CHAPTER THREE
AGGREGATE DEMAND IN THE CLOSED ECONOMY
Foundations of the Theory of Aggregate Demand
1Classical theory seemed incapable of explaining the Depression. According to that theory, national
income depends on factor supplies and the available technology, neither of which changed substantially
from 1929 to 1933. After the onset of the Depression, many economists believed that a new model was
needed to explain such a large and sudden economic downturn and to suggest government policies that
might reduce the economic hardship so many people faced.In 1936 the British economist John Maynard
Keynes revolutionized economics with his book The General Theory of Employment, Interest, and
Money. Keynes proposed a new way to analyze the economy, which he presented as an alternative to
classical theory. His vision of how the economy works quickly became a center of controversy. Yet, as
economists debated The General Theory, a new understanding of economic fluctuations gradually
developed.
Keynes proposed that low aggregate demand is responsible for the low income and high
unemployment that characterize economic downturns. He criticized classical theory for assuming that
aggregate supply alone—capital, labor, and technology—determines national income.
Economists today reconcile these two views with the model of aggregate demand and aggregate supply.
In the long run, prices are flexible, and aggregate supply determines income. But in the short run,
prices are sticky, so changes in aggregate demand influence income.
The model of aggregate demand developed in this chapter, called the IS–LM model, the leading
interpretation of Keynes’s theory. The goal of the model is to show what determines national income for
any given price level. There are two ways to view this. We model can view the IS– LM model as showing
what causes income to change in the short run when the price level is fixed. Or we can view the model
as showing what causes the aggregate demand curve to shift. The two 1parts of the IS–LM model are,
not surprisingly, the IS curve and the LM curve. 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 is happening to the supply and demand for money.
1The Goods Market and the IS Curve
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 national income and
is a building block for the more complex and realistic IS–LM model.
(A) The Keynesian Cross
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.2
Keynesian cross by differentiating between actual and planned expenditure.
Actual expenditure is the amount households, firms, and the government spend on goods and services
and it equals the economy’s gross domestic product (GDP).
Planned expenditure is the amount households, firms, and the government would like to spend on
goods and services.2
Assuming the economy is closed, so that net exports are zero, we write planned expenditure AD as the
sum of consumption(C), investment (I) and government purchase (G)2
