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MACROECONOMICS Imperfections, Institutions 8 Policies Wendy Carlin David Soskice INDIAN EDITION
Aggregate Demand,2 Aggregate Supply, and Business Cycles This chapter begins the process of setting out the short-to medium-run macro model. The fnst aim of the chapter is to explain how the level of output and employment is determined by the level of aggregate demand in the short run-Leo when wages and prices are sticky. This provides a model of the business cycle, i.e. how the level of output and employment fluctuates in response to changes inaggregate demand. We begin with the standard approach of introducing the goods market equilibrium and then the money market equilibtium in the IS/LM model. The IS refers to the goods market and the LM to the money market. There are two broad ways of thinking about how monetary policy is implemented by governments or central banks and hence about the usefulness of the LM analysis. On the one hand, the government or central banl< can be modelled as implementing monetary policy through its control over the level or the growth rate of the money supply. We shall see that this approach is best handled using the LM. On the other hand, the government or central bank can be seen as setting the interest rate so as to stabilize the economy and steer it toward an inflation target. This is the so-called monetary rule (MR) approach developed in Chapter 3. Given the increasing prevalence of monetary rules in monetary policy-making, the question arises as to why should we bother with presenting the LM analysis at all? • First, if we are to understand why governments and central banks have moved toward the use of monetary rules, it is useful to have a sound understanding of the LM approach as a benchmark. Moreover, even if the central bank is using the MR approach, theLM still exists since it represents equilibrium in the money market. • Second, the LM approach is helpful in analysing problems of deflation-Leo when prices are falling in the economy. Even ifthe central bank uses a monetary rule to adjust the interest rate to achieve an inflation target, we need to understand the circumstances under which this may be ineffective. An important example is the situation where the nominal interest rate is close to zero and the economy is characterized by a falling price level,as has characterized theJapanese economy for nearly a decade. • Third, as we shall see in Chapter 9, much open economy analysis is conducted using the IS/LM modeL All three reasons suggest that even ifthe LM is less relevant for practical policy analysis than was once thought, it remains a useful modelling tool. The ISjLM model can be used
28 me MACROECONOMIC; MODn for anaJysing the deterrnirwnts of output in the short run when the government controls the money supply. It also provides components that are useful later on. We shall see that the lS curve is a key part of the 3·cquation IS-PC-MR macro model developed in Chapter 3 for use with a monetary rule.