Download chap 9 & 10

Introduction
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This chapter integrates the elements of our model
that were separately presented in chapters 3,4, and
7, covering labor, goods, and asset markets.
It develops a graphical depiction of our theory that is
called the IS-LM/AD-AS model.
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IS and LM refer to two equilibrium conditions in the model
(investment equals saving; money demand, or liquidity
preference, equals money supply).
AD and AS refer to aggregate demand and aggregate
supply.
The FE Line
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I will be using some diagrams that plot the real rate
of interest, r, and output Y on the axes.
Recall that labor market equilibrium determines a
quantity of labor, which, via the production function,
determines a full-employment level of output.

Since that level of output presumably does not depend on
the rate of interest, we can plot the full-employment line as
a vertical line in a diagram in which r and Y appear on
vertical and horizontal axes.
The FE line
FE Curve Shifters
Variable Increases
FE Curve Shifts
Productivity
Right
Labor Supply (Population)
Right
Capital Stock
Right
Deriving the IS Curve

Recall the Goods Market Equilibrium
Condition:
Sd  Id
Goods Market Equilibrium
r
S
I
Sd, Id
Goods Market Equilibrium
S
r
r
I
Sd = Id
Sd, Id
Consider a Rise in Income

As income rises, the desired saving curve
shifts right, and the equilibrium rate of interest
falls as we slide down the desired investment
curve (next slide).
Goods Market Equilibrium
S
r
r0
I
Sd = Id
Sd, Id
Goods Market Equilibrium
S
r
S (Higher Income)
r0
r1
I
Sd = Id
Sd, Id
Deriving IS
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The previous slide shows that as income varies and
goods market equilibrium is maintained, a higher
value of income is associated with a lower value of
the expected real interest rate
Plot the income-interest rate pairs that satisfy the
goods market equilibrium condition to get the IS
curve

The inverse relationship between income and interest rate
implies that the IS curve is downward sloping
Deriving the IS curve
Shifting IS
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Recall that IS was derived by considering how the
desired saving curve moved along the desired
investment curve as income changed.
Suppose a shock (say a government spending
increase) causes saving to decline at each level of
income

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Then the interest rate is higher at each level of income.
Then we must redraw IS, with higher r for each level of Y.
IS has shifted to the right.
For other shocks that shift saving or investment
schedules, we can also infer how IS shifts.
IS Curve Shifters
Variable Increases
IS Curve Shifts
Expected Future Output
Right
Wealth
Government Spending
Right
Right
Taxes
None (Ricardian) or Left
Expected future MPK
Right
Effective Tax Rate on K
Left
The LM Curve

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The IS plots income interest-rate pairs such
that desired spending is equal to output, or
desired saving is equal to desired investment
We will now derive the LM curve, which plots
income-interest rate pairs such that the
quantity of money demanded is equal to the
quantity of money supplied.
Money Market Equilibrium
Revisited
The LM Curve
The Derivation of LM
LM Curve Shifters
Variable Increases
LM Curve Shifts
Nominal Money Supply Right
Price Level
Left
Expected Inflation
Nominal interest rate
on money im
Right
Left
Anything Else
Left
Increasing the Demand
for Money
General Equilibrium in the ISLM Model

In general equilibrium, all markets satisfy their
respective equilibrium conditions.
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Labor, Goods, and Money Markets Must all be in
equilibrium.
The logic of general equilibrium:

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The labor market determines output.
Given output (income) the goods market then determines
an interest rate.
Given output, the interest rate, and the expected inflation
rate, then the money market determines the price level.
General Equilibrium in the ISLM Model (Diagram)
Equilibrium: A Coincidence?
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Labor Market equilibrium requires that the economy
be on the FE line
Goods Market equilibrium requires that the economy
be on the IS Curve
Money Market equilibrium requires that the economy
be on the LM Curve
General equilibrium requires that the economy be on
all three curves simultaneously
Does this require a happy coincidence? (No)
Review on Equilibrium
To review, output is determined by the
FE line
 Given output the intersection of IS and
FE determines the interest rate
 Finally, the price level adjusts so that
LM intersects both IS and FE

Timing of Movement to
Equilibrium
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Our model, as formulated, does not tell us the order
in which variables move—we just infer that the
economy moves from one equilibrium to another
(after a shock).
Here are some thoughts on timing:
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Interest rates (and financial markets generally) adjust very
quickly
Nominal (and real) wages adjust slowly (often wages are
set for long periods of time
Prices may also adjust slowly
The goods market adjusts with intermediate speed (we
often see unanticipated inventory movements, but firms
may alter production before revising prices)
A Look Ahead:
Keynesian and Classical Views
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We will say much more about “Keynesian”
and “Classical” macroeconomic theories
Keynesians emphasize the short-term rigidity
of prices and wages
Classical economists emphasize that all
markets reach equilibria rather quickly
Aggregate Demand and
Aggregate Supply

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We have now specified a complete model
However, sometimes it is convenient to look
at the model differently—with a different
diagram
We next introduce AD and AS curves
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These curves plot output, Y, and the price level,
P.
These diagrams allow us to focus attention on the
determination of the price level, which was not
directly visible in the IS-LM diagram.
The AD Curve
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Consider the IS-LM diagram.
A given LM curve is drawn for a fixed level of P.
If P changes, then the LM curve shifts.
Consider various levels of P.

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For each price level, draw the appropriate LM curve
The sequence of IS-LM intersections determines Y values
to be associated with each level of P.
Plotting these P-Y pairs yields the aggregate
demand (AD) curve.
Deriving AD
The Long Run Aggregate
Supply Curve

When all markets clear, we are in long-run
equilibrium.
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Note: This is not necessarily a matter of time. In the
classical model, when all markets equilibrate
instantaneously, then we reach the long-run immediately.
The AS curve plots output supplied versus the price
level.
Output supplied is determined by the labor market
and the production function; it is the full employment
level of output, Y .
Output supplied does not vary with P, so the AS
curve is vertical at Y .
Aggregate Supply in the ShortRun
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Assume that the short-run is a time frame in
which the price level is fixed, and the quantity of
output is determined by demand (whatever that
level may be)
So the AS curve is horizontal at a given price
level
Our original labor market equilibrium model has
been discarded for the short run

The short-run horizontal AS curve is really only a
feature of Keynesian interpretations of our theory
AS: Long Run and Short Run
Long-run and Short-run
Equilibria
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In long-run equilibrium, the economy must be on AD, SRAS, and
LRAS.
In a short-run equilibrium, the economy must be on AD and
SRAS.
To go to a new long-run equilibrium, price (and SRAS) must shift.
Note that our assumptions now make it clear that an increase in
AD can lead to an increase in output in the short-run, but an
increase in price in the long-run
The vertical long-run supply illustrates the money neutrality
property
 Increases in M, causing increases in AD, do not change output,
but they do change P.
AD Shifters
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Any variable that shifts IS or LM, with the exception
of P, will also shift AD
The direction of the shift is determined by whether
the IS-LM diagram shows an increase in income as
a result of the shift in the IS-LM diagram: if IS and
LM intersect at a higher level of income, then the AD
curve shifts to the right.

At any price level, if IS and AD determine a higher level of
income, then that price level is now associated with a
higher level on income on AD.
LRAS Shifters
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The LRAS curve will change when the full
employment level of output changes
This means that it is shifted by the same
variables that shift the FE Curve:
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Productivity
Labor supply
Capital stock
SRAS Shifters
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The SRAS curve shifts only when the price
level changes from one “fixed” level to
another
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This period price might be fixed at a given level,
but in a future period it might be fixed at some
other level
Upcoming Chapters
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In the next two chapters, we will use the ISLM / AS-AD model to illustrate short- and
long-run consequences of a variety of shocks
to the economy
Chapter 10
Analysis: Market-Clearing
Macroeconomics
II.
Money in the Classical Model (Sec. 10.2)
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A) Monetary policy and the economy
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Money is neutral in the classical model
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B) Monetary nonneutrality and reverse causation
C)
The nonneutrality of money: Additional
evidence
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1. Friedman and Schwartz have extensively
documented that often monetary changes have
had an independent origin; they weren’t just a
reflection of changes or future changes in
economic activity
2. More recently, Romer documented additional
episodes of monetary nonneutrality since 1960
3. So money does not appear to be neutral
4. There is a version of the classical model in
which money isn’t neutral—the misperceptions
theory discussed next
III.
The Misperceptions Theory and the Nonneutrality of
Money (Sec. 10.3)
 A) Introduction to the misperceptions theory
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If producers misperceive the aggregate price
level, then the relevant aggregate supply curve
in the short run isn’t vertical
a. This happens because producers have
imperfect information about the general price
level
b. As a result, they misinterpret changes in the
general price level as changes in relative prices
c. This leads to a short-run aggregate supply
curve that isn’t vertical
d. But prices still adjust rapidly
B)
The misperceptions theory is that the aggregate
quantity of output supplied rises above the fullemployment level when the aggregate price
level P is higher than expected

The equation Y = + b(P – Pe) [Eq. (10.4)]
summarizes the misperceptions theory
:In the short run, the aggregate supply (SRAS)
curve slopes upward and intersects the long-run
aggregate supply (LRAS) curve at P = Pe (Figure
10.2; like text Figure 10.6)
C) Monetary policy and the
misperceptions theory
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1. Because of misperceptions, unanticipated
monetary policy has real effects; but
anticipated monetary policy has no real
effects because there are no misperceptions
2. Unanticipated changes in the money
supply (Figure 10.3; like text Figure 10.7)
3. Anticipated changes in
the money supply
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a. If people anticipate the change in the
money supply and thus in the price level, they
aren’t fooled, there are no misperceptions,
and the SRAS curve shifts immediately to its
higher level
b. So anticipated money is neutral in both
the short run and the long run
D)
Rational expectations and the role of
monetary policy
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1. The only way the Fed can use monetary
policy to affect output is to surprise people
2. But people realize that the Fed would want to
increase the money supply in recessions and
decrease it in booms, so they won’t be fooled
3. The rational expectations hypothesis
suggests that the public’s forecasts of economic
variables are well-reasoned and use all the
available data
4. If the public has rational expectations, the
Fed won’t be able to surprise people in response
to the business cycle; only random monetary
policy has any effects
6. Propagating the effects of
unanticipated changes in the money
supply
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a. It doesn’t seem like people could be
fooled for long, since money supply figures
are reported weekly and inflation is reported
monthly
b. Classical economists argue that
propagation mechanisms allow short-lived
shocks to have long-lived effects
c. Example of propagation: The behavior of
inventories
E)
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Box 10.1: Are price forecasts rational?
Economists can test whether price forecasts are
rational by looking at surveys of people’s
expectations
If people have rational expectations, forecast
errors should be unpredictable random
numbers; otherwise, people would be making
systematic errors and thus not have rational
expectations
Many statistical studies suggest that people
don’t have rational expectations
But people who answer surveys may not have a
lot at stake in making forecasts, so couldn’t be
expected to produce rational forecasts
Instead, professional forecasters are more likely
to produce rational forecasts