Chapter 9. Chapter 9. Introduction. Figure 9.1 The FE line. The FE Line. FE Curve Shifts. Deriving the IS Curve

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1 Chapte 9. ntoduction Chapte 9 The -LM/AD-A Model: A Geneal Famewok fo Macoeconomic Analysis This chapte integates the elements of ou model that wee sepaately pesented in chaptes 3,4, and 7, coveing labo, goods, and asset makets. t develops a gaphical depiction of ou theoy that is called the -LM/AD-A model. and LM efe to two equilibium conditions in the model (investment equals saving; money demand, o liquidity pefeence, equals money supply). AD and A efe to aggegate demand and aggegate supply. The FE Line Figue 9.1 The FE line will be using some diagams that plot the eal ate of inteest,, and output Y on the axes. Recall that labo maket equilibium detemines a quantity of labo, which, via the poduction function, detemines a full-employment level of output. ince that level of output pesumably does not depend on the ate of inteest, we can plot the full-employment line as a vetical line in a diagam in which and Y appea on vetical and hoizontal axes. FE Cuve hiftes Deiving the Cuve Vaiable nceases Poductivity Labo upply (Population) Capital tock FE Cuve hifts Recall the Goods Maket Equilibium Condition: d = d 1

2 Goods Maket Equilibium Goods Maket Equilibium d, d d = d d, d Conside a Rise in ncome Goods Maket Equilibium As income ises, the desied saving cuve shifts ight, and the equilibium ate of inteest falls as we slide down the desied investment cuve (next slide). 0 d = d d, d Goods Maket Equilibium Deiving 0 1 (Highe ncome) The pevious slide shows that as income vaies and goods maket equilibium is maintained, a highe value of income is associated with a lowe value of the expected eal inteest ate Plot the income-inteest ate pais that satisfy the goods maket equilibium condition to get the cuve The invese elationship between income and inteest ate implies that the cuve is downwad sloping d = d d, d 2

3 Figue 9.2 Deiving the cuve hifting Recall that was deived by consideing how the desied saving cuve moved along the desied investment cuve as income changed. uppose a shock (say a govenment spending incease) causes saving to decline at each level of income Then the inteest ate is highe at each level of income. Then we must edaw, with highe fo each level of Y. has shifted to the ight. Fo othe shocks that shift saving o investment schedules, we can also infe how shifts. Cuve hiftes Vaiable nceases Expected Futue Output Wealth Govenment pending Taxes Expected futue MPK Effective Tax Rate on K Cuve hifts None (Ricadian) o The LM Cuve The plots income inteest-ate pais such that desied spending is equal to output, o desied saving is equal to desied investment We will now deive the LM cuve, which plots income-inteest ate pais such that the quantity of money demanded is equal to the quantity of money supplied. Money Maket Equilibium Revisited The LM Cuve 3

4 The Deivation of LM LM Cuve hiftes Vaiable nceases Nominal Money upply Pice Level Expected nflation Nominal inteest ate on money i m Anything Else nceasing the Demand fo Money LM Cuve hifts Geneal Equilibium in the - LM Model Geneal Equilibium in the - LM Model (Diagam) n geneal equilibium, all makets satisfy thei espective equilibium conditions. Labo, Goods, and Money Makets Must all be in equilibium. The logic of geneal equilibium: The labo maket detemines output. Given output (income) the goods maket then detemines an inteest ate. Given output, the inteest ate, and the expected inflation ate, then the money maket detemines the pice level. Equilibium: A Coincidence? Labo Maket equilibium equies that the economy be on the FE line Goods Maket equilibium equies that the economy be on the Cuve Money Maket equilibium equies that the economy be on the LM Cuve Geneal equilibium equies that the economy be on all thee cuves simultaneously Does this equie a happy coincidence? (No) Review on Equilibium To eview, output is detemined by the FE line Given output the intesection of and FE detemines the inteest ate Finally, the pice level adjusts so that LM intesects both and FE 4

5 Timing of Movement to Equilibium Ou model, as fomulated, does not tell us the ode in which vaiables move we just infe that the economy moves fom one equilibium to anothe (afte a shock). Hee ae some thoughts on timing: nteest ates (and financial makets geneally) adjust vey quickly Nominal (and eal) wages adjust slowly (often wages ae set fo long peiods of time Pices may also adjust slowly The goods maket adjusts with intemediate speed (we often see unanticipated inventoy movements, but fims may alte poduction befoe evising pices) A Look Ahead: Keynesian and Classical Views We will say much moe about Keynesian and Classical macoeconomic theoies Keynesians emphasize the shot-tem igidity of pices and wages Classical economists emphasize that all makets each equilibia athe quickly Aggegate Demand and Aggegate upply We have now specified a complete model Howeve, sometimes it is convenient to look at the model diffeently with a diffeent diagam We next intoduce AD and A cuves These cuves plot output, Y, and the pice level, P. These diagams allow us to focus attention on the detemination of the pice level, which was not diectly visible in the -LM diagam. The AD Cuve Conside the -LM diagam. A given LM cuve is dawn fo a fixed level of P. f P changes, then the LM cuve shifts. Conside vaious levels of P. Fo each pice level, daw the appopiate LM cuve The sequence of -LM intesections detemines Y values to be associated with each level of P. Plotting these P-Y pais yields the aggegate demand (AD) cuve. Deiving AD The Long Run Aggegate upply Cuve When all makets clea, we ae in long-un equilibium. Note: This is not necessaily a matte of time. n the classical model, when all makets equilibate instantaneously, then we each the long-un immediately. The A cuve plots output supplied vesus the pice level. Output supplied is detemined by the labo maket and the poduction function; it is the full employment level of output, Y. Output supplied does not vay with P, so the A cuve is vetical at Y. 5

6 Aggegate upply in the hot- Run A: Long Run and hot Run Assume that the shot-un is a time fame in which the pice level is fixed, and the quantity of output is detemined by demand (whateve that level may be) o the A cuve is hoizontal at a given pice level Ou oiginal labo maket equilibium model has been discaded fo the shot un The shot-un hoizontal A cuve is eally only a featue of Keynesian intepetations of ou theoy Long-un and hot-un Equilibia n long-un equilibium, the economy must be on AD, RA, and LRA. n a shot-un equilibium, the economy must be on AD and RA. To go to a new long-un equilibium, pice (and RA) must shift. Note that ou assumptions now make it clea that an incease in AD can lead to an incease in output in the shot-un, but an incease in pice in the long-un The vetical long-un supply illustates the money neutality popety nceases in M, causing inceases in AD, do not change output, but they do change P. AD hiftes Any vaiable that shifts o LM, with the exception of P, will also shift AD The diection of the shift is detemined by whethe the -LM diagam shows an incease in income as a esult of the shift in the -LM diagam: if and LM intesect at a highe level of income, then the AD cuve shifts to the ight. At any pice level, if and AD detemine a highe level of income, then that pice level is now associated with a highe level on income on AD. LRA hiftes The LRA cuve will change when the full employment level of output changes This means that it is shifted by the same vaiables that shift the FE Cuve: Poductivity Labo supply Capital stock RA hiftes The RA cuve shifts only when the pice level changes fom one fixed level to anothe This peiod pice might be fixed at a given level, but in a futue peiod it might be fixed at some othe level 6

7 Upcoming Chaptes n the next two chaptes, we will use the - LM / A-AD model to illustate shot- and long-un consequences of a vaiety of shocks to the economy The End 7