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The Aggregate Model of The Macro Economy
The Aggregate Model of The Macro Economy
of the Macro
Economy
Lesson 14
The IS-LM Framework
The IS curve
shows an inverse relationship
between equilibrium levels of the
interest rate and real income
IS: Y = f (r, TP, CC, W, CR, D, TB,
PR, CU, G, Y*, R)
The IS-LM Framework
The LM curve
There is a positive relationship between
the interest rate and real income that
achieves equilibrium in the money
market.
This positive relationship results in an
upward sloping LM curve.
Changes in Fed policies or price level
cause the LM curve to shift
LM: r = f (Y, MS, P)
Assume that at a level of
national income, Y1,
the demand for money is L'
Rate of interest
Rate of interest
L'
O O Y1
Money National income
fig
Assume that at a level of
national income, Y1,
the demand for money is L'
MS
Rate of interest
Rate of interest
L'
O O Y1
Money National income
fig
MS
Rate of interest
Rate of interest
r1 r1
L'
O O Y1
Money National income
fig
MS
Rate of interest
Rate of interest
r1 r1
c
L'
O O Y1
Money National income
fig
Now assume that at the higher
level of national income, Y2,
the demand for money rises to L"
MS
Rate of interest
Rate of interest
r1 r1
c
L"
L'
O O Y1 Y2
Money National income
fig
Now assume that at the higher
level of national income, Y2,
the demand for money rises to L"
MS
Rate of interest
Rate of interest
r2 r2
r1 r1
c
L"
L'
O O Y1 Y2
Money National income
fig
MS
Rate of interest
Rate of interest
d
r2 r2
r1 r1
c
L"
L'
O O Y1 Y2
Money National income
fig
MS LM
Rate of interest
Rate of interest
d
r2 r2
r1 r1
c
L"
L'
O O Y1 Y2
Money National income
fig
MS LM
Rate of interest
Rate of interest
d
r2 r2
r1 r1
c
L"
L'
O O Y1 Y2
Money National income
fig
Shifts in the IS Curve
Changes in any variable in the
previous equation
– causes IS curve to shift outward or inward,
– resulting in new equilibrium levels of
income
Variables include fiscal policy tools,
consumer confidence, wealth, credit
and debt, expectations, and business
profits
Equilibrium in both the goods and
money markets LM
Rate of interest
IS
O
fig
National income
Equilibrium in both the goods and
money markets LM
But at r1, national income
is below the goods market
equilibrium level (Y2)
Rate of interest
a b
r1
IS
O Y1 Y2
fig
National income
Equilibrium in both the goods and
money But as income rises, so there
markets
will be a movement up the
LM
LM curve. The interest rate
will rise, thereby reducing
national income below Y2.
Rate of interest
a b
r1
IS
O Y1 Y2
fig
National income
Equilibrium in both the goods and
money markets LM
Rate of interest
re
IS
O Ye
fig
National income
IS Curve Shifts
The IS-LM framework allows for
examination of all variable
changes influencing aggregate
expenditure
Increase in autonomous spending
shifts IS curve out to right while
decrease in autonomous spending
shifts it back to the left
LM
Rate of interest
r1
IS
O Y1
fig
National income
LM
Expansionary
fiscal policy
Rate of interest
r2
r1
IS2
IS1
O Y1 Y2
fig
National income
Shifts in the LM Curve
Changes in any variable in the
previous equation …
– causes LM curve to shift outward or
inward,
– resulting in new equilibrium levels of
income
Variables include
LM
Rate of interest
r1
IS
O Y1
fig
National income
LM1 LM2
Expansionary
monetary policy
Rate of interest
r1
r3
IS
O Y1 Y3
fig
National income
Fiscal and Monetary
Policy
Implementation
Fiscal policies are made by the
President, the administration, and
Congress
– making it a slow process
Automatic stabilizers:
– Boost economy during recession
– Slow down economy during high activity
– Unemployment compensation and welfare
payments are nondiscretionary
expenditures
Non-discretionary expenditures:
– Increase or decrease as a result of
individuals eligible for spending programs
Fiscal and Monetary
Policy
Implementation
Discretionary expenditures:
– program funds authorized and
appropriated where specific
decisions are made on the size of
the programs
Progressive tax system:
– higher tax rates are applied to
increased amounts of income
Monetary Policy
More precise than fiscal policy
– Focuses on federal funds with
assumption that long-term rates will
have similar effects
– May be outdated by other changes in
economy
– No distinct correlation between prime
rates and other rates on business
loans
Interaction of Monetary
and
Fiscal Policy
either from expansionary
fiscal policy or other
autonomous spending change
– Results in shift of the IS curve
Final level of income and the
interest rate
– Determined by the Fed following the
spending increase
ISLM analysis of fiscal and monetary
policy LM
Rate of interest
r1
IS
O Y1
fig
National income
ISLM analysis of fiscal and monetary
policy LM1 LM2
Expansionary
fiscal and
monetary policy
Rate of interest
r1
IS2
IS1
O Y1 Y4
fig
National income
Aggregate Demand Curve
Shows alternative combinations
of P and Y …
– that result in equilibrium in both real
goods and money markets
– Summarizes the IS-LM analysis
– Does not show where the economy
will actually operate
– Gives total amounts of real GDP
demanded by all sectors
Shifting the Aggregate
Demand Curve
Monetary policy:
– shift of the LM curve
Fiscal policy:
– shift of the IS curve
Other autonomous spending
increases:
– shift of the IS curve
Aggregate Supply Curve
Aggregate supply curve:
– shows price level at which firms in
economy are willing to produce
different levels of real goods and
services and resulting level of real
income
AS
Price level
O
fig
National output
Aggregate Production
Aggregate production function:
– shows quantity and quality of resources
used in production
Incorporates information on:
– Quantity and quality of resources used in
production
– Efficiency with which resources are used
– Production technology existing at any
point in time
Aggregate Supply Curve
Potential output:
– maximum amount of real goods and
services and real income that can be
produced any time based on
aggregate production function
Aggregate Production
Aggregate production function:
– shows quantity and quality of resources
used in production
Incorporates information on:
– Quantity and quality of resources used in
production
– Efficiency with which resources are used
– Production technology existing at any
point in time
Aggregate Supply Curve
Potential output:
– maximum amount of real goods and
services and real income that can be
produced any time based on
aggregate production function
Aggregate Supply Curve
Short-run AS:
P = f (Yf, Resource costs)
O
fig
National output
Long-run Aggregate
Supply
Curve
Long-run AS:
Yf = f (P, Resources, Efficiency,
Technology)
This equation implies that the long-run
aggregate supply curve is vertical and
not influenced by price level
Can be shifted right or left over time by
changes in resources
AD-AS Equilibrium
Aggregate demand-aggregate
supply equilibrium:
– level of real income and price level
that occurs at intersection of
aggregate demand and supply
curves
AD-AS Equilibrium
AD1
O Y1
fig
National output
AS
Price level
AD1 AD2
O Y1 Y2
fig
National output
AS
Price level
AD3
AD1 AD2
O Y1 Y2 Y3
fig
National output
AS
Price level
AD4
AD3
AD1 AD2
O Y1 Y2 Y3 Y4
fig
National output
AS
Price level
AD4
AD3
AD1 AD2
O Y1 Y2 Y3 Y4 YP
fig
National output
Shifting Aggregate Supply
Shifts in short-run aggregate supply
– Curve will shift from productivity
changes
– Changes in costs of output
independent of overall demand
changes
– Changes would be widespread
throughout economy
Shifting Aggregate Supply
Stagflation:
Combination of higher price level and
increases in price and lower real output
and income
Policy makers need to use contractionary
monetary or fiscal policy
However, this measure results in lower
level of real income and output
It also shifts aggregate demand curve to
right,
– Resulting in higher price level and possible
inflation
Shifting Aggregate Supply
Shifts in long-run aggregate supply
– Can shift over time if inputs increase
– Increases in labor, land, capital, and
raw materials are favorable to the
economy
– Increases in long-run aggregate supply
can assist the Fed in reaching policy
goals
Changes in Aggregate
Demand and Supply
Leading indicators:
– Economic variables that generally
turn down before a recession begins
and turn back up before the
recovery starts
– such as manufacturing,
employment, monetary, and
consumer expectation statistics
Changes in Aggregate
Demand and Supply
Coincident indicators:
– Variables that tend to move with the
overall phases of the business cycle
– include employment, income, and
business production
Changes in Aggregate
Demand and Supply
Lagging indicators:
Variables that turn down after the
beginning of a recession and turn
up after a recovery has begun.
include measures of inflation,
unemployment, labor costs, and
consumer and business debt and
credit levels
Managerial Rule of
Thumb:
Judging Trends in Indicators
Managers need to