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

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1 General Equilibrium and IS-LM 1. Some points about IS-LM graphs Some points about IS-LM graphs 1 2. The FE curve: equilibrium in the labor market 3. The IS curve: equilibrium in the goods market 4. Real equilibrium 5. The LM curve: equilibrium in the money market 6. General equilibrium 7. A temporary adverse supply shock 8. What happens if the money supply increases? 9. The AD-AS model 2 They are conceptually difficult. They are fundamentally different animals than demand-supply graphs. They are useful for three reasons: 1. They collapse the three important markets into one graph. 2. They allow the graphical analysis of both Classical and Keynesian (or sticky price ) models of short-run macro- economic behavior. 3. It is the standard model for short-run macro-economic behavior outside the academic world. Derivation for the FE curve The FE curve: Equilibrium in the Labor Market FE curve represents one half of real side of economy. Neither labor supply nor labor demand schedules depend on r. 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. 3 FE stands for Full Employment. 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. FE curve represents those (Y,r) combinations associated with the labor market clearing. (Labor supply equals labor demand). 4 Shifts in the FE curve (line). The FE line shifts anytime there is a change in A, K, orn. 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.

2 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. An increase in output shifts the saving curve to the right, because people save more when their income is higher. Desired investment is not affected by current Y. 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 At a higher level of output, the saving curve is shifted to the right compared to the situation at the lower level of output. 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. 5 The IS curve: Equilibrium in the Goods Market The IS curve represents the second half of the real side of the economy. IS stands for investment equals saving. IS curve represents those (Y,r) combinations where the investment-saving market clears (investment equals saving). Recall adjustments in the real interest rate bring about equilibrium. For any level of output Y, the IS curve shows the real interest rate r for which the goods market is in equilibrium. 6 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. To restore equilibrium, the quantity of goods supplied would have to decline. So higher real interest rates are associated with lower output. That is the IS curve slopes downward. 7 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.) 8 The IS curve shifts up because of: an increase in expected future output (consumption rises, desired saving falls) a temporary increase government purchases (desired national saving falls) 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)

3 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 )) 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.) Example: A temporary (one-period) increase in A - total factor productivity. 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. The LM curve: Money Market Equilibrium 9 10 The LM curve represents the monetary or nominal side of the economy. 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 M s. Derivation of the LM curve Notes of the LM curve The real money demand function, L(Y,i), depends negatively on r because i depends on r (and π e ). The real money demand function, L(Y,i), depends positively on Y directly. For a given price level P, and nominal money supply M s, the real money supply, M s /P, is fixed. 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. N.B. The LM curve is not a supply curve. An LM curve is for a particular value of M s /P, the real money supply. Shifts in the LM curve. The LM curve shifts anytime there is a change in M s, P,or anything else that changes real money demand, L(Y,i), other than Y or r. If M s 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.) 11 12

4 General Equilibrium 13 When all three markets are simultaneously in equilibrium, there is a general equilibrium. What is wrong with saying that all three markets are in equilibrium at the point where all three lines intersect? Answer: What will guarantee that the three lines will intersect at the same point? 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. 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? 14 A Temporary Adverse Supply shock in the IS-LM Framework Suppose there is a temporary (one-period) decrease in total factor productivity, A. The supply shock reduces the marginal product of labor. So labor demand falls. 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. 15 The nominal money supply M s 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. Keynesian economists tend see a rather slow adjustment of the price level 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. 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. To summarize: The real wage, employment and output decline. The real interest rate and the price level are higher. There is a temporary burst of inflation consumption and investment are lower (since the real interest rate is higher and output is lower). 16 Is this a good description of the oil price shocks of the 1970 s? If you look at the two oil price shock of the 1970s: one in and the other in 79-80, you see: 1. output, employment and the real wage declined. 2. consumption fell slightly and investment fell substantially 3. inflation surged The IS-LM framework nails this so far. But the real interest rate did not rise in the oil price shock, though it did in the shock. Could be that people expected the oil price shock to be permanent. In that case, desired investment would decline. IS curve would shift back.

5 What happens if the money supply, M s, increases? The adjustment of the price level. Since the demand for goods exceeds firms desired supply of goods, firms raise prices. 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 result is no change in employment, output or the real interest rate. 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. Money is neutral in the long-run. Changes in the money supply has real effects in the short run. Again to over-generalize. Classicals believe that the price level adjust quickly. Keynesian believe this adjustment takes more time. 17 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 FE curve is slow to respond, because job matching and wage renegotiation take time. 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 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. The decline in the real interest rate cause consumption and investment to increase temporarily. Output is assumed to increase temporarily to meet extra demand. 18 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 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. 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. 19 The Aggregate Demand-Aggregate Supply Model We are going to use the IS-LM model to derive the AD-AS model But the two models are equivalent. 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 20 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.

6 The Aggregate Supply Curve 21 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 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.