CH-3: AGGREGATE DEMAND IN CLOSED ECONOMY

Simple Economic Model: Saving and Investment

 In this section, we will see some important

identities from a set of national income
relationship,
 To begin with, let us put the following
assumptions:
 Disposal income is equal to GDP
 No depreciation
 No tax and government transfer payments
 National income=GDP
 No government and foreign sector
 Output produced equals out put sold
 Then, output= expenditure
1
C + I ………………………….(1)
12/1/2015
SAVING & INVESTMENT- SIMPLE CLOSED ECONOMY MODEL…COND.
 With no government & external sector; the private
sector receives the whole disposal income,
 The private income will partly consumed and partly
saved
Y = C +S …………..…………………..(2)
 Next, combining identity (1) & (2), we have

C + I = Y = C+S ……………………..(3)
o The left-hand side of the identity shows components
of demand; while the right-hand side‟s shows the
allocation of income.
o To see the relation between saving & investment,
identity (3) can be rewritten as:
I = Y-C = S …………………………….(4) 2

12/1/2015
 SAVING & INVESTMENT- OPEN ECONOMY – WITH GOVERNMENT
& FOREIGN TRADE
 Now consider an economy with government sector,
where:
 Gov‟t purchase is denoted by „G‟,
 Gov‟t tax receipt is denoted by „TA‟,
 Gov‟t Net Trasfer by „TR‟
 Net Expert = Export-Import = NX
o Now, we can write identity (1) above as:
Y = C + I + G + NX………………………….(5)
o Note that part of income spent on tax & the private
sector receives net transfer(TR), in additional to
national income, Disposal Income(YD) is thus equal to
income plus transfer less tax
YD = Y + TR –TA ……………..…………...(6) 3

12/1/2015
SAVING & INVESTMENT- OPEN ECONOMY – WITH GOVERNMENT &
FOREIGN TRADE
 Disposal income in-turn is allocated to:
YD = C + S …………………………..(7)
 Combining (6) and (7), we have:
C +S = YD = Y +TR-TA ……………..(8a)
or
C = YD-S = Y + TR-TA-S …………..(8b)
 Substituting the right hand side of (8b) into (5) and rearranging,
we get:
S-I = (G +TR-TA) + NX …………………(9)
 The right hand side expression( G +TR-TA) is gov’t budget deficit,

 Identity (9) shows that excess of saving over investment(S-I) of

private sector is equal to the government budget deficit plus
trade surplus.

12/1/2015
 1. THE AGGREGATE DEMAND (AD) ANALYSIS

Mankiw, Chapters 10~12

Blanchard and Johnson, Chapters 5, 7~8 12/1/2015
THE MODEL OF AGGREGATE DEMAND(AD)

 Is the paradigm most mainstream economists and

policymakers use to think about economic fluctuations
and policies to stabilize the economy

 Shows how the price level and aggregate output are

determined,

 Shows how the economy’s behavior is different in the

short run and long run 6

12/1/2015
AGGREGATE DEMAND

 The aggregate demand curve shows the

relationship between the price level and the
quantity of output demanded.

 For our introductory analysis of AD model, we

use a simple theory of aggregate demand based
on the quantity theory of money.

12/1/2015
THE QUANTITY EQUATION AS AGGREGATE DEMAND
 An aggregate demand curve shows the relationship
between the price level and the quantity of output
demanded,
 For our introductory analysis of AD model, we use a simple
theory of aggregate demand based on the quantity theory
of money , which is given as:
MV = PY (quantity equation)

 Quantity theory of money (QTM) states that the general price

level of goods and services is directly proportional to the amount of
money in circulation, or money supply,

 For given values of M and V, this equation implies an

inverse relationship between P and Y, 8

12/1/2015
THE DOWNWARD-SLOPING AD CURVE

P
An increase in the
price level causes
a fall in real
money balances
(M/P ),
causing a
decrease in the
demand for goods AD
& services.
Y
The demand for output is proportional to real money balances9
according to the simple money demand function implied by the
quantity theory of money. 12/1/2015
SHIFTING THE AD CURVE

P
An increase in the
money supply
shifts the AD
curve to the right.

AD2
AD1
Y
With velocity of money fixed, the quantity equation implies that PY is
determined by M., 10
 An increase in M causes an increase in PY, which means :
o higher Y for each value of P, or
o higher P for each value of Y. 12/1/2015
AGGREGATE SUPPLY IN THE LONG RUN

 In the long run, output is determined by factor

supplies and technology
Y  F (K , L )
 Output
Y is the full-employment or natural
level of output (“potential GDP” ), at
which the economy’s resources are
fully employed.

NB: “Full employment” means that

unemployment equals its natural rate (not zero). 11

12/1/2015
THE LONG-RUN AGGREGATE SUPPLY CURVE
P LRAS
Y does not
depend on P,
so LRAS is
vertical.

Y
Y
 F (K , L ) 12

12/1/2015
LONG-RUN EFFECTS OF AN INCREASE IN M

P LRAS
An increase
in M shifts
AD to the
right.
In the long P2
run, this raises
the price P1 AD2
level… AD1

…but leaves Y
output the
Y
13
same.
12/1/2015
AGGREGATE SUPPLY IN THE SHORT RUN

 Many prices are sticky in the short run.

 For now, we assume
 all prices are stuck at a predetermined level in the short
run.
 firms are willing to sell as much at that price level as their
customers are willing to buy.
 Therefore, the short-run aggregate supply (SRAS)
curve is horizontal:

14

12/1/2015
 THE SHORT-RUN AGGREGATE SUPPLY CURVE

P
The SRAS
curve is
horizontal:
The price level
is fixed at a
predetermined SRAS
P
level, and firms
sell as much as
buyers
demand. Y
15

12/1/2015
SHORT-RUN EFFECTS OF AN INCREASE IN M
ON AGGREGATE DEMAND

In the short P
…an increase
run when in aggregate
prices are demand…
sticky,…

SRAS
P
AD2
AD1
Y
…causes Y1 Y2
output to rise. 16

12/1/2015
FROM THE SHORT RUN TO THE LONG RUN

Over time, prices gradually become “unstuck.”

When they do, will they rise or fall?

In the short-run then over time,

equilibrium, if P will…
Y Y rise
Y Y fall

Y Y remain constant

NB: The adjustment of prices is what moves

the economy to its long-run equilibrium. 17

12/1/2015
 THE SR & LR EFFECTS OF M > 0

A = initial P LRAS
equilibrium

B = new short-run
equilibrium P2 C
after Central B SRAS
Bank/National P A AD2
Bank/
AD1
increases M
Y
C = long-run Y Y2
equilibrium 18

12/1/2015
 Long run:
 prices flexible
 output determined by factors of production &
technology
 unemployment equals its natural rate

 Short run:
 prices fixed
 output determined by aggregate demand
 unemployment negatively related to output

19

12/1/2015
 THE KEYNESIAN CROSS - ASSUME CLOSED ECONOMY
 A simple closed-economy model in which income is determined by expenditure.
(due to J. M. Keynes)
 Actual expenditure-is the amount households, firms and the gov’t spend on goods
& services; which is equal to economies gross output(GDP)

 Planned expenditure- is the amount households, firms and the gov’t would like to
spend on goods and services

 Notation:
PE = C + I + G = planned expenditure; where C = c(Y-T)
(assume gov‟t purchase and Tax is fixed)
Y = real GDP = actual expenditure
I = planned investment (assume it is exogenously fixed;

 Difference between actual & planned expenditure = unplanned inventory

investment.
 This happen b/s firms may engage in unplanned inventory investment as their
sales may not meet their expectation

 When sales less than product their planned stock of inventory rise; and when
they sales is more than planned, their inventory stock drop.
20

12/1/2015
ELEMENTS OF THE KEYNESIAN CROSS

consumption function: C  C (Y T )
govt policy variables: G  G , T T
for now, planned
investment is exogenous: I I

planned expenditure: PE  C (Y T )  I  G

equilibrium condition:
actual expenditure = planned expenditure
Y  PE 21

12/1/2015
GRAPHING PLANNED EXPENDITURE

PE
planned
expenditure
PE =C +I +G

MPC
1

income, output, Y

22

12/1/2015
GRAPHING THE EQUILIBRIUM CONDITION

PE
planned PE =Y
expenditure

No unplanned Inventory
Investment, or no shortage
or excess inventory
investment

45º

income, output, Y

23

12/1/2015
THE EQUILIBRIUM VALUE OF INCOME

PE
planned PE =Y
expenditure
PE =C +I +G

income, output, Y
Equilibrium
income 24

12/1/2015
FISCAL POLICY AND MULTIPLIER EFFECT-AN
INCREASE IN GOVERNMENT PURCHASES( G)

PE
At Y1, PE =C +I +G2
there is now an
unplanned drop PE =C +I +G1
in inventory…

G
…so firms
increase output,
and income Y
rises toward a
new equilibrium. PE1 = Y1 Y PE2 = Y2
25

12/1/2015
FISCAL POLICY AND MULTIPLIER EFFECT-AN INCREASE
IN GOVERNMENT PURCHASES…(COND.)

SOLVING FOR Y
Y  C  I  G equilibrium condition

Y  C  I  G in changes

 C  G because I exogenous

 MPC  Y  G because C = MPC Y,

assume T = 0)
Collect terms with Y Solve for Y :
on the left side of the
equals sign:  1 
Y     G
(1  MPC)Y  G  1  MPC 
26

12/1/2015
FISCAL POLICY AND MULTIPLIER EFFECT-GOVERNMENT
PURCHASE MULTIPLIER

Definition: the increase in income resulting

from a $1 increase in G.
In this model, the govt
Y 1
purchases multiplier equals 
G 1  MPC

Example: If MPC = 0.8, then

Y 1 An increase in G
  5 causes income to
G 1  0.8
increase 5 times
as much! 27

12/1/2015
FISCAL POLICY AND MULTIPLIER EFFECT-GOVERNMENT
PURCHASE MULTIPLIER

WHY THE MULTIPLIER IS GREATER THAN 1?

 Initially, the increase in G causes an equal

increase in Y: Y = G.

 But Y  C
 further Y
 further C
 further Y

 So the final impact on income is much bigger

than the initial G. 28

12/1/2015
FISCAL POLICY AND MULTIPLIER EFFECT- AN
INCREASE IN TAXES

PE
Initially, the tax
increase reduces PE =C1 +I +G
consumption and PE =C2 +I +G
therefore PE:

C = MPC T At Y1, there is now

an unplanned
inventory buildup…
…so firms
reduce output,
and income falls Y
toward a new
PE2 = Y2 Y PE1 = Y1
equilibrium 29

12/1/2015
FISCAL POLICY AND MULTIPLIER EFFECT- AN
INCREASE IN TAXES…COND.

SOLVING FOR Y
eq’m condition in
Y  C  I  G
changes
 C I and G exogenous

 MPC   Y  T 
Solving for Y : (1  MPC)Y   MPC  T

  MPC 
Final result: Y     T
 1  MPC 
30

12/1/2015
FISCAL POLICY AND MULTIPLIER EFFECT- TAX
MULTIPLIER

def: the change in income resulting from

a $1 increase in T :
Y  MPC

T 1  MPC

If MPC = 0.8, then the tax multiplier equals

Y  0.8  0.8
   4
T 1  0.8 0.2
31

12/1/2015
FISCAL POLICY AND MULTIPLIER EFFECT- TAX
MULTIPLIER

…is negative:
A tax increase reduces C, which reduces income.
…is greater than one (in absolute value):
A change in taxes has a multiplier effect on
income.
…is smaller than the govt spending multiplier:
Consumers save the fraction (1 – MPC) of a tax
cut,
so the initial boost in spending from a tax cut is
smaller than from an equal increase in G.

32

12/1/2015
PRACTICE WITH THE KEYNESIAN CROSS

Use a graph of the Keynesian cross

to show the effects of an increase in
planned investment(I) on the
equilibrium level of income/output.

33

12/1/2015 33
PRACTICE WITH THE KEYNESIAN CROSS

PE
At Y1, PE =C +I2 +G
there is now an
unplanned drop PE =C +I1 +G
in inventory…

I
…so firms
increase output,
and income Y
rises toward a
new equilibrium. PE1 = Y1 Y PE2 = Y2 34

34
12/1/2015
THE IS CURVE

def: a graph of all combinations of r and Y that

result in goods market equilibrium
i.e. actual expenditure (output)
= planned expenditure
The equation for the IS curve is:

Y  C (Y T )  I (r )  G

35

12/1/2015
DERIVING THE IS CURVE -FROM KEYNESIAL CROSS

PE PE =Y PE =C +I (r )+G
2

r  I PE =C +I (r1 )+G

 PE I

 Y Y1 Y2 Y
r
r1

r2
IS
Y1 Y2 Y
36

12/1/2015
WHY THE IS CURVE IS NEGATIVELY SLOPED ?

A fall in the interest rate motivates firms

to increase investment spending, which
drives up total planned spending (PE ).

 To restore equilibrium in the goods

market, output (a.k.a. actual expenditure,
Y ) must increase.

37

12/1/2015
HOW FISCAL POLICY SHIFTS IS CURVE ?

 We can use the IS-LM model to see how

fiscal policy (G and T ) affects
aggregate demand and output.

 Let‟sstart by using the Keynesian cross

to see how fiscal policy shifts the IS
curve…

39
SHIFTING THE IS CURVE: G

PE PE =Y PE =C +I (r )+G
At any value of r, 1 2

G  PE  Y PE =C +I (r1 )+G1

…so the IS curve
shifts to the right.

The horizontal Y1 Y2 Y
r
distance of the
IS shift equals r1

1
Y  G Y
1 MPC IS1 IS2
Y1 Y2 Y
40

12/1/2015
SHIFTING THE IS CURVE: T

Use the diagram of the Keynesian

cross or loanable funds model to
show how an increase in taxes shifts
the IS curve.

Ifyou can, determine the size of the

shift.
41

12/1/2015 41
SHIFTING THE IS CURVE: T

PE =Y PE =C +I (r )+G

12/1/2015
At any value of r, PE 1 1

T  C  PE PE =C2 +I (r1 )+G

…so the IS curve
shifts to the left.

Y2 Y1 Y
The horizontal r
distance of the r1
IS shift equals
MPC Y
Y  T
1 MPC IS2 IS1
42
Y2 Y1 Y
42
MONEY MARKET AND THE LM CURVE

THE THEORY OF LIQUIDITY PREFERENCE

 Due to John Maynard Keynes.

 A simple theory in which the interest rate is

determined by money supply and money
demand.

43

12/1/2015
MONEY SUPPLY
r
M P
s
The supply of interest
real money rate
balances
is fixed:

M P M P
s

M/P
M P real money
balances
44

12/1/2015
 MONEY DEMAND
r
M P
s
Demand for interest
real money rate
balances:

M P
d
 L (r )

L (r )
We are assuming the price level M/P
is fixed, so  = 0 and r = i. M P real money
balances
45

12/1/2015
EQUILIBRIUM
r
The interest interest M P
s

rate adjusts rate

to equate the
supply and
demand for
money: r1

M P  L (r ) L (r )

M/P
M P real money
balances
46

12/1/2015
HOW THE CENTRAL BANK RAISES THE INTEREST RATE ?

r
interest
To increase r, rate
Central
Bank/National
Bank/ reduces M
r2

r1
L (r )

M/P
M2 M1 real money
P P balances
47

12/1/2015
THE LM CURVE

Now let‟s put Y back into the money demand

function:
M P
d
 L (r ,Y )
The LM curve is a graph of all combinations
of r and Y that equate the supply and
demand for real money balances.
The equation for the LM curve is:
M P  L (r ,Y )
48

12/1/2015
DERIVING THE LM CURVE

(a) The market for

(b) The LM curve
real money balances
r r
LM

r2 r2

L (r , Y2 )
r1 r1
L (r , Y1 )
M1 M/P Y1 Y2 Y
P 49

12/1/2015
WHY THE LM CURVE IS UPWARD SLOPING ?

 An increase in income raises money demand.

 Since the supply of real balances is fixed, there is

now excess demand in the money market at the
initial interest rate.

 The interest rate must rise to restore equilibrium

in the money market.

50

12/1/2015
HOW M SHIFTS THE LM CURVE-REDUCTION IN
MONEY SUPPLY (ASSUMING CONSTANT PRICE)

(a) The market for

(b) The LM curve
real money balances
r r
LM2

LM1
r2 r2

r1 r1
L ( r , Y1 )

M2 M1 M/P Y1 Y
P P 51

12/1/2015
SHIFTING THE LM CURVE

 Suppose a wave of credit card fraud causes consumers

to use cash more frequently in transactions.

 Use the liquidity preference model to show how these

events shift the LM curve.

52

12/1/2015 52
SHIFTING THE LM CURVE

(a) The market for

(b) The LM curve
real money balances
r r
LM2

LM1
r2 r2
L ( r , Y2 )
r1 r1
L (r , Y1 )

M1 M/P Y1 Y53
P
12/1/2015 53
THE SHORT-RUN EQUILIBRIUM

The short-run equilibrium is r

the combination of r and Y
LM
that simultaneously
satisfies the equilibrium
conditions in the goods &
money markets:
IS
Y  C (Y T )  I (r )  G
Y
M P  L (r ,Y ) Equilibrium
Equilibrium
interest
rate level of
income 54

12/1/2015
 THE BIG PICTURE

Keynesian IS
cross curve
IS-LM
model Explanation
Theory of LM of short-run
liquidity curve fluctuations
preference
Agg.
demand
curve Model of
Agg.
Demand
Agg.
and Agg.
supply
Supply
curve
55

12/1/2015
 SUMMARY
1. Long run: prices are flexible, output and employment
are always at their natural rates, and the classical
theory applies.
Short run: prices are sticky, shocks can push output
and employment away from their natural rates.
2. Aggregate demand and supply:
a framework to analyze economic fluctuations

56

12/1/2015 56
 SUMMARY
3. The aggregate demand curve slopes downward.
4. The long-run aggregate supply curve is vertical,
because output depends on technology and factor
supplies, but not prices.
5. The short-run aggregate supply curve is horizontal,
because prices are sticky at predetermined levels.

57

57
12/1/2015
 SUMMARY
6. Keynesian cross
 basic model of income determination
 takes fiscal policy & investment as exogenous
 fiscal policy has a multiplier effect on income

7. IS curve
 comes from Keynesian cross when planned
investment depends negatively on interest rate
 shows all combinations of r and Y
that equate planned expenditure with
actual expenditure on goods & services 58

58
12/1/2015
 SUMMARY
8. Theory of liquidity preference
 basic model of interest rate determination
 takes money supply & price level as exogenous
 an increase in the money supply lowers the
interest rate
9. LM curve
 comes from liquidity preference theory when
money demand depends positively on income
 shows all combinations of r and Y that equate
demand for real money balances with supply
59

12/1/2015 59
 SUMMARY
10. IS-LM model
 Intersection of IS and LM curves shows the
unique point (Y, r ) that satisfies equilibrium in
both the goods and money markets.

60

12/1/2015 60
2. THE AGGREGATE DEMAND AND
AGGREGATE SUPPLY

61

Mankiw, Chapters 10~12

Blanchard and Johnson, Chapters 5, 7~8 12/1/2015
EQUILIBRIUM IN THE IS -LM MODEL

The IS curve represents

r
equilibrium in the goods
market.
LM

Y  C (Y  T )  I (r )  G
r1
The LM curve represents
money market equilibrium.
M P  L (r ,Y ) IS
Y
The intersection determines Y1
the unique combination of Y and r
that satisfies equilibrium in both markets. 62
POLICY ANALYSIS WITH THE IS -LM MODEL

Y  C (Y  T )  I (r )  G r
LM
M P  L (r ,Y )

We can use the IS-LM

model to analyze the r1
effects of
•fiscal policy: G and/or T IS
•monetary policy: M Y
Y1

63

12/1/2015
AN INCREASE IN GOVERNMENT PURCHASES
1. IS curve shifts right
1 r
by G LM
1  MPC
causing output & r2
income to rise. 2.
r1
2. This raises money
demand, causing the 1. IS2
interest rate to IS1
rise… Y
Y1 Y2
3. …which reduces
3.
investment, so the final
increase in Y 64
1
is smaller than G
1  MPC 12/1/2015
CHANGE IN TAX (TAX CUT)
Consumers save r
(1MPC) of the tax cut, LM
so the initial boost in
spending is smaller for
T than for an equal r2
2.
G… r1
and the IS curve shifts 1. IS2
by 1. MPC IS1
T
1  MPC Y
Y1 Y2
…so the effects on r 2.
2
and Y are smaller
for T than for an 65

equal G. 12/1/2015

MONETARY POLICY: AN INCREASE IN M

1. M > 0 shifts r
LM1
the LM curve down
(or to the right) LM2

2. …causing the r1
interest rate to fall r2

3. …which increases IS
investment, Y
Y1 Y2
causing output &
income to rise.
66

12/1/2015
INTERACTION BETWEEN MONETARY & FISCAL POLICY

 Model:
 Monetary & fiscal policy variables (M, G, and T ) are
exogenous.

 Real world:
 Monetary policymakers may adjust M in response to
changes in fiscal policy,
or vice versa.

 Such interactions may alter the impact of the original

policy change.

67

12/1/2015
THE CENTRAL BANK RESPONSE TO G > 0
 Suppose gov‟t increases G.
 Possible Central Bank/National Bank/ responses:
1. hold M constant
2. hold r constant
3. hold Y constant
 In each case, the effects of the G are different…

68

12/1/2015
RESPONSE 1: HOLD M CONSTANT

If government raises r

G, the IS curve shifts LM1
right.

If central r2
bank/national bank/ r1
holds M constant, then
IS2
LM curve doesn‟t shift.
IS1
Results: Y
Y1 Y2
Y  Y 2  Y1
69
r  r2  r1
12/1/2015
RESPONSE 2: HOLD R CONSTANT

If government raises r

G, the IS curve shifts LM1
right. LM2

To keep r constant, r2

Fed increases M r1
to shift LM curve IS2
right. IS1
Results: Y
Y1 Y2 Y3
Y  Y 3  Y1
r  0
70

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 RESPONSE 3: HOLD Y CONSTANT

If government raises G, r LM2

the IS curve shifts right. LM1

r3
To keep Y constant, Fed r2
reduces M to shift LM r1
curve left.
IS2
IS1
Results:
Y
Y1 Y2
Y  0
r  r3  r1 71

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SHOCKS IN THE IS -LM MODEL

IS shocks: exogenous changes in the

demand for goods & services.
Examples:
 stock market boom or crash
 change in households‟ wealth
 C
 change in business or consumer
confidence or expectations
 I and/or C
72

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SHOCKS IN THE IS -LM MODEL
LM shocks: exogenous changes in the
demand for money.
Examples:

 A wave of credit card fraud increases

demand for money.
 More ATMs or the Internet reduce
money demand.

73

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 ANALYZE SHOCKS WITH THE IS-LM MODEL

Use the IS-LM model to analyze the effects of

1. a housing market crash that reduces consumers‟
wealth
2. consumers using cash in transactions more
frequently in response to an increase in identity
theft
For each shock,
a. use the IS-LM diagram to determine the effects
on Y and r.
b. figure out what happens to C, I, and the
74
unemployment rate.
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HOUSING MARKET CRASH

IS shifts left, causing

r and Y to fall. r
LM1
C falls due to lower
wealth and lower r1
income,
r2
I rises because
r is lower IS1
IS2
u rises because Y
Y2 Y1
Y is lower 75

(Okun’s law)
75
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INCREASE IN MONEY DEMAND

LM shifts left, causing

LM2
r to rise and Y to fall. r
LM1
C falls due to lower r2
income, r1
I falls because
r is higher
IS1
u rises because
Y
Y is lower Y2 Y1
(Okun’s law) 76

76
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IS-LM AND AGGREGATE DEMAND

 So far, we‟ve been using the IS-LM model to

analyze the short run, when the price level
is assumed fixed.
 However, a change in P would shift LM and
therefore affect Y.
 Theaggregate demand curve
captures this relationship between P and Y.

77

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DERIVING THE AD CURVE
r LM(P2)
Intuition for slope LM(P1)
r2
of AD curve:
r1
P  (M/P )
IS
 LM shifts left Y2 Y1 Y
P
 r
P2
 I
P1
 Y
AD
Y2 Y1 Y 78

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MONETARY POLICY AND THE AD CURVE

r LM(M1/P1)
The Central bank can
r1 LM(M2/P1)
increase aggregate
demand: r2

M  LM shifts right IS
Y1 Y2 Y
 r P

 I P1
 Y at each AD2
value of P AD1
Y1 Y2 Y 79

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FISCAL POLICY AND THE AD CURVE

Expansionary fiscal
r
policy (G and/or T ) LM
increases aggregate r2
demand: r1 IS2
T  C IS1
 Fiscal expansion Y1 Y2 Y
P
shift IS curve right
 Y at any given P1
value of P AD2
AD1
Y1 Y2 Y 80

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IS-LM AND AD-AS IN THE SHORT RUN & LONG RUN

The force that moves the economy from the

short run to the long run is the gradual
adjustment of prices.

In the short-run then over time, the

equilibrium, if price level will
Y Y rise
Y Y fall

Y Y remain constant
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THE SR & LR EFFECTS OF AN IS SHOCK
r LRAS LM(P )
1
A negative IS shock
shifts IS and AD left,
causing Y to fall.
IS1
IS2
Y Y
P LRAS
P1 SRAS1

AD1
AD2
Y Y 82
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THE SR AND LR EFFECTS OF AN IS SHOCK

r LRAS LM(P )
1

In the new short-

run equilibrium, IS1
IS2
Y Y Y Y
P LRAS
P1 SRAS1

AD1
AD2
Y Y 83
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THE SR AND LR EFFECTS OF AN IS SHOCK
r LRAS LM(P )
In the new short- 1

run equilibrium,

Y Y IS1
IS2
Y Y
Over time, P gradually
falls, causing: P LRAS
•SRAS to move down P1 SRAS1

•M/P to increase,
which causes LM AD1
AD2
to move down
Y Y 84
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THE SR AND LR EFFECTS OF AN IS SHOCK

r LRAS LM(P )
1
LM(P2)

IS1
IS2
Y Y
Over time, P gradually
falls, causing: P LRAS
•SRAS to move down P1 SRAS1

•M/P to increase, P2 SRAS2

which causes LM AD1
to move down AD2
Y Y 85
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THE SR AND LR EFFECTS OF AN IS SHOCK

r LRAS LM(P )
1
LM(P2)

This process continues IS1

until economy reaches a IS2
long-run equilibrium Y
Y
with Y Y P LRAS
P1 SRAS1

P2 SRAS2
AD1
AD2
Y Y 86
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 ANALYZE SR & LR EFFECTS OF M

a. Draw the IS-LM and AD-AS r LRAS LM(M /P )

1 1
diagrams as shown here.
b. Suppose NB /CB/increases
M. Show the short-run IS
effects on your graphs.
c. Show what happens in the Y Y
transition from the short run P LRAS
to the long run.
d. How do the new long-run SRAS1
P1
equilibrium values of the
endogenous variables
AD1
compare to their initial 87

values? Y Y
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87
SHORT-RUN EFFECTS OF M

LM and AD shift right. r LRAS LM(M /P )

1 1

r1 LM(M2/P1)
r2
r falls, Y rises above Y
IS

Y Y2 Y
P LRAS

P1 SRAS
AD2
AD1 88
Y Y2 Y
88
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TRANSITION FROM SHORT RUN TO LONG RUN

Over time, r LRAS LM(M /P )

1
2 1
3

 P rises r3 = r1 LM(M2/P1)

 SRAS moves upward r2

IS
 M/P falls
 LM moves leftward Y2 Y
Y
P LRAS
New long-run equilibrium P3 SRAS
 P higher P1 SRAS
 all real variables back at AD2
their initial values AD1 89
Money is neutral in the long run. Y Y2 Y
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89
 SUMMARY
1. IS-LM model
 a theory of aggregate demand
 exogenous: M, G, T,
P exogenous in short run, Y in long run
 endogenous: r,
Y endogenous in short run, P in long run
 IS curve: goods market equilibrium
 LM curve: money market equilibrium
95

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 SUMMARY
2. AD curve
 shows relation between P and the IS-LM model‟s
equilibrium Y.
 negative slope because
P  (M/P )  r  I  Y
 expansionary fiscal policy shifts IS curve right,
raises income, and shifts AD curve right.
 expansionary monetary policy shifts LM curve
right, raises income, and shifts AD curve right.
 IS or LM shocks shift the AD curve. 96

91
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