Part 1: Introduction to Aggregate Demand

This video is the first in a set of four explaining the Hicks-Hansel model of Keynes' theory of Aggregate Demand,
specifically the IS-LM interpretation. This model is very important to short run macroeconomics and attempts to explain
shifts in the aggregate demand curve and what determines national income for any price level
This video reviews the components of aggregate demand, income, the consumption function. taxes, finding equilibrium
in this short run model, and the factors affecting the slope and position of the aggregate demand curve. The second
video covers the IS curve, regarding the goods market, the third video covers the LM curve regarding the money
market and the final video puts the two together to find equilibrium in both markets
Components

We begin our discussion of Aggregate Demand by looking at its components and their symbols. You will likely be
familiar with the concept of Aggregate Demand, the total demand for all finished goods in the economy. It is usually
broken down into the demand for the following factors:
C for Consumption, I for Investment, G for Government Spending and NX for Net Exports. Some textbooks break it
down into exports and imports but net exports is simply exports minus imports.
Initially we will only consider changes in consumption, making investment, government spending and net
exports exogenous to our model which we designate by putting a horizontal bar over top of them.
Consumption Function

To begin we're going to look at how consumption is related to income. We're going to break down consumption into its
separate components. Beginning with autonomous consumption. This is the base level of consumption. In this model,
consumption cannot fall below autonomous consumption, regardless of what people are making as income. Next we
have disposable income. This is the "after tax" income. Although "disposable income" is commonly used as the money
you have remaining after you've paid your rent and bills, that's now what it means in economic terms. Disposable
income is multiplied by the coefficient c, the "marginal propensity to consume". This tells us how much consumption
increases for every $1 increase in income. The MPC coefficient can be between zero and one.

Consumption Function Graph

Graphically, the consumption function displays the relationship between consumption and disposable
income. Consumption, the dependent variable, is on the Y-axis. Disposable income, the independent variable, is on the
X-axis. The level of autonomous consumption determines the Y-intercept. As you recall, this is the level of consumption
when disposable income is zero. Marginal propensity to consume determines the slope of this curve. As disposable

income increases from left to right it is modified by the MPC. A high MPC of 0.9 would lead to a steep curve. A
lower MPC would mean a more gradual slope.
Income

Now we're going to take a closer look at disposable income. This is an aggregate measure of all the income paid to
households plus government transfers (such as welfare of social security) minus income taxes. As it's presented here,
government transfers and taxes do not change relative to our dependent variable, income. Again, this is shown by the
horizontal bar above the two exogenous variables.
Generally income taxes are some percentage of income. Although it's not that simple in practice, in this model we're
going to think of taxes as flat rate, denoted by the lower case t. The coefficient could be any number between zero,
meaning no tax, and one, meaning all income would be paid in taxes. This is then multiplied by income.
Now that our disposable income has taxes incorporated into it, we're going to plug it back into the consumption
function.
Taxes

Here is the consumption function as previously shown. Disposable income is now replaced with tax-rate formula. Some
simple algebraic factoring will clean up this formula. The terms with Income in them are grouped together, leaving the
transfer payments to be multiplied by MPC. To simplify the bottom term, Y is taken out the bracket, leaving one
minus taxes, all multiplied by MPC. Putting it all together we have the updated consumption function that includes
income tax. Consumption = autonomous consumption + transfer payments + MPC x (1- taxes ) xincome.
Aggregate Demand Equation

Next incorporate this updated consumption function into the aggregate demand equation. The first step is to separate
the factors into exogenous, and endogenous. Exogenous demand is represented by A-bar. Investment, government
spending and net exports are exogenous because they aren't affected by national income in this model, so their value
won't change when income changes. These factors will be grouped at the bottom under A-bar. When we substitute the
consumption function in for C we can see that there are some exogenous variables, such as exogenous consumption
and transfer payments. These can be grouped down below with the other external factors. We can bring two groups
together with the simplified A-bar to represent all of the exogenous factors and the c(1-t)Y representing the determining
factors.
Equilibrium Output

In this model, aggregate supply is equal to income at any point in time. Therefore, supply=demand when aggregate
demand= income. When we have aggregate demand on the y axis and income on the x-axis, equilibrium is reached at

any point on the 45 angle, where the values for both axis are equal.
The aggregate demand curve starts out on Y-axis at a value equal to the exogenous demand (A bar) and then
continues upward with increasing levels of income. Equilibrium occurs when the two lines intersect, this indicates the
equilibrium income and equilibrium level of aggregate demand.
Change in MPC

Moving forward we are going to see how equilibrium changes in reaction to a change in the Marginal Propensity to
Consume. If a country becomes more inclined to spend their disposable income, their MPC is larger. An increase in
the marginal propensity to consume creates a steeper aggregate demand curve. The point of origin is the same, but
steeper line crosses the equilibrium line at a higher point. This results in larger equilibrium values for aggregate
demand and national income.
Change in Tax Rate
If there is a change tax rate, say from 30% to 50%, the
slope will be more gradual, resulting in lower
equilibrium levels of aggregate demand and national
income.

Change in Exogenous Demand

A change in Exogenous Demand would result from a change in any of the following, autonomous consumption,
transfer payments, investment, government spending, or net exports. If there was an increase in any of these
components, the entire aggregate demand curve would shift up. This leads to higher equilibrium values for aggregate
demand and national income. Note that the slope remains unchanged in this scenario.
This concludes the introduction on Aggregate Demand. Please watch the second video, which explains how to find
equilibrium in the goods market

Part 2: IS Curve
This video is the second in a set of four explaining the Hicks-Hansel model of Keynes' theory of Aggregate Demand,
specifically the IS-LM interpretation. This model is very important to short run macroeconomics and attempts to explain
shifts in the aggregate demand curve. These topics are usually taught in an intermediate Macroeconomics class, and
these videos are intended as a visual aid to further your understanding of the models.This video covers the investment
demand curve, integrates investment into the aggregate demand curve, introduces the IS-curve and provides an

overview of the factors that determine the slope and position of the IS curve. If you did not view the introductory video,
you can find ithere
The I - S stands for Investment and Saving and the IS curve displays the equilibrium in the goods and service market
for various interest rates.
Investment

To begin we revisit the aggregate demand equation. While investment was previously considered to be exogenous,
we're going to see how it relates to interest rate, so it becomes endogenous and loses the bar above the variable.
There is, however, still a portion of investment that is unaffected by interest rate. It is represented by "I-bar" and called
exogenous investment. Next we have interest rate, represented by "i". And as you see by the minus sign, investment is
negatively related to the interest rate. The degree to which firms adjust investment spending relative to the interest rate
is called interest sensitivity which is represented by "b". This coefficient will be anywhere between zero and one.
Investment Curve

Now we'll examine this relationship graphically. Investment is on the x-axis and interest rate is on the y-axis. Typically
the independent variable (in this case, investment) is put on the Y-axis, but we will be using interest rate as the
independent variable when we graph the IS curve, so it's put here now for consistency.
Exogenous investment determines the initial level. Again, a higher interest rate results in lower investment spending. A
high interest rate means firms reduce their investment spending to avoid high interest payments. A low interest rate
means firms can increase their capital spending and pay relatively low interest.
Slope & Position
The slope of the investment curve is determined by the
interest sensitivity coefficient. A high interest sensitivity
results in a more gradual slope. In this case, there is a
drastic increase in investment spending in reaction to a
relatively small reduction in the interest rate, because
of the higher sensitivity.

The position of the curve is determined by the exogenous investment. An increase would result in an outward shift of
the curve.

Incorporated Investment into the Aggregate Demand Equation

Now we're going to incorporate this investment function into the aggregate demand equation. Recall in the first
video we separated the components into exogenous and endogenous to arrive at this formula. Investment was
previously grouped with the exogenous components, but our new formula has endogenous as well as exogenous
components. The "I-bar" will go back into the exogenous group, while the interest and sensitivity coefficient move to
the back of the equation.
Review: AD for aggregate demand. A-bar for exogenous demand, lower case c is the marginal propensity to consume.
lower case t for tax rate, Y for income, lower case b for interest sensitivity and i for interest rate. You will notice that all
of the lower case variables are rates between zero and one.
Aggregate Demand Curve with Investment
We're going to display this function graphically, and just
as before the 45 degree line where aggregate demand
= income is our equilibrium criteria. Here is upward
sloping demand function. Higher levels of national
income lead to higher levels of aggregate demand. The
y-intercept is given by exogenous demand minus
interest rate * sensitivity. The intersection of the lines
gives us the equilibrium level of national income.

Reduction in Interest Rate

A reduction in the interest rate results in an upward
shift in the aggregate demand curve. This results in a
higher equilibrium level of national income. So the
interest rate went down and the equilibrium income
went up.

Increase in Interest Sensitivity

An increase in interest sensitivity results in a downward
shift in both aggregate demand curves. The downward
shift is more pronounced for the curve with the higher
interest rate (i-1). This means that the distance
between the two resulting equilibrium levels of income
is larger.

IS Curve
Now we can move on to the IS Curve, which denotes
the equilibrium levels of national income for different
interest rates. Just as we did in the previous slide, we
will be graphing the aggregate demand curve for
different interest rates in the top graph. The bottom
graph also has income on it's x-axis and will show the
different interest rates.

Here is the curve for interest rate #1. The equilibrium level of income is the same for both graphs. When we put interest
rate #1 on our bottom graph we have the first point of our IS curve. The second aggregate demand curve has a lower
interest rate, so its parallel and higher up. On the lower graph the intersection of interest rate #2 and equilibrium
income #2 produce the second point of the IS curve. This could be repeated for every different interest rate in this
range to produce the IS curve. Since this model only uses linear curves, we need a minimum of two points to graph the
IS curve. There you have it, at any point on this IS curve the goods & services market is in equilibrium.
Slope of IS Curve - Interest Sensitivity
Now we're going to discuss the determinants of the IS
curve's slope. Holding other factors constant, an
increase in interest sensitivity will result in a more
gradually sloped IS curve. b prime will signify the new,
higher level of interest sensitivity. Lets watch how this
happens. For i-1, the higher interest rate, the
downward shift is more prominent and produces a low
equilibrium level of national income, Y* 3. For i 2, the
lower interest rate, there is a downward shift, but not as
big. When we connect the points to form the second IS
curve we see that it's slope is more gradual.

Slope of IS Curve - MPC

Another determinant of the IS curve's slope is the

marginal propensity to consume. As we saw in the
introductory video, An increase in the MPC creates a
steeper aggregate demand curve. c prime will

represent the higher MPC. When we graph the steeper

aggregate demand curves it becomes apparent that
the second IS curve is more gradual as a result of the
increased MPC.

Slope of IS Curve - Tax Rate

The last determinant of slope is the tax rate. An
increase in the tax rate reduces the slope of the
aggregate demand curve. t prime will represent the
higher tax rate. The flatter aggregate demand curves
produce an IS curve that is steeper as a result of the
increase tax rate.

Position of IS Curve - Exogenous Demand

Moving on to the position of the IS curve, an increase
in exogenous demand results in an upward shift of the
aggregate demand curve. 'A' bar prime will represent
the higher level of exogenous demand. The higher
aggregate demand curves produce an IS curve that is
shifted outward as a result of the increase in
exogenous demand.
This concludes the video on the IS curve. We covered
the investment demand curve, integrated investment
into the aggregate demand curve, introduced the IS
curve and looked at the determinants of its slope and
position.

Part 3: LM Curve
The LM curve is used to determined equilibrium in the money market. The L stands for liquidity and M for Money. The
video covers the demand for money, the supply of money, the LM curve, the factors affecting its slope and position and
finally the algebraic formula for the curve.
Demand for Money

Demand for real money is represented by the letter 'L'. Real money is adjusted for inflation, so this indicates the actual
purchasing power of money. The amount of demand depends on income, because that determines the amount people
have to spend and it depends on the interest rate because money can be put to better use if it is invested. As the
minus sign indicates, the higher the interest rate, the more inclined people are to invest their money rather than having
it available to spend.
These two variables are moderated by sensitivity coefficients: the income sensitivity of demand for real money and the
interest sensitivity of demand for real money. Both of these have a value greater than zero.
Demand for Money Graph

Now we're going to examine this relationship graphically. Interest rate, the independent variable, goes on the Y-axis
because its going to be relating to the LM graph, which as interest rate on the same axis. Demand for money, the
dependent variable, goes on the X-axis. As the interest rate decreases, the demand for money increases, which gives
us the downward sloping demand for money curve.
An increase in the national income results in an upward and outward shift of the demand for money curve. The amount
of shift depends on the increase in income as well as the income sensitivity of demand for money.
Increase in Interest Sensitivity of Demand for Money

An increase in the interest sensitivity for real money reduces the slope of the demand for money curve. The original h
value is low because a large drop in interest rate is required to increase the demand for money.

h' is higher, meaning the interest sensitivity is higher. The slope is less steep which means a relatively small decrease
in interest rate causes a large increase in the demand for money.
Money Supply

Now that we've covered the demand for money, we're going to introduce the supply of real money. This is composed
of the nominal money supply, the number value of all the cash balances in a country. In this model the amount of
money is set by the central bank and therefore exogenous. This value is divided by price level, the correction for
inflation. Since this model is applied to the very short run, inflation is not a factor so the price level is exogenous. This
calculation produces the real money supply.
Represented graphically, the money supply is a vertical line. In the very short run it is fixed. This graph shows two
demand for money curves for different levels on national income. The intersection of the demand for money curves and
the money supply line indicate the equilibrium rates of interest, i1 and i2.

LM Curve

We're ready for the LM curve. On the left we have the money demand/money supply graph. The LM curve will be
graphed in the interest, income space on the left. The vertical money supply line is already showing. Here is the
demand for money curve for Y1. The point at which it crosses the money supply line produces the first equilibrium rate
of interest, i1. This line is extended to the LM space and creates our first point as it intersects with Y1. This is repeated
for a higher level of national income, Y2. This produces the second equilibrium rate of interest, i2. We extend this line
across to the LM space and it intersects with Y2. These two sampled points are all we need to draw the LM curve. It
denotes the levels of national income and interest rates that allow the money market to be in equilibrium.

Slope of the LM Curve

Now we're going to examine the determinants of the LM curve's slope. Here we have the original LM curve. We're
going to increase the income sensitivity of demand for real money, k. When we graph the new demand for money

curves on the left they have shifted upward. Because k' is a coefficient of Y, the upward shift for Y2 will be even more
pronounced. When the new equilibrium interest rates i3 and i4 are extended over to the LM space we can see that the
slope of the LM curve has increased.

In this example the initial demand for money curves are relatively flat. We're going to decrease the interest sensitivity of
demand for real money. The curves produced with the lower h' indicate that it would take a relatively large decrease in
interest rate to produce a dramatic increase in the demand for money. When the lines are drawn for both our sample
income levels we see that the resulting LM curve's slope has increased.
***Correction: In the video I read this as income sensitivity but it should be interest sensitivity***

Position of LM

As for the position of the LM curve, this is determined by the real money supply. An increase shifts the money supply
line outward. The resulting equilibrium interest rates are lower. This results in a downward shift of the LM curve.
Algebraic Relationship

Now that we've gone through the relationship graphically, we're going to examine this equilibrium condition
algebraically. Here is the demand for real balances formula. Equilibrium is reached when supply equals demand so we
will substitute real money supply in for L. We want to solve this equation for 'i' because it is the dependent variable in
the LM curve. We bring 'h i' over to the left side of the equation and move the money supply to the right side. We divide
both sides by h', the interest sensitivity of demand for money. It cancels out on the left side and stays on the right side.
And here is the formula for the LM curve. This will give you the equilibrium interest rates for different levels of national
income, Y.
Slope of LM Curve

The slope of the LM curve is the coefficient of Y, k over h, or the income sensitivity of demand for real money over the
interest sensitivity of demand for real money. This ratio is important for monetary policy.
That concludes the video on the LM curve. It covered the demand for money, the supply of money, the LM curve, the
factors affecting its slope and position and then the formula behind it. Please watch the next video regarding the
interaction of I
Goods Market

This section covers the finding simultaneous equilibrium in the goods market and the money market by combining the
IS and LM curves. This leads to a method for deriving the Aggregate Demand curve. This model is also used to
anticipate the economy's response to fiscal and monetary policy.
This slide displays the goods and services market on the top right hand side. The money market is on the left.
First, in the goods market, the horizontal line is the equilibrium condition and the aggregate demand equation extends
upward. The equilibrium interest rate and level of income are extended down to derive the IS curve. The higher interest
rate results in a higher equilibrium income. Connecting these points creates the IS Curve.
In the money market, on the left, the real money supply is the grey vertical line. When the demand for money curve
crosses it the equilibrium interest rate is found. For a higher level of national income (Y2), the equilibrium interest rate
is higher, these points create the LM curve.
The intersection of the IS and LM curves denotes the equilibrium level of interest and income that will have both
markets in simultaneous equilibrium.
Money Market

In the money market, on the left, the real money supply is the grey vertical line. When the demand for money curve
crosses it the equilibrium interest rate is found. For a higher level of national income (Y2), the equilibrium interest rate
is higher, these points create the LM curve.
Simultaneous Equilibrium

The intersection of the IS and LM curves denotes the equilibrium level of interest and income that will have both
markets in simultaneous equilibrium.
Deriving the Aggregate Demand Curve

From this information we can derive the aggregate demand curve in the Price/Income graph on the top right. This is
done by finding the IS-LM equilibrium for different price levels. Price levels are in the real money supply equation that
is represented by the grey vertical bar. By drawing LM curves for different price levels, we can produce enough points
in the P/Y space to derive the aggregate demand curve.
The LM curve is drawn for the first price level, producing the first point at the intersection of P1 and the resulting
equilibrium level of national income.

A reduction the price level increases the real money supply because people can buy more with the money they
have. The lower price level shifts the money supply line outward. This causes the LM curve to shift down and the
equilibrium income (Y2) to be further to the right. Where this line intersects with P2, the second point of the Aggregate
demand curve is drawn. This process could be repeated again to produce an even higher level of equilibrium with
lower prices. By connecting these points the downward sloping demand curve is formed.
Monetary Policy

Now for the reactions of the markets to a change in monetary policy. If the central bank increases the money supply
(M) the real money supply line shifts outward and the LM curve shifts outward accordingly.
Here is the LM curve being formed for M1, a low supply of money. This forms the first point of equilibrium at i1 and Y1.
When the central bank increases the money supply to M2 the LM curve shifts down.

The immediate result is that the interest rate drops from its original equilibrium to the intersection of Y1 and the lower
LM curve. This is based on the assumption that the money markets adjust quickly. At this point the money market is in
balance because the point is on the LM curve, but the interest rate is too low for the goods market to be in equilibrium.
At this position there is an excessive demand for goods so output and income start to increase. The Money market
adjusts quickly to the increased income: an increase in income increases the demand for money and in turn increases
the interest rate. This plays out as the point of equilibrium moves up the LM curve until it reaches the IS curve. At this
point the interest rate and Income stabilize and the economy reaches equilibrium. So the end result of the policy of
increasing the money supply lower interest rates and a higher level of national income.
Fiscal Policy

Fiscal policy takes the form of government spending. The two red aggregate demand functions contain exogenous
demand, of which government spending is a factor. Here the IS curve is derived using the first value of exogenous

demand. Equilibrium income and interest rate are found.

By increasing government spending the red aggregate demand curves are shifted upward. The resulting IS2 is shifted
outward. The money market quickly responds and a new point of equilibrium is reached at i2 and Y2. So by increasing
government spending, the equilibrium level of national income has risen and the interest rate has also risen.