Chapter 4: Aggregate Demand Models

4.1. Foundations of the Theory of Aggregate Demand

 Of all the economic fluctuations in world history, the one that stands out as
particularly large, painful, and intellectually significant is the Great
Depression of the 1930s.

–This Great Depression is accompanied with widespread unemployment

and income reduction.

–In the worst year (1933), 25% of the U.S. labor force was unemployed.

– Real GDP was 30% below its 1929 level.

This devastating economic event led to questioning classical economic theory

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 Classical theory assumes national income is determined by factor

supplies (capital, labor) and technology. But from 1929 to 1933, neither
of these changed substantially.

 Classical theory could not explain the dramatic downturn –High

unemployment and reduced national income despite no major change in
factor supplies.

⸫ Economists recognized the need for new models to explain and address
economic fluctuations.

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 John Maynard Keynes revolutionized economics in 1936 with The

General Theory of Employment, Interest, and Money.

– Proposed a new model to understand economic downturns.

– Criticized classical economics, which ignored the role of aggregate

demand.

 Keynes’s theory introduced the concept that low aggregate demand

leads to low income and high unemployment during downturns.

 Classical theory assumed that national income was only determined by

supply-side factors (capital, labor, technology).

 Keynes argued that demand-side factors—specifically aggregate

demand—also play a critical role in determining national income and
employment.
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 In the long run, classical economics holds that aggregate supply determines
income and output.

 In the short run, however, Keynes suggested that aggregate demand

influences income and employment because prices are sticky (they don't
adjust quickly to changes). Sticky prices prevent the economy from self-
correcting quickly.

The IS–LM Model helps explain Keynes's views on the short-run impact of
changes in aggregate demand.

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The IS–LM Model

The IS–LM model (Investment-Savings, Liquidity-Money) is a central part of

Keynesian economics.
– IS curve: Represents equilibrium in the goods market, where
investment equals savings.
– LM curve: Represents equilibrium in the money market, where
money demand equals money supply.
This model is used to determine national income for any given price level in the
short run.

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 4.2. The Goods Market and the IS Curve

 The IS curve plots the relationship between the interest rate and the level of
income(GDP) that arises in the market for goods and services.

 It's derived from the Keynesian Cross, which is a simple model explaining
how national income is determined in an economy based on aggregate
demand

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A. The Keynesian Cross:
– A simple representation of the relationship between aggregate demand
(AD) and national income (Y).

– In this model, aggregate demand is made up of:

• Consumption (C): Household spending based on income.

• Investment (I): Spending on capital goods by businesses,

which can depend on interest rates.

• Government spending (G): Expenditures by the government

on goods and services.

• Net Exports (NX): Exports minus imports.

– Aggregate demand (AD) is the sum of C + I + G + NX.

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 In his 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. The Keynesian cross is an attempt to model this
insight.

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We begin our derivation of the Keynesian cross by differentiating

between actual and planned expenditure.

 Actual Expenditure: This is the total amount spent by households,

firms, and the government on goods and services in the economy. It
is equal to the economy’s GDP—the value of all goods and services
produced.

 Planned Expenditure: This refers to the amount that households,

firms, and the government intend to spend on goods and services. It
reflects the desired level of expenditure, not necessarily what is
actually spent.

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Unplanned changes in inventory investment cause actual expenditure to

diverge from planned expenditure.

• Actual expenditure > planned expenditure when firms sell more than
expected, reducing inventories.

• Actual expenditure < planned expenditure when firms sell less than
expected, leading to an increase in inventories.

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Grapically,

it shows how much planned expenditure increases when

income rises by $1

Fig. Planned Expenditure as a function of income

The slope MPC shows how much PE↑ when Y↑ by $1. It slopes upward
because higher income higher Cand thus higher PE.
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B. The Economy in Equilibrium
The economy is said to be in equilibrium when,
Actual Expenditure = Planned Expenditure
Y = E

along the 45 degree line Y=E

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C. How does the economy get to the equilibrium?
– through inventory adjustment.
i.e unplanned changes in inventories induce firms to change production levels,
which in turn changes income and expenditure

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• The graph shows ↑𝐆 leads to an even greater ↑Y. That is, ΔY>ΔG.
The ratio ΔY/ΔG is called the government expenditure multiplier;
• tells us by how much Y rises in response to a $1 increase in G.
Given Y = C(Y-T) + I + G
If we consider a change in G of size ΔG then the following sequence of
events occurs:
– STEP 1: Initially E changes by ΔG, there by ΔY
– STEP 2: Next, the ΔY causes a change in C — i.e. by MPC × ΔG.
– STEP 3: The ΔC causes E and Y to change again by MPC ×MPC×ΔG.
– STEP 4: The extra ΔY causes a further ΔC— i.e. C changes by a further
MPC ×MPC ×MPC × ΔG.
– STEP 5: And so on, with the changes in C and Y getting smaller with
each step.
ΔY =ΔG+MPC ×ΔG+ MPC2 ×ΔG+ MPC3 × ΔG

ΔY = (1+MPC +MPC2 +MPC3 + . . .)ΔG

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The government-purchases multiplier is therefore given by

ΔY/ΔG = 1 + MPC + MPC2 + MPC3 + . . .

This expression for the multiplier is an example of an infinite geometric series.

A result from algebra allows us to write the multiplier as:
ΔY/ΔG = 1/ (1 - MPC)

For example, if the marginal propensity to consume is 0.6, the multiplier is

ΔY/ΔG = 1 + 0.6 + 0.62 + 0.63 + . . .
= 1/ (1 - 0.6)
= 2.5.
In this case, a $1.00 increase in government purchases raises income by $2.50.

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 The Interest Rate, Investment, and the IS Curve

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 Deriving The IS curve from the Keynesian cross and the investment function

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 How Fiscal Policy Shifts the IS Curve

 The IS curve is just pairs of r and Y such that income (Y ) equals planned
expenditure (E) ==> the goods market equilibrium

 The IS curve is drawn for a given fiscal policy; that is, when we
construct the IS curve, we hold G and T fixed. However, when fiscal
policy changes(i.e G and T are relaxed), the IS curve shifts

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 How Fiscal Policy Shifts the IS Curve

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 ALGEBRA OF THE IS CURVE

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 4.3. THE Money Market and the LM Curve

 For the economy to be in equilibrium not only requires equilibrium in the

goods market, but also in the money markets.

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

A. The Theory of Liquidity Preference:- is a theory of interest rate

determination in the short run

• It argues that interest rate, in the short run, is determined in the money
market, where the demand and supply of real money balances intersect

• Just as the Keynesian cross is a building block for the IS curve, the theory
of liquidity preference is a building block for the LM curve
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 Money Supply

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 Money demand

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 According to the theory of liquidity preference, the supply and demand

for real money balances determine what interest rate prevails in the
economy. That is, the interest rate adjusts to equilibrate the money
market.

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 B. Income, Money Demand, and the LM Curve

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 Deriving the LM curve
 Using the theory of liquidity preference, we can see what happens to the
interest rate when the level of income changes.
 For example, consider what happens when income increases from Y1 to Y2.

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 C. How Monetary Policy Shifts the LM Curve
 The LM curve shows the combinations of the interest rate and the level of
income that are consistent with equilibrium in the money market
 Earlier the LM curve is drawn for a given/fixed supply of real money
balances
 However, If real money balances change— for example, if the Central bank
alters the money supply—the LM curve shifts.

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 4.4.The Short-Run Equilibrium: The IS-LM Model
 Derived from the IS curve in the goods market and the LM curve in the money
market

Y=C(Y-T)+I(r)+G…………..IS equation

M/P= L(r,Y)………………….LM equation

 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
 The equilibrium of the economy is the point at which the IS curve and the
LM curve intersect
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 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.
 That is, at this intersection, actual expenditure = planned
expenditure, and Money demand = money supply.

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 How Fiscal Policy Shifts the IS Curve and Changes the
Short-Run Equilibrium
Changes in Government Purchases

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Changes in Taxes

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 How Monetary Policy Shifts the LM Curve and Changes
the Short-Run Equilibrium

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 From the IS–LM Model to the Aggregate Demand Curve

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 What causes the aggregate demand curve to shift?
 Because the AD curve summarizes the results from the IS–LM model,
events that shift the IS curve or the LM curve (for a given price level)
cause the AD curve to shift

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