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Chapter

Week 8 chapter notes


Department
Economics for Management Studies
Course Code
MGEB06H3
Professor
Jack Parkinson

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Chapter 10 Aggregate Demand I: Building the IS-LM Model Notes
x IS-LM model Æ a model of aggregate demand that shows what determines aggregate income for a given price level by
analyzing the interaction between the goods market and the money market
x IS curve Æ negative relationship between interest rate and the level of income that arises in the market for goods and services
x LM curve Æ the positive relationship between the interest rate and the level of income (while holding the price level fixed) that
arises in the market for real money balances
x IS stands for “investment” and “saving”, and the IS curve represents what’s going on in the market for goods and services
x LM stands for “liquidityand “money, and the LM curve represents what’s happening to the supply and demand for money
10.1 The Goods Market and the IS Curve
x Keynesian cross Æ a simple model of income determination, based on the ideas in Keynes’s General Theory, which shows how
changes in spending can have a multiplied effect on aggregate income
The Keynesian Cross
x in the General Theory Keynes proposed that an economy’s total income was, in the short run, determined largely by the desire to
spend by households, firms, and the government; thus the problem during recessions and depressions was inadequate spending
x actual expenditure is amount households, firms, and government spend on goods and services and it equals economy’s GDP
x planned expenditure is the amount households, firms, and the government would like to spend on goods and services
x government-purchases multiplier Æ the change in aggregate income resulting from a one-dollar change in government purchases
x tax multiplier Æ the change in aggregate income resulting from a one-dollar change in taxes
How Fiscal Policy Shifts the IS Curve
x IS curve shows combinations of interest rate and income level that are steady with equilibrium in market for goods and services
x the IS curve is drawn for a given fiscal policy
x changes in fiscal policy that raise the demand for goods and services shift the IS curve to the right
x changes in fiscal policy that reduce the demand for goods and services shift the IS curve to the left
10.2 The Money Market and the LM Curve
x theory of liquidity preferences Æ a simple model of the interest rate, based on the ideas in Keynes’s General Theory, which says
that the interest rate adjusts to equilibrate the supply and demand for real money balances
How Monetary Policy Shifts the LM Curve
x LM curve shows combinations of interest rate and income level that are steady with stability in market for real money balances
x the LM curve is drawn for a given supply of real money balances
x decreases in the supply of real money balances shift the LM curve upward
x increases in the supply of real money balances shift the LM curve downward
Summary
1. The Keynesian cross is a basic model of income determination. It takes fiscal policy and planned investment as exogenous and
then shows that there is one level of national income at which actual expenditure equals planned expenditure. It shows that
changes in fiscal policy have a multiplied impact on income.
2. Once we allow planned investment to depend on the interest rate, the Keynesian cross yields a relationship between the interest
rate and national income. A higher interest rate lowers planned investment, and this in turn lowers national income. The
downward-sloping IS curve summarizes this negative relationship between the interest rate and income.
3. The theory of liquidity preference is a basic model of the determination of the interest rate. It takes the money supply and the
price level as exogenous and assumes that the interest rate adjusts to equilibrate the supply and demand for real money balances.
The theory implies that increases in the money supply lower the interest rate.
4. Once we allow the demand for real balances to depend on national income, the theory of liquidity preference yields a
relationship between income and the interest rate. A higher level of income raises the demand for real balances, and this in turn
raises the interest rate. The upward-sloping LM curve summarizes this positive relationship between income and the interest rate.
5. The IS-LM model combines the elements of the Keynesian cross and the elements of the theory of liquidity preference. The IS
curve shows the points that satisfy equilibrium in the goods market, and the LM curve shows the points that satisfy equilibrium
in the money market. The intersection of the IS and LM curves shows the interest rate and income that satisfy equilibrium in
both markets for a given price level.
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