Macroeconomic for Economits II Chapter five .pptx

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1. CHAPTER FIVE PRODUCT/GOODS AND MONEY MARKET Prepared by : Dagim f. Department of economics, mizan-tepi university

2. 5.1. The Goods Market and IS Curve The IS and LM model , first developed by Sir John Hicks and Alvin Hansen , has been used from 1937 onwards to summarize a major parts of Keynesian macroeconomic. The IS curve shows the combination of interest rate and levels of output for which planned spending equals income . In the term IS, ‘I’ stands for investment and ‘S’ for saving since these are the major determinant of the variable represented by the IS curve In order to derive the IS curve, we need to drop the assumption that planned investment is autonomous (fixed). 12/16/2022 [email protected] 2

3. Cont… By relaxing this assumption we can say that planned investment depends on interest rate and they are negatively related. This means that when interest rate is high, less investment will be made. Thus , higher levels of interest rate are associated with lower level of output. This is why Keynesians recommended that injection of money during economic contraction would reduce interest rate and thereby increase output . 12/16/2022 [email protected] 3

4. Methods of deriving the IS curve There are different three methods of deriving the IS curve, two of them are graphical method and the third one is a mathematical method. These derivations are also used as proving techniques of the negative relationship between interest rate and the output. Specifically these methods are the following: Deriving the IS curve from Keynesian cross Deriving the IS curve from investment and saving curve Deriving the IS curve mathematically 12/16/2022 [email protected] 4

5. Cont… i. Deriving the IS curve from Keynesian cross We already said that the IS curve represents the relationship between interest rate and income or output in the goods market . To derive the relationships, we need to add this relationship between the interest rate and investment to our model; we write the level of investment as I = I(r). Hence, the model will be: Y = a + b(Y – T) + I(r) + G ………………………………( 2.1) 12/16/2022 [email protected] 5

6. Cont… This investment function is graphed in panel (a) of Figure 2.1. Because the interest rate is the cost of borrowing to finance investment projects, an increase in the interest rate reduces planned investment . On the other hand, higher interest rate also implies that individuals will prefer to save their money rather than making investment in more productive activities. This is also because the opportunity cost of such investment is higher when interest rate is higher as this will be an alternative where one can put his money to get more profit. As a result, the investment function slopes downward . 12/16/2022 [email protected] 6

7. Cont… To determine how income changes when the interest rate changes, we can combine the investment function with the Keynesian-cross diagram. Because investment is inversely related to the interest rate , an increase in the interest rate from r1 to r2 reduces the quantity of investment from I(r1) to I(r2 ). The reduction in planned investment, in turn, shifts the planned-expenditure function downward, as in panel (b) of Figure 2.1. The shift in the planned-expenditure function causes the level of income to fall from Y1 to Y2 . Hence , an increase in the interest rate lowers income. 12/16/2022 [email protected] 7

8. Cont… The IS curve, shown in panel (c) of Figure 2.1, summarizes this relationship between the interest rate and the level of income . In essence, the IS curve combines the interaction between r and I expressed by the investment function and the interaction between I and Y demonstrated by the Keynesian cross . Because an increase in the interest rate causes planned investment to fall , which in turn causes income to fall, the IS curve slopes downward. 12/16/2022 [email protected] 8

9. Cont… 12/16/2022 [email protected] 9

10. Cont… ii. Deriving the IS curve from the Investment and Saving curves In this case let’s begin with an increase in income or output and then see the possible impact of the change on the interest rate. Let say that for a given level of income there will be a given level of saving, which is represented by the line S( below. Y1 ) in the figure 2.2 Then what do you think will happen the saving if the person income increases? The answer is simple, the higher income will let the person have excess money over and above his consumption and enable him/her to save more. 12/16/2022 [email protected] 10

11. Cont… This will shift the saving line to the right and this higher saving can be represented by the line S(Y2). The saving here represents the supply of loan-able funds and investment represents the demand for these funds. This higher saving makes the loans cheaper measured in terms of lower interest rate. Graphically this is shown in the figure below as movement from point A to B where the saving and Investment curves intersect. 12/16/2022 [email protected] 11

12. Cont… 12/16/2022 [email protected] 12

13. Cont… iii. Deriving the IS Curve Mathematically We can also represent the IS curve using the national income accounting . Note that if it is expressed in terms of the relationship between the income and interest rate and rearranged, the national income identity represents the IS curve . It is given as follows. Y = C + I + G ……………………………………………………( 2.2) Where , I = I0 – i(r) ; here ‘i’ is marginal propensity to invest C = a + b(Y – T); here ‘b’ is marginal propensity to consume 12/16/2022 [email protected] 13

14. Cont… To see how this produce the IS curve , substitute the investment function I = I – i(r) and the consumption function C = a + b(Y – T) for I and C respectively. Y = a + b(Y – T) + I0 – i(r) + G, by rearranging the identity, we will get Y – a – b(Y – T) – G = I – i(r) ………………………………………… (2.3) The left side of the identity states that the supply of loan-able funds depends on income and fiscal policy (T and G). 12/16/2022 [email protected] 14

15. Cont… The right hand side of the identity (2.3) state that the demand for loan-able fund depends on the interest rate . The interest rate adjusts to equilibrate the supply and demand for loans. Using the identity (2.3) we can reach at or prove that the IS curve shows an inverse relationship between interest rate and output. The proof is done as follow. First re-write the identity (2.3) as given next: 12/16/2022 [email protected] 15

16. Cont… 12/16/2022 [email protected] 16

17. Cont… 12/16/2022 [email protected] 17

18. Fiscal Policy and the IS curve We have seen that government purchase and taxes have an impact on the aggregate demand for goods and services. Any change in the major fiscal policy instruments, namely government purchase and/or taxes, can alter aggregate demand and related macroeconomic variables . Hence, fiscal policy plays a crucial role in attaining some of the society’s economic goals by changing aggregate demand. The use of government purchase and taxes to achieve certain macroeconomic goals is called fiscal policy . 12/16/2022 [email protected] 18

19. Cont… The impact of the change in the fiscal policy instruments is reflected through shifts in the IS curve. For instance, if the level of aggregate demand is less than full employment level of income, an increase in government purchase or reduction in taxes may result in an increase in these variables towards the full employment level. Such an increase in aggregate demand and income or output is represented by a right ward shift in the IS curve. This kind of policy is known as expansionary policy. 12/16/2022 [email protected] 19

20. Cont… If the level of aggregate demand is greater than the full employment level of income then the appropriate policy prescription would be a reduction in government purchase or an increase in taxes. This kind of change may be used to control or reduce inflation rate and it is represented by a backward shift in the IS curve. This kind of policy is known as contractionary fiscal policy. The two major types of fiscal policy impact can be demonstrated by the following examples. 12/16/2022 [email protected] 20

21. Cont… A. An increase in government expenditure and a reduction on tax An increase in the government expenditure increases the aggregate demand and producers respond to this by increasing their production on which they receive more income. If the interest rate is unchanged, such an increase in income is attained through a rightward shift in the IS curve as given in the figure (2.3) below. 12/16/2022 [email protected] 21

22. Cont… 12/16/2022 [email protected] 22

23. Cont… B. A decrease in government expenditure and an increase in tax A decrease in government expenditure reduces government’s demand for goods and services. Lower demand for goods and services implies that producers have to cut their production or supply. Moreover , increasing tax means that relatively larger proportion of household’s income goes to government . So, households will be left with smaller amount of income to consume after the increase in the tax than before. Thus , consumption will be lower and so will aggregate demand and income. Such smaller income and output are represented by a leftward shift in the IS curve. 12/16/2022 [email protected] 23

24. 2.2. The Money Market and the LM Curve LM curve is a line that connects points of different level of outputs or income and interest rate in the money market. The term LM is derived from two different words, ‘L’ from the word liquidity and ‘M’ from the word money demand. Note that both the IS and the LM curves show the relationship between the interest rate and the output or income, but in different market. IS curve is in the commodity market whereas the LM curve is in the money market. Moreover , the IS curve is downward slopping curve whereas the LM curve is upward slopping curve. To discuss the relationship between the LM curve and the transaction in the monetary market, let’s briefly consider the theory of liquidity preference. 12/16/2022 [email protected] 24

25. The Theory of Liquidity Preference This theory is very old theory in monetary economics and macroeconomics. The theory of liquidity preference explains how the supply and demand for real money balance determines the interest rate. To develop this theory, we begin with the supply of real money balances and next with the demand for real money . i. Supply of Real money balance If M stands for the supply of money and P stands for the price level, then M/P is the supply of real money balances. The theory of liquidity preference assumes there is a fixed supply of real money balances. That is , 12/16/2022 [email protected] 25

26. Cont… 12/16/2022 [email protected] 26

27. Cont… ii. Demand for real money balance Next, consider the demand for real money balances. People hold money because it is a “liquid” asset ; that is, because it is easily used to make transaction . The theory of liquidity preference posits that the interest rate is one determinant of how much money people choose to hold. The reason is that the interest rate is the opportunity cost of holding money. When the interest rate rises, people want to hold less of their wealth in the form of money. We can write the demand for real money balances as 12/16/2022 [email protected] 27

28. Cont… This equation states that the quantity of real money balance demanded is a function of the interest rate. This inverse relationship between money demand and interest rate can be shown as a downward slopping demand curve. 12/16/2022 [email protected] 28

29. Cont… At the equilibrium interest rate, the quantity of real balance demanded equals the quantity supplied. The equilibrium condition is defined at the point intersection between the two curves in the figure below. 12/16/2022 [email protected] 29

30. Cont… The adjustment of the interest rate to this equilibrium of money supply and money demand occurs because whenever the money is not in equilibrium, people try to adjust their portfolios of assets and, in the process, alter the interest rate. For instance, if the interest rate is above the equilibrium level (too high), the quantity of real money balances supplied exceeds the quantity demanded. Individuals holding the excess supply of money try to convert some of their non-interest-bearing money into interest-bearing bank deposits or bonds. 12/16/2022 [email protected] 30

31. Cont… 12/16/2022 [email protected] 31

32. Cont… The Keynesian theory of demand for money says that transaction and precautionary demand for money are directly related to income level alone, i.e. Mt = K(Y) …………………………………………………… (2.7) On the other hand, speculative demand for money is a function of interest rate, i.e. Msp = L(r) ………………………………………………………… (2.8) So, adding the two identities above (2.7) and (2.8), we can get the total demand for money as follows. Md = Mt + Msp = K(Y) + L(r) 12/16/2022 [email protected] 32

33. Cont… Since, individual and firms money demand is for the demand for real balance, we can rewrite the total money demand function as follows. ( Md/P ) = k(Y) + L(r) …………………………………………… (2.9) Where :( Md/P)is demand for real money; and ‘P’ is price level Supply of money is assumed to be determined outside the model. In other words, it is exogenously given by the central bank and this can be represented as follows. Ms = M …………………………………………………………( 2.10) 12/16/2022 [email protected] 33

34. Cont… Since this is a national money supply, the real money supply can be obtained by dividing the nominal money supply by price level. Then , the equilibrium will be rewritten as follows. ( Ms/P ) = M / P ……………………………………………… (2.11) Here, M represents the amount of money that is in circulation, which is determined by monetary authority . It is also assumed that the price level (P) is stable or constant. 12/16/2022 [email protected] 34

35. Cont… LM curve is represented by different combination of interest rate and income for which the demand for and supply of real money balance are equal. ( Md/P ) = k(Y) + L(r)……………………. Demand for real money balance ( Ms/P ) = M /P ……………………………… Supply of real money balance ( Md/P ) = M / P …………………………………………………( 2.12) 12/16/2022 [email protected] 35

36. Cont… The identity (2.12) represents the equilibrium condition in the money market. Then different values of interest rate and output (income) represent the LM curve. Graphically , we can represent these equations and get LM curves. We can derive the LM curve in two different ways. These are: a. From income and speculative demand for money b. From income and total demand for money 12/16/2022 [email protected] 36

37. Income, Money Demand, and the LM Curve This method of deriving LM curve is easier than the first method i.e. deriving LM curve from income and speculative demand for money. Because the method assumed that only the interest rate influences the quantity of real balances demanded ( Md/P). But, as we have seen previously, more realistically, the level of income (Y) also affects money demand. When income is high, expenditure is high , so people engage in more transaction that requires this use of money. Thus , the larger income implies the larger money demanded. 12/16/2022 [email protected] 37

38. Cont… We now write the real money demand function as we have specified above in equation (2.9) ( Md/P ) = L(r, Y) or ( Md/P ) = k(Y) + L(r) The quantity of real money balance demanded is negatively related to the interest rate and positively related to income level. Using the theory of liquidity preference, we can see what happens to the interest rate when the level of income changes. Theory of liquidity preference refers to the fact people prefer to keep more money to meet different transaction more conveniently or short term investment than long time investment even if its return is larger. 12/16/2022 [email protected] 38

39. Cont… For example, consider what will happens when income increase from Y1 to Y2 given in the figure below . 12/16/2022 [email protected] 39

40. Cont… As can see in the figure above, increase income level shifts the money demand curve upward. As the supply of real money balance is constant, to bring the equilibrium in the money market for money balances, the interest rate must rise from r1 to r2. Therefore , higher income leads to higher interest rate. The LM curve plots this relationship; the higher the level of income, the higher the demand for real money balance and the higher will be the equilibrium interest rate. Then , the LM curve can be drawn by connecting the points representing the corresponding interest rate and income level. 12/16/2022 [email protected] 40

41. Monetary policy and Shift in the LM curve The LM curve tells us the equilibrium interest rate for any given level of income in the money market. The theory of liquidity preference shows that the equilibrium interest rate depends on the supply of real money balance. The LM curve is drawn for a given supply of real money balances . This means that a given LM curve shows the relationship between interest rate and income or output for a given level of supply of real money balance. If supply of real money balances changes, the LM curve will shift from its initial position. Thus , we understand that a change in the supply of real money balance is an important factor that leads to a shift in the LM curve. 12/16/2022 [email protected] 41

42. Cont… A. decrease in money supply In order to show the direction of a shift, let us assume that the Fed (Central Bank of Ethiopia) has decided to decrease the money supply from M1 to M2. This causes the supply of real balances to fall from ( M1/P ) to ( M2/P ), for M1 > M2 . Assuming the level of income and demand curve for real money balance are constant, a reduction in the supply of real balance raises the interest rate as shown in figure (2.9) below. This would ultimately shift the LM curve upward. 12/16/2022 [email protected] 42

43. Cont… It is also possible to see from the figure that at a lower interest rate, the corresponding income level on the new LM curve ‘LM2’ is smaller. For instance, take any point to the left of point ‘A’ on the LM2 curve. Thus , it is clear that a reduction in the real money supply leads to the higher interest rate and a lower income level. Therefore , reducing supply of real money balance is a contaractionary policy. 12/16/2022 [email protected] 43

44. Cont… 12/16/2022 [email protected] 44

45. Cont… B. A decrease in money supply On the other hand, one can find that an increase in the supply of money would shift the LM curve downward. Therefore , an increase in the supply of real money balance leads to lower interest rate and higher output or income; and it is known as expansionary monetary policy. The LM curve is drawn for a given supply of real money balances. Thus , a decrease in the supply of real money balances shift the LM curve upward and an increase in the supply of real money balances shift the LM curve downward. These are called contarctionary and expansionary monetary policy. 12/16/2022 [email protected] 45

46. 2.3. Goods and Monetary Market Equilibrium T here is only one combination of ‘Y’ and ‘r’ at which the supply of goods and service equals demand for the goods and services in the goods market and the supply of real money balance equals the demand for real money balance in the money market. In other words, there is only one point where goods and money markets are simultaneously in equilibrium. This combination of ‘Y’ and ‘r’ can easily be obtained by bringing both markets together as shown in the figure below (2.10). 12/16/2022 [email protected] 46

47. Cont… 12/16/2022 [email protected] 47

48. Cont… The equilibrium defined at the point of intersection between the IS and the LM curves. Mathematically , the IS and the LM equations are calculated from the components of the goods market and of the money market using the equation (2.3) and (2.12) respectively. We now have all the components of the IS and LM model. Thus , the two equations of the model are as follow: Y = a – b(Y – T) + I0 – i(r) + G …………………………………………IS ( Md/P ) = M ̅/P = k(Y) + L(r) ……………………………………………LM 12/16/2022 [email protected] 48

49. Cont… The models takes fiscal policy variables ( G and T ), monetary policy instrument (M), and the price level as exogenous variable (constant); and income or output level (Y) and interest rate (r) as endogenous variables. Given these variables, the IS curve provides the combination of ‘r’ and ‘Y’ that satisfy the equation representing the goods market; and the LM curve provides the combinations of ‘r’ and ‘Y’ that satisfy the equation representing the money market. These two curves are shown together in the figure above. The equilibrium of the economy is defined by the point at which IS curve and the LM curve intersect. 12/16/2022 [email protected] 49

50. Cont… Any deviation from this equilibrium is believed to be corrected by different corrective measures. Classical economists believe that there is an automatic adjustment by the markets themselves whereas Keynesians believes that government corrective intervention is needed. Now , first, we will see the arguments of the non-interventionist, next we discuss the possible government intervention and its impact in detail. 12/16/2022 [email protected] 50

51. 2.4. Monetary and Fiscal Policy and the IS-LM model Change in Fiscal policy Suppose that we start in equilibrium and the government spending increased by ∆ G. Then , the IS curve shifts to the right. The increased government spending will increase the level of income which ultimately increases consumption following the multiplier principle we have discussed in the previous sections. As consumption increases, again income will increases as consumption of a person is income of another person. So income increases further and the intensity of the increase depends on the value of the multiplier. Recall that the rightward shift of the IS curve equals to (∆G/(1-MPC)). 12/16/2022 [email protected] 51

52. Cont… But the increase in income, in turn, increases the demand for money for transaction purposes. This increased demand for money forces up the interest rate, leading in-turn, to a decline in investment. Thus , we observe short-run crowding out effect. So , in this two market cases, the increase in GDP may be less than the simple Keynesian cross model’s because of the fact that Keynesian model omits changes in interest rate. Similarly , a decline in taxes, like an increase in government spending, shifts the IS curve out, causing interest rate and GDP to rise. 12/16/2022 [email protected] 52

53. Cont… Mathematical derivation of the impact of the fiscal policy, considering both the markets simultaneously, can be done as follow: Y = a – b(Y – T) + I0 – i(r) + G …………………………………… (2.13) ( Md/P ) = k(Y) + L(r) ………………………………………………….( 2.14) Differentiating (2.13) and (2.14), we obtain the following: First from IS curve (2.13) we get dY = da – bd (Y –T) + dI0 – id(r) + dG , assuming the tax rate is fixed, (da = dI0= dT = 0), we get dY = bdY – idr + dG or dY(1-b) = idr + dG ..………( 2.15) 12/16/2022 [email protected] 53

54. Cont… 12/16/2022 [email protected] 54

55. Cont… 12/16/2022 [email protected] 55

56. Cont… As you remember from chapter one, dY/ dG is government purchase multiplier; hence, 1/((1 – b + ik⁄L) ) is government purchase multiplier in both (goods and money) market. Just like that of government purchase multiplier in goods market, the value of multiplier is greater than zero (i.e. 1/((1 – b + ik⁄L) ) > 0). This is because first, 1 – b >0 as 0 < b < 1; second, i and L < 0 and last K > 0. That is both the numerator and denominator of ( ik /L) are negative. Thus, government purchase has expansionary impact. But, it is clearly understood that the multiplier is smaller in this case than the only goods market case. 12/16/2022 [email protected] 56

57. Cont… 2. Change in Monetary policy Consider the effect of an increase in the money supply . This shifts the LM curve rightwards. The increased money supply causes interest rates to fall in order to bring the demand for money in line with the new higher supply. This fall in the interest rates encourages investments, leasing, ultimately, to an increase in GDP or income. Thus , interest rates are lower and GDP is higher . The linkage from a change in the money supply to GDP is known as the monetary transmission mechanisms given by the following chain of relations. 12/16/2022 [email protected] 57

58. Mathematical derivation of the monetary policy The impact of the monetary policy can also be derived from equation (2.17) above, which is …………….…………… (2.18) Since both the denominator and nominator are positive the value of money multiplier (dY/ dM ) is greater than zero ( i.e. This shows that an increase in money supply raises the level of income. The transmission mechanism in the context of IS-LM model is that an increase in the money supply lowers the interest rate, which in-turn stimulates investment and thereby expands the demand for goods and services. 12/16/2022 [email protected] 58

59. 2.4. The Interaction Between Monetary and Fiscal Policy When analyzing any change in monetary or fiscal policy, it is important to keep in mind that the policymakers who control these policy tools are aware of what the other policymakers are doing . A change in one policy, therefore, may influence the other, and this interdependence may alter the impact of a policy change. For example, suppose fiscal authority raises tax. What effect should this policy have on the economy? According to the IS–LM model, the answer depends on how the monetary authority responds to the tax increase. Figure 2.11 shows three of the many possible outcomes. 12/16/2022 [email protected] 59

60. Cont… In panel (a), if the monetary authority holds the money supply constant, the tax increase shifts the IS curve to the left. Hence , income falls (because higher taxes reduce consumer spending), and the interest rate falls (because lower income reduces the demand for money ). The fall in income indicates that the tax increase causes a recession. In panel (b) shows what the monetary authority merely do if it wants to hold the interest rate constant. In this case, when the tax increase shifts the IS curve to the left, the monetary authority must decrease the money supply to keep the interest rate at its original level. 12/16/2022 [email protected] 60

61. Cont… This fall in the money supply shifts the LM curve upward. The interest rate does not fall, but income falls by a larger amount than if the monetary authority had held the money supply constant. Whereas in panel (a) the lower interest rate stimulated investment and partially offset the contractionary effect of the tax hike, in panel (b) the Fed deepens the recession by keeping the interest rate high. 12/16/2022 [email protected] 61

62. Cont… In panel (c), shows what the monetary authority merely do if it wants to prevent the tax increase from lowering income. It must, therefore, raise the money supply and shift the LM curve downward enough to offset the shift in the IS curve . In this case, the tax increase does not cause a recession, but it does cause a large fall in the interest rate. Although the level of income is not changed, the combination of a tax increase and a monetary expansion does change the allocation of the economy’s resources. The higher taxes depress consumption, while the lower interest rate stimulates investment. Income is not affected because these two effects exactly balance. 12/16/2022 [email protected] 62

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66. IS–LM as a theory of Aggregate Demand We have been using the IS–LM model to explain national income in the short run when the price level is fixed. To see how the IS–LM model fits into the model of aggregate supply and aggregate demand introduced in Chapter 1, we now examine what happens in the IS–LM model if the price level is allowed to change. As was promised when we began our study of this model, the IS–LM model provides a theory to explain the position and slope of the aggregate demand curve. 12/16/2022 [email protected] 66

67. From the IS–LM Model to the Aggregate Demand Curve To understand the determinants of aggregate demand more fully, we now use the IS–LM model, to derive the aggregate demand curve. First , we use the IS–LM model to show why national income falls as the price level rises—that is, why the aggregate demand curve is downward sloping. Second , we examine what causes the aggregate demand curve to shift. To explain why the aggregate demand curve slopes downward, we examine what happens in the IS–LM model when the price level changes. 12/16/2022 [email protected] 67

68. Cont… This is done in Figure 2.12. For any given money supply M, a higher price level P reduces the supply of real money balances M/P . A lower supply of real money balances shifts the LM curve upward, which raises the equilibrium interest rate and lowers the equilibrium level of income, as shown in panel (a ). Here the price level rises from P1to P2, and income falls from Y1to Y2 . The aggregate demand curve in panel (b) plots this negative relationship between national income and the price level. In other words, the aggregate demand curve shows the set of equilibrium points that arise in the IS–LM model as we vary the price level and see what happens to income. 12/16/2022 [email protected] 68

69. Cont… What causes the aggregate demand curve to shift? Because the aggregate demand curve is merely a summary of results from the IS–LM model, events that shift the IS curve or the LM curve (for a given price level) cause the aggregate demand curve to shift. For instance, an increase in the money supply raises income in the IS–LM model for any given price level; it thus shifts the aggregate demand curve to the right, as shown in panel (a) of Figure 2.13 . Similarly , an increase in government purchases or a decrease in taxes raises income in the IS-LM model for a given price level; it also shifts the aggregate demand curve to the right, as shown in panel (b) of Figure 2.13 . 12/16/2022 [email protected] 69

70. Cont… Conversely, a decrease in the money supply, a decrease in government purchases, or an increase in taxes lowers income in the IS–LM model and shifts the aggregate demand curve to the left. We can summarize these results as follows: A change in income in the IS–LM model resulting from a change in the price level represents a movement along the aggregate demand curve. A change in income in the IS–LM model for a fixed price level represents a shift in the aggregate demand curve. 12/16/2022 [email protected] 70

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74. 2.5.The IS–LM Model in the Short Run and Long Run Panel (a) of Figure 2.14 shows the three curves that are necessary for understanding the short-run and long-run equilibrium: the IS curve, the LM curve, and the vertical line representing the natural rate of output Y. The LM curve is, as always, drawn for a fixed price level, P1. The short-run equilibrium of the economy is point K, where the IS curve crosses the LM curve. Notice that in this short-run equilibrium, the economy’s income is less than its natural rate. 12/16/2022 [email protected] 74

75. Cont… Panel (b) of Figure 2.14 shows the same situation in the diagram of aggregate supply and aggregate demand. At the price level P1, the quantity of output demanded is below the natural rate. In other words, at the existing price level, there is insufficient demand for goods and services to keep the economy producing at its potential. In these two diagrams we can examine the short-run equilibrium at which the economy finds itself and the long-run equilibrium toward which the economy gravitates. Point K describes the short-run equilibrium, because it assumes that the price level is stuck at P1. 12/16/2022 [email protected] 75

76. Cont… Eventually, the low demand for goods and services causes prices to fall, and the economy moves back toward its natural rate. When the price level reaches P2, the economy is at point C, the long-run equilibrium. The diagram of aggregate supply and aggregate demand shows that at point C, the quantity of goods and services demanded equals the natural rate of output. This long-run equilibrium is achieved in the IS–LM diagram by a shift in the LM curve: the fall in the price level raises real money balances and therefore shifts the LM curve to the right. 12/16/2022 [email protected] 76

77. Cont… To make the same point somewhat differently, we can think of the economy as being described by three equations. The first two are the IS and LM equations: Y = C(Y − T) + I(r) + G ………………………………….. (IS), M/P = L(r, Y) ………………………………………………… (LM) The IS equation describes the goods market, and the LM equation describes the money market. These two equations contain three endogenous variables : Y, P, and r. The Keynesian approach is to complete the model with the assumption of fixed prices, so the Keynesian third equation is P = P1. This assumption implies that r and Y must adjust to satisfy the IS and LM equations. 12/16/2022 [email protected] 77

78. Cont… The classical approach is to complete the model with the assumption that output reaches the natural rate, so the classical third equation is Y = Y. This assumption implies that r and P must adjust to satisfy the IS and LM equations. Which assumption is most appropriate? The answer depends on the time horizon. The classical assumption is best in describing the long run. Hence , our long-run analysis of national income assumes that output equals the natural rate. The Keynesian assumption best describes the short run. Therefore , our analysis of economic fluctuations relies on the assumption of a fixed price level. 12/16/2022 [email protected] 78

79. Cont… 12/16/2022 [email protected] 79