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NOTES 9: Putting The Economy Together - IS/LM: Let's Start at The Beginning
NOTES 9: Putting The Economy Together - IS/LM: Let's Start at The Beginning
The purpose of these notes is to review all the markets, and components of those markets,
that we have looked at so far. This set of notes - in my opinion - are the most important
notes that you will have all quarter. It is a review of the first 6-7 weeks of the class!
Lets start at the beginning:
I.
A review of the major curves and markets we have covered in our graphical
analysis:
A.
Labor Market:
Labor Demand (Nd): Affected by A and K. An increase in either A or K will shift
the labor demand curve to the right. Remember, the labor demand curve is just
the MPN.
Labor Supply (Ns): Affected by the PVLR, value of leisure, taxes and the labor
force participation rate. We have studied the labor supply in depth in the first part
of the course. If you have questions about these factors and how they shift the
labor supply curve, look at Notes 4 and the slides for Topic 2.
B.
We draw the goods demand curve in {Y, r} space because we are eventually going
to see how the money market (particularly, the Fed) affects output (Y).
That leads us to the money market and the LM curve:
Money Market Equilibrium (LM curve):
This curve summarizes
EVERYTHING that happens in the money market. This curve represents the
relationship between money supply and money demand. As discussed in Notes 8,
the Federal Reserve sets the money supply curve. Real money demand is a
function of Y and expected inflation. Household decisions affect the money
demand! The more stuff there is to buy, the higher your demand for money (as
opposed to keeping your earnings in bonds or stocks or home equity). Read
Notes 8 if you have questions. The real money supply is the money supply
deflated by the price level (M/P).
In the money market, if Y increases, the demand for money will increase (see
Notes 8). An increase in the demand for money will drive up real interest rates.
This generates a positive relationship between real interest rates and output. This
is the LM curve. In equilibrium, the IS curve which provides a relationship
between interest rates and output must coexist with the equilibrium in the money
market - the LM curve. Suppose interest rates fall IS curve says Investment will
increase which will increase output. However, the money market says that an
increase in income (output) will INCREASE interest rates. The IS LM curves
create a balance between the effects of changing interest rates on output in
the goods market (goods market is Y = C + I + G + NX) with the effects of
changing output on interest rates in the money market. There is one interest
rate (and consequently one level of output) where the two markets (the goods
market and the money market) are in balance: That interest rate is the rate where
the IS curve intersects the LM curve!
What shifts the LM curve?
Anything that affects the money market besides changes in output (remember,
changes in output is why the LM curve slopes upwards). An increase in the
money supply (real or nominal) will shift the LM curve to the right (increasing the
money supply will drive down interest rates in order for interest rates to stay the
same in the money market, Y will have to increase (increasing the demand for
money). Another way to say it - if money supply increases, output could increase
in the economy without having an effect on interest rates. This is why the curve
shifts to the right. An increase in prices will shift the LM curve (real money
balances fall driving up real interest rates - holding the nominal money supply
constant) to the left. An increase in expected inflation will also shift the LM
curve to the right!
What does equilibrium in the IS-LM market tell us?
Together the IS and LM curves summarize the demand side of the economy. It
tells us an interest rate which generates a certain amount of output (IS) and a
certain amount of output which sustains a given interest rate (LM). <<This last
sentence is subtle - think about it for a little while - this is the key to the IS-LM
market.>> The Fed, through its influence over the money supply, Congress and
the President, and through its influence on G and Taxes, can affect the equilibrium
level of output and interest rates in the economy!
Remember there is nothing new in this market!!!!! We have been talking
about the components of the IS curve for about 5 weeks. Dont be scared off
just use your intuition!
C.
The AS AD market
The Aggregate Demand Curve (AD) The aggregate demand is just another
representation of the IS curve. They are nearly the same. The IS curve is just the
definition, Y = C + I + G + NX: it separately interacts with the money market
(the LM curve). The AD curve is the summary of both the IS curve and the LM
curve (much the same as the LM curve represents both money supply and money
demand). The Aggregate Demand curve represents the whole demand side of
the economy (including both the money and goods market). You should not
think of the IS and AD curves as dramatically different curves!!!! They are
basically the same except changes in the money market will shift the AD curve
but they will not shift the IS curve (they will cause movements along the IS
curve).
So, if the AD curve is essentially the same as the IS curve, why do we need two
curves? The answer is simple they are not exactly the same curve the AD
curve summarizes both the IS and the LM curve in one graphical representation.
Also, the AD curve is drawn in {Y,P} space (the same as the aggregate supply
curves). The goods demand (IS) money market (LM) interaction tells us what
happens explicitly to interest rates. The AD curve (interacted with the AS) tells us
explicitly what happens to prices. They are two sides of the same coin. Interest
rates are set in the IS-LM market. Prices are set in the AD - AS market. If you
want to talk about prices or inflation, you need the AD-AS representation. If you
want to talk about interest rates, you need the IS-LM representation. We will talk
about both (although, many times, I will focus on the AS-AD market - this does
not mean that we should ignore the IS-LM market).
Why does the AD curve slope down? An increase in P reduces real money
balances, which in turn shifts the real money supply curve in and shifts the LM
curve to the left. The shift in of the LM curve drives up interest rates and causes a
move up the IS curve because the higher interest rates causes Investment and
Output to be lower. Thus, through both the interactions of the LM curve and the
IS curve, an increase in prices will lower output! That is the AD curve!!!!
What shifts the AD curve? Anything that shifts the IS curve to the right will
shift the AD curve to the right. Anything that shifts the LM curve to the right
(except a change in prices) will also shift the AD curve to the right. A change in P
does shift the LM curve, but only causes a movement along the AD curve (this is
by definition of the AD curve - it is drawn in {Y,P} space. Remember, the AD
curve is just a summary of the LM curve and the IS curve. Things to remember:
A change in prices will not shift the AD curve (it will cause a movement along
the AD curve) but it will cause a shift in the LM curve.
The AS curves:
Long Run Aggregate Supply: This is straight forward. Y* = f(A,K, N*).
If A, K, or N* change, Y* changes. N* is set in the labor market so,
basically, anything that affects the labor market affects N*. Note: By
definition, K is fixed in the long run. So, basically, only A or N* affect Y*
(the LRAS curve).
Short Run Aggregate Supply:
Here is how I think of the SRAS curve: Basically, anything that makes
production cheaper in the short run will shift the SRAS curve (more on
this in a second).
Why does the SRAS curve slope up?
If prices increase, real wages will fall (we assume nominal wages are fixed
in the short run). When there is an increase in demand, firms raise prices
(to maximize profits). Workers cannot have their wages adjusted because
they are under contract. Workers may like to have higher wages to offset
the higher prices firms are charging, but they cannot. As a result, real
wages fall in the short term and firms ask workers to work more (or higher
more workers at the prevailing contract wages). We discussed many
reasons for this disequilibrium in the labor market during Topic 2. This
has been a central component of the macroeconomic debates for the last
15-20 years. I am giving you one version of the story here (there are many
- we touched on a few more in class). We know we need something to
If we assume both P and W are fixed in the short run - the SRAS is
horizontal (prices are fixed regardless of the level of Y).
If we assume only W is fixed in the short run - then the SRAS
curve is upward sloping!!! We did this in depth in class - hopefully
you will understand this!
Basically, the SRAS results from disequilibrium (at least according to our
models) in the labor market!
I know some of you struggle with the concept of the labor market in the
short run. YOU CANNOT GRAPH the short run labor market (for
whatever reason, our analysis does not hold in the short run - perhaps due
to contracts or efficiency wages or other stories).
Here is all we know about the labor market:
1.
2.
3.
4.
2.
3.
4.
PVLR only changes when real wages change! (dont say that
PVLR change until real wages change). Just because Y goes up,
dont assume that PVLR changes (although it may we will talk
about this next week). For now, only assume that PVLR changes
when real wages change.
The AS-AD curve is our main graph of analysis. It links the Demand and
Supply sides of the economy. Prices (via their effect on interest rates)
cause demand and supply to be equated in both the short and the long run.
The IS-LM curve has NOTHING to do with the production side of the
economy. The IS-LM just represents the demand side: the goods market
and the money market. The goods market is Y = C + I + G + NX. The
money market is money supply and money demand. In the goods market,
interest rates affect Y (via investment). In the money market, Y affects
interest rates (via money demand - in particular, households desire for
money to transact). In the demand side of the economy there is both a
positive relationship between output and interest rates (the money market)
and a negative relationship between output and interest rates (the goods
market - i.e., Investment -Savings). Those two forces must offset each
other - hence the IS-LM analysis.
Why cant we use just the money market alone?
Think about it - if the Fed increases M, the real money supply will increase
(assuming no P effect). This will lower interest rates and spur investment. Higher
investment (all else equal) will lead to higher Y. Higher Y will increase money
demand and raise interest rates. Higher interest rates will lead to lower
investment and lower Y. We get circularity. To account for this relationship, we
need to draw the IS-LM curve. This graph accounts for BOTH effects at once.
Hence, we do not get any of the circularity described above. It solves for the one
{Y, r} pair that satisfies the money market and the goods market at the same time.
That is why we need the IS-LM curves.