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Chapter 10

Week 7 - Chapter 10.docx

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ECON 2000

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Week 7Chapter 10Aggregate Demand I Building the ISLM ModelThe Depression caused many economists to question validity of classical economic theory as it seemed incapable of explaining the DepressionAccording to the theory national income depends on factor supplies and available technology neither of which changed from 1929 to 1933Economists believed new model was needed to explain large and sudden economic downturnJohn Maynard Keynes came up with his own theoryoProposed low aggregate demand is responsible for low income and high unemployment that characterized economic downturnsoCriticized classical theory for assuming aggregate supply alonecapital labour and technologydetermines national incomeChapter 10 introduced model of aggregate demand and aggregate supplyLong RunoPrices are flexibleoAggregate supply factors of production determine incomeoutputoUnemployment equals its natural rate YShort RunoPrices are sticky fixedoChanges in aggregate demand influence incomeoutputoUnemployment negatively related to outputThis chapter looking more closely at aggregate demand curveoIdentifying variables that shift the AD curve causing fluctuations in national incomeAlso examine tools policymakers can use to influence aggregate demandoGovernment can influence AD with both monetary and fiscal policyISLM model is leading interpretation of Keynes theoryoGoal of model is to show what determines national income for any given price leveloShows what causes income to change in short run when price level is fixed oroShows what causes AD curve to shiftIS curve stands for investment and savingrepresents whats going on in markets for goods and servicesLM curve stands for liquidity and moneyrepresents whats happening to supply and demand for moneyInterest rate influences both investment and money demand which links the two halves of ISLM modelModel shows how interaction between these markets determine position and slope of AD curve and therefore level of national income in short run101 THE GOODS MARKET AND THE IS CURVEIS curve plots relationship between interest rate and level of income that arises in market for goods and servicesTo develop this relationship begin with basic model called Keynesian crossoSimplest interpretation of Keyness theory of how national income is determinedThe Keynesian CrossIn The General Theory Keynes proposed that the economys total income was in short run determined largely by desire to spend by households firms and the govtoThe more people want to spend firms can sell more goods and services and the more output they will choose to produce and the more workers they will choose to hireThus problem during recessions and depressions was inadequate spendingPlanned ExpenditureActual expenditureamount households firms and govt spend on goods and servicesoEquals economys GDPPlanned expenditureamount households firms and govt would like to spend on GSDifference between actual and planned expenditureunplanned inventory investment because sales do not meet their expectationsoBecause unplanned changes in inventory counted as investment spending by firms actual expenditure can be either above or below planned expenditureNow consider determinants of planned expenditure closed economy no NXoIplanned investmentoPECIGplanned expenditureTo this equation we add consumption functionoCCYTIFor now we assume planned investment is exogenous I GAlso assume that fiscal policylevels of govt purchases and taxesis fixed G TTCombination of these five equationsoPECYTIGIShows that planned expenditure is function of income Y level of planned investmentGTand the fiscal policy variablesand Planned expenditureSlope of line is marginal propensity to consume shows how much PE increases when income rises by 1The Economy in EquilibriumNext piece of Keynesian cross is assumption that economy is in equilibrium when actual expenditure equals planned expenditure
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