Summary of IS-LM and AS-AD
Karl Whelan
September 19, 2014
The Goods Market
• This is in equilibrium when the demand for goods
equals the supply of goods.
• Higher real interest rates mean there is less
demand for spending.
– Consumers choose to save instead of spend.
– Businesses discouraged from borrowing for
investment.
• So higher real interest rates mean the goods
market equilibrium (demand = supply) occurs at a
lower level of supply, i.e. lower GDP>
The IS Curve
Shifts in the IS Curve
• Anything that leads to higher demand for
spending that is NOT real interest rates will shift
the IS curve to the right. This includes
– Improvements in consumer\business sentiment.
– Higher government spending.
– Lower taxes.
– Good news about the future of the economy.
• The opposite type of developments (e.g. lower
consumer sentiment) will shift the IS curve to the
left.
A Fall in Consumer Confidence
The Money Market: Demand
• You have to keep all of your assets in one of two forms
– Money, which bears no interest but can be used for
transactions.
– Bonds, which pay an interest rate of r.
• Three factors determine the demand for money
– GDP: More GDP means you need more money for
transactions.
– Prices: Doubling prices means you need double the money
for transactions
– Interest Rates: Higher interest rates means less demand
for money and more demand for bonds.
An Equation for Money Demand
An equation to describe this would look like this:
Where
Money Supply
• This is set by the central bank.
• In reality, the central bank only controls the
monetary base (currency and reserves at the
central bank).
• The money supply includes bank deposits and
depends in a complex way on the behaviour of
the banking system.
• So this is a major simplification of the IS-LM
model.
Money Market Equilibrium
• This occurs when the amount of money demanded
equals the amount supplied by the central bank.
• Assume, the market is in equilibrium, what happens
when GDP goes up, thus raising demand for money.
• If the price level and money supply are fixed, then
equilibrium can only be restored via higher interest
rates.
• This is why the LM curve slopes up.
The LM Curve
(Ignore the Pi term in the graph. Imagine it says r instead!)
Shifts in the Money Supply
• Remembering
• If the market starts out in equilibrium, then a
higher supply of money requires a higher
demand for money.
• For every fixed level of interest rates, we need
a higher level of GDP to generate this extra
demand.
• The LM curve shifts out.
An Increase in the Money Supply
Equilibrium in the IS-LM Model
(Again, ignore the labelling).
Aggregate Supply
• We have derived a model of the aggregate demand for goods
and services.
• But we need to also think about the supply side of the
economy.
• Supply capacity is a function of capital and labour inputs and
the efficiency of the economy.
• Labour market equilibrium delivers employment of N*
• So the equilibrium level of output should be
An Equilibrium With Demand = Supply
What if Supply Capacity Falls?
The Role of Price System
• In microeconomics, prices adjust to equate
supply and demand.
• If this was to happen in this model, then prices
would rise to reduce aggregate demand until it
equals supply?
• How does this happen?
– Higher prices raise the demand for money.
– For each level of the interest rate, GDP must now be
lower to maintain money market equilibrium.
– In other words, the LM curve shifts in.
Prices Moving
to Equate Supply and Demand
The AS-AS Model
• This is just the IS-LM model but with a more
explicit focus on the role played by prices.
• We have just shown that a higher price level
means an inward shift in the LM curve.
• Money and prices have symmetric effects in the
model. A doubling of prices has the same impact
as a halving of the money supply.
• The Aggregate Demand curve is just a set of
price-GDP combinations consistent with IS-LM
equilibrium for a fixed money supply.
The AD Curve
Shifts in the AD Curve
• Anything that gives an IS-LM equilibrium with
higher output for a given price level will shift
the AD curve to the left.
• This include
– Increase in the money supply.
– Increased government expenditure.
– Increases in the part of consumption and
investment that are unrelated to interest rates.
Short-Run and Long-Run
• Most economists assume that, over time, prices
do adjust so that aggregate demand equals the
long-run aggregate supply capacity of the
economy.
• But it is clear that GDP often differs from its long-
run supply capacity. High unemployment is a sign
that the economy has lots of spare capacity.
• For this reason, Keynesian macroeconomists have
suggested that prices are “sticky” and don’t
always move to match aggregate demand with
aggregate supply.
Short-Run AS with Fixed Prices:
Right Shift in AD Means Higher Output
But Then Prices Gradually Increase:
Fiscal\Monetary Policy Have No LR Effect on Y
An Alternative Theory
of Aggregate Supply
• This approach assumes that prices are flexible but
wages are fixed in the short-run.
• An increase in the real wage (W/P) has a negative
effect on firm profitability and thus has a negative
effect on output.
• Higher prices thus reduce the real wage, firms
hire more labour and produce more.
• This gives an upward-sloping short-run AS curve.
• Over time, wages adjust to catch up with prices,
so the economy moves back to its long-run
supply capacity.
Sticky Wages and Aggregate Supply
Upward Sloping Short-Run AS Curve
