Chapter 10: Aggregate Demand I

The goal of this, and the next chapter, is to identify variables that shift the aggregate demand curve, causing short-run fluctuations in national income. The IS-LM model takes the price level as given and shows what causes income to change.

Goods Market equilibrium and the IS Curve:

1. Planned expenditure is the amount that households, business firms, and government plan to spend on goods and services. In a closed economy planned expenditure, E, is the as follows:

E = C + I + G

C = C(Y-T)

I = Io

G = Go

T = To

2. The Keynesian Cross equates actual expenditure with planned expenditure. If the economy is in equilibrium actual expenditure equals planned expenditure so that Y = E (a 45 degree line.)

3. Only when E crosses this 45 degree line is the economy in equilibrium, where aggregate supply of goods and services equals aggregate demand for goods and services.

4. Income below this level results in too few goods or an unintended drop in inventories. Income above this level results in too many goods or unplanned inventory accumulations. The change in inventories will induce subsequent changes in production and output until Y = E when there are no unplanned changes in inventories.

The Income Multiplier:

1. Autonomous changes in spending, such as government purchases, will increase income by a multiplier because it induces more consumption spending. The endogenous response of consumption spending to the exogenous change in government spending adds to the influence of government purchases on aggregate demand.

2. The value of the multiplier is the reciprocal of the “leakage rate.” A higher propensity to save will lower the multiplier. Similarly, induced public savings through an income tax will lower the value of the multiplier (called an “automatic” stabilizer).

3. The tax multiplier is less than the spending multiplier (and in the opposite direction) since the marginal propensity to consume is less than 1.

Deriving the IS curve:

1. If investment spending is dependent upon interest rates then equilibrium income will be different for different interest rates. Specifically, higher interest rates lower investment spending and lower equilibrium income.

2. The combination of interest rates and income that result in equilibrium between planned and actual spending in the goods market is called the IS curve.

Shifting the IS curve results in different levels of equilibrium income at the same interest rate. Government spending shifts the IS curve outward while higher taxes shifts the IS curve inward.

A Loanable-Funds Interpretation of the IS Curve: In equilibrium the supply of loanable funds S(Y) equals the demand for loanable funds I(r) which only occurs for values of (Y,r) on the IS curve. For a given I(r) schedule more income raises savings and thus lowers the interest rate that equates the supply and demand fo loanable funds. This may be used to derive the IS curve.

The Money Market and the LM Curve:

The Keynesian demand for money function is called the theory of liquidity preference.

(The supply of money is determined exogenously by the Federal Reserve.)

1. The Theory of Liquidity Preference includes both the demand for money as a medium of exchange and the demand for money as an asset. The demand for real money balances as a medium of exchange is positively related to real income. But, the demand for money as an asset is inversely related to the rate of interest that can be earned from other financial assets, represented by a consol.

2. If the price level is given and inflationary expectations are given, then Keynes argued that the demand for money would increase with lower interest rates. (note that both nominal and real interest rates fall proportionally.)

3. This speculative demand for money is based upon the fact that bond prices (and yields in the inverse direction) can change with interest rates relative to the value of money. (In fact, portfolio managers are speculating on the value of bonds, rather than the value of money).

4. The key to this speculative motive is the present interest rate compared with what people think is normal. If currrent interest rates are “low” then more people will hold (demand) more money relative to bonds and wait until bond prices fall and bond yields increase. If current interest rates are “high” then more people will hold less money and substitute into bonds while their yields are high and their prices are low. Hence, the demand for money is high when interest rates are low and low when interest rates are high.

5. Given the price level and the level of inflationary expectations, the LM Curve is the combination of real interest rates, r, and real income,Y, which equates the demand for real money balances with the supply of real money balances.

Monetary Policy and the LM Curve:

1. An increase in the supply of money shifts the LM curve to the right because at every level of income determining transactions demand there must be a lower interest rate in order to increase the speculative demand for money until total money demanded equals the higher money supply.

2. A lowering in the demand for money will shift the LM curve to the right. Suppose, for some reason, more people adjusted there perception of the “normal” yield on bonds downward. Then with fewer people expecting interest rates to rise in the future there would be fewer people substituting from bonds to money. The demand for money would fall and the LM curve would shifts to the right.

3. Can an increase in the supply of money affect the demand for money? As the Fed increases the money supply it buys bonds in the open market, bidding up their price and lowering their yield. If people respond to the lower yield by increasing their demand for money, then the velocity of money will fall offsetting some of the desired effect of more money on spending and income. In an extreme case (the liquidity trap) all new money balances would be demanded and there would be no effect on spending for goods and services.

Short Run Equilibrium: IS = LM

Aggregate demand is determined by simultaneous equilibrium in both the goods market and the money market. For a given price level, the intersection of the IS and LM curves determines equlibrium real interest rates and real output.

The Derivation of the Keynesian Aggregate Demand Curve: Aggregate demand = f (Price level) (From end of next chapter)

1. For a given price level the supply of real money balances is given.

2. For the same money supply a lower price level will increase the supply of real money balances and shift the LM curve to the right. This results in higher equilibrium real income. (Called the “Keynes effect.”)

3. A lower price level that increases the value of real wealth may influence the level of consumer spending and shift the IS curve to right resulting in higher equlibrium real income. This adds to the price elasticity of the aggregated demand curve. (Called the “Pigou effect.”)

4. Exogenous shifts in the IS curve and/or LM curve cause shifts in the aggregate demand curve.