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5. The IS-LM model
Abel, Bernanke and Croushore
(chapters 9.4, 9.5 and 9.6)
I. The IS-LM equilibrium
 Building blocks
 Negative relationship between r and Y that clears the
goods market (IS curve)
 Positive relationship between r and Y that clears the
money market (LM curve)
 There exists one single intersection point between the
IS and LM curves where both markets are in
equilibrium. Such equilibrium point belongs to the AD
curve.
 Prices are fixed in the short-run (Keynesian)
 Long-run equilibrium when Y=full-employment output
because the labor market also clears (general
equilibrium)
I. The IS-LM equilibrium (cont.)
 When all markets are simultaneously in
equilibrium there is a general equilibrium
 This occurs where the FE, IS, and LM curves
intersect
Check the sign of the
excess demand in the
outside areas from the
IS-LM curves
II. The Aggregate Demand (AD) curve
 1.
The AD curve shows the relationship between
the quantity of goods demanded and the price level
when the goods market and money market are in
equilibrium
 So the AD curve represents the price level and output
level at which the IS and LM curves intersect
 Negative relationship between P and Y. Rise in the
price level shifts the LM curve to the left, increases
the real interest rate and reduces both desired
consumption and desired investment. Output falls as
producers reduce their production to eliminate the
excess supply (see Figure in next slide)
 Make proposed problem on computation of the AD
curve
II. The Aggregate Demand (AD) curve (cont.)
 2.


Factors that shift the AD curve
a. Any factor that causes the intersection of the IS
and LM curves to shift to the left causes the AD
curve to shift down and to the left; any factor
causing the IS-LM intersection to shift to the right
causes the AD curve to shift up and to the right
b. For example, a temporary increase in
government purchases shifts the IS curve up and
to the right, so it shifts the AD curve up and to the
right as well
 (see Figure in next slide)
II. The Aggregate Demand (AD) curve (cont.)
 Summary Table 14, page 340: Factors that shift the
AD curve


(1) Factors that shift the IS curve to the right and thus
the AD curve to the right as well
 (a)
Increases in future output (Yf), wealth,
government purchases (G), or the expected future
marginal productivity of capital (MPKf)
 (b)
Decreases in taxes (T) if Ricardian equivalence
doesn’t hold, or the effective tax rate on capital ()
(2) Factors that shift the LM curve to the right and thus
the AD curve to the right as well
 (a)
Increases in the nominal money supply (M) or in
expected inflation (e)
 (b)
Decreases in the nominal interest rate on money
(im) or the real demand for money
III. Short-run and long-run equilibria
 The Aggregate Supply (AS) curve
 1. The aggregate supply curve shows the
relationship between the price level and the
aggregate amount of output that firms supply
 2. In the short run, prices remain fixed, so
firms supply whatever output is demanded


a.The short-run aggregate supply curve (SRAS)
is horizontal
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
III. Short-run and long-run equilibria (cont.)
 Equilibrium in the AD-AS model
- AD obtained from IS-LM model
- AS under short-run
or long-run assumptions


1. Short-run equilibrium: AD intersects SRAS
2. Long-run equilibrium: AD intersects LRAS
 a. Also called general equilibrium
 b. AD, LRAS, and SRAS all intersect at same point
 c. If the economy isn’t in general equilibrium, economic
forces work to restore general equilibrium both in AD-AS
diagram and IS-LM diagram
III. Short-run and long-run equilibria (cont.)
 Application: Monetary neutrality in the AD-AS model






1. Suppose the economy begins in general equilibrium, but
then the money supply is increased by 10%
2. This shifts the AD curve upward by 10% (from AD1 to AD2)
because to maintain the aggregate quantity demanded at a
given level, the price level would have to rise by 10% so that
real money supply wouldn’t change and would remain equal
to real money demand
3. In the short run, with the price level fixed, equilibrium
occurs where AD2 intersects SRAS1, with a higher level of
output
4. Since output exceeds , over time firms raise prices and
the short-run aggregate supply curve shifts up to SRAS2,
restoring long-run equilibrium
5. The result is a higher price level—higher by 10%
6. Money is neutral in the long run, as output is unchanged
III. Short-run and long-run equilibria (cont.)


One supply-side application: An oil price shock.
This adverse supply shock increases marginal costs which reduces the marginal
productivity of labor, and shifts the labor demand curve to the left




There’s no effect of a temporary supply shock on the IS or LM curves
Since the new FE line, and the old IS, and LM curves don’t intersect, the price
level adjusts (Excess AD), shifting the LM curve until a general equilibrium is
reached



a.With lower labor demand, the equilibrium real wage and employment fall
b.Lower employment reduces the equilibrium level of output, thus shifting the FE
line to the left
a.In this case the price level rises to shift the LM curve up and to the left to
restore equilibrium
b.The inflation rate rises temporarily, not permanently
Summary: Output declines to its full-employment level, while the real interest
rate and price level are higher


a.There is a temporary burst of inflation as the price level moves to a higher level
b.Since the real interest rate is higher and output is lower, consumption and
investment must be lower
III. Short-run and long-run equilibria (cont.)
 The key question is: How long does it take to get from the short run to
the long run?
 The answer to this question is what separates classicals from
Keynesians.
 Classical economists see rapid adjustment of the price level
 (1) So the economy returns quickly to full employment after
a shock
 (2) If firms change prices instead of output in response to a
change in demand, the adjustment process is almost
immediate
 Keynesian economists see slow adjustment of the price level
 (1) It may be several years before prices and wages adjust
fully
 (2) When not in general equilibrium, output is determined
by aggregate demand at the intersection of the IS and LM
curves, and the labor market is not in equilibrium