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Chapter IX IS-LM and AD-AS - Chapter IX The ISLM ADAS Model...

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Chapter IX The IS–LM / AD–AS Model: A General Framework for Macroeconomic Analysis a. The FE Line: Equilibrium in the Labor Market The Full-employment level of employment , N , is the equilibrium level of employment reached after wages and prices have fully adjusted, so that the quantity of labor supplied equals the quantity of labor demanded. Full-employment output , Y , is the amount of output produced when employment is at its full employment level, for the current level of the capital stock and the production function. ) , ( N K AF Y = The full-employment line represents equilibrium in the labor market. When the labor market is at equilibrium, employment equals N and output equals Y , regardless of the value of the real interest rate. Thus it is a vertical line. The Factor That Shift the FE Line The factors that will shift the FE line are: Full-employment output , ) , ( N K AF Y = When capital stock changes, K When labor supply increase, N When there is a beneficial or adverse supply shock (change in wealth, expected future real wages, working age, participation rate). b. The IS Curve: Equilibrium in the Goods Market The goods market is in equilibrium when desired investment and desired national savings are equal (i.e. when the quantity of goods demanded are equal to the quantity of the goods supplied. The IS curve shows the real interest rate for which the goods market is at equilibrium. Another way of defining IS curve is, for any level of output IS curve will show the real interest rate that clears the goods market. The IS curve is named this way because at all points in the curve I d = S d . The slope of the Is curve could be interpreted in terms of the alternative version, which states that in equilibrium the aggregate Q d of goods must equal the aggregate Q s of goods. 1

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Suppose r increase: What will happen to C d and I d ? Factors That Shift the IS Curve A shift on the IS curve up and to the right With output held constant, any change in the economy that reduces desired national savings relative to desired investment will increase the real interest rate that clears the goods market. A shift on the IS curve down and to the left With output held constant, any change in the economy that increases desired saving relative to desired investment, thereby reducing the market-clearing real interest rate. Factors are: Expected future output Wealth G MPK f T τ on capital. We can also use the Y = C d + I( Y , r +π) + G to see how IS curve shifts. If C or G increases and Y is constant, what variable(s) will be able to change? c. The LM Curve: Equilibrium in the Asset Market This is the asset market. The asset market is at equilibrium when the quantities of assets demanded by holders of wealth for their portfolios equal the supplies of those assets in the economy.
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