Aggregate Demand I Building the IS -LM Model

Aggregate Demand I: Building the IS -LM Model Done by: Abdrakhman Aida Bolatova Bakhyt Nursadyk Nazym Stanbaeva Assel

The IS/LM model (Investment—Saving / Liquidity preference—Money supply) is a macroeconomic tool that demonstrates the relationship between interest rates and real output in the goods and services market and the money market. The intersection of the IS and LM curves is the "general equilibrium" where there is simultaneous equilibrium in both markets

The model is presented as a graph of two intersecting lines in the first quadrant. The horizontal axis represents national income or real gross domestic product and is labelled Y. The vertical axis represents the real interest rate, i. Since this is a non-dynamic model, there is a fixed relationship between the nominal interest rate and the real interest rate (the former equals the latter plus the expected inflation rate which is exogenous in the short run); therefore variables such as money demand which actually depend on the nominal interest rate can equivalently be expressed as depending on the real interest rate. The point where these schedules intersect represents a short-run equilibrium in the real and monetary sectors (though not necessarily in other sectors, such as labor markets): both the product market and the money market are in equilibrium. This equilibrium yields a unique combination of the interest rate and real GDP.

IS curve For the Investment—Saving curve, the independent variable is the interest rate and the dependent variable is the level of income (even though the interest rate is plotted vertically). The IS curve is drawn as downward-sloping with the interest rate (i) on the vertical axis and GDP (gross domestic product: Y) on the horizontal axis. The initials IS stand for "Investment and Saving equilibrium" but since 1937 have been used to represent the locus of all equilibria where total spending (consumer spending + planned private investment + government purchases + net exports) equals an economy's total output (equivalent to real income, Y, or GDP). To keep the link with the historical meaning, the IS curve can be said to represent the equilibria where total private investment equals total saving, where the latter equals consumer saving plus government saving (the budget surplus) plus foreign saving (the trade surplus). In equilibrium, all spending is desired or planned; there is no unplanned inventory accumulation. The level of real GDP (Y) is determined along this line for each interest rate.

LM curve For the Liquidity preference and Money supply curve, the independent variable is "income" and the dependent variable is "the interest rate. " The LM curve shows the combinations of interest rates and levels of real income for which the money market is in equilibrium. It is an upward-sloping curve representing the role of finance and money. The LM function is the set of equilibrium points between the liquidity preference (or Demand for Money) function and the money supply function (as determined by banks and central banks). Each point on the LM curve reflects a particular equilibrium situation in the money market equilibrium diagram, based on a particular level of income. In the money market equilibrium diagram, the liquidity preference function is simply the willingness to hold cash balances instead of securities. For this function, the nominal interest rate (on the vertical axis) is plotted against the quantity of cash balances (or liquidity), on the horizontal. The liquidity preference function is downward sloping. Two basic elements determine the quantity of cash balances demanded (liquidity preference) and therefore the position and slope of the function: 1) Transactions demand for money: this includes both (a) the willingness to hold cash for everyday transactions and (b) a precautionary measure (money demand in case of emergencies). 2) Speculative demand for money: this is the willingness to hold cash instead of securities as an asset for investment purposes. Speculative demand is inversely related to the interest rate. As the interest rate rises, the opportunity cost of holding cash increases - the incentive will be to move into securities.

Incorporation into larger models By itself, the IS-LM model is used to study the short run when prices are fixed or sticky and no inflation is taken into consideration. But in practice the main role of the model is as a sub-model of larger models (especially the Aggregate Demand-Aggregate Supply model - the AD-AS model) which allow for a flexible price level. In the aggregate demand-aggregate supply model, each point on the aggregate demand curve is an outcome of the ISLM model for aggregate demand Y based on a particular price level. Starting from one point on the aggregate demand curve, at a particular price level and a quantity of aggregate demand implied by the IS-LM model for that price level, if one considers a higher potential price level, in the IS-LM model the real money supply M/P will be lower and hence the LM curve will be shifted higher, leading to lower aggregate demand; hence at the higher price level the level of aggregate demand is lower, so the aggregate demand curve is negatively sloped.

Aggregate Demand Aggregate Supply in the Long Run

Model Background This model uses the quantity equation as aggregate demand assumes long run supply to be perfectly vertical and short run supply to be perfectly horizontal. If the model is out of equilibrium it is the changing price level that returns the model to equilibrium.

Building Aggregate Demand The quantity theory of money says MV=PY Rearranging we get (M/P)=k. Y, where k = 1/V, so as P increases Y decreases If we map this out we get an AD function P • An increase in M or a decrease in k implies that for any given P, Y is higher, hence an outward shift of AD. Changing M is monetary policy. Also because Y = C + I + G + NX, demand side variables can shift AD as well. Changing G or T is fiscal policy. • Similarly a decrease in M or increase in k would shift AD in. AD AD AD Y

Building Aggregate Supply: long run In the long run output is determined by factor inputs (Y=F(K, L)) and is not dependent on price. Hence, long run aggregate supply is vertical. P LRAS • In this context a shift in AD causes a change in the price level but has no effect on Y. P* P* AD AD Y

Building Aggregate Supply: short run In the short run price is fixed so the aggregate supply curve is horizontal. P • In this context a shift in AD causes a change in Y but has no effect on P. SRAS P* AD AD Y Y

From the Short Run to the Long Run The economy begins in long run equilibrium at point 1. LRAS P • If aggregate demand shifts out, the 3 economy moves from point 1 to point 2, above full employment output. • As we approach the long run there is upward pressure on P. As P increases Y decreases and we move along AD to point 3. 2 AD 1 AD • The end result is that Y returns to the natural level but P is permanently higher. SRAS P* Y Y

Stabilization Policy Fluctuations in the economy can shift either AD or AS. P LRAS • Fiscal and monetary policies are able • to shift AD. Because of this a shock to AD can be corrected with P and Y returning to their pre-shock levels. However if there were a supply shock then a policy adjustment would imply a trade off between Y or P. • With a negative supply shock accommodating the shock would mean returning the economy to Y causing a higher P in the long run. • The alternative would be to wait for the shock to pass. SRAS P* AD AD AD Y

Conclusion We constructed a basic AD/AS model. AD was derived from the quantity theory of money function. In the short run, P is sticky and SRAS is horizontal. In the long run factor inputs determine Y and P is variable so LRAS is vertical.