![The Algebra of the IS-LM theory of AD
1
1 1 1 1
a c b d
Y G T r
b b b b
( / ) (1/ ) /
r e f Y f M P
The IS curve boils down to…
The LM curve boils
down to…
Plugging “r” into the IS
curve and solving for Y
yields…
( )
1 1 1 (1 )[ /(1 )]
z a c z zb d M
Y G T
b b b b f de b P
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CH 3.2 Macro8_Aggregate Demand _Aggregate Supply long and run.ppt
- 1. Aggregate Demand and Aggregate Supply in the Short and Long Run A brief introduction to business cycles Assoc Prof Ergin Akalpler
- 2. Aggregate supply Aggregate supply (AS) is defined as the total amount of goods and services (real output) produced and supplied by an economy’s firms over a period of time. It includes the supply of a number of types of goods and services including private consumer goods, capital goods, public and merit goods and goods for overseas markets.
- 3. Components of AS • Consumer goods • Private consumer goods and services, such as motor vehicles, computers, clothes and entertainment, are supplied by the private sector, and consumed by households. For a developed economy, this is the single largest component of aggregate supply. • Capital goods • Capital goods, such as machinery, equipment, and plant, are supplied to other firms. These investment goods are significant in that their use adds to capacity, and increases the economy’s ability to supply private consumer goods in the future.
- 4. Components of AS • Public and merit goods • Goods and services produced by private firms for use by central or local government, such as education and healthcare, are also a significant component of aggregate supply. Many private firms such as those in construction, IT and pharmaceuticals, rely on contracts to supply to the public sector. • Traded goods • Goods and services for export, such as chemicals, entertainment, and financial services are also a key component of aggregate supply.
- 5. The Classical view The Classical view of real output was that it was fixed at a particular level. At this level, all the factors of production in the economy would be fully employed. (let say at output 500).
- 6. Changes in AD will only bring about changes in the price level, not the level of real output
- 7. The Keynesian view • The Keynesian AS curve assumes that prices and wages are fixed until full employment is reached. • Over the ‘Keynesian range’ there is spare capacity in the economy, the price level is stable, and real output can expand as a result of increases in AD without any inflationary pressure. • In keynesien economics in short run price is fixed and AS is horizontal and • in the long run AS becomes vertical and not affected from price changes as in classical approach
- 9. • Beyond full employment, any changes in AD will bring about higher price levels. The Keynesian view of AS was adapted to show an ‘intermediate range’ where both unemployment and inflation could occur together. In the short run as it is seen price changes are observed. In intermediate range it becomes effective on AS and shift outward. This causes higher price (inflation) and shift Y to the right.
- 10. The ‘modern’ short run-long run view • To solve the problem of the Keynesian and Classical AS curve, modern economists tend to separate the short run AS curve (SRAS) from the long run AS (LRAS) curve. • The short run is assumed to begin immediately after an increase in the price level • (for example, as a result of an increase in AD), and ends when input prices (costs of production) have increased. • Hence, during the short run producers are experiencing an increase in their ‘real’ prices and produce more output – and the supply curve slopes upwards.
- 11. • Any increase in input prices (costs) which may follow is assumed to lag behind increases in the general price level. • In this analysis, SRAS and LRAS are separated. This allows economists to be more flexible in their analysis of a modern economy. This can be seen in the following example: • PRICE LEVEL SRAS £bn LRAS £bn • P8 650 500 • P7 600 500 • P6 550 500 • P5 500 500 • P4 450 500 • P3 400 500 • P2 350 500 • P1 300 500 • P0 250 500
- 13. The most likely cause of a shift in the SRAS curve is to accommodate changes in the short run AD curve.
- 14. AD-AS Short Run Building the short run AD-AS model from the IS-LM framework
- 15. Theory of Short Run Fluctuations Keynesian Cross Money Market IS Curve LM Curve IS-LM Model AS Curve AD Curve AD-AS Model Short-run Fluctuations Explanation The IS curve is generated from the Keynesian Cross and the LM curve is generated from the market for real money balances. 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.
- 16. Fiscal Policy and the IS curve (government expenditure) Y LM Y1 r1 r IS1 An increase in government purchases shifts the IS curve to the right. Y=C(Y-T)+I(r)+G ...IS M/P=L(r,Y) ...LM IS2 r2 Y2 …which raises income... The IS curve shifts to the right by ΔG/(1-MPC),... ...and the interest rate.
- 17. Fiscal Policy and the IS curve (government expenditure) Y LM Y1 r1 r IS1 A decrease in taxes shifts the IS curve to the right. Y=C(Y-T)+I(r)+G ...IS M/P=L(r,Y) ...LM IS2 r2 Y2 …which raises income... The IS curve shifts to the right by ΔTxMPC/(1–MPC),... ...and the interest rate.
- 18. 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
- 19. Monetary Policy and the LM curve Y LM1 Y1 r1 r IS1 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 LM2 r2 Y2 …which raises income... ...and lowers the interest rate.
- 20. Together Monetary and Fiscal Policy Interactions Y LM1 r IS2 IS1 …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. • MS stay constant but • But the interest rate and output fall.
- 21. Monetary and Fiscal Policy Interactions Y LM1 r IS2 IS1 LM2 …if to hold the interest rate constant, the money supply contracts. • Only output falls. • How the economy responds to a tax increase depends on the response of the money supply. • MS decrease / contracts
- 22. Monetary and Fiscal Policy Interactions Y LM1 r IS2 LM2 IS1 …if to hold income constant, the money supply expands. • Only the interest rate falls. • How the economy responds to a tax increase depends on the response of the money supply. • MS expands
- 23. IS-LM as a theory of Aggregate Demand • We now allow price level to vary in the IS- LM model. This provides a theory for the position and slope of the AD curve. Y LM(P1) Y1 r IS1 LM(P2) Y2 Y Y1 AD Y2 P A higher price level P shifts the LM curve upward… …lowering income Y. P2 P1 The AD curve summarizes the relationship between P and Y.
- 24. IS-LM as a theory of Aggregate Demand • If we hold price constant we can see the effects of monetary and fiscal policy on AD via IS-LM. Y LM(P1) Y1 r IS1 LM(P1) Y2 Y Y2 AD1 Y1 P A monetary expansion shifts the LM curve outward… …increasing income Y. P1 Increasing AD at any given price level. AD2
- 25. IS-LM as a theory of Aggregate Demand Y LM(P1) Y1 r IS1 IS2 Y2 Y Y2 AD1 Y1 P A fiscal expansion shifts the IS curve outward… …increasing income Y. P1 Increasing AD at any given price level. AD2
- 26. 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. Y Y LM(P2) r IS LM(P1) Y AD1 P In the short run price is fixed at P1 and equilibrium is at point 1. As price falls money demand decreases and the LM curve shifts out. P1 SRAS1 LRAS Y 1 2 1 2 SRAS2 P2 • Long run equilibrium is achieved at point 2. 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.
- 27. 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.
- 28. The Algebra of the IS-LM theory of AD 1 1 1 1 1 a c b d Y G T r b b b b ( / ) (1/ ) / r e f Y f M P The IS curve boils down to… The LM curve boils down to… Plugging “r” into the IS curve and solving for Y yields… ( ) 1 1 1 (1 )[ /(1 )] z a c z zb d M Y G T b b b b f de b P
- 29. Conclusions short run • In this section we derived the AD curve via the IS- LM 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.
- 30. Model Background in the long run • This model uses the quantity equation as aggregate demand and assumes long run supply to be perfectly vertical and short run supply to be perfectly horizontal. • If the model is out of equilibrium it is the changing price level that returns the model to equilibrium.
- 31. Building Aggregate Demand long run • The quantity theory of money says MV=PY • Rearranging we get (M/P)=kY, where k = 1/V, so as P increases Y decreases • If we map this out we get an AD function Y P AD AD AD • An increase in M or a decrease in k implies that for any given P, Y is higher, hence an outward shift of AD. Changing M is monetary policy. Also because Y = C + I + G + NX, demand side variables can shift AD as well. Changing G or T is fiscal policy. • Similarly a decrease in M or increase in k would shift AD in.
- 32. Building Aggregate Supply: long run • In the long run output is determined by factor inputs (Y=F(K,L)) and is not dependent on price. Hence, long run aggregate supply is vertical. Y P LRAS AD AD Y P* P* • In this context a shift in AD causes a change in the price level but has no effect on Y.
- 33. Building Aggregate Supply: short run • In the short run price is fixed so the aggregate supply curve is horizontal. Y P SRAS AD AD Y P* Y • In this context a shift in AD causes a change in Y but has no effect on P.
- 34. From the Short Run to the Long Run • The economy begins in long run equilibrium at point 1. Y P SRAS AD AD Y P* Y LRAS 1 2 3 • If aggregate demand shifts out, the economy moves from point 1 to point 2, above full employment output. • As we approach the long run there is upward pressure on P. As P increases Y decreases and we move along AD to point 3. • The end result is that Y returns to the natural level but P is permanently higher.
- 35. Stabilization Policy • Fluctuations in the economy can shift either AD or AS. Y P SRAS AD AD Y P* LRAS AD SRAS • Fiscal and monetary policies are able to shift AD. Because of this a shock to AD can be corrected with P and Y returning to their pre- shock levels. • However if there were a supply shock then a policy adjustment would imply a trade off between Y or P. • With a negative supply shock accommodating the shock would mean returning the economy to Y causing a higher P in the long run. • The alternative would be to wait for the shock to pass.
- 36. Conclusion • We constructed a basic AD/AS model. AD was derived from the quantity theory of money function. In the short run, P is sticky and SRAS is horizontal. In the long run factor inputs determine Y and P is variable so LRAS is vertical.