The IS-LM-FE Model

Macroeconomic Theory I

ECON222

Fall 2017

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Some questions

What are the links between the real and nancial sectors?

What is general equilibrium?

How does the macroeconomy respond to economic shocks

,! productivity shocks
,! monetary expansions
,! scal expansions

How does the economy adjust in the short and long run?

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Equilibrium in the Labour Market

Represented by the full employment line, FE

The FE line is vertical

,! Y = Y , regardless of the interest rate

Y determined by capital, TFP and the full employment level of

labour:
Y = AF (K , N )
When Y = Y , unemployment is at its natural rate
,! if Y < Y , unemployment is above its natural rate
,! if Y > Y , unemployment is below its natural rate

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 Figure: Full employment line

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Equilibrium in the Goods market

IS curve: combinations of Y and r that clear the goods market

,! at all points on the curve, I d (r ) = S d (r , Y )

The IS curve slopes downward

,! as Y increases, savings rise causing r to fall

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 Figure: The IS Curve

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Factors that shift the IS curve

For a given Y , any change that reduces S d or raises I d will increase r

,! shifts the IS curve up

Examples:
,! increase in future MPK
,! decrease in G

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 Figure: Increase in future MPK

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Equilibrium in the Asset market

LM curve: combinations of Y and r that clear the asset market

,! at all points on the curve, L(Y , r + e ) = M/P

The LM curve slopes upward

,! as Y increases, the demand for money rises
,! excess demand for money ) excess supply of bonds
,! price of bonds fall ) the nominal interest rate rises
,! for a given value of e , r also rises

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 Figure: The LM Curve

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Factors that shift the LM curve

For a given Y , any change that reduces M/P or raises L, will

increase r
,! shifts the LM curve up

Examples:
,! decrease in M or an increase in P
,! increase in risk of alternative assets
,! decreases in e

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 Figure: Increase in P

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General equilibrium (GE)

When the economy is in general equilibrium:

,! the labour market is in equilibrium (FE curve)
,! the goods market is in equilibrium (IS curve)
,! the asset market is in equilibrium (LM curve)

GE always occurs at the intersection of the IS curve and the FE line

,! the LM curve adjusts to ensure this

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 Figure: General Equilibrium

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Short-run equilibrium

In the short-run, the economy may not be in GE

Asset markets adjust most rapidly, followed by goods markets and

then the labour market
,! short-run equilibrium occurs at the intersection of the IS and LM
curves

In the short run, aggregate demand may exceed or lie below Y

,! rms adjust production to satisfy demand in the short-run

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 Figure: Short-run Equilibrium

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The adjustment of the price level

Suppose Y > Y : rms are producing more output than is optimal

,! price are too low
,! they are not maximizing prots

At some point, rms begin to raise their prices and P rises

,! M/P falls
,! the LM curve starts to shift up

The LM curve shifts until Y = Y

,! process may be slow

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 Figure: Return to GE as P rises

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