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Macroeconomics ECO 403
VU
LESSON 27
AGGREGATE DEMAND AND AGGREGATE SUPPLY (Continued...)
Understanding the IS curve's slope
·
The IS curve is negatively sloped.
·
Intuition:
A fall in the interest rate motivates firms to increase investment spending, which drives up
total planned spending (E ).
To restore equilibrium in the goods market, output (actual expenditure, Y) must increase.
The IS curve and the Loanable Funds model
(a)
The L.F. model
(b) The IS curve
r
r
S2
S1
r2
r2
r1
r1
I (r)
IS
Y
S, I
Y2
Y1
Fiscal Policy and the IS curve
·
We can use the IS-LM model to see how fiscal policy (G and T) can affect aggregate
demand and output.
·
Let's start by using the Keynesian Cross to see how fiscal policy shifts the IS curve...
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Macroeconomics ECO 403
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Shifting the IS curve: ΔG
At any value of r, ↑G ⇒ ↑E ⇒ ↑Y ...so the IS curve shifts to the right.
E =Y
E
E =C +I (r1 )+G2
E =C +I (r1 )+G1
Y
Y1
Y2
r
r1
ΔY
IS2
IS1
Y2
Y1
Y
The Theory of Liquidity Preference
·
Due to John Maynard Keynes.
·
A simple theory in which the interest rate is determined by money supply and money
demand.
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Macroeconomics ECO 403
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Money Supply
(M/P)s
r
interest
rate
M/P
M
P
real money
balances
The supply of real money balances is fixed:
(M
P) =M P
s
Money Demand
s
(M/P)
r
interest
rate
L (r)
M/P
M
P
real money balances
Demand for real money balances:
(M
P)
d
= L (r )
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Macroeconomics ECO 403
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Equilibrium
(M/P) s
r
interest
rate
r1
L (r )
M/P
M
P
real money balances
The interest rate adjusts to equate the supply and demand for money:
M P = L (r )
How Central bank raises the interest rate
To increase r, Central Bank reduces M
r
interest
rate
r2
L (r )
r1
M/P
M
M
2
1
real money
balances
P
P
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Macroeconomics ECO 403
VU
The LM curve
Now let's put Y back into the money demand function:
(M
P)
d
= L (r ,Y )
The LM curve is a graph of all combinations of r and Y that equate the supply and demand for
real money balances.
The equation for the LM curve is:
M P = L (r ,Y )
Deriving the LM curve
(a)
The market for
(b) The LM curve
real money balances
r
r
LM
r2
r2
L (r , Y2 )
r1
r1
L (r , Y1 )
Y
M/P
Y1
Y2
M
1
P
Understanding the LM curve's slope
·
The LM curve is positively sloped.
·
Intuition: An increase in income raises money demand. Since the supply of real balances
is fixed, there is now excess demand in the money market at the initial interest rate.
The interest rate must rise to restore equilibrium in the money market.
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Macroeconomics ECO 403
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How ΔM shifts the LM curve
(a)
The market for
(b) The LM curve
real money balances
r
r
LM2
LM1
r2
r2
r1
r1
L (r , Y1 )
Y
M/P
Y
M
M
2
1
p
p
/
/
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.
The short-run equilibrium
The short-run equilibrium is the combination of r and Y that simultaneously satisfies the
equilibrium conditions in the goods & money markets:
Y = C ( - T ) + I (r ) + G
Y
M P = L (r ,Y )
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Macroeconomics ECO 403
VU
r
LM
IS
Y
Equilibrium interest
Equilibrium
rate
level of
income
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