NOTES 10: Putting the Economy Together - IS/LM

The purpose of these notes is to review all the markets (and components of those markets) that we have looked at so far. This set of notes - in my opinion - are the most important notes that you will have all year. It is a review of the first 6-7 weeks of the class!

Lets start at the beginning:

I.A review of the major curves and markets we have covered in our graphical analysis:

A.Labor Market:

Labor Demand (Nd): Affected by A and K. An increase in either A or K will shift the labor demand curve to the right. Remember, the labor demand curve is just the MPN.

Labor Supply (Ns): Affected by the PVLR, value of leisure, taxes and the labor force participation rate. We have studied the labor supply in depth in the first part of the course. If you have questions about these factors and how they shift the labor supply curve, look

B.Goods – Money Market:

Investment-Savings Curve (IS Curve): This curve is just the demand side of the market: Y = C + I + G + NX. This curve is drawn in {Y,r} space. How do changes in REAL interest rates effect output? An increase in (r) will increase the user cost of capital. Higher user cost of capital makes investment more expensive. As a result, firms will invest less (I falls). Given the GDP definition above, a fall in I will reduce output! This is why the goods demand curve slopes downward. Changes in investment due to changes in interest rates DO NOT shift the goods demand curve – it causes a movement along the goods demand curve. Saying that changes in interest rates shift the IS curve because Investment changes is SO WRONG and will likely make me cry like a baby!

What shifts the IS curve? Anything, besides interest rates that affects C, I, G, or NX. The usual culprits we discussed in class were:

An increase in PVLR – Increase Consumption – Shifts IS to the right.

An increase in TFP in the future – Increases Consumption and Investment – shifts IS to the right.

An increase in Taxes – Decrease in Consumption – Shifts IS to the left.

An increase in Taxes on Investment – Decrease Investment – shifts IS to the left.

An increase in Government Spending – Increase in G – shifts IS to the right.

An increase in Foreign Output – Increases NX (if Canadians get richer, they want more U.S. stuff, U.S. exports will increase!)– shifts IS to the right.

We draw the goods demand curve in {r,Y} space because we are eventually going to see how the money market (and in particular, the Fed) affects output. That leads us to the money market and the LM curve.

Money Market Equilibrium (LM curve): This curve summarizes EVERYTHING that happens in the money market. This curve represents the relationship between money supply (set by the Fed) and money demand. Real money demand is a function of Y and expected inflation. The more stuff there is to buy, the higher your demand for money (as opposed to keeping your earnings in bonds or stocks or home equity). READ my notes from last week if you have questions. The real money supply is the money supply (set by the Fed) deflated by the price level (M/P).

In the money market, if Y increases, the demand for money will increase (see notes from last week). An increase in the demand for money will drive up real interest rates. This generates a positive relationship between real interest rates and output. This is the LM curve. In equilibrium, the IS curve – which provides a relationship between interest rates and output must coexist with the equilibrium in the money market - the LM curve. Suppose interest rates fall – IS curve says Investment will increase which will increase output. However, the money market says that an increase in income (output) will INCREASE interest rates. The IS – LM curves create a balance between the effects of changing interest rates on output in the goods market (goods market is Y = C + I + G + NX) with the effects of changing output on interest rates in the money market. There is one interest rate (and consequently one level of output) where the two markets (the goods market and the money market) are in balance: That interest rate is the rate where the IS curve intersects the LM curve!

What shifts the LM curve? Answer: Anything that affects the money market besides changes in output (remember, changes in output is why the LM curve slopes upwards). An increase in the money supply (real or nominal) will shift the LM curve to the right (increasing the money supply will drive down interest rates – in order for interest rates to stay the same in the money market, Y will have to increase (increasing the demand for money). Another way to say it - if money supply increases, output could increase in the economy without having an effect on interest rates. This is why the curve shifts to the right. An increase in prices will shift the LM curve (real money balances fall driving up real interest rates - holding the nominal money supply constant) to the left. An increase in expected inflation will also shift the LM curve to the right!

What does the goods – money equilibrium tells us? Together the IS and LM curves summarize the demand side of the economy. It tells us an interest rate which generates a certain amount of output (IS) and a certain amount of output which sustains a given interest rate (LM). <This last sentence is subtle - think about it for a little while - this is the key to the IS-LM market.> The Fed, through its influence over the money supply, Congress and the President, and through its influence on G and Taxes, can affect the equilibrium level of output and interest rates in the economy!

Remember – there is nothing new in this market!!!!! We have been talking about the components of the IS curve for about 5 weeks. Don’t be scared off – just use your intuition!

  1. The AS – AD market

The Aggregate Demand Curve (AD) – The aggregate demand is just another representation of the IS curve. They are nearly the same. The IS curve is just the definition , Y = C + I + G + NX: it separately interacts with the money market (the LM curve). The AD curve is the summary of both the IS curve and the LM curve (much the same as the LM curve represents both money supply and money demand). The Aggregate Demand curve represents the whole demand side of the economy (including both the money and goods market). The AD curve is just a joint graphical representation of the goods and money markets. You should not think of the IS and AD curves as dramatically different curves!!!! They are basically the same – except changes in the money market will shift the AD curve but they will not shift the IS curve (they will cause movements along the IS curve).

So, if the AD curve is essentially the same as the IS curve, why do we need two curves? The answer is simple – they are not exactly the same curve – the AD curve summarizes both the IS and the LM curve in one graphical representation. Also, the AD curve is drawn in {Y,P} space (the same as the aggregate supply curves). The goods demand (IS) – money market (LM) interaction tells us what happens explicitly to interest rates. The AD curve (interacted with the AS) tells us explicitly what happens to prices. They are two sides of the same coin. Interest rates are set in the IS-LM market. Prices are set in the AD - AS market. If you want to talk about prices or inflation, you need the AD-AS representation. If you want to talk about interest rates, you need the IS-LM representation. We will talk about both (although, many times, I will focus on the AS-AD market - this does not mean that we should ignore the IS-LM market).

Why does the AD curve slope down? An increase in P reduces real money balances, which in turn shifts the real money supply curve in and shifts the LM curve to the left. The shift in of the LM curve drives up interest rates and causes a move up the IS curve because the higher interest rates causes Investment and Output to be lower. Thus, through both the interactions of the LM curve and the IS curve, an increase in prices will lower output! That is the AD curve!!!!

What shifts the AD curve? Anything that shifts the IS curve to the right will shift the AD curve to the right. Anything that shifts the LM curve to the right (except a change in prices) will also shift the AD curve to the right. A change in P does shift the LM curve, but only causes a movement along the AD curve (this is by definition of the AD curve - it is drawn in {Y,P} space. Remember, the AD curve is just a summary of the LM curve and the IS curve. Things to remember: A change in prices will not shift the AD curve (it will cause a movement along an given AD curve) but it will cause a shift in the LM curve.

The AS curves:

Long Run Aggregate Supply: This is straight forward. Y* = f(A,K, N*). If A, K, or N* change, Y* changes. N* is set in the labor market – so, basically, anything that affects the labor market affects N*. Note: By definition, K is fixed in the long run. So, basically, only A or N* affect Y* (the LRAS curve).

Short Run Aggregate Supply:

Here is how I think of the SRAS curve. Basically, anything that makes production cheaper in the short run will shift the SRAS curve (more on this in a second). Why does the SRAS curve slope up? If prices increase, real wages will fall (we assume nominal wages are fixed in the short run). When there is an increase in demand, firms raise prices (to maximize profits). Workers cannot have their wages adjusted because they are under contract. Workers may like to have higher wages to offset the higher prices firms are charging, but they cannot. As a result, real wages fall in the short term and firms ask workers to work more (or higher more workers at the prevailing contract wages). If this labor market situation doesn’t seem all that plausible to you, that is OK. We discussed many reasons for this disequilibrium in the labor market during the last class – this has been a central component of the macroeconomic debates for the last 15-20 years. I am giving you one version of the story here (there are many - we touched on a few more in class). We know we need something to happen in the labor market to prevent equilibrium – if not, we would always be at N* and by definition, we would always be at Y* - meaning there would never be any cyclical unemployment. This cannot be true, because we observe unemployment at certain times – so, the labor market always clearing is not always plausible. I tell you a story where nominal wages are fixed in the short run – not always the case. As a result, the nominal wage being fixed story will give us some weird results on occasion (that is why other stories developed). Our simplifications about disequilibrium in the labor market work really, really well in almost all cases!)

Notice - in class, I sometimes made a further assumption that P (and W) are fixed in the short run. In this case, the labor supply curve is not upward sloping - it is horizontal. We talked about why prices may be fixed in the short run.

So, we have two SRAS curves - depending on the assumptions we make. If we assume both P and W are fixed in the short run - the SRAS is horizontal (prices are fixed regardless of the level of Y). If we assume only W is fixed in the short run - then the SRAS curve is upward sloping!!! We did this in depth in class - hopefully you will understand this!

Basically, the SRAS results from disequilibrium (at least according to our models) in the labor market!

I know some of you struggle with the labor market in the short run. YOU CANNOT GRAPH the short run labor market (for whatever reason, our analysis does not hold in the short run - perhaps due to contracts or efficiency wages or other stories). Here is all we know about the labor market:

  1. We know we start at N*(0) [and W(0)/P(0)]. This is the intersection of the original labor supply and labor demand curves. At the beginning of our analysis, the labor market clears.
  2. We know that we will end up in the long run at N*(1) [and W(1)/P(1)]. This is the intersection of the new labor supply and labor demand curves. If labor supply and labor demand do not change N*(0) = N*(1) (likewise for real wages).
  3. In the short run, we are in disequilibrium. In this case, if Y > Y* in the goods market (AS-AD or IS-LM), then N > N* in the labor market!
  4. If N > N* for some period of time, this will cause households to demand higher wages. As a result, nominal wages, W, will increase. It is this that ensures that there will be equilibrium in the labor market in the long run. Workers will tolerate some disequilibrium for some time (that is what efficiency wages theories suggest). But, they will not tolerate the disequilibrium forever. At the point they demand higher NOMINAL wages, equilibrium will be restored. The process occurs because higher W will cause the SRAS curve to shift in putting upward pressure on prices (basically, the wage increases gets passed on as price increases).

So given that the SRAS is a disequilibrium situation, what shifts the SRAS curve? Well, anything that moves the economy back to Y* will shift the SRAS curve (ie, nominal wages). Also, anything that shifts Y* will shift the SRAS curve (basically, A and K). Finally, an increase in oil prices will shift the SRAS curve. Another way to think of the SRAS curve is anything that makes production more expensive will reduce the firm’s willingness to supply goods. An increase in oil prices or an increase in nominal wages makes production more expensive! As a result, an increase in oil prices or an increase in nominal wages will shift the SRAS curve in (to the left) – at any given fixed price, firms will want to produce less. An increase in technology or an increase in K will make production cheaper (by increasing the marginal product of labor – we get more output for each additional worker). If production becomes cheaper, will produce more at every given price! (Remember, the SRAS curve is drawn in {Y,P} space. Think about it – if you were a firm and the cost of production fell and you were still receiving a high price, you would produce more (higher profits)). Does this make sense? Let me know if it doesn’t! Oh - by definition, K is fixed in both the short run and the long run!

Summary: An increase in W or price of oil will shift the SRAS curve in (to the left) and will have no effect on the LRAS!

An increase in A or K will shift the SRAS curve to the right (out) and will increase the LRAS!

That is the summary of all major markets!

Some Caveats that will make your life so much easier!!!!!

  1. Unless I tell you otherwise, an increase in prices will have no effect on expected inflation. In other words, expected inflation is held fixed even if the price level changes (unless I explicitly tell you that expected inflation changes). This will just dramatically simplify our analysis. We will spend time on this next week.
  1. Treat a rise in the price level as being a rise in current inflation. We will see how this works next week; there is a difference and we will deal with it next week. In the back of our mind, we realize that raising prices is not the same as raising the inflation rate. But, I want us to treat an increase in P as an increase in inflation (the rate at which P changes). We will address this next week.
  1. Don’t worry about how changes in government spending, taxes or investment affect future levels of TFP or K. We will leave those effects to the REALLY LONG RUN (ie, growth). We know that more investment will lead to higher K. I want you to ignore those effects – we will treat those effects in our discussion of the really long run. The same is true for the cost/benefits of government spending. Don’t consider spillovers of I or G onto future A – we will analyze that separately (as we already have in our discussion of growth).

4.PVLR only changes when real wages change! (don’t say that PVLR change until real wages change). Just because Y goes up, don’t assume that PVLR changes (although it may – we will talk about this next week). For now, only assume that PVLR changes when real wages change.

Let me summarize a little:

The AS-AD curve is our main graph of analysis. It links the Demand and Supply sides of the economy. Prices (via their effect on interest rates) cause demand and supply to be equated in both the short and the long run.

The IS-LM curve has NOTHING to do with the production side of the economy. The IS-LM just represents the demand side: the goods market and the money market. The goods market is Y = C + I + G + NX. The money market is money supply and money demand. In the goods market, interest rates affect Y (via investment). In the money market, Y affects interest rates (via money demand - in particular, households desire for money to transact). In the demand side of the economy there is both a positive relationship between output and interest rates (the money market) and a negative relationship between output and interest rates (the goods market - ie, Investment -Savings). Those two forces must offset each other - hence the IS-LM analysis.