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The IS-LM/AS-AD Model (part 2) I. The FE line: Equilibrium in the Labour Market A. In the discussion of the labour market, we showed how equilibrium in the labour market leads to employment at its full-employment level N and output at Y . B. If we plot output against the real interest rate, we get a vertical line at Y = Y , since labour market equilibrium is unaffected by changes in the real interest rate. C. Factors that shift the FE line 1. Y is determined by the full-employment level of employment and the current levels of capital and productivity; any change in these variables shifts the FE line. 2. Summary Table 11 lists the factors that shift the full-employment line to the right. a. a beneficial supply shock b. an increase in labour supply c. an increase in the capital stock 3. The full-employment line shifts left when the opposite happens to the three factors above Output, Y Real interest rate, r FE line Y II. The IS curve: Equilibrium in the Goods Market 1 A. The goods market clears when desired investment equals desired national saving 1. Adjustments in the real interest rate bring about equilibrium 2. For any level of output Y, the IS curve shows the real interest rate r for which the goods market is in equilibrium Real interest rate, r Real interest rate, r S d , I d Output, Y S(Y1) S(Y2) Y1 Y2 r 1 r 2 I IS 3. Derivation of the IS curve from the saving-investment diagram a. Key features The saving curve slopes upward because a higher real interest rate increases saving An increase in output shifts the saving curve to the right, because people save more when their income is higher The investment curve slopes downward because a higher real interest rate reduces the desired capital stock, thus reducing investment b. Consider two different levels of output At the higher level of output, the saving curve is shifted to the right compared to the situation at the lower level of output Since the investment curve is downward sloping, equilibrium at the higher level of output has a lower real interest rate Thus a higher level of output must lead to a lower real interest rate, so the IS curve slopes downward The IS curve shows the relationship between the real interest rate and output for which investment equals saving c. Alternative interpretation in terms of goods market equilibrium Beginning at a point of equilibrium, suppose the real interest rate rises 2 The increased real interest rate causes people to increase saving and thus reduce consumption, and causes firms to reduce investment So the quantity of goods demanded declines To restore equilibrium, the quantity of goods supplied would have to decline So higher real interest rates are associated with lower output, that is, the IS curve slopes downward B. Factors that shift the IS curve 1. Any change that reduces desired national saving relative to desired investment shifts the IS curve up a. Intuitively, imagine constant output, so a reduction in saving means more ... View Full Document

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