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Lecture notes - ISLM-1

# Lecture notes - ISLM-1 - The IS-LM/AS-AD Model(part 1...

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The IS-LM/AS-AD Model (part 1) Combine the labour market, the goods market, and the asset market into a complete macroeconomic model Although the IS-LM model was originally a Keynesian model because it assumes prices are fixed, it’s possible to use the IS-LM framework to discuss the classical approach by allowing prices to adjust I. Labor Market 1.1 The Demand for Labour A. How much labour do firms want to use? 1. Assumptions a. Hold capital stock fixed—short-run analysis b. Workers are all alike c. Labour market is competitive d. Firms maximize profits 2. Analysis at the margin: costs and benefits of hiring one extra worker a. If real wage (w) > marginal product of labour (MPN), the firm is paying the marginal worker more than the worker produces, so the firm should reduce the number of workers to increase profits b. If w < MPN, the marginal worker produces more than he or she is being paid, so the firm should increase the number of workers to increase profits. c. Firms’ profits are highest when w = MPN B. The marginal product of labour and labour demand 1. The optimal condition can also be expressed in the nominal terms: W = MRPN, where W = wP is the nominal wage, and MRPN = P(MPN) is the marginal revenue product of labor 2. A change in the wage a. Begin at equilibrium where W = MRPN b. A rise in the wage rate means W > MRPN, unless N is reduced so the MRPN rises c. A decline in the wage rate means W < MRPN, unless N rises so the MRPN fails C. The marginal product of labour and labour demand curve 1. Labour demand curve shows relationship between the real wage rate and the quantity of labour demanded 2. It is the same as the MPN curve, since w = MPN in equilibrium 1

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3. So the labour demand curve is downward sloping; firms want to hire less labour, the higher the real wage Labour, N MPN, w w1 N1 w2 N2 D. Factors that shift the labour demand curve 1. Supply shocks: Beneficial supply shock raises MPN, so shifts labour demand curve to the right; opposite for adverse supply shock 2. Size of capital stock: Higher capital stock raises MPN, so shifts labour demand curve to the right; opposite for lower capital stock F. Aggregate labour demand 1. Aggregate labour demand is the sum of all firms’ labour demand 2. Same factors (supply shocks, size of capital stock) that shift firms’ labour demand cause shifts in aggregate labour demand Labour, N MPN, w w* N* 2
1.2 The Supply of Labour A. Supply of labour is determined by individuals 1. Aggregate supply of labour is sum of individuals’ labour supply 2. Labour supply of individuals depends on labour-leisure choice

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