El Colegio de Mxico / Centro de Estudios Econmicos

Curso Propedutico 2017:

Introduccin a la Macroeconoma

Dr. Julen Berasaluce

Classes 7 & 9: Aggregate Demand I: Building the IS-LM Model

Class Outline
7.1 Introduction
7.2. IS-LM model
7.3. The Keynesian Cross
7.4. Fiscal Policy and the Multiplier
7.5 The Interest Rate, Investment, and the IS Curve
7.6 How Fiscal Policy Shifts the IS Curve
7.7 The Theory of Liquidity Preference
7.8 The Short-Run Equilibrium
 7.1 Introduction

According to the classical theory, national income depends on factor

supplies and the available technology.
However, neither of these changed during the crisis of 1929 or 2008.
After the onset of the Depression, many economists believed that a
new model was needed to explain the economic downturns and to
suggest government policies that might reduce their impact.
In 1936, John Maynard Keynes published The General Theory of
Employment, Interest and Money, where he explained an alternative to the
classical theory.
He proposed that the low aggregate demand was responsible for he
low income and its undesirable effects (such as unemployment).
He criticized classical theory for assuming that aggregate supply of
productive factors and technology determined national income.
 Currently many economists consider that
In the long run prices are flexible aggregate supply determines income
classical theory applies.
In the short run prices are sticky aggregate demand influences income
keynesian theory applies.
In this chapter we will continue studying economic fluctuation by focusing on
aggregate demand.
We will identify the variables that shift the aggregate demand curve and how
do they influence national income.
We will analyze which tools policymakers can use to influence aggregate
demand.
Last week we analyzed the effects of the monetary policy on the aggregate
demand curve.
With the IS-LM model we will be able to consider both monetary and fiscal
policy.
 7.2. IS-LM model
The objective of the IS-LM model is to analyze how the income of a
country is determined for a fixed price level
If we accept that the price level is fixed in the short run, the IS-LM model may
be adeccuate to understand how the income is determined in such short run.
We can also see the IS-LM model as one which helps to explain how the
aggregate demand is affected by some variables and policies.
2 3
1

SRAS

1 2 3
 IS curve
Investment Saving
Market for goods and services
LM curve
Liquidity Money
Market for money
The variable that links both markets is the interest rate
We will show how interactions between both markets determine the
aggregate demand and the level of income.
 7.3. The Keynesian Cross
Keynes proposed that the economys total income is basically determined
by the spending plans of households, business and govermnet.
The more these agents spend, the more firms sell.
If firms sell more, they hire more workers.
During recessions there is not enough spending
Make the distinction:
Actual expenditure: the amount households, firms, and the goverment
spend on goods and services.
Planned expenditure: the amount household, firms and the
government would like to spend on goods and services.
 One of the differences between planned expenditure and actual
expenditure are changes in inventory.
If the firms sells less than planned inventories rise.
If the firm sells more than planned inventories fall.
Determinants of planned expedniture in a closed economy (XN=0)
= + +
where
= ( ), = , T=
Foir simplicity, we assume that, also, I=
Thus, we obtain,
= + +
PE

= + +

When income increases 1$,

MPC consumption increases by
the Marginal Propension to
Consume (MPC)
1$
Therefore, the slope of PE,
w. r. t. Y is given by the MPC

Y
EQUILIBRIUM
When is the economy in equilibrium?
When the actual expenditure = planned expenditure
I. e. when peoples plan are realized, they will do what they planned to do.
Remember that Y (equivalent to GDP) equals income as well as total
expenditure on goods and services. Therefore,

Actual Expenditure = Planned Expenditure

=
PE

Y=PE

= + +

45
Y
Equilibrium income
PE, Y Actual expenditure
1

= + +

If firms produce at level

1 then,

45
Y
Equilibrium income 1
PE, Y Actual expenditure
1 Unplanned
inventory
accumulation
1
= + +

Since planned expenditure

falls short 1 > 1 , firms
accumulate inventories

45
1 Y
Equilibrium income
PE, Y Actual expenditure = + +

1 Unplanned
inventory
accumulation
1

The inventory
accumulation induces
firms to decrease
production

45
1 Y
Equilibrium income
PE, Y Actual expenditure

= + +

If firms produce at level

2 then,

45
Y
2 Equilibrium income
PE, Y Actual expenditure

Unplanned = + +
drop in
inventory
Since planned expenditure
2 exceeds production 2 <
2 , firms run down their
inventories
2

45
2 Y
Equilibrium income
PE, Y Actual expenditure

Unplanned = + +
drop in
inventory
The inventory drop
induces firms to
2
increase production

45
Y
2 Equilibrium income
 7.4. Fiscal Policy and the Multiplier

GOVERNMENT PURCHASES
How changes in government purchases affect the economy?
Because government purchases are one component of expenditure higher
government purchases result in higher planned expenditure
If the government purchases rise by , then PE shifts upward by
 Actual expenditure
PE, Y

Planned expenditure

The increase in
government
purchases leads to an
even greater increase
in income

45

Y
1 2
 >
The ratio / is called the government-purchases multiplier: how
much income rises in response to a $1 increase in government
purchases.
An increase in government purchases raises income, which raises
consumption, which raises income, which
First, income rises by
Second, the increase in income rises consumption by MPC , which rises
income
Third, by the previous increase in income, consumption rises by 2

= (1 + + 2 + 3 + )
 Y
= (1 + + 2 + 3 + )

The multiplier is an infinite geometric series. For |x|<1
= 1 + + 2 + 3 +
= + 3 + 4 +
The first equation minus the second
x- = 1
1
=
1
Y 1
Therefore: =
1
That is, if MPC=0.8, ; the multiplier is 5
TAXES
A reduction in taxes of increases disposable income (Y-T) in
Therefore, it increases consumption by MPC
Then, income raises by MPC
Because of such increase of income, consumption increases by 2

= ( + 2 + 3 + )
So,
Y
=
T 1
So, if the MPC=0.8; a cut in taxes of $1 raises equilibrium in $4
 Actual expenditure
PE, Y

Planned expenditure

The increase in
government
purchases leads to an
even greater increase
in income

45

Y
1 2
 Notice that the tax multiplier is smaller than the government purchase multiplier.
This is because the reduction in taxes increases the planned expenditure
indirectly through the increase of disposable income, which raises
consumption.
However, the increase of government purchases raises the planned
expenditure both directly, since the government purchases constitute one of
the determinants of the total expenditure, and also indirectly, through the
increase of disposable income and its effect on consumption.
Therefore, what would happen if we increase both government expenditure and
taxes in the same level?
1
=
1 1
1
= = > 0
1
 7.5 The Interest Rate, Investment, and the IS Curve
We have analyze how the spending plans of households, firms, and
the government determine the economys income
Now, let us add to the model, that the level of planned investment is
a function of the interest rate
=
Then an increase of the interest rate, reduces the planned
investment,
A reduction of the planned investment, reduces the planned
expenditure
That, relationship between the interest rate is summarized in the IS
curve
 Expenditure
Actual expenditure

Planned expenditure

a

r r Income, output, Y

2 2
a

1 1
IS
I(r)

(2 )(1 ) I 2 1 Y
 When the interest rate increses from 1 to 2 , the planned investment,
which is a decreasing function of the interest rate, decreases
1 < 2
The decrease in the planned investment reduces the planned
expenditure.
The reduction, in the planned expenditure, reduces the output in
equilibrium.
Therefore, we can construct a curve (IS) which relates changes in the
interest rate to changes in the equilibrium output.
 7.6 How Fiscal Policy Shifts the IS Curve

The IS curve shows, for each interest rate, the level of income that
brings the goods makert into equilibrum.
However, as we have seen before, the equilibrium level of income
does not only depend on the interest rate.
It also depends on government spending G and taxes T.
The IS curve is drawn for a given fiscal policy:
I. e. when we construct the IS curve we hold G and T fixed.
Therefore, when fiscal policy changes, the IS curve shifts.
 Let us analyze how an increase in government purchases shifts
the IS curve.
The Keynesian cross in the panel above shows that the change in
fiscal policy raises planned expenditure.
Such increase of the government expenditure increases equilibrium
income from 1 to 2 .
Since the interest rate has not changed we must shift the IS curve, so
that at the same interest rate we have a higher equilibrium income.
 Expenditure
Actual expenditure

Planned expenditure
G
a

r r Income, output, Y

IS2
I(r)
IS1
(1 ) I 1 2 Y
 7.7 The Theory of Liquidity Preference

Keynes explained how the interest rate is determined in the short run.
This is the Theory of Liquidity Preference.
According to this, the interest rate adjunts to balance the supply
and demand for money, i. e. the economys most liquid asset.
The Theory of Liquidity Preference is the origin of the LM curve, as
the Keynesian cross explains the IS curve.
Let us begin with the supply of real money balances. Remember that
M stands for the supply of real money and P for the price level.
Therefore, M/P is the supply of of real money balances.
 The theory of liquidity preference assumes there is a fixed supply of
real money balances.

() =

The money supply M is an exogenous policy variable chosen by the
central bank, such as Banco de Mxico.
The price level P is also an exogenous variable.
Remember that, since we are explaining the short run, the price
level is fixed.
We are assuming that the supply of real money balances is fixed and,
therefore, does not depend on the interest rate.
If we plot the real money balances against the interest rate, we obtain
a vertical supply curve.
r
Supply

M/P


 Now, let us consider the demand for real money balances.
The theory of liquidity states that the interest rate is one determinant
of how much money people choose to hold.
This is because the interest rate is the opportunity cost of holding
money.
I. e. if you hold your assets in money, instead of in a bank deposit
or bonds, you fail to obtain the interest rate.
Then, when the interest rate rises, people want to hold less of their
wealth in money.
() = ()
where the function L() represents that the quantity of real money
balances demanded depend (negatively) on the interest rate.
r

Demand, L(r)
M/P
 The supply and demand for real money balances determine what
interest rate prevails in the economy.
That is, the interest rate adjusts to equilibrate the money maket.
At the equilibrium interest rate, the quantity of real money
balances demanded equals the quantity supplied.
The adjustment occurs whenever the money market is not in
equilibrum.
If the interest rate is above the equilibrium level, the quantity of
real money balances supplied exceeds the quantity demanded.
Individuals holding the excess supply of money try to convert
some of their non-interest-bearing money into interest-bearing
bank deposits or bonds.
Banks, which prefer to pay lower interest rates, respond to this
excess supply of money by lowering the interest rate.
Eventually, the interest rate reaches the equilibrium level.
r
Supply

Demand, L(r)

M/P


 We can use the theory of liquidity preference to show how the
interest rate responds to changes in the supply of money.
Suppose that Banco de Mxico decreases the money supply.
A fall in M reduces M/P, because P is fixed in the model
The supply of real money balances shifts to the left.
The equilibrium interest rate rises from from 1 to 2 (1 < 2 ).
The higher interest rate makes people satisfied to hold the smaller
quantity of real money balances.
Therefore, a decrease in the money supply raises the interest rate,
and an increase in the money supply lowers the interest rate.
 7.6 Income, Money Demand, and the LM Curve

We have developed the theory of liquidity preference as an

explanation for how the interest rate is determined.
Now we use the theory to derive the LM curve.
How does a change in the economys level of income affect the
market for real money balances?
The level of income affects the demand of money.
When income is high, expenditure is high, so people engage in
more transactions that require the use of money.
Greater income implies greater money demand.
 Therefore, we can express the money demand function as

() = (, )

The quantity of real money balances

is negatively related to the interest rate
is positively related to income
 Let us analyze what happens when the income rises from 1 to 2 ,
where 1 < 2 .
Observe the graph in the left how this increase in income shifts the
money demand curve to the right.
That is, the demand of money real balances increases for each
interest rate.
With the supply of real money balances unchanged the interest rate
must rase from 1 to 2 .
Therefore, higher income leads to a higher interest rate.
The LM curve in the second graph resumes this relationship between
the level of income and the interest rate.
 r r

LM

1
(, 2 )
(, 1 )

M/P 1 2 Y

 7.7 How Monetary Policy Shifts the LM Curve

The LM curve tells us the interest rate that equilibrates the money
market at any level of income.
The equilibrium interest rate, as we saw before, also depens on the
supply of real money balances M/P
Therefore, the LM curve is drawn for a given supply of real balances.
That is, if real money balances change, the LM curve shifts.
 Suppose that Banco de Mxico increases the money supply from
1 to 2 (where 1 < 2 ).
1 2
This causes the supply of real money balances to raise from to .

Notice that we hold constant the amount of income, and thus the
demand curve for real money balances.
Then, the increase of the supply of real money balances decreases
the interest rate that equilibrates the money market
Hence an increase in the money supply shifts the LM curve
downward.
 r r 1

2

(, )
1 2 M/P Y

7.8 The Short-Run Equilibrium

We have all the pieces of the IS-LM model

= + + IS

= (, ) LM

The model takes fiscal policy (G and T), monetary policy (M) and the
price level (P) as exogenous.
IS curve provides the combinations of r and Y that satisfy the
equation representing the goods market
LM curve provides the combinations of r and Y that satisfy the
equation representing the money market.
r LM

r*

IS

Y
Y*
 The equilibrium of the economy is the point at which the IS curve and
the LM curve cross
This point gives the interest rate r and the level of income Y that
satisfy conditions for equilibrium in both the goods market and the
money market.
At the intersection
Actual expenditure = Planned expenditure
Demand for real money balances = Supply of real money balances
 Suponga en el aspa keynesiana que la funcin de consumo viene dada
por
C=200+0.75(Y-T)
La inversin planeada es 100; las compras del Estado y los impuestos
son ambos de 100
a) Represente grficamente el gasto planeado en funcin de la renta.
PE= C + I + G = 200 + 0.75 (Y-100)+100+100= 400-75 +0.75Y
PE=325+0.75Y
 PE

PE = 325 + 0.75Y

325

Y
 b) Cul es el nivel de renta de equilibrio?
PE = 325+ 0.75 Y
PE = Y

Y= 325Y +0.75Y
0.25Y=325

Y* = 325/0.25=325*4= 1,300
 c) Si las compras del Estado aumentan hasta 125, cul es la nueva
renta de equilibrio?
Si G aumenta hasta 125, el aumento de gasto gubernamental es de 25.
Recordemos que el multiplicador asociado al gasto gubernamental es
de = 1/(1-MPC)=1/0.25=4
Esto nos dice que por cada unidad de gasto pblico que aumente la
renta de equilibrio aumentara en 4 unidades.
Dado que el gasto gubernmanetal aument en 25. La renta de
equilibrio ha de aumentar en 4x25= 100 unidades, con respecto al
equilibrio anterior.
Es decir, la nueva renta de equilibrio es 1,300+100=1,400
Alternativamente, tambin se podra calcular la nueva renta de
equilibrio con el gasto gubernamental de 125.
 d) Qu nivel de compras del Estado es necesario para conseguir una
renta de 1,600?
Con respecto al apartado b) una renta de equilibrio de 1,600 implica un
aumento del nivel de renta de 300.
Como hemos visto, el multiplicador de gasto pblico es de 4; por lo
que, visto de otra manera, para generar un aumento del nivel de
renta de 1 unidad, el gasto del Estado ha de aumentar en de
unidad.
Por lo tanto, para que la renta aumente 300 unidades, el gasto del
Estado ha de aumentar en 300/4=75 unidades.
 Examine el efecto de un aumento de la frugalidad en el aspa
keynesiana. Suponga que la funcin de consumo es
= + ( )
donde es un parmetro llamado consumo autnomo y c es la
propensin marginal al consumo.
a) Qu ocurre con la renta de equilibrio cuando la sociedad se vuelve
ms frugal, lo que se representa por medio de una disminucin de

?

PE=C+I+G=+c(Y-T)+I+G
Una disminucin de se comporta de la misma manera que una
disminucin de G. Por lo tanto generara una disminucin de la
renta de equilibrio equivalente a la disminucin de multiplicada
por 1/(1-c)
 b) Qu ocurre con el ahorro de equilibrio?
S= Y-C-G
Una disminucin de , como hemos visto, disminuye el consumo (C)
y aumenta el ahorro, en la misma cantidad en que aumenta .
Sin embargo, la disminucin de , genera un disminucin de Y &

reduccin del ahorro -, en la cantidad dada por 1/(1-c) x.
Ntese, que esto tendra un segundo efecto en C por la parte de C que
depende de Y.
Dado que S=Y-C-G=Y- c Y T G
=
1 1 1
= c()=
c(

)=
1 1 1
1 11+
=( 1 )= = 0,
1 1 1
 Suponga que la funcin de demanda de dinero es

( ) = 1000 100

donde r es el tipo de inters en porcentaje. La oferta monetaria, M, es
1000 y el nivel de precios, P, es 2.
a) Represente grficamente la oferta y la demanda de saldos reales.
Cul esl el tipo de intrs de equilibrio?
Oferta de saldos reales = 1000/2=500
Demanda de saldos reales = 1000-100r
En el tipo de inters de equilibrio
500=1000-100r; r=500/100=5
r
Oferta
Demanda

5%

( ) = 1000 100

500 M/P
 Suponga que el nivel de precios se mantiene fijo Qu ocurre con el
tipo de inters de equilibrio si se eleva la oferta monetaria de 1,000 a
1,200?
Si la oferta monetaria se eleva a 1,200 y el nivel de precios se queda en
2. La oferta de saldos reales aumentara a 1,200/2=600
En equilibrio el tipo de inters bajara a:
600=1000-100r
r=400/100=4
r
Oferta
Demanda

5%
4%
( ) = 1000 100

500 600 M/P

 Si el banco central desea subir el tipo del intrs al 7%, qu oferta
monetaria debe fijar?
Consideremos que el nivel de precios se mantiene fijo en 2, y queremos
que el tipo de inters sea del 7%.
M/2=1000-100x7
M/2=300
M=600
Para que el tipo de inters sea del 7% la oferta monetaria ha de ser de
600, por lo que, para que suba el tipo de inters al 7% habra que
reducir la oferta monetaria en 400 unidades.
r
Oferta
Demanda

7%

5%

( ) = 1000 100

300 500 M/P

 Las siguientes ecuaciones describen una economa
Y=C+I+G
C=120+0.5(Y-T)
I=100-10r
G=50
T=40

( ) = 20

M=600
P=2
Utilice de la lista anterior el conjunto de ecuaciones necesario para
obtener la curva IS.
Y=120+0.5(Y-40)+50+100-10r
Y=270+0.5Y-20-10r
0.5Y=250-10r
Y=500-20r
 r
25%

IS

Y
500
Utilice de la lista anterior el conjunto de ecuaciones necesario para
obtener la curva LM.
600/2=Y-20r
300=Y-20r
Y=300+20r
r

LM

Y
300
Cules son el nivel de renta de equilibrio y el tipo de inters de
equilibrio?
IS Y=500-20r
LM Y=300+20r

0=200-40r; r=200/40=5%

Y= 300+20x5= 400

El tipo de inters de equilibrio es del 5% y el nivel de renta de equilibrio

es de 400.
 r

LM

IS
5%

Y
400