Explain why the aggregate demand curve slopes downward.

The aggregate demand curve represents the negative relationship between the price level and
the level of national income. We can see why the aggregate demand curve slopes downward by
considering what happens in the IS–LM model when the price level changes. As Figure 12-5(A)
illustrates, for a given money supply, an increase in the price level from P1 to P2 shifts the LM
curve upward because real money balances decline; this reduces income from Y1 to Y2. The
aggregate demand curve in Figure 12-5(B) summarizes this relationship between the price level
and income that results from the IS–LM model.
This problem asks you to analyze the IS–LM model algebraically. Suppose consumption is a
linear function of disposable income:

C (Y−T)=a+b (Y−T)

where a > 0 and 0 < b < 1. The parameter b is the marginal propensity to consume, and the
parameter a is a constant sometimes called autonomous consumption. Suppose also that
investment is a linear function of the interest rate:

I(r)=c−dr

where c > 0 and d > 0. The parameter d measures the sensitivity of investment to the interest
rate, and the parameter c is a constant sometimes called autonomous investment.

a. Solve for Y as a function of r, the exogenous variables G and T, and the model’s parameters a,
b, c, and d.

b. How does the slope of the IS curve depend on the parameter d, the interest sensitivity of
investment? Refer to your answer to part (a) and explain the intuition.

c. Which will cause a bigger horizontal shift in the IS curve, a $100 tax cut or a $100 increase in
government spending? Refer to your answer to part (a) and explain the intuition.

Now suppose demand for real money balances is a linear function of income and the interest
rate:

L (r, Y)=eY−fr

where e > 0 and f > 0. The parameter e measures the sensitivity of money demand to income,
while the parameter f measures the sensitivity of money demand to the interest rate.

d. Solve for r as a function of Y, M, and P and the parameters e and f.

e. Using your answer to part (d), determine whether the LM curve is steeper for large or small
values of f and explain the intuition.

f. How does the size of the shift in the LM curve resulting from a $100 increase in M depend on i.
the value of the parameter e, the income sensitivity of money demand? ii. the value of the
parameter f, the interest sensitivity of money demand?

g. Use your answers to parts (a) and (d) to derive an expression for the aggregate demand curve.
Your expression should show Y as a function of P, exogenous policy variables M, G, and T, and
the model’s parameters. This expression should not contain r.

h. Use your answer to part (g) to prove that the aggregate demand curve has a negative slope.

i. Use your answer to part (g) to prove that increases in G and M and decreases in T shift the
aggregate demand curve to the right. How does this result change if the parameter f, the
interest sensitivity of money demand, equals zero? Explain the intuition for your result.
a. Solve for Y as a function of r, the exogenous variables G and T, and the model’s parameters a,
b, c, and d.

a. The goods market is in equilibrium when output is equal to planned expenditure, or Y = PE. Starting

with this equilibrium condition, and making the substitutions from the information given in the

problem, we obtain an expression for equilibrium output Y:

Y = C(Y – T) + I(r) + G

Y = a + b(Y – T) + c – dr + G

(1 – b)Y = a – bT + c – dr + G

a - bT + c - dr + G .
Y=
1- b

b. How does the slope of the IS curve depend on the parameter d, the interest sensitivity of
investment? Refer to your answer to part (a) and explain the intuition.
b. Using the expression from part (a), we obtain the slope of the IS curve as follows:

r 1 1 1 b
   .
Y Y / r d / (1  b) d

As d increases, the absolute value of the slope of the IS curve decreases, making the IS curve

flatter. Intuitively, a flatter IS curve makes output more sensitive to changes in the interest rate.

This is driven by the increased sensitivity of investment to the interest rate.

c. Which will cause a bigger horizontal shift in the IS curve, a $100 tax cut or a $100 increase in
government spending? Refer to your answer to part (a) and explain the intuition.
c. A $100 increase in government spending will cause a larger horizontal shift in the IS curve than a $100

tax cut. The equation for equilibrium output in part (a) shows that the government spending

multiplier is 1/(1 – b) and the tax multiplier is –b/(1 – b). Since the marginal propensity to

consume satisfies 0 < b < 1, the government spending multiplier is larger in absolute value.

Intuitively, this makes sense because the entire $100 increase in government spending will be

spent, whereas part of the tax cut will be saved.

d. Solve for r as a function of Y, M, and P and the parameters e and f.

e. Using your answer to part (d), determine whether the LM curve is steeper for large or small
values of f and explain the intuition.
f. How does the size of the shift in the LM curve resulting from a $100 increase in M depend on i.
the value of the parameter e, the income sensitivity of money demand? ii. the value of the
parameter f, the interest sensitivity of money demand?
f. Consider the horizontal shift in the LM curve—the change in output—caused by a change in the money

supply. We can rearrange the equation in part (d) to see that output can be expressed as

M / P  fr
Y  .
e

This implies that the change in output for a given change in the money supply is ΔY = ΔM/e. As e

increases, a given change in the money supply has a smaller effect on output. In other words, as

money demand becomes more sensitive to income, a given change in the money supply does not

require as large a change in output for the change in money demand to match it. The parameter f

has no effect on the size of the horizontal shift in the LM curve caused by a change in the money

supply. It does matter, however, for the size of the vertical shift, since it measures the sensitivity

of money demand to the interest rate.

g. Use your answers to parts (a) and (d) to derive an expression for the aggregate demand curve.
Your expression should show Y as a function of P, exogenous policy variables M, G, and T, and
the model’s parameters. This expression should not contain r.

h. Use your answer to part (g) to prove that the aggregate demand curve has a negative slope.
i. Use your answer to part (g) to prove that increases in G and M and decreases in T shift the
aggregate demand curve to the right. How does this result change if the parameter f, the
interest sensitivity of money demand, equals zero? Explain the intuition for your result.
i. An increase in government spending, an increase in the money supply, and a decrease in taxes all shift

the aggregate demand curve to the right—output increases for any given price level—as can be

seen from the equation for the aggregate demand curve found in part (g). It is straightforward to

see that in this case ΔY = ΔG/(1 – b), ΔY = ΔM/e, and ΔY = – bΔT/(1 – b) are all positive. If f = 0,

then the aggregate demand curve is given by Y = M/(eP). This can be rearranged as M/P = eY,

which is simply the quantity theory of money from Chapter 10. In this case, the LM curve is

vertical, so changes in fiscal policy that shift the IS curve have no effect on output. Monetary

policy is still effective in stabilizing output, as an increase in the money supply still shifts the

aggregate demand curve to the right.