CHAPTER 11 - Aggregate Demand I: IS-LM Model Construction

Give the 3 key points of the Tax Multiplier

1- NEGATIVE: a tax increase reduces consumption which reduces income. 2- GREATER THAN 1 (in absolute value): as a change in taxes has a multiplier effect on income. 3- SMALLER THAN THE G MULTIPLIER: consumers save the fraction (1-MPC) of a tax cut, so the initial boost in spending from a tax cut is smaller than from an equal increase in G.

Give the equations of the IS and LM curves, and state whether any of these variables are exogenous.

IS: Y=C(Y-T)+I(r)+G LM: (M/P) = L(r,Y) G and T (fiscal policy) and M and P (monetary policy) are exogenous variables to the IS-LM model.

Give the full Planned Expenditure equation

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

The theory of liquidity preference

a simple theory in which the interest rate is determined by money supply and money demand. (M/P)^d = L(r, Y) (M/P)^s = M/P

How would an increase in G effect the IS curve?

an increase in G would shift the PE schedule upwards (keynesian cross) which would increase output. Therefore an increase in G would shift the IS schedule to the right. The IS curve shifts to the right by Δ G/(1-MPC) since we know output in the keynesian cross model increased by this amount. However output in the IS-LM model increases by less than that in the Keynesian cross due to the dampening effect of an increase in r. (I is crowded out by r).

Draw the effects of an increase in G in the Keynesian Cross Model, and state any key points.

an increase in G would shit the PE line upwards, which would in turn increase the level of income. Key point: the increase in income [Δ Y] exceeds the increase in government purchases [Δ G]. Thus FISCAL POLICY has a multiplied effect on income.

Draw the effects of an increase in T in the Keynesian Cross Model, and stante any key points.

an increase in T would decrease consumption, and therefore decrease PE which would in turn reduce income. Key point: FISCAL POLICY has a multiplier effect on income, where the ΔY is greater than the Δ C (due to higher T).

Derive the LM curve, and thus show why it is upward sloping.

an increase in income would shift the money demand curve upward [ (M/P)^d = L(r, Y) ]. This shift would increase the equil interest rate but maintain the money supply constant. The +ve relationship between output and interest rate is thus demonstrated by the LM curve.

Derive the IS curve, and thus show why it is downward sloping.

an increase in r would reduce investment (on the investment-interest rate schedule). This decrease in I would decrease PE in the keynesian cross model and thus lower output. The IS curve shows this -ve relationship between interest rate and output.

How would an increase in the demand for real money balances affect the LM curve?

an increase in real money balances would shift the money demand curve up (theory of liquidity preference), which would increase the interest rate. Therefore the LM curve would shift to left.

Why is the G multiplier greater than 1?

because higher income causes higher consumption (C=c(Y-T)). When an increase in G raises income, it also raises consumption , which further raises income, which further raises consumption etc. So the impact on income is much greater than the initial Δ G.

IS-LM Model

model used to show what determines national income for a given interest rate by analyzing the intersection between the goods market and the money market.

Draw the Keynesian cross model, and state what happens if income is above, and below the equilibrium level.

model: (y-axis: AE,PE. x-axis: Y) AE=Y = 45 degree line PE=C+I+G If income is below the equil level; then PE > AE and firms run down their inventories. This fall in inventories induces firms to increase production. If income is above the equil level; then PE < AE and firms build up their inventories. The inventory accumulation induces firms to decrease production. In both cases the firms decision drives the economy towards equilibrium.

LM Curve

the +ve relationship between the interest rate and the level of income (holding the price level constant) that arises in the market for real money balances.

IS Curve

the -ve relationship between the interest rate and the level of income that arises in the market for goods and services.

Actual Expenditure (AE)

the amount households, firms, and the government spend on goods and services. AE=GDP

Planned Expenditure (PE)

the amount households, firms, and the government would like to spend on goods and services

Keynesian Cross

the simplest interpretation of Keynes's theory of how national income is determined. It is also a building block for the more realistic IS-LM model.

Draw and explain the theory of liquidity preference

the supply and demand for real money balances determine the r. The supply curve for real money balances is vertical because supply does not depend on r. The demand curve is downward sloping as a higher interest rate raises the cost of holding money and thus lowers the quantity demanded.

Why might PE and AE differ?

they might differ because firms might engage in unplanned inventory investment due to sales not meeting their expectations.

What is the equilibrium in the Keynesian Cross Model?

where AE=PE (Y=PE)

The Government purchases multiplier

Δ Y/Δ G = 1/1-MPC tells us how much income rises in response to a $1 increase in G. (the G multiplier is greater than 1).

The Tax multiplier

Δ Y/Δ T = -MPC/1-MPC the amount income changes in response to a $1 change in taxes.