Notes on General Equilibrium the IS/LM/FE model and the AS/AD model in detail.

To begin !e must re"ogni#e that there are three endogenous $ariables that !e
need to %nd equilibrium $alues &or. 'e also need to reali#e that this is a re"ursi$e
model !ith re"ursi$e meaning that (order matters.) S*e"i%"all+ !e need to %nd ,-
.&ull em*lo+ment out*ut/ %rst b+ setting labor demand = labor supply (this is
our frst equilibrium condition) and sol$e &or the mar0et "learing .same as
equilibrium/ real !age .!/ and em*lo+ment .N/. Gi$en A .total &a"tor *rodu"ti$it+/
and 1 .the desired "a*ital sto"0/ !e "an then sol$e &or ,- our %rst solution &or the
%rst endogenous $ariable. This is the s"are"ro!.
'e then use ,- to obtain r- our se"ond endogenous $ariable. 'e do this b+ going
to our second equilibrium condition .our %rst !as N
d
2N
s
/ and that is goods
mar0et equilibrium .34 5 material/ !here desired saving must equal desired
investment .i.e. S
d
2 I
d
same as , 2 3 6 I 6 G/. Note that the desired sa$ings
&un"tion is t+*i"all+ .e7*li"itl+/ e7*ressed as a &un"tion o& , and r. The desired
in$estment &un"tion is t+*i"all+ .e7*li"itl+/ e7*ressed as a &un"tion o& r so all told
!e ha$e t!o equations and t!o un0no!ns. 8ut sin"e !e ha$e alread+ sol$ed &or ,-
then !e ha$e t!o equations and one un0no!n.
Finall+ our third endogenous $ariable the general *ri"e le$el .9-/ that "lears the
mone+ mar0et (this is our third equilibrium condition: M
S
/P = L (! r " #
e
)! is
obtained b+ using ,- and r- to obtain 9-. :n"e !e obtain all three endogenous
$ariables !e are said to be at general equilibrium !hi"h in our "onte7t sim*le
means !e are at a *oint !here all three mar$ets clear i.e. ;/ the labor mar0et
"lears </ the goods mar0et "lears and =/ the mone+ mar0et "lears.
8e&ore !e do a *roblem that de*i"ts the abo$e let us deri$e anal+ti"all+ .!ithout
numbers/ the %& line the 'S curve and the LM curve. Note im*ortantl+ that all
*oints on the FE "ur$e re*resent labor mar0et "learing !here labor su**l+ 2 labor
demand .that is !e are at &ull em*lo+ment .FE// all *oints on an IS "ur$e .stands
&or In$estment 2 Sa$ings/ re*resent goods mar0et "learing and all *oints on an LM
"ur$e .stands &or L .real mone+ demand/ 2 M .real mone+ su**l+//.
(eriving the %& line the FE line is al!a+s going to be $erti"al sin"e the
assum*tion is that ,- onl+ "hanges !hen there is a "hange in labor mar0et
"onditions i.e. either a "hange labor demand and / or labor su**l+ .this is a
3lassi"al *ro*osition 1e+nesians !ould argue other!ise mu"h more on this later/.
Sin"e !e are !or0ing in r and , s*a"e !e argue that "hanges in r ha$e no dire"t
im*a"t on the labor mar0et or *rodu"tion &un"tion that is ,- is inde*endent o&
"hanges in r and thus the FE "ur$e is $erti"al .see belo!/.
;
<
(eriving the 'S curve. To deri$e the IS "ur$e !e begin at an initial equilibrium "all
it *oint A .at ,A and rA
-
/. 'e no! let change (all else constant) and obser$e
!hat ha**ens to the equilibrium real interest rate. For e7am*le let>s let , go u*
&rom ,A to ,8. Sin"e desired sa$ings go u* as a result .a higher , "auses *eo*le to
"onsume more and sa$e more/ the equilibrium interest rate that "lears the goods
mar0et !ill &all to r8
-
. The intuition is that !hen , rises that is the same thing as
sa+ing su**l+ has in"reased and thus to obtain a ne! general equilibrium demand
must rise as !ell. 9art o& the in"rease in demand is indu"ed b+ the higher in"ome
."onsumers !ill s*end more and sa$e more/ but that &alls short o& the in"rease in
su**l+ sin"e "onsum*tion is onl+ going u* b+ a *ortion o& the "hange in , .i.e. the
marginal *ro*ensit+ to "onsume/. To increase demand )urther and to get to
equilibrium! the real interest rate needs to )all resulting in more
consumption via the substitution e*ect and more investment given that
the user cost o) capital )alls +ith the real rate o) interest. The real rate !ill
"ontinue to &all until the "hange in aggregate demand equals the "hange , due to
the su**l+ sho"0. 'hen !e "onne"t *oints A and 8 !e ha$e the IS "ur$e. Note
im*ortantl+ that any change in the equilibrium in the goods mar$et caused
by anything other than a change in ! +ill result in a shi)t o) the 'S curve,
9ut di?erentl+ an+ thing that shi&ts the sa$ings &un"tion other than a "hange in ,
!ill shi&t the IS "ur$e. An+ thing that shi&ts the desired in$estment &un"tion !ill
undoubtedl+ shi&t the IS "ur$e. So !e ha$e many 'S shi)t variables. Also note
that IS "ur$e "a*tures the Fis"al 9oli"+ dimension o& the mar"oe"onom+ i.e. the F9
!heel on the "ruise shi*. As !e shall soon see it is the LM "ur$e that "a*tures the
monetar+ *oli"+ dimension o& the ma"roe"onom+.
=
(eriving the LM curve. 'e deri$e the LM "ur$e in a very similar )ashion as !e
deri$ed the IS "ur$e but here !e &o"us on ho+ the money mar$et equilibrium
changes +hen +e change .all else "onstant/. Let us begin again at an initial
equilibrium "all it *oint A .at ,A and rA
-
/. 'e no! let , rise @ust as be&ore and
obser$e !hat ha**ens to the equilibrium real interest rate. Gi$en that real money
demand L rises +ith ! !e see that the real interest rate must rise to "lear the
mone+ mar0et. The intuition is that *eo*le !ant more mone+ to satis&+ the higher
transa"tions demand &or mone+. All else "onstant means that the Fed is not
Aa""ommodating> this higher demand &or mone+ and thus *eo*le must sell non-
monetary assets to obtain the money . prices o) bonds )all! yield on bonds
rises. This !ill "ontinue to o""ur until the mone+ mar0et "lears at a higher real
interest rate. As !as the "ase !ith the IS "ur$e an+thing that "hanges .alters/
mone+ mar0et equilibrium other than "hanges in , !ill result in a shi&t in the LM
"ur$e. For e7am*le an+thing that "hanges the *osition o& the real mone+ su**l+
"ur$e !ill result in a shi&t in the LM "ur$e .Fed *oli"+ "hanges in 9 mone+ multi*lier
sho"0s/. Li0e!ise an+thing that shi&ts the real mone+ demand "ur$e .L/ e7"e*t &or
"hanges in , !ill also shi&t the LM "ur$e .i.e. *ort&olio sho"0s/.
5
(eriving aggregate demand. Aggregate demand is a $er+ *o!er&ul "on"e*t as
any point on the aggregate demand curve is consistent +ith goods and
money mar$et equilibrium! at varying price levels and output. 'e start at
*oint A in the IS LM &rame!or0 .at ,A and rA
-
/ and let the general *ri"e le$el &all.
The &all in the *ri"e le$el all else "onstant results in a higher real mone+ su**l+
and at the same real rate o& interest the mone+ mar0et is no longer in equilibrium
sin"e real mone+ su**l+ e7"eeds real mone+ demand. 4ouseholds get rid o& their
e7"ess mone+ b+ bu+ing bonds bidding their *ri"e u* their +ield do!n. The lo!er
real rate o& interest !ill stimulation 3onsum*tion .$ia the substitution e?e"t/ and
In$estment $ia the lo!er user "ost o& "a*ital. The higher 3 and I results in higher ,
sin"e , 2 3 6 I 6 G. This is the aggregate demand "ur$e. The ne7t questions isB
'hat are the shi&t $ariables o& aggregate demandC An+thing that shi&ts the IS "ur$e
or an+thing that shi&ts the LM "ur$e e7"e*t o& "ourse "hanges in 9 !ill also shi&t the
AD "ur$e.
D
E