Chapter 1. “Introduction: The Theory of Aggregate Demand.

”
in Macroeconomic Theory and Stabilization Policy,
by A. Stevenson, V. Muscatelli, and M. Gregory

Product Market

Let e = c + i + g + x

where e is expenditure, c is consumption, i is investment, g is government expenditures

and x is net exports.

c
Further, c = c0 + c(y - t) 0 < cy = < 1
y
i = i0 + i(r)

g = g0 , t = t0

x
x = x0 + x(y) -1 < xy = < 0
y

where cy is marginal propensity to consume, and xy is marginal propensity to import due

to the simplifying assumptions that net exports are a negative function of real domestic

income and xo is autonomous (exogenous) because changes in competitiveness (relative

prices) and foreign income levels are assumed to have no effects on net exports. Note

assumptions concerning magnitudes of cy and xy.

Substitution of the above equations into the e equation below yields

e = c0 + c(y - t0) + i0 + i(r) + g0 + x0 + x(y).

Simplifying,

e = e0 + e(y, r, t0) 0 < ey < 1;

er < 0; -1 < et < 0; et = -cy

where

e0 = c0 + i0 + g0 + x0 ,
 2

e
e(y, r, t0 ) = c(y - t0 ) + i(r) + x(y), and ey = .
y

Note, that the product market is in equilibrium when y = e,

y = e0 + e(y, r, t0 ).

One can totally differentiate this equation to obtain

dy = de0 + ey dy + er dr + et dt0

dy (1 - ey ) = de0 + er dr + et dt0 collect terms

 1 
dy =   (de0 + er dr + et dt0 )
 1 − ey 

where

de0 = dc0 + dg0 + dx0 + di0

and

ey = cy + xy ; er = ir ; et = - cy

Thus, ey is the sum of marginal propensities to consume and import, and it is less than

unity by assumption. Note that e0 is made up of the intercepts of IS, so changes in these

variables shift the IS. (They are shifters.)

dy 1
If we assume that dr = 0 (and dto=0), that is, r is constant, then = ,
d e0 1− e y

1 1
=
1− e y 1− (c y + x y )
which gives us the simple model multiplier. Note that .

Note: Define s = 1- cy as the marginal propensity to save. Letting xy = -m where m is

1 1 1
= =
1− e y 1− (c y + x y ) s + m
marginal propensity to import. Thus, . (Dornbush, R. Open

Macroeconomics, 1980, p. 38.). Note cy = 1 − s.

 3

Note: How to simplify when de0  0, and dr =dt 0 = 0 :

 1 
dy =   de0 + er dr + et dt 0
 1− e 
 y 

so that
=0 =0
dy  1  de0 + er dr + et dt 0
=
de0  1− e y  de0

 1  de0 1
=   =
 1 − ey  de0 1 − ey

and since e0 = c0 + g0 + x0 + i0 , a change in any one of these gives us the same

multiplier.

Now solve for dy / dt0 when dt 0  0, and de0 =dr = 0 :

=0 =0
dy  1   de0 er dr et dt0 
=  + + 
dt  1− ey   dt0 dt0 dt0 

 1  cy
=   et = −
 1 − ey  1 − ey

since et = - cy
________________________________________________________________________

Thus, an expansionary policy in the form of an increase in expenditures or in the

lowering of taxes is expressed as a (horizontally) rightward shift in IS.

 4

IS
y

Note that an increase in government expenditure shifts the IS curve further to the

right than that of a tax decrease of the same nominal magnitude.

y 1
=
 g0 1 − ey

y e cy
= t =−
 t0 1 − e y 1− ey

and

1 cy
 since cy < 1 .
1− e y 1− e y

Also, an autonomous increase in net exports also shifts IS horizontally to the

right:

y 1  y 
=  Same as  .
x0 1− e y  e0 

dr
What about the slope of IS? This is given as .
dy

dy
The easiest way to obtain this is to calculate and then invert:
dr
 5

dy 1  de0 er dr et dt0 
=  + + 
dr 1− ey  dr dr dr 

er
=
1− e y

dr 1− ey
which implies =  0 (since er < 0 and 1 - ey > 0) so that the slope is negative.
dy er

Ceteris paribus, at higher r, relatively less investment expenditure (to keep I = S) results

in relatively lower income.

The steepness of slope depends on ey and er (the income and interest sensitivity

of expenditure, respectively.) (Chain Rule)

d ( f g ) f g − g  f
Use = to show that
dg g2

 (dr / dy ) 1
=− 0
 ey er

 (dr / dy )
=−
(1− ey )  0
 er er 2

Thus, the greater is the income sensitivity of expenditure (and thus the simple multiplier),

the flatter is the IS curve (more elastic).

As interest sensitivity approaches 0, then the slope approaches infinity (vertical).

In the limit, IS approaches horizontal as marginal propensity to spend out of

income approaches unity or the interest sensitivity of expenditures approaches infinity. A

vertical IS curve results in zero interest sensitivity of expenditures.

 6

r IS
r
IS

ey → 1 or er →  y er → 0 y

Money Market

Assume zero inflation so that nominal r and real r are identical. Let l represent

demand for money. Then l = l(y,r) ly > 0; lr < 0.

In the original Keynes treatment, he had three reasons for holding money:

transaction; precautionary; and speculative demands. The level of y drove the first two, r

the last. Later, Baumol introduced r as a determinant of transactions balances (i.e.,

transactions demand is a function of r), and Tobin did with the mean-variance approach.

On the supply side, M = Mo, that is, money supply is exogenous. First assume no

banks so that there is only high-powered money.

Equilibrium condition:

= l ( y, r )
M Mo
l= 
P P
Mo
Now take the total derivative of (with dP = 0),
P
 7

 Mo 
d  = ly dy + lr dr .
 P 
To get the position of the curve, solve for
dy
(with dr = 0)
 Mo 
d 
 P 
dy 1
= 0 .
 Mo  ly
d 
 P 

Note that the size of the shift in the LM curve depends inversely on ly, the income

dr
sensitivity of the demand for money. The slope is given by . Now, a simplified way
dy

 Mo 
to calculate this is to take the d   equation, solve for dr and then “divide” by dy
 p 

1   Mo  
dr =  d   − ly dy  .
lr   p  
  Mo  
Next, setting the change in the real money supply to zero  i.e., d   = 0  ,
  P  
dr ly
= −  0.
dy lr

Since ly  0 and lr  0 , the LM curve has a positive slope. Steepness depends on the size

of ly and lr. As lr → 0 , then LM becomes vertical. As lr →  , LM become horizontal

(liquidity trap). As ly → 0 , LM becomes horizontal; as ly →  , LM becomes vertical.

Ceteris paribus, at high levels of income, one has higher transaction demand for

money.
 8

r LM
r
LM

y ly →  y
ly → 0

r LM
r
LM

y lr → 0
y
lr → 
dr / dy = −ly / lr  0

IS - LM Equilibrium

Continue assuming fixed P, so we can calculate equilibrium income and the

 Mo 
y * = y * e0 , , t0 
 P 
equilibrium interest rate, , where y * and r * are functions of
 Mo 
r * = r * e0 , , t0 
 P 

exogenous variables.
 9

Background: Remember that

 1 
IS: dy =   (de0 + er dr + et dt0 ) .
 1 − ey 
Rearranging to

(1− ey )dy − er dr = de0 + et dt0

gives the first equation of the matrix below.

 Mo 
LM: ly dy + lr dr = d  
 P 

gives second equation of the matrix below.

Thus, (using et = -cy),

dy 
(1) 1− ey 
− er   = de0 − c y dt0  and
dr 

dy    Mo 
(2) ly lr   = d   .
dr    P 

Combining, we get

de − c dt 
1 − ey − er  dy   0 y 0 
 ly lr   dr  =  d  Mo   .
   
  P  

________________________________________________________________________
 10

Geometrically,

LM

r*

IS

y*

Again, the IS schedule represents the points of equilibrium in the products market

for all combinations of r and y; the LM schedule represents the equilibrium in the money

market for all combinations of y and r. Thus, the intersection of the two schedules is the

equilibrium point for both markets.

In terms of total differentiation,

de − c dt 
(1 − ey ) − er  dy   0 y 0 
 ly =  Mo  .
 lr   dr   d   
  P  

Substitution is one method to solve for dy* and dr*. (Cramer’s rule is another method.)

 (de0 + er dr − c y dt0 ) in the first equation,

 1 
By substitution, one can solve for dy = 
 1 − ey 
substitute it for dy into the second equation, and solve for dr*,

(de0 + er dr − c y dt0 ) + lr dr = d 
 1   Mo 
ly 
 1 − ey   P  (after substituting for dy)
 11

 ly er   Mo   de0 − c y dt 0 
dr + lr  = d   −   ly
 1−ey   P   1 − ey 
 ly er + (1 − ey )lr   Mo   ly 
dr  = d  −  (de0 − c y dt 0 )
 1 − ey   P   1 − ey 

dr * = dr =
−ly
(de0 − c y dt0 )+  1 − ey  d  Mo 
(1 − ey ) lr + lyer  (1 − ey ) lr + lyer   P 

Finally, one can substitute dr* into the first equation and solve for dy*. The result is

     Mo 
dy * = 
lr
 
 de0 − c y dt0 + 
er
 d  .
 (1 − ey )lr + ly er   (1 − ey )lr + ly er   P 
One should note that the denominators of the two fractions of the first and second terms

to the right of the equal sign are equal and less than zero.

________________________________________________________________________

Alternatively, one can first solve for dr in the first equation,

er dr = (1 − ey )dy − (de0 − c y dt0 )

 1 − ey 
dy − (de0 − c y dt0 )
1
dr = 
 er  er
Substitute dr into the second equation, and solve for dy*,

 1 − ey
dy − (de0 − c y dt0 ) = d 
1   Mo 
ly dy + lr  .
 er er   P 
 12

  1 − ey  
 + (de0 − c y dt 0 )
 Mo  lr
dy ly + lr   = d 
  (er )    P  er

 l y er + lr (1 − ey ) 
 = d   + (de0 − c y dt 0 )
Mo  lr
dy
 er   P  er
     Mo 
(de0 − c y dt 0 )+ 
lr er
dy * =   d  
 (1 − ey )lr + lyer   (1 − ey )l r + lyer   P 

Then substitute dy* in dr equation and solve for dr*.

______________________________________________________________________

Mo
Income varies positively with e0 and unambiguously so that if autonomous spending
P
Mo
is up or is up (with fixed P), y increases. The source of the increase does not matter.
P

Also, the higher real money (in this simplistic model), the higher is output. This

lr er
is because lr  0 and er  0 , but ly  0 s.t.  0 and  0 , the
(1 − ey ) lr + ly er (1 − ey ) lr + ly er
fractions in the first and second terms, respectively, to the right of the equal sign in the

dy* equation. The interest rate affects output differently since the equilibrium interest

rate varies positively with autonomous spending increases, but negatively with Ms

changes. For equilibrium r*, a change in de0 leads to an increase in r, but inversely with

ly
a change in Ms. This is because ly  0 , but lr  0 so that −  0 , which
(1 − ey )l r + l y er

is the fraction in the first term to the right of the equal sign in the dr* equation on

previous page. However, since (1 − ey )  0 and the denominator is less than zero,
 13

1 − ey
 0 , which is the fraction in the second term to the right of the equal sign
((1 − ey)lr + lyer )
in the dr* equation on the previous page.

     Mo 
dy * = 
lr
 
 de0 − c y dt0 + 
er
 d  
 (1 − ey )lr + ly er   (1 − ey )lr + ly er   P 

− ly  1 − ey   Mo 
dr * = dr =
(1 − ey ) lr + ly er
( de0 − c y dt0 ) +   d  
 (1 − ey ) lr + ly er   P 

In terms of sensitivity, for change in y with respect to e0 , one gets greater

change of y as: higher interest sensitivity of demand for money, lr →; or as
ey →1 and either er →0 or l y →0 .

Get the greatest responsiveness to change in money as: er → ; or as

ey →1 and ly → 0 .
Also, the flatter LM, the greater the effect of change in IS (and the steeper is IS).

r
r LM
C
LM B
r r A A ’ IS2’
IS IS’ IS1 ’
IS1 IS2

Yo Y1 Y2 Y
Extreme Keynesian Position

For a given LM curve, the steeper is IS, the greater is expansion of output for sift in IS
curve.
(Note: The horizontal sifts from A to A’ of ISi and ISi’ (i=1,2) are equi-distant with dr =
0).

A shift in an LM curve has the greatest effect when IS flat and LM is steep.
 14

r LM LM’

r IS

Yo Y1 Y
Extreme Monetarist position

r LMo LMo’ LM

LM’

r A A’
B
C IS
Y0 Y1 Y2 Y

For given IS Curve, the steeper is LM curve, the greater is expansion of output for a shift

in LM curve. In the limiting cases, where the IS (LM) is horizontal, the slope of the LM

(IS) curve has no affect on income change.

All the analyses so far are accomplished with fixed prices which implicitly means

that we have a fixed and horizontal aggregate supply curve (perfectly elastic).
 15

NOTE: Another way to see this mathematically and relate it back to dy * is to again

look at slope of IS and LM

dr − ly dr
LM = so that as lr → 0, LM →
dy lr dy
dr
as lr → , LM →0
dy
dr
as ly → 0, LM →0
dy
dr
as ly → , LM →
dy

dr 1 − ey dr
= as er → , IS →0
dy IS
er dy
dr
as ey →1, IS →0
dy
dr
as er → 0, →
dy IS

Exogenous Change in Price Levels

Note that expenditures and money demand function are specified as homogeneous

of degree zero in the price level. Thus, the relationships are invariant with respect to

Mo
price level changes. However, Ms = does vary with P. This insures that generally
P

aggregate demand varies inversely with price changes. (Look at graphs on next page).

 Mo 
Initially start at LM   . If P1 falls to P2, then LM1 decreases to LM2 and Y1 → Y2
 P1 
 16

(Y1 < Y2). A similar condition holds as P2 falls to P3. The relationship to aggregate

demand is shown in the next figure.

LM(P1)
LM(P2)
r 1
LM(P3)
r 2

r
3

IS

Y1 Y2 Y3

P1

P2

P3
AD

Y1 Y2 Y3 Y

Note that we can map out aggregate demand curve based on changes in price.
 17

______________________________________________________________________
Note:

To see relationship, solve for dr in IS, sub into LM, solve for dy and “divide” by
dP.

1 − ey
dy − (de0 − c y dt0 )
1
IS: dr =
er er

 
 
 1 − ey   1  Mo 
 dy − (de0 − c y dt 0 ) = dMo −  2 dP
1
ly dy + lr 
 er  er  P 
P

LM:  
 
 lyer + (1 − ey )lr  1
 = dMo −  2 dP + r (de0 − c y dt 0 )
 Mo  l
dy
 er  P P  er

Note

dMo de0 dt
= = 0 =0
dP dP 0 dP
dy −er  Mo 
=   0
dP (1 − ey )lr + lyer  P 2 

since lr  0, er  0, ly  0, ey  0 .
________________________________________________________________________
 Mo 
Note: How to get LM in terms of d  
 P 
 Mo  1 Mo
d  = dMo − 2 dP
 P  P P

 f
 
g 1
from d   = df
 df  g
 
 

 f 
 
g f g − gf − fg dMo
and d  = and in this case 2 since =0 (i.e., f ' = 0 )
 dg  g 2
g dg
 
 
_______________________________________________________________________
 18

Extending IS - LM equilibrium, the equation for aggregate demand is

y* = y * (P, e0 , Mo, t0 ) , yP*  0 .

Now aggregate demand depends on nominal money stock, exogenous expenditures, price

level, and taxes.

In differential form with variable price level, IS-LM equations become

IS: (1 − ey )dy − er dr = de0 − c y dt0

1  Mo 
LM: ly dy + lr dr =   dMo −  2 dP
P P 
such that
dy −er  Mo 
=  0
dP (1 − ey )lr + ly er  P 2 
The slope of aggregate demand curve depends on all structural parameters of IS and LM

functions. Keynes states that the slope of the IS and LM curves are steep and flat,

respectively.

Keynes
LMo
LM1
r0
Keynes has steep IS, flat LM
r1 such that aggregate demand is
IS inelastic so for same price
change, get smaller output
Y 0 Y1
change.

P0

P1
Ag. demand

Y0 Y1
 19

Alternatively, a steeper LM and flatter IS gives us a flatter (more elastic) aggregate

demand curve. (Remember that LM is steeper as ly →  and lr → 0 , while IS is flatter

as er → and ey →1 .)

Monetarist position is that aggregate demand is elastic (i.e., steep LM, flat IS curves).

LM0 LM1
r Monetarist view

r0
r1
An increase in real money
IS
supply from price change
results in a strong effect
Y0 Y1 Y
on aggregate demand and
P the real interest rate
relative to the Keynesian
P0 view.
P1
Aggregate demand

Y0 Y1 Y

_______________________________________________________________________

Note: Inclusion of net exports would tend to make aggregate demand flatter. This is

because of international competitiveness, which causes a fall in P to increase demand for

exports and hence total demand. Accordingly, even in a strict Keynesian model, the

foreign sector provides a further means of allowing the price level to affect aggregate

demand. This is important!!!

_______________________________________________________________________
 20

The position of aggregate demand is determined by autonomous components of e0

(together with t0) and Mo, the nominal stock of money. These are aggregate demand

shifters for a given P. Shift size depends on all structural parameters of IS-LM equations.

Thus, both expanding monetary and fiscal policies shift aggregate demand to right, but

relative impact depends on IS-LM system.

LM
r
r1 B

r0 A
IS1
IS0

Yo Y1 Y

P1

AD1 AD2

Yo Y1 Y

As government spending (g0) goes up, IS0 → IS1, equilibrium goes from A to B, r0 → r1,

and Y0 → Y1 . Note, there is no price change.

 21

r LM0
Nominal monetary
LM1
r0 A expansion.
r1 B

IS

Y0 Y1 Y

P1 A B

Y0 Y1 Y
 Mo 
Let Mo increase, thus   increases, so get shift in LM0 (p1) to LM1 (p1). Again,
 p1 

Y0 →Y1 , and r0 → r1 . For aggregate demand, we get a shift to right the distance of

Y0 → Y1 . Note, there was no price change.

Note that the above results are due to no price change!!! This implicitly means

we have a horizontal aggregate supply curve. (See Chrystal and Price’s Model II.)

Further Notes on Aggregate Demand

Let’s continue looking at IS-LM and aggregate demand when P changes. What

 Mo 
happens when P decreases. First, real money balances,   , go up. This shifts LM
 P 

curve to right and increases y. We can do this for all P and thus by mapping out the (P,

y) space, we get aggregate demand.

 22

LM (P0)
r
LM (P1)
r0
r1
Case of a price change.
IS The price decreases
and LM shifts to right,
Y0 Y1 Y Y increases, aggregate
demand does not shift.
P

P0
P1
AD

Y0 Y1 Y

Question: Why doesn’t AD shift when P changes?

r LM (P0)
Case of shift outward
r1 and to the right of IS
curve. Y increases, r
r0
IS’ increases, and aggre-
gate demand shifts to
IS the right.
Y0 Y1 Y
P

P0

AD’
AD
Y0 Y1 Y
 23

The above result may be due to a change in autonomous spending such as g0 increasing.

When the IS curve shifts out to right, y increases and the AD curve shifts to right.

LM
r LM’
Case where Mo increases.
r0 LM shifts to right, Y
r1 increases, r decreases, and
aggregate demand shifts
IS to right.

Y0 Y1 Y

AD’
AD

Y0 Y1 Y

When Mo increases without price level change, then we get a shift in LM to right which

thus shifts AD curve to right. Why does AD shift with change in Mo but not with a

change in P?

Whether or not price changes when M increases or G0 increases depends on

aggregate supply as well as aggregate demand. We look at this in future lectures.

Derivation of Aggregate Demand Slope (Unfixed Prices)

With unfixed prices, the IS equation remains unchanged but not the LM equation.

When we totally differentiate,

 24

IS : (1 − e y ) dy − er d r = deo − cydto
1 PdMo − ModP
LM : l y dy + l r dr = dM +
P P2
1 Mo
= dM − 2 dP
P P

What direction is the slope and what affects the size of the slope? To calculate the slope,

dP/dy, first solve dy/dP and invert. Solve for dr in IS equation, solve for dy after

substitution for dr and then "divide" by dP.

1− ey
From IS : dr = dy −
1
(deo − cy dto )
er er

Substituting this result for dr into the LM equation,

 1− ey
ly dy + lr  dy −
1
(deo − c y dto ) = 1 dMo − Mo2 dP
 er er  P P

 l y er + (1− e y ) lr 
dy 
1 Mo
 = dMo − 2 dP +
1
(deo − c y dto )
 er  P P er

dMo deo dt
And noting that = = o = 0,
dP dP dP

dy er Mo
= −
(1− ey )lr + l y er P2  0
,
dP

since lr  0 , er  0 , ly  0 , e y  0 , and

dP
= −
(1− ey ) lr + l y er P2 .
dy er Mo

Thus, as er → 0 , AD slope →  ;

as er →  , AD slope → 0 ;

as e y → 1 and l y → 0 , slope AD → 0

as lr → 0 and l y → 0 , slope AD → 0
 25

Also, note that the slope depends on all structural parameters of the model.

In other words, the steeper is LM and the flatter is IS, the flatter is AD. This is the

classical condition.

The steeper is IS and flatter is LM, the steeper is AD. This is Keynes’ voew.

________________________________________________________________________

If er → 0 , AD slope → 

If er →  , AD slope → 0

________________________________________________________________________

Keynes: if lr →  and er → 0 , AD slope → 

Classical: if lr → 0 and er →  , AD slope → 0

________________________________________________________________________

LM2’
r r LM2
LM1 LM ’
1
LM0
r
r IS2’ IS
IS2 IS1’
IS1
Y0 Y1 Y2 Y Y0 Y1 Y2 Y

P P
P0 P0
p1
AD2
p1 AD2

AD1 AD1

Y0 Y1 Y2 Y Y0 Y1 Y2 Y
 26

For the left top and left bottom graphs to be consistent, must have an exogenous

shift in IS, a decrease in price level, AND a decrease in nominal money in the same

proportions as the decrease in price level such that LM does not shift.

In the right top and right bottom graphs, we just need a decrease in price level with

nominal money constant.

IS-LM and Stock of Wealth

Let wealth be represented by W, M for money and B for bonds, respectively.

Thus, W  M + B

Ct B’

B B’ E C
t+1

 1 
Current wealth at time t is Wt = W0 +Yt +Yt +1  .
1 + r 
 27

1
Thus Wt +1 = (1 + r )Wt with slope of curve BB = − . An increase in wealth is
(1 + r )
increase in W0 , Yt , or Yt +1 which will shift BB out to B B . Thus, if Ct is a normal good,

consumption rises. On the other hand, an increase in r rotates BB to DE; one consumes

less in period t and more in period t+1 as a result of the increase in r. Thus, although we

can define consumption to be a function of only wealth and the interest rate, future

borrowing constraints would lead us to also include current disposable income so that we

 w
expand ct = c(wt , r ) c = c y − t , r ,  to link Keynesians with neoclassicals such as done
 P

by Patinkin. We also have the following constraints on the parameters,

c y  0, cr  0, 0  c w  1 .
p

The restriction on cr  0 incorporates the assumption that the substitution effect of the

interest rate on current consumption outweighs its wealth effect. The restriction that

0  c w  1 follows from assumption that ct and ct+1 are normal goods.

p

Now. redefining the IS relationship to include wealth gives us

 w 
y = e0 + e y, r , , t0  ey  0, er  0, 0  ew  1, et = −c y
 p  p

 w
totally differentiating and rearranging gives us (1 − ey )dy = de0 + er dr + ew d   − c y dt0 .
p 
P
 28

As before, slope of IS varies inversely with both ey and er. Its position is now

determined by the level of real wealth in addition to autonomous spending. Hence, now

IS can be shifted by changes in either nominal stock of wealth (M + B) or by a change in

the price level.

w
Noting that w = , a decrease in P causes w to increase and we get a shift in the
p

wealth constraint, an increase in consumption and thus a shift of the IS curve to the right.

This makes aggregate demand curve flatter since it allows an additional effect of prices

on output.

In the absence of wealth effects, it is possible to have a vertical aggregate demand

curve if we assume a perfectly interest-elastic demand for money (liquidity trap) or

perfectly interest-inelastic expenditure (not taking into account effects of export

sensitivity). Accordingly, price level changes have no effect on output or unemployment.

However, with wealth effects on expenditure, then even with a vertical IS and a

horizontal LM, can get a direct shift in IS from change in wealth and thus a negatively

sloped aggregate demand curve.

A further and more important wealth effect is the real balance effect for money.

Changes in the price level change the real stock of money which then directly affects

aggregate spending and aggregate demand. This is the monetarist view.

Changes in asset stocks can also affect aggregate demand. But, for this to happen,

the change in asset stocks must constitute outside wealth. For example, a bond issued by

a private firm may not constitute outside wealth since a price level change affects the

issuer in the opposite direction of the bond holder and the wealth effects cancel each

other out.
 29

Wealth and LM Curve

When we include wealth into the demand for money, Reunite LM to lr.

 Mo   W
  = l y, r ,  ly  0, lr  0, l W  0
 P   P P

Now changes in bond stocks as well as money stocks can affect (shift) LM. Thus, the

government can increase bond stocks which increases wealth while increasing demand

for money (which shifts out LM). (This assumes that government bonds are outside

wealth which according to Barro may not be the case.)

When wealth affects both IS and LM, then we have complication in the case of an

increase in bonds stock, which would increases in the value of bonds and shift the IS to

the right through the wealth effect on expenditure, but shirting the LM to the left because

an increase in the wealth stock increases the demand for money.

LM1
B Increase in real stock of
r1 LM0 bonds shifts IS to right and
A LM to left. The end result
r0
shown here is
IS1 constractionary.
IS0

Y1 Y0

P0 A
B

AD0
AD1
Y1 Y0 Y
 30

Aggregate Demand: Further Considerations

When we disaggregate our portfolio decision to include bonds, money, and real capital,

we can get different results depending on whether we treat these as perfect or imperfect

substitutes.

Also, including a banking sector complicates our analysis because money may no

longer be exogenous or uniquely determined by the money authority.

One last complication involves the so-called budget identity,

PSD = H + OMO – BP,

where PSD is the public sector debt, H is high-powered money, OMO is open market

bond sales, and BP is the balance of payments. This budget identity points out that a

public sector deficit can be financed in several ways: by printing money or by issuing

assets which fall within definition of high-powered money, open market sales of bonds to

private sector, and selling foreign currency. The latter only works under fixed exchange

rate since BP=0 under flexible exchange rate regime.