The IS curve
def: a graph of all combinations of r and Y
that 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
CHAPTER 10
Aggregate Demand I
slide 20
Deriving the IS curve
E =Y E =C +I (r )+G
2
E
E =C +I (r1 )+G
↓r ⇒ ↑ I
⇒ ↑E
⇒ ↑Y
ΔI
r
Y1
Y
Y2
r1
r2
IS
Y1
CHAPTER 10
Y2
Aggregate Demand I
Y
slide 21
1
Understanding the IS curve’s slope
ƒ The IS curve is negatively sloped.
ƒ Intuition:
A fall in the interest rate motivates firms to
increase 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.
CHAPTER 10
Aggregate Demand I
slide 22
The IS curve and the Loanable Funds model
(b) The IS curve
(a) The L.F. model
r
S2
r
S1
r2
r2
r1
I (r )
r1
S, I
CHAPTER 10
Aggregate Demand I
IS
Y2
Y1
Y
slide 23
2
Fiscal Policy and the IS curve
ƒ We can use the IS-LM model to see
how fiscal policy (G and T ) can affect
aggregate demand and output.
ƒ Let’s start by using the Keynesian Cross
to see how fiscal policy shifts the IS
curve…
CHAPTER 10
Aggregate Demand I
slide 24
Shifting the IS curve: ΔG
At any value of r,
↑G ⇒ ↑E ⇒ ↑Y
…so the IS curve
shifts to the right.
The horizontal
distance of the
IS shift equals
ΔY =
E =Y E =C +I (r )+G
1
2
E
E =C +I (r1 )+G1
r
Y1
r1
1
ΔG
1 −MPC
ΔY
Y1
CHAPTER 10
Y
Y2
IS1
Y2
Aggregate Demand I
IS2
Y
slide 25
3
Exercise: Shifting the IS curve
ƒ Use the diagram of the Keynesian Cross
or Loanable Funds model to show how
an increase in taxes shifts the IS curve.
CHAPTER 10
Aggregate Demand I
slide 26
The Theory of Liquidity Preference
ƒ due to John Maynard Keynes.
ƒ A simple theory in which the interest rate
is determined by money supply and
money demand.
CHAPTER 10
Aggregate Demand I
slide 27
4
Money Supply
The supply of
real money
balances
is fixed:
(M
r
interest
rate
(M
P)
s
P) =M P
s
M/P
M P
CHAPTER 10
real money
balances
Aggregate Demand I
slide 28
Money Demand
r
Demand for
real money
balances:
(M
P)
d
interest
rate
(M
P)
s
= L (r )
L (r )
M P
CHAPTER 10
Aggregate Demand I
M/P
real money
balances
slide 29
5
Equilibrium
The interest
rate adjusts
to equate the
supply and
demand for
money:
M P = L (r )
r
(M
interest
rate
P)
r1
L (r )
M P
CHAPTER 10
s
Aggregate Demand I
M/P
real money
balances
slide 30
How the Fed raises the interest rate
r
interest
rate
To increase r,
Fed reduces M
r2
r1
L (r )
M2
P
CHAPTER 10
Aggregate Demand I
M1
P
M/P
real money
balances
slide 31
6
CASE STUDY
Volcker’s Monetary Tightening
ƒ Late 1970s: π > 10%
ƒ Oct 1979: Fed Chairman Paul Volcker
announced that monetary policy
would aim to reduce inflation.
ƒ Aug 1979-April 1980:
Fed reduces M/P 8.0%
ƒ Jan 1983: π = 3.7%
How
How do
do you
you think
think this
this policy
policy change
change
would
would affect
affect interest
interest rates?
rates?
CHAPTER 10
Aggregate Demand I
slide 32
Volcker’s Monetary Tightening, cont.
The effects of a monetary tightening
on nominal interest rates
model
short run
long run
Liquidity Preference
Quantity Theory,
Fisher Effect
(Keynesian)
(Classical)
prices
sticky
flexible
prediction
Δi > 0
Δi < 0
actual
outcome
8/1979: i = 10.4%
4/1980: i = 15.8%
1/1983: i = 8.2%
CHAPTER 10
Aggregate Demand I
slide 33
7
The LM curve
Now let’s put Y back into the money demand
function:
d
(M
P)
= L (r ,Y )
The LM curve 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:
M P = L (r ,Y )
CHAPTER 10
Aggregate Demand I
slide 34
Deriving the LM curve
(a) The market for
r
real money balances
(b) The LM curve
r
LM
r2
r2
L (r , Y2 )
r1
r1
L (r , Y1 )
M1
P
CHAPTER 10
M/P
Aggregate Demand I
Y1
Y2
Y
slide 35
8
Understanding the LM curve’s slope
ƒ The LM curve is positively sloped.
ƒ Intuition:
An increase in income raises money
demand.
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.
CHAPTER 10
Aggregate Demand I
slide 36
How ΔM shifts the LM curve
(a) The market for
r
real money balances
(b) The LM curve
r
LM2
LM1
r2
r2
r1
L (r , Y1 )
M2
P
CHAPTER 10
M1
P
r1
M/P
Aggregate Demand I
Y1
Y
slide 37
9
Exercise: Shifting the LM curve
ƒ Suppose a wave of credit card fraud
causes consumers to use cash more
frequently in transactions.
ƒ Use the Liquidity Preference model
to show how these events shift the
LM curve.
CHAPTER 10
Aggregate Demand I
slide 38
The short-run equilibrium
The short- run equilibrium is
the combination of r and Y
that simultaneously satisfies
the equilibrium conditions in
the goods & money markets:
r
Y = C (Y − T ) + I (r ) + G
LM
IS
Y
M P = L (r ,Y )
Equilibrium
interest
rate
CHAPTER 10
Aggregate Demand I
Equilibrium
level of
income
slide 39
10
The Big Picture
Keynesian
Cross
IS
curve
Theory of
Liquidity
Preference
LM
curve
IS-LM
model
Agg.
demand
curve
Agg.
supply
curve
CHAPTER 10
Explanation
of short-run
fluctuations
Model of
Agg.
Demand
and Agg.
Supply
Aggregate Demand I
slide 40
Chapter summary
1. Keynesian Cross
ƒ basic model of income determination
ƒ takes fiscal policy & investment as exogenous
ƒ fiscal policy has a multiplied impact on income.
2. IS curve
ƒ comes from Keynesian Cross when planned
investment depends negatively on interest rate
ƒ shows all combinations of r and Y that
equate planned expenditure with actual
expenditure on goods & services
CHAPTER 10
Aggregate Demand I
slide 41
11
Chapter summary
3. Theory of Liquidity Preference
ƒ basic model of interest rate determination
ƒ takes money supply & price level as exogenous
ƒ an increase in the money supply lowers the
interest rate
4. LM curve
ƒ comes from Liquidity Preference Theory when
money demand depends positively on income
ƒ shows all combinations of r andY that equate
demand for real money balances with supply
CHAPTER 10
Aggregate Demand I
slide 42
Chapter summary
5. IS-LM model
ƒ Intersection of IS and LM curves shows the
unique point (Y, r ) that satisfies equilibrium
in both the goods and money markets.
CHAPTER 10
Aggregate Demand I
slide 43
12
Preview of Chapter 11
In Chapter 11, we will
ƒ use the IS-LM model to analyze the impact
of policies and shocks
ƒ learn how the aggregate demand curve
comes from IS-LM
ƒ use the IS-LM and AD-AS models together
to analyze the short-run and long-run
effects of shocks
ƒ learn about the Great Depression using our
models
CHAPTER 10
Aggregate Demand I
slide 44
CHAPTER 10
Aggregate Demand I
slide 45
13