#12 Aggregate Demand I: Building The IS-LM Model Flashcards
Long run
Prices are flexible
Output determined by factors of production and technology
Unemployment equals its natural rate
Short run
Prices fixed
Output determined by aggregate demand
Unemployment negatively related to output
Keynesian Cross
Simple closed-economy model in which income is determined by expenditure
Planned Expenditure
PE = C + I + G
Actual Expenditure
Y = real GDP = actual expenditure
Difference between actual expenditure and planned expenditure
Unplanned inventory investment
Elements of Keynesian cross
Consumption C = C(Y-T)
Actual Expenditure = Planned Expenditure
Y = PE
Change in Y (income) equal to
G
Delta Y / Delta G = 1 / 1 - MPC
Increase in government purchases…
Increases PE by Delta G
Change in Y (income) is equal to…
T
Delta Y / Delta T = -MPC / 1 - MPC
Decrease in taxes…
Increases PE by MPC x Delta T
Tax multiplier…
Is negative
Tax increase reduces C —> reduces income
Is greater than 1
Is smaller than gov.spending multiplier
IS Curve
Graph of all combinations of r and Y that result in goods market equilibrium
IS Curve equation
Y = C(Y-T) + I(r) + G
IS Curve
Real interest rate decreased…
Planned investment increased
Income increased
Why is IS negativity sloped
Fall in the interest rate motivates firms to increase investment spending which drives up total planned spending (PE)
Theory of liquidity preference
Simple theory in which the interest rate is determined by money supply and money demand
LM Curve
Graph of all combinations of r and Y that equate the supply and demand for real money balances
LM Curve equation
M / P = L(r, Y)
LM Curve
Income increase
Money demand to right
Interest rate increases
LM Curve
Reducing money
Interest rates Increasing
LM Curve shifting up
