Chapter 9. The IS LM/AD AS Model: A General Framework for Macroeconomic Analysis. Copyright 2009 Pearson Education Canada

Introduction to the IS-LM Model Now, we put the labour, goods and asset markets into a single framework so we can analyze them simultaneously This name (IS-LM) originates from its basic equilibrium conditions: investment, I, equals saving, S; money demanded, L, equals money supplied, M. The model was first developed by Keynesians but can be used to represent both Classical and Keynesian models. Copyright 2009 Pearson Education Canada 9-2

Introduction to the IS-LM Model The FE Line (Labour Market) The IS Curve (Goods Market) The LM Curve (Asset Market) General Equilibrium in the IS-LM Attainment of General Equilibrium We will analyze this economic model graphically (Ch 9), numerically (App 9A) and algebraically (App 9B) Ch 9 assumes a closed economy Ch 10 Ch 9 assumes a closed economy. Ch 10 relaxes this assumption Copyright 2009 Pearson Education Canada 9-3

The FE Line: Equilibrium in the Labour Market Equilibrium in the labour market is represented by full employment line, FE. N is reached after wages and prices have fully adjusted so N S =N D : firms have hired N up to the point where profits are maximized When the labour market is in equilibrium, output equals its full employment level, Y regardless of the interest t rate (FE line is vertical in the (Y, r) diagram) r has no role for full employment: only r has no role for full employment: only affects firms' long run investment decisions Copyright 2009 Pearson Education Canada 9-4

Factors that Shift the FE line From our analysis, Y shifts right if: Anything shifts N S or N D curves right Beneficial supply shock (e.g. an increase in A) An increase in N S An increase in the capital stock That is, anything that affects the full employment level of output will cause the FE line to shift. Copyright 2009 Pearson Education Canada 9-6

The IS Curve: Equilibrium in the Goods Market The IS curve shows for any level of output, Y, the interest rate, r, clears the goods market. Recall, in a closed economy, r adjusts so that I d = S d where the saving curve slopes up; investment curve slopes down. At all points on the IS curve, I = S IS curve slopes down because an increase in Y leads to an increase in S d and r must fall to clear the goods market. Copyright 2009 Pearson Education Canada 9-7

The IS Curve: Equilibrium in the Goods Market (continued) We can derive the IS curve using the fact that when I = S we have AD = AS Suppose we have: C d = c 0 + c y (1-τ)Y c r r T = τy I d = ι 0 ι r r. where the symbols c and ι are coefficients and τ is the income tax rate. They are all positive numbers. Recall the goods market equilibrium Recall the goods market equilibrium condition: Y = C d + I d + G (board) Copyright 2009 Pearson Education Canada 9-8

Factors That Shift the IS Curve IS curve consists of all the pairs (Y,r) such that the goods market is in equilibrium. For constant output, any change in the economy that reduces desired national saving relative to desired investment will increase the real interest rate that clears the goods market and, thus, shift the IS curve upward. Factors that might cause S d to fall: An increase in Future Output or Wealth, shifts IS up C, d increases, S d decreases, r increases to clear goods market Copyright 2009 Pearson Education Canada 9-10

Factors That Shift the IS Curve (continued) An increase in G, shifts IS up: (board) I d =S d = Y C d G G increases, S d decreases, r increases to clear goods market A decrease in T, shifts IS up, only if Ricardian equivalence doesn t hold. An increase in private (after-tax) disposable income, C d increases, S d decreases, r increases to clear goods market Factors that cause I d to rise (for constant output ): increase in MPK f or decrease in the effective tax rate on capital Copyright 2009 Pearson Education Canada 9-11

Factors That Shift the IS Curve (continued) The shift of the IS curve can also be interpreted in terms of an alternative goods equilibrium condition: AD=AS For a given level of output, any change that increases the aggregate demand for goods shifts the IS curve up. Why? An increase in AD for goods causes the quantity of goods demanded to exceed supply. GME can be restored by an increase in r which reduces C d and I d A increase in G with output constant will A increase in G with output constant, will shift the IS curve and interest rates up. Copyright 2009 Pearson Education Canada 9-13

The Interest Rate and the Price of a Nonmonetary Asset Before we show that the asset market equilibrium can be represented by the LM curve, we discuss the relationship between the price and interest rate of a NM asset Given the promised schedule of repayments of a bond or other NM asset, the higher the price of the asset, the lower is the nominal interest rate of the asset: P = coupon/(1+i) For a given rate of inflation the price of a non- monetary asset and its real interest rate are also inversely related. Copyright 2009 Pearson Education Canada 9-14

The Price of a Nonmonetary Asset (continued) If the price of the bond were to fall, because people were selling them, then the interest rate would rise, given an unchanged stream of payments or coupons. This is a key relationship in deriving the LM curve and will be used to explain how equilibrium occurs in the money market. Copyright 2009 Pearson Education Canada 9-15

The Equality of Money Demanded and Supplied The real money supply curve (MS) is a vertical line, it does not depend on the real interest rate but rather on central bank actions. The money demand curve (MD) slopes downward. With higher r the attractiveness of money as an asset decreases. Asset market equilibrium occurs at the intersection ti of the MS and the MD curves. When MD increases people sell nonmonetary assets, their price falls and the interest rate increases. Copyright 2009 Pearson Education Canada 9-16

The LM Curve: Asset Market Equilibrium The LM curve is a graphical representation of the relationship between output and the real interest rate that clears the asset market. The LM curve slopes upward. At all points of the LM curve MD=MS. Copyright 2009 Pearson Education Canada 9-17

The LM Curve: Asset Market Equilibrium (continued) As in the case of the IS curve, we can demonstrate the slope of the LM curve as an equilibrium relationship, this time between real money demand and supply. Suppose that real money demand was represented by the following: M d /P = l 0 + l y Y l r (r + π e ) where the symbols l represent positive coefficients Equilibrium i condition: M d /P = M s /P (board) Copyright 2009 Pearson Education Canada 9-18

The LM Curve: Asset Market Equilibrium (continued) The LM curve slopes upward because an increase in Y leads to an increase in M D and r must rise to clear the asset market (or else there would be excess M D ) If Y increases, the demand for real money (M/P) increases, at any given r, and shifts M D curve up. People try to sell assets for money. M S is fixed by Bank of Canada Price of asset falls/r increases Money demand decreases until M D = M S Copyright 2009 Pearson Education Canada 9-20

Factors that Shift the LM Curve For constant output, any change that reduces real money supply relative to real money demand d will increase the real interest rate that clears the asset market and cause the LM curve to shift up. Factors that might cause real money supply (M S /P) to rise: (board) An increase in the nominal M S A decrease in the price level P Copyright 2009 Pearson Education Canada 9-21

Factors that Shift the LM Curve (continued) Factors that might cause M D to fall: An increase in π e, the expected inflation As π e rises, the demand for money falls (money is expected to be worth less) and people start buying NM assets. A decrease in i m (interest bank pays on money) A decrease in wealth (reduces number of transactions) A decrease in the risk of NM assets An increase in the liquidity of NM assets Copyright 2009 Pearson Education Canada 9-23

Changes in the Real Money Demand A change in any variable that affects real money demand, other than output or the real interest t rate, will also shift the LM curve. The process works as before: any excess demand (supply) for money causes wealth holders to sell (buy) non-monetary assets. These actions bid down (up) those asset prices and cause the real interest rate to rise (fall). Copyright 2009 Pearson Education Canada 9-24

General Equilibrium in the Complete IS-LM Model The general equilibrium of the economy: the FE line along which the labour market is in equilibrium; lb the IS curve, along which the goods market is in equilibrium; the LM curve, along which the asset market is in equilibrium. Labour market, Goods market and Asset market are simultaneously in equilibrium Copyright 2009 Pearson Education Canada 9-26

General Equilibrium (continued) The general equilibrium of the economy always occurs at the intersection of the IS curve and the FE line. Adjustments of the price level cause the LM curve to shift until it passes through the general equilibrium point. Copyright 2009 Pearson Education Canada 9-27

A Temporary Adverse Supply Shock Suppose the productivity parameter A in the production function drops temporarily. It reduces the MPN and shifts the labour demand curve down. The labour supply curve is unaffected. Because the shock is temporary, MPK f is unaffected and accordingly gythe demand for K remains unchanged. The FE line shifts (Y falls) left because of lower N and A. Copyright 2009 Pearson Education Canada 9-29

A Temporary Adverse Supply Shock (continued) A temporary adverse supply shock is a movement along the IS curve, not a shift of the IS curve since the shock doesn t change any factor affecting S d or I d A temporary adverse supply shock has no direct effect on the demand for, or the supply of money, but... It s the LM curve that shifts until it passes through the intersection of the FE line and the IS curve. Copyright 2009 Pearson Education Canada 9-30

A Temporary Adverse Supply Shock (continued) This shift in the LM curve is caused by changes in the price level P which changes the real money supply, M/P, and therefore the asset market equilibrium To restore general equilibrium, LM shifts left since the adverse shock causes prices to rise and thus M/P to fall In the new general equilibrium, the real rate of interest is higher, output is lower and the price level is higher. Copyright 2009 Pearson Education Canada 9-31

Price Adjustment and the Attainment of General Eqm We can use the IS-LM model to illustrate how the economy moves to a general equilibrium i point where the three curves intersect. We can also use this model to show some basic differences between the Classical and Keynesian schools. Consider what happens to the economy if the nominal money supply increases i.e. the central bank decides to raise M Copyright 2009 Pearson Education Canada 9-33

The Effects of a Monetary Expansion Effects of a Monetary expansion: LM curve shifts down (P does not change right away) LM: Asset market responds right away FE: Labour market, slow response IS: Goods market response is in between; and we move along the IS curve in the short run So, short run equilibrium is where the IS- LM intersect Copyright 2009 Pearson Education Canada 9-34

The Effects of a Monetary Expansion (continued) People rebalance portfolios: get rid of excess M balances by buying NM assets, NM prices rise, r decreases What does low r mean for C d and I d? lower r means higher C d, I d firms are willing to temporarily produce more to meet this demand (key assumption) At the short run equilibrium point, the demand is met Copyright 2009 Pearson Education Canada 9-36

The Effects of a Monetary Expansion (continued) The economy is at the short run equilibrium, what's next? We have fixed P so far, which h is not likely l to happen for a long period of time Firms are producing more than full employment Y right now (e.g. through overtime, or reduction in inventories). This is not sustainable; prices must adjust Copyright 2009 Pearson Education Canada 9-37

The Adjustment of the Price Level Firms start charging higher prices P starts rising, M/P is falling, and the LM curve shifts back This process continues until we get back to the FE point, and the GE is restored Classical and Keynesians debate on how long this price adjustment takes. Copyright 2009 Pearson Education Canada 9-38

The Adjustment of the Price Level (continued) What happened here? M s went up, and there was a short run effect, but NO real long run effect P eventually rose to restore long run equilibrium Real: (r, Y, W/P) unchanged. This is referred to as monetary neutrality. Nominal: (W, P) rose proportionally to the increase in M s in the long run Copyright 2009 Pearson Education Canada 9-39

Attaining General Equilibrium with the Equations Let s use the IS and LM curves derived earlier to find the general equilibrium in the IS-LM model (board) IS curve r = α IS β IS Y (eq 1) LM curve r = α LM (1/l r )(M/P) + β LM Y (eq 2) where: α IS = (c 0 + ι 0 + G)/(c r + ι r ) α LM = (l 0 /l r ) π e β IS = (1 (1-τ)c y )/(c r + ι r ) β LM = (l y /l r ) α s are constant terms; β s are slopes. Copyright 2009 Pearson Education Canada 9-40

Classics vs. Keynesians Still debating... How rapidly do we reach a new GE? What are the effects of monetary policy? There is little controversy about the fact that the price level will adjust and restore general equilibrium. Classics: rapid price adjustment, P rises fast, so no persistent t real effect Keynesians: slow price adjustment, Y rises and P slow to adjust, then there are persistent real effects since labour market is not in equilibrium for an extended period. Copyright 2009 Pearson Education Canada 9-41

Monetary Neutrality There is monetary neutrality if a change in the nominal money supply changes the price level l proportionately t but has no effect on real variables in the long run. We have already shown that this is a feature of the model presented here. Monetary expansion left Y, r, N unchanged Keynesians believe in monetary neutrality in the long-run but not in the short-run. run. Copyright 2009 Pearson Education Canada 9-42

Stabilization Policy Unexpected shifts in the IS, LM and the FE curves are the sources of business cycles. Stabilization ti policy is the use of fiscal and monetary policy to shift the position of the IS and LM curves so as to offset the effects of such shocks. Classics believe there is no need for stabilization policies (economy is self-correcting) Keynesians advocate stabilization polices to avoid suffering the consequences of a prolonged disequilibrium. Copyright 2009 Pearson Education Canada 9-43

The AD-AS Model The AD-AS and the IS-LM models are equivalent and express the same basic macroeconomic theory Each version can be used to focus on either r or P. IS-LM: relates (Y, r) more useful for saving, investment AS-AD: AD: relates (Y, P) more useful for inflation Copyright 2009 Pearson Education Canada 9-44

The Aggregate Demand Curve The aggregate demand (AD) curve shows the relation between the aggregate quantity of goods demanded d d (C d +I d +G) and the general price level, P. The AD curve slopes downward because an increase in the price level will shift the LM curve up and to the left. Copyright 2009 Pearson Education Canada 9-45

The Aggregate Demand Curve (continued) Recall what happens if P goes up in IS-LM M/P falls, so LM shifts left IS-LM says new equilibrium i is at a lower Y So P rises, Y falls If we plot these equilibrium points, we get the AD curve So, the reduction in the real money supply, y pp y will raise the real interest rate which reduces the demand for goods by households/firms, thus lowers aggregate demand. Copyright 2009 Pearson Education Canada 9-46

The Aggregate Demand Curve (continued) Recall the expression for the IS and LM curves. We can use these expressions to derive the AD curve: r = α IS β IS Y r = α LM (1/l r )(M/P) + β LM Y To get the AD curve we set each equal to eliminate r, which then gives us an expression in P and Y: Y = [α IS - α LM + (1/l r )(M/P)]/(β IS + β LM ) Copyright 2009 Pearson Education Canada 9-48

Factors That Shift the AD Curve From this expression, we can see that Y is a decreasing function of P For a constant price level: any factor that changes the aggregate demand for output will cause the AD curve to shift; any factor that causes the intersection of the IS and the LM curves to shift will cause the AD to shift. Copyright 2009 Pearson Education Canada 9-49

The Aggregate Supply Curve The aggregate supply (AS) curve shows the relation between the price level and the aggregate amount of output that firms supply. The prices remain fixed in the short run and prices adjust to clear all the markets in the long-run, thus: SRAS: price level fixed for any Y (horizontal line) LRAS: labour market clears (FE) and we are at full employment (vertical line) Copyright 2009 Pearson Education Canada 9-51

The Aggregate Supply Curve (continued) From the expression for the IS and LM curves. We can use these expressions to derive the AS curves: SRAS: P= P and AD curve determine SR equilibrium: Y = [α IS - α LM + (1/l r )(M/ P)]/(β IS + β LM ) LRAS: Y= Y and AD curve determine LR equilibrium (solving for LR price level): P = M/{l r [α LM - α IS + (β IS + β LM ) ]} Copyright 2009 Pearson Education Canada 9-53 Y

Factors That Shift the AS Curve LRAS shifts due to anything that affects FE output (or shifts the FE curve) SRAS shifts if firms change their prices in the short run shifts up if costs rise in the short run Copyright 2009 Pearson Education Canada 9-54

Equilibrium in the AD-AS Model Long-run equilibrium is the same as general equilibrium because in long- run equilibrium, all markets clear. In general equilibrium, or long-run equilibrium, AD, SRAS, and LRAS curves intersect at a common point. Copyright 2009 Pearson Education Canada 9-55

Monetary Neutrality in the AD-AS Model Consider an increase in M when the economy is in LR equilibrium. This shifts the AD curve up and to the right. (board) In the short run the price level remains fixed and SRAS does not change. In the long run the price level rises, the SRAS shifts up to the point where the AD and the LRAS curves intersect. We conclude that money is neutral in the long-run. Copyright 2009 Pearson Education Canada 9-57