L-12 is-LM Macroeconomic Analysis

8/10/2019 L-12 is-LM Macroeconomic Analysis

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Purpose of the IS-LM framework To explain general equilibrium of the economy using

the three markets-

Labor marketGoods market and

Money market

To explain response of the economy against any shock

While using the IS-LM framework to understand thegeneral equilibrium of the economy we shall, in thislecture, assume that the economy is closed (just tokeep things simple).

2



The FE line: equilibrium in the labor market

FE line

r

Y

3



Shift of FE line

A beneficialsupply shock

will shift the

FE line to theright.

On the otherhand, anadverse

supply shock will shift theFE line to theleft

FE line

r

Y

Adverse supplyshock

Favorablesupply shock

4



The IS curve: equilibrium in the goods market

The goods market is in equilibrium when savings is equal toinvestment.

The IS curve shows the real interest rate for which the goodsmarket is in equilibrium.

The IS curve is so called because at all points on it savings isequal to investment

The IS curve slopes downward because if output (income)increases, savings also increases reducing the interest rate and

vice versa.

For constant output, any change in the economy that changesnational savings relative to investment will change the interestrate that clears the market and shift the IS curve.

We plot IS curve only by changing savings curve (NOTinvestment curve), because savings determine the level ofinvestment.

5



The IS curve

S1I

r

D7%

S, I

r

F

5%

D

F

IS

Y

S2

Y1 Y2

6



Shift of the IS curve: an example

S1S2

I IS1IS2

1. A decrease inexpenditure increasessavings

r1

r2

2. and reducesinterest rate

r

S, I

r

Y Y*

3. But theoutput is

fixed at Y*

4. Therefore, IS1shifts to the left toIS2 to match theconstant outputlevel

A

B

A

B

B*

7



Factors that shift IS curve An increase in Shifts the IS curve Reason

Expected futureoutput

Up and to the right

Consumption rises, savings falls,

interest rate rises Wealth Up and to the right

Governmentpurchases

Up and to the right

Expected futureMPK

Up and to the right Investment increases, interest raterises

Tax No change(RicardianEquivalence)

If the consumers think that in futurethey will get an equivalent amountof tax-cut

Down and to the left If the consumers reduceconsumption because of the tax

8



The LM curve: equilibrium in the asset market

From the study of asset market we know that equilibrium in the assetmarket will be established at the point where demand for and supply ofasset will be equal.

We also found that this condition can be reduced to: Equilibrium at thepoint where demand for and supply of money will be equal.

Demand for money depends on interest rate paid to nonmonetary

assets. If interest rate on nonmonetary assets rise people will holdmore nonmonetary assets and lesser money. This means that there isan inverse relationship between demand for money and interest rate.For this reason, the demand for money curve always slopes downward.On the other hand, as the money supply is fixed, it is always verticalirrespective of the interest rate.

The LM curve, like the IS curve, represents a locus of equilibriumpoints of the money market at various interest rates. LM curve is called so because on all points of the curve the demand for

money (L) is equal to the supply of money (M). In our closed economy, we assume that money supply is determined by

Bangladesh Bank and is fixed. Therefore, determination of equilibrium will depend on the demand for money.

9



The LM curve

LM

r

Y

r

M/P

C

A

A

C

Y1 Y2

r1

r2

M1/P

10

At output level Y1 equilibrium is at point A and equilibrium interest rate is r1.

If output level changes to Y2 it will increase demand for money and

equilibrium will be established at point C where the equilibrium interest rate

will be r2. Interest rate rises because by increasing interest rate the excess

demand for money imposed by the increased level of output can be offset.



Shift of the LM curve For constant output, any change in the real money supply

relative to real money demand will change the real interest rateand cause the LM curve to shift.

MS1 MS2

MD

r r

Y

LM1LM2

M1/P M2/P

r1

r2

Y*

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Shift of the LM curve For constant output, any change in the real money demand

relative to real money supply will change the real interest rateand cause the LM curve to shift.

MS

MD1

r r

Y

LM1LM2

r1

r2

Y*

MD2

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Factors that shift the LM curve An increase in Shifts the LM curve Reason

M Down and to the right Reduces r as M/P increases

P Up and to the left Increases r as M/P falls

Down and to the right Reduces r as demand formoney falls

Wealth Up and to the left Demand for money increases

and r increasesPayment technology Down and to the right Demand for money falls and

r falls

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General equilibrium in the IS-LM model

The whole economy comes to a general equilibrium whenall the three markets (labor market, goods market and theasset market) come to equilibrium at the same time.

FE

LMIS

r

Y

General

Equilibrium point

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Effect of a change on the IS-LM framework

15

FE LMIS

r

Y

E

• The initialgeneralequilibriumis at point E



Effects of a change in the IS-LM framework A 10% increase

in the moneysupply willshift the LM

curve to theright.

IS and LMcurves meet atF, but the FEline does not.

At F people will want moregoods andfirms willrespond.

16

FELM1IS

r

Y

E

F

LM2

Y1



Effects of a change in the IS-LM framework But as the

firms are outof the FE linethey will

want to goback to it.

To do so they will push theprice up so

that LMcurve shiftsback again toE.

17

FELM1IS

r

Y

E

F

LM2





General equilibrium in the IS-LM framework:

Classical vs. Keynesian debate We have seen that an increase in the money supply will reduce the

interest rate and shift the LM curve to the right to intersect the IS curvein a new point, where a temporary equilibrium only in the goods andasset market will be established.

The labor market will not be in this equilibrium and consequentlyfirms will push the price up to return to the general equilibrium state. The question is how fast this adjustment process takes place? According to the Classical view the adjustment process takes place very

quickly. On the other hand, the Keynesian view proposes that the adjustment

process may take long time and as a result the state out of generalequilibrium may persist for a long time. About the monetary neutrality , both agrees. The difference in their

view is that- the Classical economists thinks money is always neutraland the Keynesians think that money is neutral but takes aconsiderable time to be neutral.

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Aggregate demand curve

The aggregate demand curveshows the relationshipbetween the aggregatequantity of goods demandedand the price level.

The intersection point of theIS and the LM curves

determine the aggregatedemand for goods. Therefore, if the IS or the LM

curve shifts it will indicate adifferent price level and adifferent aggregate quantitydemanded.

At the intersection of IS andLM1, Y1 output will bedemanded. But if the pricelevel increases it will shift theLM curve up and to the leftand the correspondingintersection point will show a

reduced level of output, Y2. 21

LM1LM2

IS

AD

r

Y

Y

P

Y1 Y2

P2P1



Shift of the AD curve

For any given price level,any change in the quantitydemanded will shift the

AD curve.

For example, if thegovernment reducesexpenditure it will shift theIS curve to the left.

For constant price levelthis will result in a shift ofthe Ad curve.

Any factor that shifts theIS-LM intersection point tothe left will shift the ADcurve to the left and vice

versa.

22

LM

IS1

AD1

r

Y

Y

P

Y1 Y2

P1

IS2

AD2



Factors that shift the AD curve Some factors that shift the AD curve to the right:

Increase in expected future output

Increase in wealth

Increase in government expenditure

Increase in expected future MPK

Increase in the nominal money supply

Rise in expected inflation

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Aggregate supply (AS) curve

The AS curve shows the relationship between the price level andthe aggregate amount of output that firms supply.

In reality firms’ supply actions are different than our theoreticalmodel of supply studied in microeconomics.

Our assumptions for aggregate supply are-1. Prices remain fixed in the short run and firms supply the quantity

of output at that fixed price level.2. In the long run price and wages adjust fully and market clears

completely. Therefore, in the long run the market is in fullemployment level.

Assumption 1 indicates that our short run aggregate supply(SRAS) curve is horizontal.

Assumption 2 indicates that out long run aggregate supply(LRAS) is vertical.

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SRAS curve in the Keynesian view

25

LRAS

SRAS

Y

P



Equilibrium in the AD-AS model

26

LRAS

SRAS

Y

P

AD

E

1. In the AD-AS modellong run equilibrium will be established atthe point where LRAS,

SRAS and AD meet(point E in the graph)

2. Output willbe at the fullemploymentlevel.



SRAS curve in the classical view

The horizontal SRAScurve is proposed by theKeynesians.

The classical economists

does not agree to this. According to classical view prices adjustquickly and thereforehorizontal SRAS doesnot exist.

Classical view proposes

the usual left to rightupward moving SRAS.

However, they agree with the vertical LRAS.

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LRAS

SRAS

Y

P

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L-12 is-LM Macroeconomic Analysis