CHAPTER 9 THE IS-LM/AD-AS MODEL

The FE Line: Equilibrium in the Labor Market

o
o

N
The full-employment level of employment, , is the equilibrium level of employment
reached after wages and prices have fully adjusted.
Y
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.
Y Y
The FE line is vertical at
because when the labor market is in equilibrium,
N
employment equals its full-employment level, , and output equals its fullY
employment level, , regardless of the value of the real interest rate.
Factors that Shift the FE Line
Y
Any change that affects the full-employment level of output will cause the FE
line to shift.
Y

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

o 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

o 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

o Any
change that increases the aggregate demand for goods shifts the IS curve up and to
the right.
The LM Curve: Asset Market Equilibrium
o 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
o The price of a nonmonetary asset and its nominal interest rate are negatively related.
o 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
o The LM curve represents asset market equilibrium
o The equality of money supplied and demanded uses the money supply-money demand
diagram.
o The real interest rate is on the vertical axis and money is on the horizontal axis.
o The MS line shows the economys real money supply, M/P.
o The nominal money supply M is set by the central bank.
o 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.
o 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.
o 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
o 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.
o

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.

o 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

o 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

o 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.
o 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.
o 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.
o 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.
o 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
o The aggregate demand curve shows the relation between the aggregate quantity of goods

Cd I d G

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

o
o
o
o

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 equals

which is the level of employment that

N
maximizes firms profits. When employment equals the aggregate amount of output
AF ( K , N )
Y
supplied is the full-employment level which equals
regardless of the price
level.
Y
In the long run, firms supply at any price level, so the long-run aggregate supply
curve (LRAS) is a vertical line at

Y Y

Factors the Shift the Aggregate Supply Curve

o

the

Any factor that increases the full-employment level of output

shifts the long-run

Y
aggregate supply curve (LRAS) to the right, and any factor that reduces shifts 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
AD-AS
Model
o
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

o The real business cycle theory argues that real shocks to the economy are the primary
cause of business cycles.
o 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.
o Nominal shocks are shocks to money supply or money demand.
o Real shocks directly affect the IS curve or the FE line, whereas nominal shocks directly
affect only the LM curve.
o 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
o An adverse productivity shock lowers the general equilibrium levels of the real wage,
employment, and output.
o 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
o RBC theory predicts recurrent fluctuations in aggregate output, pro-cyclical employment
movement, and higher real wages during booms than during recessions.
o Pro-cyclical average labor productivity
Are Productivity Shocks the Only Source of Recessions?
o Business cycles may be the result of productivity shocks, even though identifying
specific, large shocks is difficult.
Does the Solow Residual Measure Technology Shocks?
o The Solow residual is the most common measure of productivity shock an empirical
measure of total factor productivity, A.
Y
Solow residual d 1 a A
K N
o
o Solow residual is procyclical rising in economic expansions and falling in recessions
A(uK K ) a (u N N )1 a
AuK a u N 1 a
a 1 a
K N
o Solow residual =
o 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
o An increase in government purchases increases output, employment, the real
interest rate, and the price level.
o 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
o 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
o 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
o According to the misperceptions theory, the aggregate quantity of output supplied
Y
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.
Y Y b( P P e )

b is a positive number that describes how strongly output responds

when the actual price level exceeds the expected price level.

o
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
money supply are

changes in the
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.