CHAPTER 10: AGGREGATE DEMAND I: BUILDING THE IS-LM MODEL 1 Harit Lalia

Overview:
The classical theory could not explain the Great depression Classical theory implies that national income depends on factor supplies and the available technology During the depression, the factor (capital, labor) supplies not the available technology changed, but the national income decreased dramatically John Maynard Keynes proposed a new theory where he established that low aggregate demand is responsible the low income and high unemployment that characterize economic downturns. Economists today combined Keynes theory and the classical theory to explain change in national income In the long run, prices are flexible and aggregate supply determines income. In the short run, prices are sticky, so the changes in aggregate demand influence income The IS-LM model is the leading interpretation of Keynes theory. The model shows what determines national income at a given price level The IS-LM model can be interpreted in 2 ways, but both are essentially the same: IS-LM model can be used to show what causes income to change in the short run when price level is fixed. IS-LM model can also be used to show what causes aggregate demand curve to shift IS stands for investment and savings represents whats going on in the market of goods and services LM stands for liquidity and money represents whats happening to the supply and demand for money Because interest rates influence both investment and money demand, interest rates link the IS and LM curves together The IS-LM model shows how interactions between markets determine the position and slope of the aggregate demand curve and therefore the level of national income in the short run.

10-1 THE GOODS MARKET AND THE IS CURVE:

The IS curve plots the relationship between the interest rate and the level of income that arises in the market for goods and services To develop the model, look at the Keynesian Cross model

THE KEYNESIAN CROSS The General Theory that Keynes proposed was that an economys total income was, in the short run, determined largely by the desire to spend by households, firms, and the government So, the more people want to spend, the more a firm can sell. The more the firm can sell, the more it will choose to produce. The more it produces, the more workers it hires. According to Keynes, inadequate spending was the cause behind recessions and depressions

CHAPTER 10: AGGREGATE DEMAND I: BUILDING THE IS-LM MODEL 2 Harit Lalia Planned Expenditure To derive the Keynesian Cross, distinguish between actual and planned expenditure Actual expenditure is the amount households, firms and the government spend on goods and services which equals the GDP Planned expenditure is the amount households, firms and the government would like to spend on goods and services. Why would planned and actual expenditure differ? The firms might engage in unplanned inventory investment because their sales do not meet their expectations When firms sell less than planned, their stock of inventories rises When firms sell more than planned, their stock of inventories falls Because these unplanned changes in inventory are counted as investment spending by firms, the actual expenditure can be either above or below planned expenditure In this chapter, a closed economy is assumed. Thus, PE (Planned expenditure) is the sum of Consumption (C), planned investment (I) and government purchases (G) PE= C+I+G To this function, add the consumption function: C= C(Y-T) , consumption depends on disposable income (Y-T) PE= C(Y-T) +I+G This equation shows that planned expenditure is a function of income Y , the level of planned investment I and the fiscal policy variables G and T

CHAPTER 10: AGGREGATE DEMAND I: BUILDING THE IS-LM MODEL 3 Harit Lalia Planned expenditure depends on income because higher income leads to higher consumption, which is part of planned expenditure. The slope of this planned expenditure is marginal propensity to consume MPC- it shows how much planned expenditure increases when income rises by $1 Planned Expenditure is the first piece of the Keynesian Cross

The Economy in Equilibrium The next piece of the Keynesian Cross is the assumption that the economy is in equilibrium when actual expenditure equals planned expenditure This means that when people get what they want, they have no reason to change what theyre doing Recall, Y (GDP) is equal to total income as well as total actual expenditure on goods and services Actual Expenditure= Planned Expenditure Y= PE

At the 45- degree line, is where Y=PE

CHAPTER 10: AGGREGATE DEMAND I: BUILDING THE IS-LM MODEL 4 Harit Lalia KEYNESIAN CROSS

The equilibrium in the Keynesian Cross model is where Actual Expenditure equals Planned Expenditure How does the economy get to the equilibrium? Whenever he economy is not in equilibrium, firms experience unplanned changes in inventories and this induces them to change production levels Changes in production in turn influence total income and expenditure, moving the economy towards equilibrium So, for example, the economy is above the equilibrium level of GDP. In this case, firms planned expenditure is less than production, so firms are selling less than theyre producing. All the unsold goods than go into inventory which makes firm lay off workers and produce less. This reduces the GDP and over time, GDP falls to the equilibrium level. The opposite happens when GDP is below the equilibrium level

Fiscal Policy and the Multiplier: Government Purchases Government purchases are one component of expenditure in the economy, higher government purchases result in higher planned expenditure for any given level of income If government purchases rise by G, then the planned expenditure schedule shifts upward G. The equilibrium will also move up It is important to note that the increase in income Y is greater than the increase in G. Therefore, fiscal policy has a multiplied effect on income The ratio Y/G is called the government purchases multiplier- IT TELLS US HOW MUCH INCOME RISES IN RESPONSE TO A $1 change in government purchases

CHAPTER 10: AGGREGATE DEMAND I: BUILDING THE IS-LM MODEL 5 Harit Lalia Why does fiscal policy have a multiplied effect on income? According to the consumption function, C= C(Y-T), higher income causes higher consumption. Thus, an increase in government purchases raises income, consumption which then increases income, which again increases consumption and the trend continues (multiplier effect) How big is the multiplier? Initial Change in Government Purchases= G First Change in Consumption= MPC G Second Change in Consumption= MPC2 G Third Change in Consumption = MPC3Gand continues indefinitely The government purchases multiplier is: Y/G= 1+ MPC+ MPC2+ MPC3 The multiplier is: Multiply both sides by z: Subtract the second equation from the first: Rearrange z= 1+x+x2+x3+ xz= x+x2+ x3+ z-xz=1 z(1-x)=1