiplier multiplier rate
Any decrease in taxes (T) causes r effect
the IS curve to shift right by the
amount of the tax cut magnified
r1
by the Keynesian Cross tax-cut
multiplier
Y
IS1 IS2
Y1 Y2 Y
 The IS Curve: shifts
To sum up the previous two slides:
The IS curve shifts right if there is:
an increase in Co + Io + G, or
a decrease in T.
 Deriving the IS curve:
P
graphs
PE =Y
PE =C +I (r )
2
E +G
r I PE =C +I (r1 )
+G
PE I

Y Y1 Y2 Y
r
Any change in the real r1
interest rate will cause
an opposite change in
real total GDP by a r2
multiple determined by IS
the size of the interest
rate effect. Y1 Y2 Y
 The natural rate of interest
P PE = PE = C + I() +
Recall chapter 3 gave Y

us a long-run theory
E G
PE = C + I(r1)
of the real interest
rate +G
At the long-run
interest rate, both
Y = C + I + G (or,
Y1 Y
equivalently, S = I) and r
Y=
are true. r1
Note that in the The natural
diagram satisfies the rate of
requirements of long- interest will
run equilibrium IS re-appear in
This is the natural
Y1 Y chapter 14.
rate of interest But there it
will be
denoted .
 Why the IS curve is negatively sloped

A fall in the interest rate motivates

firms to increase investment
spending, which drives up total
planned spending (PE ).
To restore equilibrium in the goods
market, output (a.k.a. actual
expenditure, Y )
must increase.
 Fiscal Policy and the IS
curve
We can use the IS-LM model to see
how fiscal policy (G and T ) affects
aggregate demand and output.
Lets start by using the Keynesian
cross
to see how fiscal policy shifts the IS
curve
 Shifting the IS curve: G
PE PE PE =C +I (r1 )
At any value of r, =Y
G PE Y +G2=C +I (r )
PE 1

so the IS curve +G1

shifts to the right.

The horizontal Y1 Y2 Y
r
distance of the
r1
IS shift equals
1
Y G Y
1 MPC IS1 IS2
Y1 Y2 Y
NOW YOU TRY:
Shifting the IS curve: T
Use the diagram of the Keynesian cross
or loanable funds model to show how
an increase in taxes shifts the IS curve.
The theory of short-run equilibrium in the money market

THE MONEY MARKET IN

THE SHORT RUN: THE LM
CURVE
 The Theory of Liquidity Preference

The theory of short-run equilibrium in

the money market is exactly the
same as the theory of long-run
equilibrium in the money market that
we saw in Chapter 5
Please review Chapter 5

Review of
 Money demand and the interest
rate
Liquid assets are assumed to earn no
interest
Illiquid assets are assumed to earn
the nominal interest rate i
Therefore, an increase in i is
assumed to reduce the demand for
money
That is, money demand (Md) is
assumed to be inversely related
toofthe nominal interest rate (i)
Review
 Money demand and the price level

We also hold some of our wealth in

the form of moneyin liquid form
because money is an excellent
medium of exchange

Review of
 Money demand and the price level

Recall that nominal GDP is the market value

of all final goods and services
It is also the total expenditure on all final
goods and services
Therefore, the bigger our nominal GDP, the
bigger will be our need for money, as
money is a medium of exchange
It is, therefore, assumed that money
demand is directly related to nominal
GDP

Review of
 Money demand and the
price level
Let P represent the overall level of
prices, as measured by the GDP
Deflator
From Chapter 2:
Therefore,
It is, therefore, assumed that money
demand (Md) is directly related
to nominal GDP ()

Review of
 Money Demand
So, Md is
inversely related to i, and
directly related to PY

L(i) is the liquidity function

It is inversely related to i, the nominal
interest rate

Review of
 Money Demand: example

L(i) is the liquidity function
It is inversely related to i, the nominal
interest rate
Specific form of L(i):

Lo represents all factors other than P, Y

and i that also affect money demand

Review of
 Money Demand = Money
Supply
M
denotes money supply
denotes money demand
Therefore, denotes equilibrium in the
money market

Review of
 Money Demand = Money
Supply

For the specific form , the above equation

becomes
 Money Demand = Money
Supply

Now, recall that the ex ante real
interest rate is the nominal
interest rate minus the expected
inflation rate: r = i E
Therefore, r + E = i
So, the money market equilibrium
equation becomes
At this point, you should be able to do
problem 5 on page 326 of the textbook.
 The LM Equation
So,
for the specific form , the money
market equilibrium equation then becomes

Traditionally, this equation is called

the LM equation
 Money Demand = Money
Supply

Assumption: As always, the money
supply (M), which is controlled by the
central bank, is exogenous
Assumption: unlike the long-run analysis of
Chapter 5, expected inflation (E) is
exogenous.
Assumption: unlike the long-run analysis of
Chapter 5, the overall price level (P) is
exogenous
Prices are sticky in the short
run
Recall that the long-run analysis of
Chapter 5 assumed that P is endogenous.
Recall also that in the long run P changes
proportionately with M.
The short-run analysis in the IS-LM model
assumes that P is exogenous: it is what it
is, it is historically determined
That is, the overall price level is sticky: what
it was last week, it will be this week too
Prices are sticky in the short
run
This sticky-prices assumption is the
crucial distinction between long-run
and short-run macroeconomic analysis
Except this assumption, all
assumptions made in short-run analysis
are also assumed in long-run analysis
So, the differences between long-run
and short-run theories are caused by
this sticky-prices assumption
 Money Demand = Money
Supply
LM
equation:
Note that if the real interest rate (r)
increases, the real GDP (Y) must
increase too, in order to keep money
demand equal to money supply
 The LM Curve: algebra to
graph

The LM curve
shows all
combinations of r r
and Y for which the LM
money market is in
equilibrium r
Note that the LM 2

r
curve is upward
rising
1

Y1 Y2 Y
 The LM Curve: algebra to
graph

The LM curve shifts
(down) right if:
M/P or E increases
Lo decreases r
Moreover, if E LM LM
increases 1 2

(decreases), the LM r
curve shifts down 1

(up) by the exact r

same amount!
2

Y0 Y
NOW YOU TRY:
Shifting the LM curve
Suppose a wave of credit card fraud
causes consumers to use cash more
frequently in transactions.
Use the liquidity preference model
to show how these events shift the
LM curve.
Both the goods market and the money market need to be
in equilibrium

SHORT-RUN EQUILIBRIUM
IN THE IS-LM MODEL
 Short-run equilibrium
The short-run equilibrium r
is the combination of r
LM
and Y that simultaneously
satisfies the equilibrium
conditions in both the
goods and money
Y C (Y T ) I (r ) G
markets: IS
M L(r E ) P Y Y
Equilibrium
interest Equilibrium
rate level of
income
 Short-run equilibrium
By insisting that both the r
goods market and the
LM
money market need to be
in equilibrium, we have
managed to find a way to
pinpoint both r and Y
simultaneously!
Y C (Y T ) I (r ) G IS
Y
M L(r E ) P Y Equilibrium
interest Equilibrium
rate level of
income
 Short-run equilibrium
that the short-run
Note
r
equilibrium GDP does not
have to be equal to the long- LM
run equilibrium GDP (, also
called potential GDP and
natural GDP)
Thus, like the Keynesian Cross
model, the IS-LM model can IS
explain recessions and booms. Y

But, the Keynesian Cross Equilibrium
model could determine interest Equilibrium
only equilibrium GDP. The
rate level of
IS-LM model determines income
the equilibrium interest
rate as well.
 The IS-LM Model: summary
Short-run equilibrium in the goods market is represented
by a downward-sloping IS curve linking Y and r.
Short-run equilibrium in the money market is represented
by an upward-sloping LM curve linking Y and r.
The intersection of the IS and LM curves determine the
short-run equilibrium values of Y and r.
The IS curve shifts right if there is: r
an increase in Co + Io + G, or L
a decrease in T. M
The LM curve shifts right if:
M/P or E increases, or
Lo decreases

IS
Y
 The Big Picture
Keynesia
Keynesia
nn IS
IS
Cross curve
curve IS-LM
IS-LM
Cross Explanatio
Explanatio
Theory
Theory of
of mode
mode nn of
of short-
short-
Liquidity
Liquidity LM
LM ll run
run
Preferenc
Preferenc curve
curve fluctuation
fluctuation
ee ss
Agg.
Agg.
deman
deman
dd Model
Model of
of
curve
curve Agg.
Agg.
Demand
Demand
Agg.
Agg. and
and
supply
supply Agg.
Agg.
curve
curve Supply
Supply
 Preview of Chapter 12
In Chapter 12, we will
use the IS-LM model to analyze the
impact of policies and shocks.
learn how the aggregate demand curve
comes from IS-LM.
use the IS-LM and AD-AS models together
to analyze the short-run and long-run
effects of shocks.
use our models to learn about the
Great Depression.