The Is-Lm and As-Ad Models

Chapter 9 THE IS-LM AND AS-AD MODELS.

Introduction. . Up until now we have been describing the different individual components of the macroeconomic picture but we didn't try to put them together. . We are going to do that and even go a step beyond; we are going to study how those pieces interact and we will propose different government policies to affect the economy.

. The IS-LM model is the basic framework that economic policy makers employ to analyze the implications of alternative economic policies used to solve different economic problems. (i.e.: how can unemployment be reduced? how can we fight inflation?) . This model represents the workings of the economy as the interaction between two curves: - The IS curve, showing the different combinations of real interest rates (r) and real output (Y) that result in equilibrium in the goods market. - The LM curve, showing the different combinations of real interest rates (r) and real output (Y) that result in equilibrium in the money market. . It is based on Keynesian economic premises translated into graphs by 1972 Nobel Prize laureate John R. Hicks. . Although this particular model faces the basic shortcoming of considering prices as being fixed, we will adapt it later on to incorporate that price flexibility.

. We will also present the AS-AD model, a more realistic representation of the economy under classical premises of price flexibility and instantaneous market clearing. . This model represents the workings of the economy as the interaction between two curves: - The AD curve, showing the relationship between the price level (P) and aggregate demand (AD,) that is, real output (Y.) - The AS curve, showing the relationship between the price level (P) and aggregate supply (AS,) that is, real output (Y.)

. We will use both models to show how different economic policies and shocks affect the economy and what can be done about it. 9.1 Full Employment. . When economists refer to full employment they don't expect the unemployment rate to be 0. . Full employment represents the idea of the economy experiencing just the natural rate of unemployment (u*); unemployment that is only voluntary and frictional. . At the full employment level (N*) the economy produces the full employment level of output (Y*,) represented by the full employment line (FE.) (See Figure 9.1) . The FE line is sometimes referred to as the Long-Run Aggregate Supply (LRAS) line because it captures the idea of the economy producing at full capacity, with all the available labor (N) and capital (K) employed. . That situation is expected to be achieved in the long run, when all factors of production are flexible and the economy can recover from temporary recessions. . At that point in time, no change in interest rates (or prices, for that matter) can increase actual output beyond Y*.

. Shifts in the FE line: - The FE line shifts right if:  The labor force grows in size N (e.g.: migrations)  The capital stock increases K.  Technological advances increase productivity A.

- The FE line shifts left if:  The labor force diminishes N (e.g.: wars)  The capital stock decreases K.  Negative productivity shocks A.

. At any given moment in time when the economy is at an output level to the left of Y* we would assume that it is in a recession. . At any given moment in time when the economy is at an output level to the right of Y* we would assume that it is in an expansion. 9.2 The IS Curve. . The IS curve represents the equilibrium points in the goods market: the combinations of r and Y for which investment (I) is equal to saving (S.) . Remember that: - Investment is negatively related to the real interest rate and does not depend on the level of real output / income. - Saving is positively related to the real interest rate and also increases with income. (Plotting that relationship: see Figure 9.2) . The IS curve will then be downward sloping.

. Shifts in the IS curve: - The IS line shifts right if:  Expected future income increases: S.  Wealth increases: S.  Taxes decrease: S. S (if the Ricardian equivalence holds.)  Government expenditure increases: S.  MPK increases: I  Taxes on capital decrease: I

- The IS line shifts left if:  Expected future income decreases: S.  Wealth decreases: S.  Taxes increase: S. S (if the Ricardian equivalence holds.)  Government expenditure decreases: S.  MPK decreases: I  Taxes on capital increase: I

. The IS curve is basically affected by fiscal policy ( in T and G.) - Expansionary fiscal policy shifts the IS line right - Contractionary fiscal policy shifts the IS line left 9.3 The LM Curve. . The LM curve represents the equilibrium points in the money market: the combinations of r and Y for which money demand (Md) is equal to money supply (M.) . Remember that: - Money demand is negatively related to the real interest rate and depends on the level of real output / income and prices (because we use money for transaction purposes.) - Money supply is determined by the Fed and is independent of the real interest rate and real income. (Plotting that relationship: see Figure 9.4) . The LM curve will then be upward sloping.

. Shifts in the LM curve: - The LM line shifts right if:  Money supply increases: M.  Prices decrease: Md.  Inflationary expectations increase: Md.

- The LM line shifts left if:  Money supply decreases: M.  Prices increase: Md.  Inflationary expectations decrease: Md.

. The LM curve is basically affected by monetary policy ( in M.) - Expansionary monetary policy shifts the LM line right. - Contractionary monetary policy shifts the LM line left.

9.4 Macroeconomic Analysis with the IS-LM Model.

. The crossing of the IS and LM curves (YE) will represent simultaneous short-run equilibrium in the goods and money markets. . Whether or not that short-run equilibrium represents the full employment (Y*) of all factors of production (K and N) can be determined with relation to the FE line:  When the short-run equilibrium is to the left of the FE line there is a recessionary gap:

(YE < Y*, and therefore, uE > u*; there is a recession)  When the short-run equilibrium is to the right of the FE line there is an inflationary gap:

(YE > Y*, and therefore, uE < u*; there is an expansion –to be discussed later on.) . Two different types of economic policies can be applied to close a recessionary gap: - Expansionary fiscal policy: T or G (at the new equilibrium Y but also r)  T may be ineffective if the Ricardian equivalence holds.  G may cause some crowding out of private investment.  The time lags for fiscal policy are quite long and so may render it ineffective. - Expansionary monetary policy: M (at the new equilibrium Y and also r)  M causes other problems, such as high inflation, not captured by this model.  Monetary policy is more immediate, but M may be ineffective if there is a liquidity trap. . Since Congress controls fiscal policy through the federal budget, the Fed controls monetary policy, and both are independent from each other, the issue of policy coordination is crucial. (e.g.: a simultaneous fiscal expansion and monetary contraction would be disastrous)

CASE STUDIES: - Japan and the liquidity trap (completely elastic Md curve, flat section of LM) - Inelastic investment (completely inelastic I curve, very steep IS) - The Great Depression (reduction in C, contraction in M) - The Vockler deflation (contraction in M to fight inflation, causing drop in Y)

- Alan Greenspan and the slow deceleration (YE > Y*, slow contraction in M to reduce C)

9.5 The Aggregate Supply and Aggregate Demand Model. . Since the IS-LM model does not provide us with any information about how the price level changes as the economy expands or contracts we need another analytical tool. . The AS-AD model is a more realistic representation of the economy under classical premises of price flexibility and instantaneous market clearing. . This model represents the workings of the economy as the interaction between two curves: - The AD curve, showing the relationship between the price level (P) and aggregate demand (AD), that is, real output (Y) - The AS curve, showing the relationship between the price level (P) and aggregate supply (AS), that is, real output (Y) The Aggregate Demand Curve . Through the expenditure approach to GDP calculation we can figure out which were the uses given to all the goods and services produced during a year (that is, who demanded them) Y = GDP = C + I + G + NX = AD

where: C = Consumption (expenditure by households) I = Investment (expenditure by firms) G = Government Expenditure (you take a guess) NX = Net Exports (expenditure by the rest of the world)

. All the components of Aggregate Demand (except G) are inversely related to the price level: - P reduces Consumption (C) - P reduces Investment (I) because the nominal interest rate rises (i) - P reduces Net Exports (NX) because the price of X increase relative to the price of M - Government Expenditure (G) does not depend on the price level . Therefore the Aggregate Demand curve is going to be a downward sloping line. (See Figure 9.10)

. Movements along the AD curve: - We move up along the AD curve only if the price level increases: P  Q of AD. - We move down along the AD curve only if the price level decreases: P  Q of AD.

. Shifts in the AD curve: - The AD curve shifts right if:  Any of the AD components increases: C, I, G.  Expansionary fiscal policy is applied: T, G.  Expansionary monetary policy is applied: M  i  I

- The AD curve shifts left if:  Any of the AD components decreases: C, I, G.  Contractionary fiscal policy is applied: T, G.  Contractionary monetary policy is applied: M  i  I

. The AD curve is basically affected by monetary and fiscal policies ( in M, T, G) that are also known as demand policies (as opposed to supply policies.) - Expansionary monetary or fiscal policies shift the AD line right. - Contractionary monetary or fiscal policies shift the AD line left. (See Figure 9.11)

The Aggregate Supply Curve

. We will distinguish between:

- The Long-Run Aggregate Supply curve LRAS, that represents the relation between the price level (P) and the level of output (Y) produced by firms in the long-run. . When we studied the determinants of long-run growth we described the production function: LRAS = Y = A. F (K, N) . Since the levels of physical capital (K), or labor (N), available in the long-run to any given country do not depend on the price level we can represent the LRAS as a vertical line. (See Figure 9.12)

. Shifts in the LRAS curve: - The LRAS curve shifts right if:  Any of the factors of production increase: K, N.  There is a technological improvement: A.

- The LRAS curve shifts left if:  Any of the factors of production decrease: K, N.  There is a reduction in technology: A.

- The Short-Run Aggregate Supply curve SRAS, that represents the relation between the price level (P) and the level of output (Y) produced by firms in the short-run. . Private firms increase their output level as the selling price of their goods increase (P) but they also take into consideration the production costs (P of inputs). SRAS = Y = A. F (K, N) / P of inputs . We can then represent the SRAS as an upward sloping line. . For the sake of simplifying the analysis we may as well consider that the aggregate output supplied in the short-run is completely elastic with respect to the price level. In that case we will represent the SRAS with a horizontal line. (See Figure 9.12) . Movements along the SRAS curve: - We move up along the SRAS curve only if the price level increases: P  Q of SRAS. - We move down along the SRAS curve only if the price level decreases: P  Q of SRAS.

. Shifts in the SRAS curve: - The SRAS curve shifts right if:  Any of the factors of production increase: K, N.  There is a technological improvement: A.  There is a decrease in production costs: P of inputs.

- The SRAS curve shifts left if:  Any of the factors of production decrease: K, N.  There is a reduction in technology: A.  There is an increase in production costs: P of inputs.

. Note that neither fiscal nor monetary policies affect the supply side of the economy. Only long- run government policies (e.g.: universal education, support of scientific enterprises) have an impact on aggregate supply.

Equilibrium . At any given moment in time the level of economic activity is going to be determined by the interaction of the aggregate demand and the aggregate supply curves. . The different phases of the business cycle can be described in terms of the AS-AD model - When the SRAS and AD curves intercept to the left of the LRAS curve the short-run level of

output is below the full-employment level of output (Y*>YE), creating what is known as a

recessionary gap (uE > u*). - When the SRAS and AD curves intercept to the right of the LRAS curve the short-run level of

output is above the full-employment level of output (YE > Y*), creating what is known as an

inflationary gap (u*>uE). - When the SRAS and AD curves intercept over the LRAS curve the short-run level of output is

the same as the full-employment level of output (Y*=YE), a situation known as a long-run

equilibrium (u*=uE).

. See above a discussion of the different fiscal and monetary policies available for macroeconomic stabilization, as well as their drawbacks.