Lecture Notes
Chapter 3 – Aggregate Demand in the Closed Economy
1. Foundations of the Theory of Aggregate Demand
1.1 Classical Theory
National income depends on factor supplies (labor, capital) and technology.
These factors do not change much in the short run.
Classical view: Aggregate supply alone determines national income; prices adjust to maintain
equilibrium.
1.2 Keynesian Revolution (1936)
Introduced by John Maynard Keynes in The General Theory of Employment, Interest, and Money.
Low aggregate demand causes low income and high unemployment during downturns.
Keynes criticized the classical theory for ignoring short-run demand effects.
1.3 Modern View
Long Run: Prices are flexible → Aggregate supply determines income.
Short Run: Prices are sticky → Aggregate demand influences income.
IS–LM Model: Main tool for analyzing short-run aggregate demand.
IS Curve – Goods market equilibrium (Investment & Saving).
LM Curve – Money market equilibrium (Liquidity & Money).
2. The Goods Market and the IS Curve
The IS curve shows combinations of interest rates (r) and income (Y) where the goods market is in
equilibrium.
2.1 The Keynesian Cross
Actual expenditure (AE): Actual spending = GDP.
Planned expenditure (E): Desired spending by households, firms, and government.
Planned expenditure in a closed economy:
E=C+I+G
C= c(Y-T) → Consumption is a function of disposable income.
I = fixed (exogenous) planned investment (for now).
G = fixed government purchases & taxes.
2.2 Equilibrium Condition
Y=E
3. Fiscal Policy and the Multiplier
3.1 Government Purchases Multiplier
Increase in G → IncreasesE → Larger increase inY due to repeated spending.
Formula:change in Y / change in G > 1
3.2 Tax Multiplier
Decrease inT → Increases disposable income → Increases C .
Formula: Change in Y /Change in T = -MPC/1 - MP
4. Interest Rate, Investment, and IS Curve
Investment depends negatively on interest rate:
I = I(r)
Downward-sloping IS curve: Higher interest rates reduce equilibrium income.
5. The Money Market and the LM Curve
LM curve shows combinations of r and Y where the money market is in equilibrium.
5.1 Theory of Liquidity Preference
Money supply: (real balances) is fixed by the central bank.
Money demand: Decreases when rises (opportunity cost of holding money).
5.2 Income and Money Demand
Higher income → More transactions → Higher money demand.
To keep money market balanced, must rise when rises → Upward-sloping LM curve.
5.3 Shifts in LM Curve
Increase in money supply (↑) → ↑ → LM shifts right (downward).
Decrease in money supply → LM shifts left (upward).
6. Short-Run Equilibrium in IS–LM Model
Intersection of IS and LM curves gives:
Equilibrium interest rate (r*)
Equilibrium income (Y*)
Policy effects:
Fiscal policy shifts IS curve.
Monetary policy shifts LM curve.
7. Interaction of Fiscal and Monetary Policy
Policy outcomes depend on coordination between:
National Bank (monetary policy)
Ministry of Finance and Development (fiscal policy)
Example:
Tax increase to cool economy:
If NB keeps money supply constant → Output falls more.
If NB offsets with more money supply → Output fall is smaller.
8. From IS–LM to Aggregate Demand
IS–LM is short-run model with fixed prices.
Changing price level () changes real money balances (), shifting LM curve.
AD curve shows relationship between and :
→ → LM shifts left → Y falls.
→ LM shifts right → Y rises.
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