Preface

This mini-text is an introduction to a canonical, “Keynesian” model of business cycles. The first part focuses on the idea of an “Aggregate Demand” relationship, which is presented somewhat informally in the textbook treatment of the model. By giving more structure to the aggregate demand curve, we can think more about the channels by which policy affect the economy, and how the microeconomics of household and firm behavior generate macroeconomic outcomes. Adding explicit structure also makes it more transparent to think about adding alternative features into the model. It will also allow us to introduce us to an important concept, of “multipliers” which is at the heart of applied macroeconomic policy analysis and advice.

The model has a lot of moving parts, so we introduce them in stages. At first, we will focus on the determination of aggregate consumption, investment, and income for a particular real interest rate. We’ll call this a “partial equilibrium” relationship because it takes all the prices in the economy as given.

We’ll then show that when the interest rate varies, income will also vary in a systematic way (higher real rates will lead to lower aggregate income). We’ll call the resulting relationship between these two variables the “IS” (Investment-Savings) Curve. We’ll assume that monetary policy also relates real interest rates to output and inflation. The equilibrium between the investment-savings relationship and the monetary policymakers’ actions will determine an equilibrium relationship between inflation and output, which we’ll call the aggregate demand (AD) curve.

Finally, we’ll motivate an aggregate supply (AS) relationship which explains short run production decisions as a function of inflation. The equilibrium between short-run aggregate supply and aggregate demand will determine the economy-wide level of inflation and production/income/GDP.

Unlike the classical model, we generally won’t assume that money is neutral or that the classical dichotomy holds, although we’ll see how that is, in some ways, a special case of the model we’ll consider. This will let us use our model to talk about real effects of monetary policy and how fiscal policy may also play a role in stabilizing the economy.

About these notes

This set of notes was written by Ethan Struby Spring 2020 and updated Winter 2023. It’s based on versions of notes used in my Principles of Macro (Econ 110) classes at Carleton, and incorporates Shiny apps that were first tested in Winter 2020. The treatment of the AD side of the model is somewhat similar to Principles of Macroeconomics 11e by Karl Case, Ray Fair, and Sharon Oster, while the AS side follows an approach somewhat similar to Mankiw’s Principles of Economics treatment.

If you have suggestions or feedback, please feel free to e-mail. (If you’re a student at a different institution who has stumbled on these notes, hi! I’d suggest asking your professor or TA about your course material instead of Googling.).

Thanks to my students who provided lots of constructive feedback how to make the model more clear. Thanks also to Mike Tie for technical support with Carleton’s Shiny server.