CHAPTER TEN

Aggregate Demand I

macroeconomics

fifth edition

N. Gregory Mankiw

PowerPoint ® Slides by Ron Cronovich

© 2002 Worth Publishers, all rights reserved

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 is negatively related to output

CHAPTER 10

Aggregate Demand I slide 2

Context

 This chapter develops the curve. IS-LM model, the theory that yields the aggregate demand  We focus on the short run and assume the price level is fixed.

CHAPTER 10

Aggregate Demand I slide 3

The Keynesian Cross

 A simple closed economy model in which income is determined by expenditure. (due to J.M. Keynes)  Notation:

I

= planned

E Y

=

C

+

I

investment +

G

= planned expenditure = real GDP = actual expenditure  Difference between actual & planned expenditure: unplanned inventory investment

CHAPTER 10

Aggregate Demand I slide 4

Elements of the Keynesian Cross

consumption function: govt policy variables: for now, investment is exogenous: planned expenditure: Equilibrium condition:

E



, I



I ) ) CHAPTER 10 Y



E

Aggregate Demand I slide 5

Graphing planned expenditure

E

planned expenditure

E

=

C

+

I

+

G

1 MPC income, output,

Y CHAPTER 10

Aggregate Demand I slide 6

Graphing the equilibrium condition

E

planned expenditure

E

=

Y

45 º income, output,

Y CHAPTER 10

Aggregate Demand I slide 7

The equilibrium value of income

E

planned expenditure

E

=

Y E

=

C

+

I

+

G CHAPTER 10

Equilibrium income Aggregate Demand I income, output,

Y

slide 8

An increase in government purchases E

At

Y

1 , there is now an unplanned drop in inventory…

E

=

C

+

I

+

G 2 E

=

C

+

I

+

G 1



G

…so firms increase output, and income rises toward a new equilibrium

E

1 =

Y

1 

Y E

2 =

Y

2

Y CHAPTER 10

Aggregate Demand I slide 9

Solving for



Y

Y



C



I



G



Y

  

C

MPC  

I

 

G Y G

 

G

equilibrium condition in changes because

I

exogenous because 

C

= MPC 

Y

Collect terms with  on the left side of the equals sign:

Y G

 Finally, solve for 

Y

:

Y

   1    

G CHAPTER 10

Aggregate Demand I slide 10

The government purchases multiplier

Example: MPC = 0.8 

Y

 1 

G

 1 

G

 1 

G

 5 

G

The increase in

G

causes income to increase by 5 times as much!

CHAPTER 10

Aggregate Demand I slide 11

The government purchases multiplier

Definition: the increase in income resulting from a $1 increase in

G

.

In this model, the

G

 

Y G

 multiplier equals 1 In the example with MPC = 0.8,  

Y G

 1  5

CHAPTER 10

Aggregate Demand I slide 12

Why the multiplier is greater than 1

 Initially, the increase in increase in Y: 

Y

=

G



G

.

causes an equal  But 

Y

 

C

 further 

Y

 further 

C

 further 

Y

 So the final impact on income is much bigger than the initial 

G

.

CHAPTER 10

Aggregate Demand I slide 13

An increase in taxes E

Initially, the tax increase reduces consumption, and therefore

E

:

E

=

C 1

+

I

+

G E

=

C 2

+

I

+

G



C

=  MPC 

T

At

Y

1 , there is now an unplanned inventory buildup… …so firms reduce output, and income falls toward a new equilibrium

E

2 =

Y

2 

Y E

1 =

Y

1

Y CHAPTER 10

Aggregate Demand I slide 14



Y

 

C

 MPC

Solving for



Y

I G

eq’m condition in changes

I

and

G

exogenous 

T

 Solving for 

Y

: 

Y

  MPC  

T

Final result: 

Y

    MPC    

T CHAPTER 10

Aggregate Demand I slide 15

The Tax Multiplier

def: the change in income resulting from a $1 increase in

T

:  

Y T

  MPC If MPC = 0.8, then the tax multiplier equals  

Y T

      4

CHAPTER 10

Aggregate Demand I slide 16

The Tax Multiplier

…is negative : An increase in taxes reduces consumer spending, which reduces equilibrium income.

…is greater than one income. ( in absolute value ) : A change in taxes has a multiplier effect on …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 slide 18

Exercise:

 Use a graph of the Keynesian Cross to show the impact of an increase in investment on the equilibrium level of income/output.

CHAPTER 10

Aggregate Demand I slide 19

The IS curve

def: a graph of all combinations of

r

and that result in goods market equilibrium,

Y

i.e.

actual expenditure (output) = planned expenditure The equation for the IS curve is:

Y



)

 

G CHAPTER 10

Aggregate Demand I slide 20



r

 

I

 

E

 

Y

Deriving the IS curve

E E

=

Y E

=

C

+

I

(

r 2

)+

G E

=

C

+

I

(

r 1

)+

G



I r r 1 Y 1 Y 2 Y r 2 Y 1 Y 2

IS

Y CHAPTER 10

Aggregate Demand I slide 21

Understanding the IS curve’s slope

 The IS curve is negatively sloped.  Intuition: A fall in the interest rate motivates firms to increase investment spending, which drives up total planned spending (

E

). To restore equilibrium in the goods market, output (a.k.a. actual expenditure,

Y

) must increase.

CHAPTER 10

Aggregate Demand I slide 22

The IS curve and the Loanable Funds model r

(a) The L.F. model

S

2

S

1

r

(b) The IS curve

r 2 r 1 r 2 r 1 I

(

r

)

S

,

I CHAPTER 10

Aggregate Demand I

Y 2 Y 1

IS

Y

slide 23

Fiscal Policy and the IS curve

 We can use the IS-LM how fiscal policy (

G

model to see and

T

) can affect aggregate demand and output.  Let’s start by using the Keynesian Cross to see how fiscal policy shifts the curve… IS

CHAPTER 10

Aggregate Demand I slide 24

Shifting the IS curve:



G

At any value of

r

, 

G

 

E

 

Y

…so the IS curve shifts to the right.

E E

=

Y E

=

C

+

I

(

r 1

)+

G 2 E

=

C

+

I

(

r 1

)+

G 1

The horizontal distance of the IS shift equals 1 

G r r 1 Y 1 Y 1



Y Y 2 Y 2

IS 1

Y

IS 2

Y CHAPTER 10

Aggregate Demand I slide 25

Exercise: Shifting the IS curve

 Use the diagram of the Keynesian Cross or Loanable Funds model to show how an increase in taxes shifts the IS curve.

CHAPTER 10

Aggregate Demand I slide 26

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 slide 27

Money Supply

The supply of real money balances is fixed: 

M P



s



M P

interest rate

r



M P



s CHAPTER 10

Aggregate Demand I

M P M/P

real money balances slide 28

The LM curve

Now let’s put

Y

function: back into the money demand 

M P



d

 The

LM Y curve

is a graph of all combinations of

r

and that equate the supply and demand for real money balances.

The equation for the LM curve is:

M P



CHAPTER 10

Aggregate Demand I slide 34

Deriving the LM curve

r

(a) The market for real money balances

r 2 r 1 r 2 L

(

r , Y 2

)

r 1 M

1

P L

(

r , Y 1

)

M/P CHAPTER 10

Aggregate Demand I

r

(b) The LM curve

LM Y 1 Y 2 Y

slide 35

Understanding the LM curve’s slope

 The LM curve is positively sloped.  Intuition: 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 slide 36

How



M

shifts the LM curve

r

(a) The market for real money balances

r 2 r

(b) The LM curve

LM 2 LM 1 r 2 r 1 L

(

r , Y 1

)

r 1 M

2

P CHAPTER 10 M

1

P M/P

Aggregate Demand I

Y 1 Y

slide 37

Exercise: 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.

CHAPTER 10

Aggregate Demand I slide 38

The short-run equilibrium

The short-run equilibrium is the combination of

r

and

Y

that simultaneously satisfies the equilibrium conditions in the goods & money markets:

Y



M P



)

 

G

Equilibrium interest rate

r LM IS Y

Equilibrium level of income

CHAPTER 10

Aggregate Demand I slide 39

The Big Picture

Keynesian Cross Theory of Liquidity Preference

IS

curve

LM

curve

IS-LM

model Agg. demand curve Agg. supply curve

CHAPTER 10

Aggregate Demand I Model of Agg. Demand and Agg. Supply Explanation of short-run fluctuations slide 40

Chapter summary

1.

Keynesian Cross  basic model of income determination   takes fiscal policy & investment as exogenous fiscal policy has a multiplied impact on income.

2.

IS   curve comes from Keynesian Cross when planned investment depends negatively on interest rate shows all combinations of

r

and equate planned expenditure with actual expenditure on goods & services

Y

that

CHAPTER 10

Aggregate Demand I slide 41

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 10

Aggregate Demand I slide 42

Chapter summary

5.

IS-LM  model Intersection of IS and LM curves shows the unique point (

Y

,

r

) that satisfies equilibrium in both the goods and money markets.

CHAPTER 10

Aggregate Demand I slide 43

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 to analyze the short-run and long-run effects of shocks AD-AS models together learn about the Great Depression using our models

CHAPTER 10

Aggregate Demand I slide 44

CHAPTER 10

Aggregate Demand I slide 45