CHAPTER 9 THE IS-LM/AD-AS MODEL The FE Line: Equilibrium in the
Labor Market The full-employment level of employment,, is the
equilibrium level of employment reached after wages and prices have
fully adjusted. The full-employment output,, is the amount of
output produced when employment is at its full-employment level,
for the current level of the capital stock and the production
function. Equilibrium in the labor market is represented by the
full-employment line, FE. Real interest rate r on the y-axis and
Output Y on the x-axis.
The FE line is vertical at because when the labor market is in
equilibrium, employment equals its full-employment level,, and
output equals its full-employment level, , regardless of the value
of the real interest rate. Factors that Shift the FE Line Any
change that affects the full-employment level of output will cause
the FE line to shift. increases (FE line shifts to right) when
labor supply increases, capital stock increases, or when there is a
beneficial supply shock.
The IS Curve: Equilibrium in the Goods Market For any level of
output, Y, the IS curve shows the real interest rate r for which
the goods market is in equilibrium. The IS curve is named because
at all points on the curve desired investment equals desired
national saving.
Factors the Shift the IS Curve Any change in the economy that
reduces desired national saving relative to desired investment will
increase the real interest rate that clears the goods market and
thus shift the IS curve up and to the right
Any change that increases the aggregate demand for goods shifts
the IS curve up and to the right. The LM Curve: Asset Market
Equilibrium The asset market is in equilibrium when the quantities
of assets demanded by holders of wealth for their portfolios equal
the supplies of those assets in the economy. The Interest Rate and
the Price of a Nonmonetary Asset The price of a nonmonetary asset
and its nominal interest rate are negatively related. For a given
expected rate of inflation, movements in the nominal interest rate
are matched by equal movements in the real interest rate, so the
price of a nonmonetary asset and its real interest rate are also
inversely related. The Equality of Money Demanded and Money
Supplied The LM curve represents asset market equilibrium The
equality of money supplied and demanded uses the money supply-money
demand diagram. The real interest rate is on the vertical axis and
money is on the horizontal axis. The MS line shows the economys
real money supply, M/P. The nominal money supply M is set by the
central bank. Thus, for a given price level, P, the real money
supply, M/P, is a fixed number and the MS line is vertical.
When output rises, increasing real money demand, a higher real
interest rate is needed to maintain equilibrium in the asset
market. For any level of output, the LM curve shows the real
interest rate for which the asset market is in equilibrium, with
equal quantities of money supplied and demanded. The term LM comes
from the asset market equilibrium condition that the real quantity
of money demanded, as determined by the real money demand function,
L must equal the real money supply, M/P. Factors that Shift the LM
Curve For constant output, any change that reduces real money
supply relative to real money demand will increase the real
interest rate that clears the asset market and cause the LM curve
to shift up and to the left.
Changes in the Real Money Supply An increase in the real money
supply M/P will reduce the real interest rate that clears the asset
market and shift the LM curve down and to the right.
With fixed output, an increase in the real money supply lowers
the real interest rate that clears the asset market and causes the
LM curve to shift down and to the right. Changes in Real Money
Demand With output constant, an increase in the real money demand
raises the real interest rate that clears the asset market and thus
shifts the LM curve up and to the left.
General Equilibrium in the Complete IS-LM Model A situation in
which all markets in an economy are simultaneously in equilibrium
is called a general equilibrium. Shown are: The full-employment, or
FE line, along which the labor market is in equilibrium The IS
curve, along which the goods market is in equilibrium The LM curve
along which the asset market is in equilibrium
Price Adjustment and the Attainment of General Equilibrium The
Effects of a Monetary Expansion
With the price level constant, an increase in the nominal money
supply takes the economy to the short-run equilibrium point, F, at
which the real interest rate is lower and output is higher than at
the initial general equilibrium point, E. Two assumptions: (1) when
the economy isnt in general equilibrium, the economys short-run
equilibrium occurs at the intersection of the IS and LM curves; and
(2) when the aggregate demand for goods rises, firms are willing to
produce enough extra output to meet the expanded demand. The
Adjustment of the Price Level The return of the economy to general
equilibrium requires adjustment of the nominal wage (the price of
labor) as well as the price of goods. Trend Money Growth and
Inflation Changes in M or P relative to the expected or trend rate
of growth of money and inflation shift the LM curve. Classical
Versus Keynesian Versions of the IS-LM Model The economy is brought
into general equilibrium by adjustment of the price level. A
decrease in the price level raises the real money supply and shifts
the LM curve down and to the right, until all three curves again
intersect, returning the economy to general equilibrium. Under the
classical assumption that prices are flexible, the adjustment
process is rapid. Under the Keynesian assumption, sluggish
adjustment of prices might prevent general equilibrium from being
attained for a much longer period, perhaps even several years. When
the economy is not in general equilibrium, output is determined by
the level of aggregate demand, represented by the intersection of
the IS and LM curves; the economy is not on the FE line and the
labor market is not in equilibrium. Monetary Neutrality Monetary
neutrality says that money is neutral, if a change in the nominal
money supply changes the price level proportionally but has no
effect on real variables. Keynesians believe monetary neutrality in
the long run but not in the short run. Classicals accept the view
that money is neutral even in the relatively short run. Aggregate
Demand and Aggregate Supply The aggregate demand curve shows the
relation between the aggregate quantity of goods demanded,, and the
price level, P. Factors that Shift the AD Curve The AD curve
relates the aggregate quantity of output demanded to the price
level. Any factor that changes the aggregate demand for output will
cause the AD curve ot shift, with increases in aggregate demand
shifting the AD curve up and to the right and decreases in
aggregate demand shifting it down and to the left.
The Aggregate Supply Curve The aggregate supply curve shows the
relationship between the price level and the aggregate amount of
output that firms supply. Assumption: prices remain fixed in the
short run and that firms supply the quantity of output demanded at
this fixed price level. The short-run aggregate supply curve
(SRAS), is a horizontal line.
In the long-run, prices and wages adjust to clear all markets in
the economy. The labor market clears so that employment equalswhich
is the level of employment that maximizes firms profits. When
employment equalsthe aggregate amount of output supplied is the
full-employment levelwhich equalsregardless of the price level.
In the long run, firms supply at any price level, so the
long-run aggregate supply curve (LRAS) is a vertical line at.
Factors the Shift the Aggregate Supply Curve
Any factor that increases the full-employment level of output
shifts the long-run aggregate supply curve (LRAS) to the right, and
any factor that reducesshifts the LRAS curve to the left. The SRAS
curve shifts whenever firms change their prices in the short run.
Any factor, such as an increase in costs, that leads firms to
increase prices Monetary Neutrality in the AD-AS Model When the
money supply rises by 10%, points on the new AD curve are those for
which the price level is 10% higher at each level of output
demanded.
CHAPTER 10 CLASSICAL BUSINESS CYCLE ANALYSIS Business Cycles in
the Classical Model The real business cycle theory argues that real
shocks to the economy are the primary cause of business cycles.
Real shocks are disturbances to the real side of the economy, such
as shocks that affect the production function, the size of the
labor force, the real quantity of government purchases, and the
spending and saving decisions of consumers. Nominal shocks are
shocks to money supply or money demand. Real shocks directly affect
the IS curve or the FE line, whereas nominal shocks directly affect
only the LM curve. Productivity shocks include the development of
new products or production methods, the introduction of new
management techniques, changes in the quantity of capital or labor,
changes in the availability of raw materials or energy, unusually
good or unusually bad weather, changes in government regulations
affecting production, and any other factor affecting productivity.
The Recessionary Impact of an Adverse Productivity Shock An adverse
productivity shock lowers the general equilibrium levels of the
real wage, employment, and output. An adverse productivity shock
raises the real interest rate, depresses consumption and
investment, and raises the price level. Real Business Cycle Theory
and the Business Cycle Facts RBC theory predicts recurrent
fluctuations in aggregate output, pro-cyclical employment movement,
and higher real wages during booms than during recessions.
Pro-cyclical average labor productivity Are Productivity Shocks the
Only Source of Recessions? Business cycles may be the result of
productivity shocks, even though identifying specific, large shocks
is difficult. Does the Solow Residual Measure Technology Shocks?
The Solow residual is the most common measure of productivity shock
an empirical measure of total factor productivity, A. Solow
residual is procyclical rising in economic expansions and falling
in recessions Solow residual = Labor hoarding occurs when, because
of the costs of firing and hiring workers, firms retain some
workers in a recession that they would otherwise lay off. Fiscal
Policy Shocks in the Classical Model Another type of shock that can
be a source of business cycles in the classical model is a change
in fiscal policy, such as an increase or decrease in real
government purchases of goods and services. Classical: An increase
in government purchases will affect labor supply by reducing
workers wealth. A decrease in wealth increases labor supply, so an
increase in government purchases leads to an increase in labor
supply. FE line shifts to right IS curve shifts up and to the right
An increase in government purchases increases output, employment,
the real interest rate, and the price level. Increasing government
purchases for the sole purchase of increasing output and employment
makes people worse off rather than better off. Thus government
purchases should be increased only if the benefits of the expanded
government program exceed the costs to taxpayers. Money in the
Classical Model Monetary Policy and the Economy A change in the
money supply, M, causes the price level, P, to change
proportionally, but a change in the money supply has no effect on
real variables, such as output, employment, or the real interest
rate. Reverse causation means that expected future increases in
output cause increases in the current money supply and that
expected future decreases in output cause decreases in the current
money supply, rather than the other way around. Based on the idea
that money demand depends on both expected future output and
current output The Nonneutrality of Money: Additional Evidence
Changes in the behavior of the money stock have been closely
associated with changes in economic activity, nominal income, and
prices The interrelation between monetary and economic change has
been highly stable Monetary changes have often had an independent
origin; they have not been simply a reflection of changes in
economic activity The Misperceptions Theory and the Nonneutrality
of Money According to the misperceptions theory, the aggregate
quantity of output supplied rises above the full-employment level,,
when the aggregate price level, P, is higher than expected. The
amount of output that producers choose to supply depends on the
actual general price level compared to the expected general price
level. When the price level exceeds what was expected, producers
are fooled into thinking that the relative prices of their own
goods have risen, and they increase their output. Similarly, when
the price level is lower than expected, producers believe that the
relative prices of their goods have fallen, and they reduce their
output. b is a positive number that describes how strongly output
responds when the actual price level exceeds the expected price
level.
Unanticipated Changes in the Money Supply The reason money isnt
neutral is that producers are fooled. Each producers misperceives
the higher nominal price of her output as an increase in its
relative price, rather than as an increase in the general price
level. Although output increases in the short run, producers arent
better off. They end up producing more than they would have if they
had known the true relative prices.
Anticipated changes in the money supply are neutral in the short
run as well as in the long run. Rational expectations states that
the publics forecasts of various economic variables, including the
money supply, the price level, and GDP, are based on reasoned and
intelligent examination of available economic data. A propagation
mechanism is an aspect of the economy that allows short-lived
shocks to have relatively long-term effects on the economy.