The Aggregate Model

of the Macro
Economy
Lesson 14
The IS-LM Framework

The IS curve
 shows an inverse relationship
between equilibrium levels of the
interest rate and real income
 IS: Y = f (r, TP, CC, W, CR, D, TB,
PR, CU, G, Y*, R)
The IS-LM Framework
The LM curve
 There is a positive relationship between
the interest rate and real income that
achieves equilibrium in the money
market.
 This positive relationship results in an
upward sloping LM curve.
 Changes in Fed policies or price level
cause the LM curve to shift
LM: r = f (Y, MS, P)
 Assume that at a level of
national income, Y1,
the demand for money is L'
Rate of interest

Rate of interest
L'

O O Y1
Money National income

fig
 Assume that at a level of
national income, Y1,
the demand for money is L'
MS
Rate of interest

Rate of interest
L'

O O Y1
Money National income

fig
 MS
Rate of interest

Rate of interest
r1 r1

L'

O O Y1
Money National income

fig
 MS
Rate of interest

Rate of interest
r1 r1
c

L'

O O Y1
Money National income

fig
 Now assume that at the higher
level of national income, Y2,
the demand for money rises to L"
MS
Rate of interest

Rate of interest
r1 r1
c
L"
L'

O O Y1 Y2
Money National income

fig
 Now assume that at the higher
level of national income, Y2,
the demand for money rises to L"
MS
Rate of interest

Rate of interest
r2 r2
r1 r1
c
L"
L'

O O Y1 Y2
Money National income

fig
 MS
Rate of interest

Rate of interest
d
r2 r2
r1 r1
c
L"
L'

O O Y1 Y2
Money National income

fig
 MS LM
Rate of interest

Rate of interest
d
r2 r2
r1 r1
c
L"
L'

O O Y1 Y2
Money National income

fig
 MS LM
Rate of interest

Rate of interest
d
r2 r2
r1 r1
c
L"
L'

O O Y1 Y2
Money National income

fig
Shifts in the IS Curve
 Changes in any variable in the
previous equation
– causes IS curve to shift outward or inward,
– resulting in new equilibrium levels of
income
 Variables include fiscal policy tools,
consumer confidence, wealth, credit
and debt, expectations, and business
profits
 Equilibrium in both the goods and
money markets LM
Rate of interest

IS

O
fig
National income
 Equilibrium in both the goods and
money markets LM
But at r1, national income
is below the goods market
equilibrium level (Y2)
Rate of interest

a b
r1

IS

O Y1 Y2
fig
National income
 Equilibrium in both the goods and
money But as income rises, so there
markets
will be a movement up the
LM
LM curve. The interest rate
will rise, thereby reducing
national income below Y2.
Rate of interest

a b
r1

IS

O Y1 Y2
fig
National income
 Equilibrium in both the goods and
money markets LM
Rate of interest

re

IS

O Ye
fig
National income
IS Curve Shifts
 The IS-LM framework allows for
examination of all variable
changes influencing aggregate
expenditure
 Increase in autonomous spending
shifts IS curve out to right while
decrease in autonomous spending
shifts it back to the left
 LM
Rate of interest

r1

IS

O Y1
fig
National income
 LM
Expansionary
fiscal policy
Rate of interest

r2
r1

IS2

IS1

O Y1 Y2
fig
National income
Shifts in the LM Curve
 Changes in any variable in the
previous equation …
– causes LM curve to shift outward or
inward,
– resulting in new equilibrium levels of
income
 Variables include
 LM
Rate of interest

r1

IS

O Y1
fig
National income
 LM1 LM2
Expansionary
monetary policy
Rate of interest

r1

r3

IS

O Y1 Y3
fig
National income
Fiscal and Monetary
Policy
Implementation
 Fiscal policies are made by the
President, the administration, and
Congress
– making it a slow process
 Automatic stabilizers:
– Boost economy during recession
– Slow down economy during high activity
– Unemployment compensation and welfare
payments are nondiscretionary
expenditures
 Non-discretionary expenditures:
– Increase or decrease as a result of
individuals eligible for spending programs
Fiscal and Monetary
Policy
Implementation
 Discretionary expenditures:
– program funds authorized and
appropriated where specific
decisions are made on the size of
the programs
 Progressive tax system:
– higher tax rates are applied to
increased amounts of income
Monetary Policy
 More precise than fiscal policy
– Focuses on federal funds with
assumption that long-term rates will
have similar effects
– May be outdated by other changes in
economy
– No distinct correlation between prime
rates and other rates on business
loans
Interaction of Monetary
and
Fiscal Policy
 either from expansionary
fiscal policy or other
autonomous spending change
– Results in shift of the IS curve
 Final level of income and the
interest rate
– Determined by the Fed following the
spending increase
 ISLM analysis of fiscal and monetary
policy LM
Rate of interest

r1

IS

O Y1
fig
National income
 ISLM analysis of fiscal and monetary
policy LM1 LM2
Expansionary
fiscal and
monetary policy
Rate of interest

r1

IS2

IS1

O Y1 Y4
fig
National income
Aggregate Demand Curve
 Shows alternative combinations
of P and Y …
– that result in equilibrium in both real
goods and money markets
– Summarizes the IS-LM analysis
– Does not show where the economy
will actually operate
– Gives total amounts of real GDP
demanded by all sectors
Shifting the Aggregate
Demand Curve
 Monetary policy:
– shift of the LM curve
 Fiscal policy:
– shift of the IS curve
 Other autonomous spending
increases:
– shift of the IS curve
Aggregate Supply Curve
 Aggregate supply curve:
– shows price level at which firms in
economy are willing to produce
different levels of real goods and
services and resulting level of real
income
 AS
Price level

O
fig

National output
Aggregate Production
 Aggregate production function:
– shows quantity and quality of resources
used in production
 Incorporates information on:
– Quantity and quality of resources used in
production
– Efficiency with which resources are used
– Production technology existing at any
point in time
Aggregate Supply Curve
 Potential output:
– maximum amount of real goods and
services and real income that can be
produced any time based on
aggregate production function
Aggregate Production
 Aggregate production function:
– shows quantity and quality of resources
used in production
 Incorporates information on:
– Quantity and quality of resources used in
production
– Efficiency with which resources are used
– Production technology existing at any
point in time
Aggregate Supply Curve
 Potential output:
– maximum amount of real goods and
services and real income that can be
produced any time based on
aggregate production function
Aggregate Supply Curve

Short-run AS:
 P = f (Yf, Resource costs)

 This equation shows that absolute

price level
– is a function of the costs of resources or
inputs of production
– either horizontal or upward sloping
 depending on whether the absolute price
level increases as firms produce more output
Long-run Aggregate
Supply
Curve
 Assumed to be vertical
– At level of potential or full-
employment output
 Level of output determined
– By amount of resources
 Full-employment level of output
– Represents constraint on increases
in aggregate demand
 AS
Price level

O
fig

National output
 Long-run Aggregate
Supply
Curve
Long-run AS:
Yf = f (P, Resources, Efficiency,
Technology)
 This equation implies that the long-run
aggregate supply curve is vertical and
not influenced by price level
 Can be shifted right or left over time by
changes in resources
AD-AS Equilibrium
 Aggregate demand-aggregate
supply equilibrium:
– level of real income and price level
that occurs at intersection of
aggregate demand and supply
curves
AD-AS Equilibrium

 Equilibrium level of output

changes
– as both the economy’s aggregate
demand and aggregate supply
curves shift AD-AS Equilibrium
AD-AS Equilibrium
 Keynesian Model:
– horizontal short-run aggregate
supply curve in which all changes in
aggregate demand result in changes
in real output and income
 AS
Price level

AD1
O Y1
fig

National output
 AS
Price level

AD1 AD2
O Y1 Y2
fig

National output
 AS
Price level

AD3
AD1 AD2
O Y1 Y2 Y3
fig

National output
 AS
Price level

AD4

AD3
AD1 AD2
O Y1 Y2 Y3 Y4
fig

National output
 AS
Price level

AD4

AD3
AD1 AD2
O Y1 Y2 Y3 Y4 YP
fig

National output
Shifting Aggregate Supply
 Shifts in short-run aggregate supply
– Curve will shift from productivity
changes
– Changes in costs of output
independent of overall demand
changes
– Changes would be widespread
throughout economy
Shifting Aggregate Supply
Stagflation:
 Combination of higher price level and
increases in price and lower real output
and income
 Policy makers need to use contractionary
monetary or fiscal policy
 However, this measure results in lower
level of real income and output
 It also shifts aggregate demand curve to
right,
– Resulting in higher price level and possible
inflation
Shifting Aggregate Supply
 Shifts in long-run aggregate supply
– Can shift over time if inputs increase
– Increases in labor, land, capital, and
raw materials are favorable to the
economy
– Increases in long-run aggregate supply
can assist the Fed in reaching policy
goals
Changes in Aggregate
Demand and Supply
 Leading indicators:
– Economic variables that generally
turn down before a recession begins
and turn back up before the
recovery starts
– such as manufacturing,
employment, monetary, and
consumer expectation statistics
Changes in Aggregate
Demand and Supply
 Coincident indicators:
– Variables that tend to move with the
overall phases of the business cycle
– include employment, income, and
business production
Changes in Aggregate
Demand and Supply
Lagging indicators:
 Variables that turn down after the
beginning of a recession and turn
up after a recovery has begun.
 include measures of inflation,
unemployment, labor costs, and
consumer and business debt and
credit levels
Managerial Rule of
Thumb:
Judging Trends in Indicators
 Managers need to

– React to both policy changes and

other aggregate spending changes
– Examine and make judgments about
trends
– Analyze sources of data available to
them to make rational decisions