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Chapter 9. The IS—LM/AD—AS Model: A General Framework for Macroeconomic Analysis. Goals of Chapter 9. A) Combine the labor market (Chapter 3), the goods market (Chapter 4), and the asset market (Chapter 7) into a complete macroeconomic model (for a closed economy)

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chapter 9

Chapter 9

The IS—LM/AD—AS Model: A General Framework for Macroeconomic Analysis

goals of chapter 9
Goals of Chapter 9
  • A) Combine the labor market (Chapter 3), the goods market (Chapter 4), and the asset market (Chapter 7) into a complete macroeconomic model (for a closed economy)
  • B) the IS-LM model was originally a Keynesian model
  • C) Using one model for both approaches (the classical model and the Keynesian model)
i the fe line equilibrium in the labor market sec 9 1
I. The FE Line: Equilibrium in the Labor Market (Sec. 9.1)
  • A) In the discussion of the labor market in Chapter 3, equilibrium in the labor market leads to employment at its full-employment level and output at B) labor market equilibrium is unaffected by changes in the real interest rate (Figure 9.1)
  • C) Factors that shift the FE line
  • 1. is determined by the full-employment level of employment and the current levels of capital and productivity; any change in these variables shifts the FE line
  • 2. Summary Table 11 lists the factors that shift the full-employment line
ii the is curve equilibrium in the goods market sec 9 2
II. The IS Curve: Equilibrium in the Goods Market (Sec. 9.2)
  • A) The goods market clears when desired investment equals desired national saving
  • 1. Adjustments in the real interest rate bring about equilibrium
  • 2. the goods market is in equilibrium
  • 3. Derivation of the IS curve from the saving-investment diagram (Figure 9.2)
b factors that shift the is curve
B) Factors that shift the IS curve
  • 1. Any change that reduces desired national saving relative to desired investment shifts the IS curve up and to the right
  • 2. Similarly, a change that increases desired national saving relative to desired investment shifts the IS curve down and to the left
  • 3. An alternative way of stating this is that a change that increases aggregate demand for goods shifts the IS curve up and to the right
  • 4. Summary Table 12 lists the factors that shift the IS curve
iii the lm curve asset market equilibrium sec 9 3
III. The LM Curve: Asset Market Equilibrium (Sec. 9.3)
  • A) The interest rate and the price of a nonmonetary asset
  • 1. The price of a nonmonetary asset is inversely related to its interest rate or yield
  • 2. For a given level of expected inflation, the price of a nonmonetary asset is inversely related to the real interest rate
  • B) The equality of money demanded and money supplied
  • 1. Equilibrium in the asset market requires that the real money supply equal the real quantity of money demanded
  • 2. Real money supply is determined by the central bank and isn’t affect by the real interest rate
  • 3. Real money demand falls as the real interest rate rises
  • 4. Real money demand rises as the level of output rises
  • 5. The LM curve
  • 6. By what mechanism is equilibrium restored?
  • 7. The LM curve shows the combinations of the real interest rate and output that clear the asset market
c factors that shift the lm curve
C) Factors that shift the LM curve
  • 1. Any change that reduces real money supply relative to real money demand shifts the LM curve up
  • real interest rate is shown as an upward shift of the LM curve
  • 2. Similarly, a change that increases real money supply relative to real money demand shifts the LM curve down and to the right
  • 3. Summary Table 13 lists the factors that shift the LM curve
  • 4. Changes in the real money supply
  • 5. Changes in real money demand
iv general equilibrium in the complete is lm model sec 9 4
IV. General Equilibrium in the Complete IS-LM Model (Sec. 9.4)
  • A) When all markets are simultaneously in equilibrium there is a general equilibrium
  • 1. This occurs where the FE, IS, and LM curves intersect (Figure 9.7)
  • B) Applying the IS-LM framework: A temporary adverse supply shock
  • 1. Suppose the productivity parameter in the production function falls temporarily
  • 2. The supply shock reduces the marginal productivity of labor, hence labor demand
  • 3. There’s no effect of a temporary supply shock on the IS or LM curves
  • 4. Since the FE, IS, and LM curves don’t intersect, the price level adjusts, shifting the LM curve until a general equilibrium is reached
  • 5. The inflation rate rises temporarily, not permanently
  • 6. Summary: The real wage, employment, and output decline, while the real interest rate and price level are higher
c application oil price shocks revisited
C) Application: Oil price shocks revisited
  • 1. Does the IS-LM correctly predict the results of an adverse supply shock?
  • 2. The data from the 1973–1974 and 1979–1980 oil price shocks shows the following
  • a. As discussed in Chapter 3, output, employment, and the real wage declined
  • b. Consumption fell slightly and investment fell substantially
  • c. Inflation surged temporarily
  • d. All the above results are consistent with the theory
  • e. But the real interest rate did not rise during the 1973–1974 oil price shock (though it did during the 1979–1980 shock)
v price adjustment and the attainment of general equilibrium sec 9 5
V. Price Adjustment and the Attainment of General Equilibrium (Sec. 9.5)
  • A) The effects of a monetary expansion
  • 1. An increase in money supply shifts the LM curve down and to the right
  • 2. Because financial markets respond most quickly to changes in economic conditions, the asset market responds to the disequilibrium
  • 3. The increase in the money supply causes people to try to get rid of excess money balances by buying assets, driving the real interest rate down
  • 4. The adjustment of the price level
  • 5. Trend money growth and inflation
b classical versus keynesian versions of the is lm model
B) Classical versus Keynesian versions of the IS-LM model
  • 1. There are two key questions in the debate between classical and Keynesian approaches
  • 2. Price adjustment and the self-correcting economy
  • 3. Monetary neutrality
  • a. Money is neutral if a change in the nominal money supply changes the price level proportionately but has no effect on real variables
  • b. The classical view
  • c. Keynesians
vi aggregate demand and aggregate supply sec 9 6
VI. Aggregate Demand and Aggregate Supply (Sec. 9.6)
  • A) Use the IS-LM model to develop the AD-AS model
  • 1. The two models are equivalent
  • 2. Depending on the issue, one model or the other may prove more useful
  • a. IS-LM relates the real interest rate to output
  • b. AD-AS relates the price level to output
  • B) The aggregate demand curve
  • The AD curve shows the relationship between the quantity of goods demanded and the price level when the goods market and asset market are in equilibrium
2 factors that shift the ad curve
2. Factors that shift the AD curve
  • 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
  • Summary Table 14: Factors that shift the AD curve
  • (1) Factors that shift the IS curve up and to the right and thus the AD curve up and 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 down and to the right and thus the AD curve up and 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
c the aggregate supply curve
C) The aggregate supply 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
  • 3. Full-employment output isn’t affected by the price level, so the long-run aggregate supply curve (LRAS) is a vertical line at Y = in Figure 9.12
  • 4. Factors that shift the aggregate supply curves
  • a. The SRAS curve shifts whenever firms change their prices in the short run
  • b. Anything that increases shifts the LRAS curve right; anything that decreases shifts LRAS left
  • c. Examples include changes in the labor force or productivity changes that affect labor demand
  • D. Equilibrium in the AD-AS model
e monetary neutrality in the ad as model figure 9 14
E) Monetary neutrality in the AD-AS model (Figure 9.14)
  • In the short run, with the price level fixed, equilibrium occurs where AD2 intersects SRAS1, with a higher level of output
  • Since output exceeds , over time firms raise prices and the short-run aggregate supply curve shifts up to SRAS2, restoring long-run equilibrium
  • Money is neutral in the long run, as output is unchanged
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