Download General Equilibrium and IS-LM 1. Some points about IS

General Equilibrium and IS-LM
Some points about IS-LM graphs
1. Some points about IS-LM graphs
• They are fundamentally different animals than demand-supply graphs.
4. Real equilibrium
• They are useful for three reasons:
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• They are conceptually difficult.
3. The IS curve: equilibrium in the goods market
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2. The FE curve: equilibrium in the labor market
5. The LM curve: equilibrium in the money market
1. They collapse the three important markets into one graph.
6. General equilibrium
2. They allow the graphical analysis of both Classical and Keynesian (or “sticky
price”) models of short-run macro- economic behavior.
7. A temporary adverse supply shock
3. It is the standard model for short-run macro-economic behavior outside the academic world.
8. What happens if the money supply increases?
9. The AD-AS model
Derivation for the FE curve
• Neither labor supply nor labor demand schedules depend on r.
The FE curve: Equilibrium in the Labor Market
• Nevertheless, for given K and A, the N ∗ associated with labor market clearing produces a certain Y ∗ = AF (K, N ∗). FE curve is vertical at Y ∗.
• FE curve represents one half of “real” side of economy.
• FE stands for “Full Employment.”
• FE curve represents those (Y, r) combinations associated with the labor market clearing. (Labor supply equals labor demand).
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• In our discussion of the labor market, we showed how equilibrium in the labor market
lead to employment at its full-employment level N ∗ and output at Y ∗.
Shifts in the FE curve (line).
The FE line shifts anytime there is a change in A, K, or N ∗.
• If A increases, FE curve shifts out.
• If labor demand curve shifts out, N ∗ increases and FE curve shifts out.
• If labor supply curve shifts out, N ∗ increases and FE curve shifts out.
• If the capital stock decreases (a bomb), the FE curve shifts in.
Derivation of the IS curve
• The saving-investment market
– The saving curve depends on Y .
– The saving curve slopes upward because a higher real interest rate increases saving.
The IS curve: Equilibrium in the Goods Market
– An increase in output shifts the saving curve to the right, because people save
more when their income is higher.
• The IS curve represents the second half of the “real” side of the economy.
– Desired investment is not affected by current Y .
• IS stands for “investment equals saving.”
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• IS curve represents those (Y, r) combinations where the investment-saving market
clears (investment equals saving).
– The desired investment curve slopes downward because a higher real interest rate
reduces the desired capital stock, thus reducing investment.
• Consider two different levels of current output
• Recall adjustments in the real interest rate bring about equilibrium.
– At a higher level of output, the saving curve is shifted to the right compared to
the situation at the lower level of output.
• For any level of output Y , the IS curve shows the real interest rate r for which the
goods market is in equilibrium.
– Since the investment curve is downward sloping, equilibrium at the higher level of
output has a lower real interest rate.
– Thus a higher level of output must lead to a lower real interest rate, so the IS
curve slopes downward.
• N.B. The IS curve is not a demand curve.
An alternative interpretation
• Beginning at a point of equilibrium in the goods market, suppose the real interest
rate rises.
• The increased real interest rate causes people to increase saving and thus reduce
consumption. It also causes firms to reduce investment.
• So the quantity of goods demanded declines.
• The IS curve shifts up because of:
• To restore equilibrium, the quantity of goods supplied would have to decline.
– an increase in expected future output (consumption rises, desired saving falls)
• So higher real interest rates are associated with lower output. That is the IS curve
slopes downward.
– a temporary increase government purchases (desired national saving falls)
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Shifts in the IS curve.
• Anything that shifts the saving curve or the investment curve in the saving-investment
market, other than changes in Y , shifts the IS curve.
• Anything that shifts the investment curve out in the saving-investment market shifts
the IS curve out. or up. (Reason: Shifting the investment curve out causes the
investment-saving market, all else equal, to clear at a higher r.)
• Anything, other than changes in Y , which shifts the saving curve in, shifts the IS
curve out or up. (Whatever caused the saving curve to shift in will cause higher r,
all else equal.)
– a decline in taxes (if Ricardian equivalence does not hold)
– an increase in the expected future marginal product of capital (investment increases)
– a decrease in the effective tax rate on capital (investment increases)
Real Equilibrium.
The intersection of the FE line and the IS line represents the equilibrium of the real side
of the economy. This is essentially what we did before the midterm.
• Y ∗ is determined in the labor market (Y = AF (K, N ∗))
• The LM curve represents the “monetary” or nominal side of the economy.
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• r is determined by the IS line. (IS line gives the market clearing r associated with
every Y level. The particular r where the IS curve intersects the FE curve gives the
market clearing r associated with Y ∗.)
The LM curve: Money Market Equilibrium
• Example: A temporary (one-period) increase in A - total factor productivity.
• LM stands for “real money demand (L) equals real money supply (M ).”
• LM curve represents those (Y, r) combinations where the asset market clears (money
supply equals money demand), for a given price level P, and nominal money supply
Ms .
The IS-LM approach: (without the LM for now).
• FE shifts out because labor demand shifts out (causing N ∗ to increase) and because
Y increases directly.
• In the goods market, the saving curve shifts out temporarily, lowering the real interest
rate.
Notes of the LM curve
Derivation of the LM curve
• N.B. The LM curve is not a supply curve.
• The real money demand function, L(Y, i), depends negatively on r because i depends
on r (and π e).
• An LM curve is for a particular value of Ms/P , the real money supply.
• Shifts in the LM curve. The LM curve shifts anytime there is a change in Ms, P , or
anything else that changes real money demand, L(Y, i), other than Y or r.
• The real money demand function, L(Y, i), depends positively on Y directly.
• Only certain (Y, r) combinations will cause real money demand L(Y, i) to equal the
given real money supply.
• Since L is increasing in Y and decreasing in r (real money demand goes up as Y goes
up and goes down as r goes up), in order for real money demand to equal a given real
money supply, low levels of Y must be associated with low levels of r and high levels
of Y must be associated with high levels of r, or the LM curve slopes up.
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• For a given price level P , and nominal money supply Ms, the real money supply,
Ms/P , is fixed.
– If Ms increases, LM curve shifts out or down. (Intuition. For a given level of Y,
it takes a lower r to get people to hold the extra money.)
– If P increases, LM curve shifts back or up. (Intuition. The real money supply is now lower. This means, for given Y , higher interest rates necessary to
correspondingly lower real money demand.)
– If anything else (other than Y or r) raises real money demand schedule, LM curve
shifts back or up. (Intuition: For given Y , higher interest rates necessary to keep
the same equilibrium money demand.)
General Equilibrium
• When all three markets are simultaneously in equilibrium, there is a general equilibrium.
A Temporary Adverse Supply shock in the IS-LM Framework
• What is wrong with saying that all three markets are in equilibrium at the point
where all three lines intersect?
• Suppose there is a temporary (one-period) decrease in total factor productivity, A.
• Answer: What will guarantee that the three lines will intersect at the same point?
• The supply shock reduces the marginal product of labor. So labor demand falls.
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• One of the lines is going to have to be ignored, or one of them is going to have to be
a “follower” where something causes it to happen to intersect the other two at the
point they intersect each other.
• In many ways, the fights between the various groups in macroeconomics can be seen as
fights regarding how these curves move in the short run or which two are the relevant
two in the short run.
– With lower labor demand, the equilibrium real wage and employment fall
– Lower employment and lower productivity both reduce the equilibrium level of
output, thus shifting the FE curve to the left.
• There is no effect on the IS or LM curves.
• Since the FE, IS, and LM curves don’t intersect, something must give to get the
system back into equilibrium.
• In long run there is agreement: FE and IS curves “lead,” LM curve “follows.”
• Real Business Cycle Theorists (or simply “Classicals”) believe this in the short run
as well.
• How does the LM curve “follow?”
• The nominal money supply Ms is fixed, but to Classicals, P isn’t. To Classicals, P
adjusts rather quickly to make real money supply equal real money demand at the
levels of r and Y determined by the labor and saving-investment markets.
Is this a good description of the oil price shocks of the 1970’s?
• Keynesian economists tend see a rather slow adjustment of the price level
• If you look at the two oil price shock of the 1970s: one in ’73-’74 and the other in
’79-80, you see:
– It may take several years before prices and wages fully adjust.
– When not in general equilibrium, output is determined by the intersection of the
IS and LM curves. The labor market is not in equilibrium.
• To summarize:
– The real wage, employment and output decline.
2. consumption fell slightly and investment fell substantially
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• Either way the price level eventually rises to shift the LM curve up to restore equilibrium. The inflation rate rises temporarily (during this disequilibrium period), not
permanently.
1. output, employment and the real wage declined.
3. inflation surged
• The IS-LM framework nails this so far.
• But the real interest rate did not rise in the 1973-1974 oil price shock, though it did
in the 1979-1980 shock.
– The real interest rate and the price level are higher.
– Could be that people expected the 1973-1974 oil price shock to be permanent.
– There is a temporary burst of inflation
– In that case, desired investment would decline. IS curve would shift back.
– consumption and investment are lower (since the real interest rate is higher and
output is lower).
What happens if the money supply, Ms, increases?
• The adjustment of the price level.
– Since the demand for goods exceeds’ firms desired supply of goods, firms raise
prices.
• An increase in the money supply shifts the LM curve down (or out).
– Because financial markets respond most quickly to changes in economic conditions,
the asset market responds first to the disequilibrium.
– The rise in the price level cause the LM curve to shift up.
– The price level continues to rise until the LM curve intersects with the FE line
and the IS curve in general equilibrium.
– The FE curve is slow to respond, because job matching and wage renegotiation
take time.
– The result is no change in employment, output or the real interest rate.
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– The IS curve responds somewhat slowly.
– We assume the labor market is temporarily out of equilibrium, so there is a shortrun equilibrium at the intersection of the IS and LM curves.
– The price level is higher by the same proportion as the increase in the money
supply.
– So all real variables (including the real wage) are unchanged, while the nominal
values have risen proportionally with the change in the money supply.
• The increase in the money supply cause people to try to get rid of excess money
balances by buying assets, driving down the real interest rate.
– Money is neutral in the long-run. Changes in the money supply has real effects
in the short run.
– The decline in the real interest rate cause consumption and investment to increase
temporarily.
• Again to over-generalize. Classicals believe that the price level adjust quickly. Keynesian believe this adjustment takes more time.
– Output is assumed to increase temporarily to meet extra demand.
The aggregate demand curve
• The AD curve shows the relationship between the quantity of goods demanded and
the price level when the goods market and assets market are in equilibrium
• So the AD curve represents the set of price levels and output levels at which the IS
and LM curves intersect.
The Aggregate Demand-Aggregate Supply Model
• The AD curve is unlike other demand curves, which relate the quantity demanded of a good to its relative price; the AD curve relates total quantity of
goods demanded to the general price level – not the a relative price.
• We are going to use the IS-LM model to derive the AD-AS model
– Depending on the issue, one model may prove more or less useful.
1. IS-LM relates the real interest rate to output
2. AD-AS relates the price level to output
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– But the two models are equivalent.
• The AD curve slopes downward because a higher price level is associated with lower
real money supply, shifting the LM curve up, raising the real interest rate, and decreasing output demanded.
Factors that shift the AD curve
• Any factor that cause the intersection of the IS and LM curves to shift to the left
cause the AD curve to shift to the left; any factor causing the IS-LM intersection to
shift to the right causes the AD curve to shift to the right.
• For example, a temporary increase n government purchases shifts the IS curve to the
right, so it shifts the AD curve to the right as well.
The Aggregate Supply Curve
• The aggregate supply curve shows the relationship between the price level and the
aggregate amount of output that firms supply.
• In the short-run prices remain fixed, so firms supply whatever output is demanded.
The SRAS is horizontal.
• The full-employment output isn’t affected by the price level, so the long-run aggregate
supply curve (LRAS) is a vertical line at Y = Y ∗.
• Factors that shift the aggregate supply curves
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– The SRAS curve shifts whenever firms change their prices in the short run. Factors
like increased cost of producing goods lead firm to increase prices, shifting SRAS
up.
– Anything that increases Y ∗ shifts the LRAS curve right; anything that decreases
Y ∗ shifts the LRAS left.
• Equilibrium in the AD-AS model
– Short-run equilibrium: AD intersects SRAS.
– Long-run equilibrium: AD intersects LRAS. All three curves, AD, SRAS, and
LRAS, intersect at the same point. General equilibrium.