CHAPTER 11

Aggregate Demand I:
Building the IS -LM Model

MACROECONOMICS
The Great Depression caused many economists to question the
validity of classical economic theory (from Chapters 3-7). They
believed they needed a new model to explain such a pervasive
economic downturn and to suggest that government policies might
ease some of the economic hardship that society was experiencing.

In 1936, John Maynard Keynes wrote The General Theory of

Employment, Interest and Money. In it, he proposed a new way to
analyze the economy, which he presented as an alternative to
the classical theory.

Keynes proposed that low aggregate demand is responsible for the low
income and high unemployment that characterize economic downturns.
He criticized the notion that aggregate supply alone determines national
income.
 “Keynesian” means different things to different
people. It’s useful to think of the basic textbook
Keynesian model as an elaboration and extension
of the “classical theory”. Its variable velocity
of money and “sticky” prices reflects Keynes’s
belief that the Classical model’s shortcomings arose
from its overly-strict assumptions of constant
velocity and highly flexible wages and prices.

The model of aggregate demand (AD) can be split into two parts:
IS model of the “goods market” and the
LM model of the “money market”. “IS stands for Investment Saving,
Whereas LM stands for Liquidity Money.”
 The Keynesian Cross
• A simple closed economy model in which income is
determined by expenditure.
(due to J.M. Keynes)
• Notation:
I = planned investment
E = C + I + G = planned expenditure
Y = real GDP = actual expenditure
• Difference between actual & planned expenditure =
unplanned inventory investment
 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
Graphing planned expenditure
E
planned
expenditure
E =C +I +G

MPC
1

income, output, Y
Graphing the equilibrium condition
E
planned E =Y
expenditure

45º

income, output, Y
The equilibrium value of income
E
planned E =Y
expenditure
E =C +I +G

income, output, Y
Equilibrium
income
 An increase in government purchases
E
At Y1, 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 = Y1 Y E2 = Y 2
 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 Solve for Y :

on the left side of the
equals sign:  1 
Y     G
(1  MPC) Y  G  1  MPC 
 The government purchases multiplier
Definition: the increase in income resulting from a $1
increase in G.
In this model, the govt
Y 1
purchases multiplier equals 
G 1  MPC

Example: If MPC = 0.8, then

An increase in G
Y 1
  5 causes income to
G 1  0.8 increase 5 times
as much!
 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.
 An increase in taxes
E
Initially, the tax
increase reduces E =C1 +I +G
consumption, and E =C2 +I +G
therefore E:

C = MPC T At Y1, there is now

an unplanned
inventory buildup…
…so firms
reduce output,
and income falls Y
toward a new
E2 = Y2 Y E1 = Y1
equilibrium
 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

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

…is negative:
A tax increase reduces C,
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.
 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
 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
 Why the IS curve is negatively sloped

• 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.
 The IS curve and the loanable funds model

(a) The L.F. model (b) The IS curve

r S2 S1 r

r2 r2

r1 r1
I (r )
IS
S, I Y2 Y1 Y
 Fiscal Policy and the IS curve
• We can use the IS-LM model to see
how fiscal policy (G and T) affects
aggregate demand and output.
• Let’s start by using the Keynesian cross
to see how fiscal policy shifts the IS curve…
 Shifting the IS curve: G
E E =Y E =C +I (r )+G
At any value of r, G 1 2

 E  Y E =C +I (r1 )+G1
…so the IS curve
shifts to the right.

The horizontal Y1 Y2 Y
r
distance of the
IS shift equals r1

Y 
1
G Y
1 MPC IS1 IS2
Y1 Y2 Y
 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.
 Money supply
r
M P
s
The supply of interest
real money rate
balances
is fixed:

M P M P
s

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

M P
d
 L (r )

L (r )

M/P
M P
real money
balances
 Equilibrium
r
M P
s
The interest interest
rate adjusts rate
to equate the
supply and
demand for
money: r1

M P  L (r ) L (r )

M/P
M P
real money
balances
 How the Fed raises the interest rate
r
interest
To increase r, Fed rate
reduces M
r2

r1
L (r )

M/P
M2 M1 real money
P P balances
 Monetary Tightening & Rates, cont.
The effects of a monetary tightening
on nominal interest rates

short run long run

Quantity theory,
Liquidity preference
model Fisher effect
(Keynesian)
(Classical)

prices sticky flexible

prediction i > 0 i < 0

actual 8/1979: i = 10.4% 8/1979: i = 10.4%

outcome 4/1980: i = 15.8% 1/1983: i = 8.2%
 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 )
 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
 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.
 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
 The short-run equilibrium
The short-run equilibrium is the r
combination of r and Y that
LM
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
 The Big Picture
Keynesian IS
Cross curve
IS-LM
model Explanation
Theory of LM of short-run
Liquidity curve fluctuations
Preference
Agg.
demand
curve Model of
Agg.
Demand
Agg.
and Agg.
supply
Supply
curve
 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 AD-AS models together to
analyze the short-run and long-run effects of
shocks.
– use our models to learn about the
Great Depression.
 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. IScurve
– comes from Keynesian cross when planned investment
depends negatively on interest rate
– shows all combinations of r and Y
that equate planned expenditure with
actual expenditure on goods & services
 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 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.