IS-LM and Aggregate Demand

1. IS-LM and Aggregate Demand

2. Learning Objectives • Learn how to use the IS and LM curves to graphically derive the aggregate demand curve. • Understand how changes in fiscal policy and monetary policy shift the aggregate demand curve. • Understand the monetary policy transmission mechanism. • Understand the fiscal policy transmission mechanism.

3. IS/LM: Equilibrium Equilibrium in the IS/LM model occurs at the intersection of the IS curve and the LM curve. At every point on the IS curve, the capital market is in equilibrium. At every point on the LM curve, the money market is in equilibrium. Only at the intersection are both markets simultaneously in equilibrium. Equilibrium may or may not occur at full employment Y*. i LM C A B IS 0 Y* Y

4. Aggregate Demand • Aggregate demand is a relationship between aggregate output and the price level. • As the price level rises, national output falls. • As the price level falls, national output rises.

5. Aggregate Demand: Graphical Derivation • In the IS/LM model, the price level helps to determine real money demand. • Increases in the price level decrease real money balances and increase money demand, shifting the MD right and the LM curve to the left. • Decreases in the price level, increase real money balances and decrease money demand, shifting MD left and the LM curve to the right. • We use this relationship to derive aggregate demand.

6. Aggregate Demand: Derivation r LM(P1) At point E1, equilibrium exists in the real goods market and the money market. The price level is P1 and output is Y1. Let the price level fall to P2. At the lower price level, real money balances are higher. The LM curve shifts right to LM2. The new equilibrium occurs at the point E2. The price level is P2 and output is Y2. When points E1 and E2 are plotted in the P-Y space, they represent two points on an aggregate demand curve. LM(P2) E1 E2 IS Y 0 P P1 E1 0 P2 E2 AD Y Y1 Y2 0

7. Aggregate Demand Shift r Expansionary Monetary Policy LM(P1) LM(P1) An increase in the nominal money supply, when there is no change in the price level, increases real money balances and shifts the LM curve to the right. As interest rates fall, investment spending increases, causing Y to rise. The change in policy is not initiated by a change in the price level so aggregate demand shifts right. E1 r2 E2 r1 IS 0 Y P E2 P1 E1 AD2 AD1 0 Y1 Y2 Y

8. Aggregate Demand Shift r Expansionary Fiscal Policy LM An increase in government spending or a decrease in taxes, when there is no change in the price level, shifts the IS curve to the right. The increase in aggregate spending causes interest rates and output to rise. The change in government policy is not initiated by a change in the price level so aggregate demand shifts right. E2 r2 E1 r1 IS2 IS1 0 Y P E2 P1 E1 AD1 AD2 0 Y1 Y2 Y

9. The Short Run and the Long Run LRAS P r LM(P2) LM(P1) S P2 S r1 P1 r2 L L IS AD 0 Y* Y 0 Y Y* Y

10. Short Run and Long Run: • The difference between the short-run approach and the long-run approach is the assumptions made about P and Y. • In the short-run we assume that prices are sticky; ie., they do not adjust quickly to changes in the economy. • This means that r and Y must adjust to bring the model back to equilibrium.

11. Short Run and Long Run: • Short-run assumptions are reflected in point S. • Prices do not adjust so Y can be less than full employment Y, even while there is equilibrium in both markets. • The policy implication is that government intervention is required to reach full employment.

12. Short Run and Long Run: • The difference between the short-run approach and the long-run approach is the assumptions made about P and Y. • In the long-run we assume that prices are flexible; ie., they adjust quickly to changes in the economy. • This means that P must adjust to bring the model back to equilibrium.

13. Short Run and Long Run: • Long-run assumptions are reflected in point L. • Prices change so the economy self-adjusts back to full employment Y. • The policy implication is that no government intervention is required to reach full employment.

14. Summary • The IS/LM model provides a general theory of aggregate demand. • The IS curve represents the negative relationship between interest rates and income in the capital market. • The LM curve represents the positive relationship between interest rates and income in the money market.

15. Summary • Changes in fiscal policy shift the IS curve and the aggregate demand curve. • Expansionary fiscal policy shifts the IS and AD curves to the right. • Ceteris paribus, income and interest rates rise. • Changes in the price level depend on the slope of the aggregate supply curve.

16. Summary • Changes in fiscal policy shift the IS curve and the aggregate demand curve. • Contractionary fiscal policy shifts the IS and AD curves to the left. • Ceteris paribus, income and interest rates fall. • Changes in the price level depend on the slope of the aggregate supply curve.

17. Summary • Changes in monetary policy shift the LM curve and the aggregate demand curve. • Expansionary monetary policy shifts the LM and AD curves to the right. • Ceteris paribus, interest rates fall and Y rises. • Changes in the price level depend on the slope of the aggregate supply curve.

18. Summary • Changes in monetary policy shift the LM curve and the aggregate demand curve. • Contractionary monetary policy shifts the LM and the AD curves to the left. • Ceteris paribus, interest rates rise and Y falls. • Changes in the price level depend on the slope of the aggregate supply curve.