SEVENTH EDITION
MACROECONOMICS
N. Gregory Mankiw
PowerPoint® Slides by Ron Cronovich
CHAPTER
10
Aggregate Demand I:
Building the IS-LM Model
Modified for EC 204
by Bob Murphy
© 2010 Worth Publishers, all rights reserved
In this chapter, you will learn:
the IS curve, and its relation to:
the Keynesian cross
the loanable funds model
the LM curve, and its relation to:
the theory of liquidity preference
how the IS-LM model determines income and
the interest rate in the short run when P is
fixed
Context
Chapter 9 introduced the model of aggregate
demand and aggregate supply.
Long run
prices flexible
output determined by factors of production &
technology
unemployment equals its natural rate
Short run
prices fixed
output determined by aggregate demand
unemployment negatively related to output
CHAPTER 10 Aggregate Demand I 3
Context
This chapter develops the IS-LM model,
the basis of the aggregate demand curve.
We focus on the short run and assume the price
level is fixed (so, SRAS curve is horizontal).
This chapter (and chapter 11) focus on the
closed-economy case.
Chapter 12 presents the open-economy case.
CHAPTER 10 Aggregate Demand I 4
The Keynesian Cross
A simple closed economy model in which income
is determined by expenditure.
(due to J.M. Keynes)
Notation:
I = planned investment
PE = C + I + G = planned expenditure
Y = real GDP = actual expenditure
Difference between actual & planned expenditure
= unplanned inventory investment
CHAPTER 10 Aggregate Demand I 5
Elements of the Keynesian Cross
consumption function:
govt policy variables:
for now, planned
investment is exogenous:
planned expenditure:
equilibrium condition:
actual expenditure = planned expenditure
CHAPTER 10 Aggregate Demand I 6
Graphing planned expenditure
PE
planned PE =C +I +G
expenditure
MPC
1
income, output, Y
CHAPTER 10 Aggregate Demand I 7
Graphing the equilibrium condition
PE PE =Y
planned
expenditure
45º
income, output, Y
CHAPTER 10 Aggregate Demand I 8
The equilibrium value of income
PE PE =Y
planned PE =C +I +G
expenditure
income, output, Y
Equilibrium
income
CHAPTER 10 Aggregate Demand I 9
An increase in government purchases
PE
Y
=
At Y1,
PE
PE =C +I +G2
there is now an
unplanned drop PE =C +I +G1
in inventory…
ΔG
…so firms
increase output,
and income rises Y
toward a new
equilibrium. PE1 = Y1 ΔY PE2 = Y2
CHAPTER 10 Aggregate Demand I 10
Solving for ΔY
equilibrium condition
in changes
because I exogenous
because ΔC = MPC ΔY
Collect terms with ΔY Solve for ΔY :
on the left side of the
equals sign:
CHAPTER 10 Aggregate Demand I 11
The government purchases multiplier
Definition: the increase in income resulting from a
$1 increase in G.
In this model, the govt
purchases multiplier equals
Example: If MPC = 0.8, then
An increase in G
causes income to
increase 5 times
as much!
CHAPTER 10 Aggregate Demand I 12
Why the multiplier is greater than 1
Initially, the increase in G causes an equal increase
in Y: ΔY = ΔG.
But ↑Y ⇒ ↑C
⇒ further ↑Y
⇒ further ↑C
⇒ further ↑Y
So the final impact on income is much bigger than
the initial ΔG.
CHAPTER 10 Aggregate Demand I 13
An increase in taxes
PE
Y
=
Initially, the tax
PE
PE =C1 +I +G
increase reduces
consumption, and PE =C2 +I +G
therefore PE:
ΔC = −MPC ΔT At Y1, there is now
an unplanned
…so firms inventory buildup…
reduce output,
and income falls Y
toward a new PE2 = Y2 ΔY PE1 = Y1
equilibrium
CHAPTER 10 Aggregate Demand I 14
Solving for ΔY
eq’m condition in
changes
I and G exogenous
Solving for ΔY :
Final result:
CHAPTER 10 Aggregate Demand I 15
The tax multiplier
def: the change in income resulting from
a $1 increase in T :
If MPC = 0.8, then the tax multiplier equals
CHAPTER 10 Aggregate Demand I 16
The tax multiplier
…is negative:
A tax increase reduces C,
which reduces income.
…is greater than one
(in absolute value):
A change in taxes has a
multiplier effect on income.
…is smaller than the govt 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.
CHAPTER 10 Aggregate Demand I 17
The IS curve
def: a graph of all combinations of r and Y that
result in goods market equilibrium
i.e. actual expenditure (output)
= planned expenditure
The equation for the IS curve is:
CHAPTER 10 Aggregate Demand I 19
Deriving the IS curve
PE PE =Y
PE =C +I (r2 )+G
↓r ⇒ ↑I PE =C +I (r1 )+G
⇒ ↑PE ΔI
⇒ ↑Y Y1 Y2 Y
r
r1
r2
IS
Y1 Y2 Y
CHAPTER 10 Aggregate Demand I 20
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.
CHAPTER 10 Aggregate Demand I 21
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.
Let’s start by using the Keynesian cross
to see how fiscal policy shifts the IS curve…
CHAPTER 10 Aggregate Demand I 23
Shifting the IS curve: ΔG
PE PE =Y PE =C +I (r )+G
1 2
At any value of r,
↑G ⇒ ↑PE ⇒ ↑Y PE =C +I (r1 )+G1
…so the IS curve
shifts to the right.
The horizontal Y1 Y2 Y
r
distance of the
r1
IS shift equals
ΔY
IS1 IS2
Y1 Y2 Y
CHAPTER 10 Aggregate Demand I 24
The Theory of Liquidity Preference
Due to John Maynard Keynes.
A simple theory in which the interest rate
is determined by money supply and
money demand.
CHAPTER 10 Aggregate Demand I 26
Money supply
r
The supply of interest
rate
real money
balances
is fixed:
M/P
real money
balances
CHAPTER 10 Aggregate Demand I 27
Money demand
r
Demand for interest
rate
real money
balances:
L (r )
M/P
real money
balances
CHAPTER 10 Aggregate Demand I 28
Equilibrium
r
The interest interest
rate adjusts rate
to equate the
supply and
demand for
money: r1
L (r )
M/P
real money
balances
CHAPTER 10 Aggregate Demand I 29
How the Fed raises the interest rate
r
interest
To increase r, rate
Fed reduces M
r2
r1
L (r )
M/P
real money
balances
CHAPTER 10 Aggregate Demand I 30
CASE STUDY:
Monetary Tightening & Interest Rates
Late 1970s: π > 10%
Oct 1979: Fed Chairman Paul Volcker
announces that monetary policy
would aim to reduce inflation
Aug 1979-April 1980:
Fed reduces M/P 8.0%
Jan 1983: π = 3.7%
How do you think this policy change
would affect nominal interest rates?
CHAPTER 10 Aggregate Demand I 31
Monetary Tightening & Interest Rates, cont.
The effects of a monetary tightening
on nominal interest rates
short run long run
Quantity theory,
Liquidity preference
model Fisher effect
(Keynesian)
(Classical)
prices sticky flexible
prediction Δi > 0 Δi < 0
actual 8/1979: i = 10.4% 8/1979: i = 10.4%
outcome 4/1980: i = 15.8% 1/1983: i = 8.2%
The LM curve
Now let’s put Y back into the money demand
function:
The LM curve is a graph of all combinations of r
and Y that equate the supply and demand for
real money balances.
The equation for the LM curve is:
CHAPTER 10 Aggregate Demand I 33
Deriving the LM curve
(a) The market for
(b) The LM curve
real money balances
r r
LM
r2 r2
L (r , Y2 )
r1 r1
L (r , Y1 )
M/P Y1 Y2 Y
CHAPTER 10 Aggregate Demand I 34
Why the LM curve is upward sloping
An increase in income raises money demand.
Since the supply of real balances is fixed, there
is now excess demand in the money market at
the initial interest rate.
The interest rate must rise to restore equilibrium
in the money market.
CHAPTER 10 Aggregate Demand I 35
How ΔM shifts the LM curve
(a) The market for
(b) The LM curve
real money balances
r r
LM2
LM1
r2 r2
r1 r1
L (r , Y1 )
M/P Y1 Y
CHAPTER 10 Aggregate Demand I 36
The short-run equilibrium
The short-run equilibrium is r
the combination of r and Y LM
that simultaneously satisfies
the equilibrium conditions in
the goods & money markets:
IS
Y
Equilibrium
interest Equilibrium
rate level of
income
CHAPTER 10 Aggregate Demand I 38
The Big Picture
Keynesian IS
Cross curve
IS-LM
model Explanation
Theory of LM of short-run
Liquidity curve fluctuations
Preference
Agg.
demand
curve Model of
Agg.
Demand
Agg.
and Agg.
supply
Supply
curve
Preview of Chapter 11
In Chapter 11, 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.
CHAPTER 10 Aggregate Demand I 40
Chapter Summary
1. Keynesian cross
basic model of income determination
takes fiscal policy & investment as exogenous
fiscal policy has a multiplier effect on income
2. IS curve
comes from Keynesian cross when planned
investment depends negatively on interest rate
shows all combinations of r and Y
that equate planned expenditure with
actual expenditure on goods & services
Chapter Summary
3. Theory of Liquidity Preference
basic model of interest rate determination
takes money supply & price level as exogenous
an increase in the money supply lowers the
interest rate
4. LM curve
comes from liquidity preference theory when
money demand depends positively on income
shows all combinations of r and Y that equate
demand for real money balances with supply
Chapter Summary
5. IS-LM model
5. Intersection of IS and LM curves shows the
unique point (Y, r ) that satisfies equilibrium in
both the goods and money markets.
