Aggregate Demand I: Building the IS-LM Model

Chapter 11 of Macroeconomics, 8th edition, by N. Gregory Mankiw

ECO62 Udayan Roy

THE GOODS MARKET IN THE SHORT RUN

Recap: Long-Run Theory of Output

Actual Output ≠ Potential Output

Short-Run Theory of Output: it’s all about demand

• The short-run theory of total real GDP is also called– Keynesian theory, after the economist John

Maynard Keynes, or – Aggregate Demand Theory

• This theory assumes that, in the short run, output is determined by aggregate demand: the economy will produce as much output as there is demand for

THE KEYNESIAN CROSSThe simplest theory of short-run equilibrium in the goods market

Planned Expenditure• Assumption: The economy is a closed

economy• Planned Expenditure (PE) is the total desired

expenditure of the three sectors of the economy:– Households (C)– Businesses (I) and– Government (G)

• PE = C + I + G

Consumption Expenditure

• PE = C + I + G• What determines the planned expenditure of

households (C)?– We did this before in chapter 3

Consumption, C

Consumption, C• Assumption: Planned expenditure by households is

directly related to disposable income

• Consumption function: C = C (Y – T )

Consumption Function: algebra• Consumption function: C = C (Y – T )

• Specifically, C = Co + Cy✕(Y – T)

• Co represents all other exogenous variables that affect consumption, such as asset prices, consumer optimism, etc.

• Cy is the marginal propensity to consume (MPC), the fraction of every additional dollar of income that is consumed

Consumption Function: graphC

Y – T

C (Y –T) = Co + Cy✕(Y – T)

1

MPCThe slope of the consumption function is the MPC.

Marginal propensity to consume (MPC) is the increase in consumption (C) when disposable income (Y – T) increases by one dollar. It is also Cy.

Co

Consumption Function: shiftsC

Y – T

C = Co1 + Cy✕(Y – T)

C = Co2 + Cy✕(Y – T)

Consumption shift factor: greater consumer optimism, higher asset prices (Co↑)

F(K, L) – T1 F(K, L) – T2

T1 > T2

Consumption Function: example

• Suppose Y = 30.85 and T = 0.85. • Therefore, disposable income is Y – T = 30. • Now, suppose C = 2 + 0.8 ✕ (Y – T). • Then, C = 2 + 0.8 ✕ 30 = 26

Y

C(Y – T), T

C

Private Saving is defined as disposable income – consumption, which is Y – T – C = 30 – 26 = 4.

Income and Private Saving

• The marginal propensity to consume is a positive fraction (0 < MPC < 1)

• That is, when income (Y) increases, consumption (C) also increases, but by only a fraction of the increase in income.

• Therefore, Y↑⇒ C↑ and Y – C↑ and Y – T – C↑

• Similarly, Y↓⇒ C↓ and Y – C↓ and Y – T – C↓

Planned Investment

• PE = C + I + G• Assumption: Planned investment spending by

businesses (I) is exogenous

• This assumption is a big deal. • Recall that business investment was

endogenous in long-run analysis of chapters 3, 8 and 9.

Government Spending

• PE = C + I + G• Assumption: government spending (G) is

exogenous• Public Saving is defined as the net tax revenue

of the government minus government spending, which is T – G – This is also called the budget surplus

Planned Expenditure

• PE = C + I + G• Therefore, PE = C(Y – T) + I + G• Or, more specifically, PE = Co + Cy✕(Y – T) + I +

G

Equilibrium

• Assumption: The goods market will be in equilibrium. That is, actual expenditure will be equal to planned expenditure.

Actual and planned expenditure

• Actual and planned expenditure do not have to be equal in all circumstances

• Actual expenditure = planned expenditure + unplanned increase in inventory– When unplanned increase in inventory > 0, more

is bought than was intended. – When unplanned increase in inventory < 0, less is

bought than was intended.

Equilibrium

• When unplanned increase in inventory > 0, more is bought than was intended.

• So, actual expenditure > planned expenditure• In this case, output will shrink• In other words, the current output level

cannot represent equilibrium

Equilibrium

• When unplanned increase in inventory < 0, less is bought than was intended.

• So, actual expenditure < planned expenditure• In this case, output will increase• In other words, the current output level

cannot represent equilibrium

Equilibrium

• For an economy to be in equilibrium, unplanned increase in inventory must be zero

• Therefore, actual expenditure = planned expenditure + unplanned increase in inventory = planned expenditure

• But recall that actual expenditure is actual GDP or Y, and planned expenditure is C + I + G

• Therefore, in equilibrium, Y = C + I + G

Short-Run GDP: calculation

• We just saw that in equilibrium Y = C + I + G• Therefore, Y = Co + Cy ✕ (Y – T) + I + G

• This is one equation with one unknown, Y• So, this equation can be used to solve for Y

– Example: C = 2 + 0.8✕(Y – T), T = 0.85, G = 3, and I = 1.85

– Then, Y = 2 + 0.8✕(Y – 0.85) + 1.85 + 3– Check that Y = 30.85

Short-Run GDP: calculation

• In equilibrium, Y = C + I + G

y

yo

yoy

yoy

yyo

yo

C

GITCCY

GITCCYC

GITCCYCY

GITCYCCY

GITYCCY

1

)1(

)(

Every variable on the right hand-side of the equation is exogenous. So, this equation tells us everything we can say about Y in the Keynesian Cross model.

At this point, you should be able to do problems 2 and 4 on pages 325-26 of the textbook. Please try them.

Short-Run GDP: predictions

y

yo

C

GITCCY

1

Every variable on the right hand-side of the equation is exogenous. So, this equation tells us everything we can say about Y in the Keynesian Cross model.

Predictions Grid

Y

Co +

T −

I +

G +

In other words, the Keynesian Cross model is able to explain why recessions and booms happen.

The Keynesian Cross Equation

TC

CGIC

CC

GITCCY

y

yo

yy

yo

1)(

1

1

1

The Spending Multiplier

• Note that for every $1.00 increase in Co + I + G, Y increases by $1/(1 – Cy).

• As Cy is the marginal propensity to consume, 1/(1 – Cy) may be written as 1/(1 – MPC).

• This is called the spending multiplier.

TC

CGIC

CY

y

yo

y

1

)(1

1

The Spending Multiplier

• As the marginal propensity to consume is a positive fraction (0 < MPC < 1), 1 – MPC is also a positive fraction.

• Therefore, 1/(1 – MPC) > 1.• So, for every $1.00 increase in Co + I + G, Y

increases by more than $1.00!

TC

CGIC

CY

y

yo

y

1

)(1

1

The Spending Multiplier

• The spending multiplier is 1/(1 – MPC).• Example: If MPC = 0.2, the spending multiplier = 1/(1 – 0.2)

= 1.25. Therefore, if the government spends $3 billion on a new highway, real GDP will increase by $3.75 billion

• Example: If MPC = 0.8, the spending multiplier = 1/(1 – 0.8) = 5. Therefore, if the government spends $3 billion on a new highway, real GDP will increase by $15 billion

• The bigger MPC is, the bigger the spending multiplier will be. Why???

TC

CGIC

CY

y

yo

y

1

)(1

1

The Tax-Cut Multiplier

• Note that for every $1.00 decrease in T, Y increases by $Cy/(1 – Cy).

• As Cy is the marginal propensity to consume, Cy

/(1 – Cy) may be written as MPC/(1 – MPC).

• This is the tax-cut multiplier.

TC

CGIC

CY

y

yo

y

1

)(1

1

The Tax-Cut Multiplier

• As the marginal propensity to consume is a positive fraction (0 < MPC < 1), – MPC/(1 – MPC) < 1/(1 – MPC) – Tax-cut multiplier < spending multiplier– That is, a $1.00 tax cut provides a smaller boost to

the economy than a $1.00 increase in government spending. Why??

TC

CGIC

CY

y

yo

y

1

)(1

1

At this point, you should be able to do problem 1 on page 325 of the textbook. Please try it.

The Tax-Cut Multiplier

• The tax-cut multiplier is MPC/(1 – MPC).• Example: If MPC = 0.2, the tax-cut multiplier = 0.2/(1 –

0.2) = 0.25 < 1. Therefore, if the government cuts taxes by $3 billion, real GDP will increase by $0.75 billion

• Example: If MPC = 0.8, the tax-cut multiplier = 0.8/(1 – 0.8) = 4. Therefore, if the government cuts taxes by $3 billion, real GDP will increase by $12 billion

TC

CGIC

CY

y

yo

y

1

)(1

1

Fiscal Policy

• The practice of changing the levels of government spending (G) and/or taxes (T) in order to affect the macroeconomic outcome is called fiscal policy– Spending more (G↑) and/or cutting taxes (T↓) is

called expansionary fiscal policy– Spending less (G↓) and/or raising taxes (T↑) is

called contractionary fiscal policy

Fiscal Policy

• The consequences of expansionary and contractionary fiscal policy in the Keynesian Cross model were analyzed in previous slides

• In any case, they can be easily seen from the Keynesian Cross model’s equation:

TC

CGIC

CY

y

yo

y

1

)(1

1

K.C. Spending multiplier

K.C. Tax-cut multiplier

Fiscal Policy: balanced budget multiplier

• Note that expansionary fiscal policy (G↑ and/or T↓) leads to lower public saving (T – G↓) – This could mean a rise in the budget deficit or a

fall in the budget surplus

• Is there no way to stimulate an economy in a recession while keeping the budget balanced?

• There is!

Fiscal Policy: balanced budget multiplier

Fiscal Policy: balanced budget multiplier

• The balanced budget multiplier shows that if both government spending and taxes are increased by the same amount—thereby keeping the budget balanced—then output will increase by the same amount.

Graphing planned expenditure

income, output, Y

PE

planned

expenditure

PE =C +I +G

MPC1

Graphing the equilibrium condition

income, output, Y

PE

planned

expenditure

PE =Y

45º

The equilibrium value of income

Y

PE

planned

expenditure

PE =Y

PE =C +I +G

Equilibrium income

Output gap

An increase in government purchases

Y

PE

PE =

Y

PE =C +I +G1

PE1 = Y1

PE =C +I +G2

PE2 = Y2

Y

At Y1,

there is now an unplanned drop in inventory…

…so firms increase output, and income rises toward a new equilibrium.

G

Solving for YY C I G

Y C I G

MPC Y G

C G

(1 MPC) Y G

1

1 MPC

Y G

equilibrium condition

in changes

because I exogenous

because C = MPC

Y

Collect terms with Y on the left side of the equals sign:

Solve for Y :

The government purchases multiplier

Example: If MPC = 0.8, then

Definition: the increase in income resulting from a $1 increase in G.In this model, the govt purchases multiplier equals

1

1 MPC

YG

15

1 0.8

YG

An increase in G causes income to increase 5 times

as much!

An increase in G causes income to increase 5 times

as much!

Why the multiplier is greater than 1

• Initially, the increase in G causes an equal increase in Y: Y = G.

• But Y C further Y further C further Y

• So the final impact on income is much bigger than the initial G.

An increase in taxes

Y

PE

PE

=Y

PE =C2 +I +G

PE2 = Y2

PE =C1 +I +G

PE1 = Y1

Y

At Y1, there is now

an unplanned inventory buildup……so firms

reduce output, and income falls toward a new equilibrium

C = MPC T

Initially, the tax increase reduces consumption, and therefore PE:

Solving for YY C I G

MPC Y T

C

(1 MPC) MPC Y T

eq’m condition in changes

I and G exogenous

Solving for Y :

MPC

1 MPC

Y TFinal result:

The tax multiplierdef: the change in income resulting from a $1 increase in T :

MPC

1 MPC

YT

0.8 0.84

1 0.8 0.2

YT

If MPC = 0.8, then the tax multiplier equals

The tax multiplier…is negative: A tax increase reduces C, which reduces income.

…is smaller than the spending 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 (or Co or Io).

NOW YOU TRY:

Practice with the Keynesian Cross

• Use a graph of the Keynesian cross to show the effects of an increase in planned investment on the equilibrium level of income/output.

Tax Cuts: JFK

• Kennedy cut personal and corporate income taxes in 1964

• An economic boom followed. – GDP grew 5.3% in 1964 and 6.0 in 1965. – Unemployment fell from 5.7% in 1963 to 5.2% in 1964

to 4.5% in 1965.• However, it is not easy to prove that the tax cuts

caused the boom• Even when they agree that the tax cuts caused

the boom, economists can’t agree on the reason

Tax Cuts: JFK

• Keynesians argued that the tax cuts boosted demand, which led to higher production and falling unemployment

• Supply-siders argued that demand had nothing to do with it. The tax cuts gave people the incentive to work harder. So, L increased. Therefore, Y = F(K, L) also increased.– Personally, I feel this argument doesn’t explain

why the unemployment rate fell

Tax Cuts: GWB• Bush cut taxes in 2001 and 2003• After the second tax cut, a weak recovery from

the 2001 recession turned into a strong recovery– GDP grew 4.4% in 2004– Unemployment fell from its peak of 6.3% in June 2003

to 5.4% in December 2004• In justifying his tax cut, Bush used the Keynesian

explanation: – “When people have more money, they can spend it

on goods and services. … when they demand an additional good or service, somebody will produce the good or service.”

Spending Stimulus: Barack Obama

• When President Obama took office in January 2009, the economy had suffered the worst collapse since the Great Depression

• Obama helped enact an $800 billion (5% of annual GDP) stimulus to be spent over a two-year period

• About 40% was tax cuts, and 60% was additional government spending– White House economists had estimated the

spending multiplier to be 1.57 and the tax-cut multiplier to be 0.99

Spending Stimulus: Barack Obama

• Much of the new spending was on infrastructure projects

• These projects were fine for the long run, but took a long time to be implemented, and were therefore not ideal as a short-run boost

• Obama publicly justified his stimulus bill using Keynesian demand-side reasoning

THE IS CURVE

A slightly more complex theory of short-run equilibrium in the goods market

Planned Investment

• The Keynesian Cross model assumed that planned expenditure by businesses (I) is exogenous

• Recall that, in chapter 3, we had assumed that investment spending is inversely related to the real interest rate

• The IS Curve theory of the goods market brings back the investment function I = I(r)

The Real Interest Rate

• Recall from chapter 3 that, the real interest rate is the inflation-adjusted interest rate

• To adjust the nominal interest rate for inflation, you simply subtract the inflation rate from the nominal interest rate– If the bank charges you 5% interest rate on a cash

loan, that’s the nominal interest rate (i = 0.05). – If the inflation rate turns out to be 3% during the

loan period (π = 0.03), then you paid the real interest rate of just 2% (r = i − π = 0.02)

The Real Interest Rate

• The problem is that when you are taking out a loan you don’t quite know what the inflation rate will be over the loan period

• So, economists distinguish between– the ex post real interest rate: r = i − π– and the ex ante real interest rate: r = i − Eπ,

where Eπ is the expected inflation rate over the loan period

– We will use the ex ante interpretation of the real interest rate

Investment and the real interest rate

• Assumption: investment spending is inversely related to the real interest rate

• I = I(r), such that r↑⇒ I↓r

I

I (r )

Investment and the real interest rate

• Specifically, I = Io − Irr• Here Ir is the effect of r

on I and • Io represents all other

factors that also affect business investment spending – such as business

optimism, technological progress, etc.

I

r

Io1 − Irr

Io2 − Irr

Investment: example

• Suppose I = 11.85 – 2r is the investment function

• Then, if r = 5 percent, we get I = 11.85 – 2r = 1.85.

The IS Curve

• Recall that the goods market is in equilibrium when Y = C + I + G

• The IS curve is a graph that shows all combinations of r and Y for which the goods market is in equilibrium

• Therefore, the basic equation underlying the IS curve is Y = C(Y – T) + I(r) + G

Deriving the IS Curve: algebra

rC

IT

C

CGIC

CY

GrIITCCYC

GrIITCCYCY

GrIITCYCCY

GrIITYCCY

GrITYCY

y

r

y

yoo

y

royoy

royoy

royyo

royo

11)(

1

1

)1(

)(

)()(

K.C. Spending multiplier

K.C. Tax-cut multiplier

IS Interest rate effect

Deriving the IS Curve: algebra

rC

IT

C

CGIC

CY

y

r

y

yoo

y

11

)(1

1

So, although the basic equation underlying the IS curve is …

GrITYCY )()(

… for my specific consumption and investment functions, the equation underlying the IS curve can also be expressed as:

The two equations are equivalent forms of the IS curve.

Comparing the Equations of the Keynesian Cross and the IS Curve

rC

IT

C

CGIC

CY

y

r

y

yoo

y

11

)(1

1

TC

CGIC

CY

y

yoo

y

1

)(1

1

Keynesian Cross

IS Curve

K.C. Spending multiplier

K.C. Tax-cut multiplier

IS Interest rate effect

K.C. Spending multiplier

K.C. Tax-cut multiplier

This is the only difference

The IS Curve

rC

IT

C

CGIC

CY

y

r

y

yoo

y

11

)(1

1

K.C. Spending multiplier

K.C. Tax-cut multiplier

IS Interest rate effect

Y2Y1

r

Y

r1

ISr2

ΔY

Δr

Any change in the real interest rate will cause an opposite change in real total GDP by a multiple determined by the size of the interest rate effect.

This is why the IS curve is negatively sloped.

The IS Curve: effect of fiscal policy

rC

IT

C

CGIC

CY

y

r

y

yoo

y

11

)(1

1

K.C. Spending multiplier

K.C. Tax-cut multiplier

IS Interest rate effect

Y2Y1

r

Y

r1

IS1IS2

Y

Any increase in Co + Io + G causes the IS curve to shift right by an amount magnified by the Keynesian Cross spending multiplier

That is, if the real interest rate is unchanged, the Keynesian Cross model is the same as the IS curve model.

The IS Curve: effect of fiscal policy

rC

IT

C

CGIC

CY

y

r

y

yoo

y

11

)(1

1

K.C. Spending multiplier

K.C. Tax-cut multiplier

IS Interest rate effect

Y2Y1

r

Y

r1

IS1IS2

Y

Any decrease in taxes (T) causes the IS curve to shift right by an amount magnified by the Keynesian Cross tax-cut multiplier

The IS Curve: shifts

• To sum up the previous two slides:• The IS curve shifts right if there is:

– an increase in Co + Io + G, or

– a decrease in T.

Y2Y1

Y2Y1

Deriving the IS curve: graphs

r I

Y

PE

r

Y

PE =C +I (r1 )+G

PE =C +I (r2 )+G

r1

r2

PE =Y

IS

I PE

Y

Any change in the real interest rate will cause an opposite change in real total GDP by a multiple determined by the size of the interest rate effect.

Y1

Y1

The natural rate of interest

Y

PE

r

Y

PE = C + I(r1) + G

r1

PE = Y

IS

The natural rate of interest will re-appear in chapter 14. But there it will be denoted ρ. (Confused???)

Why the IS curve is negatively sloped

• A fall in the interest rate motivates firms to increase investment spending, which drives up total planned spending (PE ).

• To restore equilibrium in the goods market, output (a.k.a. actual expenditure, Y ) must increase.

Fiscal Policy and the IS curve

• We can use the IS-LM model to see how fiscal policy (G and T ) affects aggregate demand and output.

• Let’s start by using the Keynesian cross to see how fiscal policy shifts the IS curve…

Y2Y1

Y2Y1

Shifting the IS curve: G

At any value of r, G PE Y

Y

PE

r

Y

PE =C +I (r1 )+G1

PE =C +I (r1 )+G2

r1

PE =Y

IS1

The horizontal distance of the IS shift equals

IS2

…so the IS curve shifts to the right.

1

1 MPC

Y G Y

NOW YOU TRY:

Shifting the IS curve: T

• Use the diagram of the Keynesian cross or loanable funds model to show how an increase in taxes shifts the IS curve.

THE MONEY MARKET IN THE SHORT RUN: THE LM CURVE

The theory of short-run equilibrium in the money market

The Theory of Liquidity Preference

• The theory of short-run equilibrium in the money market is exactly the same as the theory of long-run equilibrium in the money market that we saw in Chapter 5– Please review Chapter 5

Review of Ch. 5

Money demand and the interest rate

• Liquid assets are assumed to earn no interest• Illiquid assets are assumed to earn the

nominal interest rate i • Therefore, an increase in i is assumed to

reduce the demand for money• That is, money demand (Md) is assumed to be

inversely related to the nominal interest rate (i)

Review of Ch. 5

Money demand and the price level

• We also hold some of our wealth in the form of money—in liquid form—because money is an excellent medium of exchange

Review of Ch. 5

Money demand and the price level

• Recall that nominal GDP is the market value of all final goods and services

• It is also the total expenditure on all final goods and services

• Therefore, the bigger our nominal GDP, the bigger will be our need for money, as money is a medium of exchange

• It is, therefore, assumed that money demand is directly related to nominal GDP

Review of Ch. 5

Money demand and the price level

• Let P represent the overall level of prices, as measured by the GDP Deflator

• Recall from chapter 2 that the GDP Deflator = Nominal GDP / Real GDP

• Therefore, Nominal GDP = GDP Deflator ✕ Real GDP = P ✕ Y

• It is, therefore, assumed that money demand (Md) is directly related to nominal GDP (PY)

Review of Ch. 5

Money Demand

• So, Md is– inversely related to i, and– directly related to PY

• Md = L(i)PY– L(i) is the liquidity function– It is inversely related to i, the nominal interest rate

Review of Ch. 5

Money Demand: example

• Md = L(i)PY– L(i) is the liquidity function– It is inversely related to i, the nominal interest rate

• Specific form of L(i):– L(i) = Lo/i

– Lo represents all factors other than P, Y and i that also affect money demand

Review of Ch. 5

Money Demand = Money Supply

• M denotes money supply• Md = L(i)PY denotes money demand• Therefore, M = L(i)PY denotes equilibrium in

the money market

Review of Ch. 5

Money Demand = Money Supply

At this point, you should be able to do problem 5 on page 326 of the textbook. Please try it.

The LM Equation

Money Demand = Money Supply

Prices are sticky in the short run

• Recall that the long-run analysis of Chapter 5 assumed that P is endogenous. – Recall also that in the long run P changes

proportionately with M.

• The short-run analysis in the IS-LM model assumes that P is exogenous: it is what it is, it is historically determined– That is, the overall price level is “sticky”: what it

was last week, it will be this week too

Prices are sticky in the short run

• This sticky-prices assumption is the crucial distinction between long-run and short-run macroeconomic analysis

• Except this assumption, all assumptions made in short-run analysis are also assumed in long-run analysis

• So, the differences between long-run and short-run theories are caused by this sticky-prices assumption

Money Demand = Money Supply

The LM Curve: algebra to graph

• The LM curve shows all combinations of r and Y for which the money market is in equilibrium

• Note that the LM curve is upward rising

r

YY1

r1

r2

Y2

LM

The LM Curve: algebra to graph

• The LM curve shifts (down) right if:– M/P or Eπ increases– Lo decreases

• Moreover, if Eπ increases (decreases), the LM curve shifts down (up) by the exact same amount!

r

Y

r2

Y0

LM1 LM2

r1

NOW YOU TRY:

Shifting the LM curve

• Suppose a wave of credit card fraud causes consumers to use cash more frequently in transactions.

• Use the liquidity preference model to show how these events shift the LM curve.

SHORT-RUN EQUILIBRIUM IN THE IS-LM MODEL

Both the goods market and the money market need to be in equilibrium

Short-run equilibrium

The short-run equilibrium is the combination of r and Y that simultaneously satisfies the equilibrium conditions in both the goods and money markets:

( ) ( )Y C Y T I r G

Y

r

IS

LM

Equilibriuminterestrate

Equilibriumlevel ofincome

YPErLM )(

Short-run equilibrium

By insisting that both the goods market and the money market need to be in equilibrium, we have managed to find a way to pinpoint both r and Y simultaneously!

( ) ( )Y C Y T I r G Y

r

IS

LM

Equilibriuminterestrate

Equilibriumlevel ofincome

YPErLM )(

Short-run equilibrium

Y

r

IS

LM

Equilibriuminterestrate

Equilibriumlevel ofincome

But, the Keynesian Cross model could determine only equilibrium GDP. The IS-LM model determines the equilibrium interest rate as well.

The IS-LM Model: summary• Short-run equilibrium in the goods market is represented

by a downward-sloping IS curve linking Y and r.• Short-run equilibrium in the money market is represented

by an upward-sloping LM curve linking Y and r.• The intersection of the IS and LM curves determine the

short-run equilibrium values of Y and r.• The IS curve shifts right if there is:

– an increase in Co + Io + G, or– a decrease in T.

• The LM curve shifts right if:– M/P or Eπ increases, or– Lo decreases

Y

r

IS

LM

The Big Picture

KeynesianCrossKeynesianCross

Theory of Liquidity Preference

Theory of Liquidity Preference

IScurve

IScurve

LM curveLM

curve

IS-LMmodelIS-LMmodel

Agg. demand

curve

Agg. demand

curve

Agg. supplycurve

Agg. supplycurve

Model of Agg.

Demand and Agg. Supply

Model of Agg.

Demand and Agg. Supply

Explanation of short-run fluctuations

Explanation of short-run fluctuations

Preview of Chapter 12

In Chapter 12, we will– use the IS-LM model to analyze the impact of

policies and shocks.– learn how the aggregate demand curve comes

from IS-LM.– use the IS-LM and AD-AS models together to

analyze the short-run and long-run effects of shocks.

– use our models to learn about the Great Depression.