Lecture 8

Short Run Output Determination:

The IS/LM/AS Framework
Mark Gertler
NYU
Intermediate Macro Theory
Spring 2015

Motivation
Competitive equilbrium neoclassical model
Output always at "full employment"
Money only aects nominal variables
Di cult for model to explain:
Recessions and Depressions
The eect of monetary policy on the real economy
The eects of scal policy

A Model of the Short Run: Preliminaries

Start with the competitive equilibrium model and introduce 3 frictions:
(i) Money
(ii) Imperfect competition
(iii) Imperfect price adjustment
(i) permits introducing nominal variables and an analysis of monetary policy
(iii) permits analyzing price setting behavior by rms as a prelude to introducing
imperfect price adjustment
Cant model price adjustment with perfect competition since rms take prices
as given
(i), (ii) and (iii) imply:
output can be below "full employment"
monetary policy can aect the real economy
2

Model Ingredients
Consumption goods only. Later we add investment and government spending.
Eventually introduce nancial market frictions.
The model includes households, rms and a central bank:
The representative household consumes a nal good Ct, supplies labor Nt, holds
real money balances Mt=Pt, saves in the form of private bonds Bt (which, in
equilibrium will be in zero net supply, since everyone is the same).
Firms are monopolistic competitors and each produce a dierentiated product
Yt (f ) using labor Nt (f ). These rms set nominal prices Pt (f ). f denotes rm
f:
The central bank controls the money supply Mt:

Resource Constraints and Money Supply

Resource constraint
Yt = Ct

(1)

Monetary policy: Central bank sets Mt = M t:

Mt = M t

(2)

We next derive aggregate consumption demand and money demand by households

Doing so allows constructing IS/LM model to determine output and interest
rates given nominal prices
Output may be below full employment
We then derive the aggregate supply side from labor demand and supply
Permits deriving the gap between output and full employment output
Permits analysis of price adjustment.
4

Household Decision Problem

Goal: Derive (i) consumption demand (ii) money demand and (iii) labor supply
Maximization problem problem: Choose Ct; Bt; Mt and Nt to solve

max

1
1

Ct

+ am

1
1

Mt 1
)
Pt

Ct +

Ct+1 =

an
1+
Nt
1+ n

Mt Bt
Wt
+
=
Nt
Pt
Pt
Pt

Pt Bt
Pt Mt
+ (1 + it)
Pt+1 Pt
Pt+1 Pt

1
1

Ct+1

(3)

(4)

(5)

where ; n; an; am > 0.

Money in the utility function captures convenience yield.
5

Unconstrained Maximzation Problem

t ; Mt ; N ) to solve
Choose ( B
t
Pt Pt

maxf

1
1
1

Wt
( Nt
Pt

Mt
Pt

Bt 1
)
Pt

+ am

Pt Mt
Pt Bt 1
(
+ (1 + it)
)
Pt+1 Pt
Pt+1 Pt

1
1

Mt 1
( )
Pt

an
1+
Nt
1+ n

First order condition for labor supply

Wt
Ct
Pt

= an Nt n

(6)

Consumption and Money Demand

t :
First order condition for B
Pt

= (1 + it)

Ct

Pt
Ct+1
Pt+1

(7)

t
First order condition for M
Pt

Ct

Pt
Ct+1 + am(Mt=Pt)
Pt+1

Absent the non-pecuniary return am(Mt=Pt)

money so long as it > 0 :

(8)

; the household would not hold

If am = 0 and it = 0, bonds always dominate.

Consumption and Money Demand (con0t)

Household rst order condition implies relation for consumption demand
Pt
Ct+1 !
= (1 + it)
Pt+1

Ct
1

(C t )

Pt
Ct+1]
= [(1 + it)
Pt+1

Ct =

1
[(1 + it) PPt
t+1

Ct+1

(9)

Consumption demand depends inversely on (1 + it) PPt and positively on Ct+1

t+1
Intuition comes from permanent income hypothesis that we studied earlier
A rise in interest rates induces an increase in saving and a decline in Ct
Desire for consumption smoothing: Ct+1 "! Ct "
8

Consumption and Money Demand (con0t)

t and
A relation for money demand follows from the rst order conditions for B
Pt
Mt
P :
t

Ct
Ct

= (1 + it)

Pt
Ct+1
Pt+1

Pt
=
Ct+1 + am(Mt=Pt)
Pt+1

Combining yields a relation for money demand

Mt
1
= ( + 1) amCt
Pt
it
Money demand depends inversely on its opportunity cost it:

Depends positively on Ct

Aggregate Demand: IS Curve

Aggregate Demand
Yt = Ct
Ct =

1
[(1 + it) PPt
t+1

Ct+1

Combining yields an IS curve

Yt =

1
[(1 + it) PPt
t+1

Yt+1

Given PPt and Yt+1, IS curve is downward sloping in (Yt; it) space.
t+1
An increase in it increases the real interest rate, which reduces spending.
Yt+1 " shifts IS curve out: PPt " shifts it in.
t+1
10

it

Yt =

1


Pt
(1+i) P

Yt+1

t+1

Yt
Figure 1:

IS Curve.

it

I
I

S
S

Yt
Figure 2:

Increase in Yt+1

it

I
I

S
S

Yt
Figure 3:

Increase in

Pt
.
Pt+1

Monetary Sector: LM Curve

Monetary Sector
1
Mt
= ( + 1) amYt
Pt
it

(10)

Mt = M t

LM Curve:
1
Mt
= ( + 1) amYt
Pt
it
Given Pt, upward sloping in (Yt; it) space
Yt "! money demand " ! it " to reduce money demand
Mt "! LM Curve shifts out: Rise in real money suppy ! it down to raise money
demand
t "! LM curve shifts out.
Pt #! M
Pt
11

it

M
Pt

1
it

+1

amYt

Yt
Figure 4:

LM Curve

it

Yt
Figure 5:

Increase in M t

it

Yt
Figure 6:

Increase in Pt

Fixed Price IS/LM Model

Sticky price assumption:
Pt+i = P t+i; i = 0; 1
! IS/LM jointly determines (Yt; it)

IS:
Yt =

1
[(1 + it) P t
P t+1

Yt+1

LM:
Mt
1
= ( + 1) amYt
Pt
it

12

it

iet

S
L
Yte
Figure 7:

IS/LM Model

Yt

Some Comparative Statics

Fixed Price IS/LM:
Yt =

1
[(1 + it) P t
P t+1

Yt+1

1
Mt
= ( + 1) amYt
Pt
it
Yt+1 " (rise in optimism)! IS curve shifts out! Yt ", it "
M t " (expansionary monetary policy)! LM curve shifts out ! it # Yt " :
Pt
"
P t+1

Increase in expected deation ! curve shifts down Yt #, it #

If zero lower bound on it binds, drop in Yt increases.

Explains central bank aversion to deation.

13

it

iet

S
L
Yte
Figure 8:

Impact of Increase in Yt+1

Yt

it

iet

S
L
Yte
Figure 9:

Increase in M

Yt

it

iet

Yt

Yte

L
Figure 10:

Increase in

Pt
Pt+1

with zero lower bound on i

10

Flexible Price IS/LM

Suppose Pt adjusts so that Yt = Yt (full employment output)/
For now take Yt as given
Shortly we introduce supply side to determine Yt :
Flexible price IS/LM model:
Yt =

1
[(1 + it) PPt
t+1

Yt+1

Mt
1
= ( + 1) amYt
Pt
it

Given expected deation, ex price IS/LM determines (Pt; it):

Simple Quantity Theory Holds: M t "! Pt " proportionately: No eect on Yt :
14

it

it

S
L
Yt
Figure 11:

Flexible Price IS/LM model

11

Yt

Aggregate Supply
Supply side needed for:
Deriving full employment output Yt
Describing how prices adjust over time
We rst derive aggregate labor supply curve
Relates real wage to aggregate employment
We then derive rm labor demand labor demand
Flexible price case: rms choose price, output and employment each period
Helps determine full employment output
Fixed price case: Firms choose output and employment to meet demand
So long as it is protable

15

Aggregate Labor Supply

Firm f uses the following technology to produce output Yt (f ) with employment
N t (f ) :
Yt (f ) = AtNt (f )

Aggregating across rms

Yt = AtNt

(11)

Use (11) and the resource constraint (1) to eliminate Yt and Ct in the household
labor supply curve:
Wt
= a n Nt n Ct
Pt
+
= anAt Nt n

(12)

! Real wages vary positively with employment.

16

w
P

Ns

N
Figure 12:

Aggregate Labor Supply

12

Aggregate Labor Demand

Monopolistically competitive rm chooses (Pt(f ); Yt(f ); Nt(f )) to solve
max t =

Pt (f )
Yt (f )
Pt

Wt
N t (f )
Pt

subject to (i) demand curve and (ii) production function:

"

Pt (f )
Yt (f ) =
Pt

# "

Yt

Yt (f ) = AtNt (f )

Two cases: Flex Price (long run); Fix Price (short run).
Flex Price: Choose (Pt(f ); Yt(f ); Nt(f )) to maximizes prots
Fix Price: Choose (Yt(f ); Nt(f )) to meet demand, so long as protable
17

Aggregate Labor Demand: Flexible Price Cases

Use constraints to eliminate Yt(f ); Nt(f ) ! unconstrained problem:
"

Pt (f ) Pt (f )
max t =
Pt
Pt
Pt(f )

# "

Yt

Pt(f )
Wt Pt

Pt

"

Yt

At

t
where the rm takes W
Pt ; At; and aggregate output Yt as given.

First order necessary condition (marginal revenue = marginal cost)

(1

")

"

Pt (f )
Pt

# "

Yt

"

# " 1
Wt "
Pt Pt (f )

At

Pt

Yt = 0

18

Aggregate Labor Demand: Flexible Prices (cont)

price markup over marginal cost !
Rearranging rst order condition:
Wt

Pt (f )
P
= (1 + ) t
Pt
At

1+

1
1 1="

P (f )

Firm sets price tP as a markup over marginal case

t
Markup varies inversely with demand elasticity ":
As " ! 1 (perfect competition),

! 0 : i.e. price = marginal cost.

19

Flexible Price Equilbrium Employment

Wt

Pt (f )
P
= (1 + ) t
Pt
At

Since all rms are identical: Pt (f ) = Pt !

1 = (1 + )

Wt
Pt

At
Wt
At = (1 + )
Pt

! Marginal product of labor At = markup

t
over real wage W
Pt

t :
Use aggregate labor supply curve to eliminate W
Pt

At = (1 + )anAt (Nt ) n+
Nt

exible price equilibrium employment (i.e. full employment).

20

Flexible Price Equilbrium Employment and Output

Nt and Yt determined by:
Labor market equilibrium
At = (1 + )anAt (Nt ) n+

Production function
Yt = AtNt

Eliminating Nt
At = (1 + )anAt
1
Yt = (
)
(1 + )an

n+ !
)
t

n (Y
1
n+

1+ n
+
A n

= 0 ! Yt ; Nt = competitive equilbrium values Yto; Nto

> 0 ! Yt ; Nt < Yto; Nto
21

W
P

NS

At

A
w/P

=1+

w
P

No

Labor Market Equilibrium: Flexible Prices. N is ht eflexible price equilibrium

amount of labor, while N o is ht ecompetitive equilibrium amount.
Figure 13:

13

Aggregate Labor Demand: Fixed Price Case

With xed prices the rm produces to meet demand so long as it is protable:
Protable so long as markup t(f ) = 0 (i.e. price

marginal cost).

Since Pt(f ) xed at P t(f ); t(f ) varies

Wt

P t (f )
P
= (1 + t(f )) t ;
Pt
At

Symmetric equilibrium: All rms charge P t(f ) ! P t(f ) = Pt !

1 = (1 + t)

Wt
Pt

At
Wt
At = (1 + t)
Pt

Wt
varies
inversely
with
t
Pt : since price xed, markup falls as marginal cost rises.
22

Aggregate Demand and the Markup: Fixed Price Case

Given Yt: Nt and t determined by
Labor market equilibrium
At = (1 + t)anAt (Nt) n+

(13)

Yt = AtNt

(14)

Production function

(13) and (14) !inverse relation between Yt and t (countercyclical markup):

+

1
Yt n
= an 1+
1+ t
At

(15)

(As we show later), ination varies inversely with t

Firms raise prices when markups low, and vice-versa
23

Fixed Price IS/LM/AS Model

IS Curve:
Yt =

1
[(1 + it) P t
P t+1

Yt+1

LM Curve:
M
= am 1
Pt

1
(1 + it)

! 1

Yt

AS Curve:
+

1
Yt n
= an 1+
(1 + t)
At

IS/LM determines (Yt; it): Given Yt; AS determines t

t then aects ination, as we show later.

24

Flexible Price IS/LM/AS Model

[(1 + it ) PPt ]
t+1

it

exible price (i.e. natural) real rate of interest

exible price nominal rate (given PPt )

t+1
IS Curve:
Yt =

1
f[(1 + it ) PPt ]
t+1

LM Curve:
M
= am 1
Pt

1
(1 + it )

Yt+1

! 1

Yt

AS Curve:
1
Yt n
= an 1+
(1 + )
At

+
n

25

W
P

LM

NS

IS

ie
At

Ye

Ne

Ne

No

Y
Ye

Figure 14:

Price Rigidity Case

14

General IS/LM/AS Model

IS Curve:
Yt =

1
f[(1 + it) PPt ] g
t+1

LM Curve:
M
= am 1
Pt

1
(1 + it)

Yt+1

! 1

Yt

AS Curve:
+ n

1
Y
= an t1+
(1 + t)
At

Two polar cases:

Fix Price: Pt xed ! IS/LM determines Yt; it and AS determines t
Flex Price: xed ! AS determines Yt and IS/LM determines Pt; it
26

Fixed Price IS/LM/AS with Output Gap

IS Curve:
Yt =

1
[(1 + it) P t
P t+1

LM Curve:
M
= am 1
Pt

1
(1 + it)

Yt+1

! 1

Yt

AS Curve (after combining AS curves for x and ex price models):

1+
Y
=( t ) +
(1 + t)
Yt

1+
"Markup gap" (1+
varies inversely with output gap
t)
Y

1+
As we show later, ination varies positively with (1+
and hence with Yt
)
t
t
27

Some Comparative Statics

Y

Yt+1 "! Yt "; it "; Yt #; t #

t
Y

M t "! Yt "; it #; Yt "; t #

t
Y

Yt # (supply shock)! Yt #; t #
t

Later we will show that ination moves inversely with t and thus inversely with
Yt
Yt

28