General Framework for Macroeconomic Analysis

1. The IS-LM/AD-AS Model: A General Framework for Macroeconomic Analysis

2. Introduction • This chapter integrates the elements of our model that were separately presented in chapters 3,4, and 7, covering labor, goods, and asset markets. • It develops a graphical depiction of our theory that is called the IS-LM/AD-AS model. • IS and LM refer to two equilibrium conditions in the model (investment equals saving; money demand, or liquidity preference, equals money supply). • AD and AS refer to aggregate demand and aggregate supply.

3. The FE Line • I will be using some diagrams that plot the real rate of interest, r, and output Y on the axes. • Recall that labor market equilibrium determines a quantity of labor, which, via the production function, determines a full-employment level of output. • Since that level of output presumably does not depend on the rate of interest, we can plot the full-employment line as a vertical line in a diagram in which r and Y appear on vertical and horizontal axes.

4. The FE line

5. FE Curve Shifters

6. Deriving the IS Curve • Recall the Goods Market Equilibrium Condition:

7. Goods Market Equilibrium S r I Sd, Id

8. Goods Market Equilibrium S r r I Sd, Id Sd = Id

9. Consider a Rise in Income • As income rises, the desired saving curve shifts right, and the equilibrium rate of interest falls as we slide down the desired investment curve (next slide).

10. Goods Market Equilibrium S r r0 I Sd, Id Sd = Id

11. Goods Market Equilibrium S r S (Higher Income) r0 r1 I Sd, Id Sd = Id

12. Deriving IS • The previous slide shows that as income varies and goods market equilibrium is maintained, a higher value of income is associated with a lower value of the expected real interest rate • Plot the income-interest rate pairs that satisfy the goods market equilibrium condition to get the IS curve • The inverse relationship between income and interest rate implies that the IS curve is downward sloping

13. Deriving the IS curve

14. Shifting IS • Recall that IS was derived by considering how the desired saving curve moved along the desired investment curve as income changed. • Suppose a shock (say a government spending increase) causes saving to decline at each level of income • Then the interest rate is higher at each level of income. • Then we must redraw IS, with higher r for each level of Y. IS has shifted to the right. • For other shocks that shift saving or investment schedules, we can also infer how IS shifts.

15. IS Curve Shifters

16. The LM Curve • The IS plots income interest-rate pairs such that desired spending is equal to output, or desired saving is equal to desired investment • We will now derive the LM curve, which plots income-interest rate pairs such that the quantity of money demanded is equal to the quantity of money supplied.

17. Money Market Equilibrium Revisited

18. The LM Curve

19. The Derivation of LM

20. LM Curve Shifters

21. General Equilibrium in the IS-LM Model • In general equilibrium, all markets satisfy their respective equilibrium conditions. • Labor, Goods, and Money Markets Must all be in equilibrium. • The logic of general equilibrium: • The labor market determines output. • Given output (income) the goods market then determines an interest rate. • Given output, the interest rate, and the expected inflation rate, then the money market determines the price level.

22. General Equilibrium in the IS-LM Model (Diagram)

23. Equilibrium: A Coincidence? • Labor Market equilibrium requires that the economy be on the FE line • Goods Market equilibrium requires that the economy be on the IS Curve • Money Market equilibrium requires that the economy be on the LM Curve • General equilibrium requires that the economy be on all three curves simultaneously • Does this require a happy coincidence? (No)

24. Review on Equilibrium • To review, output is determined by the FE line • Given output the intersection of IS and FE determines the interest rate • Finally, the price level adjusts so that LM intersects both IS and FE

25. Timing of Movement to Equilibrium • Our model, as formulated, does not tell us the order in which variables move—we just infer that the economy moves from one equilibrium to another (after a shock). • Here are some thoughts on timing: • Interest rates (and financial markets generally) adjust very quickly • Nominal (and real) wages adjust slowly (often wages are set for long periods of time • Prices may also adjust slowly • The goods market adjusts with intermediate speed (we often see unanticipated inventory movements, but firms may alter production before revising prices)

26. A Look Ahead:Keynesian and Classical Views • We will say much more about “Keynesian” and “Classical” macroeconomic theories • Keynesians emphasize the short-term rigidity of prices and wages • Classical economists emphasize that all markets reach equilibria rather quickly

27. Aggregate Demand and Aggregate Supply • We have now specified a complete model • However, sometimes it is convenient to look at the model differently—with a different diagram • We next introduce AD and AS curves • These curves plot output, Y, and the price level, P. • These diagrams allow us to focus attention on the determination of the price level, which was not directly visible in the IS-LM diagram.

28. The AD Curve • Consider the IS-LM diagram. • A given LM curve is drawn for a fixed level of P. • If P changes, then the LM curve shifts. • Consider various levels of P. • For each price level, draw the appropriate LM curve • The sequence of IS-LM intersections determines Y values to be associated with each level of P. • Plotting these P-Y pairs yields the aggregate demand (AD) curve.

29. Deriving AD

30. The Long Run Aggregate Supply Curve • When all markets clear, we are in long-run equilibrium. • Note: This is not necessarily a matter of time. In the classical model, when all markets equilibrate instantaneously, then we reach the long-run immediately. • The AS curve plots output supplied versus the price level. • Output supplied is determined by the labor market and the production function; it is the full employment level of output, . • Output supplied does not vary with P, so the AS curve is vertical at .

31. Aggregate Supply in the Short-Run • Assume that the short-run is a time frame in which the price level is fixed, and the quantity of output is determined by demand (whatever that level may be) • So the AS curve is horizontal at a given price level • Our original labor market equilibrium model has been discarded for the short run • The short-run horizontal AS curve is really only a feature of Keynesian interpretations of our theory

32. AS: Long Run and Short Run

33. Long-run and Short-run Equilibria • In long-run equilibrium, the economy must be on AD, SRAS, and LRAS. • In a short-run equilibrium, the economy must be on AD and SRAS. • To go to a new long-run equilibrium, price (and SRAS) must shift. • Note that our assumptions now make it clear that an increase in AD can lead to an increase in output in the short-run, but an increase in price in the long-run • The vertical long-run supply illustrates the money neutrality property • Increases in M, causing increases in AD, do not change output, but they do change P.

34. AD Shifters • Any variable that shifts IS or LM, with the exception of P, will also shift AD • The direction of the shift is determined by whether the IS-LM diagram shows an increase in income as a result of the shift in the IS-LM diagram: if IS and LM intersect at a higher level of income, then the AD curve shifts to the right. • At any price level, if IS and AD determine a higher level of income, then that price level is now associated with a higher level on income on AD.

35. LRAS Shifters • The LRAS curve will change when the full employment level of output changes • This means that it is shifted by the same variables that shift the FE Curve: • Productivity • Labor supply • Capital stock

36. SRAS Shifters • The SRAS curve shifts only when the price level changes from one “fixed” level to another • This period price might be fixed at a given level, but in a future period it might be fixed at some other level

37. Upcoming Chapters • In the next two chapters, we will use the IS-LM / AS-AD model to illustrate short- and long-run consequences of a variety of shocks to the economy

38. Chapter 10 Analysis: Market-Clearing Macroeconomics

39. II. Money in the Classical Model (Sec. 10.2) • A) Monetary policy and the economy • Money is neutral in the classical model • B) Monetary nonneutrality and reverse causation

40. C) The nonneutrality of money: Additional evidence • 1. Friedman and Schwartz have extensively documented that often monetary changes have had an independent origin; they weren’t just a reflection of changes or future changes in economic activity • 2. More recently, Romer documented additional episodes of monetary nonneutrality since 1960 • 3. So money does not appear to be neutral • 4. There is a version of the classical model in which money isn’t neutral—the misperceptions theory discussed next

41. III. The Misperceptions Theory and the Nonneutrality of Money (Sec. 10.3) • A) Introduction to the misperceptions theory • If producers misperceive the aggregate price level, then the relevant aggregate supply curve in the short run isn’t vertical • a. This happens because producers have imperfect information about the general price level • b. As a result, they misinterpret changes in the general price level as changes in relative prices • c. This leads to a short-run aggregate supply curve that isn’t vertical • d. But prices still adjust rapidly

42. The misperceptions theory is that the aggregate quantity of output supplied rises above the full-employment level when the aggregate price level P is higher than expected • The equation Y = + b(P – Pe) [Eq. (10.4)] summarizes the misperceptions theory:In the short run, the aggregate supply (SRAS) curve slopes upward and intersects the long-run aggregate supply (LRAS) curve at P = Pe (Figure 10.2; like text Figure 10.6)

43. C) Monetary policy and the misperceptions theory • 1. Because of misperceptions, unanticipated monetary policy has real effects; but anticipated monetary policy has no real effects because there are no misperceptions • 2. Unanticipated changes in the money supply (Figure 10.3; like text Figure 10.7)

44. 3. Anticipated changes in the money supply • a. If people anticipate the change in the money supply and thus in the price level, they aren’t fooled, there are no misperceptions, and the SRAS curve shifts immediately to its higher level • b. So anticipated money is neutral in both the short run and the long run

45. D) Rational expectations and the role of monetary policy • 1. The only way the Fed can use monetary policy to affect output is to surprise people • 2. But people realize that the Fed would want to increase the money supply in recessions and decrease it in booms, so they won’t be fooled • 3. The rational expectations hypothesis suggests that the public’s forecasts of economic variables are well-reasoned and use all the available data • 4. If the public has rational expectations, the Fed won’t be able to surprise people in response to the business cycle; only random monetary policy has any effects

46. 6. Propagating the effects of unanticipated changes in the money supply • a. It doesn’t seem like people could be fooled for long, since money supply figures are reported weekly and inflation is reported monthly • b. Classical economists argue that propagation mechanisms allow short-lived shocks to have long-lived effects • c. Example of propagation: The behavior of inventories

47. E) Box 10.1: Are price forecasts rational? • Economists can test whether price forecasts are rational by looking at surveys of people’s expectations • If people have rational expectations, forecast errors should be unpredictable random numbers; otherwise, people would be making systematic errors and thus not have rational expectations • Many statistical studies suggest that people don’t have rational expectations • But people who answer surveys may not have a lot at stake in making forecasts, so couldn’t be expected to produce rational forecasts • Instead, professional forecasters are more likely to produce rational forecasts