Beruflich Dokumente
Kultur Dokumente
AND AGGREGATE
DEMAND
C H A P T E R 8
S pending balance, as discussed in the last chapter, involves finding the level
of GDP that makes the spending plans of consumers and others consistent
with their actual levels of income. In this chapter, we complete the discussion
of spending balance by bringing in another key variable, the interest rate.
Spending depends on the interest rate because of the sensitivity of investment
and net exports to the interest rate. To tell the full story of the interest rate, we
have to consider the money market. We introduce the IS-LM framework to
help develop the story. The IS-LM framework combines the money market
and the spending process. We use the IS-LM approach in the rest of the book
to describe the determination of output and interest rates in the short run. At
189
190 CHAPTER 8 Financial Markets and Aggregate Demand
the end of this chapter, we use the IS-LM framework to derive the aggregate
demand curve.
I e dR. (8.1)
As before, I is investment, R is the interest rate, and e and d are constants. In-
vestment is measured in billions of dollars, and the interest rate is measured in
8.1 Investment and the Interest Rate 191
I 1,000 2,000 R.
5 10 15 20
INTEREST RATE (R ) (%)
When the interest rate is 5 percent, investment I is
1,000 2,000(0.05), or $900 billion. An increase in
the interest rate of 1 percent reduces investment by FIGURE 8.1 THE INVESTMENT FUNCTION
$20 billion. Note that we speak about the interest rate When the interest rate rises, the demand for investment
falls. A higher interest rate means that the cost of funds re-
R as a percent, but use decimals in algebraic formulas: quired for investment is higher; only those investment pro-
“The interest rate is 5 percent” means R 0.05. This jects that are particularly profitable are undertaken.
convention is used throughout the book.
windows to indicate what they will pay for different types of deposits. The
real interest rate corrects the nominal rate for expected changes in the price
level. Specifically, the real interest rate is the nominal interest rate minus the
expected rate of inflation. For example, if your bank is paying 10 percent on
deposits for a year and you expect inflation to be 6 percent for the year, then
the real rate of interest for you is 4 percent. The real rate of interest mea-
sures how much you earn on your deposit after taking account of the fact
that inflation increases the price of goods that you might purchase in a year.
We usually mean the real interest rate when we use the symbol R in this
book, but we do not generally add the adjective real, unless the meaning is
ambiguous or we want to point out a particular reason to distinguish be-
tween the real and the nominal rates. For low rates of inflation, the real rate
and the nominal rate are very close.
term to the net export function of Equation 7.7 to incorporate the negative ef-
fect of the interest rate R on net exports:
X g mY nR. (8.2)
The new coefficient n measures the decrease in net exports that occurs when
the interest rate rises by 1 percentage point.
EX AMPLE Suppose g is 525, m is 0.1, and n is 500. Then the net export func-
tion is
1. People want to hold less money when the interest rate is high and, con-
versely, hold more money when the interest rate is low. This means that
there is a negative relation between the demand for money and the inter-
est rate R. People hold money for transactions purposes, to pay daily ex-
penses and monthly bills. But they could obtain higher earnings by
keeping their wealth in other forms, such as savings accounts or bonds.
Currency pays no interest. And, even though many checking deposits pay
interest, the rate is less than on other forms of wealth. Because of this,
people tend to economize on the use of money for transaction purposes. A
common way to do this is to go to the ATM or bank more often to with-
draw money from a high-interest savings account to obtain currency, or
simply to transfer funds to a lower-interest checking account. With more
frequent trips, a smaller amount can be withdrawn each time from savings
accounts. This means that, on average, a smaller amount of currency or
194 CHAPTER 8 Financial Markets and Aggregate Demand
checking balances are held by the individual. For example, you could go to
the ATM every week, rather than every month, to obtain currency and
thereby hold a smaller amount of currency on average.
How much economizing occurs depends on the interest rate. The inter-
est rate R represents how much a consumer or firm could earn by holding
more wealth in forms that pay full interest instead of in currency, which
pays no interest, or checking deposits, which pay less than full interest.
Clearly, the more that can be earned by holding those other forms—the
higher R is—the less money an individual or firm wants to hold.
2. People want to hold more money when income is higher and, conversely,
less money when income is lower. The more a family receives as income,
the more the family normally spends, and the more money the family
needs for transaction purposes. When income increases, the transaction de-
mand for money increases. More money is needed to buy and sell goods.
This means that there is a positive relationship between income Y and
the demand for money. As income in the economy increases, on average,
each family’s income increases and the demand for money in the entire
economy increases.
3. People want to hold more money when the price level is higher and, con-
versely, less money when the price level is lower. If the price level rises,
people need more dollars to carry out their transactions, even if their real
income does not increase. At a higher price level, goods and services are
more expensive; more currency is needed to pay for them and checks are
written for larger amounts. This means that the demand for money is an
increasing function of the price level.
To summarize these three basic ideas, the demand for money depends
negatively on the interest rate R, positively on income Y, and positively on
the price level P. An algebraic relationship that summarizes the effect of
these three variables on the demand for money is presented in the following
equation:
1
Note that the appropriate interest rate for the money demand function is the nominal rate.
Most alternatives to holding currency, such as bonds, pay a nominal interest rate. To keep our
analysis simple, we place the real interest rate R in the money demand function. If inflation is
low, this is a very good approximation.
8.3 Demand and Supply of Money 195
EX AMPLE If k equals 0.1583 and h equals 1,000, then Equation 8.3 looks
like this:
M (0.1583Y 1,000R)P.
If income Y is $6,000 billion, the interest rate is 5 percent (R 0.05), and the
price level P is 1, then the demand for money equals $900 billion. An increase
in income of $10 billion increases the demand for money by $1.583 billion. An
increase in the interest rate of 1 percentage point decreases the demand for
money by $10 billion.
2. The demand for money falls if the interest rate rises, income falls, or the
price level falls.
Predetermined Variable:
Price level P
The IS and LM curves are convenient ways to describe the solution to the
problem.
In the short-run model, we take the price level as given or predetermined.
Five economic relationships must be considered: the income identity, the con-
sumption function, the investment demand function, the net export function,
and the money demand function. The theory implies that all five relationships
must hold at the same time.
The analysis proceeds as follows: We take as given the values for the variables
determined outside our model in any year, for example, 2005. These are the ex-
ogenous variables: the money supply M and government spending G. They are
determined by the Federal Reserve, the President, and Congress. We want to find
values for income, consumption, investment, net exports, the interest rate, and
the price level that are implied by the model and by the values of the money sup-
ply and government spending for that year. We also want to find out what hap-
pens if the money supply or government spending changes. Will interest rates and
output rise or fall, and by how much? The economic relationships and the key
macroeconomic variables are summarized in the box on key macro relationships.
Suppose that P 1. Then the five macro relationships determine values
for the five remaining endogenous variables. The situation is analogous to that
in Chapter 7 where we had to find values for two variables to satisfy two rela-
tionships. We first use graphs and then algebra.
Because graphs allow for only two variables, we need to reduce the five re-
lationships to two relationships. A way to do this was originally proposed in
1937 by J. R. Hicks, the British economist who won the Nobel Prize in 1972.
Hick’s graphical approach, called the IS-LM approach, is still used widely
today because of its great intuitive appeal.2
The IS Curve
The IS curve is shown in Figure 8.2. The IS curve shows all the combinations of
the interest rate R and income Y that satisfy the income identity, the consumption
function, the investment function, and the net export function. In other words, it is
the set of points for which spending balance occurs. The left-hand panel of Fig-
ure 8.2 shows how higher levels of the interest rate are associated with lower
levels of GDP along the IS curve.
SLOPE The first thing to remember about the IS curve is that it slopes down-
ward. Understanding the intuitive economic reason for this downward slope is
very important. The IS curve slopes downward because a higher interest rate reduces
2
See J. R. Hicks, “Mr. Keynes and the Classics: A Suggested Interpretation,” Econometrica, Vol. 6
(1937), pp. 147–159. The IS curve gets its name because, when all relationships are satisfied,
investment demand, I, must equal income less consumption demand, or saving, S. The M in
the LM curve stands for the money supply and the L stands for liquidity preference, which is a
synonym for money demand. (Money is more liquid—easier to exchange for goods and other
items—than bonds or corporate stock.)
198 CHAPTER 8 Financial Markets and Aggregate Demand
1
Government spending increases by ∆G
10 10
2
9 IS curve shifts
8 to right by
1
7 --–––––––––––––––– ∆G
1 – b (1 – t ) + m
6
5 5
IS curve
4
New
3 IS
2 Old
1 IS
5,800 5,900 6,000 6,100 6,200 5,800 5,900 6,000 6,100 6,200
GDP (Y ) GDP (Y )
investment and net exports and thereby reduces GDP through the multiplier
process. To find a specific point on the IS curve, choose an interest rate and cal-
culate how much investment and net exports result using the investment func-
tion and the export function. The higher is the rate of interest, the lower the
level of investment and net exports. Pass this level of spending through the
multiplier process to find out how much GDP results. The less there are of
both, the less GDP. The interest rate and this level of GDP are a point on the
IS curve. A self-contained explicit graphical derivation of the IS curve is shown
in Figure 8.3
SHIF TS The second thing to remember about the IS curve is that an increase
in government spending shifts the IS curve to the right. An increase in government
spending increases GDP through the multiplier; as GDP increases, we move
the IS curve to the right. Note that, conversely, a decrease in government
spending pushes the IS curve to the left.
To find how much the IS curve shifts, pick an interest rate R and calculate
a corresponding level of investment and net exports. Now increase government
spending. Through the multiplier process, output increases by the multiplier
times the increase in government spending. Holding the interest rate constant,
the IS curve shifts to the right along the horizontal GDP axis by the amount of
8.4 The IS Curve and the LM Curve 199
SPENDING
45-degree line
1
5,800 GDP is reduced by --–––––––––––––––– (d + n ) ∆R
1 – b (1 – t ) + m
New 7
interest
rate 6.2
∆R Step 5 Draw a line through
Old
5 the dots to see the IS curve
interest
rate
4
Step 1 Mark
new and old 3 IS curve
interest rates
2
New level Old level
1 of GDP of GDP
RE SE AR CH IN PRACTICE
The Stock Market
the multiplier times the increase in government spending. This is shown in the
right-hand panel of Figure 8.2.
The LM Curve
The LM curve is shown in Figure 8.4. The LM curve shows all combinations of
the interest rate R and income Y that satisfy the money demand relationship for a
fixed level of the money supply and a predetermined value of the price level. The
left-hand panel of Figure 8.4 shows that higher levels of the interest rate are
associated with higher levels of GDP along the LM curve.
SLOPE The first thing to remember about the LM curve is that it slopes up-
ward. The reason for this is somewhat involved, but important to keep in
mind. Imagine that the interest rate increases. What must happen to income if
money demand is to remain equal to money supply? An increase in the inter-
est rate R reduces the demand for money. But the money supply is fixed.
Hence, income must adjust to bring money demand back up. A rise in income
is what is required. A rise in income increases the demand for money and off-
sets the decline in money demand brought about by the rise in the interest
rate. In sum, the increase in the interest rate is associated with an increase in
income. Therefore, the LM curve slopes upward.
To understand better the derivation of the LM curve, it is helpful to recall
the concept of real money introduced in Chapter 1. Real money is defined as
5,800 5,900 6,000 6,100 6,200 5,800 5,900 6,000 6,100 6,200
GDP (Y ) GDP (Y )
the money supply M divided by the price level P. Because the term real money
is used so much in macroeconomics, we sometimes use the term nominal
money when we mean just plain money M. Real money M/P is a convenient
measure of money that corrects for changes in the price level. For example, if
the money supply increases by 10 percent and the price level increases by 10
percent, then real money does not change. The money demand function from
Equation 8.3 can be written in terms of real money if we simply divide both
sides by the price level. That is,
This says that the demand for real money depends positively on real GDP and
negatively on the interest rate. The real money demand equation is an attrac-
tive way to think about money demand because it depends on two rather than
three variables. Looking at Equation 8.4, we see that real money demand con-
sists of two parts: one part, kY, increases with income, while the other part,
hR, decreases with the interest rate. Of course the same economic principles
apply whether we write the money demand function in terms of real money or
nominal money.
Looking at Equation 8.4, we see clearly why the LM curve slopes up. If the
Fed holds nominal money constant and the price level does not move, then the
real money supply is also constant. If the real money supply is constant, then
an increase in the interest rate R, which reduces money demand by hR, must
be offset by an increase in Y, which increases money demand by kY. Hence,
when the interest rate R increases, income Y increases.
A self-contained graphical derivation of the LM curve, based on this line of
reasoning, is shown in Figure 8.5. The left-hand panel of Figure 8.5 is a graph
of the demand for real money as a function of the interest rate. Real money de-
mand decreases with the interest rate. But note that an increase in GDP in-
creases money demand and this shifts the money demand line to the right. If
money demand is to stay equal to money supply, then the interest rate must
increase, as shown in the diagram.
SHIF TS The second thing to remember about the LM curve is that an in-
crease in the money supply shifts the LM curve to the right. Conversely, a decrease
in the money supply shifts the LM curve to the left. Looking again at Equation
8.4, we can get an economic understanding for this. An increase in the money
supply increases the variable on the left-hand side, M/P. If money demand is to
remain equal to money supply, then either output Y must rise or the interest
rate R must fall. If we hold the interest on the LM diagram at a particular
value, then output Y must increase as the LM curve shifts to the right. This is
shown in the right-hand panel of Figure 8.4.
Changes in the price level also shift the LM curve. Again, look at the sym-
bols in Equation 8.4 to keep track of what is going on. An increase in the price
level reduces real balances. Hence, an increase in the price level does exactly
the same thing to the LM curve as a decrease in the money supply. An increase
8.4 The IS Curve and the LM Curve 203
in the price level shifts the LM curve to the left. The rationale is this: An increase
in the price level means that less real money is available for transactions pur-
poses. This means that either the interest rate must rise or real income must
fall to reduce money demand. Either way the LM curve shifts to the left. Con-
versely, a decrease in the price level shifts the LM curve to the right, just like
an increase in the money supply.
Note that the right-hand side is just the consumption function plus the invest-
ment function plus the net export function plus government spending. We
want to express the IS curve as an equation giving the value of R that gives
spending balance at a specified level of Y. We solve Equation 8.5 for R by mov-
ing the R term to the left-hand side and dividing by d n:
a e g 1 b(1 t) m 1
R Y G. IS Curve (8.6)
dn dn dn
Government spending G increases the interest rate for a given level of income.
Graphically, this looks like a shift of the IS curve to the right, a result that we
saw in Figure 8.2. A higher value of G raises the IS curve or, equivalently, shifts
the IS curve to the right.
The coefficient
1 b(1 t) m
dn
that multiplies Y in Equation 8.6 is the slope of the IS curve. Note that the
slope of the IS curve depends on the sensitivity of investment to the interest
rate, represented by the coefficient d. The algebraic formula shows that the
slope of the IS curve is small—this means that the IS curve is fairly flat—if
investment is very responsive to the interest rate. Then, small changes in the
interest rate result in large changes in investment and hence large fluctua-
tions in GDP. Similarly, the IS curve is flat if net exports are highly sensitive
to the interest rate, that is, if the coefficient n is large. What matters is the
sum of the two interest-rate coefficients, d n. Note that the IS curve is flat
if the marginal propensity to consume b is large, if the tax rate t is small, or if
the marginal propensity to import m is small. In these cases, the multiplier is
large and changes in the interest rate have large effects on GDP.
1,745 1 0.53 1
R Y G
2,500 2,500 2,500
or
The slope of the IS curve is 0.000188: Along the IS curve, when GDP rises
by $100 billion, the interest rate falls by 1.88 percentage points. The IS curve
that appears in Figure 8.2 is drawn accurately to scale for this numerical exam-
ple. The IS curve on the left is drawn for government spending G equal to
8.4 The IS Curve and the LM Curve 205
$1,200 billion. The shift in the IS curve to the right in Figure 8.2 is due to an
increase in government spending of $40 billion.
The algebraic expression for the LM curve is obtained simply by moving R
to the left-hand side of the money demand equation (8.3) and dividing by the
coefficient h. That is,
k 1M
R Y . LM Curve (8.8)
h h P
Equation 8.8 says that an increase in real money balances M/P lowers the in-
terest rate for a given level of income. This means that the LM curve shifts to
the right, a result that corresponds to the graph in Figure 8.4. The slope of the
LM curve is k/h. Note that the slope of the LM curve k/h is small—meaning
that the LM curve is fairly flat—if the sensitivity of money demand to the in-
terest rate is large, that is, if the coefficient h is large. Then, a small decline in
the interest rate raises the demand for money by a large amount and requires a
large offsetting increase in income. The small change in the interest rate com-
bined with the large change in income trace out a flat LM curve. Note also that
the LM curve is flat if the sensitivity of money demand to income k is small.
0.1583 1 M
R Y
1.000 1,000 P
or
M
R 0.0001583Y 0.001 . Numerical Example of LM Curve (8.9)
P
This LM curve is drawn to scale in Figure 8.4. The shift of the LM curve for an
initial money stock of 900 in the right-hand side of Figure 8.4 corresponds to
an increase in the money supply of $40 billion.
5,800 5,900 6,000 6,100 6,200 5,800 5,900 6,000 6,100 6,200
GDP (Y ) GDP (Y )
Old level New level Old level New level
of GDP of GDP of GDP of GDP
people demand. This makes the interest rate fall, so the demand for money in-
creases. The lower interest rate then stimulates investment and net exports;
this raises GDP through the multiplier process. In sum, GDP rises and the in-
terest rate falls.
Fiscal Policy
Suppose Congress passes a bill that increases defense spending. This is an ex-
ample of fiscal policy, the use of tax rates and government spending to influ-
ence the economy. We now know that an increase in government spending
pushes the IS curve to the right. Figure 8.7 shows what happens to interest
rates and GDP. In the right-hand panel, an increase in government spending in-
creases the interest rate and increases income.
What goes on in the economy when the government purchases more
goods? First, the increase in government demand increases GDP through the
multiplier. But the increase in GDP increases the demand for money: More
money is needed for transactions purposes. Since the Fed does not change
the money supply, we know that interest rates must rise to offset the increase
208 CHAPTER 8 Financial Markets and Aggregate Demand
in money demand that came from the increase in GDP. This increase in the
interest rate reduces investment demand and net exports, offsetting some of
the stimulus to GDP caused by government spending. The offsetting nega-
tive effect is called crowding out.
M
Y 2,015 2.887 1.155G. (8.10)
P
rates rise and crowd out investment and net exports. As for monetary policy, if
the price level is 1, then an increase in the money supply of $1 billion increases
GDP by $2.887 billion.
3. These are short-run results with the price level predetermined. When the
time frame is lengthened in the next chapter, so that the price level can
adjust, these results will have to be modified.
Old AD
.8 .8
5,700 5,900 6,100 6,300 6,500 5,700 5,900 6,100 6,300 6,500
GDP (Y ) GDP (Y )
3
IS
2 GDP
Step 3 Reduce GDP to the
new IS-LM intersection
falls
1
PRICE LEVEL (P )
Now suppose that the price level rises. The LM curve shifts to the left; this
raises the interest rate, lowers investment and net exports, and ultimately low-
ers GDP. Therefore, a higher price level reduces GDP because it increases the
demand for money. The increase in demand causes interest rates to rise and
GDP to fall. The different values for the price level and GDP constitute the
aggregate demand curve.
2. The two economic principles governing the aggregate demand curve are
spending balance and the equality of the demand and supply of money.
3. The aggregate demand curve slopes downward. A higher price level means
that real money balances are lower and therefore the real interest rate is
higher. This means that investment, net exports, and GDP are lower.
Determination of Output
Figure 8.10 shows how aggregate demand determines output at a predeter-
mined price. The aggregate demand curve is the same one derived in the previ-
ous section. The predetermined price is shown by the horizontal line drawn at
P0. GDP is determined by the point of intersection of the aggregate demand
curve and the flat predetermined-price line.
Shifts in the aggregate demand curve—caused perhaps by changes in the
money supply or government spending—result in increases or decreases in out-
put. A rightward shift in the aggregate demand curve results in an expansion of
output; a leftward shift in the aggregate demand curve results in a contraction
of output.
P0 P0
Aggregate
demand New AD
curve Old AD
Y* Y*
P0 P0
Aggregate
Aggregate
demand curve
demand curve
Output Output
below above
potential potential
The price level inherited from last year, when combined with the aggre-
gate demand curve, determines the level of output this year. Output can be
below potential output. Then, we observe unemployment and other unused
resources. Or output can exceed potential output. These two possibilities are
shown in Figure 8.11, where we superimpose the vertical potential GDP line
to indicate potential. In the left-hand panel of Figure 8.11, output is below po-
tential. In the right-hand panel, output is above potential.
Although the price level does not change immediately when firms find
themselves producing above or below equilibrium, there is an incentive to
move back to equilibrium, as we discussed in Chapter 7. The incentive is to
lower prices when output is below potential and raise prices when output is
above potential. A price cut raises output and a price increase lowers output,
so these moves take the firm and the economy back toward equilibrium.
These adjustments lead to a changed price level for the next year or
period—not this year. For example, if output is above potential in the year
2011, then the price level will be higher in 2012. When the aggregate demand
curve is drawn to determine output for the year 2012, the predetermined price
is drawn at a higher level. If the intersection of the aggregate demand curve for
the year 2012 and this new price line is still not at an output level equal to po-
tential, then there is a further adjustment in prices, but this does not occur
until the year 2013. The process continues this way until aggregate demand
equals potential output, at which point the desire for firms to adjust their
prices no longer is present. How the process converges depends on the explicit
price-adjustment process, which we consider in the next chapter.
214 CHAPTER 8 Financial Markets and Aggregate Demand
Determination of Unemployment
We noted in Chapter 3 that Okun’s law establishes a close relation between
real GDP and unemployment. When an adverse shock shifts the aggregate de-
mand curve inward, real GDP falls. Figure 8.12 starts with that shift and shows
how it generates an increase in unemployment as well. From the decline in real
GDP, the lower left-hand diagram converts it into a change in the percentage
deviation of GDP from potential, (Y Y*)/Y*. Then, the right-hand part of
the diagram computes the resulting increase in unemployment by applying
Okun’s law.
A number of important mechanisms are at work in the process described
in Figure 8.12. If GDP declines, employers need a smaller amount of labor
input. They cut the length of the workweek, reduce the intensity of work,
and cut the size of the workforce. Most workers who are laid off become un-
employed. In addition, people who are looking for work find it harder to lo-
PRICE
1
The AD curve
shifts inward
2
Y declines
from Y * to Y '
AD
AD '
Y' Y* GDP
cate jobs. Because of the importance of hours reductions and the common
pattern of retaining workers during temporary declines in demand (called
labor hoarding), a 3 percent decline in GDP is associated with only a 1 per-
centage point increase in unemployment. This close negative relation is one
of the most reliable generalizations that macroeconomists have found.
Whenever some force causes GDP to decline, you can be confident that un-
employment will rise.
3. In the short run, output can be below or above its potential level.
4. Okun’s Law describes the relation between real GDP and unemployment.
2. Net exports also depend negatively on the interest rate. A higher interest
rate attracts capital from other countries; this drives up the exchange rate
and lowers net exports.
3. The IS-LM model determines output, the interest rate, and each of the
spending components in the short run. It does not require that the econ-
omy operate at its long-run equilibrium.
4. The IS curve shows the level of GDP that brings spending balance for
each interest rate. It slopes downward.
5. The LM curve shows the interest rate that brings equality of supply and
demand in the money market for each level of GDP. It slopes upward.
6. The IS-LM model answers questions about the effect of policy over the
period when it is reasonable to consider prices fixed. Monetary expansion
216 CHAPTER 8 Financial Markets and Aggregate Demand
raises output and lowers the interest rate. Fiscal expansion raises output
and raises the interest rate.
7. The intersection of the IS and LM curves tells the levels of GDP and the
interest rate for a given price level and fiscal-monetary policies. It corre-
sponds to a point on the aggregate demand schedule.
8. The aggregate demand curve shows all combinations of GDP and the price
level that satisfy spending balance and money market equilibrium for
given fiscal and monetary policies. Fiscal and monetary expansions shift
the aggregate demand curve out.
2. What are the determinants of the demand for money? For each one, trace
out what happens if it changes.
4. What is the difference between the nominal interest rate and the real in-
terest rate?
Problems
NUMERIC AL
1. This problem pertains to the numerical example in the box on key macro
relationships. Set the price level equal to 1.
a. Use the algebraic form of the aggregate demand curve to find the leval
of GDP that occurs when the money supply is $900 billion and gov-
ernment spending is $1,200 billion.
b. Use the IS curve and the LM curve to find the interest rate that occurs
in this situation. Explain why you get the same answer in each case.
d. Show that the sum of your answers for consumption, investment, gov-
ernment spending, and net exports equals GDP.
2. For savings and budget deficits, the problem pertains to the numerical ex-
ample in the box on macro relationships and uses the answers to problem 1.
a. What is the slope of each IS curve? Explain in words why the second
IS curve is flatter.
b. Derive the aggregate demand curve in each case. Which has a larger
coefficient for M/P?
218 CHAPTER 8 Financial Markets and Aggregate Demand
4. Compare the LM curve in the numerical example on page 000 with the
LM curve you get by increasing the coefficient h to 2,000.
a. What is the slope of each LM curve? Explain why the slopes are different.
b. Derive the aggregate demand curve in each case. Which has a larger
coefficient for M/P?
5. Using the numerical example of the chapter, calculate values for the
money supply and government spending that increase GDP from $6,000
billion to $6,100 billion without changing the interest rate at all.
a. Sketch the IS curve and the LM curve for the year 1999 on a diagram
and show the point where the interest rate and output are deter-
mined. Show what happens in the diagram if the money supply is in-
creased above 900 in 1999.
b. Sketch the aggregate demand curve. Show what happens in the dia-
gram if the money supply is decreased below 900 in 1999.
d. What are the values of output and the interest rate in 1999 when the
money supply is 900?
ANALYTIC AL
1. Higher interest rates reduce investment and increase foreign saving. What
then must happen to the combination of private and government saving
after a rise in interest rates? If neither private nor government saving de-
pends directly on the interest rate, how can this change come about?
3. Suppose that money demand depended only on income and not on inter-
est rates.
c. Show the same thing algebraically. Explain why the LM equation be-
comes the aggregate demand equation.
4. Show how the IS curve and the LM curve can be shifted to get an increase
in output without a change in interest rates. What kind of mix of mone-
tary and fiscal policy is needed to do this? Will a reduction in interest rates,
while holding output constant, do this?
5. Suppose that two administrations, one Democratic and the other Republi-
can, both use fiscal and monetary policy to keep output at its potential
level, but the Democratic administration raises more in taxes and main-
tains a larger money supply than the Republican administration.
a. On a single graph, show how the IS and LM curves of these two ad-
ministrations differ.
b. Indicate whether the following variables are higher under the Demo-
cratic or Republican administration or whether they are unchanged:
consumption, investment, net exports, government saving, and private
saving.