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.

The Is-Lm and As-Ad Models

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