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MACROECONOMICS
Chapter 10
Aggregate Demand I:
Building the IS-LM Model
Can We Ignore Short Run?
In 1933, unemployment rate was 25% and
GDP was one-third below its 1929 level.
 Classics: supply creates its own demand.
 Keynes: aggregate demand fluctuates
independent of the supply.
 Classics: prices adjust fast.
 Keynes: prices are sticky.

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Expenditures
PE = C + I + G + NX
Leave NX for Ch. 12; NX=0
C = c(Y-T)
Consumption is determined by MPC times disposable income.
T, I, G are exogenous: values given outside of the model.
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Keynesian Cross
For the economy to
be in equilibrium
(the circular flow to
have top and bottom
flows matched) the
horizontal distance
has to equal to the
vertical distance.
The 45-degree line
represents Y=PE.
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Equilibrium in Keynesian Cross
Firms
Households
Review your circular
flow diagram: Ch. 2,
slide #5
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Multiplier: Response of Y to a
Change in Expenditure
Y  G  ( MPC )Y
Y G

 MPC
Y Y
G
1  MPC 
Y
Y
1

G 1  MPC
If ΔG=700 and MPC=0.33,
what is ΔY?
Y  G  G(MPC )  G(MPC )( MPC )  G(MPC ) 3  ...  G(MPC ) n
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Multiplier for a Tax Cut
Y  ( MPC )T  ( MPC )Y
Y T ( MPC )

 MPC
Y
Y
T ( MPC )
1  MPC 
Y
Y
MPC

T 1  MPC
Which fiscal policy gives
more bang for the buck?
Increasing government
expenditures or reducing
taxes?
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Derivation of IS Curve
PE  C  I  G
C  c(Y  T )
I  I (r )
Y  PE
G,T, and r are exogenous.
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Shifts in IS
What shifts Keynesian PE curve?
Any increase in the components of PE:
C, I, G.
Any decrease in taxes.
If real interest rate drops and PE shifts up,
what will happen to IS?
Movement along the IS!
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Monetary Sector and
Nominal Interest Rate
How does the
sector move
from the first
equilibrium to
the second?
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Derivation of the LM Curve
d
Demand for money (liquidity preference) increases with real income
M 
   L(r , Y ) but decreases with higher interest rates.
 P
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Shifts in LM
Money supply increases will shift LM right; money supply decreases will
shift it to the left.
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Equilibrium: r* and Y*
John Hicks
IS:
PE  C  I  G
C  c(Y  T )
I  I (r )
Y  PE
LM:
M

P
Ms
d

  L( r , Y )

Md
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Theory of Short Run Fluctuations
Y=C+I+G
Y=f(r)
Equate Ys
solve for r
Equate rs
solve for Y
Y=f(r,M/P)
Y=f(P)
LR: Y=f(K,L)
M/P=L(r,Y)
SR: Y=f(AD)
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Contradiction?
IS-LM Model says if the Central Bank
increases the money supply, interest rates
will fall.
 Fisher effect said that if inflation rises,
interest rates will rise.



Money supply increases trigger inflation.
What is going on?
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Contradiction?
Ms
LM
r
r
IS
M/P
Y
Fisher effect: Nominal interest rate = real interest rate + inflation
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