Building the short run AD-AS model from the IS-LM framework AD-AS Short Run Building the short run AD-AS model from the IS-LM framework

Theory of Short Run Fluctuations The IS curve is generated from the Keynesian Cross and the LM curve is generated from the market for real money balances. Now we will generate the AD curve from IS-LM and use short run and long run models of AS to explain short run economic fluctuations. Keynesian Cross IS Curve IS-LM Model AD Curve Money Market LM Curve AD-AS Model Short-run Fluctuations Explanation AS Curve

Fiscal Policy and the IS curve (government expenditure) An increase in government purchases shifts the IS curve to the right. The IS curve shifts to the right by ΔG/(1-MPC),... r LM ...and the interest rate. r2 r1 IS2 IS1 …which raises income... Y Y1 Y2

Fiscal Policy and the IS curve (government expenditure) A decrease in taxes shifts the IS curve to the right. The IS curve shifts to the right by ΔTxMPC/(1–MPC),... r LM ...and the interest rate. r2 r1 IS2 IS1 …which raises income... Y Y1 Y2

Fiscal Policy and the IS curve (tax changes) Note that government expenditure has a larger effect than does the same change in taxes.

Monetary Policy and the LM curve An increase in the money supply shifts the LM curve to the right,... r LM1 LM2 ...and lowers the interest rate. r1 r2 IS1 …which raises income... Y Y1 Y2

Monetary and Fiscal Policy Interactions …if the money supply is held constant, the LM curve stays the same. How the economy responds to a tax increase depends on the response of the money supply. r LM1 The interest rate and output fall. IS1 IS2 Y

Monetary and Fiscal Policy Interactions …if to hold the interest rate constant, the money supply contracts. How the economy responds to a tax increase depends on the response of the money supply. r LM2 LM1 Only output falls. IS1 IS2 Y

Monetary and Fiscal Policy Interactions …if to hold income constant, the money supply expands. How the economy responds to a tax increase depends on the response of the money supply. r LM1 LM2 IS1 Only the interest rate falls. IS2 Y

IS-LM as a theory of Aggregate Demand LM(P2) A higher price level P shifts the LM curve upward… LM(P1) …lowering income Y. IS1 Y We now allow price level to vary in the IS-LM model. This provides a theory for the position and slope of the AD curve. Y2 Y1 The AD curve summarizes the relationship between P and Y. P P2 P1 AD Y Y2 Y1

IS-LM as a theory of Aggregate Demand LM(P1) A monetary expansion shifts the LM curve outward… LM(P1) …increasing income Y. IS1 Y Y1 Y2 If we hold price constant we can see the effects of monetary and fiscal policy on AD via IS-LM. Increasing AD at any given price level. P P1 AD2 AD1 Y Y1 Y2

IS-LM as a theory of Aggregate Demand LM(P1) A fiscal expansion shifts the IS curve outward… IS2 IS1 Y …increasing income Y. Y1 Y2 Increasing AD at any given price level. P P1 AD2 AD1 Y Y1 Y2

IS-LM and AD-AS the Short Run and the Long Run Now let’s add short-run and long-run AS to our IS-LM and AD models. Assume the economy is operating below full employment output. LRAS r LM(P1) LM(P2) As price falls money demand decreases and the LM curve shifts out. 1 2 IS Y In the short run price is fixed at P1 and equilibrium is at point 1. P In the long run price falls to P2, quantity demanded increases, and equilibrium moves to point 2. This is characterized by a shifting SRAS curve. P1 SRAS1 1 P2 SRAS2 2 AD1 Long run equilibrium is achieved at point 2. Y

The Algebra of the IS-LM theory of AD The algebra behind the system is a bit tedious. But, by solving the LM curve for “r” and plugging into the IS curve which contains “r” on the right hand side you obtain the IS-LM equilibrium condition or AD curve.

The Algebra of the IS-LM theory of AD The IS curve boils down to… The LM curve boils down to… Plugging “r” into the IS curve and solving for Y yields…

Conclusions In this section we derived the AD curve via the IS-LM equilibrium condition. We looked at fiscal and monetary policy effects on the IS-LM model. We looked at the shifting effects that monetary and fiscal policies have on the AD curve and used the IS-LM model with the AD-AS model to explain short run and long run changes to the economy.