Chapter 9: The IS-LM/AD-AS Model

Relevant Textbook Solutions (some have been omitted)

Review Questions

1. (Homework Problem)

2. (Homework Problem)

3. (Homework Problem)

4. For constant output, if real money supply exceeds the real quantity of money demanded, the
real interest rate will decline to increase the real quantity of money demanded until equilibrium
is reached. This process occurs because people who find themselves with excess money balances
purchase nonmonetary assets, thus increasing the market price of the nonmonetary assets and
reducing the real interest rate.

5. (Homework Problem)

6. There is monetary neutrality if a change in the nominal money supply changes the price level
but has no effect on real variables. Once prices adjust, money is neutral in the IS–LM model,
because a change in the money supply that shifts the LM curve is matched by a proportional
change in the price level that returns the real money supply back to its original level and moves
the LM curve back to its original location. Classical economists believe that money is neutral in
the short-run, but Keynesians believe that there may be sluggish adjustment of the price level, so
that changes in the money supply affect output and the real interest rate in the short-run. Both
classicals and Keynesians believe money is neutral in the long run.

7. (Homework Problem)

8. The short-run aggregate supply (SRAS) curve is horizontal and the long-run aggregate supply
(LRAS) curve is vertical. The short-run aggregate supply curve is horizontal because prices
remain fixed in the short-run. The long-run aggregate supply curve is vertical because the
aggregate amount of output supplied is the full-employment level, regardless of the price level.

9. In the short-run, money is not neutral. But in the long-run, it is neutral. Suppose the economy
is initially in general equilibrium, as shown in the figure below, where LRAS, SRAS1, and AD1
intersect.

Now suppose the money supply declines by 10%, so the aggregate demand curve shifts down
and to the left to AD2. In the short run, the equilibrium occurs at the intersection of AD2 and
SRAS1, so output declines and the price level is unchanged. Since output declines, money is not
neutral. In the long-run, however, the price level will decline so the short-run aggregate supply
curve shifts down to SRAS2. The long-run equilibrium occurs at the intersection of AD2, SRAS2,

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and LRAS, at which output has been restored to its original level and the price level is lower.
Since output is back at its original level in the long-run, money is neutral in the long-run.

Numerical Problems

1.
(a) S d = Y − C d − G
= Y − (4000 − 4000r + 0.2Y) − 2000
= −6000 + 4000r + 0.8Y.

(b)
(i) Using the equation that goods supplied equals goods demanded gives
Y = Cd + Id + G
Y = (4000 − 4000r + 0.2Y) + (2400 − 4000r) + 2000
Y = 8400 − 8000r + 0.2Y.

So 0.8Y = 8400 − 8000r, or

8000r = 8400 − 0.8Y.

(ii) Using the equivalent equation that desired saving equals desired investment gives
S d = Id
−6000 + 4000r + 0.8Y = 2400 − 4000r
0.8Y = 8400 − 8000r, or
8000r = 8400 − 0.8Y.

So we can use either equilibrium condition to get the same result.

When Y = 10,000,
8000r = 8400 − (0.8 ∗ 10,000) = 400,
so r = 0.05.

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When Y = 10,200,
8000r = 8400 − (0.8 ∗ 10,200) = 240,
so r = 0.03.

(c) When G = 2400, desired saving becomes S d = −6400 + 4000r + 0.8Y. S d is now 400 less for
any given r and Y.

Setting S d = I d, we get
−6400 + 4000r + 0.8Y = 2400 − 4000r
8000r = 8800 − 0.8Y.

Similarly, using the equation that goods supplied equals goods demanded gives
Y = Cd + Id + G
Y = (4000 − 4000r + 0.2Y) + (2400 − 4000r) + 2400
Y = 8800 − 8000r + 0.2Y.

So 0.8Y = 8800 − 8000r, or

8000r = 8800 − 0.8Y.

At Y = 10,000, this is 8000r = 8800 − (0.8 ∗ 10,000) = 800, so r = 0.10. The market-clearing
real interest rate increases from 0.05 to 0.10. Thus the IS curve shifts up and to the right from IS1
to IS2 in the figure below.

2.
(a) M D /P = 3000 + 0.1Y − 10,000i
= 3000 + 0.1Y – 10,000(r + π e)
= 3000 + 0.1Y – 10,000(r + .02)
= 2800 + 0.1Y – 10,000r.

Setting MS/P = MD/P

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6000/2 = 2800 + 0.1Y − 10,000r
10,000r = −200 + 0.1Y
r = −0.02 + (Y/100,000).

When Y = 8000, r = 0.06.

When Y = 9000, r = 0.07.

These points are plotted as line LMa in the figure below.

(b) MS = 6600, so MS/P = 3300. Setting money supply equal to money demand
3300 = 2800 + 0.1Y – 10,000r
10,000r = –500 + 0.1Y
r = –0.05 + (Y/100,000).

When Y = 8000, r = 0.03.

When Y = 9000, r = 0.04.

The LM curve is shifted down and to the right from LMa to LMb, since the same level of Y gives
a lower r at equilibrium.

(c) M D/P = 3000 + 0.1Y − 10,000(r + π e)

= 3000 + 0.1Y − 10,000r − (10,000 ∗ .03)
= 2700 + 0.1Y − 10,000r.

Setting money supply equal to money demand

3000 = 2700 + 0.1Y − 10,000r
10,000r = − 300 + 0.1Y
r = − 0.03 + (Y/100,000).

When Y = 8000, r = 0.05.

When Y = 9000, r = 0.06.

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The LM curve is shifted down and to the right from LMa to LMc , since there is a higher real
interest rate for every given level of output. The LM curve shifts down and to the right by one
percentage point (the increase in π e ) because for any given Y, the same nominal interest rate
clears the asset market. With an unchanged nominal interest rate, the increase in π e is matched
by an equal decrease in r.

3.
(a) First, we’ll find the IS curve.

S d = Y – C d – G = Y − [200 + 0.8(Y − T) − 500r] − G = Y − [200 + (0.6Y − 16) − 500r] − G

= −184 + 0.4Y + 500r − G

Setting S d = I d gives −184 + 0.4Y + 500r − G = 200 − 500r.

Solving this for Y in terms of r gives Y = (960 + 2.5G) − 2500r.

When G = 196, this is Y = 1450 − 2500r.

Next, we’ll find the LM curve. Setting money demand equal to money supply gives 9890/P =
0.5Y − 250r − 25, which can be solved for Y = 19,780/P + 50 + 500r.

With full-employment output of 1000, using this in the IS curve and solving for r gives r = 0.18.

Using Y = 1000 and r = 0.18 in the LM curve and solving for P gives P = 23. Plugging these
results into the consumption and investment equations gives C = 694 and I = 110.

(b) With G = 216, the IS curve becomes Y = 1500 − 2500r. With Y = 1000, the IS curve gives r
= 0.20, the LM curve gives P = 23.27, the consumption equation gives C = 684, and the
investment equation gives I = 100.

4. Omitted

5. The IS curve is found by setting desired saving equal to desired investment. Desired saving is
S d = Y − C d − G = Y − [1275 + 0.5(Y − T) − 200r] − G. Setting S d = I d gives Y − [1275 +
0.5(Y−T) − 200r] − G = 900 − 200r, or Y = 4350 − 800r + 2G − T. The LM curve is MS/P = L (.)
which is 0.5Y − 200i = 0.5Y − 200(r + π ) = 0.5Y − 200r.

(a) T = G = 450, MS = 9000. The IS curve gives Y = 4350 − 800r + 2G − T = 4350 − 800r + (2
∗ 450) −450 = 4800 − 800r. The LM curve gives 9000/P = 0.5Y − 200r. To find the aggregate
demand curve, eliminate r in the two equations by multiplying the LM curve through by 4 and
rearrange the resulting equation and the IS curve.

LM: 9000/P = 0.5Y − 200r. Multiplying by 4 gives 36,000/P = 2Y − 800r. Rearranging gives
800r = 2Y − 36,000/P.

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IS: Y = 4800 − 800r. Rearranging gives 800r = 4800 − Y. Setting the right-hand sides of these
two equations to each other (since both equal 800r) gives: 2Y − (36,000/P) = 4800 − Y, or 3Y =
4800 + (36,000/P), or Y = 1600 + (12,000/P); this is the AD curve.

With Y = 4600 at full employment, the AD curve gives 4600 = 1600 + (12,000/P), or P = 4.
From the IS curve Y = 4800 − 800r, so 4600 = 4800 − 800r, or 800r = 200, so r = 0.25.
Consumption is C = 1275 + 0.5(Y − T) − 200r = 1275 + 0.5(4600 − 450) − (200 ∗ 0.25) = 3300.
Investment is I = 900 − 200r = 900 − (200 ∗ 0.25) = 850.

(b) Following the same steps as above, with MS = 4500 instead of 9000, gives the aggregate
demand curve AD: Y = 1600 + (6000/P). With Y = 4600, this gives P = 2. Nothing has
changed in the IS equation, so it still gives r = 0.25. And nothing has changed in either the
consumption or investment equations, so we still get C = 3300 and I = 850. Money is neutral
here, as no real variables are affected and the price level changes in proportion to the money
supply.

(c) T = G = 330, MS = 9000. The IS curve is Y = 4350 − 800r + 2G − T = 4350 − 800r + (2 *

330) − 330 = 4680 − 800r.

LM: 36,000/P = 2Y − 800r, or 800r = 2Y − 36,000/P.

IS: Y = 4680 − 800r, or 800r = 4680 − Y.

AD: 2Y − (36,000/P) = 4680 − Y, or (36,000/P) + 4680 = 3Y, or Y = 1560 + (12,000/P).

With Y = 4600 at full employment, the AD curve gives 4600 = 1560 + (12,000/P), or P = 3.95.
From the IS curve, Y = 4680 − 800r, so 4600 = 4680 − 800r, or 800r = 80, so r = 0.10.
Consumption is C = 1275 + 0.5(Y − T) − 200r = 1275 + 0.5(4600 − 330) − (200 ∗ 0.10) = 3390.
Investment is I = 900 − 200r = 900 − (200 ∗ 0.10) = 880.

6. Omitted

Analytical Problems

1.
(a) The increase in desired investment shifts the IS curve up and to the right, as shown in the figure
below. The price level rises, shifting the LM curve up and to the left to restore equilibrium. Since
the real interest rate rises, consumption declines. In summary, there is no change in the real
wage, employment, or output; there is a rise in the real interest rate, the price level, and
investment; and there is a decline in consumption.

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(b) The rise in expected inflation shifts the LM curve down and to the right, as shown in the
figure below. The price level rises, shifting the LM curve up and to the left to restore
equilibrium. Since the real interest rate is unchanged, consumption and investment are
unchanged. In summary, there is no change in the real wage, employment, output, the real
interest rate, consumption, or investment; and there is a rise in the price level.

(c) The increase in labor supply is shown as a shift in the labor supply curve in the figure below.
This leads to a decline in the real wage rate and an increase in employment. The rise in
employment causes an increase in output, shifting the FE line to the right as shown in panel (b).
To restore equilibrium, the price level must decline, shifting the LM curve down and to the right.
Since output increases and the real interest rate declines, consumption and investment increase.
In summary, the real wage, the real interest rate, and the price level decline; and employment,
output, consumption, and investment rise.

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(d) The reduction in the demand for money gives results identical to those in part (b).

2. Omitted

3.
(a) The decrease in expected inflation increases real money demand, shifting the LM curve up, as
shown in the figure below. The real interest rate rises and output declines.

(b) The increase in desired consumption shifts the IS curve up and to the right, as shown in the
figure below. This causes the real interest rate and output to rise.

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(c) The increase in government purchases shifts the IS curve up and to the right, with the same
result as in part (b). (The FE line also shifts, as the increase in government expenditures reduces
people’s wealth and leads them to increase labor supply, but this shift will not affect the short-
run equilibrium, as the economy will be off the FE line.)

(d) If Ricardian equivalence holds, the increase in taxes has no effect on either the IS or LM
curves, so there is no change in either the real interest rate or output.

If Ricardian equivalence doesn’t hold, so that the increase in taxes reduces consumption
spending, the IS curve shifts down and to the left, as shown in the figure below. Both the real
interest rate and output decline.

(e) An increase in the expected future marginal productivity of capital shifts the IS curve up and
to the right, with the same result as in part (b).

4. Omitted

5. Omitted