Lecture 7 Business Cycles (3) IS-LM and AD-AS
The Big Picture
1
Keynesian Cross
Theory of Liquidity Preference
IS curve
LM curve
IS-LM model
Agg. demand curve
Agg. supply curve
Model of Agg. Demand and Agg. Supply
Explanation of short-run fluctuations
The FE Line: Equilibrium in the Labor Market
Labor market showed how equilibrium in the labor market leads to employment at its full-employment level ( ) and output at its full-employment level ( )
If we plot output against the real interest rate, we get a vertical line, since labor market equilibrium is unaffected by changes in the real interest rate (Fig. )
Figure The FE line
The FE Line
The full-employment line shifts right because of
a beneficial supply shock
an increase in labor supply
an increase in the capital stock
The full-employment line shifts left when the opposite happens to the three factors above
The IS curve
def: a graph of binations of r and Y that result in goods market equilibrium,
. actual expenditure (output) = planned expenditure
The equation for the IS curve is: (Investment depends on r)
5
Deriving the IS curve
r I
6
Y2
Y1
Y2
Y1
Y
E
r
Y
E =C +I (r1 )+G
E =C +I (r2 )+G
r1
r2
E =Y
IS
I
E
Y
Understanding the IS curve’s slope
The IS curve is negatively sloped.
Intuition: A fall in the interest rate motivates firms to increase investment spending, which drives up total planned spending (E ).
To restore equilibrium in the goods market, output (actual expenditure, Y ) must increase.
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Fiscal Policy and the IS curve
We can use the IS-LM model to see how fiscal policy (G and T ) can affect aggregate demand and output.
Let’s start by using the Keynesian Cross to see how fiscal policy shifts the IS curve…
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Shifting the IS curve: G
At any value of r, G E Y
9
Y2
Y1
Y2
Y1
Y
E
r
Y
E =C +I (r1 )+G1
E =C +I (r1 )+G2
r1
E =Y
IS1
The horizontal distance of the IS shift equals
IS2
…so the IS curve shifts to the right.
Y
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