Chapter Three

Aggregate Demand in the Closed Economy

3.1 Foundations of Theory of Aggregate Demand

Of all the economic fluctuations in world history, the one that stands out as particularly large,
painful, and intellectually significant is the Great Depression of the 1930s. During this time, the
United States and many other countries experienced massive unemployment and greatly reduced
incomes.

This devastating episode caused many economists to question the validity of classical economic
theory. Classical theory seemed incapable of explaining the Depression. According to that
theory, national income depends on factor supplies and the available technology, neither of
which changed substantially from 1929 to 1933. After the onset of the Depression, many
economists believed that a new model was needed to explain such a large and sudden economic
downturn and to suggest government policies that might reduce the economic hardship so many
people faced.

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. His vision of how
the economy works quickly became a center of controversy. Yet, as economists debated The
General Theory, a new understanding of economic fluctuations gradually developed.

Keynes proposed that low aggregate demand is responsible for the low income and high
unemployment that characterize economic downturns. He criticized classical theory for assuming
that aggregate supply alone—capital, labor, and technology—determines national income.
Unlike to this output also depends on the demand for goods and services. Demand, in turn, is
influenced by monetary policy, fiscal policy, and various other factors. Because monetary and
fiscal policy can influence the economy’s output over the time horizon when prices are sticky,
price stickiness provides a rationale for why these policies may be useful in stabilizing the
economy in the short run.

1
Aggregate demand (AD): is the relationship between the quantity of output demanded and the
aggregate price level. In other words, the aggregate demand curve tells us the quantity of goods
and services people want to buy at any given level of prices.
The quantity Theory of Money is:
MV =PY
Where M is the money supply, V is the velocity of money, P is the price level, and Y is the
amount of output. If the velocity of money is constant, then this equation states that the money
supply determines the nominal value of output, which in turn is the product of the price level and
the amount of output.
The quantity equation states that the supply of real money balances M/P equals the demand
(M/P) d and that the demand is proportional to output Y.
d
M / P=(M / P) =kY
For any fixed money supply and velocity, the quantity equation yields a negative relationship
between the price level P and output Y.
Price level, P

AD
Output, Y
The aggregate demand curve AD shows the relationship between the price level P and the
quantity of goods and services demanded Y. It is drawn for a given value of the money supply M.
The aggregate demand curve slopes downward: the higher the price level P, the lower the level
of real balances M/P, and therefore the lower the quantity of goods and services demanded Y.

Shifts in the Aggregate Demand: Changes in the money supply shift the aggregate demand
curve. A decrease in the money supply M reduces the nominal value of output PY. For any given
price level P, output Y is lower. Thus, a decrease in the money supply shifts the aggregate
demand curve inward from AD1 to AD2 (b). An increase in the money supply M raises the
nominal value of output PY. For any given price level P, output Y is higher. Thus, an increase in
the money supply shifts the aggregate demand curve outward from AD1 to AD2 (a).
2
P P

AD2 AD1
AD1 AD2
Y Y
(a)Increase in M (b) Decrease in M

3.2 The goods Market and the IS curve

The IS curve plots the relationship between the interest rate and the level of income that arises in
the market for goods and services. In The General Theory, Keynes proposed that an economy’s
total income was, in the short run, determined largely by the desire to spend by households,
firms, and the government. The more people want to spend, the more goods and services firms
can sell. The more firms can sell, the more output they will choose to produce and the more
workers they will choose to hire. Thus, the problem during recessions and depressions, according
to Keynes, was inadequate spending.

The Keynesian cross: is a model of Keynes designed to explain the relationship between
expenditure and output. Accordingly there are two types of expenditure:
 Actual expenditure: it is the amount households, firms, and the government spends on
goods and services which is equal with the GDP.
 Planned expenditure: it is the amount households, firms, and the government would like
to spend on goods and services.
In closed economy, since net exports are zero, we write planned expenditure E as the sum of
consumption C, planned investment I, and government purchases G:
E=C+ I +G
To this equation, we add the consumption function
C=C (Y −T )
This equation states that consumption depends on disposable income (Y −T), which is total
income Y minus taxes T.
To keep things simple, for now we take planned investment as exogenously fixed:
I =I .

3
And assume that fiscal policy—the level of government purchases and taxes—is fixed:
G=G ,
T =T
Combining these five equations, we obtain
E=C(Y −T )+ I +G .
This equation shows that planned expenditure is a function of income Y, the level of planned
investment I , and the fiscal policy variables G andT .

Planned Expenditure as a function of Income

Planed Expenditure, E
E=C(Y −T )+ I +G

MPC
1

Income, output, Y
Planned expenditure depends on income because higher income leads to higher consumption,
which is part of planned expenditure. The slope of this planned-expenditure function is the
marginal propensity to consume, MPC.
At equilibrium of the economy:
Actual Expenditure=Planned Expenditure
Y =E .
Actual Expenditure
Expenditure, E Y =E

Planed Expenditure

A E=C+ I +G

0
45 Y

Equilibrium Income

The equilibrium in the Keynesian cross is at point A, where income (actual expenditure) equals
planned expenditure.

4
The Adjustment to Equilibrium in the Keynesian Cross: If firms were producing at level Y1,
then planned expenditure E1 would fall short of production and firms would accumulate
inventories (a). This inventory accumulation would induce firms to reduce production. Similarly,
if firms were producing at level Y2, then planned expenditure E2 would exceed production, and
firms would run down their inventories (b). This fall in inventories would induce firms to raise
production. In both cases, the firms’ decisions drive the economy toward equilibrium.

Expenditure, E Actual Expenditure

Y1

a Planed Expenditure

E1 A

E2 b
0
Y2 45

Y1 Equilibrium Income Y2 Y

In summary, the Keynesian cross shows how income Y is determined for given levels of planned
investment I and fiscal policy G and T. We can use this model to show how income changes
when one of these exogenous variables changes.

Fiscal Policy and the Multiplier

a. Government Purchases: Because government purchases are one component of expenditure,
higher government purchases result in higher planned expenditure for any given level of
income. If government purchases rise by∆ G , then the planned-expenditure schedule shifts
upward by∆ G . An increase in government purchases leads to an even greater increase in
income. That is, ∆ Y is larger than∆ G . The ratio ∆ Y /∆ G is called the government purchases
multiplier; it tells us how much income rises in response to a Birr 1 increase in government
purchases. An implication of the Keynesian cross is that the government-purchases multiplier
is larger than 1.

5
 Expenditure, E Actual Expenditure
E2=Y2 B Planed Expenditure

∆Y (1) ∆ G

E1=Y1 A
0
45 (2)

Y1=E1 ∆ Y Y2=E2 Income, output, Y

An increase in government purchases of ∆ G raises planned expenditure by that amount for any
given level of income (1). The equilibrium moves from point A to point B, and income rises
from Y1 to Y2. Note that the increase in income ∆ Y (2) exceeds the increase in government
purchases∆ G . Thus, fiscal policy has a multiplied effect on income.
∆Y 1
Exercise: How big is the multiplier? Show mathematically? (Hint: = )
∆ G 1−MPC
b. Taxes: A decrease in taxes of ∆ T immediately raises disposable income Y −T by
∆ T and, therefore, increases consumption by MPC × ∆ T . Hence the planned-
expenditure schedule shifts upward by MPC × ∆ T .
Actual Expenditure

E2=Y2 B Planed Expenditure

∆Y MPC × ∆ T (1)

E1=Y1 A

(2)

Y1=E1 Y2=E2

A decrease in taxes of ∆ T raises planned expenditure by MPC × ∆ T for any given level of
income. The equilibrium moves from point A to point B, and income rises from Y1 to Y2. Again,
fiscal policy has a multiplied effect on income.
Just as an increase in government purchases has a multiplied effect on income, so
∆ Y −MPC
does a decrease in taxes. The tax multiplier is therefore = .
∆ T 1−MPC
The Interest Rate, Investment, and the IS Curve: planned investment depends on the interest
rate r.

6
 I =I (r ).

Since the interest rate is the cost of borrowing to finance investment projects, an increase in the
interest rate reduces planned investment. As a result, the investment function slopes downward.
The IS curve combines the interaction between r and I expressed by the investment function and
the interaction between I and Y demonstrated by the Keynesian cross. Because an increase in the
interest rate causes planned investment to fall, which in turn causes income to fall, the IS curve
slopes downward.

a) Investment function b) the Keynesian cross c) the IS curve

Interest rate, r Expenditure
Actual E
r1 E1 r2

r2 E2 ∆ I Planed E r1

I(r)

I(r 2) I(r 1) Investment Y2Y1 Income, Y Y 2 Y 1Income, Y

Panel (a) shows the investment function: an increase in the interest rate from r1 to r2 reduces
planned investment from I ¿ ) to I (r 2 ). Panel (b) shows the Keynesian cross: a decrease in planned
investment from I(r1) to I(r2) shifts the planned expenditure function downward and there by
reduces income from Y1 to [Link] (c) shows the IS curve summarizing this relationship
between the interest rate and income: the higher the interest rate, the lower the level of income .

The IS curve shows us, for any given interest rate, the level of income that brings the goods
market into equilibrium. The IS curve is drawn for a given fiscal policy; that is, when we
construct the IS curve, we hold G and T fixed. When fiscal policy changes, the IS curve shifts.
In summary, the IS curve shows the combinations of the interest rate and the level of income that
are consistent with equilibrium in the market for goods and services. The IS curve is drawn for a
given fiscal policy. Changes in fiscal policy that raise the demand for goods and services shift
the IS curve to the right. Changes in fiscal policy that reduce the demand for goods and services
shift the IS curve to the left.

7
 a. Keynesian cross b. IS curve
Actual E
Y2 Planed E

∆Gr IS2

Y1 IS1

Y1 Y2 Y1 Y2

An Increase in Government Purchases Shifts the IS Curve Outward Panel (a) shows that an
increase in government purchases raises planned expenditure. For any given interest rate, the
upward shift in planned expenditure of ∆ G leads to an increase in incomeY of∆ G /(1−MPC ).
Therefore, inpanel (b), the IS curve shifts to the right by this amount.
Y −C−G=I
S=I .
The left-hand side of this equation is national saving S, and the right-hand side is investment I.
Y −C (Y −T )−G=I (r).
The left-hand side of this equation shows that the supply of loan able funds depends on income
and fiscal policy. The right-hand side shows that the demand for loan able funds depends on the
interest rate. The interest rate adjusts to equilibrate the supply and demand for loans.

3.3 The Money Market and the LM Curve

The LM curve plots the relationship between the interest rate and the level of income that arises
in the market for money balances. It is best expressed by the theory of the interest rate, called the
theory of liquidity preference.

Just as the Keynesian cross is a building block for the IS curve, the theory of liquidity preference
is a building block for the LM curve. The theory of liquidity preference posits that the interest
rate adjusts to balance the supply and demand for the economy’s most liquid asset—money.
The theory of liquidity preference assumes there is a fixed supply of real money balances. That
is,
s
( M / P) =M / P .

8
This is because M is exogenous variable determined by the government and price is fixed in the
short run. The theory of liquidity preference posits that the interest rate is one determinant of
how much money people choose to hold. The reason is that the interest rate is the opportunity
cost of holding 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. When the interest
rate rises, people want to hold less of their wealth in the form of money. We can write the
demand for real money balances as
d
(M / P) =L( r),
Where the function L(r) shows that the quantity of money demanded depends on the interest rate.
Thus, the demand curve slopes downward because higher interest rates reduce the quantity of
real money balances demanded.

According to the theory of liquidity preference, the supply and demand for real money balances
determine what interest rate prevails in the economy. That is, the interest rate adjusts to
equilibrate the money market.

Interest rate, r

Supply
Equilibrium interest rate

Demand, L(r)

Real money Balance M/P

The Theory of Liquidity Preference: The supply and demand for real money balances determine
the interest rate. The supply curve for real money balances is vertical because the supply does
not depend on the interest rate. The demand curve is downward sloping because a higher
interest rate raises the cost of holding money and thus lowers the quantity demanded. At the
equilibrium interest rate, the quantity of real money balances demanded equals the quantity
supplied.
A Reduction in the Money Supply in the Theory of Liquidity Preference: If the price level is
fixed, a reduction in the money supply from M1 to M2reduces the supply of real money balances.
The equilibrium interest rate therefore rises from r1 to r2.

9
 A fall in money supply
r2

r1
Demand, L(r)

Real money Balance M/P

According to the theory of liquidity preference, a decrease in the money supply raises the interest
rate, and an increase in the money supply lowers the interest rate.

Income, Money Demand, and the LM Curve

The level of income affects the demand for money. When income is high, expenditure is high, so
people engage in more transactions that require the use of money. Thus, greater income implies
greater money demand. We can express these ideas by writing the money demand function as
d
( M / P) =L( r , Y ) .
The quantity of real money balances demanded is negatively related to the interest rate and
positively related to income. The LM curve plots this relationship between the level of income
and the interest rate. 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.
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 (1) and thus raises the interest rate from r1 to
r2. Panel (b) shows the LM curve summarizing this relationship between the interest rate and
income: the higher the level of income, the higher the interest rate.
a. The market for Real Money Balance b. The LM curve

Interest rate (1) Interest rate LM

r2 r2

r1 L(r, Y2) r1

L(r, Y1)
Real money Balance M/P
Y1 Y2
10
In summary, the LM curve shows the combinations of the interest rate and the level
of income that is consistent with equilibrium in the market for real money balances.
The LM curve is drawn for a given supply of real money balances. Decreases in the
supply of real money balances shift the LM curve upward. Increases in the supply of
real money balances shift the LM curve downward.

Quantity-Equation Interpretation of the LM Curve

According to the liquidity-preference model, the demand for real money balances
also depends on the interest rate: a higher interest rate raises the cost of holding
money and reduces money demand. When people respond to a higher interest rate
by holding less money, each dollar they do hold must be used more often to support
a given volume of transactions-that is, the velocity of money must increase.
We can write this as
MV (r)=PY .
The velocity function V(r) indicates that velocity is positively related to the interest rate. This
form of the quantity equation yields an LM curve that slopes upward. Because an increase in the
interest rate raises the velocity of money, it raises the level of income for any given money
supply and price level. The LM curve expresses this positive relationship between the interest
rate and income.

Besides this for any given interest rate and price level, the money supply and the level of income
must move together. Thus, increases in the money supply shift the LM curve to the right, and
decreases in the money supply shift the LM curve to the left.
a. The market for real money balance b. The LM curve
Interest Interest LM2

r2 LM1

r1

M1/P Real money Balance M/P Y

11
A Reduction in the Money Supply Shifts the LM Curve Upward Panel (a) shows that for any
given level of incomeY , a reduction in the money supply raises the interest rate that equilibrates
the money market. Therefore, the LM curve in panel (b) shifts upward.

3.4 The Short-Run Equilibrium

We now have all the pieces of the IS–LM model. The two equations of this model are
Y =C (Y −T )+ I (r )+ GIS ,
M / P=L(r , Y )LM .
The model takes fiscal policy, G and T, monetary policy M, and the price level P as exogenous.
Given these exogenous variables, the IS curve provides the combinations of r and Y that satisfy
the equation representing the goods market, and the LM curve provides the combinations of r and
Y that satisfy the equation representing the money market.

The equilibrium of the economy is the point at which the IS curve and the LM curve cross. This
point gives the interest rate r and the level of income Y that satisfy conditions for equilibrium in
both the goods market and the money market. In other words, at this intersection, actual
expenditure equals planned expenditure, and the demand for real money balances equals the
supply.

Equilibrium in the IS–LM Model

Interest LM

Equilibrium interest rate

IS
Income, output, Y
Equilibrium level of income

The intersection of the IS and LM curves represents simultaneous equilibrium in the market for
goods and services and in the market for real money balances for given values of government
spending, taxes, the money supply, and the price level.

Note: A change in either fiscal or monetary policy leads to changes in equilibrium output and
equilibrium interest rate.

12
Fiscal policy: an increase in G or a reduction in T shifts the IS curve out, hence both equilibrium
output and equilibrium interest rate increases.
Monetary policy: an increase in money supply shifts the LM curve out. Hence it will increase
output but it will decrease equilibrium interest rate.

Interaction of Fiscal and Monetary policies:

What would happen to equilibrium when there is an increase in tax?
a. If the government keeps money supply constant?
LM curve stay the same IS curve shift down hence equilibrium r and Y decrease.
b. If the government wants to keep interest rate constant?
The government should decrease money supply. This shifts both the IS and LM curve
inward. Hence it greatly reduces Y greatly as compared to A.
c. If the government holds the income level constant?
Here the government should increase the money supply, the LM curve shifts out and the
IS curve shifts down. This will lead to a reduction in the equilibrium interest rate

3.5 From IS-LM to Aggregate Demand

Note that in the IS-LM model price is considered as exogenous fixed variable. But an increase in
price will reduce the real money balance M/P and hence the LM curve shifts up. This will intern
reduces the equilibrium level of output.

a. The IS-LM model b. The aggregate demand curve

Interest LM (P2) Price

r2 LM (P1) P2

r1 P1

IS AD

Y2 Y1 Income, output, Y Y1 Y2 Y

Panel (a) shows the IS–LM model: an increase in the price level from P1 to P2 lowers real
money balances and thus shifts the LM curve upward. The shift in the LM curve lowers income

13
from Y1 to Y2. Panel (b) shows the aggregate demand curve summarizing this relationship
between the price level and income: the higher the price level, the lower the level of income.

14