Algebraic Versions of the IS-LM and AD-AS

Models
1
1 The Goods Market
Desired consumption is
C
d
= c
0
+c
Y
(1 T) c
r
r, (1)
where 1 T is disposable income, r is the real interest rate, c
Y
is the
marginal propensity to consume (0 < c
Y
< 1), and c
0
captures other factors
that aect desired consumption (e.g. wealth, expected future income).
Taxes are
T = t
0
+t1, (2)
where t is tax rate on income (0 t < 1), and t
0
is a lump-sum tax.
Desired investment is
1
d
= i
0
i
r
r, (3)
where i
r
0, and i
0
0 captures other factors aecting desired investment
(e.g. expected future '11).
1.1 Equilibrium in the Goods Market
The goods market equilibrium condition in a closed economy
1 = C
d
+1
d
+G. (4)
This condition is equivalent to o
d
= 1
d
. Substituting (1) with taxes in (2),
and (3) into the equilibrium condition (4), we get
1 = c
0
+c
Y
(1 t
0
t1 ) c
r
r +i
0
i
r
r +G
[1 (1 t)c
Y
]1 = c
0
+i
0
+Gc
Y
t
0
(c
r
+i
r
)r.
This equation relates output, 1, to the real interest rate, r, that clears the
goods market. This denes the 1o curve which can be rewritten as
r = c
IS
,
IS
1, (5)
where c
IS
, ,
IS
are both positive numbers dened as
1
From Abel et al. (2008)
1
c
IS
=
c
0
+i
0
+Gc
Y
t
0
c
r
+i
r
and
,
IS
=
1 (1 t)c
Y
c
r
+i
r
The coecient of 1 , or ,
IS
, is the slope of the 1o curve (check slides
Ec222_Lectures_5_8 for graph and implications of changing ,
IS
for mone-
tary/scal policy).
Changes in the constant term c
IS
shift the 1o curve. Anything that in-
creases c
IS
(e.g. increase in consumer optimism, c
0
, increase in expected '11,
i
0
, increase in G) shifts the 1o curve up and to the right.
2 The Asset Market
Real demand for money (1) depends on real income and the nominal interest
rate, i, which equals expected real interest rate, r, plus expected rate of ination,

e
.
'
d
1
= |
0
+|
Y
1 |
r
(r +
e
),
where '
d
is nominal demand for money, 1 is price level, the constant |
0
includes other factors such as liquidity of alternative assets.
2.1 Equilibrium in the Asset Market
When the real quantity of money demanded equals the real money supply, ',1.
'
1
= |
0
+|
Y
1 |
r
(r +
e
). (6)
For xed levels of ', 1, and
e
, equation (6) relates output and the real
interest rate that clears the asset market (1' curve):
r = c
LM


1
|
r

'
1

+,
LM
1, (7)
where
c
LM
=

|
0
|
r

e
and
,
LM
=

|
Y
|
r

.
2
The graph of (7) is the LM curve. The coecient ,
LM
is the slope of the
LM curve. Variables that change the intercept of the equation in (7), c
LM

1
lr

M
P

, shift the LM curve (check slides Ec222_Lectures_5_8 for graph and

implications of changing intercept and slope of LM curve for monetary/scal
policy).
3 General Equilibrium in the IS-LM Model
Using the full-employment level of output, 1 , which would be derived in the
labour market, we obtain the general equilibrium real interest rate by substi-
tuting 1 for 1 in (5):
r = c
IS
,
IS
1 . (8)
Having output, 1 , and the real interest rate, r determined in (8), we nd
the general equilibrium values of taxes, consumption, and investment using
equations (2), (1), and (3), respectively.
The nal important macroeconomics variable whose equilibrium value needs
to be determined is the price level, 1. We use the asset market equilibrium
condition, (6). We plug in the full-employment output, 1 , and the real interest
rate from (8) in (6) to get
1 =
'
|
0
+|
Y
1 |
r
(c
IS
,
IS
1 +
e
)
. (9)
This equation conrms that the equilibrium price level, 1, is proportional
to the nominal money supply, '.
We could analyse the eects of an adverse productivity shock (reduction
in parameter in the production function of Ec222_Lectures_1_4) which is
similar to a reduction in 1 .
4 The AD-AS Model
Building on the algebraic version of the 1o 1' model we can now derive an
algebraic version of the 1 o model.
4.1 The Aggregate Demand Curve
Aggregate output demanded at any price level, 1, is the amount of output
corresponding to the intersection of the 1o and 1' curves. We nd the value
of 1 at the intersection of the 1o and 1' curves by setting the right sides of
(5) and (7) equal and solving for 1 in order to get the 1 curve:
1 =
c
IS
c
LM
+

1
lr

M
P

,
IS
+,
LM
. (10)
3
For constant nominal money supply, ', equation (10) shows that the aggre-
gate quantity of goods demanded, 1 , is a decreasing function of the price level,
1, so that the 1 curve slopes downward.
Note that for a constant price level, any change that shifts the 1o curve
up and to the right or shifts the 1' curve down and to the right increases
aggregate output demanded and shifts the 1 curve up and to the right.
4.2 The Aggregate Supply Curve
In the short run, rms supply the output demanded at the xed price level, 1
sr
.
The short-run aggregate supply (SRAS) is a horizontal line
1 = 1
sr
. (11)
The long-run aggregate supply (LRAS) curve is a vertical line at the full-
employment level of output, 1 ,
1 = 1 . (12)
4.3 Short-Run and Long-Run Equilibrium
The short-run equilibrium of the economy is represented by the intersection of
the AD curve and the SRAS, that is substituting (11) into (10) to obtain
1 =
c
IS
c
LM
+

1
lr

M
Psr

,
IS
+,
LM
.
The long-run equilibrium of the economy, which is reached when the labour,
goods, and asset markets are all in equilibrium, is represented by the intersection
of the AD curve and the LRAS. Substitute (12) into (10) to obtain
1 =
'
|
r

c
LM
c
IS
+ (,
IS
+,
LM
)1
.
4
Numerical Example
Consider an economy that is described by the following equations:
C
d
= 300 + 0.75(1 T) 300r
T = 100 + 0.21
1
d
= 200 200r
1 = 0.51 500i
and 1 = 2500; G = 600; ' = 133, 200;
e
= 0.05; 1
sr
= 120.
In the short run, the price level is xed at 1
sr
. Find the short-run and
long-run equilibrium values of 1, 1, r, C, 1, and i.
1) Find the IS curve by using goods market equilibrium condition (4):
1 = C
d
+1
d
+G
= f300 + 0.75 [1 (100 + 0.21 )] 300rg + [200 200r] + 600
:o
0.41 = [300 75 + 200 + 600] (300 + 200)r
:o
500r = 1025 0.41
T/crc)orc
r =
1025
500

0.4
500
1
and the IS curve is
r = 2.05 0.00081
2) Find the LM curve by using the asset market equilibrium condition (6):
133, 200
1
= 0.51 500(r + 0.05)
:o
500r = 0.51 25
133, 200
1
a:d
r = 0.0011 0.05
266.4
1
which is the LM curve for an unspecied value of 1. For 1 = 1
sr
= 120 the
LM curve is
r = 0.0011 2.27
3) Find the short-run equilibrium by the intersection of the IS and LM
curves:
5
2.05 0.00081 = 0.0011 2.27
and therefore 1 = 4.32,0.0018 = 2, 400. Now we can use the value of 1 in
either the IS or LM to get the short-run equilibrium of r, e.g. r = 0.0011 2.27 =
0.001 2400 2.27 = 0.13.
Plug these values of 1, and r into the other equations to nd equilibrium
values for T, C, 1, and i.
T = 100 + 0.2 2400 = 580
C = 300 + [0.75(2400 580)] (300 0.13) = 1626
1 = 200 200 0.13 = 174
(Note that C +1 +G = 2400)
i = 0.13 + 0.05 = 0.18
4) Find the long-run equilibrium by using 1 = 1 = 2500, into the IS equa-
tion to nd equilibrium real interest rate, r = 2.05 0.0008 2500 = 0.05.
Plug the equilibrium values of 1 and r into the other equations to nd
equilibrium values for T, C, 1, and i.
T = 100 + 0.2 2500 = 600
C = 300 + [0.75(2500 600)] (300 0.05) = 1710
1 = 200 200 0.05 = 190
(Note that C +1 +G = 2500)
i = 0.05 + 0.05 = 0.10
Plug the equilibrium values of 1 and i into the money demand equation
to obtain the value of the real money demand, 1, 1 = 0.51 500i = 1200.
The price level can be obtained by equating real money supply with real money
demand,
M
P
= 1, or
133;200
P
= 1200, and therefore 1 = 111.
5) Find the equation for the AD curve by using the IS and LM curves. Use
the form of the LM curve for an unspecied value of 1.
2.05 0.00081 = 0.0011 0.05
266.4
1
0.00181 = 2.10 +
266.4
1
1 = 1166.6 +
148, 000
1
AD curve
6) We can illustrate the use of the AD curve and the short-run and long-run
equilibria.
6
In the short run, the SRAS curve is 1 = 1
sr
= 120. The short-run equilib-
rium occurs at the intersection of the AD and SRAS curves. Plug 1 = 120 into
the AD to obtain 1 = 1166.6 +
148;000
120
= 2, 400.
In the long run, output is 1 = 1 = 2500 (LRAS), and the AD curve is
2500 = 1 = 1166.6 +
148;000
P
, which implies that the price level will be 1 = 111.
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