Aggregate Demand 1 : IS-LM Model (CHAPTER 10)

Aggregate Demand 1 : IS-LM Model (CHAPTER 10)

1. Keysian Cross (determines output(Y))

   • Change in Gov't Spending
     • EX) If G purchases INCREASES
       • PE line shift UPWARDS
       • Output INCREASE
     • Gov't Purchases Multiplier
       • Gov't purchases lead to greater production, measures the change in income of $1 increase in gov't spending
         • Equation: dY/dG = 1 / (1 - c)
         • This is due to government spending increasing consumption so there is an overall larger increase from G and C
     • Tax Multiplier
       • Measures the change income from a $1 increase in taxes
         • Equation: dY/dG = c / ( 1 - c )
         • *Change in $1 Gov't spending > $1 Tax multiplier
   • Planned Expenditure (PE)
     • 3 PARTS:
       • Consumption (C)
         • C= a + c (Y-T(-))
       • Planned Investment (I)
         • I (r(-))
       • Government (G)
         • G(-)
     • PE = a + c(Y-T(-)) + I(r(-)) + G(-)
   • Actual Expenditure (Y)
   • 3 Different Situations:
     • Equilibrium
       • PE = Y
         • Y = C + I + G
         • Putting all 'Y' variables on one side
           • Y = [((1/1-c) x (a + I(r(-)) + G(-))] - [((c/1-c) x T)]
     • PE > Y
       • Firms increase output until equilibrium
     • PE < Y
       • Firms decrease output until equilibrium
   • IS CURVE
     • Definition: NEGATIVE relation between interest rate and output when GOOD MARKET is in equilibrium
     • IS Curve Shifts
       • Gov't purchases cause PE to shift UP, IS shift RIGHT, output to INCREASE
       • Tax causes PE to shift DOWN, IS to shift LEFT, output to decrease
     • Equation: Y = [(a - c ( T (-)) + d + G(-))/(1-c)) ]+ [(e / (1-c)) x r]
       • ( 1- c ) / e is slope of IS curve
     • SHORT RUN
       • Combination of LM and IS curves
   • MONEY MARKET (determine interest rate (r))
     • Theory of Liquidity Preference
       • Purpose: Determine 'r' for given 'y' through money supply and money demand
       • Money Supply
         • Assumption: Money SUPPLY((M/P)S) is controlled by central bank making M/P constant
           • (M/P)S = ((M/P)S)(-)
       • Money Demand
         • Money DEMAND ((M/P)D) depends on nominal interest
           • EX 1) As real interest rate (r) INCREASE, INCREASE in oppuratunity cost holding money, DECREASE in demand for money
           • *Assumption: Real interest rate = Nominal interest rate, NO rate of change in this circumstance
           • EX 2) Y INCREASES, (Since Y and r inverse), r DECREASE, demand for money INCREASE
         • (M/P)D = L(r,Y)
       • Money Market Equilibrium
         • (M/P)S = (M/P)D
           • Therefore, replace (M/P)D : (M/P)S = L(r,Y)
           • Ex) To INCREASE interest rates, DECREASE money supply, leads to shift LEFT for (M/P)S, and INCREASE r
             • Ex) Effect of INCREASE in income(Y), INCREASE in (M/P)D, INCREASE r
     • LM CURVE
       • Definition: Opposite of IS Curve, POSITIVE relation btw r and Y during equilibrium in MONEY MARKET
         • Upward Slope
         • Equation: r = (f/g) x Y - (1/g) x (M(-)/P(-))
           • Ex) INCREASE M leads to INCREASE (M/P)S, leads to RIGHT shift in (M/P)S, LM curve shifts DOWN
           • (f / g) is slope of LM curve
       • *Change in Nominal money supply (M) SHIFTSIS and LM curves, r moves ALONG curve
       • EQUILIBRIUM

2. *ASSUMPTIONS: Price level is fixed, and closed economy (NX = 0)

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