AD-AS Short Run
Building the short run AD-AS
model from the IS-LM
framework
Theory of Short Run Fluctuations
The IS curve is generated from
the Keynesian Cross and the
LM curve is generated from the
market for real money
balances.
Keynesian
Cross
Now we will generate the AD
curve from IS-LM and use
short run and long run models
of AS to explain short run
economic fluctuations.
IS
Curve
IS-LM
Model
Money
Market
AD
Curve
LM
Curve
AD-AS
Model
AS
Curve
Short-run
Fluctuations
Explanation
Fiscal Policy and the IS curve (government expenditure)
An increase in government purchases
shifts the IS curve to the right.
The IS curve shifts to the
right by ΔG/(1-MPC),...
Y=C(Y-T)+I(r)+G
...IS
M/P=L(r,Y)
...LM
r
LM
...and the interest rate.
r2
r1
IS2
IS1
…which raises income...
Y1
Y2
Y
Fiscal Policy and the IS curve (government expenditure)
A decrease in taxes shifts the IS curve to
the right.
The IS curve shifts to the right
by ΔTxMPC/(1–MPC),...
Y=C(Y-T)+I(r)+G
...IS
M/P=L(r,Y)
...LM
r
LM
...and the interest rate.
r2
r1
IS2
IS1
…which raises income...
Y1
Y2
Y
Fiscal Policy and the IS curve
(tax changes)
• Note that government expenditure has a
larger effect than does the same change in
taxes.
Y=C(Y-T)+I(r)+G
...IS
M/P=L(r,Y)
...LM
Monetary Policy and the LM curve
An increase in the money supply shifts
the LM curve to the right,...
Y=C(Y-T)+I(r)+G
...IS
M/P=L(r,Y)
...LM
r
LM1
...and lowers the interest rate.
LM2
r1
r2
IS1
…which raises income...
Y1 Y2
Y
Monetary and Fiscal Policy Interactions
…if the money
supply is held
constant, the
LM curve stays
the same.
• How the economy
responds to a tax
increase depends on
the response of the
money supply.
r
LM1
• The interest
rate and
output fall.
IS1
IS2
Y
Monetary and Fiscal Policy Interactions
…if to hold the
interest rate constant,
the money supply
contracts.
• How the economy
responds to a tax
increase depends on
the response of the
money supply.
• Only output
falls.
r
LM2
LM1
IS1
IS2
Y
Monetary and Fiscal Policy Interactions
…if to hold
income
constant, the
money supply
expands.
• How the economy
responds to a tax
increase depends on
the response of the
money supply.
r
LM1
LM2
• Only the
interest rate
falls.
IS1
IS2
Y
IS-LM as a theory of Aggregate Demand
r
LM(P2)
A higher price level P shifts the
LM curve upward…
LM(P1)
…lowering income Y.
IS1
• We now allow price
level to vary in the ISLM model. This
provides a theory for
the position and
slope of the AD
curve.
Y2
P
Y
Y1
The AD curve
summarizes the
relationship between
P and Y.
P2
P1
AD
Y2 Y1
Y
IS-LM as a theory of Aggregate Demand
r
LM(P1)
A monetary expansion shifts the
LM curve outward…
…increasing income Y.
IS1
Y1
• If we hold price
constant we can see
the effects of monetary
and fiscal policy on AD
via IS-LM.
LM(P1)
P
Y
Y2
Increasing AD at any
given price level.
P1
AD2
AD1
Y1 Y2
Y
IS-LM as a theory of Aggregate Demand
r
LM(P1)
A fiscal expansion shifts the IS
curve outward…
IS2
IS1
…increasing income Y.
Y1
Y2
Y
Increasing
AD at any
given price
level.
P
P1
AD2
AD1
Y1
Y2
Y
IS-LM and AD-AS the Short Run and the Long Run
• Now let’s add short-run and long-run
AS to our IS-LM and AD models.
Assume the economy is operating
below full employment output.
LRAS
r
LM(P1)
LM(P2)
1
As price falls money demand
decreases and the LM curve shifts
out.
2
IS
Y
Y
In the short run price is fixed at P1
and equilibrium is at point 1.
P
In the long run price falls to P2,
quantity demanded increases, and
equilibrium moves to point 2. This
is characterized by a shifting SRAS
curve.
P1
P2
SRAS1
1
2
• Long run equilibrium is achieved
at point 2.
SRAS2
AD1
Y
Y
The Algebra of the IS-LM theory of AD
• The algebra behind the system is a bit tedious.
But, by solving the LM curve for “r” and
plugging into the IS curve which contains “r” on
the right hand side you obtain the IS-LM
equilibrium condition or AD curve.
The Algebra of the IS-LM theory of AD
The IS curve boils down to…
ac 1
b
d
Y

G
T
r
1 b 1 b
1 b 1 b
r  (e / f )Y  (1/ f )M / P
The LM curve boils
down to…
z ( a  c)
z
zb
d
M
Y

G
T
1 b
1 b
1 b
(1  b)[ f  de /(1  b)] P
Plugging “r” into the IS
curve and solving for Y
yields…
Conclusions
• In this section we derived the AD curve via the ISLM equilibrium condition. We looked at fiscal and
monetary policy effects on the IS-LM model. We
looked at the shifting effects that monetary and
fiscal policies have on the AD curve and used the
IS-LM model with the AD-AS model to explain short
run and long run changes to the economy.