AGGREGATE DEMAND I

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AGGREGATE DEMAND I

• Chapter 10

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The work of John Maynard Keynes

• During the Great Depression of the 1930s output
  and employment experienced severe fluctuations
• The classical theory was incapable of explaining
  these fluctuations
• In his book The General Theory of Employment,
  Interest, and Money, Keynes proposed a new way of
  analyzing the economy
• He suggested that low aggregate demand is the
  reason for low income and high unemployment
• Keynes argued the AS alone does not determine
  output and employment

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Our Goals

• Identify variables that shift AD
• Analyze the impact of government monetary and
  fiscal policy on AD
• Develop the IS-LM model the model is an
  interpretation of Keyness theory
• IS stands for investment and saving
• LM stands for liquidity and money
• The interest rate equilibrates both markets and
  is the link between the two parts of the model

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The goods market and the IS curve

• The IS curve shows the relationship between the
  interest rate and income that arises from the
  goods market
• According to the Keynesian cross model income in
  the SR is determined by the desire of households,
  businesses and government to spend
• Actual expenditure is the amount households,
  firms and governments spend on goods and services
• Planned expenditure is the amount households,
  firms and governments plan to spend on goods and
  services

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• Actual expenditure may differ from planned
  expenditure if firms have unplanned inventory
  investment (sales did not meet expectations)
• Planned expenditure in a closed economy is given
  by E C I G where C C (Y T) the values
  of I, G, and T are fixed
• E C(Y Tbar) Ibar Gbar
• E is a function of consumption and fiscal policy
• The slope of E is the MPC
• The economy is in equilibrium when actual
  expenditure equals planned expenditure, EY
• When things go according to plan, theres no
  reason to change anything

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• The 45 degree line shows all point for which the
  equilibrium condition holds
• The economys equilibrium is in point A
• How is equilibrium reached?
• When actual expenditure is not equal to planned
  expenditure there are unplanned changes in
  inventories
• At Y1, YgtE and the unplanned inventory
  accumulation signals to firms to reduce
  production
• At Y2, YltE and the unplanned reduction in
  inventories signals to firms to increase
  production

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• Use the Keynesian cross model to show how income
  changes as a result of changes in the exogenous
  variables I, G, and T.
• Fiscal policy and the multiplier An increase in
  government purchases
• Effects if government purchases go up by ?G,
  planned expenditure increases (shifts up) by ?G
• The increase in equilibrium income ?Y is larger
  than ?G
• ?Y/?G is the government purchases multiplier
• It is given by 1/(1-MPC)
• Conceptually, what is the meaning of the
  multiplier?

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• Fiscal policy and the multiplier a decrease in
  taxes
• Effects a decrease in taxes by ?T increases
  disposable income by ?T and increases consumption
  by MPC ?T. Planned expenditure increases (shifts
  up) by MPC ?T
• The increase in equilibrium income exceeds the
  decrease in taxes
• ?Y/?T is the tax multiplier
• It is given by MPC/(1-MPC)
• Conceptually, what is the meaning of the tax
  multiplier?

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From the Keynesian cross to the IS curve

• Assume the planned investment is not fixed, but
  is a function of the real rate of interest
• The investment function is II(r )
• Combine the investment function and the Keynesian
  cross to determine how income changes as a result
  of interest rate changes
• Assume that the interest rate increases,
  determine the reduction in investment, planned
  expenditure and equilibrium income

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Fiscal policy and the IS curve

• The IS curve shows the level of income where the
  goods market is in equilibrium
• It is drawn for a given fiscal policy
• An increase in G, shifts the IS curve to the
  right
• Changes in fiscal policy that increase 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

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The loanable funds interpretaiton of the IS curve

• The national accounts identity can be written as
  Y C G I, or SI
• Substitute the consumption and investmetn
  functions Y C(Y-T) G I(r)
• The rate of interest adjusts to equilibrate the
  demand and supply of loanable funds
• An increase in income, increases saving, which
  decreases the rate of interest

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• Fiscal policy and the IS curve
• an increase in G or a reduction in T decrease S
  for a given level of Y
• The decrease in S increases r
• R is higher for a given Y, indicating that the IS
  curve has shifted upwards
• In conclusion, the IS curve represents the
  equilibrium in the goods and the loanable funds
  market

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The money market and the LM curve

• The LM curve shows the relationship between
  income and the rate of interest that arises from
  the market for money balances
• The theory of liquidity preference the interest
  rate in the short run is determined by the demand
  and supply of money
• The theory is a building block for deriving the
  LM curve

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• The supply of real money balances is fixed and is
  not a function of the real interest rate
  M/PsMbar/Pbar
• The quantity of money is an exogenous variable
  determined by the policy of the central bank
• Price is also exogenous
• The demand for real money balances is a function
  of r
• R is the opportunity cost of holding money
• R is negatively related to the quantity of money
  balances demanded
• (M/P)dL(r )

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• How is equilibrium reached
• If r1gtr, the supply of money balances exceeds
  the demand, people buy bonds, increasing the
  price of bonds and reducing the rate of interest
• If r2ltr, the demand for money balances exceeds
  the supply, people sell bonds, reducing the price
  of bonds and increasing the rate of interest
• Changes in money supply
• A reduction in money supply increases the
  equilibrium rate of interest
• An increase in money supply reduces the
  equilibrium rate of interest

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• Deriving the LM curve
• (M/P)d L(r, Y)
• The quantity of real money balances demanded is
  negatively related to r and positively related to
  Y
• Consider an increase in Y
• Money demand shifts up, increasing the
  equilibrium rate of interest
• Higher levels of income are associated with
  higher interest rates
• The LM curve slopes upwards

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Monetary policy and the LM curve

• The LM curve is drawn for a given supply of real
  money balances
• If the Bank of Canada decreases the money supply,
  the supply curve for real money balances will
  shift to the left, causing the equilibrium real
  interest rate to increases
• For a given level of income, r increases,
  indicating that the LM curve has shifted up

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• Decreases in the quantity of money shift the LM
  curve up, increases in the quantity of money
  shift the LM curve down
• A quantity theory interpretation of the Lm curve
• Relax the assumption of constant velocity
• Velocity is positively related to r (why?)
• MV(r )PY
• An increase in r increases V which requires an
  increase in Y r and Y are positively related
  along the LM curve
• Changes in M shift the LM curve in the same way
  as before

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The short-run equilibrium

• IS equation YC(Y-T) I(r ) G
• LM equation M/PL(r, Y)
• Fiscal policy (G and T), monetary policy (M) and
  the price level P are exogenous
• Given the exogenous variables we can solve for
  the endogenous variables Y and r
• The equilibrium is where the IS and LM curves
  cross these are the values of r and Y for which
  the goods market and the money markets are in
  equilibrium

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