Review of the Previous Lecture

• Policy Analysis in IS-LM Model

• Interaction between Monetary and Fiscal Policy

• Shocks in IS-LM Model

• Central Bank’s Policy Instrument

Topics under Discussion

• IS-LM and Aggregate Demand

• IS-LM and AD in Short-run and Long-run

–Shocks to IS Curve

–Shocks to LM Curve

IS-LM and Aggregate Demand

• So far, we’ve been using the IS-LM model to analyze the short run, when the price level is assumed fixed.

• However, a change in P would shift the LM curve and therefore affect Y.

• The aggregate demand curve captures this relationship between P and Y

Y1Y2

Deriving the AD curve

Y

r

Y

P

IS

LM(P1)

LM(P2)

AD

P1

P2

Y2 Y1

r2

r1

Intuition for slope of AD curve:

P (M/P )

LM shifts left

r

I

Y

Monetary policy and the AD curve

Y

P

IS

LM(M2/P1)

LM(M1/P1)

AD1

P1

Y1

Y1

Y2

Y2

r1

r2

The central bank can increase aggregate demand:

M LM shifts right

AD2

Y

r

r

I

Y at each value of P

Y2

Y2

r2

Y1

Y1

r1

Fiscal policy and the AD curve

Y

r

Y

P

IS1

LM

AD1

P1

Expansionary fiscal policy (G and/or T ) increases agg. demand:

T C

IS shifts right

Y at each value of P AD2

IS2

IS-LM and AD-AS in the short run & long run

Recall :The force that moves the economy from the short run to the long run is the gradual adjustment of prices.

rise

fall

remain constant

In the short-run equilibrium, if

then over time, the price level

willY Y

Y Y

Y Y

The SR and LR effects of an IS shock

A negative IS shock shifts IS and AD left, causing Y to fall.

Y

r

Y

P LRAS

LRAS

IS1

SRAS1P1

LM(P1)

IS2

AD2

AD1

Y

Y

In the new short-run equilibrium, Y Y

AD2

The SR and LR effects of an IS shock

Y

r

Y

P LRAS

LRAS

IS1

SRAS1P1

LM(P1)

IS2

AD1

Over time, P gradually falls, which causes• SRAS to move down•M/P to increase, which

causes LM to move down

SRAS2P2

LM(P2)

Y

Y

AD2

SRAS2P2

LM(P2)

The SR and LR effects of an IS shock

Y

r

Y

P LRAS

LRAS

IS1

SRAS1P1

LM(P1)

IS2

AD1

This process continues until economy reaches a long-run equilibrium with

Y Y Y

Y

Now it’s time to determine the effects on the

variables in the economy. +, because Y moved

0, because prices are sticky in the SR. +, because a +Y leads to a rise in r as IS slides along the LM curve.+, because a + Y increases the level ofconsumption (C=C(Y-T)).– , since r increased, the level of investment decreased.

Y

Pr

C

I

Short run Impacts

+, in order to eliminate the excess demand at P0.

0, because rising P shifts LM to left, returning Y to Y* as required by long-run LRAS.

+, reflecting the leftward shift in LM due to + P0, since both Y and T are back to their initiallevels (C=C(Y-T))– – , since r has risen even more due to the + P.

YY

PP

rr

CC

II

Long Run Impacts

Analyze SR & LR effects of M

a.We Have IS-LM and AD-AS diagrams as shown here.

b.Suppose central bank increases M.

Y

r

Y

P LRAS

LRAS

IS1

SRAS1P1

LM(M1/P1)

AD1

Y

Y

AD2

LM(M2/P1)

Analyze SR & LR effects of M

c. The Graph Shows the Short run effects of the change in M and what happens in the transition from the short run to the long run.

Y

r

Y

P LRAS

LRAS

IS1

SRAS1P1

LM(M1/P1)

AD1

Y

Y

AD2

LM(M2/P1)

IS2

SRAS2

Analyze SR & LR effects of M

d. The new long-run equilibrium values of the endogenous variables as compared to their initial values Y

r

Y

P LRAS

LRAS

IS1

SRAS1P1

LM(M1/P1)

AD1

Y

Y

AD2

LM(M2/P1)

IS2

SRAS2P2

Now it’s time to determine the effects on the variables in the economy.

+, because Y moved

0, because prices are sticky in the SR.

–, because a +DY leads to a decrease in r as LM slides along the IS curve.+, because a +DY increases the level ofconsumption (C=C(Y-T)).+ , since r increased, the level ofinvestment decreased.

Y

P

r

C

I

Short Run Impacts

+, in order to eliminate the excess demand at P0.

0, because rising P shifts LM to left, returningY to Y* as required by LRAS.

0, reflecting the leftward shift in LM due to +DP, restoring r to its original level.0, since both Y and T are back to their initiallevels (C=C(Y-T)).

0, since Y or r has not changed.

Y

P

r

C

I

Notice that the only LR impact of an increase in the money supply was an increase in the price level.

Long Run Impacts

Summary

• IS-LM and Aggregate Demand

• IS-LM and AD in Short-run and Long-run

–Shocks to IS Curve

–Shocks to LM Curve

Upcoming Topics

• The Mundell-Fleming Model– IS-LM curve for Small Open Economy

• Floating vs Fixed Exchange Rate– Fiscal Policies– Monetary Policies– Trade Policies