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Chapter 10 Macroeconomics - Aggregate Demand I: Building

the IS-LM Model (VI)

• The Theory of Liquidity Preference Due to John Maynard Keynes
• A simple theory in which the interest rateis determined by money supply and moneydemand

Demand for real money Money Demand

balances:

real money balancesM/P

interestrate^ r  M P ^ s M P

 M P^ ^ d^  L r^ (^ ) L ( r )

The interest rate adjusts Equilibrium

to equate thesupply anddemand formoney:

real money balances^ M/P

interestrate^ r  M P ^ s M P  L r( )^ r^1 M P^ L^ (^ r^ )

How the Fed Changes Money Supply • Open Market Operations

• • Reserve RequirementDiscount Rate

Now let’s put Y back into the money demand function: The^ LM^ Curve

M P  L r Y( , )

The r real money balances. The equation for the and LM Y curve that equate the supply and demand for is a graph of all combinations of^ M P LM^ dcurve is:^ ^ L r Y(^ ,^ )

• Why the An increase in income raises money demand^ LM^ Curve is Upward Sloping
• 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

How  M Shifts the LM Curve M/P

r r (^1) MP 1 L ( r , Y 1 ) r 2 r r (^1) Y 1 Y r 2 LM^1

(a) The market for realmoney balances (b) The LM curve MP 2

LM 2

Answer: Shifting the LM Curve

M/P

r r (^1) MP 1 L ( r , Y 1 ) r 2 r r (^1) Y 1 Y r 2 LM^1

(a) The market for realmoney balances (b) The LM curve LM 2 L ( r , Y 1 )

The short-run equilibrium is the combination ofsimultaneously satisfies the The Short-Run Equilibrium r and Y that

equilibrium conditions in the goods & money markets:Y  C Y( T )  I ( )r G

Y

r M P L r Y( , )^ IS

LM

Equilibriuminterest rate Equilibrium level of income

In Chapter 11, we will: Preview of Chapter 11

• – – Use the IS-LM model to analyze the impact of policies andshocksLearn how the aggregate demand curve comes from IS-LMUse the IS-LM models to analyze the short-run and long-run effects of shocks
• Use our models to learn about the Great Depression

1. Keynesian Cross – – Basic model of income determinationTakes fiscal policy and investment as exogenous Chapter Summary
2. IS^ – –^ CurveFiscal policy has a multiplier effect on incomeComes from Keynesian cross when planned investment depends negatively on interest rate
   • Shows all combinations of planned expenditure with actual expenditure on goods and services r and Y that equate

5. IS-LM – Intersection of Model Chapter Summary IS and LM curves shows the unique point ( goods and money markets Y , r ) that satisfies equilibrium in both the