The FE Line: Equilibrium in the Labor Market

The IS Curve: Equilibrium in the Goods Market

The LM Curve: Money Market Equilibrium

General Equilibrium in the Complete IS–LM Model

Price Adjustment and the Attainment of General

Equilibrium

Aggregate Demand and Aggregate Supply

Equilibrium in the AD-AS model.

2
 Labor market showed how equilibrium in the labor market
leads to employment at its full-employment level ( N*) and
output at its full-employment level ( Y* )

Y* = f(N*,K,A)

 If we plot output against the real interest rate, we get a

vertical line, since labor market equilibrium is unaffected
by changes in the real interest rate.

3
• Factors Affecting Labor Supply
– The Real Wage (w/p)
– The Household’s Present Value of Lifetime Resources
(PVLR)
– The Marginal Tax Rate on Labor Income (tn)
– The Marginal Tax Rate on Consumption (tc)
– Value of Leisure (reservation wage)
– non-labor income (R)
– The Working Age Population (pop)

• Factors affecting Labor Demand:

– TFP (A)
– Capital (K)
Y* is not sensitive to r! 4
The full employment level of output is determined by
the full-employment level of employment and the
current levels of capital and productivity; any change
in these variables shifts the FE line 5
– Anything that affects the labor market will affect FE

– If N* increases, FE will shift to the right.

– If N* decreases, FE will shift to the left.

– For example, FE will shift right if:

– A increases
– K increases
– population increases
– labor income taxes fall (and income effect is small
relative to substitution effect)
– labor income taxes rise (and income effect is large
relative to substitution effect)
6
7
• IS curve represents the equilibrium in the goods market:

Y = C + I + G + NX (1)

• Recall the definition of private savings:

Spvt = (Y + NFP – T + TR + INT) – C
• Recall the definition of government savings
Sgovt = (T – TR – INT) – G
• Recall the definition of national savings S = Spvt + Sgovt
S = Y + NFP – C – G
S= GNP – C – G (2)
• From (1) and (2) the demand side of the economy can be
written as: S = I + NX+NFP, thus S= I + CA

The IS curve is named as it is because it documents the

relationship between Investment and Saving (holding CA 8
constant).
• C is a function of PVLR (Y, Yf, a, r), tax policy, expectations, etc.

• I is a function of r, Af, K, and investment tax policy.

• G is a function of government policy (we will discuss this

shortly)

• NX (for the U.S., NX is small)

• The goods market clears when desired investment equals

desired national saving

• Adjustments in the real interest rate bring about equilibrium

• For
. any level of output Y, the IS curve shows the real interest rate
r for which the goods market is in equilibrium. 9
 Key features

 The saving curve slopes upward because a higher real

interest rate increases saving. (substitution effect dominates)

 An increase in output shifts the saving curve to the right,

because people save more when their income is higher

 The investment curve slopes downward because a higher

real interest rate reduces the desired capital stock of the
profit maximizing firm, thus reducing investment
10
 Consider two different levels of output

 At the higher level of output, the saving curve is shifted to the

right compared to the situation at the lower level of output

 Since the investment curve is downward sloping, equilibrium

at the higher level of output has a lower real interest rate

 Thus a higher level of output must lead to a lower real

interest rate, so the IS curve slopes downward

 The IS curve shows the relationship between the real interest

rate and output for which investment equals saving

 IS curve is downward sloping in {r, Y} space 11

12
 Alternative interpretation in terms of goods market equilibrium

 Beginning at a point of equilibrium, suppose the real interest

rate rises

 The increased real interest rate causes people to increase

saving and thus reduce consumption, and causes firms to
reduce investment

 So the quantity of goods demanded declines

 To restore equilibrium, the quantity of goods supplied would

have to decline

 So higher real interest rates are associated with lower output,

that is, the IS curve slopes downward 13
 r

r* r*

IS

Y Y

Suppose r is set by the Fed at the level of r* (we will explore this in depth
later in the course). For a given r, we can solve for the level of output
desired by the demand side of the economy.
Because the demand side of the economy can be boiled down to I = S
(when NX is zero)We represent the demand side of the economy, drawn in
{r,Y} space as the I-S curve. 14
 What shifts the IS curve to the right?

 Any change that reduces desired national saving relative to desired

investment shifts the IS curve up and to the right. That is, anything that
increases aggregate demand for goods shifts the IS curve up and to the
right :
• higher expected income or wealth => higher PVLR => higher C
• higher consumer confidence=> higher PVLR => higher C
• higher Tr or lower T (if the Ricardian equivalence fails) => higher
PVLR => higher C
f f
• higher expectations about A => higher MPK => higher I
f
• higher business confidence => higher MPK => higher I
• lower δ, taxes or lower pK =>lower adjusted user cost of K => higher I
• higher G
• Changes in r WILL NOT cause IS curve to shift, it causes
movement along IS curve. 15
An decrease in desired S requires r to increase if Y is unchanged.
Intuitively, imagine constant output, so a reduction in saving means more
investment relative to saving; the interest rate must rise 16
to reduce investment and consumption and increase saving.
17
LM curve represents the equilibrium in the money market

The Money Market is in Equilibrium when real money supply

equal the real quantity of money demanded

Ms/P = Ld(Y, r + πe)

The money supply is decided by the Fed and does not change
with interest rates
Real money demand falls as the real interest rate rises

What shifts real money supply: M, P

What shifts real money demand: Y, πe

LM curve is named as it is because it documents the relationship

between Liquidity and Money. 18
 Starting at equilibrium, suppose output rises, so real money demand shifts right
 The rise in people’s demand for money makes them sell nonmonetary assets, so
the price of those assets falls and the real interest rate rises
 As the interest rate rises, the demand for money declines until equilibrium is
reached
19
• The LM curve shows the combinations of the real interest rate and
output that clear the money market

• Intuitively, in the short run P is fixed for any given level of output, the
LM curve shows the real interest rate necessary to equate real money
demand and supply.

• What shifts the LM curve to the right?

• Any change that increases real money supply relative to real money
demand shifts the LM curve down and to the right:
• Higher nominal money supply => higher Ms/P
• Lower prices => higher Ms/P
• higher πe => higher i and hence lower money demand
• For a given level of output, the increase in real money supply relative
to real money demand causes the equilibrium real interest rate to
decrease
• The reduction in the real interest rate is shown as an downward shift
20 of
the LM curve.
20
21

21
22

22
23
1) MARKET I: LABOR MARKET: FULL EMPLOYMENT CURVE (FE)
• Does not depend on the interest rate

1) MARKET II : GOODS MARKET

• Goods demand = C + I + G (+NX) = Y = goods supply
(set by maximizing firms)
• Investment Saving curve (IS)
• as the interest rate increases, I and C fall and the demand for goods falls
• IS curve is downward sloping

2) MARKET III : MONEY MARKET

• Real money demand = Ld(Y, r + πe) = Ms/P = real money supply
(set by the Fed)
• Liquidity and Money (LM) curve
• as output increases, money demand increases and the interest rate has to
increase to bring the demand back to the supply
• LM curve is upward sloping

• IS-LM EQUILIBRIUM = EQUILIBRIUM IN MARKETS I , II and III 24

25
 Applying the IS–LM framework: A temporary adverse supply
shock
 Suppose the productivity parameter in the production function (A)
falls temporarily

1. The supply shock reduces the marginal productivity of labor,

hence labor demand
 With lower labor demand, the equilibrium real wage and
employment fall.
 Lower employment and lower productivity both reduce the
equilibrium level of output, thus shifting the FE line to the left.

 There’s no effect of a temporary supply shock on the IS or LM

curves

2. Since the FE, IS, and LM curves don’t intersect, the price level
adjusts, shifting the LM curve until a general equilibrium is reached.
 In this case the price level rises to shift the LM curve up and to 26
26
the left to restore equilibrium.
27
 Applying the IS–LM framework: A temporary adverse supply
shock

 The inflation rate rises temporarily, not permanently

 Summary: The real wage, employment, and output decline, while

the real interest rate and price level are higher.

 There is a temporary burst of inflation as the price level moves

to a higher level

 Since the real interest rate is higher and output is lower,

consumption and investment must be lower
28
 The effects of a monetary expansion
 An increase in money supply shifts the LM curve down and to the right
 Because financial markets respond most quickly to changes in
economic conditions, the asset market responds to the disequilibrium
 The FE line is slow to respond, because job matching and wage
renegotiation take time
 The IS curve responds somewhat slowly
 We assume that the labor market is temporarily out of equilibrium,
so there’s a short-run equilibrium at the intersection of the IS and LM
curves
 The increase in the money supply causes people to try to get rid of
excess money balances by buying assets, driving the real interest rate
down
 The decline in the real interest rate causes consumption and
investment to increase temporarily
 Output is assumed to increase temporarily to meet the extra demand
29
 The effects of a monetary expansion

 The adjustment of the price level

 Since the demand for goods exceeds firms’ desired supply of
goods (shortage), firms raise prices
 The rise in the price level causes the LM curve to shift up
 The price level continues to rise until the LM curve intersects
with the FE line and the IS curve at general equilibrium

 The result is no change in employment, output, or the real interest

rate
 The price level is higher by the same proportion as the increase in
the money supply.

 So all real variables (including the real wage) are unchanged,

while nominal values (including the nominal wage) have risen
proportionately with the change in the money supply 30
As M increase, money holders have more In the long-run, monetary policy has
money than what they need and increase the no effect
demand for bonds and decrease r. This increases
I and C.
31
 The effects of a monetary expansion

 Trend money growth and inflation

 This analysis also handles the case in which the money supply
is growing continuously

 If both the money supply and price level rise by the same
proportion, there is no change in the real money supply, and
the LM curve doesn’t shift

 If the money supply grew faster than the price level, the LM
curve would shift down and to the right

32
 The effects of a monetary expansion

 Often, then, we’ll discuss things in relative terms

 The examples can often be thought of as a change in M or P

relative to the expected or trend growth of money and inflation

 Thus when we talk about “an increase in the money supply,”

we have in mind an increase in the growth rate relative to the
trend

 Similarly, a result that the price level declines can be

interpreted as the price level declining relative to a trend; for
example, inflation may fall from 7% to 4%.
33
 Classical versus Keynesian versions of the IS–LM model

 There are two key questions in the debate between classical

and Keynesian approaches

 How rapidly does the economy reach general equilibrium?

 What are the effects of monetary policy on the economy?

 Price adjustment and the self-correcting economy

 The economy is brought into general equilibrium by
adjustment of the price level.
 The speed at which this adjustment occurs is much
debated 34
 Price adjustment and the self-correcting economy

 Classical economists see rapid adjustment of the price level

 So the economy returns quickly to full employment after a
shock
 If firms change prices instead of output in response to a
change in demand, the adjustment process is almost
immediate
 Keynesian economists see slow adjustment of the price level.
 It may be several years before prices and wages adjust fully
 When not in general equilibrium, output is determined by
aggregate demand at the intersection of the IS and LM
curves, and the labor market is not in equilibrium.
35
• Price adjustment and the self-correcting economy
• This short run scenario is an equilibrium in the sense that the
aggregate quantity of goods produced is equal to the quantity
demanded

• It is not an equilibrium in the sense that to meet the

aggregate demand of goods, firms have to produce more (or
less) output than their potential levelY*

• Y* is the level of output that maximizes firms’ profits. Hence, firms

are producing more (or less) than what they would like.

• This will induce at some point firms to change prices. If M

increases, firms will start to increase prices up to the point that 36
M/P is the same as before, so that the demand is equal to Y*.
 Monetary neutrality
 Money is neutral if a change in the nominal money supply
changes the price level proportionately but has no effect on
real variables.

 The classical view is that a monetary expansion affects

prices quickly with at most a transitory effect on real
variables.

 Keynesians think the economy may spend a long time in

disequilibrium, so a monetary expansion increases output
and employment and causes the real interest rate to fall

 Keynesians believe in monetary neutrality in the long run

but not the short run, while classical economist believe it
37
holds even in the relatively short run
Suppose G increases

Y* = f(N*,K,A)
r LM = f(M,P,πe)

As r increases, private I and C

are somehow crowded out
r*

IS = f(G0)

Y* Y

38
If fiscal policy doesn’t affect Y*, then prices will rise and LM shifts in….

Y* = f(N*,K,A)
r Inflationary pressures
LM = f(M,P,πe)

r2*

r1*

IS = f(G0)

Y* Y
Output is unchanged and G has crowded out C and I (through higher r)
39
• The IS–LM model relates the real interest rate to output, hence, we have
worked in the {Y, r} space.

• What happens to aggregate demand if prices increase?

• The AD–AS relates the price level to output.

• The Aggregate Demand Curve

• The AD curve is drawn in {Y, P} space. It represents how the demand

side of the economy responds to a change in prices.

• The AD curve shows the relationship between the quantity of goods

demanded and the price level when the goods market and asset
market are in equilibrium
• So the AD curve represents the price level and output level at which
the IS and LM curves intersect. So, in essence, the AD curve is a
40
representation of BOTH the IS curve AND the LM curve.
41
•As the IS, the AD curve represents the demand side of the economy:
Y = C+I+G+NX

• Any factor that causes the intersection of the IS and LM curves to

shift to the left, except price changes, causes the AD curve to shift
down and to the left;
• Any factor causing the IS–LM intersection to shift to the right,
except price
.
changes, causes the AD curve to shift to the right.

Example: Nominal money (M) increases:

 LM shifts right
 Move along the IS curve Interest rates fall
 C and I increase
 AD shifts right.
A change in prices causes the LM to shift, but causes only a
movement along the AD curve. 42
43
44
 The aggregate supply curve:
 The aggregate supply curve shows the relationship between
the price level and the aggregate amount of output that firms
supply

I. Short Run: labor market is not in equilibrium: cyclical

unemployment may occur (N adjusts, but it need not be at
N*, K is fixed)

Firms cannot adjust prices nor wages, that is, all prices are
“sticky”!

Firms are always willing to produce extra output to meet the

increased demand, so the short-run aggregate supply
45
curve is a horizontal line.
•Some Macro Economists believe that prices are fixed in the
short run. It is costly to keep changing your prices when faced
with every given shock. As a result, prices in the market tend to
change slowly.

•Firms keep prices and wages fixed and just meet demand
by requiring workers to work a little harder sometimes and a
little less hard during other times. This is how they meet
changes in demand without changing prices.

•This is what we have assumed so far, when we were working with

the IS- LM framework keeping P as fixed.

•In this case - the labor market isn’t really in equilibrium at all in
the short run.

• In such a case - prices are fixed…….. SRA is horizontal

46
 Labor Market:

Ns(PVLR,taxes,value of leisure,
population)

W0/P0

Nd(A,K)

N*

The level of full employment N* and real wages (W0/P0) are set in this
market.
47
 Y* = f(N*,K,A)
P

SRAS(1) =Pe

Pe

AD = f(G,PVLR,taxes,Yf,M,Πe)

Y* Y

48
What Shifts any SRAS curve? SRAS = F(A, K, N, raw materials).

The SRAS curve shifts whenever firms change their prices in the
short run

• Factors like increased costs of producing goods lead firms to

increase prices, shifting SRAS up

Example: an increase in price of raw materials shifts the SRAS

up. For given labor and capital, if the price of raw materials get
more expensive, firms will produce less

• Factors leading to reduced prices shift SRAS down

Example: an increase in A shifts the SRAS down

49
• When the economy is in disequilibrium for a while (Y not
equal Y*), the economy will naturally move towards Y*.

• Reason: Labor market will eventually clear. The

reason that Y does not equal Y* is because N does not equal
N*. As soon as the labor market clears, we will be back at
N*.

• How does the labor market eventually clear? Workers will

not continue to work off their labor demand supply for
long periods of time.

50
•When N > N*, workers will be working more than their desired
amount and will require the firm to raise nominal wages (W) so
as to compensate them for their additional effort. Doing so,
will cause labor market to clear.

• But, as W increases, the short run AS will shift in (higher cost

of production).

• The exact opposite will work when N < N*.

• As the labor market starts to clear, the SRAS will adjust to

bring us back to Y*.

51
II. Long Run: labor market is in equilibrium ,N=N*

• The full employment level of output is the level of output Y*

associated with N*: Y* = A F(K, N*, Raw Materials)

• Full-employment output isn’t affected by the price level, so the

long-run aggregate supply curve (LRAS) is a vertical line.
(or FE line)

• Factors that shift the long run aggregate supply curves

• Anything that increases full-employment output shifts the LRAS

curve right; anything that decreases full-employment output
shifts LRAS left

• Examples include changes in the labor force or productivity 52

changes that affect labor demand, or the cost of raw materials
• The Equilibrium level Y* is not necessarily optimal: Tax
distortions can mean Y* is lower than is economically
efficient. Equilibrium just means balance between private
costs and benefits (in this case to household supply of labor
and firm demand for labor). At an equilibrium, there is no
incentive for people to change their behavior.

• The Equilibrium is not constant: Changes to A, K and N*

change Y*, and hence shift the LRAS.

• Y* trends upward in most countries (because A and K and

population grow over time - shifting out N*).

• Many economists believe its growth rate is fairly stable. 53

• Equilibrium is a point of attraction for the economy:

• Most macroeconomists believe that, in the absence of

shocks, the economy would reach equilibrium after
perhaps 5 years. Thus the economy is in equilibrium in
the “long run” (after 5 years).

• Is the economy ever in long run equilibrium?

• Given that shocks are always hitting, the economy is not

likely to be in long run equilibrium at any point in time.
Yet the force of attraction of equilibrium keeps the
economy hovering around the equilibrium.

54
• Why is the long run equilibrium point attractive?

• Because at this point the labor market clears. Away from

Y* workers are not on their labor supply curve (and
firms may be off their labor demand curve).

• Maximizing behavior by workers and firms push the

economy towards long run equilibrium. Shocks push
the economy away temporarily.

55
 Y* = f(N*,K,A)
P
In the short run, with the price level fixed,
the new equilibrium occurs where the
new AD curve intersects the SRAS, with a
higher level of output

Pe SRAS=Pe

M increases by 10%

AD = f(G,PVLR,taxes,Yf,M,Πe)

Y* Y2 Y
Suppose the economy begins in general equilibrium, but then the money supply is
increased by 10%
This shifts the AD curve upward by 10% because to maintain the aggregate quantity
demanded at a given level, the price level would have to rise by 10% so that real
56
money supply wouldn’t change and would remain equal to real money demand.
 Y* = f(N*,K,A)
P M increases

SRAS2 =P2e
Prices increase by 10%
Pe SRAS1 =P1e

M increases by 10%

AD = f(G,PVLR,taxes,Yf,M,Πe)

Y* Y2 Y
Since output (Y2) exceeds full-employment output (Y*), over time firms raise
prices and the short-run aggregate supply curve shifts up, restoring long-run
equilibrium.
The result is a higher price level (higher by 10%) but the same level of 57
output.
 Monetary neutrality in the AD-AS model

 Money is neutral in the long run, as output is

unchanged

 The key question is: How long does it take to get from
the short run to the long run?

 The answer to this question is what separates classical

from Keynesian economist.

58