AS-AD MODEL

LEARNING OBJECTIVESAt the end of the topic, the students should be able to: understand IS-LM understand the correlations between AS & AD model in short run and medium run understand the impact of fiscal policy and monetary policy on AS & AD understand the impact of changes in oil price on AS & AD

IS LM MODEL IS-LM model is one model that was developed by Sir John Hicks in 1937 based on John Maynards Keyness book, The General Theory of Employment, Interest and Money, published in 1936. IS-LM model explains how interest rates and total output produced in the economy (aggregate output or aggregate income) are determined, given a fixed price level.

IS-LM MODEL, cont..Definition of IS: the relationship between the interest rate and aggregate output for which the goods market is in equilibrium.

Interest RateAggregate Output, YIS

How Does IS curve shift?*Assuming Interest Rate Constant

IS1IS2AAInterest Rate,rAggregate Output, YIS will shift from IS1 to IS2 if there is:-An increase in autonomous consumer spendingAn increase in planned investment spending due to business optimismAn increase in gov spendingA decrease in taxesAn increase in net export in unrelated to interest rate,r

IS-LM MODEL, cont.. Definition of LM: the relationship between real income level (Y) and nominal interest rate where money market is in equilibrium. Interest rate, rAggregate output, YLM

How Does LM curve shift?*Assuming Income (Y) fixed

Interest rate, rLM will shift from LM1 to LM2 if there is :Increase in money supplyDecrease in money demandDecrease in price level

LM2LM1

Fiscal Expansion Fiscal expansion is a situation where the government increases government expenditures (G). (AD = C + I + G + (X-M))

This is synonymous to an increase in the government deficit.

This corresponds to a shift of the IS curve to the right.

Fiscal Expansion, cont..The shift of the IS curve to the right means that the AD curve also shifts to the right.

This leads to a higher level of prices. Prices now exceed the expected level of prices.

Output and prices are higher compared to the initial level.

Fiscal Expansion, cont..Moving from the short to the medium run, since prices rose, wage setters will increase their price expectations. In turn, this increase in expected prices will shift the AS curve upward, so actual prices will rise again. The process comes to an end, when output, moving along the new AD curve returns to its natural level.

Fiscal Expansion, cont.. When output reaches again its natural level, wage setters have no reason to adjust their expectations and the spiral price increase ends. Now, we are at our new medium run equilibrium (point C). Output is the same compared to the initial level but prices are higher

Fiscal Expansion, cont..

The rise in prices that occurred from the short run to the medium run means that the supply of real money balances (M/P) decreased. This means that the LM curve will shift to the left (up). It will keep shifting left (up) until output reaches its previous natural level (point C). The interest rate now is even higher.

Cont..IS1YYnY1Panel AIS2LM1LM2i2i1i3ACBiAD1YYnY1Panel BAD2AS1AS2P2Pe = P1ACBPPe = P3Starting at the natural level of output, an initial increase in G shifts the IS to the right in Panel A. This results in a level of output higher than the natural level and a higher interest rate. In Panel B the AD curve shifts to the right leading to higher output and actual prices higher than the expected level. The short run equilibrium is at point B in both panels. Over time, the higher prices induce wage setters to increase their price expectations shifting up the AS curve in Panel B. Shifting stops at the new medium run equilibrium at point C along the new AD curve, where output is back to its initial natural level and prices are higher. Back to Panel A, the increase in prices reduces the supply of real money balances shifting the LM curve to the left (up). In the medium run we end up at point C, back to the natural level of output but with a higher interest rate.

Fiscal ContractionA fiscal contraction is a situation where the government decreases government expenditures (G).

This is synonymous to a decrease in the government deficit (G - T).

As we have mentioned, this corresponds to a shift of the IS curve to the left.

Fiscal Contraction, cont.. The shift of the IS curve to the left means that the AD curve also shifts to the left.

This leads to a lower level of prices. Prices now are below the expected level of prices.

Monetary ExpansionMonetary expansion is a situation where the central bank increases the money supply.We also know that this shifts the LM curve to the right (down).The result is a higher a level of output and a lower level of interest rate.

Monetary Expansion, cont.. The shift of the LM curve to the right means that the AD curve also shifts to the right. This leads to a higher level of prices. Prices now exceed the expected level of prices.

Monetary Expansion, cont..*ISYYnY1Starting at the natural level of output, an initial increase in money supply shifts the LM to the right (down) in Panel A. This results in a level of output higher than the natural level and a lower interest rate. In Panel B the AD curve shifts to the right leading to higher output and actual prices higher than the expected level. The short run equilibrium is at point B in both panels. Over time, the higher prices induce wage setters to increase their price expectations shifting up the AS curve in Panel B. Shifting stops at the new medium run equilibrium at point C in Panel B along the new AD curve, where output is back to its initial natural level and prices are higher. Back to Panel A, the increase in prices reduces the supply of real money balances shifting the LM curve back to the left (up). In the medium run in Panel A, we end up back at point A, back to the natural level of output but with the same interest rate compared to the initial level.Panel ALM1LM2i2i1ABiAD1YYnY1Panel BAD2AS1AS2P2Pe = P1ACBPPe = P3

Monetary Contraction, cont..a monetary contraction is a situation where the central bank decreases the money supply.We also know that this shifts the LM curve to the left (up).The result is a lower a level of output and a higher level of interest rate.

Monetary Contraction, cont.. The shift of the LM curve to the left means that the AD curve also shifts to the left. This leads to a lower level of prices. Prices now are below the expected level of prices. Output and prices are lower compared to the initial level.