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7/31/2019 Chap10(Agg Demand I)0
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CHAPTER 10 Aggregate Demand I slide 1
Context
Chapter 9 introduced the model of aggregatedemand 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
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CHAPTER 10 Aggregate Demand I slide 2
Context
This chapter develops the IS-LMmodel,the theory that yields the aggregate demandcurve.
We focus on the short run and assume the
price level is fixed.
This chapter (and chapter 11) focus on theclosed-economy case. Chapter 12 presents
the open-economy case.
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CHAPTER 10 Aggregate Demand I slide 3
The Keynesian Cross
A simple closed economy model in whichincome is determined by expenditure.(due to J.M. Keynes)
Notation:
I = plannedinvestment
E = C + I + G = planned expenditure
Y = real GDP = actual expenditure
Difference between actual & plannedexpenditure: unplanned inventory investment
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CHAPTER 10 Aggregate Demand I slide 4
Elements of the Keynesian Cross
( )C C Y T
I I
,G G T T
( )E C Y T I G
Actual expenditure Planned expenditure
Y E
consumption function:
for now, plannedinvestment is exogenous:
planned expenditure:
Equilibrium condition:
govt policy variables:
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CHAPTER 10 Aggregate Demand I slide 5
Graphing planned expenditure
income, output,Y
Eplannedexpenditure
E=C+I+G
MPC1
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CHAPTER 10 Aggregate Demand I slide 6
Graphing the equilibrium condition
income, output,Y
Eplannedexpenditure
E=Y
45
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CHAPTER 10 Aggregate Demand I slide 7
The equilibrium value of income
income, output,Y
Eplannedexpenditure
E=Y
E=C+I+G
Equilibrium
income
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CHAPTER 10 Aggregate Demand I slide 8
An increase in government purchases
Y
E
E=C+I+G1
E1 = Y1
E=C+I+G2
E2 = Y2Y
At Y1,
there is now an
unplanned drop
in inventory
so firms
increase output,
and income
rises toward a
new equilibrium
G
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CHAPTER 10 Aggregate Demand I slide 9
Solving for Y
Y C I G Y C I G
MPC Y G
C G
(1 MPC) Y G
1
1 MPCY G
equilibrium conditionin changes
because I exogenous
because C= MPC Y
Collect terms with Y
on the left side of theequals sign:
Finally, solve for Y:
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CHAPTER 10 Aggregate Demand I slide 10
The government purchases multiplier
Example: If MPC = 0.8, then
Definition: the increase in income resultingfrom a $1 increase in G.
In this model, the govt purchasesmultiplier equals 1
1 MPC
Y
G
1 51 0.8
YG
An increase in Gcauses income to
increase by 5 times
as much!
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CHAPTER 10 Aggregate Demand I slide 11
Why the multiplier is greater than 1
Initially, the increase in G causes an equalincrease in Y: Y= G.
But Y C
further Y further C
further Y
So the final impact on income is muchbigger than the initial G.
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CHAPTER 10 Aggregate Demand I slide 12
An increase in taxes
Y
E
E=C2+I+G
E2 = Y2
E=C1+I+G
E1 = Y1Y
At Y1, there is now
an unplanned
inventory buildupso firms
reduce output,and income falls
toward a new
equilibrium
C= MPC T
Initially, the tax
increase reduces
consumption, and
therefore E:
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CHAPTER 10 Aggregate Demand I slide 13
Solving for Y
Y C I G
MPC Y T
C
(1 MPC) MPCY T
eqm condition inchanges
I and G exogenous
Solving for Y:
MPC
1 MPCY T
Final result:
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CHAPTER 10 Aggregate Demand I slide 14
The Tax Multiplier
def: the change in income resulting froma $1 increase in T:
MPC
1 MPC
Y
T
0 8 0 8 41 0 8 0 2
. .. .
YT
If MPC = 0.8, then the tax multiplier equals
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CHAPTER 10 Aggregate Demand I slide 15
The Tax Multiplier
is negative:A tax hike reducesconsumer spending,which reduces income.
is greater than one(in absolute value):A change in taxes has amultiplier 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 issmaller than from an equal increase in G.
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CHAPTER 10 Aggregate Demand I slide 16
Exercise:
Use a graph of the Keynesian Crossto show the impact of an increase in
planned investment on the equilibrium
level of income/output.
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CHAPTER 10 Aggregate Demand I slide 17
The IScurve
def: a graph of all combinations ofr and Ythat 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
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CHAPTER 10 Aggregate Demand I slide 18
Y2Y1
Y2Y1
Deriving the IScurve
r I
Y
E
r
Y
E=C+I(r1)+GE=C+I(r2)+G
r1
r2
E=Y
IS
IE
Y
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CHAPTER 10 Aggregate Demand I slide 19
Why the IScurve is negatively sloped
A fall in the interest rate motivates firms toincrease 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.
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CHAPTER 10 Aggregate Demand I slide 20
The IS curve and the Loanable Funds model
S, I
r
I(r )
r1
r2
r
YY1
r1
r2
(a) The L.F. model (b) The IS curve
Y2
S1S2
IS
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CHAPTER 10 Aggregate Demand I slide 21
Fiscal Policy and the IScurve
We can use the IS-LMmodel to seehow fiscal policy (G and T) can affectaggregate demand and output.
Lets start by using the Keynesian Crossto see how fiscal policy shifts the IScurve
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CHAPTER 10 Aggregate Demand I slide 22
Y2Y1
Y2Y1
Shifting the IScurve: G
At any value ofr,G E Y
Y
E
r
Y
E=C+I(r1)+G1E=C+I(r1)+G2
r1
E=Y
IS1
The horizontal
distance of the
IS shift equals
IS2
so the IS curve
shifts to the right.
1
1 MPCY G
Y
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CHAPTER 10 Aggregate Demand I slide 23
Exercise: Shifting the IS curve
Use the diagram of the Keynesian Crossor Loanable Funds model to show how
an increase in taxes shifts the IS curve.
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CHAPTER 10 Aggregate Demand I slide 24
The Theory of Liquidity Preference
due to John Maynard Keynes.
A simple theory in which the interest rateis determined by money supply and
money demand.
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CHAPTER 10 Aggregate Demand I slide 25
Money Supply
The supply ofreal money
balances
is fixed:
s
M P M P
M/Preal money
balances
rinterest
rate
sM P
M P
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CHAPTER 10 Aggregate Demand I slide 26
Money Demand
Demand forreal money
balances:
M/Preal money
balances
rinterest
rate
sM P
M P
( )d
M P L r
L(r)
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CHAPTER 10 Aggregate Demand I slide 27
Equilibrium
The interestrate adjusts
to equate the
supply and
demand formoney:
M/Preal money
balances
rinterest
rate
sM P
M P
( )M P L r L(r)
r1
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CHAPTER 10 Aggregate Demand I slide 28
How the Fed raises the interest rate
To increase r,
Fed reduces M
M/Preal money
balances
rinterest
rate
1M
P
L(r)
r1
r2
2M
P
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CHAPTER 10 Aggregate Demand I slide 29
CASE STUDY
Volckers Monetary Tightening
Late 1970s:
> 10% Oct 1979: Fed Chairman Paul Volcker
announced that monetary policy
would aim to reduce inflation.
Aug 1979-April 1980:
Fed reduces M/P 8.0%
Jan 1983: = 3.7%
How do you think this policy changewould affect interest rates?
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CHAPTER 10 Aggregate Demand I slide 30
Volckers Monetary Tightening, cont.
i < 0i > 0
1/1983: i= 8.2%8/1979: i= 10.4%
4/1980: i= 15.8%
flexiblesticky
Quantity Theory,
Fisher Effect(Classical)
Liquidity Preference
(Keynesian)
prediction
actualoutcome
The effects of a monetary tightening
on nominal interest rates
prices
model
long runshort run
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CHAPTER 10 Aggregate Demand I slide 31
The LM curve
Now lets put Y back into the money demandfunction:
( , )M P L r Y
The LMcurve 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:
d
M P L r Y ( , )
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CHAPTER 10 Aggregate Demand I slide 32
Deriving the LM curve
M/P
r
1M
P
L(r,Y1)
r1
r2
r
YY1
r1
L(r,Y2)
r2
Y2
LM
(a) The market forreal money balances(b) The LM curve
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CHAPTER 10 Aggregate Demand I slide 33
Why the LMcurve is upward-sloping
An increase in income raises moneydemand.
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.
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CHAPTER 10 Aggregate Demand I slide 34
How M shifts the LM curve
M/P
r
1M
P
L
(r
,
Y1
)
r1
r2
r
YY1
r1
r2LM1
(a) The market forreal money balances(b) The LM curve
2M
P
LM2
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CHAPTER 10 Aggregate Demand I slide 35
Exercise: Shifting the LM curve
Suppose a wave of credit card fraudcauses consumers to use cash more
frequently in transactions.
Use the Liquidity Preference modelto show how these events shift the
LMcurve.
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CHAPTER 10 Aggregate Demand I slide 36
The short-run equilibrium
The short-run equilibrium isthe combination ofr and Y
that simultaneously satisfies
the equilibrium conditions in
the goods & money markets:
( ) ( )Y C Y T I r G
Y
r
( , )M P L r Y
IS
LM
Equilibrium
interest
rate
Equilibrium
level of
income
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CHAPTER 10 Aggregate Demand I slide 37
The Big Picture
KeynesianCross
Theory of
Liquidity
Preference
IScurve
LM
curve
IS-LM
model
Agg.
demand
curve
Agg.
supply
curve
Model of
Agg.
Demandand Agg.
Supply
Explanation
of short-run
fluctuations
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CHAPTER 10 Aggregate Demand I slide 38
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 ofr and Ythat equate planned expenditure with
actual expenditure on goods & services
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CHAPTER 10 Aggregate Demand I slide 39
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. LMcurve
comes from Liquidity Preference Theory when
money demand depends positively on income shows all combinations ofr andY that equate
demand for real money balances with supply
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CHAPTER 10 Aggregate Demand I slide 40
Chapter summary
5. IS-LMmodel
Intersection ofISand LMcurves shows the
unique point (Y, r) that satisfies equilibrium
in both the goods and money markets.
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CHAPTER 10 A D d I
Preview of Chapter 11
In Chapter 11, we will use the IS-LMmodel to analyze the impact
of policies and shocks
learn how the aggregate demand curve
comes from IS-LM
use the IS-LMandAD-ASmodels togetherto analyze the short-run and long-run
effects of shocks use our models to learn about
the Great Depression