AD-AS Short RunBuilding the short run AD-AS

model from the IS-LM framework

Theory of Short Run Fluctuations

KeynesianCross

MoneyMarket

ISCurve

LMCurve

IS-LMModel

ASCurve

ADCurve

AD-ASModel

Short-runFluctuationsExplanation

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.

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.

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.

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

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.

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.

• The interest rate and output fall.

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.

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.

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

YY1

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.

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

YY2

AD1

Y1

P

A monetary expansion shifts the LM curve outward…

…increasing income Y.

P1

Increasing AD at any given price level.

AD2

IS-LM as a theory of Aggregate Demand

Y

LM(P1)

Y1

r

IS1

IS2

Y2

YY2

AD1

Y1

P

A fiscal expansion shifts the IS curve outward…

…increasing income Y.

P1

Increasing AD at any given price

level.

AD2

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.

YY

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 SRAS2P2

• 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.

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.

The Algebra of the IS-LM theory of AD

1

1 1 1 1

a c b dY 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 MY G T

b b b b f de b P

Conclusions

• 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.