

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 ISLM
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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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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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
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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
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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.
119
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
shortrun equilibrium
The
shortrun 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
)
120
Macroeconomics
ECO 403
VU
r
LM
IS
Y
Equilibrium
interest
Equilibrium
rate
level
of
income
121
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