CHAPTER THREE

Aggregate Demand in a closed

economy

slide 0
 3.1 Foundation of theory of
aggregate demand
 Of all the economic fluctuations in world history, the
one that stands out as particularly large, painful, and
intellectually significant is the Great Depression of the
1930s.
 The Great Depression caused many economists to
question the validity of classical economic theory.
 They believed they needed a new model to explain such
a pervasive economic downturn and to suggest that
government policies might ease some of the economic
hardship that society was experiencing.
slide 1
In 1936, John Maynard Keynes wrote The General Theory of
Employment, Interest and Money.
 In it, he proposed a new way to analyze the economy, which he
presented as an alternative to the classical theory.
His vision of how the economy works quickly became a center
of controversy.
Yet, as economists debated The General Theory, a new
understanding of economic fluctuations gradually developed.

slide 2
 Cont..

Keynes proposed that low aggregate demand is responsible

for the low income and high unemployment that characterize
economic downturns.
He criticized the notion that aggregate supply-capital, labor,
and technology alone determines national income.
Economists today reconcile these two views with the model
of aggregate demand and aggregate supply.

slide 3
 In the long run, prices are flexible, and aggregate supply
determines income. But in the short run, prices are sticky, so
changes in aggregate demand influence income.
 The model of aggregate demand called the IS(Investment-
saving)–LM(liquidity-money) model, is the leading
interpretation of Keynes’s theory.
 The goal of the model is to show what determines national
income for any given price level.

slide 4
 Aggregate Demand

 Aggregate demand is the total amount of goods

demanded by different economic agents (households,
firms, governments and foreigners) in the economy.
 It shows the level of real GDP purchased by
households (C), business firms (I), government (G)
and foreigners (NX) at different level of prices.
Aggregate demand, therefore expressed in terms of its
components as:
 AD=C+I+G+NX
slide 5
 Aggregate Demand Analysis in
Goods Market(IS curve)
 Components of Aggregate Demand
1 , Consumption :- Households decides how much
to spend on goods and services and save
depend on their income after tax (disposable
income). That is consumption spending of
individuals depends on their real personal
disposable income (Y-T).
 Households save great proportion of their
income if their real income increases more than
increase in consumption.
slide 6
 Cont..

 C = a + b (Y-T), 0<b<1 a>0

 „b‟ represent marginal propensity to consume,
 a’ represents autonomous consumptions
 T- Tax revenue
 T is an exogenous variable and is not determine
with in the model we will just assume some
number outside the model .

slide 7
 Investment

 It is the amount of spending made by firms on

capital goods to add to their stock of capital and
to replace existing capital as it wears out.
 In other words, investment is the demand for
capital goods that are used to produce other
goods and services. When a firm buys capital
goods, costs are incurred today but revenues
are earned in the future from sales of goods and
services produced using the capital goods up on
which investment made.

slide 8
 Cont..

 I=I(r)
 If interest rate increases, cost of investment
increase so that the investment becomes less
profitable and these would cause decline in the
quantity of investment demand.
 Government spending (G)
 Government spending (G) represents public
sector‟s demand for goods and services.

slide 9
 .
 Government spending is assumed to be
determined by the government independently of
the state of macroeconomic. It is exogenous
and denoted by G.
 Foreign spending –Net export (NX)
 Net export (NX) is the final component of aggregate
demand which represent demand for domestic goods
and services by the rest of the world. The home country
will sell goods to foreign residents which are called
export, denoted by X. While some of domestic income
will be spent on foreign products. These goods are
called imports, denoted by M.

slide 10
 Cont..

 Net export therefore the difference between the

demand for domestic products by the rest of the
world and demand for foreign product by
domestic consumer (NX=X-M).

slide 11
 closed economy, NX=0 and
restate aggregate demand
 Y= C+I+G
Keynesian cross
 In general theory propose that an economy total
income was in short run , determined largely by the
desire to spend households firms and Gov’t.
 The more peoples want to spend , the more goods and
services firms can sell . The more firms can sell the
more output they will choose to produce and the more
worker to hire thus the problem during recession and
depression . slide 12
 Keynesian
. cross model on the built from the
concept of planned and actual expenditure. So
we have to define these concepts before they
are used to construct the model.
 Actual expenditure is the amount households,
firms and government spend on goods and
services. It is equal to GDP of an economy (Y).
 Planned expenditure is the amount
households, firms and government would like to
spend on goods and services. This implies
planned expenditure is the same as aggregate
demand of closed economy
slide 13
 The.income expenditure relationship (also called
the Keynesian cross model) is the first step to
deriving the interest rate/income relationship. It
relates planned expenditure (E) to actual
expenditure.
 actual expenditure equals income (Y ), because
any unsold goods are defined as inventory
investment, but planned expenditure may not
equal income. For example, firms and
households may purchase more goods and
services than are produced in a year, so that
inventories are run down.
slide 14
 Elements of The Keynesian Cross
 A simple closed economy model in which income is
determined by expenditure. ( J.M. Keynes)
 Notation:
I = planned investment
E = C + I + G = planned expenditure
Y = real GDP = actual expenditure
 Difference between actual & planned expenditure =
unplanned inventory investment

slide 15
 Elements of the Keynesian Cross
Consumption function: C  C (Y T )
Government policy variables: G  G , T T
For now, planned
investment is exogenous: I I

Planned expenditure: E  C (Y T )  I  G
Equilibrium condition:
actual expenditure = planned expenditure
Y  E
slide 16
Graphing Planned Expenditure
E
Planned
expenditure
E =C +I + G

MPC
1

income, output, Y

slide 17
Graphing the equilibrium condition
E
planned E =Y
expenditure

45º

income, output, Y

slide 18
The equilibrium value of income
E
planned E =Y
expenditure
E =C +I + G

income, output, Y
Equilibrium
income
slide 19
 An increase in government purchases
E
At Y1, E =C +I +G2
there is now an
unplanned drop E =C +I +G1
in inventory…

G
…so firms
increase output,
and income Y
rises toward a
new equilibrium. E1 = Y1 Y E2 = Y2

slide 20
 Solving for Y
Y  C  I  G equilibrium condition

Y  C  I  G in changes

 C  G because I exogenous
because C = MPC Y
 MPC  Y  G MPC=marginal propensity to
consume.
Collect terms with Y
on the left side of the Solve for Y :
equals sign:
 1 
(1  MPC)  Y  G Y     G
 1  MPC 
slide 21
 The government purchases multiplier
Definition: the increase in income resulting from a
$1 increase in G.
In this model, the govt Y 1
purchases multiplier equals 
G 1  MPC

Example: If MPC = 0.8, then

An increase in G
Y 1
  5 causes income to
G 1  0.8 increase 5 times
as much!

slide 22
 Why the multiplier is greater than 1

 Initially, the increase in G causes an equal increase

in Y: Y = G.
 But Y  C
 further Y
 further C
 further Y
 So the final impact on income is much bigger than
the initial G.

slide 23
 An increase in taxes
E
Initially, the tax
increase reduces E =C1 +I +G
consumption, and E =C2 +I +G
therefore E:

C = MPC T At Y1, there is now

an unplanned
inventory buildup…
…so firms
reduce output,
and income falls Y
toward a new
E2 = Y2 Y E1 = Y1
equilibrium

slide 24
 Solving for Y
eq‟m condition in
Y  C  I  G
changes
 C I and G exogenous

 MPC   Y  T 
Solving for Y : (1  MPC)  Y   MPC  T

  MPC 
Final result: Y     T
 1  MPC 

slide 25
 The tax multiplier

def: the change in income resulting from

a $1 increase in T :
Y  MPC

T 1  MPC

If MPC = 0.8, then the tax multiplier equals

Y  0.8  0.8
   4
T 1  0.8 0.2

slide 26
 The tax multiplier

…is negative:
A tax increase reduces C,
which reduces income.
…is greater than one
(in absolute value):
A change in taxes has a
multiplier effect on income.
…is smaller than the govt spending multiplier:
Consumers save the fraction (1 – MPC) of a tax cut,
so the initial boost in spending from a tax cut is
smaller than from an equal increase in G.
slide 27
 3.2 The goods market and the IS
curve

def: a graph of all combinations of r and Y that result in

goods market equilibrium

i.e. actual expenditure (output) = planned expenditure

The equation for the IS curve is:

Y  C (Y T )  I (r )  G

slide 28
 Cont..
 Income of HHs is allocated for (a) consumption, (b)
saving and (c) taxes.
Y = C+S +T, On the expenditure side, AD equals
Y= C + I + G and At equilibrium
S- I = G-T
 If government has a balanced budget G = T then, S =
I and this is called Saving-Investment Identity.
• If government runs a budget deficit G>T; then S>I
• If government has a budget surplus, private
investment exceeds saving.
slide 29
 Deriving the IS curve
E E =Y E =C +I (r )+G
2

r  I E =C +I (r1 )+G

 E I

 Y Y1 Y2 Y
r
r1

r2
IS
Y1 Y2 Y

slide 30
 Why the IS curve is negatively
sloped
 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.

slide 31
 Fiscal Policy and the IS curve

 We can use the IS-LM model to see

how fiscal policy (G and T ) affects
aggregate demand and output.
 Let‟s start by using the Keynesian cross
to see how fiscal policy shifts the IS curve…

slide 32
 Shifting the IS curve: G
E E =Y E =C +I (r )+G
At any value of r, 1 2

G  E  Y E =C +I (r1 )+G1
…so the IS curve
shifts to the right.

The horizontal Y1 Y2 Y
r
distance of the
IS shift equals r1

Y 
1
G Y
1 MPC IS1 IS2
Y1 Y2 Y

slide 33
 This slide has two purposes. First, to show which
way the IS curve shifts when G changes. Second, to
actually measure the distance of the shift.
 We can measure either the horizontal or vertical
distance of the shift. The horizontal distance of the
IS curve shift is the change in Y required to restore
goods market equilibrium AT THE INITIAL
INTEREST RATE when G is raised.

slide 34
 Since the interest rate is unchanged at r1,
investment will also be unchanged.
 This is why, in the upper panel, we write “I(r1)” in
the E equation for both expenditure curves – to
remind us that investment and the interest rate
are not changing.

slide 35
 Exercise: Shifting the IS curve

 Use the diagram of the Keynesian cross to show

how an increase in taxes shifts the IS curve.
 Use the diagram of the Keynesian cross to
show how a decrease in taxes shifts the IS curve
 Use the diagram of the Keynesian cross to show
how a decrease in government expenditure
shifts the IS curve

slide 36
 Numerical Exercise
1. In Keynesian cross assume consumption function is given
by: C= 400 +0.75(Y-T), Planned investment is 200 and both
government purchase and taxes are both 200
a. Graph planned expenditure as a function of income
b. What is the equilibrium level of income
c. If government purchase increase to 250, what is the new
equilibrium income?
d. What level of government purchase needed to achieve
an income of 4000?

slide 37
 3.3. Money Market and the LM Curve
• M oney: Money is the stock of assets that can be readily used to make
transactions and can be immediately used for payments.
Money Functions:
• Medium of exchange, most convenient way of making transaction of goods and
services;
• Store of value: transfers purchasing power from the present to the future
and
• Unit of account: the common unit of measuring prices and values by
everyone.
Types of Money
a) Fiat money: Money with no intrinsic value such as paper currency or cheque
we use.
b) Commodity Money: Money with intrinsic value; for instance, silver, gold
coins, etc.

slide 38
 3.3. Money Market and the LM Curve con..
Money can take different forms:
• Currency in Circulation: Fiat money and commodity money that we see
circulating in the market.
• Demand Deposit: It is non-interest bearing deposit; it can be transferred easily to
bearer of the check.
• Saving Deposit: The common kind of deposits that we know, a deposit that bears
interest but can be drawn at any time (depending sometimes on the amount).
• Time Deposit: An interest bearing deposit, which cannot be withdrawn
from banks before the agreement set between the bank and the client.
Types of money based on composition
1. Narrow money (M1) : M1 = C + DD, where C =currency in
Circulation, D D = demand deposit.
2. Broad money (M2): M2 = M1 + SD + TD, SD = Saving deposits and DT = Time
deposit

slide 39
 3.3. Money Market and the LM Curve con..
The Demand for Money: Three motives for holding money.
1. Precautionary Demand for Money: Money kept aside for precautionary (for
fear of risks). It is affected by transaction and speculative demand for money.
2. Speculative Demand for Money: A person can put his liquid assets into either
bonds (investment) or money. An increase in interest rate, which is a return on
bonds, induces to hold assets in the form of bond and hold less in the form of
money. Such demand for money depends, therefore, on the cost of holding
money – interest and it is called speculative demand for money.
3. Transaction Demand for Money: It is the motive for holding money to
bridge the time gap between receipt of income and payments to be
made for transaction purposes.
• Transaction demand for money increases as income increases in
income; for given interest rate.
• L[R, Y] = eY − fR
slide 40
 3.3 The money market and the LM
curve con…

 The Theory of Liquidity Preference

 A simple theory in which the interest rate
is determined by money supply and
money demand.
 As just Keynesian cross is a building block for IS
curve the theory of liquidity preference is a
building block for LM curve.

slide 41
 Money supply
r
M P
s
The supply of interest
real money rate
balances
is fixed:

M P M P
s

We are assuming a fixed supply of real M/P

money balances because M P real money
P is fixed by assumption (short-run), and balances
M is an exogenous policy variable.
slide 42
 Money demand
r
M P
s
Demand for interest
real money rate
balances:

M P
d
 L (r )

L (r )
The nominal interest rate is the
opportunity cost of holding money M/P
(instead of bonds), so money demand M P real money
depends negatively on the nominal balances
interest rate.
slide 43
 Equilibrium
r
M P
s
The interest interest
rate adjusts rate
to equate the
supply and
demand for
money: r1

M P  L (r ) L (r )

M/P
M P real money
balances

slide 44
 How the Fed raises the interest rate
r
interest
To increase r, rate
Fed reduces M
r2

r1
L (r )

M/P
M2 M1 real money
P P balances

slide 45
 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 )

slide 46
 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 )
M1 M/P Y1 Y2 Y
P

slide 47
 Why the LM curve is upward sloping

 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.

slide 48
 Monetary policy and LM curve

 Changes in R and Y will be movements along the LM

curve, but any change in an exogenous variable will
shift the position of the LM curve.
 Suppose the central bank of a given country decrease
money supply from M1 to M2. For constant level of
income and price, it will decrease real balance
causing shift to the left.

slide 49
 How M 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 )

M2 M1 M/P Y1 Y
P P

slide 50
 When the Fed increase M, the vertical distance
of the shift tells us what happens to the
equilibrium interest rate associated with a given
value of income.
 Or, we can think of the LM curve shifting
horizontally:
 When the Fed reduces M, the horizontal
distance of the shift tells us what would have to
happen to income to restore money market
equilibrium at the initial interest rate
slide 51
 Exercise: 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.

slide 52
Numerical Exercise

slide 53
 3.4 The short-run equilibrium

 When the economy is in disequilibrium, it moves toward

equilibrium through the interaction of both markets.
Algebraically we can present ISLM model with the following
two equations:

 Once ISLM model is constructed, we use it next to see how

change in exogenous policy variables such as tax , government
spending and money supply influence equilibrium level of
output and interest rate in the short run (with the assumption of
fixed price level).

slide 54
 3.4 The short-run equilibrium
The short-run equilibrium is r
the combination of r and Y
LM
that simultaneously satisfies
the equilibrium conditions in
the goods & money markets:

Y  C (Y T )  I (r )  G IS
M P  L (r ,Y ) Y
Equilibrium
interest Equilibrium
rate level of
income

slide 55
 Monetary and fiscal policies in IS
- LM model
 Monetary and fiscal policies are generally
termed as demand management policy.
 Fiscal policy
 Increase in G implies expands planned expenditure and this
implies increase in income, IS curve shifts outward and result
in new equilibrium level of income higher than the original.
 But the increase in income resulted from change in
government expenditure increases transaction demand for
money. With fixed supply of real money balance the increase
demand for money causes increase in interest rate.
slide 56
Cont.…

slide 57
 Monetary policy

 Thus increase in money supply causes LM curve

downward to the right. The decline in interest rate
increases investment demand and raises the level of
output and income moving the economy from (r1, Y1
)to higher level of income and lower level of interest
rate (r2, Y2).

slide 58
Cont.….

slide 59
 The Aggregate Demand Curve
Deriving The Ad Curve
 The final step in constructing the AD curve is to relax the
price level which has so far been kept fixed in value in
deriving the LM curve.
 When change the price level then the IS-LM model can
be used to derive the quantity of aggregate output
demanded in an economy.
 As an example, consider a decrease in the price level from
P1 to P2 which is shown in the following graph:

slide 60
Cont..

slide 61
 Why the AD Curve is Downward Sloping
 the effect changes in P have on an asset, the stock of
money balances, which is also a nominal variable.
Say P increases, then the real value of this asset
decreases. The supply of real assets has fallen while
the demand for them has not changed. This leads to r
increasing, I decreasing, induced C falling, and Y
decreasing.

slide 62
 A Shift of the AD Curve
 Changes in P will cause a movement along the AD
curve, as outlined above. Changes in the exogenous
variables (except P — and we will let that vary
eventually) cause shifts of the AD curve.

slide 63
 The Big Picture

Keynesian IS
Cross curve
IS-LM
model Explanation
Theory of LM of short-run
Liquidity curve fluctuations
Preference
Agg.
demand
curve Model of
Agg.
Demand
Agg.
and Agg.
supply
Supply
curve

slide 64
Numerical Exercise

slide 65
Cont.…

slide 66