Chapter 4: Aggregate Demand in the closed Economy

4.1. Types of models in the economy and concepts of

aggregate demand
4.1.1. Types of models in the economy
Using the elements of expenditure approach of the
national income accounting identity there are different
models such as:
a. A simple economy model (two sector model) given
as:
Y = C + I --------------------------------------------------
(1.1)
Here the aggregate demand model is given by the sum
of the total demand in the two sectors given by:
AD = C + I ----------------------------------------------- (1.2)

1
4.1.1. Types of models in the economy

b. The three sector model (closed economy model) given as:

Y = C + I + G ---------------------------------------------------(1.3)

In this case the aggregate demand model is given by the sum of

the total demand in the three sectors given by the following:

AD = C + I + G -------------------------------------------------(1.4)

c. The four sector model (open economy model) given by:

Y = C + I + G + NX ---------------------------------------------------------(1.5)

2
Cont’d…
In this case the aggregate demand model is given by the sum

of the total demand in the three sectors given by the following:

AD = C + I + G + NX

-------------------------------------------------------(1.6)

Where: AD represents aggregate demand

C represents demand for consumption expenditure

I represents demand for investment expenditure

G represents demand for government expenditure

NX represents demand for expenditure on foreign products

3
4.1.2 . Concepts of aggregate demand
Aggregate demand (AD) refers to the collective demand for all

goods and services, rather than the market demand for a particular

good or service.

It shows the level of real GDP including the purchases by

households, business, government, and foreigners (net exports) at

different possible price levels during a given time period.

Aggregate demand curve shows the total amount of goods and

services that are demanded in the economy at various price levels.

Other factors remaining constant, the lower the price level, the

greater the aggregate quantity demanded for real goods and services.

4
Cont’d…
An increase in price level reduces the purchasing
capacity of the demanders or consumers of the
goods and services; and reduces the total demand.
Thus, aggregate demand is downward sloping (see
the figure below, figure 4.1). Hence has similar
shape to that simple individual or market demand
for a particular normal good as you might have
seen in microeconomics, the theory of demand.

5
Cont’d…
Figure: 4.1. Aggregate demand curve as function of price
PRICE
LEVEL
P

AD

Y
OUTPUT, INCOME

In this case aggregate demand curve, it is a function of the price

level given as AD = f(P).

6
Cont’d…
If substitute other determinants of the
aggregate demand the aggregate
demand curve will be positively
sloped upward (see figure 4.2. below).

7
Cont’d…

AD, C, I, G,
NX

AD

Y
OUTPUT, INCOME

Figure 4.2: AD curve as function of other determinants

8
Cont’d…
4.2. Foundation of Theory of Aggregate Demand

In general the basic objective of this unit is to systematically

derive the Aggregate Demand Curve. The analysis is entirely

based on the standard Keynesian Model. The aggregate demand

is derived in several steps:

First the IS curve is derived by constructing relationships between

interest rate and income to get the goods market equilibrium

Keynesian cross model

Second, the LM curve is derived by constructing relationship

between interest and income to obtain the money market equilibrium

9
Cont’d…

Third, the relationship between interest and

income is obtained when the two markets are

simultaneously at equilibrium, and

Finally, the relationship between price and

income (AD-Aggregate Demand) will be

derived from the interest-income relationship.

10
Cont’d…
Because of the interest rate influences both

investment and money demand, it is the variable

that links the two halves of the IS–LM model.

The model shows how interactions between these

markets determine the position and slope of the

aggregate demand curve.

The model of aggregate demand developed in this

chapter, called the IS–LM model.

11
Cont’d…
The goal of the model is to show what determines

national income for any given price level.

 IS stands for “investment’’ and “saving,’’ and the

IS curve represents what’s going on in the market

for goods and services.

 LM stands for “liquidity’’ and “money,’’ and the

LM curve represents what’s happening to the

supply and demand for money.

12
4.3. The Goods Market and the IS curve
4.3.1. The Keynesian Cross
In the General Theory, Keynes proposed that an economy’s

total income was, in the short run, determined largely by the

desire to spend by households, firms, and the government.

The more people want to spend, the more goods and services

firms can sell. The more firms can sell, the more output they

will choose to produce and the more workers they will

choose to hire.

Thus, the problem during recessions and depressions,

according to Keynes, was inadequate spending.

13
4.3.1. The Keynesian Cross

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 this relationship, we start with a

basic model called the Keynesian cross.

This model is the simplest interpretation of Keynes’s theory

of how national income is determined and is a building block

for the more complex and realistic IS–LM model. To derive

the Keynesian cross, we begin by looking at the determinants

of planned expenditure or planned aggregate demand.

14
Cont’d…
Planned expenditure (or planned aggregate
demand): is the amount of households, firms, and
the government plan to spend on goods and services.

Actual expenditure: are the amount households,

firms, and the government spending on goods and
services.

The difference between actual and planned

expenditure is unplanned inventory investment.
15
Cont’d…
When firms sell less of their product than
planned, their stock of inventories
automatically rises. Conversely, when firms
sell more than planned, their stock of
inventories falls.
Because these unplanned changes in inventory
either above or below planned expenditure.

16
Cont’d…
Assuming that the economy is closed, so
that net exports are zero, we write planned
aggregate demand (or planned expenditure)
AD as the sum of consumption (C),
planned investment (I), and government
purchases G.

17
Cont’d…

18
Cont’d…
Figure 4.3: Planned aggregate demand (planned
expenditure)

19
Cont’d…
In the figure above planned expenditure as a function of the
level of income since the other variables are fixed.

The line slopes upward because higher income leads to

higher consumption and thus higher planned expenditure.

The demand for goods is an increasing function of output.

The slope of this line is the marginal propensity to consume
(MPC).

MPC: shows by how much planned expenditure increases

when income rises by one unit.

20
Cont’d…

The Economy in Equilibrium

Actual aggregate demand = Planned aggregate
demand
Y= AD

21
Cont’d…
Graphically:

AD Actual aggregate demand (Y=AD)

Planned aggregate demand
A AD = C + I + G

Equilibrium Income
450
Y-Income (Output)
Figure 4.4. The Keynesian Cross

22
Cont’d…
How does the economy get to the
equilibrium? In this model, inventories
play an important role in the adjustment
process.
AD Actual Expenditure

Planned Expenditure
Unplanned Inventory Accumulation
causes income to fall
Unplanned drop in inventory
450 causes income to rise

Y2 Y* Y1 Y –Income (Output)
Figure 4.5. Adjustment to Equilibrium in Keynesian Cross

23
Cont’d…
If firms were producing at Y1 then Y > AD

 Because actual expenditure exceeds planned

expenditure, inventory accumulates, stimulating a
reduction in production.

Similarly at Y2, Y < AD

 Because planned expenditure exceeds actual

expenditure, inventory drops, stimulating an
increase in production
24
4.3.2. Fiscal Policy and the Multiplier: Government Purchases

Since government purchases are one

component of expenditure, high government
purchases imply, for any given level of
income, higher planned aggregate demand.
If government purchases rise by ΔG, then the
planned aggregate demand schedule shifts
upward by ΔG, as shown in the figure below.

25
Cont’d…

Figure: 4.6: Effect of increases in government purchase on

Keynesian cross

26
Cont’d…
The graph shows that an increase in government
purchases leads to an even greater increase in
income.
That is, dY > dG. The ratio ∆Y/∆G is called the
government purchase multiplier; and it tells how
much income rises in response to a one-unit increase
in government purchases.
An implication of the Keynesian cross is that the
government purchases multiplier is larger than one.
27
Cont’d…
Why does fiscal policy have a multiplied effect on income?
 The reason is that, according to the consumption function,
higher income causes higher consumption.
 Because an increase in government purchases raises income,
it also raises consumption, which further raises
consumption, and so on.
 Therefore, in this model, an increase in government
purchases causes a greater increase in income. Initially, the
increase in G causes an equal increase in Y: Y = G.

28
Cont’d…
But Y  C
 further Y
 further C
 further Y
So the final impact on income is much
bigger than the initial G.

29
Cont’d…

The process of the multiplier begins when expenditure rises

by ∆G, which implies that income rises by ∆G as well.

This increase in income in turn raises consumption by

MPC* ∆G.

This increase in consumption raises aggregate demand and

income once again. This second increase in income of MPC

* ∆G again raises consumption by MPC* (MPC * ∆G),

which again raises aggregate demand and income, and so

on. We can thus write this process compactly as:

30
Cont’d…
Methods of gov’t multiplier derivation

∆𝑌 = ∆𝐶 + ∆𝐼 + ∆𝐺

∆𝑌 = 𝑀𝑃𝐶 ሺ∆𝑌 − ∆𝑇ሻ+∆𝐺 Since, I is exogenous

∆𝑌 = 𝑀𝑃𝐶 ሺ∆𝑌ሻ+∆𝐺 Since, T is exogenous

∆𝑌ሺ1 − 𝑀𝑃𝐶 ሻ = ∆𝐺
∆𝒀 𝟏
= This is the overall effect change in government
∆𝑮 𝟏−𝑴𝑷𝑪

purchase on income

31
Cont’d…

Example: If MPC = 0.8, then

Y 1
 5
G 1  0.8
Interpretation: an increase government purchase cause’s
income to increase 5 times as much.

32
Cont’d…
Numerical Example: In the Keynesian cross, assume that the consumption

function is given by:

C = 475 + 0.75(Y-T)

Planned Investment, I = 150, G = 250, T = 100. Then, answer the following

questions:

a. Graph planned expenditure as a function of income

b. What is the equilibrium level of income

c. If government purchases increase by 125, what is the new equilibrium

income?

d. What level of government purchases is needed to achieve an equilibrium

income of 2600?

33
Cont’d…
Solution:
We know that, AD=C +I +G, where
C=400+0.75Y, I = 150, G = 250. After
summing them together, we get
AD=800+0.75Y.

AD Y= AD

AD=800+0.75Y

800

Y 34
Cont’d…
b. Equilibrium level of income
Equilibrium level of income occurs when:
Y= AD (Pla nned expenditure = Actua l expenditure
Y= AD = 800 + 0.75Y, which implies
Y-0.75Y= 800
0.25Y= 800
Y= 3200
c. New equilibrium income after ΔG↑= 125

At equilibrium Y= AD= 925+ 0.75Y

Y-0.75Y = 925
0.25Y = 925
Y= 3700 is the new equilibrium due to government expenditure
increa ses to 125.

35
Cont’d…
Graphically:

AD
Y =AD

AD=925+0.75Y

ΔG↑= 125 AD=800+0.75Y

925

800

Y1=3200 Y2=3700 Income (output)

36
Cont’d…
d. We know tha t a t equilibrium: Y=AD= C+I+ G
And C=c(Y-T)
In our exa mple: Y=2600
C=475+0.75(Y-T) → C=400+0.75Y, since
T=100, I = 150
 Therefore, Y=C+I+G at equilibrium
Y=c(Y-T)+I+ G
2600=400+0.75(2600) +150+G
Which implies G= 100

37
Cont’d…
4.3.3. Fiscal Policy Multiplier: Tax multiplier
A decrease in taxes of ΔT immediately raises
disposable income Y-T by ΔT and, therefore,
consumption by MPC * ΔT.
For any level of income Y, aggregate demand is now
higher. As shown in the figure below, the aggregate
demand schedule shifts upward by MPC*ΔT. The
equilibrium of the economy moves from point A to
point B.
38
Cont’d…

E Actual Expenditure
B Planned Expenditure
E2=Y2 T x MPC
A tax cut shifts
E1=Y1 A planned expenditure upward…

450
Y- Income (Output)
Y
Figure 4.7. A Decrease in Taxes in the Keynesian Cross

39
Cont’d…
Derivation for tax multiplier:
∆𝑌 = ∆𝐶 + ∆𝐼 + ∆𝐺

∆𝑌 = ∆𝐶 Since, I and G are exogenous

∆𝑌 = 𝑀𝑃𝐶 ሺ∆𝑌 − ∆𝑇ሻ

∆𝑌 = 𝑀𝑃𝐶∆𝑌 − 𝑀𝑃𝐶∆𝑇

∆𝑌 − 𝑀𝑃𝐶∆𝑌 = −𝑀𝑃𝐶∆𝑇

∆𝑌ሺ1 − 𝑀𝑃𝐶 ሻ = −𝑀𝑃𝐶∆𝑇

∆𝒀 −𝑴𝑷𝑪
∆𝑻
= 𝟏−𝑴𝑷𝑪
This is overall effect of change in taxes on income

This expression is the tax multiplier, the a mount income cha nges in response to a $1
cha nge in ta xes.

40
Cont’d…
Example: f the marginal propensity to
consume is 0.6, then the tax multiplier is:
Y/T = −0.6/(1 − 0.6) = −1.5.
In this example, a $1.00 cut in taxes raises
equilibrium income by $1.50.
Note: The tax multiplier is a negative effect because
tax increase reduces consumption
which reduces income.
41
Cont’d…
4.3.4. The Interest Rate, Investment Demand, and
Deriving the IS Curve

The Keynesian cross is a stepping-stone to the IS–LM

model. It is useful because it shows how the spending plans
of households, firms, and the government determine the
economy’s income.

Yet it makes the simplifying assumption that the level of

planned investment I is fixed. But in reality, investment
demand is a function of interest rate. In either case, the
cost of using fixed investment fund planned by a firm can
be measured by the market interest rate, r .
42
Cont’d…
Let’s now add the relationship between the interest rate (r) and

investment (I) to our model, writing the level of planned investment

as: I = I (r).

The investment function is graphed downward sloping showing the

inverse relationship between investment and the interest rate.

To determine how income changes when the interest rate changes, we

combine the investment function with the Keynesian-cross diagram.

The IS curve the relationship between the interest rate and the level

of income. In essence, the IS curve combines the interaction between

I and Y demonstrated by the Keynesian cross by the equation.

Y=c(Y-T)+I(r)+G
43
Cont’d…
Deriving the IS Curve:

Panel (a) shows the investment function: an increase in the interest rate

from r1 to r2 reduces planned investment from I(r1) to I(r2). As a result,

the investment function slopes downward.

Panel (b) shows the Keynesian cross: a decrease in planned investment

from I(r1) to I(r2) shifts the planned-expenditure function downward and

thereby reduces income from Y1 to Y2. Hence, an increase in the interest

rate lowers income.

Panel (c) shows the IS curve summarizing this relationship between the

interest rate and income: the higher the interest rate, the lower the level of

income.

44
Cont’d…

45
Cont’d…
In essence, the IS curve combines the interaction between r

and I expressed by the investment function and the interaction

between I and Y demonstrated by the Keynesian cross.

Each point on the IS curve represents equilibrium in the goods

market, and the curve illustrates how the equilibrium level of

income depends on the interest rate. Because an increase in

the interest rate causes planned investment to fall, which in

turn causes equilibrium income to fall, the IS curve slopes

downward.
46
Cont’d…
4.3.5. Determinants of the IS Curve: Fiscal Policy Shifts
The IS curve shows us, for any given interest rate, the level
of income that brings the goods market into equilibrium.
As we learned from the Keynesian cross, the level of
income also depends on fiscal policy. The IS curve is
drawn for a given fiscal policy; that is, when we construct
the IS curve, we hold G and T fixed. When fiscal policy
changes, the IS curve shifts. The Keynesian cross in panel
(a) shows that this change in fiscal policy raises planned
expenditure and thereby increases equilibrium income from
Y1 to Y2. Therefore, in panel (b), the increase in government
purchases shifts the IS curve outward.

47
Cont’d…
E r IS1 IS2
(a) Actual (b)

Planned
Y2

𝒓ത
Y1

450
Y1 Y2 Y Y1 Y2 Y

Figure 4.10: An Increase in Government Purchases Shifts IS Curve Outward

We can use the Keynesian cross to see how change in fiscal policy shift the IS curve.

Decrease in taxes expands expenditure and income, it too shifts the IS curve outward.

A decrease in government purchases or an increase in taxes reduces income; therefore, such a

change in fiscal policy shifts the IS curve inward.

48
Cont’d…
In summary, the IS curve shows the combinations
of the interest rate and the level of income that are
consistent with equilibrium in the market for goods
and services. The IS curve is drawn for a given
fiscal policy.
 Changes in fiscal policy that raise the demand for
goods and services shift the IS curve to the right.
 Changes in fiscal policy that reduce the demand for
goods and services shift the IS curve to the left.
49
Cont’d…
4.4. The Money Market and the LM Curve 

The LM curve plots the relationship between the interest rate and
the level of income that arises in the market for money balances.
To understand this relationship, we begin by looking at a theory
of the interest rate, called the theory of liquidity preference.

4.4.1. The Theory of Liquidity Preference

1st : We begin with the supply of real money balances. If M

stands for the supply of money and P stands for the price level, then
M/P is the supply of real money balances. The theory of liquidity
preference assumes there is a fixed supply of real balance.

50
Cont’d…
That is, the money supply M is an
exogenous policy variable chosen by the
central bank does not depend on the interest
rate.
The price level P is also an exogenous
variable in the IS-LM model considers short
run.
51
Cont’d…

Figure 4.11: Supply of real money balances

52
Cont’d…
2nd : Consider the demand for real money balances. People hold money because it is

a “liquid” asset- that is, because it is easily used to make transactions. The theory of

liquidity preference postulates that the quantity of real money balances demanded

depends on the interest rate. The theory of liquidity preference suggests that a higher

interest rate, r, lowers the quantity of real money balances demanded, because r is the

opportunity cost of holding money.

When the interest rate rises, people want to hold less of their wealth in the form of

money. We write the demand for real money balances as

(M/P)d = L(r)
Where the function L( r) denotes the demand for the liquid asset- money.

This equation states that the quantity of real balances demanded is a function of the

interest rate.

53
Cont’d…

This inverse r/ship between Md and

interest rate can be shown as a downward

sloping demand curve.

Figure 4:12: Demand for real money balances

54
Cont’d…
According to the theory of liquidity
preference, the interest rate adjusts to
equilibrate the money market. The supply
and demand for real money balances
determine the interest rate.
At the equilibrium interest rate, the quantity
of money balances demanded equals the
quantity supplied i.e(L(r) = /).
55
Cont’d…

Figure 4.13: Equilibrium level of money supply and money demand

56
Cont’d…
The adjustment of the interest rate to this equilibrium of money supply

and money demand occurs because people try to adjust their portfolios of

assets if the interest rate is not at the equilibrium level.

 If the interest rate is too high, the quantity of real balances supplied

exceeds the quantity demanded. Banks and other financial institutes

respond to this excess supply of money by lowering the interest rates

they offer.

 Conversely, if the interest rate is too low, so that the quantity of money

demanded exceeds the quantity supplied, individuals try to obtain

money by making bank withdrawals, which drives the interest rate up.

At the equilibrium interest rate people are content with their portfolios

of monetary and non-monetary assets. 57

Cont’d…
The theory of liquidity preference implies that decreases
in the money supply raise the interest rate and that
increases in the money supply lower the interest rate.
Suppose there is a reduction in money supply.
 A reduction in M reduces M/P, since P is fixed in the
model. The supply of real balances shift to the left, as
shown in the figure below. The equilibrium interest rate
rises from r1 to r2. The higher interest rate induces
people to hold a smaller quantity of real money
balances.

58
Cont’d…

Figure 4.14: Effect of decreases in the money supply on real money balance

59
4.4.2. Income, Money Demand & Deriving the LM
Curve
Cont’d…
So far we have assumed that only the interest rate

influences the quantity of real money balances

demanded. More realistically, the level of income Y also

affects money demand. When income is high,

expenditure is high, so people engage in more

transactions that require the use of money.

Thus, greater income implies greater money demand.

We now write the money demand function as:

(M/P) d = L(r, Y)
60
Cont’d…
The quantity of real money balances
demanded is negatively related to the interest
rate (because r is the opportunity cost of
holding money) and positively related to
income (because of transactions demand).
Equilibrium in financial markets implies that an
increase in income leads to an increase in the
interest rate. The LM curve is upward-sloping

61
Cont’d…

r r
(a) M (b)
r2 r2

r1 r1
L
Y-Income
ഥ
𝑴
𝑷ഥ
M/P Y1 Y2
Figure 4.15: Deriving the LM Curve (Liquidity-Money curve)

62
Cont’d…
Using the theory of liquidity preference, we
can figure out what happens to the equilibrium
interest rate when the level of income changes.
For example, consider what happens in Figure
a when income increases from Y1 to Y2. As
panel (a) illustrates, this increase in income
shifts the money demand curve to the right.
With the supply of real money balances
unchanged, the interest rate must rise from r1
to r2 to equilibrate the money market.

63
Cont’d…
According to the theory of liquidity
preference, higher income leads to a
higher interest rate. The LM curve plots
this relationship between the level of
income and the interest rate.
The higher the level of income, the
higher the demand for real money
balances, and the higher the equilibrium
interest rate. For this reason, the LM
curve slopes upward, as in panel (b).

64
4.4.3. Determinants of LM Curve: Monetary Policy Shifts

The LM curve tells us the interest rate that equilibrates the money market at any

level of income. Yet, as we saw earlier, the equilibrium interest rate also depends

on the supply of real money balances, M/P. This means that the LM curve is

drawn for a given supply of real money balances. If real money balances change

for example, if the central bank (Federal gov’t) alters the money supply the LM

curve shifts.

We can use the theory of liquidity preference to understand how monetary policy

shifts the LM curve. Suppose that the Fed decreases the money supply from M1 to

M2, which causes the supply of real money balances to fall from M1/P to M2/P.

Figure 4-16 shows what happens. Holding constant the amount of income and

thus the demand curve for real money balances, we see that a reduction in the

supply of real money balances raises the interest rate that equilibrates the money

market. Hence, a decrease in the money supply shifts the LM curve upward.

65
Cont’d…

r r
LM2
LM1

r2 r2

r1 r1
L(r, 𝒀ഥ)
Y
𝑴𝟐 𝑴𝟏
𝒀ഥ
𝑷 𝑷
Figure 4.16. A Reduction in the Money Supply Shifts the LM Curve Upward

66
Cont’d…
In summary, the LM curve shows the combinations of the

interest rate and the level of income that are consistent

with equilibrium in the market for real money balances.

The LM curve is drawn for a given supply of real money

balances.

 Decreases in the supply of real money balances shift the

LM curve upward.

 Increases in the supply of real money balances shift the

LM curve downward. 
67
Cont’d…
Finally, remember that the LM curve by itself

does not determine either income Y or the interest

rate r that will prevail in the economy. Like the IS

curve, the LM curve is only a relationship

between these two endogenous variables.

The IS and LM curves together determine the

economy’s equilibrium.

68
4.5. Short-Run Equilibrium in the Product and Money Markets

We have now derived two pieces of geometric

apparatus. One gives the equilibrium pairs of r
and y in the product market-the IS curve-and
the other gives the equilibrium pairs of r and y
in the money market-the LM curve. The two
equations of this model are:
Y= C(Y − T ) + I(r) +G ---------------IS Equation,
M/P = L(r, Y) ----------------------- LM Equation.

69
Cont’d…
The model takes fiscal policy, G and T, monetary
policy M, and the price level P as exogenous. Given
these exogenous variables, the IS curve provides the
combinations of r and Y that satisfy the equation
representing the goods market, and the LM curve
provides the combinations of r and Y that satisfy the
equation representing the money market. These two
curves are shown together in Figure 4-17.

70
Cont’d…

r LM

Equilibrium Point
r*

IS
Y – Income (Output)
Y*
Figure 4.17. Equilibrium in the IS-LM Model

71
Cont’d…
The equilibrium of the economy is the point at
which the IS curve and the LM curve cross. This
point gives the interest rate r and the level of
income Y that satisfy conditions for equilibrium in
both the goods market and the money market.
In other words, at this intersection, actual
expenditure equals planned expenditure, and the
demand for real money balances equals the
supply.
72
Numerical example
1. Consider the closed economy consumption function is given by C= 200 +0.75(Y-T).

The investment function is I = 200- 25r and government purchases and taxes are both

100. The money demand function is (M/P) = Y – 100r and the money supply M is

1000 and the price level P is 2. Based on the given information :

a. Find the equilibrium level of interest rate r and the equilibrium level of income Y

b. Graph IS and LM curve for interest rate in the vertical axis and income horizontal

c. Suppose the government purchases are raised from 100 to 200. How does the IS

curve shift? What are the new equilibrium interest rate and level of income?

Illustrate graphically.

d. If the price level rises from 2 to 4. What happen on the initial equilibrium level?

Illustrate graphically

73
Solution
a. Equilibrium r and Y are:
Step 1: Find the IS equation
Y= C+I+G
Y= a+(Y – T) +I(r) +G
Y = 200+0.75(Y-100)+200-25r+100
Y= 200+0.75Y-75+200 -25r+100
Y-0.75Y = 425- 25r
Y (1-0.75) = 425-25r
IS equation Y= 1,700 – 100r

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 Cont’d…
Step 2: Find LM equation (M/P)d = Y – 100r
(M/P)s = 1000/2 =500

LM equation/curve determined by:

(M/P)d= (M/P)s

Y – 100r = 500

LM equation/curve Y = 500+100r

At equilibrium goods and money market:

IS equation = LM equation

1,700 – 100r =500+100r

1,200= 200r

r = 6 …… equilibrium interest rate

75
Cont’d…
To obtain equilibrium level of income
substituting equilibrium interest rate in IS or
LM equation
Y = 1,700 – 100(6)

Y= 1,100….equilibrium income

76
Cont’d…
b. Graph IS and LM curve for interest rate in
the vertical axis and income horizontal

Interest
LM
rate

r= 6

IS

y =1,100 Income
500 1, 700

77
Cont’d…
c. If government purchases are raised from 100 to 200. How does
the IS curve shift? What are the new equilibrium interest rate and
level of income?

1st find the new IS equation after government purchases are raised
from 100 to 200 since gov't purchase affect only goods and service
market.
Y = 200+0.75(Y-100)+200-25r+200

Y= 200+0.75Y-75+200 -25r+200

Y-0.75Y = 525- 25r

Y (1-0.75) = 525-25r

IS equation Y= 2,100 – 100r

78
Cont’d…
2nd to find equilibrium r and Y which equate IS equation with LM
equation.

At equilibrium of goods and money market:

IS equation = LM equation

2,100 – 100r =500+100r = 1,600= 200r

r = 8 … new equilibrium interest rate after G increase

to 200
To obtain equilibrium level of income substituting equilibrium
interest rate in IS or LM equation
Y = 2,100 – 100(8)

Y= 1,300….new equilibrium income after G increase to 20

79
Cont’d…
Graphically:

Interest rate
LM

1,100 1,700 IS1 IS 2

Income

80
Cont’d…
d. If the price level rises from 2 to 4. What happen on the
initial equilibrium level?

The change in price firstly affects the real money balance.

So the real money balance after the price increase becomes:
(M/P)d = Y – 100r

(M/P)s = 1000/4 =250

LM equation/curve determined by:

(M/P)d= (M/P)s

Y – 100r = 250

LM equation/curve Y = 250+100r

81
Cont’d…
At equilibrium goods and money market:
IS equation = LM equation

1,700 – 100r =250+100r

1,450= 200r

r = 7.25 …… new equilibrium interest rate after P increase to 4

To obtain equilibrium level of income substituting

equilibrium interest rate in IS or LM equation

Y = 1,700 – 100(7.25)

Y= 975….new equilibrium income after P increase to 4

82
Cont’d…

Graphically:

Interest rate LM2

LM1

7.25

IS

975 1,100 Income

83
Cont’d…

The effects of fiscal and monetary policy on IS, LM,

output and interest rate

84
Cont’d…
The Liquidity Trap: is a situation in which the interest rate reached at very low level. In

the United States in the 1930s, interest rates reached very low levels. A similar situation

occurred in 2008. In December of that year, the Federal Reserve cut its target for the

federal funds rate to the range of zero to 0.25 percent. Some economists describe this

situation as a liquidity trap. According to the IS–LM model, expansionary monetary

policy works by reducing interest rates and stimulating investment spending. But if

interest rates have already fallen almost to zero, then perhaps monetary policy is no

longer effective. Nominal interest rates cannot fall below zero: rather than making a

loan at a negative nominal interest rate, a person would just hold cash. In this

environment, expansionary monetary policy raises the supply of money, making the

public’s asset portfolio more liquid, but because interest rates can’t fall any further, the

extra liquidity might not have any effect. Aggregate demand, production, and

employment maybe “trapped” at low levels.

85
4.6. From the IS-LM to Aggregate demand

We have been using the IS–LM model to explain

national income in the short run when the price level is

fixed. To see how the IS–LM model fits into the model

of aggregate supply and aggregate demand, we now

examine what happens in the IS–LM model if the price

level is allowed to change. As was promised when we

began our study of this model, the IS–LM model

provides a theory to explain the position and slope of

the aggregate demand curve.

86
Cont’d…
The aggregate demand curve describes a relationship

between the price level and the level of national income. To

understand the determinants of aggregate demand more

fully, we now use the IS–LM model to derive the aggregate

demand curve.

First, we use the IS–LM model to show why national income

falls as the price level raises that is, why the aggregate

demand curve is downward sloping.

Second, we examine what causes the aggregate demand

curve to shift.
87
Cont’d…
To explain why the aggregate demand curve slopes downward, we examine

what happens in the IS–LM model when the price level changes. This is done in

Figure 4-20.

 For any given money supply M, a higher price level P reduces the supply of real

money balances M/P. A lower supply of real money balances shifts the LM

curve upward, which raises the equilibrium interest rate and lowers the

equilibrium level of income, as shown in panel (a). Here the price level rises

from P1 to P2, and income falls from Y1 to Y2.The aggregate demand curve in

panel (b) plots this negative relationship between national income and the price

level.

 In other words, the aggregate demand curve shows the set of equilibrium points

that arise in the IS–LM model as we vary the price level and see what happens to

income.
88
Cont’d…

LM(P2)
r LM(P1) P
AD

P2

IS P1

Y2 Y1 Y Y2 Y1

Figure 4.18. Deriving the Aggregate Demand Curve with the IS-LM Model

89
Cont’d…
What causes the aggregate demand curve to shift? Because of the aggregate

demand curve is merely a summary results from the IS–LM model, events that

shift the IS curve or the LM curve (for a given price level) cause the aggregate

demand curve to shift.

 For instance, an increase in the money supply raises income by shifting the

LM curve to the right in the IS–LM model for any given price level; it thus

shifts the aggregate demand curve to the right.

 Similarly, an increase in government purchases or a decrease in taxes raises

income by shifting the IS curve to the right in the IS-LM model for a given

price level; it also shifts the aggregate demand curve to the right.

 Conversely, a decrease in the money supply, a decrease in government

purchases, or an increase in taxes lowers income in the IS–LM model and

shifts the aggregate demand curve to the left. 90

Cont’d…
Generally, the IS–LM model combines the elements
of the Keynesian cross and the elements of the
theory of liquidity preference. The IS curve shows
the points that satisfy equilibrium in the goods
market, and the LM curve shows the points that
satisfy equilibrium in the money market.
The intersection of the IS and LM curves shows the
interest rate and income that satisfy equilibrium in
both markets for a given price level.
91