The Keynesian

Cross Model, The

Money Market, and
IS/LM
Planned expenditure and actual
expenditure.
 Constructing the Keynesian Cross

• Actual expenditure is Y and

planned expenditure is
E = C + I + G.
• I, G, and T are assumed
E
exogenous and fixed. Y=E
• Our consumption function is
E=C+I+G
C = c(Y–T), where c is the
marginal propensity to E* mpc
consume (mpc).
• Mapping out £1

E = c(Y–T) + I + G gives us…

Y
• The slope of E is the mpc. Y*

• In equilibrium planned
expenditure equals total
expenditure or Y=E.
 Constructing the Keynesian Cross

• Equilibrium is at the point

where Y = C + I + G. Inventory
accumulates.
drops.
• If firms were producing at Y1
then Y > E E
• Because actual expenditure Y=E
exceeds planned expenditure,
inventory accumulates, E=C+I+G
stimulating a reduction in E* mpc
production.
• Similarly at Y2, Y < E £1
• Because planned expenditure
exceeds actual expenditure, Y2 Y* Y1
Y
inventory drops, stimulating
an increase in production.
 Government expenditure and tax multipliers

• An increase of G by ΔG causes an
upward shift of planned expenditure
by ΔG.
• Notice that ΔY > ΔG. This is because
although ΔG causes an initial change
in Y of ΔG, the increased Y leads to E
an increase in consumption and Y=E
triggers a multiplier effect.
• Now suppose a decrease of T by ΔT ΔG
that causes an upward shift of E2 mpc*ΔT
planned expenditure by mpc*ΔT. E3
• Notice again that ΔY > ΔT but that ΔY E1
is less than in the case with ΔG. This
is because ΔT causes no initial
change in Y as ΔG did, the decrease Y
in T simply leads to an increase in Y1 Y3 Y2
consumption and triggers the
multiplier effect.
 Building the IS curve
E
E=Y
• The IS curve maps the
relationship between r and Y for E=C+I(r1)+G
the goods market.
Let the interest rate E=C+I(r2)+G
This decrease in
increaseSo from
Y decreases from
r1 to r2 reduce
investment
The IS curve causes
mapstheout this ΔI
planned Y to
investment Y .
2 from
planned
relationship
expenditure
1
between the
I(r1) to
function
interest to I(r
rate, 2).
shiftr, down.
and output
(or income) Y. Y
Y2 Y1

r r

r2 r2

r1 r1
I(r) IS
I Y
I(r2) I(r1) Y2 Y1
 Shifting the IS curve
E
• While changing r allows us to map E=Y
out the IS curve, changes in G, T,
or mpc cause Y to change for any E=C+I+G2
level of r. This causes a shift in E=C+I+G1
the IS curve.
ΔG
Suppose an increase in G
causes planned
expenditure to shift up by Y
Y1 Y2
ΔG.
r
For any r the increase in G
causes an increase in Y of
ΔG times the government
expenditure multiplier.
r1
Therefore, the IS curve IS´
shifts to the right by this IS
amount. Y
Y1 Y2
 A loanable funds market interpretation

• The IS curve maps the

relationship between r and Y for
the loanable funds market in
equilibrium.
• Suppose Y increases from Y1 to Y2. • The IS curve maps out this
This raises savings from S(Y1) to relationship between the
S(Y2) resulting in a lower lower interest rate and
equilibrium interest rate. increased income.

r r
S(Y1) S(Y2)

r1 r1

r2 r2 IS
I(r)
I Y
Y1 Y2
A loanable funds market interpretation of fiscal policy

• While changing r allows us to map

out the IS curve, changes in G, T,
or mpc cause Y to change for any
level of r. This causes a shift in
the IS curve.
• Suppose again an increase in G. • Therefore, for a given Y there is a
In the loanable funds market this higher level of r. So, the IS curve
results in a decrease in S and an shifts up by this amount.
increase in the interest rate.

r r
S(G2) S(G1)

r2 r2
IS´
r1 r1
I(r) IS
I Y
Y1
 Building the LM curve

• The LM curve maps the

relationship between r and Y for
the money market.

Given money supply The LM curve maps

and money demand out this relationship
suppose an increase in between
income raises money r and Y.
demand.
r r
(M/P)s
LM

r2 r2

r1 r1
L(r,Y1) L(r,Y2)
Real
Y
Money Y1 Y2
Balances
 Shifting the LM curve

• While changing money demand

allows usGiven
to mapmoney
out thesupply and
LM curve,
Now
changesmoney there is
in M ordemand a higher
P causesuppose
r to reala
interest
changedecrease rate
for any level for the
of money
in the current
Y. This stock The LM curve shifts
causes a shiftlevel
in the
of LM curve.
output. up so that at the same
shifts real money supply to
the left resulting in a higher level of output the
equilibrium interest rate. interest rate is higher.

r (M2/P)s (M1/P)
s r
LM´ LM

r2 r2

r1 r1
L(r,Y)
Real
Money Y
Y
Balances
 IS=LM: The Short Run Equilibrium

• Given our IS and LM equation we

can now determine the short run
equilibrium interest rate and
output
• By mapping out the relationship
between Y and r when the goods
market (or loanable funds market)
is in equilibrium we get the IS
curve.
• By mapping out the relationship
between Y and r when the money r
market is in equilibrium we get the
LM curve. LM
• When we set IS=LM we can solve
for the equilibrium levels of r and
Y. This represents simultaneous
equilibrium in the goods market
(or loanable funds market) and the r*
money market. IS
Y
Y*
 Conclusion

• We constructed the IS curve from the goods

market and from the loanable funds market.
We discussed shifting factors for IS.
• We constructed the LM curve from the
money market and discussed shifting
factors for LM.
• Finally, we set IS=LM to achieve equilibrium
in all markets giving us short run
equilibrium r and Y.
 AD-AS Short Run
Building the short run AD-AS
model from the IS-LM
framework
 Theory of Short Run Fluctuations

The IS curve is generated from

the Keynesian Cross and the
LM curve is generated from the
market for real money
balances.

Now we will generate the AD

Keynesian IS curve from IS-LM and use
Curve short run and long run models
Cross of AS to explain short run
economic fluctuations.
IS-LM AD
Model Curve

Short-run
Money LM AD-AS
Fluctuations
Market Curve Model
Explanation

AS
Curve
Fiscal Policy and the IS curve (government expenditure)

An increase in government purchases

shifts the IS curve to the right.
Y=C(Y-T)+I(r)+G ...IS
M/P=L(r,Y) ...LM
The IS curve shifts to the
right by ΔG/(1-MPC),... r

LM

...and the interest rate. r2

r1 IS2

IS1
…which raises income... Y
Y1 Y2
Fiscal Policy and the IS curve (government expenditure)

A decrease in taxes shifts the IS curve to

the right.
Y=C(Y-T)+I(r)+G ...IS
M/P=L(r,Y) ...LM
The IS curve shifts to the right
by ΔTxMPC/(1–MPC),... r

LM

...and the interest rate. r2

r1 IS2

IS1
…which raises income... Y
Y1 Y2
 Fiscal Policy and the IS curve
(tax changes)

• Note that government expenditure has a

larger effect than does the same change in
taxes.

Y=C(Y-T)+I(r)+G ...IS
M/P=L(r,Y) ...LM
 Monetary Policy and the LM curve

An increase in the money supply shifts

the LM curve to the right,...
Y=C(Y-T)+I(r)+G ...IS
M/P=L(r,Y) ...LM

r
LM1
LM2

...and lowers the interest rate.

r1
r2
IS1
…which raises income... Y
Y1 Y2
 Monetary and Fiscal Policy Interactions

…if the money

supply is held
constant, the
• How the economy LM curve stays
responds to a tax the same.
increase depends on
the response of the r
money supply. LM1

• The interest
rate and
IS1
output fall.
IS2
Y
 Monetary and Fiscal Policy Interactions

…if to hold the

interest rate constant,
the money supply
• How the economy contracts.
responds to a tax
increase depends on
the response of the r
money supply. LM2
LM1

• Only output IS1

falls.
IS2
Y
 Monetary and Fiscal Policy Interactions

…if to hold
income
constant, the
• How the economy money supply
responds to a tax expands.
increase depends on
the response of the r
money supply. LM1
LM2

IS1
• Only the
IS2
interest rate Y
falls.
 IS-LM as a theory of Aggregate Demand

r
LM(P2)
A higher price level P shifts the LM(P1)
LM curve upward…

…lowering income Y.
IS1
• We now allow price Y2 Y1
Y

level to vary in the IS- The AD curve

P
LM model. This summarizes the
relationship between
provides a theory for P and Y.
the position and P2
slope of the AD
P1
curve.
AD
Y
Y2 Y1
 IS-LM as a theory of Aggregate Demand

r LM(P1)
A monetary expansion shifts the LM(P1)
LM curve outward…

…increasing income Y.
IS1
Y
Y1 Y2
• If we hold price
constant we can see P
Increasing AD at any
given price level.
the effects of monetary
and fiscal policy on AD
via IS-LM. P1

AD2
AD1
Y
Y1 Y2
 IS-LM as a theory of Aggregate Demand

r
LM(P1)

A fiscal expansion shifts the IS

IS2
curve outward…
IS1
Y
…increasing income Y. Y1 Y2

Increasing
P
AD at any
given price
level.
P1

AD2
AD1
Y
Y1 Y2
 IS-LM and AD-AS the Short Run and the Long Run

• Now let’s add short-run and long-run

AS to our IS-LM and AD models. r LRAS
Assume the economy is operating LM(P1) LM(P2)
below full employment output.
1
As price falls money demand
decreases and the LM curve shifts 2
out. IS
Y
In the short run price is fixed at P1 Y
and equilibrium is at point 1.
P
In the long run price falls to P2,
quantity demanded increases, and
equilibrium moves to point 2. This P1 1 SRAS1
is characterized by a shifting SRAS SRAS2
P2 2
curve.
• Long run equilibrium is achieved AD1
at point 2. Y
Y
 The Algebra of the IS-LM theory of AD

• The algebra behind the system is a bit tedious.

But, by solving the LM curve for “r” and
plugging into the IS curve which contains “r” on
the right hand side you obtain the IS-LM
equilibrium condition or AD curve.
 The Algebra of the IS-LM theory of AD

The IS curve boils down to…

ac 1 b d
Y  G T r
1 b 1 b 1 b 1 b

r  (e / f )Y  (1/ f ) M / P
The LM curve boils
down to…
z (a  c) z zb d M
Y  G T
1 b 1 b 1 b (1  b)[ f  de /(1  b)] P
Plugging “r” into the IS
curve and solving for Y
yields…
 Conclusions

• In this section we derived the AD curve via the IS-

LM equilibrium condition. We looked at fiscal and
monetary policy effects on the IS-LM model. We
looked at the shifting effects that monetary and
fiscal policies have on the AD curve and used the
IS-LM model with the AD-AS model to explain short
run and long run changes to the economy.
 AD-AS Short Run
Building the short run AD-AS
model from the IS-LM
framework
 Theory of Short Run Fluctuations

The IS curve is generated from

the Keynesian Cross and the
LM curve is generated from the
market for real money
balances.

Now we will generate the AD

Keynesian IS curve from IS-LM and use
Curve short run and long run models
Cross of AS to explain short run
economic fluctuations.
IS-LM AD
Model Curve

Short-run
Money LM AD-AS
Fluctuations
Market Curve Model
Explanation

AS
Curve
Fiscal Policy and the IS curve (government expenditure)

An increase in government purchases

shifts the IS curve to the right.
Y=C(Y-T)+I(r)+G ...IS
M/P=L(r,Y) ...LM
The IS curve shifts to the
right by ΔG/(1-MPC),... r

LM

...and the interest rate. r2

r1 IS2

IS1
…which raises income... Y
Y1 Y2
Fiscal Policy and the IS curve (government expenditure)

A decrease in taxes shifts the IS curve to

the right.
Y=C(Y-T)+I(r)+G ...IS
M/P=L(r,Y) ...LM
The IS curve shifts to the right
by ΔTxMPC/(1–MPC),... r

LM

...and the interest rate. r2

r1 IS2

IS1
…which raises income... Y
Y1 Y2
 Fiscal Policy and the IS curve
(tax changes)

• Note that government expenditure has a

larger effect than does the same change in
taxes.

Y=C(Y-T)+I(r)+G ...IS
M/P=L(r,Y) ...LM
 Monetary Policy and the LM curve

An increase in the money supply shifts

the LM curve to the right,...
Y=C(Y-T)+I(r)+G ...IS
M/P=L(r,Y) ...LM

r
LM1
LM2

...and lowers the interest rate.

r1
r2
IS1
…which raises income... Y
Y1 Y2
 Monetary and Fiscal Policy Interactions

…if the money

supply is held
constant, the
• How the economy LM curve stays
responds to a tax the same.
increase depends on
the response of the r
money supply. LM1

• The interest
rate and
IS1
output fall.
IS2
Y
 Monetary and Fiscal Policy Interactions

…if to hold the

interest rate constant,
the money supply
• How the economy contracts.
responds to a tax
increase depends on
the response of the r
money supply. LM2
LM1

• Only output IS1

falls.
IS2
Y
 Monetary and Fiscal Policy Interactions

…if to hold
income
constant, the
• How the economy money supply
responds to a tax expands.
increase depends on
the response of the r
money supply. LM1
LM2

IS1
• Only the
IS2
interest rate Y
falls.
 IS-LM as a theory of Aggregate Demand

r
LM(P2)
A higher price level P shifts the LM(P1)
LM curve upward…

…lowering income Y.
IS1
• We now allow price Y2 Y1
Y

level to vary in the IS- The AD curve

P
LM model. This summarizes the
relationship between
provides a theory for P and Y.
the position and P2
slope of the AD
P1
curve.
AD
Y
Y2 Y1
 IS-LM as a theory of Aggregate Demand

r LM(P1)
A monetary expansion shifts the LM(P1)
LM curve outward…

…increasing income Y.
IS1
Y
Y1 Y2
• If we hold price
constant we can see P
Increasing AD at any
given price level.
the effects of monetary
and fiscal policy on AD
via IS-LM. P1

AD2
AD1
Y
Y1 Y2
 IS-LM as a theory of Aggregate Demand

r
LM(P1)

A fiscal expansion shifts the IS

IS2
curve outward…
IS1
Y
…increasing income Y. Y1 Y2

Increasing
P
AD at any
given price
level.
P1

AD2
AD1
Y
Y1 Y2
 IS-LM and AD-AS the Short Run and the Long Run

• Now let’s add short-run and long-run

AS to our IS-LM and AD models. r LRAS
Assume the economy is operating LM(P1) LM(P2)
below full employment output.
1
As price falls money demand
decreases and the LM curve shifts 2
out. IS
Y
In the short run price is fixed at P1 Y
and equilibrium is at point 1.
P
In the long run price falls to P2,
quantity demanded increases, and
equilibrium moves to point 2. This P1 1 SRAS1
is characterized by a shifting SRAS SRAS2
P2 2
curve.
• Long run equilibrium is achieved AD1
at point 2. Y
Y
 The Algebra of the IS-LM theory of AD

• The algebra behind the system is a bit tedious.

But, by solving the LM curve for “r” and
plugging into the IS curve which contains “r” on
the right hand side you obtain the IS-LM
equilibrium condition or AD curve.
 The Algebra of the IS-LM theory of AD

The IS curve boils down to…

ac 1 b d
Y  G T r
1 b 1 b 1 b 1 b

r  (e / f )Y  (1/ f ) M / P
The LM curve boils
down to…
z (a  c) z zb d M
Y  G T
1 b 1 b 1 b (1  b)[ f  de /(1  b)] P
Plugging “r” into the IS
curve and solving for Y
yields…
 Conclusions

• In this section we derived the AD curve via the IS-

LM equilibrium condition. We looked at fiscal and
monetary policy effects on the IS-LM model. We
looked at the shifting effects that monetary and
fiscal policies have on the AD curve and used the
IS-LM model with the AD-AS model to explain short
run and long run changes to the economy.