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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
VU
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
VU
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
VU
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.
119
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Macroeconomics ECO 403
VU
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
121
Table of Contents:
  1. INTRODUCTION:COURSE DESCRIPTION, TEN PRINCIPLES OF ECONOMICS
  2. PRINCIPLE OF MACROECONOMICS:People Face Tradeoffs
  3. IMPORTANCE OF MACROECONOMICS:Interest rates and rental payments
  4. THE DATA OF MACROECONOMICS:Rules for computing GDP
  5. THE DATA OF MACROECONOMICS (Continued…):Components of Expenditures
  6. THE DATA OF MACROECONOMICS (Continued…):How to construct the CPI
  7. NATIONAL INCOME: WHERE IT COMES FROM AND WHERE IT GOES
  8. NATIONAL INCOME: WHERE IT COMES FROM AND WHERE IT GOES (Continued…)
  9. NATIONAL INCOME: WHERE IT COMES FROM AND WHERE IT GOES (Continued…)
  10. NATIONAL INCOME: WHERE IT COMES FROM AND WHERE IT GOES (Continued…)
  11. MONEY AND INFLATION:The Quantity Equation, Inflation and interest rates
  12. MONEY AND INFLATION (Continued…):Money demand and the nominal interest rate
  13. MONEY AND INFLATION (Continued…):Costs of expected inflation:
  14. MONEY AND INFLATION (Continued…):The Classical Dichotomy
  15. OPEN ECONOMY:Three experiments, The nominal exchange rate
  16. OPEN ECONOMY (Continued…):The Determinants of the Nominal Exchange Rate
  17. OPEN ECONOMY (Continued…):A first model of the natural rate
  18. ISSUES IN UNEMPLOYMENT:Public Policy and Job Search
  19. ECONOMIC GROWTH:THE SOLOW MODEL, Saving and investment
  20. ECONOMIC GROWTH (Continued…):The Steady State
  21. ECONOMIC GROWTH (Continued…):The Golden Rule Capital Stock
  22. ECONOMIC GROWTH (Continued…):The Golden Rule, Policies to promote growth
  23. ECONOMIC GROWTH (Continued…):Possible problems with industrial policy
  24. AGGREGATE DEMAND AND AGGREGATE SUPPLY:When prices are sticky
  25. AGGREGATE DEMAND AND AGGREGATE SUPPLY (Continued…):
  26. AGGREGATE DEMAND AND AGGREGATE SUPPLY (Continued…):
  27. AGGREGATE DEMAND AND AGGREGATE SUPPLY (Continued…)
  28. AGGREGATE DEMAND AND AGGREGATE SUPPLY (Continued…)
  29. AGGREGATE DEMAND AND AGGREGATE SUPPLY (Continued…)
  30. AGGREGATE DEMAND IN THE OPEN ECONOMY:Lessons about fiscal policy
  31. AGGREGATE DEMAND IN THE OPEN ECONOMY(Continued…):Fixed exchange rates
  32. AGGREGATE DEMAND IN THE OPEN ECONOMY (Continued…):Why income might not rise
  33. AGGREGATE SUPPLY:The sticky-price model
  34. AGGREGATE SUPPLY (Continued…):Deriving the Phillips Curve from SRAS
  35. GOVERNMENT DEBT:Permanent Debt, Floating Debt, Unfunded Debts
  36. GOVERNMENT DEBT (Continued…):Starting with too little capital,
  37. CONSUMPTION:Secular Stagnation and Simon Kuznets
  38. CONSUMPTION (Continued…):Consumer Preferences, Constraints on Borrowings
  39. CONSUMPTION (Continued…):The Life-cycle Consumption Function
  40. INVESTMENT:The Rental Price of Capital, The Cost of Capital
  41. INVESTMENT (Continued…):The Determinants of Investment
  42. INVESTMENT (Continued…):Financing Constraints, Residential Investment
  43. INVESTMENT (Continued…):Inventories and the Real Interest Rate
  44. MONEY:Money Supply, Fractional Reserve Banking,
  45. MONEY (Continued…):Three Instruments of Money Supply, Money Demand