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Appendix: Overview and Relation of the Models
In this Appendix we briefly review and relate the models that we have developed
in this textbook. We started with the Income-Expenditure diagram of 8.12, which gave us
the equilibrium in the goods market under the assumption that there is so much excess
capacity that any amount of goods that are demanded will be supplied by the firms
without any change in the price level.
The real interest rate was taken as given in Figure 8.12. This assumption is
relaxed in Figure 9.8, where the IS curve is derived by tracing out the equilibrium level of
output demanded for each real interest rate in the Income-Expenditure diagram.
Until this point money is left out of the model completely. The money market
equilibrium is considered in Figure 7.8, which is drawn for a given level of output.
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When as in Figure 10.2 we allow for changes in output in the money market we
derive the LM curve, which gives the nominal interest rate for each level of output such
that the money market is in equilibrium.
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Since expected inflation is assumed fixed in this model, the LM equation can also
be expressed as a combination of real interest rates and output levels such that the money
market is in equilibrium. This is done in Figure 10.3 where the intersection of the IS and
LM curves gives us the equilibrium real interest rate and the level of output, for a given
price level and expected inflation.
It is important to note that since the price level is assumed fixed, the equilibrium
point in the IS-LM model is only a short-run equilibrium. However, over time the price
level adjusts and the economy moves to its long-run equilibrium. This is consistent with
the assumption of a non-zero value for expected inflation in the IS-LM model, despite the
fact that this is a “fixed-price” model.
If we allow for changes in the price level, we can derive the aggregate demand
from the IS-LM model. The aggregate demand curve is shown in Figure 10.16 and is
drawn for a given expected inflation rate.
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Until this point we have completely ignored the supply side of the model. We
have assumed that output is demand determined; that is, firms will supply as much
output as is demanded. To bring the supply side into the analysis, we started with the
labour market equilibrium, Figure 5.4.
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Using the production function of Figure 5.5, together with the equilibrium labour
input from Figure 5.4, and the economy’s capital stock we can determine the economy’s
potential output.
With perfectly flexible prices and wages the economy will always be at the
potential level of output. This gives the long run aggregate supply curve, LRAS, in
Figure 10.17. Nevertheless, in the short run there will be deviations from full
employment due to labour contracts or imperfect information as in the “misperceptions
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model”. Hence, the short run aggregate supply, AS, will be upward sloping, as shown in
the same figure.
The intersection point of the expected aggregate demand, ADe and the short run
aggregate supply, AS, gives us the short run equilibrium in the economy, while the
intersection point of ADe, AS and LRAS determine the long run equilibrium price and
output as shown in Figure 10.18.
Figure 10.19 explains the importance of making a distinction between anticipated
and unanticipated shocks on the macroeconomic equilibrium.
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The AD-AS model determines the equilibrium price and output in (Y, P)-space.
Yet economists and policy makers are more interested in inflation, π, rather than the
price level. In the last section of Chapter 15, we present a new model that determines
equilibrium inflation and output in (Y, π)-space. With respect to aggregate demand, the
change of variable from P to π is accomplished by using a simple Taylor rule, that is by
assuming that the Central Bank is setting the short term interest rate in response to the
gap between actual inflation and target inflation. This gives a new AD or monetary policy
reaction function (MPRF) in terms of inflation and output as shown in Figure 10.21.
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With respect to aggregate supply, the AS curve can be easily expressed as a
relation between inflation and output. The equilibrium output and inflation rate can then
be determined as the point of intersection of this AS curve and the new AD curve or
MPRF as shown in Figure 10.23.
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Finally, we combine Okun’s law with the production function in order to obtain
the Phillips curve of Figure 11.1.
Where does the Flow of Funds equilibrium of Figure 6.2, and the analysis in
Chapter 6 fit into all this?
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Recall the Flow of Funds model is the model with flexible prices, where we are
always at full employment. Hence, the Flow of Funds model corresponds to the long run
equilibrium, or the point of intersection of the AD curve and the LRAS curve. The focus
in the Flow of Funds model is, therefore, not on the equilibrium output and interest rate,
but on equilibrium interest rate and the levels of aggregate investment and saving.
Finally, notice in all the models discussed above the capital stock is treated as
fixed, even in the long run analysis of these models. The Growth Theory models of
Chapter 3 consider a longer horizon, in which the capital stock per worker is allowed to
adjust. As shown in Figure 3.4, in the neoclassical growth model without exogenous
technological progress, the capital per worker ratio adjusts towards its constant long run
equilibrium or steady state value. Growth comes to a halt in the steady state due to
diminishing returns to capital per worker.
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On the other hand, in the endogenous growth model, economic growth can go on
forever because returns to capital per worker, broadly defined, are constant as shown in
Figure 3.9.
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