CHAPTER THREE

Aggregate Demand in the closed

economy

slide 1
3.1 Foundations of Theory of Aggregate Demand

• Aggregate demand is the total amount of goods demanded

in the economy.
• 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, the United States and many other
countries experienced massive unemployment and greatly
reduced incomes

slide 3
 In the worst year, 1933,one-fourth of the U.S. labor force was
unemployed, and real GDP was 30 percent below its 1929
level.
• 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.

slide 4
• After the Depression, many economists believed that a new
model was needed to explain such a large and sudden
economic downturn.
• They suggest government policies that might reduce the
economic hardship so many people faced.
• In 1936 the British economist John Maynard Keynes
revolutionized economics with his book “The General
Theory of Employment, Interest, and Money.

slide 5
 Keynes 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.
 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.
slide 6
• 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.
 Economists today reconcile these two views with the model of
aggregate demand and aggregate supply.

slide 7
 3.2 The Goods Market and the IS curve
• IS curve stands for “investment” and “saving”, and represents what’s
going on in the goods market.

• 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
national income
 It is a building block for the more complex and realistic IS–LM
model.

slide 8
• The product market equilibrium condition is obtained at a
point where planned aggregate demand is equal to
output/income, i.e. Y = C + I + G

slide 9
 The Keynesian Cross
• In The General Theory, Keynes proposed that an economy’s
total income was, 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.
• Planned expenditure: is the amount households, firms,
and the government would like to spend on goods and
services.

slide 10
• Actual expenditure: is the amount households, firms,
and the government spend on goods and services which is
equal to GDP.
• Actual expenditure differs from planned expenditure.
• This is that firms might engage in unplanned inventory
investment because their sales do not meet their
expectations.
• A simple closed economy model in which income is
determined by expenditure. (due to J.M. Keynes)

slide 11
 The Keynesian Cross
• Notation:
I = planned investment
E = C + I + G = planned expenditure
Y = real GDP = actual expenditure
• Difference between actual & planned expenditure:
unplanned inventory investment

slide 12
Elements of the Keynesian Cross

consumption function: C  C (Y  T )
govt policy variables: G  G , T T
for now, planned
investment is exogenous: I I
planned expenditure: E  C (Y  T )  I  G

Equilibrium condition:
Actual expenditure  Planned expenditure
Y  E
slide 13
Graphing planned expenditure

planned E =C +I +G
expenditure
MPC
1

income, output, Y

slide 14
Graphing the equilibrium condition

E E =Y

planned

expenditure

45º

income, output, Y

slide 15
The equilibrium value of income

E E =Y

planned E =C +I +G
expenditure

income, output, Y
Equilibrium
income
slide 16
slide 17
An increase in government purchases
E Y

=
At Y1, E E = C + I + G2
there is now an
unplanned drop E = C + I + G1
in inventory…

G

…so firms
increase output,
and income Y
rises toward a
new equilibrium E1 = Y 1 Y E2 = Y 2

slide 18
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 Finally, solve for Y :

on the left side of the
equals sign:  1 
Y     G
(1  MPC)  Y  G  1  MPC 

slide 19
The government purchases multiplier

Definition: the increase in income resulting

from a $1 increase in G.
In this model, the govt purchases
multiplier equals Y 1

G 1  MPC
Example: If MPC = 0.8, then
Y 1 An increase in G
  5 causes income to
G 1  0.8
increase by 5 times
as much!
slide 20
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.

slide 21
An increase in taxes
E Y

=
Initially, the tax E E = C1 + I + G
increase reduces
consumption, and E = C2 + I + G
therefore E:

C = MPC T At Y1, there is now

an unplanned
…so firms inventory buildup…
reduce output,
and income falls Y
toward a new E2 = Y 2 Y E1 = Y 1
equilibrium
slide 22
Solving for Y

eq’m condition in
Y  C  I  G
changes
 C I and G exogenous

 MPC   Y  T 
Solving for Y : (1  MPC)  Y   MPC  T

Final result:
  MPC 
Y     T
 1  MPC 

slide 23
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

slide 24
The Tax Multiplier
…is negative:
A tax hike reduces
consumer spending,
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.
slide 25
 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:

Y  C (Y  T )  I (r )  G

slide 26
Deriving the IS curve

E E =Y E =C +I (r )+G
2

r  I E =C +I (r1 )+G

 E I

 Y Y1 Y2 Y
r
r1

r2
IS
Y1 Y2 Y

slide 27
Why the IS curve is negatively sloped
• A fall in the interest rate motivates firms to increase
investment spending
• To restore equilibrium in the goods market, output
(a.k.a. actual expenditure, Y ) must increase.

slide 28
 3.2The 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.
The Theory of Liquidity Preference
A simple theory in which the interest rate is determined by
money supply and money demand.

slide 29
Money Supply

The supply of r
M P
s
interest
real money
rate
balances
is fixed:

M P M P
s

M/P
M P real money
balances
slide 30
Money Demand

Demand for r
M P
s
interest
real money
rate
balances:

M P
d
 L (r )

L (r )

M/P
M P real money
balances
slide 31
Equilibrium

The interest r
M P
s
rate adjusts interest
rate
to equate the
supply and
demand for
money:
r1
M P  L (r ) L (r )

M/P
M P real money
balances
slide 32
How the Fed raises the interest rate

r
interest
rate

To increase r,
r2
Fed reduces M
r1
L (r )

M/P
M2 M1 real money
P P balances
slide 33
The LM curve

Now let’s put Y back into the money demand

function:
M P
d
 L (r ,Y )

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:
M P  L (r ,Y )
slide 34
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 )
M1 M/P Y1 Y2 Y
P
slide 35
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.

slide 36
How M 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 )

M2 M1 M/P Y1 Y
P P
slide 37
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:

Y  C (Y  T )  I (r )  G IS
M P  L (r ,Y ) Y
Equilibrium
interest Equilibrium
rate level of
income
slide 38
Equilibrium in the IS-LM Model

The IS curve represents r

equilibrium in the goods LM
market.
Y  C (Y  T )  I (r )  G

The LM curve represents r1

money market equilibrium.
M P  L (r ,Y ) IS
Y
Y1
The intersection determines
the unique combination of Y and r
that satisfies equilibrium in both markets.
slide 39
Policy analysis with the IS-LM Model

Y  C (Y  T )  I (r )  G r
M P  L (r ,Y ) LM

Policymakers can affect

macroeconomic variables r1
with
• fiscal policy: G and/or T
• monetary policy: M IS
Y
We can use the IS-LM Y1
model to analyze the
effects of these policies.
slide 40
An increase in government purchases
1. IS curve shifts right r
1 LM
by G
1  MPC
causing output & r2
income to rise. 2.
r1
2. This raises money
demand, causing the
1. IS2
interest rate to rise… IS1
Y
3. …which reduces investment, Y1 Y2
so the final increase in Y 3.
1
is smaller than G
1  MPC
slide 41
A tax cut
Because consumers save r
(1MPC) of the tax cut,
LM
the initial boost in
spending is smaller for T
than for an equal G… r2
2.
and the IS curve r1
shifts by 1. IS2
MPC
1. T IS1
1  MPC
Y
Y1 Y2
2. …so the effects on r and Y 2.
are smaller for a T than
for an equal G.
slide 42
Monetary Policy: an increase in M
r
1. M > 0 shifts LM1
the LM curve down
(or to the right) LM2

2. …causing the r1
interest rate to fall r2

3. …which increases IS
investment, causing Y
Y1 Y2
output & income to
rise.

slide 43
Interaction between
monetary & fiscal policy
• Model:
monetary & fiscal policy variables
(M, G and T ) are exogenous
• Real world:
Monetary policymakers may adjust M
in response to changes in fiscal policy,
or vice versa.
• Such interaction may alter the impact of
the original policy change.

slide 44
The Fed’s response to G > 0
• Suppose Congress increases G.
• Possible Fed responses:
1. hold M constant
2. hold r constant
3. hold Y constant
• In each case, the effects of the G
are different:

slide 45
Response 1: hold M constant
If Congress raises G, r
the IS curve shifts LM1
right
If Fed holds M r2
constant, then LM r1
curve doesn’t shift. IS2
Results: IS1
Y
Y  Y 2  Y1 Y1 Y2

r  r2  r1
slide 46
Response 2: hold r constant
If Congress raises G, r
the IS curve shifts LM1
right LM2

To keep r constant, r2
Fed increases M to r1
shift LM curve right. IS2
Results: IS1
Y
Y  Y 3  Y1 Y1 Y2 Y3

r  0
slide 47
Response 3: hold Y constant
If Congress raises G, r LM2
the IS curve shifts LM1
right
r3
To keep Y constant, r2
Fed reduces M to r1
shift LM curve left. IS2
Results: IS1
Y  0 Y
Y1 Y2
r  r3  r1

slide 48
IS-LM and Aggregate Demand

• So far, we’ve been using the IS-LM model

to analyze the short run, when the price
level is assumed fixed.
• However, a change in P would shift the
LM curve and therefore affect Y.
• The aggregate demand curve
(introduced in chap. 9 ) captures this
relationship between P and Y

slide 49
Deriving the AD curve

r LM(P2)
Intuition for slope LM(P1)
r2
of AD curve:
r1
P  (M/P )
IS
 LM shifts left Y2 Y1 Y
P
 r
P2
 I
P1
 Y
AD
Y2 Y1 Y
slide 50
Monetary policy and the AD curve

r LM(M1/P1)
The Fed can increase
r1 LM(M2/P1)
aggregate demand:
r2
M  LM shifts right
IS
 r
Y1 Y2 Y
 I P

 Y at each
P1
value of P
AD2
AD1
Y1 Y2 Y
slide 51
Fiscal policy and the AD curve

r LM
Expansionary fiscal policy
(G and/or T ) r2
increases agg. demand: r1 IS2
T  C IS1
 IS shifts right Y1 Y2 Y
P
 Y at each
value P1
of P
AD2
AD1
Y1 Y2 Y
slide 52