Effective Demand and IS-LM
Stephen Kinsella | email@example.com | stephenkinsella.net
Outline of Macroeconomics
History & Development of the Subject
Developed by Hicks (1937) and others
Simple, BOE calculating Model (or is it?)
Lots of Problems:
Long Run/Short Run
Idea of ‘One’ Interest Rate
‘Dark Forces of Time & Ignorance’
ISLM & Effective Demand (ED)
Message: Output of Economy
Depends on Components of ED
Assume there are N workers, and a static production technology.
Let’s describe the calculations of the Firm.
Value of Output - (Factor Cost + User Cost) = Proﬁt of Firm
Firm wants to Max(Proﬁt)
Now from Economy’s POV:
Aggregate income is Factor Cost + Proﬁt
Aggregate Supply Function (ASF) is expectation of
proceeds from employment of resources in this way.
ASF = f(N), where N = No. of Workers
Aggregate Demand Function (ASD) is expectation of
proceeds from employing N workers.
ASD = f(N).
When ADF > ASF, employ more people
When ADF < ASF, ﬁre people
@ ADF = ASF, entrepreneurs' expectation of
proﬁts will be maximised
Does Supply create Demand
Or, does Demand create Supply?
If N goes up, Ag. Income goes up,
Consumption goes up.
Need increasing investment to absorb this
So eqm. level of employment depends on
level of investment
What changes investment? Marginal
Efﬁciency of Capital (MEC)
Income depends on employment of N
income/consumption relationship depends
on propensity to consume, call this IC
income/investment relationship depends on
Sum of IC and MEC is effective demand
Even better Summary
The volume of employment in equilibrium
(i) the aggregate supply function, ASF
(ii) the propensity to consume, IC, and
(iii) the volume of investment
Let’s think about
Ireland Right Now
Real GDP dropping at 4-6%
UE running at 11%, so far this year,
expectations much higher
Domestic investment in toilet.
Where is effective demand?