NOTES 9: Putting the Economy Together - IS/LM
The purpose of these notes is to review all the markets, and components of those markets,
that we have looked at so far. This set of notes - in my opinion - are the most important
notes that you will have all quarter. It is a review of the first 6-7 weeks of the class!
Let’s start at the beginning:
I.
A review of the major curves and markets we have covered in our graphical
analysis:
A.
Labor Market:
Labor Demand (Nd): Affected by A and K. An increase in either A or K will
shift the labor demand curve to the right. Remember, the labor demand curve is
just the MPN.
Labor Supply (Ns): Affected by the PVLR, value of leisure, taxes and the labor
force participation rate. We have studied the labor supply in depth in the first part
of the course. If you have questions about these factors and how they shift the
labor supply curve, look at Notes 4 and the slides for Topic 2.
B.
Goods – Money Market:
Investment-Savings Curve (IS Curve): This curve is the demand side of the
market: Y = C + I + G + NX. This curve is drawn in {Y,r} space. How do
changes in REAL interest rates affect output? An increase in (r) will increase the
user cost of capital.
Higher user cost of capital makes investment more
expensive. As a result, firms will invest less (I falls). Given the GDP definition
above, a fall in I will reduce output! This is why the goods demand curve slopes
downward.
Changes in investment due to changes in interest rates DO NOT
shift the goods demand curve – it causes a movement along the goods demand
curve. Saying that changes in interest rates shift the IS curve because
Investment changes is SO WRONG and will likely make me cry like a baby! To
review investment, look at Notes 5 and the Topic 3 slides
What shifts the IS curve? Anything (besides interest rates) that affects C, I, G, or
NX will shift the IS curve. The usual culprits we discussed in the Topic 4 lecture
were:
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

An increase in PVLR – Increase Consumption – Shifts IS to the
right.
An increase in TFP in the future – Increases Consumption and
Investment – shifts IS to the right.
An increase in Taxes – Decrease in Consumption – Shifts IS to the
left.
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


An increase in Taxes on Investment – Decrease Investment –
shifts IS to the left.
An increase in Government Spending – Increase in G – shifts IS
to the right.
An increase in Foreign Output – Increases NX (if Canadians get
richer, they want more U.S. stuff, U.S. exports will increase!)–
shifts IS to the right.
We draw the goods demand curve in {Y, r} space because we are eventually
going to see how the money market (particularly, the Fed) affects output (Y).
That leads us to the money market and the LM curve:
Money Market Equilibrium (LM curve):
This curve summarizes
EVERYTHING that happens in the money market. This curve represents the
relationship between money supply and money demand. As discussed in Notes 8,
the Federal Reserve sets the money supply curve. Real money demand is a
function of Y and expected inflation. Household decisions affect the money
demand! The more stuff there is to buy, the higher your demand for money (as
opposed to keeping your earnings in bonds or stocks or home equity). Read
Notes 8 if you have questions. The real money supply is the money supply
deflated by the price level (M/P).
In the money market, if Y increases, the demand for money will increase (see
Notes 8). An increase in the demand for money will drive up real interest rates.
This generates a positive relationship between real interest rates and output. This
is the LM curve. In equilibrium, the IS curve – which provides a relationship
between interest rates and output must coexist with the equilibrium in the money
market - the LM curve. Suppose interest rates fall – IS curve says Investment will
increase which will increase output. However, the money market says that an
increase in income (output) will INCREASE interest rates. The IS – LM curves
create a balance between the effects of changing interest rates on output in
the goods market (goods market is Y = C + I + G + NX) with the effects of
changing output on interest rates in the money market. There is one interest
rate (and consequently one level of output) where the two markets (the goods
market and the money market) are in balance: That interest rate is the rate where
the IS curve intersects the LM curve!
What shifts the LM curve?
Anything that affects the money market besides changes in output (remember,
changes in output is why the LM curve slopes upwards). An increase in the
money supply (real or nominal) will shift the LM curve to the right (increasing the
money supply will drive down interest rates – in order for interest rates to stay the
same in the money market, Y will have to increase (increasing the demand for
money). Another way to say it - if money supply increases, output could increase
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in the economy without having an effect on interest rates. This is why the curve
shifts to the right. An increase in prices will shift the LM curve (real money
balances fall driving up real interest rates - holding the nominal money supply
constant) to the left. An increase in expected inflation will also shift the LM
curve to the right!
What does equilibrium in the IS-LM market tell us?
Together the IS and LM curves summarize the demand side of the economy. It
tells us an interest rate which generates a certain amount of output (IS) and a
certain amount of output which sustains a given interest rate (LM). <<This last
sentence is subtle - think about it for a little while - this is the key to the IS-LM
market.>> The Fed, through its influence over the money supply, Congress and
the President, and through its influence on G and Taxes, can affect the
equilibrium level of output and interest rates in the economy!
Remember – there is nothing new in this market!!!!! We have been talking
about the components of the IS curve for about 5 weeks. Don’t be scared off –
just use your intuition!
C.
The AS – AD market
The Aggregate Demand Curve (AD) – The aggregate demand is just another
representation of the IS curve. They are nearly the same. The IS curve is just the
definition, Y = C + I + G + NX: it separately interacts with the money market
(the LM curve). The AD curve is the summary of both the IS curve and the LM
curve (much the same as the LM curve represents both money supply and money
demand). The Aggregate Demand curve represents the whole demand side of
the economy (including both the money and goods market). You should not
think of the IS and AD curves as dramatically different curves!!!! They are
basically the same – except changes in the money market will shift the AD curve
but they will not shift the IS curve (they will cause movements along the IS
curve).
So, if the AD curve is essentially the same as the IS curve, why do we need two
curves? The answer is simple – they are not exactly the same curve – the AD
curve summarizes both the IS and the LM curve in one graphical representation.
Also, the AD curve is drawn in {Y,P} space (the same as the aggregate supply
curves). The goods demand (IS) – money market (LM) interaction tells us what
happens explicitly to interest rates. The AD curve (interacted with the AS) tells
us explicitly what happens to prices. They are two sides of the same coin.
Interest rates are set in the IS-LM market. Prices are set in the AD - AS market.
If you want to talk about prices or inflation, you need the AD-AS representation.
If you want to talk about interest rates, you need the IS-LM representation. We
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will talk about both (although, many times, I will focus on the AS-AD market this does not mean that we should ignore the IS-LM market).
Why does the AD curve slope down? An increase in P reduces real money
balances, which in turn shifts the real money supply curve in and shifts the LM
curve to the left. The shift in of the LM curve drives up interest rates and causes a
move up the IS curve because the higher interest rates causes Investment and
Output to be lower. Thus, through both the interactions of the LM curve and the
IS curve, an increase in prices will lower output! That is the AD curve!!!!
What shifts the AD curve? Anything that shifts the IS curve to the right will
shift the AD curve to the right. Anything that shifts the LM curve to the right
(except a change in prices) will also shift the AD curve to the right. A change in
P does shift the LM curve, but only causes a movement along the AD curve (this
is by definition of the AD curve - it is drawn in {Y,P} space. Remember, the AD
curve is just a summary of the LM curve and the IS curve. Things to remember:
A change in prices will not shift the AD curve (it will cause a movement along
the AD curve) but it will cause a shift in the LM curve.
The AS curves:
Long Run Aggregate Supply: This is straight forward. Y* = f(A,K, N*).
If A, K, or N* change, Y* changes. N* is set in the labor market – so,
basically, anything that affects the labor market affects N*. Note: By
definition, K is fixed in the long run. So, basically, only A or N* affect
Y* (the LRAS curve).
Short Run Aggregate Supply:
Here is how I think of the SRAS curve: Basically, anything that makes
production cheaper in the short run will shift the SRAS curve (more on
this in a second).
Why does the SRAS curve slope up?
If prices increase, real wages will fall (we assume nominal wages are fixed
in the short run). When there is an increase in demand, firms raise prices
(to maximize profits). Workers cannot have their wages adjusted because
they are under contract. Workers may like to have higher wages to offset
the higher prices firms are charging, but they cannot. As a result, real
wages fall in the short term and firms ask workers to work more (or higher
more workers at the prevailing contract wages). We discussed many
reasons for this disequilibrium in the labor market during Topic 2.– This
has been a central component of the macroeconomic debates for the last
15-20 years. I am giving you one version of the story here (there are many
- we touched on a few more in class). We know we need something to
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happen in the labor market to prevent equilibrium – if not, we would
always be at N* and by definition, we would always be at Y* - meaning
there would never be any cyclical unemployment. This cannot be true,
because we observe unemployment at certain times – so, the labor market
always clearing is not always plausible. I tell you a story where nominal
wages are fixed in the short run – not always the case. As a result, the
nominal wage being fixed story will give us some weird results on
occasion (that is why other stories developed). Our simplifications about
disequilibrium in the labor market work really, really well in almost all
cases!
Note:–In class, I sometimes made a further assumption that P (and W) are
fixed in the short run. In this case, the labor supply curve is not upward
sloping - it is horizontal. We talked about why prices may be fixed in the
short run.
We have two SRAS curves - depending on the assumptions we make:
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
If we assume both P and W are fixed in the short run - the SRAS is
horizontal (prices are fixed regardless of the level of Y).
If we assume only W is fixed in the short run - then the SRAS
curve is upward sloping!!! We did this in depth in class hopefully you will understand this!
Basically, the SRAS results from disequilibrium (at least according to our
models) in the labor market!
I know some of you struggle with the concept of the labor market in the
short run. YOU CANNOT GRAPH the short run labor market (for
whatever reason, our analysis does not hold in the short run - perhaps due
to contracts or efficiency wages or other stories).
Here is all we know about the labor market:
1.
2.
3.
4.
We know we start at N*(0) [and W(0)/P(0)]. This is the
intersection of the original labor supply and labor demand curves.
At the beginning of our analysis, the labor market clears.
We know that we will end up in the long run at N*(1) [and
W(1)/P(1)]. This is the intersection of the new labor supply and
labor demand curves. If labor supply and labor demand do not
change N*(0) = N*(1) (likewise for real wages).
In the short run, we are in disequilibrium. In this case, if Y > Y*
in the goods market (AS-AD or IS-LM), then N > N* in the labor
market!
If N > N* for some period of time, this will cause households to
demand higher wages. As a result, nominal wages, W, will
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increase. It is this that ensures that there will be equilibrium in the
labor market in the long run. Workers will tolerate some
disequilibrium for some time (that is what efficiency wages
theories suggest). But, they will not tolerate the disequilibrium
forever. At the point they demand higher NOMINAL wages,
equilibrium will be restored. The process occurs because higher W
will cause the SRAS curve to shift in putting upward pressure on
prices (basically, the wage increases gets passed on as price
increases).
Given the SRAS is a disequilibrium situation, what shifts the SRAS curve?
Well, anything that moves the economy back to Y* will shift the SRAS
curve (i.e., nominal wages). Also, anything that shifts Y* will shift the
SRAS curve (basically, A and K). Finally, an increase in oil prices will
shift the SRAS curve. An important way to think of what shifts the
SRAS curve is anything that makes production more expensive will
reduce the firm’s willingness to supply goods. An increase in oil prices
or an increase in nominal wages makes production more expensive! As a
result, an increase in oil prices or an increase in nominal wages will shift
the SRAS curve in (to the left) – at any given fixed price, firms will want
to produce less. An increase in technology or an increase in K will make
production cheaper (by increasing the marginal product of labor – we get
more output for each additional worker). If production becomes cheaper,
will produce more at every given price! (Remember, the SRAS curve is
drawn in {Y,P} space. Think about it – if you were a firm and the cost of
production fell and you were still receiving a high price, you would
produce more (higher profits)). By definition, K is fixed in both the short
run and the long run!
Summary:
An increase in W or price of oil will shift the SRAS curve
in (to the left) and will have no effect on the LRAS!
An increase in A or K will shift the SRAS curve to the right
(out) and will increase the LRAS!
That is the summary of all major markets!
Some Caveats that will make your life so much easier!!!!!
1.
Unless I tell you otherwise, an increase in prices will have no
effect on expected inflation. In other words, expected inflation is
held fixed even if the price level changes (unless I explicitly tell
you that expected inflation changes). This will just dramatically
simplify our analysis. We will spend time on this in the next
chapter.
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2.
Treat a rise in the price level as being a rise in current inflation.
We will see how this works next week; there is a difference and we
will deal with it next week. In the back of our mind, we realize
that raising prices is not the same as raising the inflation rate. But,
I want us to treat an increase in P as an increase in inflation (the
rate at which P changes). We will address this in the next chapter.
3.
Don’t worry about how changes in government spending, taxes or
investment affect future levels of TFP or K. We will leave those
effects to the REALLY LONG RUN (i.e., growth). We know that
more investment will lead to higher K. I want you to ignore those
effects – we will treat those effects in our discussion of the really
long run. The same is true for the cost/benefits of government
spending. Don’t consider spillovers of I or G onto future A – we
will analyze that separately (as we already have in our discussion
of growth).
4.
PVLR only changes when real wages change! (don’t say that
PVLR change until real wages change). Just because Y goes up,
don’t assume that PVLR changes (although it may – we will talk
about this next week). For now, only assume that PVLR changes
when real wages change.
Let me summarize a little:

The AS-AD curve is our main graph of analysis. It links the Demand and
Supply sides of the economy. Prices (via their effect on interest rates)
cause demand and supply to be equated in both the short and the long run.

The IS-LM curve has NOTHING to do with the production side of the
economy. The IS-LM just represents the demand side: the goods market
and the money market. The goods market is Y = C + I + G + NX. The
money market is money supply and money demand. In the goods market,
interest rates affect Y (via investment). In the money market, Y affects
interest rates (via money demand - in particular, households’ desire for
money to transact). In the demand side of the economy there is both a
positive relationship between output and interest rates (the money market)
and a negative relationship between output and interest rates (the goods
market - i.e., Investment -Savings). Those two forces must offset each
other - hence the IS-LM analysis.
Why can’t we use just the money market alone?
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Think about it - if the Fed increases M, the real money supply will increase
(assuming no P effect). This will lower interest rates and spur investment.
Higher investment (all else equal) will lead to higher Y. Higher Y will increase
money demand and raise interest rates. Higher interest rates will lead to lower
investment and lower Y. We get circularity. To account for this relationship, we
need to draw the IS-LM curve. This graph accounts for BOTH effects at once.
Hence, we do not get any of the circularity described above. It solves for the one
{Y, r} pair that satisfies the money market and the goods market at the same time.
That is why we need the IS-LM curves.
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


The IS-LM curve gives us interest rates.
The AS-AD curve gives us prices and output (the IS-LM curve gives us
output too, but, I tend to focus on the output in the AS-AD market - but,
you should note that the results would be the same in either markets!).
The Labor Market gives us N and W/P in the long run!
Our growth lecture (see slides for Topic 2) gives us Y/N in the really long
run (when K is allowed to adjust -remember K is fixed in the short and
long run).
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