CHAPTER 9:

1. CHAPTER 9: THE IS-LM/AD-AS MODEL: A GENERAL FRAMEWORK FOR MACROECONOMIC ANALYSIS

2. LEARNING OBJECTIVESI. Goals of Chapter 9 Rangka kerja IS-LM-FE : qsatu system menerangkan hubungan kadar faedah dan pendapatan negara dlm satu keadaan ekonomi yg stabil qmembolehkan analisa keadaan keseimbangan ketiga-tiga pasaran wang,buruh dan barangan secara serentak. q membolehkan penelitian kesan kejutan ekonomi dlm salah satu pasaran beralih kpd pasaran lain.

3. 1. The FE Line: Eqm in the Labor Market (Sec. 9.1) • Ch 3, we showed how eqm in L mkt leads to employmt at its full- employment level and output at Y* C. If we plot output vs real int rate, we get a vertical line at Y =Y* , since labor mkt eqm is unaffected by changes in the real int rate (Fig. 9.1) Y1 N2 N1 r N1 Y1 Y2 Y2 N2 N2

4. D. the FE line Y is determined by the full-employment level of employment and the current levels of capital and productivity; any change in these variables shifts the FE line The FE line represents the eqm in the labor mkt. When labor mkt is in eqm, employment is = N (full-employment level of employment), output (Y) = Y (full-employment level of output). The FE line is vertical because interest has no effect on output Y.

5. 2.1 Factors that shift the FE line Factors FE line shifts Reasons Beneficial supply shock Right- More output can be produced for the same amount of K & N.- If MPN , ND and raises employment. For both reasons Y • NS Right Equilibrium employment rises, raising Y • K Right More output can be produced with the same amount of N. K may MPN, which ND and equilibrium employment. Eg diagrams to show effect on FE line

6. 3. EQUILIBRIUM IN THE GOODS MARKET – THE IS CURVE • Goods market is in equilibrium when: • Desired investment = desired national savings (I=S) • Aggregate quantity of goods demanded = aggregate quantity of goods supplied. (AD=AS) • Adjustment of the real interest rate (r) brings eqm in the goods mkt. • Eqm in the goods market is represented by the IS curve. • Every points on the IS curve represents eqm in then goods mkt, where Id = Sd

7. Figure 9.02 Deriving the IS curve

8. Derivation of IS Curve a. Key features (1) The saving curve slopes upward because a higher real interest rate increases saving (2) An increase in output shifts the saving curve to the right, because people save more when their income is higher (3) The investment curve slopes downward because a higher real interest rate reduces the desired capital stock, thus reducing I

9. DERIVATION OF IS CURVE (Y,r) goods mkt S3(Y3) r r r S1(Y1) S2(Y2) r3 r1 r2 I I,S Y3 Y1 Y2 Y

10. B. Factors that shift the IS curve Increase in IS shifts Reason Expected future output Up Sd, Cd, raising r that clears the goods mkt. Wealth Up Sd, Cd, raising r that clears the goods mkt. G Up Sd, dd for gds., raising r that clears the goods mkt. T No change or down- No change if consumers take into account an offsetting future tax cut & do not  C (RE). -Down if do not take into account future tax cut and Cd,  Sd and lowering r that clears the market. MPKf Up Id, raising the r that clears the market. Effective tax rate on K Down Id, lowering the r that clears the market.

11. Figure 9.03 Effect on the IS curve of a temporary increase in government purchases

12. 3 important points about IS: • IS curve represents eqm points in the goods market at different levels of income/output Y and real interest rates, r. • Points on lefthand side of IS – is a diseqm in goods market where AE>Y excess dd leading to increasing eco activities Income and output  • Points on righthand side of IS – is a diseqm in goods market where AE<Y excess ss ,decline in C leading to decreasing eco activities Income and output

13. 4. ASSETS MARKET EQUILIBRIUM-THE LM CURVE • Assets market is in eqm when the qty of assets demanded by wealth holders = ss of those assets in the mkt. • The assets mkt eqm can be represented by LM curve. • The r’ship between the Pe of non-monetary assets and r on those assets are important. 4.1 The interest rate and the price of nonmonetary assets • P of nonmonetary assets (bonds) is closely related to the int rate it pays (yield). • The higher Pbond, the lower the nominal int rate that the assets pay – negatively related. • For a given e, movement in im are matched by equal movement in r, so price of nonmonetary assets and r is also inversely related.

14. Figure 9.04 Deriving the LM curve

15. Nom MS is fixed by central bank. • If M = 2000 and P = 2, M/P = 1000 • MD curve slopes d/ward because higher r increases the relative attractiveness of the non monetary assets and causes wealth holders to dd less money.       • When output is 4000, the market is in eqm at pt A. with mkt clearing r = 3% and the real qty of money demanded is = money supplied by CB = 1000 • When o/put  to 5000, people need to conduct more transactions, so their real MD  at any r. • As a result, MD shifts to the right to MD (Y=5000). • If r remained at 3 %, real MD > real MS. • At point B real MD = 1200 but the real MS = 1000. • to restore the eqm, r must rise to 5%.

16. 4.3 How does an increase in r eliminate excess MD? What causes the increasein r? • This is related to the P of nonmonetary assets and their yield. • At 3% r, and the  in output to 5000 cause people to dd more money, MD shifts rightward to MD (Y=5000). • to satisfy their desire to hold more money, people will sell their nonmonetary assets for money. • When they rush to sell their nonmonetary assets, the P will  and r on the assets . • therefore it is the public attempt to its holding of money by selling nonmonetary assets causes r to .

17. Because the real MS is fixed, people actually cannot  the money they hold. • As long as they attempt to do so by selling non-monetary assets, r will continue to rise. • But the rising r will make the non-monetary assets more attractive relative to money, therefore reducing real MD (movement along MD for Y = 5000). • r will  until real MD = real MS (fixed by CB) and restores assets mkt eqm again at pt. C.

18. Increase in Shifts LM Reasons Nominal MS (M) Down Real MS , lowering assets mkt. clearing r (MS = MD) Price level (P) Up Real MS , raising assets mkt. clearing r. Expected inflation (e) Down MD , lowering assets mkt. clearing r Nominal interest rate Up MD, raising assets mkt. on money (im) clearing r Factors that real MD Up MD, raising assets mkt. clearing r

19. Factors that  real MD: o Wealth o Risk of alternative assets to the risk of holding money o In the liquidity of alternative assets o In the efficiency of payments technologies.

20. Figure 9.05 An increase in the real money supply shifts the LM curve down

21. Figure 9.06 An increase in the real money demand shifts the LM curve up

22. DISEQULIBRIUM IN IS-LM AND ADJUSTMENTS r DISEQULIBRIUM IN I,II,III AND IV IS (I) AE<Y MS>MD LM (IV) AE>Y MS>MD (II) AE<YMS<MD (III) AE>Y MS<MD AGG Y

23. DISEQULIBRIUM IN IS-LM AND ADJUSTMENTS r ADJUSTMENTS TO REGAIN EQUILIBRIUM IS (I) LM (IV) (II) (III) AGG Y

24. 5. GENERAL EQUILIBRIUM IN IS-LM MODEL A situation in which all the three markets in the economy are simultaneously in equilibrium is called general equilibrium.

25. 5.1 Applying IS-LM Framework: A Temporary Adverse Supply Shock What will the effects of this shock on the general equilibrium of the economy and the general equilibrium values of w, N, Y, r, P, C and I.? (a) The effect in the labor market (FE)   The effect of the temporary adverse shock (bad weather or increase in oil price) on the labor market. A temporary adverse ss cause temporary drop in parameter A (productivity). Y Y1=AF(K,N) Y2=AF(K,N) N

26. (i) The effect of temporary adverse supply shock on MPN and ND MPN , w NS LABOR MARKET w1 w2 ND1 ND2 N N2 N1 1.Labor demand (ND) fall from ND1 to ND2. 2.    Eqm real wage (w) fall from w1 to w2 and full-employment level of employment fall from N1 to N2. The adverse SS shock reduces full-employment output (Y), thus shifting FE

27. Figure 9.08 Effects of a temporary adverse supply shock

28. (b) The effect in the goods market (IS) • A temporary adverse SS shock reduces current output (Y) but does not change other factor affecting Sd or Id. • only movement along the IS curve and not a shift of IS curve. (c) The effect in the assets market (LM) • A temporary adverse SS shock has no direct effect on MD and MS and thus does not shift LM. • The shift in LM is caused by a change in price level (P), which changes real MS (M/P) and this affect the eqm in the assets mkt. • To restore general eqm, LM must shift up and to the left from LM 1 to LM2.

29. (i) The effect of temporary adverse supply shock on LM • For LM to shift to LM2, real money supply (M/P) must fall and P must rise. (FIG 9.08) • Eqm now moves to point F. • At the new eqm F, r is higher and Y is lower. • Therefore C must be lower than before the SS shock. •  This also implies that I must be lower after the shock.

30. 5.2 What is the effect of temporary supply shock on inflation rate? • Inflation rate is the growth rate of the price level (P/P). • The temporary supply shock will caused a temporary burst of inflation. • After P stabilizes at its higher value and no longer rises, inflation will settle. • The increase in inflation will only be temporary. 6. THE ROLE OF PRICE ADJUSTMENT IN ACHIEVING GENERAL EQUILIBRIUM • What happens to the economy if nominal money supply (M) increases? • This brings us into the discussion of Monetary Policy (MP) – the control of money supply.

31. Figure 9.09a Effects of a monetary expansion

32. Figure 9.09b,c Effects of a monetary expansion

33. CLASSICAL VS KEYNESIAN VERSION OF IS-LM MODEL Money Neutrality: Money is said to be neutral if a  in M,  P proportionally but has no effect on real variables.

34. 8. AGGREGATE DEMAND (AD) AND AGGREGATE SUPPLY (AS)   AD-AS and IS-LM models are equivalent: • Both use the same assumptions about economic behavior and price adjustment. • They give the same answers. • IS-LM model relates real interest rate to output. Useful when examining effect of various shocks on r, S and I. • AD-AS model relates price level (P) to output. Therefore more relevant when discussing P and inflation.

35. 8.1 THE AGGREGATE DEMAND CURVE (AD) AD curve shows the relation between agg qty of goods demanded AD= Cd + Id + G and the price level (P). The shape of AD is the same a DD curve of individual goods. The difference between the two: oD curve of a goods looks at the dd of the good to its price relative to prices of other goods (relative prices). o  AD looks at the agg qty of output demanded to the general price level o  If price level of all goods  by 10 %, the general price level (P) will  by 10% even if relative prices of goods remain unchanged.

36. Figure 9.10 Derivation of the aggregate demand curve

37. 8.2        THE AGGREGATE SUPPLY CURVE • AS is the relationship between price level and the aggregate amount of output that firms supply. • The firms behave differently in SR and LR. • SRAS – in SR, price is fixed, firm supply Y at a fixed price so the AS is horizontal. • LRAS – in LR, P and W adjust to clear the market and firms will supply Ŷ regardless at what P level.

38. Figure 9.13 Equilibrium in the AD-AS model SR equilibrium (prices are fixed) – when AD intersects with SRAS at point E. LR equilibrium(prices have fully adjusted) – when AD, SRAS and LRAS intersect (general equilibrium) and they are in equilibrium.

39. Figure 9.14 Monetary neutrality in the AD-AS framework Money Neutrality: Money is said to be neutral if a  in M,  P proportionally but has no effect on real variables.