# Review Review of IS-LM AS-AD Model Jenny Xu

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Review Review of IS-LM AS-AD Model Jenny Xu

From Chapter 5 and 6 Chapter 5 talks about the determination of output and interest rate in the short-run. Chapter 6 tells us the determination of output in the medium run – by the natural rate of unemployment. This chapter we look at the output determination in both the short-run and medium run –the AS-AD model; AS- from the labor market; AD- from the IS-LM analysis; © 2006 Prentice Hall Business Publishing Macroeconomics, 4/e Olivier Blanchard

IS Curve IS Curve is derived from the Goods Market Clearing condition:
Supply of goods: Y equals to Demands of Goods coming from: Consumption demand: C; Investment demand: I; Government Expenditure: G © 2006 Prentice Hall Business Publishing Macroeconomics, 4/e Olivier Blanchard

IS Curve IS Curve captures the effect of nominal interest rate i on output Y, for given values of T and G. (tax and government purchase). Investment demand depends negative on interest rate. Hence, when i increase, the investment and then the total demand will fall. So will the total output Y. Therefore, IS curve is downward sloping. © 2006 Prentice Hall Business Publishing Macroeconomics, 4/e Olivier Blanchard

LM Curve is derived from the financial market clearing condition.
Supply of nominal money: M equals to Demands of nominal money coming from the transaction demand, which in turn depends positively on the price level P, and the total output Y, and negatively on the nominal interest rate. (Why? Because higher i implies a higher OC of holding money). So nominal money demand is given by PYL(i) © 2006 Prentice Hall Business Publishing Macroeconomics, 4/e Olivier Blanchard

Therefore, LM curve is upward sloping.
LM Curve captures the effect of output Y on nominal interest rate i, for given values of M (nominal money supply) and P (in short run price is assumed to be fixed). Higher total output implies higher transaction demand. So for given level of nominal money supply, high demand implies the interest rate that clear the money market has to increase. So when Y increases, the nominal interest rate i increases. Therefore, LM curve is upward sloping. © 2006 Prentice Hall Business Publishing Macroeconomics, 4/e Olivier Blanchard

Aggregate Demand When we derive the AD and AS curve, we no longer assume that price level is fixed. The AD curve indicates that, for given levels of M, T, and G, when the price level change, how does the output level change. The aggregate demand relation captures the effect of the price level on output. It is derived from the equilibrium conditions in the goods and financial markets. © 2006 Prentice Hall Business Publishing Macroeconomics, 4/e Olivier Blanchard

So the AD curve is downward sloping.
Aggregate Demand Recall the equilibrium conditions for the goods and financial markets described in chapter 5: When P increases, then real money supply will decrease, so the nominal interest rate will increase, investment and output will fall. So the AD curve is downward sloping. © 2006 Prentice Hall Business Publishing Macroeconomics, 4/e Olivier Blanchard

Aggregate Demand Figure 7 - 3
The Derivation of the Aggregate Demand Curve An increase in the price level leads to a decrease in output. © 2006 Prentice Hall Business Publishing Macroeconomics, 4/e Olivier Blanchard

Shift of Aggregate Demand
AD curve describes the relationship between price level and the output. So changes in monetary or fiscal policy—or more generally in any variable, other than the price level, that shift the IS or the LM curves—shift the aggregate demand curve. © 2006 Prentice Hall Business Publishing Macroeconomics, 4/e Olivier Blanchard

Aggregate Demand Figure 7 - 4
Shifts of the Aggregate Demand Curve An increase in government spending increases output at a given price level, shifting the aggregate demand curve to the right. A decrease in nominal money decreases output at a given price level, shifting the aggregate demand curve to the left. © 2006 Prentice Hall Business Publishing Macroeconomics, 4/e Olivier Blanchard

Aggregate Demand Let’s summarize:
Starting from the equilibrium conditions for the goods and financial markets, we have derived the aggregate demand relation. This relation implies that the level of output is a decreasing function of the price level. It is represented by a downward-sloping curve, called the aggregate demand curve. Changes in monetary or fiscal policy – or more generally in any variable, other than the price level, that shifts the IS or the LM curves – shift the aggregate demand curve. © 2006 Prentice Hall Business Publishing Macroeconomics, 4/e Olivier Blanchard

Aggregate Supply The aggregate supply relation captures the effects of output on the price level. It is derived from the behavior of wages and prices. Recall the equations for wage and price determination from chapter 6: © 2006 Prentice Hall Business Publishing Macroeconomics, 4/e Olivier Blanchard

Aggregate Supply Step 1: Eliminate the nominal wage from: , then
Step 2: Express the unemployment rate in terms of output: Step 3. Substitute u, In words, the price level depends on the expected price level, Pe, and the level of output, Y (and also , z, and L, but we take those as constant). © 2006 Prentice Hall Business Publishing Macroeconomics, 4/e Olivier Blanchard

Aggregate Supply The AS relation has two important properties:
First, How does the change in Y affect P? An increase in output leads to an increase in the price level. This is the result of four steps: © 2006 Prentice Hall Business Publishing Macroeconomics, 4/e Olivier Blanchard

Aggregate Supply The second important property ask the relationship between expected price level and P : An increase in the expected price level leads, one for one, to an increase in the actual price level. This effect works through wages: © 2006 Prentice Hall Business Publishing Macroeconomics, 4/e Olivier Blanchard

Aggregate Supply Figure 7 - 1
The Aggregate Supply Curve Given the expected price level, an increase in output leads to an increase in the price level. If output is equal to the natural level of output, the price level is equal to the expected price level. © 2006 Prentice Hall Business Publishing Macroeconomics, 4/e Olivier Blanchard

Aggregate Supply The AS curve has three properties that will prove to be useful in what follows: The AS curve is upward sloping. As explained earlier, an increase in output leads to an increase in the price level. The AS curve goes through point A, where Y = Yn and P = Pe. This property has two implications: When Y > Yn, P > Pe. When Y < Yn, P < Pe. An increase in Pe shifts the AS curve up, and a decrease in Pe shifts the AS curve down. © 2006 Prentice Hall Business Publishing Macroeconomics, 4/e Olivier Blanchard

Aggregate Supply Figure 7 - 2
The Effect of an Increase in the Expected Price Level on the Aggregate Supply Curve An increase in the expected price level shifts the aggregate supply curve up. Meanwhile, changes of , z, also lead to shift of the AS curve. © 2006 Prentice Hall Business Publishing Macroeconomics, 4/e Olivier Blanchard

Aggregate Supply Let’s summarize:
Starting from wage determination and price determination in the labor market, we have derived the aggregate supply relation. This means that for a given expected price level, the price level is an increasing function of the level of output. It is represented by an upward-sloping curve, called the aggregate supply curve. Increases in the expected price level shift the aggregate supply curve up; decreases in the expected price level shift the aggregate supply curve down. © 2006 Prentice Hall Business Publishing Macroeconomics, 4/e Olivier Blanchard

Equilibrium in the Short Run and in the Medium Run
Equilibrium depends on the value of Pe. The value of Pe determines the position of the aggregate supply curve, and the position of the AS curve affects the equilibrium. © 2006 Prentice Hall Business Publishing Macroeconomics, 4/e Olivier Blanchard

Equilibrium in the Short Run
Figure 7 - 5 The Short Run Equilibrium The equilibrium is given by the intersection of the aggregate supply curve and the aggregate demand curve. At point A, the labor market, the goods market, and financial markets are all in equilibrium. © 2006 Prentice Hall Business Publishing Macroeconomics, 4/e Olivier Blanchard

Equilibrium in the Short Run
From the above figure, we can see that In the equilibrium point A. Why is that? This is because the equilibrium depends on both the AS and the AD curve. And position of AS curve depends on expected price level , while the position of the AD curve depends on , so in the short-run, output might not equal to natural level of output. So what will happen over time? © 2006 Prentice Hall Business Publishing Macroeconomics, 4/e Olivier Blanchard

From the Short Run to the Medium Run
At point A, Wage setters will revise upward their expectations of the future price level. This will cause the AS curve to shift upward. Expectation of a higher price level also leads to a higher nominal wage, which in turn leads to a higher price level. © 2006 Prentice Hall Business Publishing Macroeconomics, 4/e Olivier Blanchard

From the Short Run to the Medium Run
Will the adjustment stop at A’? No, since at A’ we still have The adjustment ends once and wage setters no longer have a reason to change their expectations. In the medium run, output returns to the natural level of output. © 2006 Prentice Hall Business Publishing Macroeconomics, 4/e Olivier Blanchard

From the Short Run to the Medium Run
Let’s summarize: In the short run, output can be above or below the natural level of output. Changes in any of the variables that enter either the aggregate supply relation or the aggregate demand relation lead to changes in output and to changes in the price level. In the medium run, output eventually returns to the natural level of output. The adjustment works through changes in the price level. © 2006 Prentice Hall Business Publishing Macroeconomics, 4/e Olivier Blanchard