Chapter 10 Aggregate Demand I.ppt

Chapter 10: Aggregate Demand I The IS-LM Model A short-run macroeconomic model which takes the price level constant and shows how changes in the level of Aggregate Demand cause changes in income. The IS curve: The Keynesian Cross Theory The LM curve: The Liquidity Preference Theory Shift in Aggregate Demand The Keynesian Cross Equilibrium in the product market: Planned Expenditures: E C Y-T + I + G Actual Expenditures: Y Aggregate Equilibrium: Y C Y-T + I + G Total income Total planned expenditures Adjustment to Equilibrium Y1 Y indicates an excess supply of goods in the market. So, businesses accumulate inventories to reduce Y1 to Y Y2 Y indicates an excess demand for goods in the market. So, businesses reduce inventories to increase Y2 to Y Effect of Stabilization Policy A government policy of changing planned expenditure, C, I, or G, would shift the Planned Expenditure line to increase the level of income. The increase in income is subject to a multiplier effect as spending by consumers receiving the new income, creates income for other consumers Effect of Government Spending Policy Government Spending Multiplier ΔG Increase in government purchases ΔY Increase in income Multiplier effect: ΔY / ΔG 1 / 1 – MPC Example, MPC 0.6, Spending Multiplier 2.50; Any $1 increase in G creates an additional $2.50 of income Effect of Government Tax Policy Government Tax Multiplier ΔT Decrease in income taxes ΔC Increase in consumption -MPC * ΔT ΔY Increase in income Multiplier effect: ΔY / ΔT -MPC / 1 – MPC Example, MPC 0.6, Tax Multiplier -1.50; Any $1 decrease in T creates an additional $1.50 of income Derivation of IS Curve IS shows level of income and interest rate that bring about equilibrium to the product market Assume an initial income level and interest rate. An increases in interest rate reduces planned investment. Then, the Planned Expenditure line shifts down, causing income to decline. IS Curve Shift of IS Curve Th