5. The IS-LM model

1. 5. The IS-LM model Abel, Bernanke and Croushore (chapters 9.4, 9.5 and 9.6)

2. 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 Y=full-employment output because the labor market also clears (general equilibrium)

3. 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

4. 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

6. 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)

8. 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 doesn’t 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

9. 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 isn’t affected by the price level, so the long-run aggregate supply curve (LRAS) is a vertical line at Y =Y _

10. 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 isn’t in general equilibrium, economic forces work to restore general equilibrium both in AD-AS diagram and IS-LM diagram

11. 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 wouldn’t 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 level—higher by 10% • 6. Money is neutral in the long run, as output is unchanged

13. 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 • There’s 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 don’t 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

15. 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