1. Copyright © 2010 Pearson Education. All rights reserved. Chapter 20 The ISLM Model

2. Copyright © 2010 Pearson Education. All rights reserved. 20-2 Determination of Aggregate Output

3. Copyright © 2010 Pearson Education. All rights reserved. 20-3 Consumption Expenditure and the Consumption Function

4. Copyright © 2010 Pearson Education. All rights reserved. 20-4 Table 1 Consumption Function: Schedule of Consumer Expenditure C When mpc = 0.5 and a = 200 ($ billions)

5. Copyright © 2010 Pearson Education. All rights reserved. 20-5 FIGURE 1 Consumption Function

6. Copyright © 2010 Pearson Education. All rights reserved. 20-6 Investment Spending Fixed investment: always planned Inventory investment: can be unplanned Planned investment spending –Interest rates –Expectations

7. Copyright © 2010 Pearson Education. All rights reserved. 20-7 FIGURE 2 Keynesian Cross Diagram

8. Copyright © 2010 Pearson Education. All rights reserved. 20-8 Expenditure Multiplier

9. Copyright © 2010 Pearson Education. All rights reserved. 20-9 FIGURE 3 Response of Aggregate Output to a Change in Planned Investment

10. Copyright © 2010 Pearson Education. All rights reserved. 20-10 FIGURE 4 Response of Aggregate Output to the Collapse of Investment Spending, 1929–1933 Source: Economic Report of the President.

11. Copyright © 2010 Pearson Education. All rights reserved. 20-11 Changes in Autonomous Spending Any change in autonomous spending will lead to a multiplied change in aggregate output The shift in the aggregate demand function can come from a change in planned investment, a change in autonomous consumer spending, or both Changes in autonomous spending are dominated by “ animal spirits ”

12. Copyright © 2010 Pearson Education. All rights reserved. 20-12 Government’s Role

13. Copyright © 2010 Pearson Education. All rights reserved. 20-13 FIGURE 5 Response of Aggregate Output to Government Spending and Taxes

14. Copyright © 2010 Pearson Education. All rights reserved. 20-14 Role of International Trade

15. Copyright © 2010 Pearson Education. All rights reserved. 20-15 FIGURE 6 Response of Aggregate Output to a Change in Net Exports

16. Copyright © 2010 Pearson Education. All rights reserved. 20-16 Summary Table 2 Response of Aggregate Output Y to Autonomous Changes in a, I, G, T, and NX

17. Copyright © 2010 Pearson Education. All rights reserved. 20-17 The ISLM Model Includes money and interest rates in the Keynesian framework Examines an equilibrium where aggregate output equals aggregate demand Assumes fixed price level where nominal and real quantities are the same IS curve is the relationship between equilibrium aggregate output and the interest rate LM curve is the combinations of interest rates and aggregate output for which M D = M S

18. Copyright © 2010 Pearson Education. All rights reserved. 20-18 Equilibrium in the Goods Market: The IS Curve Interest rates and planned investment spending –Negative relationship Interest rates and net exports –Negative relationship IS curve: the points at which the total quantity of goods produced equals the total quantity of goods demanded Output tends to move toward points on the curve that satisfies the goods market equilibrium

19. Copyright © 2010 Pearson Education. All rights reserved. 20-19 FIGURE 7 Deriving the IS Curve

20. Copyright © 2010 Pearson Education. All rights reserved. 20-20 Equilibrium in the Market for Money: The LM Curve Demand for money called liquidity preference M d /P depends on income (Y) and interest rates (i) Positively related to income –Raises the level of transactions –Increases wealth Negatively related to interest rates

21. Copyright © 2010 Pearson Education. All rights reserved. 20-21 Equilibrium in the Market for Money: The LM Curve (cont’d) Connects points that satisfy the equilibrium condition that M D = M S For each level of aggregate output, the LM curve tells us what the interest rate must be for equilibrium to occur The economy tends to move toward points on the LM curve

22. Copyright © 2010 Pearson Education. All rights reserved. 20-22 FIGURE 8 Deriving the LM Curve

23. Copyright © 2010 Pearson Education. All rights reserved. 20-23 FIGURE 9 ISLM Diagram: Simultaneous Determination of Output and the Interest Rate