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Aggregate Demand I

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**1. **Aggregate Demand I Chapter Ten

**2. **Introduction In this chapter we further investigate aggregate demand. We have two primary goals:
Identify all of the variables that shift the aggregate demand curve, causing fluctuations in real output
Examine the tools policymakers can use to influence aggregate demand (monetary and fiscal policy)
The model of AD developed in this chapter is now famously called the IS-LM model.
The IS-LM model is used to show what determines output in the short-run for any given price level.
IS curve – “investment” and “saving”; represents the interactions in the market for goods and services
LM curve – “liquidity” and “money”; represents the interactions between the supply and demand for money

**3. **Context Chapter 9 introduced the model of aggregate demand and aggregate supply.
Long run
prices flexible
output determined by factors of production & technology
Short run
prices fixed
output determined by aggregate demand
This chapter develops the IS-LM model, the theory that yields the aggregate demand curve.
We focus on the short run and assume the price level is fixed.

**4. **The Keynesian Cross Keynes proposed that output in the short-run is largely determined by households and governments desire to spend (AD).
Actual expenditure (Y) – amount households, firms, and government spend on goods/services = GDP
Planned expenditure (E) – amount households, firms, and government would like to spend on goods/services
Why would Y ever differ from E? (Unplanned inventory investment)
When firms sell less (more) of their product than they had planned, what happens to their stock of inventories?

**5. **Planned Expenditure E = C + I + G; what is I?
C = C(Y-T)
Assume: I = I, G = G, T = T
? E = C(Y-T) + I + G
What is planned expenditure a function of?
Why does the planned expenditure schedule slope up?
What does the slope of E represent?

**6. **The Economy in Equilibrium The economy is in equilibrium when planned and actual expenditure are equal: E = Y
We can represent equilibrium as combinations of (E,Y) that lie along the 45-degree line, why?
Where is the equilibrium of this economy located?
Explain how the economy gravitates towards point A? What happens if Y > E? What happens if Y < E? (See next graph)

**7. **The Adjustment to Equilibrium in the Keynesian Cross

**8. **Fiscal Policy and the Multiplier: Government Purchases Consider an increase in government spending ?G
What happens to the planned expenditure line?
What is the new equilibrium point? Explain the mechanisms involved that make the economy move towards this new equilibrium point.

**9. **Solving for ?Y

**10. **The government purchases multiplier

**11. **The government purchases multiplier

**12. **Why the multiplier is greater than 1 Initially, the increase in G causes an equal increase in Y: ?Y = ?G.
But ?Y ? ?C
? further ?Y
? further ?C
? further ?Y
So the final impact on income is much bigger than the initial ?G.

**13. **Fiscal Policy and the Multiplier: Taxes Consider the affects of a decrease in taxes ?T < 0
What does a tax reduction do to disposable income and consumption?
So what happens to the planned expenditure line?
By how much does the curve shift?
Where is the new equilibrium point located?

**14. **Solving for ?Y

**15. **The Tax Multiplier

**16. **The Tax Multiplier

**17. **The Interest Rate, Investment, and the IS Curve The Keynesian Cross that we have just analyzed is only a building block to the construction of a complete IS-LM model.
The Keynesian Cross analysis has thus far assumed that investment is fixed at I, but we know from chapter 3 that investment depends on the real interest rate r.
Add the relationship I = I(r)
Recall, is the slope of I(r) positive or negative? Why?
The IS curve graphs the relationship between Y and r.
To determine how income changes when the interest rate changes, we can combine the investment function with the Keynesian-cross diagram.

**18. **Deriving the IS curve Consider an increase in r from r1 to r2:
What happens to the quantity of investment?
What does this do to the planned expenditure schedule?
What eventually happens to actual expenditure (income)?
So, what is the relationship between r and Y? What is it telling us specifically?
What’s the difference between this relationship and the one given by the classical model?

**19. **How Fiscal Policy Shifts the IS Curve IS curve is drawn for a given fiscal policy – this means what?
So what should happen when fiscal policy changes?
Consider ?G > 0:
What happens to planned expenditure?
What happens to equilibrium income? Why?
Given that the Keynesian Cross is drawn for a given interest rate, what must happen to the IS curve?
How big is the shift in IS?
What about an increase in taxes? ?T > 0 How big is the shift?

**20. **The Money Market and the LM Curve The IS curve graphs the combinations of Y and r that guarantee equilibrium in the market for goods and services.
The LM curve graphs the combinations of Y and r that guarantee equilibrium in the market for real money balances.
Theory of Liquidity Preference:
Posits that the interest rate (real) adjusts to balance the supply and demand for real money balances (M/P)
Analogous to the Keynesian Cross (building block for a derivation of the LM curve)

**21. **The Theory of Liquidity Preference Assumes that the supply of real money balances is fixed: (M/P)s = M/P
What does this imply about the supply curve?
Assumes that the interest rate is the primary determinant of money demand. (M/P)d = L(r) why?
What does this imply about the demand curve?
The interest rate adjusts to equilibrate the money market.
Explain what happens in the money market when the interest rate is above (below) the equilibrium rate?

**22. **Affects of Changes in the Money Supply Consider the affects of a reduction in the money supply by the Fed from M1 to M2:
What happens to the supply of real money balances?
What happens to the equilibrium real interest rate?
What would happen if the Fed were to increase the money supply?

**23. **Income, Money Demand, and the LM Curve The theory of liquidity preference explains the determination of the interest rate; now use it to derive the LM curve
To derive, ask how a change in output affects the market for real money balances?
Place Y back in the money demand function:
(M/P)d = L(r,Y)
What happens to the demand for real balances when output increases? Why?
The LM curve is a graph of all combinations of r and Y that equate the supply and demand for real money balances.

**24. **Deriving the LM curve Consider an increase in income from Y1 to Y2:
What happens to the money demand curve?
What happens to the equilibrium real interest rate?
So what is the relationship between income and interest rates? Is the slope of the LM curve positive or negative?

**25. **How Monetary Policy Shifts the LM Curve The LM curve plots all the combinations of Y and r that bring about equilibrium in the money market. So what do you think happens to the LM curve when the Fed alters the money supply?
Consider a reduction in the money supply from M1 to M2:
What happens to the supply of real money balances?
If income remains unchanged, what happens to the interest rate?
So what must happen to the LM curve?
Review: changes in fiscal policy shift what? Changes in monetary policy shift what?

**26. **The short-run equilibrium

**27. **The Big Picture

**28. **Chapter summary Keynesian Cross
basic model of income determination
takes fiscal policy & investment as exogenous
fiscal policy has a multiplied impact on income.
IS curve
comes from Keynesian Cross when planned investment depends negatively on interest rate
shows all combinations of r and Y that equate planned expenditure with actual expenditure on goods & services
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

**29. **Chapter summary 4. LM curve
comes from Liquidity Preference Theory when money demand depends positively on income
shows all combinations of r andY that equate demand for real money balances with supply
IS-LM model
Intersection of IS and LM curves shows the unique point (Y, r ) that satisfies equilibrium in both the goods and money markets.