MACROECONOMICS
cover art ROW 1 (90)
C H A P T E R
© 2008 Worth Publishers, all rights reserved
SIXTH EDITION
PowerPoint® Slides by Ron Cronovich
N. GREGORY MANKIW
Aggregate Demand I:
Building the IS -LM Model
10

This chapter sets up the IS-LM model, which chapter 11 then uses extensively to analyze the effects
of policies and economic shocks.
This chapter also introduces students to the Keynesian Cross and Liquidity Preference models, which
underlie the IS curve and LM curve, respectively.
If you would like to spend less time on this chapter, you might consider omitting the Keynesian
Cross, instead using the loanable funds model from Chapter 3 to derive the IS curve.  Advantage:
students are already familiar with the loanable funds model, so skipping the KC means one less
model to learn.  Additionally, the KC model is not used anywhere else in this textbook.  Once it’s
used to derive IS, it disappears for good.
However, there are some good reasons for NOT omitting the KC model:
1) Many principles textbooks (though not Mankiw’s) cover the KC model; students who learned the KC
model in their principles class may benefit from seeing it here, as a bridge to the new material on
the IS curve.
2) The KC model is of historical importance.  One could argue that anybody graduating from college
with a degree in economics should be familiar with the KC model.

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CHAPTER 10   Aggregate Demand I
CHAPTER 10   Aggregate Demand I
In this chapter, you will learn…
§the IS  curve, and its relation to
§the Keynesian cross
§the loanable funds model
§the LM  curve, and its relation to
§the theory of liquidity preference
§how the IS-LM  model determines income and the interest rate in the short run when P is fixed

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CHAPTER 10   Aggregate Demand I
CHAPTER 10   Aggregate Demand I
Context
§Chapter 9 introduced the model of aggregate demand and aggregate supply.
§Long run
§prices flexible
§output determined by factors of production & technology
§unemployment equals its natural rate
§Short run
§prices fixed
§output determined by aggregate demand
§unemployment negatively related to output

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CHAPTER 10   Aggregate Demand I
CHAPTER 10   Aggregate Demand I
Context
§This chapter develops the IS-LM  model,
the basis of the aggregate demand curve.
§We focus on the short run and assume the price level is fixed (so, SRAS curve is horizontal).
§This chapter (and chapter 11) focus on the closed-economy case.
Chapter 12 presents the open-economy case.

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CHAPTER 10   Aggregate Demand I
CHAPTER 10   Aggregate Demand I
The Keynesian Cross
§A simple closed economy model in which income is determined by expenditure.
(due to 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

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CHAPTER 10   Aggregate Demand I
CHAPTER 10   Aggregate Demand I
Elements of the Keynesian Cross
consumption function:
for now, planned
investment is exogenous:
planned expenditure:
equilibrium condition:
govt policy variables:
actual expenditure = planned expenditure

Stress that much of this model is very familiar to students:  same consumption function as in
previous chapters, same treatment of fiscal policy variables.
Note:  In equilibrium, there is no unplanned inventory investment.  Firms are selling everything
they had intended to sell.

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CHAPTER 10   Aggregate Demand I
CHAPTER 10   Aggregate Demand I
Graphing planned expenditure
income, output, Y
E
planned
expenditure
E =C +I +G
MPC
1

Why slope of E line equals the MPC:
With I and G exogenous, the only component of (C+I+G) that changes when income changes is
consumption.  A one-unit increase in income causes consumption---and therefore E---to increase by
the MPC.
Recall from Chapter 3:  the marginal propensity to consume, MPC, equals the increase in consumption
resulting from a one-unit increase in disposable income.  Since T is exogenous here, a one-unit
increase in Y causes a one-unit increase in disposable income.

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CHAPTER 10   Aggregate Demand I
CHAPTER 10   Aggregate Demand I
Graphing the equilibrium condition
income, output, Y
E
planned
expenditure
E =Y
45º

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CHAPTER 10   Aggregate Demand I
CHAPTER 10   Aggregate Demand I
The equilibrium value of income
income, output, Y
E
planned
expenditure
E =Y
E =C +I +G
Equilibrium
income

The equilibrium point is the value of income where the curves cross.
Be sure your students understand why the equilibrium income appears on the horizontal and vertical
axes.

Answer:  In equilibrium, E (which is measured on the vertical) equals Y (which is measured on the
horizontal).

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CHAPTER 10   Aggregate Demand I
CHAPTER 10   Aggregate Demand I
An increase in government purchases
Y
E
E =C +I +G1
E1 = Y1
E =C +I +G2
E2 = Y2
DY
At Y1,
there is now an unplanned drop in inventory…
…so firms increase output, and income rises toward a new equilibrium.
DG

Explain why the vertical distance of the shift in the E curve equals G:
At any value of Y, an increase in G by the amount G causes an increase in E by the same amount.
At Y[1], there is now an unplanned depletion of inventories, because people are buying more than
firms are producing (E > Y).

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CHAPTER 10   Aggregate Demand I
CHAPTER 10   Aggregate Demand I
Solving for DY
equilibrium condition
in changes
because I exogenous
because DC  = MPC DY
Collect terms with DY  on the left side of the equals sign:
Solve for DY :

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CHAPTER 10   Aggregate Demand I
CHAPTER 10   Aggregate Demand I
The government purchases multiplier
Example:   If MPC = 0.8, then
§Definition:   the increase in income resulting from a $1 increase in G.
§In this model, the govt
purchases multiplier equals
An increase in G causes income to increase 5 times
as much!

The textbook defines the multiplier as the increase in income resulting from a $1 increase in G.
However, G is a real variable (as is Y ).  So, if you wish to be more precise, then you might
consider defining the multiplier as “the increase in income resulting from a one-unit increase in
G.”

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CHAPTER 10   Aggregate Demand I
CHAPTER 10   Aggregate Demand I
Why the multiplier is greater than 1
§Initially, the increase in G  causes an equal increase in Y:      DY = DG.
§But Y  Þ C
§ Þ further Y
§ Þ further C
§ Þ further Y
§So the final impact on income is much bigger than the initial DG.

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Students are better able to understand this if given a more concrete example, which you can explain
as you display the elements on this slide.  For instance,
Suppose the government spends an additional $100 million on defense.
Then, the revenues of defense firms increase by $100 million, all of which becomes income to
somebody:  some of it is paid to the workers and engineers and managers, the rest is profit paid as
dividends to shareholders.  Hence, income rises $100 million (Y = $100 million = G ).
The people whose income just rose by $100 million are also consumers,
and they will spend the fraction MPC of this extra income.
Suppose MPC = 0.8, so C  rises by $80 million.
To be concrete, suppose they buy $80 million worth of Ford Explorers.  Then, Ford sees its revenues
increase by $80 million, all of which becomes income to somebody - either Ford’s workers, or its
shareholders
 (Y = $80 million).  And what do these folks do with this extra income?  They spend the fraction
MPC (0.8) of it, causing C = $64 million (8/10 of $80 million).  Suppose they spend all $64
million on Hershey’s chocolate bars, the ones with the bits of mint cookie inside.  Then, Hershey
Foods Corporation experiences a revenue increase of $64 million, which becomes income to somebody
or other. (Y = $64 million).   So far, the total impact on income is $100 million + $80 million +
$64 million, which is much bigger than the government’s initial increase in spending.  But this
process continues, and the final impact on Y  is $500 million (because the multiplier is 5).

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CHAPTER 10   Aggregate Demand I
CHAPTER 10   Aggregate Demand I
An increase in taxes
Y
E
E =C2 +I +G
E2 = Y2
E =C1 +I +G
E1 = Y1
DY
At Y1, there is now an unplanned
inventory buildup…
…so firms reduce output, and income falls toward a new equilibrium
DC = -MPC DT
Initially, the tax increase reduces consumption, and therefore  E:

Experiment:  An increase in taxes  (note:  the book does a decrease in taxes)
Suppose taxes are increased by T.  Because I and G are exogenous, they do not change.  However, C
depends on (YT).  So, at the initial value of Y, a tax increase of T causes disposable income to
fall by T, which causes consumption to fall by  MPC  T.   Because consumption falls, the change
in C is negative:  C =  MPC  T
C is part of planned expenditure.  The fall in C causes the E line to shift down by the size of the
initial drop in C.
At the initial value of output, there is now unplanned inventory investment:  Sales have fallen
below output, so the unsold output adds to inventory.
In this situation, firms will reduce production, causing total output, income, and expenditure to
fall.
The new equilibrium is at Y[2], where planned expenditure once again equals actual
expenditure/output, and unplanned inventory investment is again equal to zero.

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CHAPTER 10   Aggregate Demand I
CHAPTER 10   Aggregate Demand I
Solving for DY
eq’m condition in changes
I  and G exogenous
Solving for DY :
Final result:

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CHAPTER 10   Aggregate Demand I
CHAPTER 10   Aggregate Demand I
The tax multiplier
§def:  the change in income resulting from
a $1 increase in T :
If MPC = 0.8, then the tax multiplier equals

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CHAPTER 10   Aggregate Demand I
CHAPTER 10   Aggregate Demand I
The tax multiplier
tax forms(60)
§…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.

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CHAPTER 10   Aggregate Demand I
CHAPTER 10   Aggregate Demand I
Exercise:
§Use a graph of the Keynesian cross
to show the effects of an increase in planned investment on the equilibrium level of
income/output.

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This in-class exercise not only gives students practice with the model, it also helps them
understand the next topic:  the derivation of the IS curve.

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CHAPTER 10   Aggregate Demand I
CHAPTER 10   Aggregate Demand I
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:

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CHAPTER 10   Aggregate Demand I
CHAPTER 10   Aggregate Demand I
Y2
Y1
Y2
Y1
Deriving the IS curve
§¯r  Þ I
Y
E
r
Y
E =C +I (r1 )+G
E =C +I (r2 )+G
r1
r2
E =Y
IS
DI
Þ E
Þ Y

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CHAPTER 10   Aggregate Demand I
CHAPTER 10   Aggregate Demand I
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 (a.k.a. actual expenditure, Y )
must increase.

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This slide simply states the intuition behind the graphs on the preceding slide.  Suggestion:  Omit
this slide from your presentation, and just give the students this information verbally as you
present the preceding slide.

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CHAPTER 10   Aggregate Demand I
CHAPTER 10   Aggregate Demand I
The IS curve and the loanable funds model
S, I
r
I (r )
r1
r2
r
Y
Y1
r1
r2
(a) The L.F. model
(b)  The IS curve
Y2
S1
S2
IS

The IS curve can also be derived from the (hopefully now familiar) loanable funds model from
chapter 3.
A decrease in income from Y[1] to Y[2] causes a fall in national saving.
(Recall, S = Y-C-G)
The fall in saving causes a reduction in the supply of loanable funds.  The interest rate must rise
to restore equilibrium to the loanable funds market.
Now we can see where the IS curve gets its name:
When the loanable funds market is in equilibrium, investment = saving.  The IS curve shows all
combinations of r and Y such that investment (I) equals saving (S).  Hence, “IS curve.”

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CHAPTER 10   Aggregate Demand I
CHAPTER 10   Aggregate Demand I
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…

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CHAPTER 10   Aggregate Demand I
CHAPTER 10   Aggregate Demand I
Y2
Y1
Y2
Y1
Shifting the IS curve:  DG
§At any value of r, G  Þ E  Þ Y
Y
E
r
Y
E =C +I (r1 )+G1
E =C +I (r1 )+G2
r1
E =Y
IS1
The horizontal distance of the
IS shift equals
IS2
…so the IS curve shifts to the right.
DY

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.
Since the interest rate is unchanged at r[1], investment will also be unchanged.  This is why, in
the upper panel, we write “I(r[1])” in the E equation for both expenditure curves – to remind us
that investment and the interest rate are not changing.

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CHAPTER 10   Aggregate Demand I
CHAPTER 10   Aggregate Demand I
Exercise:  Shifting the IS curve
§Use the diagram of the Keynesian cross or loanable funds model to show how an increase in taxes
shifts the IS curve.

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CHAPTER 10   Aggregate Demand I
CHAPTER 10   Aggregate Demand I
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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CHAPTER 10   Aggregate Demand I
CHAPTER 10   Aggregate Demand I
Money supply
§The supply of
real money
balances
is fixed:
M/P
real money   balances
r
interest
rate

We are assuming a fixed supply of real money balances because
P is fixed by assumption (short-run), and M is an exogenous policy variable.

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CHAPTER 10   Aggregate Demand I
CHAPTER 10   Aggregate Demand I
Money demand
§Demand for
real money
balances:
M/P
real money   balances
r
interest
rate
L (r )

As we learned in chapter 4, the nominal interest rate is the opportunity cost of holding money
(instead of bonds), so money demand depends negatively on the nominal interest rate.
Here, we are assuming the price level is fixed, so  = 0 and r = i.

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CHAPTER 10   Aggregate Demand I
CHAPTER 10   Aggregate Demand I
Equilibrium
§The interest rate adjusts
to equate the supply and demand for money:
M/P
real money   balances
r
interest
rate
L (r )
r1

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CHAPTER 10   Aggregate Demand I
CHAPTER 10   Aggregate Demand I
How the Fed raises the interest rate
§To increase r, Fed reduces M
M/P
real money   balances
r
interest
rate
L (r )
r1
r2

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CHAPTER 10   Aggregate Demand I
CHAPTER 10   Aggregate Demand I
CASE STUDY:
Monetary Tightening & Interest Rates
§Late 1970s:  p  > 10%
§Oct 1979:  Fed Chairman Paul Volcker announces that monetary policy
would aim to reduce inflation
§Aug 1979-April 1980:
Fed reduces M/P  8.0%
§Jan 1983: p  = 3.7%
How do you think this policy change
would affect nominal interest rates?

This and the next slide summarize the case study on p.295.  The data source is given on the next
slide.
At this point, students have now learned two theories about the effects of monetary policy on
interest rates.  This case study shows them that both theories are relevant, using a real-world
example to remind students that the classical theory of chapter 4 applies in the long-run while the
liquidity preference theory applies in the short run.

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Monetary Tightening & Rates, cont.
Di  < 0
Di  > 0
8/1979: i = 10.4%
1/1983: i = 8.2%
8/1979: i = 10.4%
4/1980: i = 15.8%
flexible
sticky
Quantity theory, Fisher effect
(Classical)
Liquidity preference
(Keynesian)
prediction
actual
outcome
The effects of a monetary tightening
on nominal interest rates
prices
model
long run
short run

Since prices are sticky in the short run, the Liquidity Preference Theory predicts that both the
nominal and real interest rates will rise in the short run.  And in fact, both did.  (However, the
inflation rate was not zero, and in fact it increased, so the real interest rate didn’t rise as
much as the nominal interest rate did during the period shown.)
In the long run, the Quantity Theory of Money says that the monetary tightening should reduce
inflation.  The Fisher Effect says that the fall in   should cause an equal fall in i.  By January
of 1983 (which is “the long run” from the viewpoint of 1979), inflation and nominal interest rates
had fallen.  (However, they did not fall by equal amounts.  This doesn’t contradict the Fisher
Effect, though, as other economic changes caused movements in the real interest rate.)
About the data:
i = 3-month rate on Commercial Paper
% change in M/P from previous slide:  I computed M1/CPI (the measure used in the case study), then
computed the percentage change in M1/CPI over the 8-month period beginning with the month in which
Volcker became the Fed chairman, August 1979.
Source:  FRED database, Federal Reserve Bank of St. Louis.

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CHAPTER 10   Aggregate Demand I
CHAPTER 10   Aggregate Demand I
The LM curve
§Now let’s put Y  back into the money demand function:
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:

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CHAPTER 10   Aggregate Demand I
CHAPTER 10   Aggregate Demand I
Deriving the LM curve
M/P
r
L (r , Y1 )
r1
r2
r
Y
Y1
r1
L (r , Y2 )
r2
Y2
LM
(a) The market for
real money balances
(b)  The LM curve

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CHAPTER 10   Aggregate Demand I
CHAPTER 10   Aggregate Demand I
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.

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This slide simply states the intuition behind the graphs on the preceding slide.  Suggestion:  Omit
this slide from your presentation, and just give the students this information verbally as you
present the preceding slide.

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CHAPTER 10   Aggregate Demand I
CHAPTER 10   Aggregate Demand I
How DM  shifts the LM curve
M/P
r
L (r , Y1 )
r1
r2
r
Y
Y1
r1
r2
LM1
(a) The market for
real money balances
(b)  The LM curve
LM2

If you’re as anal as I am, you might consider helping your students understand the analytical
difference between looking at a shift as a horizontal shift and looking at it as a vertical shift.
We can think of the LM curve shift as a vertical shift:
When the Fed reduces 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.  (The graphical analysis
would be a little different than what’s depicted on this slide.)

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CHAPTER 10   Aggregate Demand I
CHAPTER 10   Aggregate Demand I
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.

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                                              Answer:
This causes an increase in money demand.  In the Liquidity Preference diagram, the money demand
curve shifts up.  Hence, at the the initial value of income, the interest rate must rise to restore
equilibrium in the money market.  As a result, the LM curve shifts up:  each value of income (such
as the initial income) is associated with a higher interest rate than before.

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CHAPTER 10   Aggregate Demand I
CHAPTER 10   Aggregate Demand I
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
r
IS
LM
Equilibrium
interest
rate
Equilibrium
level of
income

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CHAPTER 10   Aggregate Demand I
CHAPTER 10   Aggregate Demand I
The Big Picture
Keynesian
Cross
Theory of Liquidity Preference
IS
curve
LM curve
IS-LM
model
Agg. demand
curve
Agg. supply
curve
Model of Agg. Demand and Agg. Supply
Explanation of short-run fluctuations

Figure 10-15, p.300.
This schematic diagram shows how the different pieces of the theory of short-run fluctuations fit
together.

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CHAPTER 10   Aggregate Demand I
CHAPTER 10   Aggregate Demand I
Preview of Chapter 11
§In Chapter 11, we will
§use the IS-LM  model to analyze the impact of policies and shocks.
§learn how the aggregate demand curve comes from IS-LM.
§use the IS-LM  and AD-AS  models together to analyze the short-run and long-run effects of shocks.
§use our models to learn about the
Great Depression.

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This slide serves as a bridge between this chapter and the next one.

Chapter Summary
1.Keynesian cross
§basic model of income determination
§takes fiscal policy & investment as exogenous
§fiscal policy has a multiplier effect on income.
2. IS  curve
§comes from Keynesian cross when planned investment depends negatively on interest rate
§shows all combinations of r  and Y
that equate planned expenditure with
actual expenditure on goods & services
CHAPTER 10   Aggregate Demand I
slide 40
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Chapter Summary
3.Theory of Liquidity Preference
§basic model of interest rate determination
§takes money supply & price level as exogenous
§an increase in the money supply lowers the interest rate
4. LM  curve
§comes from liquidity preference theory when
money demand depends positively on income
§shows all combinations of r  and Y  that equate demand for real money balances with supply
CHAPTER 10   Aggregate Demand I
slide 41
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Chapter Summary
5. IS-LM  model
§Intersection of IS  and LM  curves shows the unique point (Y, r ) that satisfies equilibrium in
both the goods and money markets.
§
CHAPTER 10   Aggregate Demand I
slide 42
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