MACROECONOMICS

1
MACROECONOMICS

• Chapter 10
• Aggregate Demand I Building the IS-LM Model

2
Can We Ignore Short Run?

• In 1933, unemployment rate was 25 and GDP was
  one-third below its 1929 level.
• Classics supply creates its own demand.
• Keynes aggregate demand fluctuates independent
  of the supply.
• Classics prices adjust fast.
• Keynes prices are sticky.

3
Expenditures
PE C I G NX Leave NX for Ch. 12
NX0 C c(Y-T) Consumption is determined by MPC
times disposable income. T, I, G are exogenous
values given outside of the model.
4
Keynesian Cross
For the economy to be in equilibrium (the
circular flow to have top and bottom flows
matched) the horizontal distance has to equal
to the vertical distance. The 45-degree line
represents YPE.
5
Equilibrium in Keynesian Cross
Firms
Households
Review your circular flow diagram Ch. 2, slide
5
6
Multiplier Response of Y to a Change in
Expenditure
If ?G700 and MPC0.33, what is ?Y?
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Multiplier for a Tax Cut
Which fiscal policy gives more bang for the
buck? Increasing government expenditures or
reducing taxes?
8
Derivation of IS Curve
G,T, and r are exogenous.
9
Shifts in IS
What shifts Keynesian PE curve?
Any increase in the components of PE C, I, G.
Any decrease in taxes.
If real interest rate drops and PE shifts up,
what will happen to IS?
Movement along the IS!
10
Monetary Sector and Nominal Interest Rate
How does the sector move from the first
equilibrium to the second?
11
Derivation of the LM Curve
Demand for money (liquidity preference) increases
with real income but decreases with higher
interest rates.
12
Shifts in LM
Money supply increases will shift LM right money
supply decreases will shift it to the left.
13
Equilibrium r and Y
John Hicks
IS
LM
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Theory of Short Run Fluctuations
Yf(r)
Equate Ys solve for r
YCIG
Equate rs solve for Y
Yf(P)
LR Yf(K,L)
Yf(r,M/P)
M/PL(r,Y)
SR Yf(AD)
15
Contradiction?

• IS-LM Model says if the Central Bank increases
  the money supply, interest rates will fall.
• Fisher effect said that if inflation rises,
  interest rates will rise.
• Money supply increases trigger inflation.
• What is going on?

16
Contradiction?
Ms
LM
r
r
IS
Y
M/P
Fisher effect Nominal interest rate real
interest rate inflation