Chp. 9: The IS-LM/AD-AS Model
Focus:
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Interactions among labor market, goods market and
assets market.
How equilibrium is achieved across the three
markets?
How disturbances in one market get transmitted to
other markets?
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FE (Full Employment) Line represents
equilibrium in the labor market. It relates real
rate of interest (r) to the real output (Y)
when the labor market is in equilibrium.
IS (Investment-Saving) Curve represents
equilibrium in the goods market. It is a curve
which relates real rate of interest to real
output, when goods market is in equilibrium.
2
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IS Curve is downward sloping. Any factor
other than the current output that affects
either the desired saving or investment shifts
the IS curve.
LM (Demand and Supply of Money) Curve
represents equilibrium in the assets market.
It is a curve which relates real rate of interest
to real output, when assets market is in
equilibrium.
3
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LM Curve is upward sloping. Any factor other
than the current output that affects either the
desired money holding or supply of money
shifts the LM curve.
LM curve is upward sloping because there is
inverse relationship between the price of a
non-monetary asset and the nominal rate of
interest paid by it.
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General Equilibrium is achieved when all the
three markets are in equilibrium
simultaneously. It is given by the level of r
and Y at which IS, LM, and FE curves
intersect each other.
Neutrality of Money: Money is neutral when
changes in nominal money supply affects
price level proportionately without affecting
real variables (e.g. Y, r, real wage).
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Keynesian economists believe that money is
neutral in the long run but not in the short
run. Classical economists believe that money
is neutral in both short and long run.
AS-AD model is equivalent to IS-LM model.
We get the same results.
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