Macroeconomics I

Chapter 11
Aggregate Demand I: Building the IS-LM Model

Professor Deokwoo Nam

Department of Economics and Finance
Hanyang University

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1. INTRODUCTION

1 Introduction

In this chapter, you will learn:

1. The IS curve that is based on the Keynesian cross (or the loanable funds model).
– IS stands for “investment” and “saving,” and the IS curve represents what’s going on in the market
for goods and services (which we …rst discussed in Chapter 3).
2. The LM curve that is based on the theory of liquidity preference (i.e., a money demand theory developed
by Keynes).
– LM stands for “liquidity” and “money,” and the LM curve represents what’s happening to the supply
and demand for money (which we …rst discussed in Chapter 4).
3. How the IS-LM model determines income/output (Y ) and the interest rate (r) in the short run—
when the price (P ) is …xed.
– Because the interest rate in‡uences both investment and money demand, it is the variable that links
the two halves of the IS–LM model.
The IS-LM model shows how interactions between the goods and money markets determine the position and
slope of the aggregate demand curve and, therefore, the level of national income in the short run.

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1. INTRODUCTION

In 1936, the British economist John Maynard Keynes revolutionized economics with his book The General
Theory of Employment, Interest, and Money.
– Keynes proposed a new way to analyze the economy, which he presented as an alternative to classical
theory.
– Keynes proposed that low aggregate demand is responsible for the low income/output and high unem-
ployment that characterize economic downturns.
He criticized classical theory for assuming that aggregate supply alone— capital, labor, and technology—
determines national income.
Economists today reconcile these two views with the model of aggregate demand and aggregate supply
introduced in Chapter 10.
In the long run, prices are ‡exible, and aggregate supply determines income.
But in the short run, prices are sticky, so changes in aggregate demand in‡uence income.
– In 2008 and 2009, as the United States and Europe descended into a recession, the Keynesian theory of
the business cycle was often in the news.
Policymakers around the world debated how best to increase aggregate demand and put their economies
on the road to recovery.

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2. THE GOODS MARKET AND THE IS CURVE

2 The Goods Market and the IS Curve

The IS curve plots the relationship between the interest rate r and the level of income/output Y that
arises in the market for goods and services.

– To develop this relationship, we start with a basic model called the Keynesian cross— it is a building
block for the IS curve.
The Keynesian cross (due to John Maynard Keynes) show that in the short run, income is determined
by expenditure (i.e., aggregate demand):
The more people want to spend, the more goods and services …rms can sell. The more …rms can
sell, the more output they will choose to produce and the more workers they will choose to hire.

2.1 The Keynesian Cross

We begin our derivation of the Keynesian cross by drawing a distinction between "actual" and "planned"
expenditure.
1. Actual expenditure is the amount households, …rms, and the government spend on goods and services—
as we …rst saw in Chapter 2, it equals the economy’s gross domestic product (GDP).
2. Planned expenditure is the amount households, …rms, and the government "would like to" spend on
goods and services.
Why would actual expenditure ever di¤er from planned expenditure?
– The answer is that …rms might engage in "unplanned" inventory investment because their sales do
not meet their expectations.
When …rms sell less of their product than they planned, their stock of inventories automatically rises;
conversely, when …rms sell more than planned, their stock of inventories falls.

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2. THE GOODS MARKET AND THE IS CURVE

– Because these unplanned changes in inventory are counted as "actual" investment spending by …rms,
actual expenditure can be either above or below planned expenditure:
Actual Expenditure Planned Expenditure = Unplanned Inventory Investment

Now 290
we| consider the determinants of "planned" expenditure— assuming that the economy is closed, so
Business Cycle Theory: The Economy in the Short Run
PA R T I V

that net exportsfirmsare zero:

sell more than planned, their stock of inventories falls. Because these
PE = C + I + G
unplanned changes in inventory are counted as investment spending by firms,
actual expenditure can be either above or below planned expenditure.
Now consider the determinants of planned expenditure. Assuming that the
where P E is planned expenditure and I is planned investment:
economy is closed, so that net exports are zero, we write planned expenditure PE
as the sum of consumption C, planned investment I, and government purchases G:
PE = C + I + G.
1. The consumption function is:
To this equation, we add the consumption function
C = C (Y T), where Y is total income
C = C(Y − T ).
This equation states that consumption depends on disposable income (Y − T ),
2. Planned investment
which is total incomeisY minus
exogenous forsimple,
taxes T. To keep things
planned investment as exogenously fixed:
now: for now we take

−
I=I
I = I.
Finally, as in Chapter 3, we assume that fiscal policy—the levels of government
3. Government policy
purchases variables
and taxes—is fixed: are exogenous:
−,
G =G
−.
G=G and T = T
T =T
Combining these five equations, we obtain
Thus, the planned-expenditure function
− ) + I− + G
PE = C(Y − T −. can be written as:
This equation shows that planned expenditure is a function of income Y, the
PE = C Y
level of planned investment I−, and the fiscal policy variables G
− and T
−. T +I +G (2.1)
Figure 10-2 graphs planned expenditure as a function of the level of income.
This line slopes upward because higher income leads to higher consumption and
– A one-unit increase in income Y causes consumption— and therefore planned expenditure P E — to increase
byF I Gthe 0 < M P C < 1.
URE 10-2

Planned Planned Expenditure as a

expenditure, PE Planned expenditure, PE  C(Y  T)  I  G Function of Income Planned
expenditure PE depends on
income because higher income
leads to higher consumption,
which is part of planned
MPC expenditure. The slope of the
$1 planned-expenditure function
is the marginal propensity to
consume, MPC.

Income, output, Y

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 planned expenditure. This assumption is based on the idea that when people’s
2. THE GOODS MARKET
plans ANDrealized,
have been THE ISthey
CURVE
have no reason to change what they are doing.
Recalling that Y as GDP equals not only total income but also total actual
expenditure on goods and services, we can write this equilibrium condition as
The Keynesian cross assumes that the economy is in equilibrium when actual expenditure Y equals
Actual Expenditure = Planned Expenditure
planned expenditure P E :
Y = PE.
The 45-degree line in Figure 10-3 plots the points where|{z} Y condition=holds. |{z}
this PE (2.2)
With the addition of the planned-expenditure function, actualthis
expenditure planned expenditure
diagram becomes
the Keynesian cross. The equilibrium of this economy is at point A, where the
Noteplanned-expenditure
that Y as GDP equals
function crossesnot only total
the 45-degree line. income but also total actual expenditure on goods and services.
How does the economy get to equilibrium? In this model, inventories play an
– This assumption
important is based
role in the adjustment process.on the idea
Whenever that iswhen
an economy people’s plans have been realized, they have no
not in equi-
librium, firms experience unplanned
reason to change what they are doing. changes in inventories, and this induces
them to change production levels. Changes in production in turn influence total
– income
This and expenditure,
condition moving
can the economy toward
be represented by equilibrium.
the 45-degree line in a diagram for the Keynesian cross below.
For example, suppose the economy finds itself with GDP at a level greater
thanEquations
Thus, the equilibrium level,and
(2:1) such (2:2)
as the level Y1 in Figure
become 10-4. In this case,
the Keynesian cross.
planned expenditure PE1 is less than production Y1, so firms are selling less than
– The equilibrium of this economy is at point A, where the planned-expenditure function crosses the 45-
degree line.
FIGURE 10-3
Expenditure The Keynesian Cross The
(Planned, PE Actual expenditure,
equilibrium in the Keynesian
Actual, Y) Y  PE
cross is the point at which
income (actual expenditure)
Planned expenditure, equals planned expenditure
A PE  C  I  G (point A).

45º
Income, output, Y
Equilibrium
income

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2. THE GOODS MARKET AND THE IS CURVE

How does the economy get to equilibrium?

– In this model, "inventories" play an important role in the adjustment process:
Whenever an economy is not in equilibrium, …rms experience "unplanned" changes in inventories,
and this induces them to change production levels.
Changes in production in turn in‡uence total income and expenditure, moving the economy toward
equilibrium.
– For example, suppose the economy …nds itself with GDP at a level greater than the equilibrium level, such
as the level Y1 .
In this case, planned expenditure P E1 is less than production Y1 , so …rms are selling less than they are
producing. Firms add the unsold goods to their stock of inventories (i.e., positive unplanned inventory
investment). This unplanned rise in inventories induces …rms to lay o¤ workers and reduce
production. These actions in turn reduce GDP.
292 | P A R T I V Business Cycle Theory: The Economy in the Short Run

This process of unintended inventory accumulation and falling income continues until income Y falls
to the equilibrium level.
FIGURE 10-4

Expenditure Actual expenditure The Adjustment to Equilibrium

(Planned, PE, in the Keynesian Cross If firms
Actual, Y) are producing at level Y1, then
planned expenditure PE1 falls
Unplanned
Y1 drop in short of production, and firms
inventory accumulate inventories. This inven-
PE1 causes Planned expenditure tory accumulation induces firms to
income to rise. decrease production. Similarly, if
PE2 firms are producing at level Y2, then
Unplanned planned expenditure PE2 exceeds
Y2 inventory production, and firms run down
accumulation their inventories. This fall in invento-
causes ries induces firms to increase pro-
income to fall. duction. In both cases, the firms’
45º decisions drive the economy toward
Y2 Y1 Income, output, Y equilibrium.
Equilibrium
income

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2. THE GOODS MARKET AND THE IS CURVE

In summary, the Keynesian cross shows how income Y is determined for given levels of planned investment I
and …scal policy G and T .
– We can use this model to show how income changes when one of these exogenous variables
changes.
First, we consider how changes in government purchases a¤ect the economy.
– Because G are one component of expenditure, – We can solve for Y:
higher government purchases result in higher
Y = C+I +G
planned expenditure for any given level of income,
thereby shifting the planned-expenditure schedule Y = C+ I+ G
upward. Y = MP C ( Y T) + I+ G
So, the equilibrium of the economy moves from Y = MP C Y + G
point A to point B (How?). Y = 1= (1 M P C) G
| {z }
the government-purchases multiplier>1
– This graph shows that an increase in govern-
ment purchases leads to an even greater in- If M P C = 0:8, 1= (1
AggregateM P C)
Demand I: Building
CHAPTER 10 : an
=the5IS–LM Model in-
| 293
crease in income: that is, Y is larger than crease in G causes income Y to increase 5
G. times as much.
FIGURE 10-5

The ratio Y = G is called the "government- Expenditure An Increase in Government

Actual expenditure
purchases multiplier" larger than 1— it tells Planned
Purchases in the Keynesian Cross
An increase in government purchases
B
us how much income rises in response to a $1 PE2  Y2 G
expenditure of ΔG raises planned expenditure by
that amount for any given level of
increase in government purchases. Y income. The equilibrium moves from
1. An increase point A to point B, and income rises
PE1  Y1 in government from Y1 to Y2. Note that the increase
A
Initially, the increase in G causes an equal purchases shifts in income ΔY exceeds the increase in
planned expenditure government purchases ΔG. Thus, fis-
increase in Y : Y = G. upward, ... cal policy has a multiplied effect on
income.

But, Y " ) C " ) Y " further ) C " 45º

further ) Y " further ) . Y
Income, output, Y

So the …nal impact on income Y is much PE1  Y1 2. ...which increases PE2  Y2

equilibrium income.
bigger than the initial G:
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2. THE GOODS MARKET AND THE IS CURVE

Next, we consider how changes in taxes a¤ect equilibrium income.

– A decrease in taxes of T < 0 immediately 2. It is smaller than the government-purchases
raises disposable income (Y T ) by T > multiplier:
0 and, therefore, increases consumption C by
MP C T . For any given level of income Y , Consumers save the fraction (1 M P C) of
planned expenditure is now higher, thereby shift- a tax cut, so the initial boost in planned
ing the planned-expenditure schedule upward by spending from a tax cut is smaller than from
MP C T. an equal increase in G.
Thus, the equilibrium of the economy moves from 3. It is greater than one in absolute value (when
point A to point B (How?). M P C > 0:5):
CHAPTER 10 Aggregate Demand I: Building the IS–LM Model | 295
– We can solve for Y: A change in taxes has a multiplier e¤ect on
Y = C+I +G income.
FIGURE 10-6
Y = C+ I+ G
Y = MP C ( Y T) Expenditure A Decrease in Taxes in the
Actual expenditure
Planned Keynesian Cross A decrease in
Y = M P C= (1 M P C) T B
taxes of ΔT raises planned expendi-
| {z } PE2  Y2 expenditure
MPC T ture by MPC × ΔT for any given
the tax multiplier
Y
level of income. The equilibrium
moves from point A to point B, and
Y= T = M P C= (1 M P C) is the "tax 1. A tax cut income rises from Y1 to Y2. Again,
PE1  Y1
multiplier," the amount income changes in re- A shifts planned fiscal policy has a multiplied effect
expenditure on income.
sponse to a $1 change in taxes. upward, ...

If M P C = 0:8, M P C= (1 M P C) = 4:
a $1:00 cut in taxes raises equilibrium income
by $4:00. 45º
Income,
Y
output, Y
– So the tax multiplier has the following:
PE1  Y1 2. ...which increases PE2  Y2
equilibrium income.
1. It is negative:
A tax cut increases C , which raises Y .
Just as an increase in government purchases has a multiplied effect on income, Page: 9
2. THE GOODS MARKET AND THE IS CURVE

Finally, we consider the e¤ects of an increase in planned investment on the equilibrium level of income/output—
note that I is assumed to be exogenous at a …xed level I .
ANSWERS
Practice with the Keynesian cross
– An increase in planned investment shifts the planned-expenditure schedule upward by I.

PE
At Y1, PE =C +I2 +G
there is now an
unplanned drop PE =C +I1 +G
in inventory…

I
…so firms
increase output,
and income Y
rises toward a
new equilibrium. PE1 = Y1 Y PE2 = Y2
18

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2. THE GOODS MARKET AND THE IS CURVE

2.2 The Interest Rate, Investment, and the IS Curve

We now use the Keynesian cross to derive the IS curve.

– We begin by considering "how does a change in the interest rate r a¤ect the market for goods
and services (or the equilibrium level of income/output Y )?"
1. As we discussed in Chapter 3, an important macroeconomic relationship is that planned investment I
depends on the interest rate r: !
I=I r
|{z}

2. We combine this investment function with the Keynesian-cross diagram to determine how
income Y changes when the interest rate r changes.
An increase in the interest rate from r1 to r2 reduces the quantity of investment from I (r1 ) to I (r2 ).
The reduction in planned investment, in turn, shifts the planned-expenditure function downward,
thereby causing the level of income to fall from Y1 to Y2 .
r " ) I # ) PE # ) Y #

– Thus, the IS curve summarizes this relationship between the interest rate and the level of income:
IS : Y =C Y T + I (r) + G (2.3)

"Each" point on the IS curve represents "equilibrium" in the goods market, and the curve illustrates
how the equilibrium level of income depends on the interest rate.
Because an increase in the interest rate causes planned investment to fall, which in turn causes
equilibrium income to fall, the IS curve slopes downward.

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2. THE GOODS MARKET AND THE IS CURVE
FIGURE 10-7
Deriving the IS Curve Panel (a) shows (b) The Keynesian Cross
the investment function: an increase in Expenditure
the interest rate from r1 to r2 reduces
planned investment from I(r1) to I(r2). 3. ...which Actual
Panel (b) shows the Keynesian cross: a shifts planned expenditure
decrease in planned investment from expenditure
I(r1) to I(r2) shifts the planned-expendi- downward ...
ture function downward and thereby
reduces income from Y1 to Y2. Panel (c) Planned
shows the IS curve summarizing this rela-
I expenditure
tionship between the interest rate and
income: the higher the interest rate, the
lower the level of income.
45º
Y2 Y1 Income, output, Y

4. ...and lowers
income.

(a) The Investment Function (c) The IS Curve

Interest Interest
rate, r rate, r
1. An increase
in the interest
rate ... 5. The IS curve
summarizes
these changes in
r2 r2 the goods market
2. ... lowers equilibrium.
r1 planned r1
investment, ...
I
I(r) IS
I(r2) I(r1) Investment, I Y2 Y1 Income, output, Y

trates how the equilibrium level of income depends on the interest rate. Because
an increase in the interest rate causes planned investment to fall, which in turn
causes equilibrium income to fall, the IS curve slopes downward.

How Fiscal Policy Shifts the IS Curve

The IS curve shows us, for any given interest rate, the level of income that brings
the goods market into equilibrium. As we learned from the Keynesian cross, the Page: 12
2. THE GOODS MARKET AND THE IS CURVE

The IS curve can also be derived from the (hopefully now familiar) loanable funds model from chapter 3:
S = I (r)

where
S=Y C Y T G

– A decrease in income from Y1 to Y2 causes a fall in national saving— S # by S = (1 M P C) Y.

The fall in saving causes a reduction in the supply of loanable funds. The interest rate must rise from r1
to r2 to restore equilibrium to the loanable funds market:
Y # ) S # ) r " to restore S = I

Now we can see where the IS curve gets its name: When the loanable funds market is in equilibrium,
investment (I ) equals saving (S).
Thus, the IS curve shows all combinations of r and Y such that investment equals saving.
The IS curve and the loanable funds model

(a) The loanable funds model (b) The IS curve

r S2 S1 r

r2 r2

r1 r1
I (r )
IS
S, I Y2 Y1 Y

CHAPTER 11 Aggregate Demand I 22

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2. THE GOODS MARKET AND THE IS CURVE

2.3 How Fiscal Policy Shifts the IS Curve

The IS curve shows us the level of income Y that brings the goods market into equilibrium for any given
interest rate r.
– As we learned from the Keynesian cross, the equilibrium level of income also depends on government
spending G and taxes T .
This means that when …scal policy (G or T ) changes, the IS curve shifts.
The …gure uses the Keynesian cross to show how an increase 300
in |government
Business Cyclepurchases
Theory: The Economy(or
PA R T I V in the a cut
Short Run in taxes) shifts

the IS curve— the …gure is drawn for a given interest rate r and thus for a given level of planned investment
I (r). FIGURE 10-8

(a) The Keynesian Cross An Increase in Government

Purchases Shifts the IS Curve
1. The Keynesian cross in panel (a) shows that this Expenditure 1. An increase in government
purchases shifts planned
Actual
expenditure
Outward Panel (a) shows that
an increase in government pur-
expenditure upward by G, ...
change in …scal policy raises planned expenditure Y2
Planned
expenditure
chases raises planned expendi-
ture. For any given interest rate,
the upward shift in planned
and thereby increases equilibrium income from Y1 expenditure of ΔG leads to an
increase in income Y of
to Y2 : Y1
ΔG/(1 − MPC). Therefore, in
panel (b), the IS curve shifts to
the right by this amount.

G " for a given r ) P E " ) Y " 2. ...which

raises income
by G ...
1  MPC
45º
2. Therefore, in panel (b), the increase in govern- Y1 Y2 Income, output, Y

ment purchases (or a cut in taxes) shifts the IS (b) The IS Curve
curve outward. Interest rate, r

3. ... and shifts

the IS curve to
the right
by G .
1  MPC

IS2
IS1

Y1 Y2 Income, output, Y

and thus for a given level of planned investment. The Keynesian cross in panel
(a) shows that this change in fiscal policy raises planned expenditure and there-
by increases equilibrium income from Y1 to Y2. Therefore, in panel (b), the
increase in government purchases shifts the IS curve outward.
Page: 14
We can use the Keynesian cross to see how other changes in fiscal policy shift
2. THE GOODS MARKET AND THE IS CURVE

2.4 Summary on the IS Curve

We can summarize the IS curve:

1. The IS curve shows the combinations of the interest rate r and the level of income Y that are consistent
with equilibrium in the market for goods and services.
2. The IS curve is drawn for a given …scal policy:
(a) Changes in …scal policy that raise the demand for goods and services (i.e., an increase in G or a cut
in T ) shift the IS curve to the right.
(b) Changes in …scal policy that reduce the demand for goods and services (i.e., a decrease in G or an
increase in T ) shift the IS curve to the left.

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3. THE MONEY MARKET AND THE LM CURVE

3 The Money Market and the LM Curve

The LM curve plots the relationship between the interest rate r and the level of income Y that arises
in the market for money balances.

– To understand this relationship, we begin by looking at a theory of the interest rate, called the theory of
liquidity preference— it is a building block for the LM curve.
In his classic work The General Theory, John Maynard Keynes o¤ered his view that in the short run,
the interest rate is determined to balance the supply and demand for the economy’s most liquid asset,
that is, money— it is called the theory of liquidity preference.

3.1 The Theory of Liquidity Preference

The liquidity preference theory assumes that there is a …xed supply of real money balances. So the supply for
real money balances can be written as:
M s M
= (3.1)
P P
where we assume that the money supply M is an exogenous policy variable chosen by a central bank (i.e.,
M = M ) and the price level P is also an exogenous variable at a …xed level in the short run (i.e., P = P ).

The liquidity preference theory posits that the interest rate is one determinant of how much money people
choose to hold. So the demand for real money balances can! be written as:
d
M
=L i
|{z}
P

– The (nominal) interest rate is the opportunity cost of holding money. Thus, when the interest rate rises,
people want to hold less of their wealth in the form of money.
It is what you forgo by holding some of your assets as money, which does not bear interest, instead of
as interest-bearing bank deposits or bonds.

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3. THE MONEY MARKET AND THE LM CURVE

– The nominal interest rate is the sum of the real interest rate and the expected in‡ation rate: i = r + e.

However, we are assuming the price level is "…xed" ( P = P ), so it is realistic to assume e =0

for the short run analysis.
Thus, in the short run, we can treat the nominal interest rate as the real interest rate:

i=r

Thus, the demand for real money balances can be rewritten as:
!
d
M
=L r
|{z} (3.2)
P

Therefore, the theory of liquidity preference tells us that the supply and demand for real money balances
determine what interest rate prevails in the economy:
M
= L (r) (3.3)
P
302 | PA R T I V Business Cycle Theory: The Economy in the Short Run

– That is, the interest rate adjusts to equilibrate the money market.
FIGURE 10-9

Interest rate, r The Theory of Liquidity

Supply Preference The supply and
demand for real money bal-
ances determine the interest
rate. The supply curve for real
money balances is vertical
Equilibrium because the supply does not
interest depend on the interest rate.
rate The demand curve is down-
ward sloping because a higher
interest rate raises the cost of
holding money and thus low-
ers the quantity demanded. At
the equilibrium interest rate,
Demand, L(r) the quantity of real money bal-
ances demanded equals the
M/P Real money balances, M/P
quantity supplied.

where the function L( ) shows that the quantity of money demanded depends
on the interest rate. The demand curve in Figure 10-9 slopes downward because Page: 17
5
3. THE MONEY MARKET AND THE LM CURVE

Now that we have seen how the interest rate is determined, we can use the theory of liquidity preference to
show how the interest rate responds to changes in the supply of money.
– Suppose, for instance, that the Fed suddenly decreases the money supply M . Then, a fall in M reduces
(M=P )s , because P is …xed in the model, thereby shifting the supply of real money balances to the left.

The equilibrium interest rate rises and the higher interest rate makes people satis…ed to hold the smaller
quantity of real money 0 Aggregate Demand I: Building the IS–LM Model | 303
C H A P T E R 1balances:

s
M
M #) # ) r " to restore equilibrium
P
FIGURE 10-10

Interest rate, r A Reduction in the Money

Supply in the Theory of
Liquidity Preference If the
1. A fall in price level is fixed, a reduction
the money in the money supply from M1
supply ... to M2 reduces the supply of
real money balances. The equi-
librium interest rate therefore
r2 rises from r1 to r2.

r1
2. ... raises
the interest L(r)
rate.
M2/P M1/P Real money
balances, M/P

the interest rate reaches the equilibrium level, at which people are content with
their portfolios of monetary and nonmonetary assets.
Now that we have seen how the interest rate is determined, we can use the
theory of liquidity preference to show how the interest rate responds to changes
in the supply of money. Suppose, for instance, that the Fed suddenly decreases the
money supply. A fall in M reduces M/P, because P is fixed in the model. The sup-
ply of real money balances shifts to the left, as in Figure 10-10. The equilibrium Page: 18
3. THE MONEY MARKET AND THE LM CURVE

3.2 Income, Money Demand, and the LM Curve

We now use the theory of liquidity preference to derive the LM curve.

– We begin by considering "how does a change in the economy’s level of income Y a¤ect the market
for real money balances (or the equilibrium interest rate r)?"
1. Let’s put Y back into the demand function for real money balances:
!
d
M
=L r ; |{z}
|{z} Y
P
+

where the quantity of real money balances demanded is positively related to income (as well as nega-
tively related to the interest rate): when income is high, expenditure is high, so people engage in more
transactions that require greater money demand.
2. Using the theory of liquidity preference, we can …gure out what happens to the equilibrium interest
rate when the level of income changes, say, increases from Y1 to Y2 .
This increase in income shifts the money demand curve to the right. With the supply of real money
balances unchanged ( (M=P )s = M =P ), the interest rate must rise from r1 to r2 to equilibrate the
money market:
Y " ) L (r; Y ) " ) r "

– Thus, the LM curve summarizes this relationship between the level of income and the interest
rate:
LM : M =P = L (r; Y ) (3.4)

"Each" point on the LM curve represents "equilibrium" in the money market, and the curve illustrates
how the equilibrium interest rate depends on the level of income.
The higher the level of income, the higher the demand for real money balances, and the higher the
equilibrium interest rate. For this reason, the LM curve slopes upward.
Page: 19
3. THE MONEY MARKET AND THE LM CURVE
FIGURE 10-11

(a) The Market for Real Money Balances (b) The LM Curve
Interest rate, r Interest
rate, r LM
1. An increase in
income raises
money demand, ...
r2 r2
3. The LM curve
summarizes
L(r, Y2) these changes in
r1 r1
the money market
L(r, Y1) equilibrium.
2. ...
increasing
the interest M/P Real money Y1 Y2 Income, output, Y
rate. balances, M/P

Deriving the LM Curve Panel (a) shows the market for real money balances: an
increase in income from Y1 to Y2 raises the demand for money and thus raises the
interest rate from r1 to r2. Panel (b) shows the LM curve summarizing this relation-
ship between the interest rate and income: the higher the level of income, the higher
the interest rate.

the equilibrium interest rate depends on the level of income. The higher the
level of income, the higher the demand for real money balances, and the higher
the equilibrium interest rate. For this reason, the LM curve slopes upward.

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. Yet, as we saw earlier, the equilibrium interest rate also depends
on the supply of real money balances M/P. This means that the LM curve is
drawn for a given supply of real money balances. If real money balances change—
for example, if the Fed alters the money supply—the LM curve shifts. Page: 20
3. THE MONEY MARKET AND THE LM CURVE

3.3 How Monetary Policy Shifts the LM Curve

The LM curve tells us the interest rate r that equilibrates the money market at "any" level of income Y .
– Yet as we saw earlier, the equilibrium interest rate also depends on the supply of real money balances
(M=P )s .

This means that when the central bank changes the money supply M , the LM curve shifts.
If the central bank reduces the money supply from M1 to M2 , what happens to the equilibrium interest rate
associated with a given value of income.
306 | PART IV Business Cycle Theory: The Economy in the Short Run
– Holding constant the amount of income and thus the demand curve for real money balances, reduction
in the supply of real money balances raises the interest rate that equilibrates the money market. So, the
LM curve
FIGURE shifts upward.
10-12

(a) The Market for Real Money Balances (b) The LM Curve
Interest rate, r Interest
rate, r LM2

LM1

1. The Fed
r2 reduces r2
the money 3. ... and
2. ... supply, ... shifting the
raising r1 r1 LM curve
the interest upward.
rate ... L(r, Y)
M2/P M1/P Real money Y Income, output, Y
balances,
M/P

A Reduction in the Money Supply Shifts the LM Curve Upward Panel (a)
−
shows that for any given level of income Y, a reduction in the money supply raises
the interest rate that equilibrates the money market. Therefore, the LM curve in
panel (b) shifts upward.

Page: 21
3. THE MONEY MARKET AND THE LM CURVE

3.4 Summary on the LM Curve

We can summarize the LM curve:

1. The LM curve shows the combinations of the interest rate r and the level of income Y that are consistent
with equilibrium in the market for real money balances.
2. The LM curve is drawn for a given supply of real money balances (i.e., a given monetary policy):
(a) Increases in the supply of real money balances (called expansionary monetary policy) shift the LM
curve downward.
(b) Decreases in the supply of real money balances (called contractionary monetary policy) shift the LM
curve upward.

Page: 22
4. CONCLUSION: THE SHORT-RUN EQUILIBRIUM

4 Conclusion: The Short-Run Equilibrium

The IS–LM model shows how the interest rate r and the level of income Y are determined in the
short run.
– The equilibrium of the economy is the point at which the IS curve and the LM curve cross— at this
intersection, actual expenditure equals planned expenditure, and the demand for real money balances
equals the supply:
IS : Y =C Y T + I (r) + G
(4.1)
LM : M =P = L (r; Y )
C H A P T E R 1 0 Aggregate Demand I: Building the IS–LM Model | 307
That is, the short-run equilibrium is the combination of r and Y that simultaneously satis…es the
equilibrium conditions in "both" the goods market and the money market.
FIGURE 10-13

Interest rate, r Equilibrium in the IS–LM

LM Model The intersection of the
IS and LM curves represents
simultaneous equilibrium in
the market for goods and ser-
vices and in the market for real
money balances for given val-
Equilibrium ues of government spending,
interest taxes, the money supply, and
rate the price level.

IS

Equilibrium level Income, output, Y

of income

In this chapter we developed the Keynesian cross and the theory of liquidity
preference as building blocks for the IS–LM model. As we see more fully in
Page: 23
the next chapter, the IS–LM model helps explain the position and slope of
 money balances for given val-
4. CONCLUSION: Equilibrium
THE SHORT-RUN EQUILIBRIUM ues of government spending,
interest taxes, the money supply, and
rate the price level.

As we conclude this chapter, let’s recall that our ultimate goal in developing the IS–LM model is to analyze
short-run ‡uctuations in economic activity.
IS
– Figure 14 illustrates how the di¤erent pieces of our theory …t together.
1. In this chapter we developed
Equilibrium level the Keynesian
Income, output, Y cross and the theory of liquidity preference as building
blocks for the IS–
ofLM
income model.

2. As we see more fully in the next chapter, the IS–LM model helps explain the position and slope of the
aggregate demand curve.
In this chapter we developed the Keynesian cross and the theory of liquidity
preference as building blocks for the IS–LM model. As we see more fully in
3. The aggregate demand curve, in turn, is a piece ofthe model of aggregate supply and aggregate
the next chapter, the IS–LM model helps explain the position and slope of
demand, which economists use to explain the short-run e¤ects of policy changes and other events on
national income.
FIGURE 10-14

Keynesian
IS Curve
Cross

Aggregate
IS–LM Demand
Model Curve Model of
Aggregate Explanation
Theory of
Supply and of Short-Run
Liquidity LM Curve
Aggregate Economic
Preference
Demand Fluctuations
Aggregate
Supply
Curve

The Theory of Short-Run Fluctuations This schematic diagram shows how the differ-
ent pieces of the theory of short-run fluctuations fit together. The Keynesian cross explains
the IS curve, and the theory of liquidity preference explains the LM curve. The IS and
LM curves together yield the IS–LM model, which explains the aggregate demand curve.
The aggregate demand curve is part of the model of aggregate supply and aggregate
demand, which economists use to explain short-run fluctuations in economic activity.

Page: 24