Chapter Ten

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A PowerPointTutorialto Accompany macroeconomics, 5th ed.

N. Gregory Mankiw

®

Aggregate Demand

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The Great Depression caused many economists to question thevalidity of classical economic theory (from Chapters 3-6). They believed they needed a new model to explain such a pervasive economic downturn and to suggest that government policies mightease some of the economic hardship that society was experiencing.

In 1936, John Maynard Keynes wrote The General Theory ofEmployment, Interest and Money. In it, he proposed a new way toanalyze the economy, which he presented as an alternative tothe classical theory.

Keynes proposed that low aggregate demand is responsible for the lowincome and high unemployment that characterize economic downturns.He criticized the notion that aggregate supply alone determines nationalincome.

The Great Depression caused many economists to question thevalidity of classical economic theory (from Chapters 3-6). They believed they needed a new model to explain such a pervasive economic downturn and to suggest that government policies mightease some of the economic hardship that society was experiencing.

In 1936, John Maynard Keynes wrote The General Theory ofEmployment, Interest and Money. In it, he proposed a new way toanalyze the economy, which he presented as an alternative tothe classical theory.

Keynes proposed that low aggregate demand is responsible for the lowincome and high unemployment that characterize economic downturns.He criticized the notion that aggregate supply alone determines nationalincome.

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‘Keynesian’ means different things to different people. It’s useful to think of the basic textbookKeynesian model as an elaboration and extensionof the ‘classical theory’. Its variable velocity of money and ‘sticky’ prices reflects Keynes’ belief that the Classical model’s shortcomings arose from its overly-strict assumptions of constant velocity and highly flexible wages and prices.

The model of aggregate demand (AD) can be split into two parts: IS model of the ‘goods market’ and the

LM model of the ‘money market’.

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Price Level, P

Income, Output, Y

SRAS

AD

Y*Y*'

AD'AD''

Y*''

In the short run, when the price level is fixed, shifts in the aggregate demand curve lead to changes in national income, Y.The model of aggregate demand developed in this chapter calledthe IS-LM is the leading interpretation of Keynes’ work. The IS-LM model takes the price level as given and shows what causes income to change. It shows what causes AD to shift.

The Keynesian model can be viewed as showing what causes the aggregate demand curve to shift.

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The IS curve (which stands for investment saving) plots the relationship between the interest rate and the level of income that arises in the market for goods and services.

The LM curve (which stands for liquidity and money) plots the relationship between the interest rate and the level of income that arises in the money market.

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In the General Theory of Money, Interest and Employment (1936),Keynes proposed that an economy’s total income was, in the shortrun, determined largely by the desire to spend by households, firms

and the government. The more people want to spend, the more goodsand services firms can sell. The more firms can sell, the more

output they will choose to produce and the more workers they willchoose to hire. Thus, the problem during recessions and depressions,

according to Keynes, was inadequate spending. The Keynesiancross is an attempt to model this insight.

In the General Theory of Money, Interest and Employment (1936),Keynes proposed that an economy’s total income was, in the shortrun, determined largely by the desire to spend by households, firms

and the government. The more people want to spend, the more goodsand services firms can sell. The more firms can sell, the more

output they will choose to produce and the more workers they willchoose to hire. Thus, the problem during recessions and depressions,

according to Keynes, was inadequate spending. The Keynesiancross is an attempt to model this insight.

Because the interest rate influences both investment and money demand, it is the variable that links the two parts of the IS-LM model.

The model shows how interactions between these markets determine the position and slope of the aggregate demand curve, and therefore,

the level of national income in the short run.

Because the interest rate influences both investment and money demand, it is the variable that links the two parts of the IS-LM model.

The model shows how interactions between these markets determine the position and slope of the aggregate demand curve, and therefore,

the level of national income in the short run.

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The Keynesian cross shows how income Y is determined for given levelsof planned investment I and fiscal policy G and T. We can use this model to show how income changes when one of the exogenous variables change. Actual expenditure is the amount households, firms and the government spend on goods and services (GDP). Planned expenditure is the amount households, firms and the governmentwould like to spend on goods and services. The economy is in equilibrium when: Actual Expenditure = Planned Expenditure or Y=E

Expenditure, E

Income, Output, Y

Actual Expenditure, Y=E

Planned Expenditure,E = C + I + G

Y2 Y1Y*

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Expenditure, E

Income, Output, Y

Actual Expenditure, Y=E

Planned Expenditure,E = C + I + G

Y2 Y1Y*

The 45-degree line (Y=E) plots the points where this condition holds.With the addition of the planned-expenditure function, this diagrambecomes the Keynesian Cross.

How does the economy get to this equilibrium? Inventories play animportant role in the adjustment process. Whenever the economy isnot in equilibrium, firms experience unplanned changes in inventories,and this induces them to change production levels. Changes inproduction in turn influence total income and expenditure, moving theeconomy toward equilibrium.

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Consider how changes in government purchases affect the economy.Because government purchases are one component of expenditure,higher government purchases result in higher planned expenditure,for any given level of income.Expenditure, E

Income, Output, Y

Actual Expenditure, Y=E

Planned Expenditure,E = C + I + G

Y1Y*

G

An increase in government purchases ofG raises planned expenditureby that amount for any given level of income. The equilibrium movesfrom A to B and income rises. Note that the increase in income Y exceeds the increase in government purchases G. Thus, fiscal policy

has a multiplied effect on income.

A

B

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If government spending were to increase by $1, then you might expect equilibrium output (Y) to also rise by $1. But it doesn’t! The multiplier shows that the change in demand for output (Y) will be larger than the initial change in spending. Here’s why:When there is an increase in government spending (G), income rises by G as well. The increase in income will raise consumption by MPC G, where MPC is the marginal propensity to consume. The increase in consumption raises expenditure and income again. The second increase in income of MPC G again raises consumption, this time by MPC (MPC G), which again raises income and so on.So, the multiplier process helps explain fluctuations in the demand for output. For example, if something in the economy decreases investment spending, then people whose incomes have decreased will spend less, thereby driving equilibrium demand down even further.

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The government-purchases multiplier is: Y/G = 1 + MPC + MPC2 + MPC3 + …

Y/G = 1 / 1 - MPC

The government-purchases multiplier is: Y/G = 1 + MPC + MPC2 + MPC3 + …

Y/G = 1 / 1 - MPC

The tax multiplier is: Y/T = - MPC / (1 - MPC)

The tax multiplier is: Y/T = - MPC / (1 - MPC)

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Let’s now add the relationship between the interest rate and investmentto our model, writing the level of planned investment as: I = I (r).

On the next slide, the investment function is graphed downward-sloping showing the inverse relationship between investmentand the interest rate. To determine how income changes when theinterest rate changes, we combine the investment function with theKeynesian-cross diagram.

The IS curve summarizes this relationship between the interest rateand the level of income. In essence, the IS curve combines the interactionbetween I and Y demonstrated by the Keynesian cross. Because anincrease in the interest rate causes planned investment to fall, which inturn causes income to fall, the IS curve slopes downward.

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E

Income, Output, Y

Y=EPlanned Expenditure,E = C + I + G

r

Income, Output, Y

r

Investment, I

I(r) IS

An increase in the interest rate (in graph a), lowers planned investment, which shifts planned expenditure downward (ingraph b) and lowers income (in graph c).

(a)

(b)

(c)

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In summary, the IS curve shows the combinations of the interest rate and the level of income that are consistent with equilibrium in the

market for goods and services. The IS curve is drawn for a given fiscal policy. Changes in fiscal policy that raise 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.

In summary, the IS curve shows the combinations of the interest rate and the level of income that are consistent with equilibrium in the

market for goods and services. The IS curve is drawn for a given fiscal policy. Changes in fiscal policy that raise 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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r

M/PM/P

Supply

Now that we’ve derived the IS part of AD, it’s now time to complete the model of AD by adding a money market equilibrium schedule, the LM curve. To develop this theory, we begin with the supply of real money balances (M/P); both of these variables are taken to be exogenously given. This yields a vertical supply curve.

Now, consider the demand for real money balances, L. The theory of liquidity preference suggests that a higher interest rate lowers the quantity of real balances demanded, because r is the opportunitycost of holding money.

Demand, L (r)

The supply and demand for real money balances determine the interest rate. At the equilibrium interest rate, the quantity of money balances demanded equals the quantity supplied.

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Money DemandMoney Demand equalsequals Real Money BalancesReal Money Balances

L(r) = M/PL(r) = M/P

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(M/P)d = L (r,Y) (M/P)d = L (r,Y)

The quantity of real money balances demanded is negatively relatedto the interest rate (because r is the opportunity cost of holding money) and positively related to income (because of transactions demand).

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r

M/PM/P

Supply

Demand, L (r,Y)

Since the price level is fixed, a reduction in the money supply reducesthe supply of real balances. Notice the equilibrium interest rate rose.

A Reduction in the Money Supply: -M/PA Reduction in the Money Supply: -M/P

Supply'

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r

M/PM/P

Supply

L (r,Y)'L (r,Y)

r1

r2

r

Y

LM

An increase in income raises money demand, which increases theinterest rate; this is called an increase in transactions demandfor money. The LM curve summarizes these changes in the moneymarket equilibrium.

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r

M/P

L (r,Y)

r

Y

LM

M/P

Supply

A contraction in the money supply raises the interest rate that equilibratesthe money market. Why? Because a higher interest rate is needed to convince people to hold a smaller quantity of real balances.As a result of the decrease in the money supply, the LM shifts upward.

r1 r1

M´/P

Supply'

LM'

r2 r2

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r

Y

LM(P0)IS

r0

Y0

The intersection of the IS curve/equation, Y= C (Y-T) + I(r) + G and the LM curve/equation M/P = L(r, Y) determines the level of aggregate demand. The intersection of the IS and LM curves represents simultaneous equilibrium in the market for goods and services and in the market for real money balances for given values of government spending, taxes, the money supply, and the price level.

The intersection of the IS curve/equation, Y= C (Y-T) + I(r) + G and the LM curve/equation M/P = L(r, Y) determines the level of aggregate demand. The intersection of the IS and LM curves represents simultaneous equilibrium in the market for goods and services and in the market for real money balances for given values of government spending, taxes, the money supply, and the price level.

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Now that we’ve assembled the IS-LM model of aggregate demand, let’s apply it to three issues:

1) Causes of fluctuations in national income

2) How IS-LM fits into the model of aggregate supply and aggregatedemand

3) The Great Depression

Now that we’ve assembled the IS-LM model of aggregate demand, let’s apply it to three issues:

1) Causes of fluctuations in national income

2) How IS-LM fits into the model of aggregate supply and aggregatedemand

3) The Great Depression

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IS-L

M

The intersection of the IS curve and the LM curve determines the level of national income. When one of these curves shifts, the short-run

equilibrium of the economy changes, and national income fluctuates. Let’s examine how

changes in policy and shocks to the economy can cause these curves to shift.

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LMr

Y

IS

A

+G Consider an increase in government purchases.This will raise the level of income by G/(1- MPC)

IS´

B

The IS curve shifts to the right by G/(1- MPC) which raises income and the interest rate.

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ISr

Y

LM

A LM

B

+M Consider an increase in the money supply.

The LM curve shifts downward and lowers the interest rate which raises income. Why? Because when the Fed increases the supply of money, people have more money than they want to hold at the prevailing interest rate. As a result, they start depositing this extra money in banks or use it to buy bonds.The interest rate r then falls until people are willing to hold all the extramoney that the Fed has created; this brings the money market to a new equilibrium. The lower interest rate, in turn has ramifications for the goodsmarket. A lower interest rate stimulates planned investment, which increasesplanned expenditure, production, and income Y.

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The IS-LM model shows that monetary policy influences income bychanging the interest rate. This conclusion sheds light on our analysisof monetary policy in Chapter 9. In that chapter we showed that in the short run, when prices are sticky, an expansion in the money supply raises income. But, we didn’t discuss how a monetary expansion induces greater spending on goods and services--a processcalled the monetary transmission mechanism.

The IS-LM model shows that an increase in the money supply lowersthe interest rate, which stimulates investment and thereby expands thedemand for goods and services.

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You probably noticed from the IS and LM diagrams that r and Y were on the two axes. Now we’re going to bring a third variable, the price level

(P) into the analysis. We can accomplish this by linking both two-dimensional graphs.

rr

PP YY

YY

ISIS

LM(PLM(P11))

AA

AA

ADAD

To derive AD, start at point A in the top graph. Now increase the price level from P1 to P2. An increase in P lowers the value of real money

balances, and Y, shifting LM leftward to point B.

The +P triggers a sequence of events that end with a -Y, the inverse relationship that defines the downward slope of AD.

Notice that r increased. Since r increased, we know that investment will decrease as it just got more costly to take on various investment projects. This sets off a multiplier process since -I causes a –Y.The - Y triggers -C as we move up the IS curve.

LM(PLM(P22))

BB

BBP2

P1

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+GThis translates into a rightward shift of the IS and AD curves.

LM (P2)

Suppose there is a +G.

In the short-run, we move along SRAS frompoint A to point B.But as the output market clears, in the long-run,the price level will increase from P0 to P2.

This +P decreases the value of real moneybalances, which translates into a leftward shift of the LM curve.

Finally, this leaves us at point C in both diagrams.

r

PY

Y

ISLM(P0)

AD

P0AD´

IS´

SRASA

A

B

B

P2C

C

LRAS

Y = C (Y-T) + I(r) + G

M/ P = L (r, Y)

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Now it’s time to determine the effects on the variables in the economy.For the variables Y, P, and r, you can read the effects right off the diagrams.

Remember that SR is the movement from A to B.Remember that SR is the movement from A to B.

+, because Y moved from Y* to Y´

0, because prices are sticky in the SR. +, because a +Y leads to a rise in ras IS slides along the LM curve.+, because a +Y increases the level ofconsumption (C=C(Y-T)).– , since r increased, the level ofinvestment decreased.

YY

PP

rr

CC

II

r

PY

Y

IS LM(P0)

AD

P0

AD´

IS´

SRASA

A

B

B

P2C

C

LRAS

*Y Y´

LM(P2)

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+, in order to eliminate the excess demand at P0.

0, because rising P shifts LM to left, returningY to Y* as required by long-run LRAS.

+, reflecting the leftward shift in LM due to +P0, since both Y and T are back to their initiallevels (C=C(Y-T))– – , since r has risen even more due to the +P.

YY

PP

rr

CC

II

For the variables Y, P and r, you can read the effects right off the diagrams.

Remember that LR is the movement from A to C.Remember that LR is the movement from A to C.

r

PY

Y

IS LM(P0)

AD

P0

AD´

IS´

SRASA

A

B

B

P2C

C

LRAS

*Y Y´

LM(P2)

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LM

B

AD´B

Notice that M\ was increased, thus increasing the value of the real money supply which translates into a rightward shift of the LM and AD curves.

Suppose there is a +M.

Look at the appropriate equationthat captures the M term:

In the short-run, we move along SRAS frompoint A to point B.But as the output market clears, in the long-run,the price level will increase from P0 to P2.

This +P decreases the value of the real money supply which translates into a leftward shift of the LM curve.

Finally, this leaves us at point C in both diagrams.

C

AD

ISr

PY

Y

LM(P0)

P0SRAS

A

A

LRAS

= C

P2

M/ P = L (r, Y)

M/ P = L (r, Y)

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Now it’s time to determine the effects on the variables in the economy.

For the variables Y, P, and r, you can read the effects right off the diagrams.

Remember that SR is the movement from A to B.

+, because Y moved from Y* to Y´

0, because prices are sticky in the SR. –, because a +Y leads to a decrease in ras LM slides along the IS curve.+, because a +Y increases the level ofconsumption (C=C(Y-T)).+ , since r increased, the level ofinvestment decreased.

YY

PP

rr

CC

II

LM

B

AD´B

C

AD

ISr

PY

Y

LM(P0)

P0 SRASA

A

LRAS

= C

P2

(P2)

Y´Y*

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+, in order to eliminate the excess demand at P0.

0, because rising P shifts LM to left, returningY to Y* as required by LRAS.

0, reflecting the leftward shift in LM due to +P, restoring r to its original level.0, since both Y and T are back to their initiallevels (C=C(Y-T)).0, since Y or r has not changed.

YY

PP

rr

CC

I

For the variables Y, P and r, you can read the effects right off the diagrams.

Remember that LR is the movement from A to C.

Notice that the only LR impact of an increase in the money supply was an

increase in the price level.

LM

B

AD´B

C

= C

P2

AD

ISr

PY

Y

LM(P0)

P0 SRASA

A

LRAS

Y´Y*

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LM(P0)1) +1) +CC causes the IS curve to shift causes the IS curve to shift

right to IS‘.right to IS‘.

LRAS

2) This leads to a rightward shift in AD 2) This leads to a rightward shift in AD to AD’.to AD’.

Short Run: Short Run: Move from A to B.Move from A to B.

Long Run:Long Run:Market clears at PMarket clears at P00 to P to P22

from B to C.from B to C.3) +3) +P causes LM(PP causes LM(P00) to shift leftward ) to shift leftward

to LM(Pto LM(P22) due to the lowering of the ) due to the lowering of the

real value of the money supply.real value of the money supply.

rr

YYPP

YY

IS

AD

IS'

P0

AD'

LRAS

LM(P2)

P2

C

C

Y = C (Y-T) + I(r) + G

IS-L

M

M/ P = L (r, Y)

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Short Run:

Y +P 0r +C +I -

Long Run:

0+

+++--

SRAS

r

YP

Y

IS

AD

IS'

P 0

AD'

LRAS

LM(P 2 )

P 2

C

C

LM(P 0 )

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The spending hypothesis suggests that perhaps the cause of thedecline may have been a contractionary shift of the IS curve.

The money hypothesis attempts to explain the effects of the historicalfall of the money supply of 25% from 1929 to 1933 during which time unemployment rose from 3.2% to 25.2.%. Some economists say that deflation worsened the Great Depression. They argue that the deflation may have turned what in 1931 was atypical economic downturn into an unprecedented period of highunemployment and depressed income. Because the falling moneysupply was possibly responsible for the falling price level, it couldvery well have been responsible for the severity of the depression. Let’ssee how changes in the price level affect income in the IS-LM model.

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LM

Y

IS

AIS´

B

An expected deflation (a negative value of e) raises the real interestrate for any given nominal interest rate, and this depresses investmentspending. The reduction in investment shifts the IS curve downward.The level of income and the nominal interest rate (i) fall, but the realinterest rate (r) rises.

i2

r1 = i1

r2

interest rate, i

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IS-LM ModelIS CurveLM CurveKeynesian crossGovernment-purchases multiplierTax multiplierTheory of liquidity preferenceMonetary transmission mechanismPigou EffectDebt-deflation theory

IS-LM ModelIS CurveLM CurveKeynesian crossGovernment-purchases multiplierTax multiplierTheory of liquidity preferenceMonetary transmission mechanismPigou EffectDebt-deflation theory