Wollo University, Department of Economics

Chapter One: Aggregate Demand and Supply

1.1 Aggregate Demand
The IS curve represents the equilibrium in the market for goods and services, that the LM
curve represents the equilibrium in the market for real money balances, and that the IS and
LM curves together determine the interest rate and national income in the short run when the
price level is fixed. Now we turn our attention to applying the IS–LM model to analyze two
main issues.

First, we examine the potential causes of fluctuations in national income. We use the IS–LM
model to see how changes in the exogenous variables (government purchases, taxes, and the
money supply) influence the endogenous variables (the interest rate and national income).We
also examine how various shocks to the goods markets (the IS curve) and the money market
(the LM curve) affect the interest rate and national income in the short run.

Second, we discuss how the IS–LM model fits into the model of aggregate supply and
aggregate demand. In particular, we examine how the IS–LM model provides a theory of the
slope and position of the aggregate demand curve. Here we relax the assumption that the
price level is fixed, and we show that the IS–LM model implies a negative relationship
between the price level and national income. The model can also tell us what events shift the
aggregate demand curve and in what direction.

1.1.1 Explaining Fluctuations With the IS–LM Model

The intersection of the IS curve and the LM curve determines the level of national income.
When one of these curves shifts, the short-run equilibrium of the economy changes, and
national income fluctuates. In this section we examine how changes in policy and shocks to
the economy can cause these curves to shift.

How Fiscal Policy Shifts the IS Curve and Changes the Short-Run Equilibrium
We begin by examining how changes in fiscal policy (government purchases and taxes) alter
the economy’s short-run equilibrium. Recall that changes in fiscal policy influence planned
expenditure and thereby shift the IS curve.The IS–LM model shows how these shifts in the IS
curve affect income and the interest rate.

Lecture Notes: Advanced Macroeconomics By: Addisu Molla (PhD)

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 Wollo University, Department of Economics

Changes in Government Purchases: Consider an increase in government purchases of G.

The government-purchases multiplier in the Keynesian cross tells us that, at any given
interest rate, this change in fiscal policy raises the level of income by G/(1- MPC).Therefore,
as Figure 11-1 shows, the IS curve shifts to the right by this amount. The equilibrium of the
economy moves from point A to point B. The increase in government purchases raises both
income and the interest rate. To understand fully what’s happening in Figure 11-1, it helps to
keep in mind the building blocks for the IS–LM model. When the government increases its
purchases of goods and services, the economy’s planned expenditure rises. The increase in
planned expenditure stimulates the production of goods and services, which causes total
income Y to rise. These effects should be familiar from the Keynesian cross.

Now consider the money market, as described by the theory of liquidity preference. Because
the economy’s demand for money depends on income, the rise in total income increases the
quantity of money demanded at every interest rate. The supply of money has not changed,
however, so higher money demand causes the equilibrium interest rate r to rise. The higher
interest rate arising in the money market, in turn, has ramifications back in the goods market.
When the interest rate rises, firms cut back on their investment plans. This fall in investment
partially offsets the expansionary effect of the increase in government purchases. Thus, the
increase in income in response to a fiscal expansion is smaller in the IS–LM model than it is

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 Wollo University, Department of Economics

in the Keynesian cross (where investment is assumed to be fixed).You can see this in Figure
11-1.

The horizontal shift in the IS curve equals the rise in equilibrium income in the Keynesian
cross. This amount is larger than the increase in equilibrium income here in the IS–LM
model. The difference is explained by the crowding out of investment caused by a higher
interest rate.

Changes in Taxes: In the IS–LM model, changes in taxes affect the economy much the same
as changes in government purchases do, except that taxes affect expenditure through
consumption. Consider, for instance, a decrease in taxes of T. The tax cut encourages
consumers to spend more and, therefore, increases planned expenditure. The tax multiplier in
the Keynesian cross tells us that, at any given interest rate, this change in policy raises the
level of income by T = MPC/(1-MPC). Therefore, as Figure 11-2 illustrates, the IS curve
shifts to the right by this amount. The equilibrium of the economy moves from point A to
point B. The tax cut raises both income and the interest rate. Once again, because the higher
interest rate depresses investment, the increase in income is smaller in the IS–LM model than
it is in the Keynesian cross.

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 Wollo University, Department of Economics

How Monetary Policy Shifts the LM Curve and Changes the Short-Run Equilibrium
We now examine the effects of monetary policy. Recall that a change in the money supply
alters the interest rate that equilibrates the money market for any given level of income and,
thereby, shifts the LM curve. The IS–LM model shows how a shift in the LM curve affects
income and the interest rate.

Consider an increase in the money supply. An increase in M leads to an increase in real

money balances M/P, because the price level P is fixed in the short run. The theory of
liquidity preference shows that for any given level of income, an increase in real money
balances leads to a lower interest rate.

Once again, to tell the story that explains the economy’s adjustment from point A to point B,
we rely on the building blocks of the IS–LM model—the Keynesian cross and the theory of
liquidity preference. This time, we begin with the money market, where the monetary-policy
action occurs. When the Federal Reserve increases the supply of money, people have more
money than they want to hold at the prevailing interest rate. As a result, they start depositing
this extra money in banks or use it to buy bonds. The interest rate r then falls until people are
willing to hold all the extra money that the Fed has created; this brings the money market to a
new equilibrium. The lower interest rate, in turn, has ramifications for the goods market. A
lower interest rate stimulates planned investment, which increases planned expenditure,
production, and income Y. Thus, the IS–LM model shows that monetary policy influences
income by changing the interest rate. The IS–LM model shows that an increase in the money
supply lowers the interest rate, which stimulates investment and thereby expands the demand
for goods and services.

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Policy Analysis With Macroeconometric Models

The IS–LM model shows how monetary and fiscal policy influences the equilibrium level of
income. The predictions of the model, however, are qualitative, not quantitative. The IS–LM
model shows that increases in government purchases raise GDP and the increases in taxes
lower GDP. But when economists analyze specific policy proposals, they need to know not
only the direction of the effect but also the size. For example, if Congress increases taxes by
$100 billion and if monetary policy is not altered, how much will GDP fall? To answer this
question, economists need to go beyond the graphical representation of the IS–LM model.

Macroeconometric models of the economy provide one way to evaluate policy proposals. A
macroeconometric model is a model that describes the economy quantitatively, rather than
only qualitatively. Many of these models are essentially more complicated and more realistic
versions of our IS–LM model. The economists who build macroeconometric models use
historical data to estimate parameters such as the marginal propensity to consume, the
sensitivity of investment to the interest rate, and the sensitivity of money demand to the
interest rate. Once a model is built, economists can simulate the effects of alternative policies
with the help of a computer.

Table 11-1 shows the fiscal-policy multipliers implied by one widely used macroeconometric
model, the Data Resources Incorporated (DRI) model, named for the economic forecasting
firm that developed it. The multipliers are given for two assumptions about how the Fed

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 Wollo University, Department of Economics

might respond to changes in fiscal policy. One assumption about monetary policy is that the
Fed keeps the nominal interest rate constant. That is, when fiscal policy shifts the IS curve to
the right or to the left, the Fed adjusts the money supply to shift the LM curve in the same
direction. Because there is no crowding out of investment due to a changing interest rate, the
fiscal-policy multipliers are similar to those from the Keynesian cross. The DRI model
indicates that, in this case, the government-purchases multiplier is 1.93, and the tax multiplier
is -1.19. That is, a $100 billion increase in government purchases raises GDP by $193 billion,
and a $100 billion increase in taxes lowers GDP by $119 billion.

The second assumption about monetary policy is that the Fed keeps the money supply
constant so that the LM curve does not shift. In this case, the interest rate rises, and
investment is crowded out, so the multipliers are much smaller. The government-purchases
multiplier is only 0.60, and the tax multiplier is only -0.26.That is, a $100 billion increase in
government purchases raises GDP by $60 billion, and a $100 billion increase in taxes lowers
GDP by $26 billion. Table 11-1 shows that the fiscal-policy multipliers are very different
under the two assumptions about monetary policy. The impact of any change in fiscal policy
depends crucially on how the Fed responds to that change.

1.1.2 IS–LM as a Theory of Aggregate Demand

We have been using the IS–LM model to explain national income in the short run when the
price level is fixed. To see how the IS–LM model fits into the model of aggregate supply and
aggregate demand. We now examine what happens in the IS–LM model if the price level is
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 Wollo University, Department of Economics

allowed to change. As was promised when we began our study of this model, the IS–LM
model provides a theory to explain the position and slope of the aggregate demand curve.

From the IS–LM Model to the Aggregate Demand Curve

Recall from the previous that the aggregate demand curve describes a relationship between
the price level and the level of national income. This relationship was derived from the
quantity theory of money. The analysis showed that for a given money supply, a higher price
level implies a lower level of income. Increases in the money supply shift the aggregate
demand curve to the right, and decreases in the money supply shift the aggregate demand
curve to the left. To understand the determinants of aggregate demand more fully, we now
use the IS–LM model, rather than the quantity theory, to derive the aggregate demand curve.
We use the IS–LM model to show why national income falls as the price level rises—that is,
why the aggregate demand curve is downward sloping.

To explain why the aggregate demand curve slopes downward, we examine what happens in
the IS–LM model when the price level changes. This is done in Figure 11-5. For any given
money supply M, a higher price level P reduces the supply of real money balances M/P.A
lower supply of real money balances shifts the LM curve upward, which raises the
equilibrium interest rate and lowers the equilibrium level of income, as shown in panel (a).
Here the price level rises from P1 to P2, and income falls from Y1 to Y2.The aggregate
demand curve in panel (b) plots this negative relationship between national income and the
price level. In other words, the aggregate demand curve shows the set of equilibrium points
that arise in the IS–LM model as we vary the price level and see what happens to income.

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1.2 Aggregate Supply

Aggregate supply is a total supply of all goods and services in an economy and made up of
two parts: Long-run aggregate supply curve (LAS) and short-run aggregate supply (SAS)
behave differently in the short-run than in the long run. In the long-run, prices are flexible
and the AS curve is vertical. When the AS is vertical, shifts in aggregate demand (AD) curve
affects the price level, but the output of the economy remains at its natural rate. By contacts,
in the short gun, prices are sticky and the AS curve is not vertical. In this case shifts in
aggregate demand, do cause fluctuation in output.

1.2.1 Aggregate supply curve under perfect information and flexible prices (LAS)
This model of aggregate supply with perfect information and flexible prices consists of three
key points, which features in all theories of AS. These are:-
1. The labour Market:- it refers to supply of labour and demand for labour
 Supply of labour:- it is the households or individuals decision on how much labour to
supply how much leisure to consume and how much consumption to undertake given the
generalize of prices & wage rates. Supply curve of labour is an upward sloping.

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 Wollo University, Department of Economics

 Demand for labour:- It is the firms decision on how much labor to employed given their
capital stock or other inputs, the price of their outputs & wage rate, the demand curve for
labour is downward-sloping.
2. Production Technology:- The technology available which describes the technical
relationship between inputs (labour & capital) and outputs produced is assumed to be the
constant return to scale.
3. The capital stock:- The capital stock which is used to produce outputs is assumed to be
constant or fixed in the short run. But it changes overtime in the long run due to the net
investment being increasing & positive.

In addition to the above stated key points, the model includes the following three assumptions
which explain about how the market works.
1. Perfect information:- It refers to everyone knows all of the current and past values of all
prices in the economy.
2. Flexible prices:- The prices of inputs and final goods are flexible so that they are free to
rise if excess demand occurs and fall if excess supply occurs.
3. Clearing markets:- It refers to there is neither excess supply nor excess demand and it
is a consequence of the first two assumptions.
Putting the three key points and the basic assumptions together the AS curve has a shape of
vertical alignment.

AS
Price levels, p

Output, y.
Vertical AS curve

Vertical AS curve depends crucially on the assumptions of prefect information and market
clearing which is the long run phenomenon. So vertical AS curve is the long run aggregate
supply curve (LAS) and hence shift in aggregate demand curve affects only the price level
but the output level remained constant.

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 Wollo University, Department of Economics

In order to analyze the profit maximization behaviour of firms we should consider the short
run production function of the competitive firm. Thus in the short run labor is the only
variable input and mixed together with the fixed capital stock so that the marginal product of
labor (MPL) is declining as more and more labor is employed with a fixed supply of capital.
Therefore, at profit maximization position, firms continue to employ labor until the marginal
cost (MC) is equated with marginal revenue (MR). Mathematically, the MC & MR can be
defined as follow:
MC  TC / Q and MR  TR / Q
Where TC, TR & Q stands for total cost, total revenue & output respectively. TC& TR can
also be defined as: TC=WL+ rk and TR=PXQ
Where w & r refers to wage rate and rent which describes the unit cost of labor & capital
respectively; L & K stands for units of labor & capital respectively; and Q & P stands for
output & price levels respectively. Since the only variable or charged input is labor the
change in total cost comes as a result of change in labor input. i.e, TC / L  W and the
change in total revenue is computed as = TR / Q  P  MR

Next, the MC can be rewritten as:

MC  (TC / Q ) (L / L)
MC  (TC / L)  (TC / L) (Q / L)

Since TC / L  w and Q / L  MPL . So, MC  w / MPL

Thus, at profit maximization condition: MR = MC  P = W/MPL
 MPL = W/P
The profit maximization condition indicates that firms are willing to employ more labor until
the marginal product of labor is equal to the real wage which is the ratio of unit cost of labor
to price of output.

1.2.2 The Lucas supply curve

Unlike the analysis of long run supply curve, expectations are assumed to be formed
rationally under the Lucas supply curve. That is, as a rational expectation firms and workers
do not have some information about the actual aggregate price level at the time of making
their respective decisions. Thus, all prices (both for input & output) in all markets are not
flexible rather it is limited and information in the market is incomplete or imperfect. For
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 Wollo University, Department of Economics

instance, the workers have incomplete information about the price level of the products which
is completely known by the firms.

Since information is incomplete and imperfect in both input & output markets both workers
and firms form their rationale expectations on the price and wage rate levels. This leads the
aggregate supply curve to be upward sloping and it is termed as the Lucas aggregate supply
curve.
Price level, p

AS
P2 ……………………
Pe ………………
P1 …………....

y1 y* y2 output, y.
Lucas Aggregate supply curve, LASC

The LASC represents the short run aggregate supply curve (SASC) in which the change in
AD curve affects both price & output levels.

Deriving the Philips curve from the Aggregate supply curve

Having discussed the concept of short run aggregate supply, we examine an implication of
the short run aggregate supply curve. This curve represents a trade off between two measures
of economic performance- inflation and unemployment. According to this trade off, to reduce
the rate of inflation policy makers must temporarily raise unemployment, and to reduce
unemployment they must accept higher inflation. Note that the trade off between inflation
and unemployment is only temporary. Implying that the policy makers face a trade off in the
short run but they do not face it in the long run.

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 Wollo University, Department of Economics

Although the economic policy makers have two main goals- low inflation and low
unemployment, these goals are usually conflicted in the short run. For example, when the
economy moves from point A to point B in the above graph in the short run the output
increases (form Y1 to Y2) and also the price level increases (from P1 to P2). Since firms need
more workers when they produce more output, higher output means lower unemployment
where as higher price level means higher inflation. Thus, the economy experiences lower
unemployment but higher inflation which shows a short run trade off between unemployment
and inflation

However, when we consider the movement of an economy from point A to point C the output
level remained constant at Y1 although there is along run increase in price level. This implies
that higher inflation is associated with constant unemployment which reflects the no more
trade off between inflation and unemployment

The short run trade of between inflation and unemployment is called the Philips curve which
is drivel from the AS curve and it is a useful way of explaining short run aggregate supply
curve. The Philips curve is derive from the As in the following manure: in the Philips curve
analysis, the inflation rate (Π) depends on three forces: expected inflation (Π e); the devotion
of unemployment (u) from the natural (u n), which is called cyclical unemployment (u-u n),
and the supply shocks (v)

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 Wollo University, Department of Economics

Thus the three forces form the following equation which summarizes the relationship
between inflation and unemployment.
i.e, Π = Π e - (u-u n)+ v
Where  is a parameter measuring the response of inflation to cyclical unemployment and the
minus sign before cyclical unemployment reflects that high unemployment tends to reduce
inflation. This equation of inflation is derived from the equation of aggregate supply through
the following algebraic manipulations.

Firstly, we need to write the aggregate supply equation as: p=p e + (1/x)(Y-Y) and add the
supply shock V to the right hand side of the equation to represent exogenous events such as a
change in world oil prices that alter the price level P and hence shifts that aggregate supply
curve.
p  p e  1  (Y  Y )  v

Secondly, to go from price level to inflation rates, subtract last year’s price level P-1 from
both sides of the equation to obtain
p  p 1  ( p e  p 1 )  1  (Y  Y )  v
The term on the left hand side, P-P-1 is the different between the current price level and last
year’s price level, which is inflation Π. Similarly the term on the right-hand side, pe –p -1, is
the difference between the expected price level and the last year’s price level, which is
expected is expected inflation Π e. therefore, we replace p-p-1 with Π and pe –p -1 with Π e and
thus the above equation can be rewritten as
   e  1  (Y  Y )  v

Thirdly, to go from output to unemployment we need to use okun’s which gives the
relationship between the two variables. This law states that the deviation of output from its
natural rate is inversely related to the deviation of unemployment from its natural rate. That
is, when output is higher than the natural rate of output, unemployment.
1  (Y  Y )    (u  u n )

So through substituting -B (u-un) for (1/x) (y-y) in the previous equation we can get
   e   (u  u n )  v

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 Wollo University, Department of Economics

Now we are in apposition that the Phillips curve is derived from the aggregate supply curve
through one addition, one subtraction and one substitution techniques of mathematical
manipulations.

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