5. The IS-LM model

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5. The IS-LM model

• Abel, Bernanke and Croushore
• (chapters 9.4, 9.5 and 9.6)

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I. The IS-LM equilibrium

• Building blocks
• Negative relationship between r and Y that clears
  the goods market (IS curve)
• Positive relationship between r and Y that clears
  the money market (LM curve)
• There exists one single intersection point
  between the IS and LM curves where both markets
  are in equilibrium. Such equilibrium point
  belongs to the AD curve.
• Prices are fixed in the short-run (Keynesian)
• Long-run equilibrium when Yfull-employment
  output because the labor market also clears
  (general equilibrium)

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I. The IS-LM equilibrium (cont.)

• When all markets are simultaneously in
  equilibrium there is a general equilibrium
• This occurs where the FE, IS, and LM curves
  intersect

Check the sign of the excess demand in the
outside areas from the IS-LM curves
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II. The Aggregate Demand (AD) curve

• 1. The AD curve shows the relationship between
  the quantity of goods demanded and the price
  level when the goods market and money market are
  in equilibrium
• So the AD curve represents the price level and
  output level at which the IS and LM curves
  intersect
• Negative relationship between P and Y. Rise in
  the price level shifts the LM curve to the left,
  increases the real interest rate and reduces both
  desired consumption and desired investment.
  Output falls as producers reduce their production
  to eliminate the excess supply (see Figure in
  next slide)
• Make proposed problem on computation of the AD
  curve

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II. The Aggregate Demand (AD) curve (cont.)

• 2. Factors that shift the AD curve
• a. Any factor that causes the intersection of the
  IS and LM curves to shift to the left causes the
  AD curve to shift down and to the left any
  factor causing the IS-LM intersection to shift to
  the right causes the AD curve to shift up and to
  the right
• b. For example, a temporary increase in
  government purchases shifts the IS curve up and
  to the right, so it shifts the AD curve up and to
  the right as well
• (see Figure in next slide)

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II. The Aggregate Demand (AD) curve (cont.)

• Summary Table 14, page 340 Factors that shift
  the AD curve
• (1) Factors that shift the IS curve to the right
  and thus the AD curve to the right as well
• (a) Increases in future output (Yf), wealth,
  government purchases (G), or the expected future
  marginal productivity of capital (MPKf)
• (b) Decreases in taxes (T) if Ricardian
  equivalence doesnt hold, or the effective tax
  rate on capital (?)
• (2) Factors that shift the LM curve to the right
  and thus the AD curve to the right as well
• (a) Increases in the nominal money supply (M) or
  in expected inflation (?e)
• (b) Decreases in the nominal interest rate on
  money (im) or the real demand for money

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III. Short-run and long-run equilibria

• The Aggregate Supply (AS) curve
• 1. The aggregate supply curve shows the
  relationship between the price level and the
  aggregate amount of output that firms supply
• 2. In the short run, prices remain fixed, so
  firms supply whatever output is demanded
• a.The short-run aggregate supply curve (SRAS) is
  horizontal
• Full-employment output isnt affected by the
  price level, so the long-run aggregate supply
  curve (LRAS) is a vertical line at Y Y

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III. Short-run and long-run equilibria (cont.)

• Equilibrium in the AD-AS model
• - AD obtained from IS-LM model
• - AS under short-run
• or long-run assumptions
• 1. Short-run equilibrium AD intersects SRAS
• 2. Long-run equilibrium AD intersects LRAS
• a. Also called general equilibrium
• b. AD, LRAS, and SRAS all intersect at same point
• c. If the economy isnt in general equilibrium,
  economic forces work to restore general
  equilibrium both in AD-AS diagram and IS-LM
  diagram

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III. Short-run and long-run equilibria (cont.)

• Application Monetary neutrality in the AD-AS
  model
• 1. Suppose the economy begins in general
  equilibrium, but then the money supply is
  increased by 10
• 2. This shifts the AD curve upward by 10 (from
  AD1 to AD2) because to maintain the aggregate
  quantity demanded at a given level, the price
  level would have to rise by 10 so that real
  money supply wouldnt change and would remain
  equal to real money demand
• 3. In the short run, with the price level fixed,
  equilibrium occurs where AD2 intersects SRAS1,
  with a higher level of output
• 4. Since output exceeds , over time firms raise
  prices and the short-run aggregate supply curve
  shifts up to SRAS2, restoring long-run
  equilibrium
• 5. The result is a higher price levelhigher by
  10
• 6. Money is neutral in the long run, as output is
  unchanged

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III. Short-run and long-run equilibria (cont.)

• One supply-side application An oil price shock.
• This adverse supply shock increases marginal
  costs which reduces the marginal productivity of
  labor, and shifts the labor demand curve to the
  left
• a. With lower labor demand, the equilibrium real
  wage and employment fall
• b. Lower employment reduces the equilibrium level
  of output, thus shifting the FE line to the left
• Theres no effect of a temporary supply shock on
  the IS or LM curves
• Since the new FE line, and the old IS, and LM
  curves dont intersect, the price level adjusts
  (Excess AD), shifting the LM curve until a
  general equilibrium is reached
• a. In this case the price level rises to shift
  the LM curve up and to the left to restore
  equilibrium
• b. The inflation rate rises temporarily, not
  permanently
• Summary Output declines to its full-employment
  level, while the real interest rate and price
  level are higher
• a. There is a temporary burst of inflation as the
  price level moves to a higher level
• b. Since the real interest rate is higher and
  output is lower, consumption and investment must
  be lower

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III. Short-run and long-run equilibria (cont.)

• The key question is How long does it take to get
  from the short run to the long run?
• The answer to this question is what separates
  classicals from Keynesians.
• Classical economists see rapid adjustment of the
  price level
• (1) So the economy returns quickly to full
  employment after a shock
• (2) If firms change prices instead of output in
  response to a change in demand, the adjustment
  process is almost immediate
• Keynesian economists see slow adjustment of the
  price level
• (1) It may be several years before prices and
  wages adjust fully
• (2) When not in general equilibrium, output is
  determined by aggregate demand at the
  intersection of the IS and LM curves, and the
  labor market is not in equilibrium