LECTURE OUTLINE
• Derivation of aggregate demand curve
– Monetary policy and the AD curve
– Fiscal policy and the AD curve
• The algebra of the IS-LM model
Aggregate Demand Curve
•The aggregate demand relation captures
the effect of the price level on output. It is
derived from the equilibrium conditions in
the goods and financial markets.
Deriving the AD curve
r LM(P2)
Intuition for slope r2
LM(P1)
of AD curve: r1
P (M/P ) IS
LM shifts left Y2 Y1 Y
P
r
P2
I
P1
Y
AD
Y2 Y1 Y
Figure 9.10 Derivation of the
aggregate demand curve
Figure 9.10 Derivation of the aggregate
demand curve (cont’d)
Monetary policy and the AD curve
r LM(M1/P1)
The Fed can increase
r1 LM(M2/P1)
aggregate demand:
r2
M LM shifts right
IS
r Y1 Y2 Y
P
I
Y at each P1
value of P
AD2
AD1
Y1 Y2 Y
Fiscal policy and the AD curve
r LM
Expansionary fiscal policy
(G and/or T ) increases r2
agg. demand: r1 IS2
T C
IS1
IS shifts right Y1 Y2 Y
Y at each P
value of P
P1
AD2
AD1
Y1 Y2 Y
Figure 9.11 The effect of an increase in
government purchases on the aggregate
demand curve
Figure 9.11 The effect of an increase in
government purchases on the aggregate
demand curve (cont’d)
Aggregate Demand
• Let’s summarize:
Starting from the equilibrium conditions for the
goods and financial markets, we have derived
the aggregate demand relation.
This relation implies that the level of output is a
decreasing function of the price level. It is
represented by a downward-sloping curve,
called the aggregate demand curve.
Changes in monetary or fiscal policy – or more
generally in any variable, other than the price
level, that shifts the IS or the LM curves – shift
the aggregate demand curve.
Labor Market
VII. Appendix 9.A: An Algebraic Version of the IS-LM Model and the AD-AS Model
A) The labor market
1. The production function is
1
Y A f1 N f2 N 2 (9.A.1)
2
2. From the production function, the marginal product of labor is
MPN A( f1 f2 N ) (9.A.2)
3. The real wage is the MPN at the amount of labor demanded ND, so
w A( f1 f2 ND) (9.A.3)
Labor Market (cont.)
4. La bor supp ly (NS ) depends on the a fte r-tax rea l w a ge , so
NS n0 nw (1 t )w (9.A .4)
5. Comb in ing Eqs. (9.A .3) a nd (9.A. 4) gives a solution for the re a l wa ge a nd e mploy me nt
f1 f2 n 0
w A (9.A .5)
1 ( 1 t ) Af 2 n w
n0 (1 t ) Af 1n w
N (9.A .6)
1 (1 t ) Af 2 nw
6. Using e mp lo yme nt in the prod uc tion func t io n g ive s
1
Y A f1 N f2 N 2
(9.A .7)
2
Setting ND = NS = N, we get a system of two
equations in the two unknowns w and N
w A( f1 f 2 N )
N n0 nw (1 t ) w
w A( f1 f 2 N )
N n0 nw (1 t ) w
Solve by substitution:
w A f1 f 2 n0 nw (1 t ) w
w Af 2 nw (1 t ) w A f1 f 2 n0
w 1 Af 2 nw (1 t ) A f1 f 2 n0
A f1 f 2 n0
w
1 Af 2 nw (1 t )
A f1 f 2 n0
N n0 nw (1 t )
1 Af 2 nw (1 t )
n0 1 Af 2 nw (1 t ) nw (1 t ) A f1 f 2 n0
N
1 Af 2 nw (1 t )
n0 nw (1 t ) Af1
N
1 Af 2 nw (1 t )
Labor Market (cont.)
4. Labor supply (NS) depends on the after-tax real wage, so
NS n0 nw (1 t )w (9.A.4)
5. Combining Eqs. (9.A.3) and (9.A.4) gives a solution for the real wage and employment
f1 f2 n0
w A (9.A.5)
1 (1 t ) Af2 nw
n0 (1 t ) Af1nw
N (9.A.6)
1 (1 t ) Af2 nw
6. Using employment in the production function gives
1
Y A f1 N f2 N 2 (9.A.7)
2
Goods Market
B) The goods market
1. Desired consumption depends on after-tax income (Y – T) and the real interest rate
C d c0 cY (Y T ) cr r (9.A.8)
2. Taxes are given by
T t0 tY (9.A.9)
3. Desired investment is
I d i0 ir r (9.A.10)
4. Equilibrium is then given by
Y Cd I d G (9.A.11)
Goods Market (cont.)
5. Substituting Eqs. (9.A.8), (9.A.9), and (9.A.10) into (9.A.11) gives
Y c0 cY (Y t0 tY ) cr r i0 ir r G (9.A.12)
6. Rearranging this, collecting terms in Y gives
[1 (1 t )cY ]Y c0 i0 G cY t 0 (cr ir )r (9.A.13)
7. Now rewriting this in terms of r gives the IS curve
r IS ISY (9.A.14)
c0 i0 G cY t 0
IS (9.A.15)
cr ir
1 (1 t )cY
IS (9.A.16)
cr ir
Goods Market (cont.)
1 1 t cY Y c0 i0 G cY t0 cr ir r
cr ir r c0 i0 G cY t0 1 1 t cY Y
c0 i0 G cY t0 1 1 t cY
r Y
cr ir cr ir
IS IS
Asset Market
C) The asset market
1. The money demand function has the form
Md
l0 lY Y lr (r e ) (9.A.17)
P
2. Equilibrium in the asset market means that
M
l0 lY Y lr (r e ) (9.A.18)
P
Asset Market (cont.)
M
lr r l0
e
lY Y
P
l0 1 M lY
r e
Y
lr lr P lr
LM LM
Asset Market (cont.)
3. Rearranging this gives the LM curve
1M
r LM LM Y (9.A.19)
lr P
l0
LM e (9.A.20)
lr
lY
LM (9.A.21)
lr
General Equilibrium
D) General equilibrium in the IS-LM model
1. The intersection of the IS curve and FE line determines the real interest rate, which is found
by plugging Y into Eq. (9.A.14)
r IS ISY (9.A.22)
2. To find the equilibrium price level, use Y and Eq. (9.A.22) in Eq. (9.A.18) to get
M
P (9.A.23)
l0 lY Y lr ( IS ISY e )