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

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.

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.

The FE line

FE Curve Shifters Variable Increases FE Curve Shifts Productivity Right Labor Supply (Population) Capital Stock

Deriving the IS Curve Recall the Goods Market Equilibrium Condition:

Goods Market Equilibrium Sd, Id

Goods Market Equilibrium Sd, Id Sd = Id

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).

Goods Market Equilibrium Sd, Id Sd = Id

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

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

Deriving the IS curve

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.

IS Curve Shifters Variable Increases IS Curve Shifts Expected Future Output Right Wealth Government Spending Taxes None (Ricardian) or Left Expected future MPK Effective Tax Rate on K Left

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.

Money Market Equilibrium Revisited

The LM Curve

The Derivation of LM

LM Curve Shifters Variable Increases LM Curve Shifts Nominal Money Supply Right Price Level Left Expected Inflation Nominal interest rate on money im Anything Else Increasing the Demand for Money

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.

General Equilibrium in the IS-LM Model (Diagram)

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)

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

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)

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

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.

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.

Deriving AD

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 .

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

AS: Long Run and Short Run

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.

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.

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

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

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

Analysis: Market-Clearing Macroeconomics Chapter 10 Analysis: Market-Clearing Macroeconomics

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

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

A) Introduction to the misperceptions theory 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

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)

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)

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

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

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

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