AD-AS Short Run

1
AD-AS Short Run

• Building the short run AD-AS model from the IS-LM
  framework

2
Theory of Short Run Fluctuations
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.
Keynesian Cross
IS Curve
IS-LM Model
AD Curve
Money Market
LM Curve
AD-AS Model
Short-run Fluctuations Explanation
AS Curve
3
Fiscal Policy and the IS curve (government
expenditure)
An increase in government purchases shifts the IS
curve to the right.
The IS curve shifts to the right by ?G/(1-MPC),...
r
LM
...and the interest rate.
r2
r1
IS2
IS1
which raises income...
Y
Y1
Y2
4
Fiscal Policy and the IS curve (government
expenditure)
A decrease in taxes shifts the IS curve to the
right.
The IS curve shifts to the right by
?TxMPC/(1MPC),...
r
LM
...and the interest rate.
r2
r1
IS2
IS1
which raises income...
Y
Y1
Y2
5
Fiscal Policy and the IS curve (tax changes)

• Note that government expenditure has a larger
  effect than does the same change in taxes.

6
Monetary Policy and the LM curve
An increase in the money supply shifts the LM
curve to the right,...
r
LM1
LM2
...and lowers the interest rate.
r1
r2
IS1
which raises income...
Y
Y1
Y2
7
Monetary and Fiscal Policy Interactions
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.

r
LM1

• The interest rate and output fall.

IS1
IS2
Y
8
Monetary and Fiscal Policy Interactions
if to hold the interest rate constant, the money
supply contracts.

• How the economy responds to a tax increase
  depends on the response of the money supply.

r
LM2
LM1

• Only output falls.

IS1
IS2
Y
9
Monetary and Fiscal Policy Interactions
if to hold income constant, the money supply
expands.

• How the economy responds to a tax increase
  depends on the response of the money supply.

r
LM1
LM2
IS1

• Only the interest rate falls.

IS2
Y
10
IS-LM as a theory of Aggregate Demand
r
LM(P2)
LM(P1)
A higher price level P shifts the LM curve upward
lowering income Y.
IS1
Y

• 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.

Y1
Y2
The AD curve summarizes the relationship between
P and Y.
P
P2
P1
AD
Y
Y1
Y2
11
IS-LM as a theory of Aggregate Demand
r
LM(P1)
LM(P1)
A monetary expansion shifts the LM curve outward
increasing income Y.
IS1
Y
Y1
Y2

• If we hold price constant we can see the effects
  of monetary and fiscal policy on AD via IS-LM.

Increasing AD at any given price level.
P
P1
AD2
AD1
Y
Y2
Y1
12
IS-LM as a theory of Aggregate Demand
r
LM(P1)
A fiscal expansion shifts the IS curve outward
IS2
IS1
Y
increasing income Y.
Y1
Y2
Increasing AD at any given price level.
P
P1
AD2
AD1
Y
Y2
Y1
13
IS-LM and AD-AS the Short Run and the Long Run

• Now lets add short-run and long-run AS to our
  IS-LM and AD models. Assume the economy is
  operating below full employment output.

LRAS
r
LM(P2)
LM(P1)
As price falls money demand decreases and the LM
curve shifts out.
1
2
IS
Y
In the short run price is fixed at P1 and
equilibrium is at point 1.
P
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.
P1
SRAS1
1
SRAS2
P2
2
AD1

• Long run equilibrium is achieved at point 2.

Y
14
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.

15
The Algebra of the IS-LM theory of AD
The IS curve boils down to
The LM curve boils down to
Plugging r into the IS curve and solving for Y
yields
16
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.