6. Elements of the Keynesian Cross consumption function: for now, investment is exogenous: planned expenditure: Equilibrium condition: govt policy variables:
9. The equilibrium value of income income, output, Y E planned expenditure E = Y E = C + I + G Equilibrium income
10. An increase in government purchases E = Y … so firms increase output, and income rises toward a new equilibrium Y E E = C + I + G 1 E 1 = Y 1 E = C + I + G 2 E 2 = Y 2 Y At Y 1 , there is now an unplanned drop in inventory… G
11. Solving for Y equilibrium condition in changes because I exogenous because C = MPC Y Collect terms with Y on the left side of the equals sign: Finally, solve for Y :
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15. An increase in taxes … so firms reduce output, and income falls toward a new equilibrium Initially, the tax increase reduces consumption, and therefore E : Y E E = Y E = C 2 + I + G E 2 = Y 2 E = C 1 + I + G E 1 = Y 1 Y At Y 1 , there is now an unplanned inventory buildup… C = MPC T
16. Solving for Y eq’m condition in changes I and G exogenous Solving for Y : Final result:
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24. The IS curve and the Loanable Funds model r 1 r 2 r 1 r 2 (a) The L.F. model (b) The IS curve IS S , I r I ( r ) r Y Y 1 Y 2 S 1 S 2
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34. Volcker’s Monetary Tightening, cont. i < 0 i > 0 1/1983: i = 8.2% 8/1979: i = 10.4% 4/1980: i = 15.8% flexible sticky Quantity Theory, Fisher Effect (Classical) Liquidity Preference (Keynesian) prediction actual outcome The effects of a monetary tightening on nominal interest rates prices model long run short run
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36. Deriving the LM curve r 1 r 2 r 1 r 2 (a) The market for real money balances (b) The LM curve M/P r L ( r , Y 1 ) r Y Y 1 L ( r , Y 2 ) Y 2 LM
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38. How M shifts the LM curve r 1 r 2 r 1 r 2 (a) The market for real money balances (b) The LM curve M/P r L ( r , Y 1 ) r Y Y 1 LM 1 LM 2
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41. The Big Picture Keynesian Cross Theory of Liquidity Preference IS curve LM curve IS-LM model Agg. demand curve Agg. supply curve Model of Agg. Demand and Agg. Supply Explanation of short-run fluctuations
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Editor's Notes
This chapter sets up the IS-LM model, which chapter 11 then uses extensively to analyze the effects of policies and economic shocks. This chapter also introduces students to the Keynesian Cross and Liquidity Preference models, which underlie the IS curve and LM curve, respectively. If you would like to spend less time on this chapter, you might consider omitting the Keynesian Cross, instead using the loanable funds model from Chapter 3 to derive the IS curve. Advantage: students are already familiar with the loanable funds model, so skipping the KC means one less model to learn. Additionally, the KC model is not used anywhere else in this textbook. Once it’s used to derive IS, it disappears for good. However, there are some good reasons for NOT omitting the KC model: 1) Many principles textbooks (though not Mankiw’s) cover the KC model; students who learned the KC model in their principles class may benefit from seeing it here, as a bridge to new material (the IS curve). 2) The KC model has historical value. One could argue that somebody graduating from college with a degree in economics should be familiar with the KC model.
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