NNACROECONON!CS ACROECONON!

CS
C H A P T E R
2007 Worth Publishers, all rights reserved
S!XTH ED!T!ON S!XTH ED!T!ON
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Slides by Ron Cronovich Slides by Ron Cronovich
NN. . CCRECORY RECORY NNANK!W ANK!W
Aggregate Demand !:
Building the !SLN Nodel

slide 1
CHAPTER 10 Aggregate Demand
!n this chapter, you will learn.
the $ curve, and its relation to
the Keynesian cross
the loanable funds model
the curve, and its relation to
the theory of liquidity preference
how the $- model determines income and
the interest rate in the short run when ! is fixed
slide 2
CHAPTER 10 Aggregate Demand
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
slide 3
CHAPTER 10 Aggregate Demand
Context
This chapter develops the $- model,
the basis of the aggregate demand curve.
We focus on the short run and assume the price
level is fixed (so, $#$ curve is horizontal).
This chapter (and chapter 11) focus on the
closed-economy case.
Chapter 12 presents the open-economy case.
slide 4
CHAPTER 10 Aggregate Demand
The Keynesian Cross
A simple closed economy model in which income
is determined by expenditure.
(due to J.. Keynes)
Notation:
! = planned investment
E = C ! C = planned expenditure
= real GDP = actual expenditure
Difference between actual & planned expenditure
= unplanned inventory investment
slide 5
CHAPTER 10 Aggregate Demand
Elements of the Keynesian Cross
( ) C C T
! !
, C C T T
( ) E C T ! C
E
consumption function:
for now, planned
investment is exogenous:
planned expenditure:
equilibrium condition:
govt policy variables:
actual expenditure = planned expenditure
slide 6
CHAPTER 10 Aggregate Demand
Craphing planned expenditure
income, output,
E
planned
expenditure
E C ! C
!
1
slide 7
CHAPTER 10 Aggregate Demand
Craphing the equilibrium condition
income, output,
E
planned
expenditure
E
45
slide 8
CHAPTER 10 Aggregate Demand
The equilibrium value of income
income, output,
E
planned
expenditure
E
E C ! C
Equilibrium
income
slide 9
CHAPTER 10 Aggregate Demand
An increase in government purchases

E
E C ! C
1
E

E C ! C
2
E

At

,
there is now an
unplanned drop
in inventory.
.so firms
increase output,
and income
rises toward a
new equilibrium.
C
slide 10
CHAPTER 10 Aggregate Demand
Solving for
C ! C
C ! C
MPC L C
C C
(1 MPC) L C
1
1 MPC

L

C
equilibrium condition
in changes
because ! exogenous
because C MPC
Collect terms with
on the left side of the
equals sign:
Solve for
slide 11
CHAPTER 10 Aggregate Demand
The government purchases multiplier
Example: f ! = 0.8, then
Definition: the increase in income resulting from a
$1 increase in .
n this model, the govt
purchases multiplier equals
1
1 MPC

C
1
5
1 0.8

C
An increase in
causes income to
increase 5 times
as much!
An increase in
causes income to
increase 5 times
as much!
slide 12
CHAPTER 10 Aggregate Demand
hy the multiplier is greater than 1
nitially, the increase in causes an equal increase
in = .
But
further
further
further
So the final impact on income is much bigger than
the initial .
slide 13
CHAPTER 10 Aggregate Demand
An increase in taxes

E
E C
2
! C
E

E C
1
! C
E

At

, there is now
an unplanned
inventory buildup.
.so firms
reduce output,
and income falls
toward a new
equilibrium
C NPC T
nitially, the tax
increase reduces
consumption, and
therefore :
slide 14
CHAPTER 10 Aggregate Demand
Solving for
C ! C

MPC L T
C
(1 MPC) MPC L L T
eq'm condition in
changes
! and C exogenous
Solving for
MPC
1 MPC

L

T
Final result:
slide 15
CHAPTER 10 Aggregate Demand
The tax multiplier
def: the change in income resulting from
a $1 increase in %:
MPC
1 MPC

T
0.8 0.8
4
1 0.8 0.2

T
f ! = 0.8, then the tax multiplier equals
slide 16
CHAPTER 10 Aggregate Demand
The tax multiplier
.is negative
A tax increase reduces ,
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 !) of a tax cut,
so the initial boost in spending from a tax cut is
smaller than from an equal increase in .
slide 17
CHAPTER 10 Aggregate Demand
Exercise:
Use a graph of the Keynesian cross
to show the effects of an increase in planned
investment on the equilibrium level of
income/output.
slide 18
CHAPTER 10 Aggregate Demand
The !S curve
def: a graph of all combinations of 7 and that
result in goods market equilibrium
i.e. actual expenditure (output)
= planned expenditure
The equation for the $ curve is:
( ) ( ) C T ! r C
slide 19
CHAPTER 10 Aggregate Demand

1
Deriving the !S curve
Gr !

E
r

E C ! r
1
C
E C ! r
2
C
r
1
r
2
E
!S
!
E

slide 20
CHAPTER 10 Aggregate Demand
hy the !S curve is negatively
sloped
A fall in the interest rate motivates firms to
increase investment spending, which drives up
total planned spending ().
To restore equilibrium in the goods market,
output (a.k.a. actual expenditure, )
must increase.
slide 21
CHAPTER 10 Aggregate Demand
The !S curve and the loanable funds
model
S !
r
!r
r
1
r
2
r

1
r
1
r
2
(a) The L.F. model (b) The $ curve

2
S

!S
slide 22
CHAPTER 10 Aggregate Demand
iscal Policy and the !S curve
We can use the $- model to see
how fiscal policy ( and %) affects
aggregate demand and output.
Let's start by using the Keynesian cross
to see how fiscal policy shifts the $ curve.
slide 23
CHAPTER 10 Aggregate Demand

1
Shifting the !S curve: C
At any value of 7,

E
r

E C ! r
1
C
1
E C ! r
1
C
2
r
1
E
!S

The horizontal
distance of the
$ shift equals
!S

.so the $ curve

C

slide 24
CHAPTER 10 Aggregate Demand
Exercise: Shifting the !S curve
Use the diagram of the Keynesian cross or
loanable funds model to show how an increase
in taxes shifts the $ curve.
slide 25
CHAPTER 10 Aggregate Demand
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.
slide 26
CHAPTER 10 Aggregate Demand
Noney supply
The supply of
real money
balances
is fixed:

s
N P N P
N/P
real money
balances
r
interest
rate

s
N P
N P
slide 27
CHAPTER 10 Aggregate Demand
Noney demand
Demand for
real money
balances:
N/P
real money
balances
r
interest
rate

s
N P
N P


d
N P L r
Lr
slide 28
CHAPTER 10 Aggregate Demand
Equilibrium
The interest
rate adjusts
to equate the
supply and
demand for
money:
N/P
real money
balances
r
interest
rate

s
N P
N P
N P L r
Lr
r
1
slide 29
CHAPTER 10 Aggregate Demand
How the ed raises the interest rate
To increase 7,
Fed reduces
N/P
real money
balances
r
interest
rate

N
P
Lr
r
1
r
2

N
P
slide 30
CHAPTER 10 Aggregate Demand
CASE STUD:
Nonetary Tightening S !nterest Rates
Late 1970s: 6 > 10%
Oct 1979: Fed Chairman Paul Volcker
announces that monetary policy
would aim to reduce inflation
Aug 1979-April 1980:
Fed reduces ! 8.0%
Jan 1983: 6 = 3.7%
ow do you think this policy change
would affect nominal interest rates?
ow do you think this policy change
would affect nominal interest rates?
Nonetary Tightening S Rates, cont.
< 0 > 0
8/1979: = 10.4%
1/1983: = 8.2%
8/1979: = 10.4%
4/1980: = 15.8%
flexible sticky
Quantity theory,
Fisher effect
(lassical)
Liquidity preference
(Keynesian)
prediction
actual
outcome
The effects of a monetary tightening
on nominaI interest rates
prices
model
long run short run
slide 32
CHAPTER 10 Aggregate Demand
The LN curve
Now let's put back into the money demand
function:
( , ) N P L r
The curve is a graph of all combinations of
7 and that equate the supply and demand for
real money balances.
The equation for the curve is:

d
N P L r ( , )
slide 33
CHAPTER 10 Aggregate Demand
Deriving the LN curve
N/P
r

N
P
Lr ,
1

r
1
r
2
r

1
r
1
Lr ,
2

r
2

2
LN
(a) The market for
real money balances
(b) The curve
slide 34
CHAPTER 10 Aggregate Demand
hy the LN 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 35
CHAPTER 10 Aggregate Demand
How N shifts the LN curve
N/P
r

N
P
Lr ,
1

r
1
r
2
r

1
r
1
r
2
LN
1
(a) The market for
real money balances
(b) The curve

N
P
LN
2
slide 36
CHAPTER 10 Aggregate Demand
Exercise: Shifting the LN 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
curve.
slide 37
CHAPTER 10 Aggregate Demand
The shortrun equilibrium
The short-run equilibrium is
the combination of 7 and
that simultaneously satisfies
the equilibrium conditions in
the goods & money markets:
( ) ( ) C T ! r C

r
( , ) N P L r
!S
LN
Equilibrium
interest
rate
Equilibrium
level of
income
slide 38
CHAPTER 10 Aggregate Demand
The Big Picture
Keynesian
Cross
Keynesian
Cross
Theory of
Liquidity
Preference
Theory of
Liquidity
Preference
$
curve
$
curve

curve

curve
$
model
$
model
Agg.
demand
curve
Agg.
demand
curve
Agg.
supply
curve
Agg.
supply
curve
Model of
Agg.
Demand
and Agg.
Supply
Model of
Agg.
Demand
and Agg.
Supply
Explanation
of short-run
fluctuations
Explanation
of short-run
fluctuations
slide 39
CHAPTER 10 Aggregate Demand
Preview of Chapter 11
n Chapter 11, we will
use the $ model to analyze the impact of
policies and shocks.
learn how the aggregate demand curve comes
from $.
use the $ and $ models together to
analyze the short-run and long-run effects of
shocks.
use our models to learn about the
Great Depression.
Chapter Summary 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. $ curve
comes from Keynesian cross when planned
investment depends negatively on interest rate
shows all combinations of 7 and
that equate planned expenditure with
actual expenditure on goods & services
CHAPTER 10 Aggregate Demand
slide 40
Chapter Summary 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. curve
comes from liquidity preference theory when
money demand depends positively on income
shows all combinations of 7 and that equate
demand for real money balances with supply
CHAPTER 10 Aggregate Demand
slide 41
Chapter Summary Chapter Summary
5. $ model
ntersection of $ and curves shows the unique
point (, 7 ) that satisfies equilibrium in both the
goods and money markets.
CHAPTER 10 Aggregate Demand
slide 42