Macroeconomic Theory and

Policy
Lecture 7
Macroeconomic Equilibrium: IS-LM
and AD-AS Analysis

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 What is macroeconomic equilibrium?
Is an Economy always in equilibrium?

Macroeconomic general equilibrium is characterised by

• prices that clear goods markets
• wage rates that clear labour markets
• interest rates that clear the capital markets
• exchange rates that clear the foreign exchange markets
• Disequilibrium may result when these prices are not free to
change because of institutional or policy reasons.
• IS-LM model explains how such disequilibrium (Gaps
between Demand and supply) may exist and could be
mitigated using deliberate policy actions.

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 Micro-Foundation to Macro:
General Equilibrium with a representative household and firm
Market p and w such that Trade
Y=C Wage payment, wL Px X-PmM= CA
LD = LS
LS +L = Lbar CA+KA =0
KD =KS Labour supply, L
Government

Households Economy Firms

Max U(C,L) Max π(LS)
ROW
Payments for goods

Max U = c φ l 1−φ Supply of Goods Max π = py − wh d

l + h =1
( )
s
d α
pc = wh s + π y≤ h
c ≥ 0; l ≥ 0; h s ≥ 0 G =T = t*Y +tw*wL+tr+rk 3
y ≥ 0; h ≥ 0
d
 Classical view
• Ideas of Adam Smith (1776), Ricardo (1817), J. B. Say,
Malthus (182) Mill (1873), Marshall (1925)
• Invisible hand sets prices to equate demand and supply.
• No excess demand or no excess supply can persist. No glut
or shortages in goods market.
• No unemployment or labour pressure in the labour market.
• Money is neutral (quantity theory of money).
• Prices proportional to money supply.
• It is long run view.
• Balance budget recommended.
• Laisser faire: minimum government is the best
government.
• Downward sloping aggregate demand and vertical supply
curve
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 Classical economy:
How perfectly flexible prices guarantee macroeconomic
equilibrium in IS-LM Framework

AS
LD IS M(D)

W i=i* i

LS LM
L
Labor market IS-LM: goods and money Money market (M/P)

F(Y)
Y P
Y

Output L Output to output , Y Price level and money supply

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 Keynesian Revolution (Short run analysis)

• Gaps between supply and demand may persist for a log

time.
• Markets (prices) may not work automatically itself because
of deficiency in demand: massive unemployment labour
and under utilisation of capital is possible.
• Cost of waiting to return to the natural level; irresponsible
to do so.
• Balancing budget is stupid and dangerous policy.
• Active role by government can mitigate deficiency in
private demand (consumption and investment).
• Positive role of fiscal policy and monetary policy.
• Multiplier effect of demand on output
• Aggregate supply is horizontal in the short run.
• Animal spirits – importance of expectations.

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 Keynesian economy: flexed prices and possibility of
underemployment equilibrium

LD IS S LM M(D)

W i=i* i

LS LM
L
Labor market IS-LM: goods and money Money market (M/P)

F(Y)
Y P
Y

Output L Output to output , Y Price level and money supply

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 Open Economy Model: Equilibrium in Six
Different Markets
Balance of Payment analysis: Graphical approach

Labour Market Goods and Money Money market Domestic bonds Foreign Bonds Foreign Exchange
LD LS IS AS LM MD MS BS BD

Wage i i i* i
Interest rt

L Y M/P DB FB exchange rate

Output
Y P Price

Employment Output Real money balance Portfolio allocation e

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 Keynesian Economist’s view on Economic
Policy
• Automatic equilibrium is not guaranteed. Animal spirits
not the rational choices dominate the economy.
• Unemployment may persist for a long period if the
deficiency in demand continues.
• Active policy can play a very positive role, because of
rigidity in the markets, particularly in the labour market
(minimum wage laws, unions, and efficiency wages).
• Also because of the monopolistic powers of the firms.
• Active policy can fine tune the economy and correct the
market failure.

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New Classical View of Fluctuation and Growth an Dconomy

yt = y0 e gt
β
Y = A Kα L
t t t t

1982 1992 2003

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 LAS LM(P2)
RE LM1(P1)
i3 LM (P0)
IV Price Feedback: Monetarists
i2 III
i1 II: LM curve: Hicksian

Crowding out
i0 I: IS curve

IS1
IS0

o y0 y1 y2 y3
A Simple Overview of Keynesian, Monetarist and New Classical 11
and New Keynesian Approaches to Analysis of short run fluctuations
Summary of Four Macro Models in the above Figure

• Government expenditure rises IS1 shifts to IS2.

Impact on output and interest rates differ across
macroeconomic models.
• Models I and II are Keynesian and new Keynesian
models.
• Model IIIA is monetarists includes a price
feedback. AD drops as real balances decline.
• Model IV monetarist proposition in the long run
and New Classical model with rational
expectation.

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Expansionary Policy to Fight Recession: AS-AD Analysis
LAS: Y=Yn

AS: Y = Yn +v(P-Pe)
P1 c

P0 a
AD1
b
P2

AD

Yr Yn
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 How does output responds to positive demand
and supply shocks in the long run?
Dynamic adjustment process of expansionary Dynamic adjustment process after a positive
monetary and fiscal policy supply shocks
AD2 LAS P = (1 + μ ) P e N s ( 1 −
Y
; z)
AD1 L
D a
SAS
P c P b
b C
AS1
a
M AS2 AD
Y = F ( , G, T ) AS3
P

Yn Y
Yn Y Aggregate demand and aggregate supply in the
Aggregate demand and aggregate supply short and the medium run

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 How does output and prices respond to a
negative demand and supply shocks in the
long run?
Dynamic adjustment process of contractionary Dynamic adjustment process after a negative
monetary and fiscal policy supply shocks (increase in oil prices)
SAS
AD

a P c
P b
B a

Yn Y
Yn Y Aggregate demand and aggregate supply in th
Aggregate demand and aggregate supply short and the medium run

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 Internal and External Stability in an Open Economy
S

K Inflow K Inflow

i=i*
K outflow X-M=0
K outflow

Unemployment Inflation
Deflation Boom

0
Yn output
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 Macroeconomic Equilibrium in a Small Open Economy
with Perfect Capital Mobility
S
IS
LM
i>i* BOP+
BOP+ K inflow
K-inflow Boom
Deflation

i=i* BOP: X-M =-KA

BOP- BOP- Outflow
K-outflow Boom/inflation
Deflation Over full employment
i<i* Under full employment.

Yf

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 A Small Open Economy with Perfect Capital Mobility:
Convergence towards A Macroeconomic Equilibrium
S
IS
LM
i>i* EXSG BOP+
BOP+ EXDM
EXDG EXSG
EXSM EXDM

i=i* BOP: X-M =-KA

BOP- BOP-
EXSG
EXDG
EXDM
i<i* ESM EXDG
EXDM

Yf
Notes: YF full employment output, BOP = Balance of Payment,
K= capital, ESG =Excess supply of goods, EDG =Excess demand for goods,
ESM =excess supply of money, EDM=excess demand for money 18
 Macroeconomic Equilibrium in a Small Open Economy
with Imperfect Capital Mobility
S
IS
LM
i>i* BOP+ K inflow
BOP+ Boom
K-inflow
Deflation BOP: NX(e(r,y))
i=i*
BOP- BOP- Outflow
K-outflow Boom/inflation
Deflation Over full employment
i<i* Under full employment.

Yf

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 Numerical Exercises
• Fixed Price Model IS-LM model

• Flexible Price IS-LM Model

• Multiplier Analysis in Keynesian Model

• Open Economy Macro Economic Model
– With perfect capital mobility
– Imperfect capital mobility

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 References
• Bhattarai (2002) Interest Rate Determination in the UK: Test of the Taylor Rule University of Hull.
• Fleming J. Marcus (1962) Domestic financial policies under fixed and under floating
• exchange rates, IMF staff paper 9, November , 369-379.
• Friedman, M. (1968), "The Role of Monetary Policy," American Economic Review, No.1 vol.
• LVIII March
• Hicks, J. R.(1937): Mr. Keynes and the "Classics"; A Suggested Interpretation, Econometrica 5: pp 147-159.
• Krugman P. and L. Taylor (1978) “Contractionary Effects of Devaluation” Journal of International Economics, 445-
56.
• Lucas, Robert Jr. and Sargent, After Keynesian Macroeconomics, Spring 1979, Federal
• Reserve Bank of Monneapolis Quarterly Review.
• Mankiw N.G. (1989) Real Business cycle: A New Keynesian Perspective, Journal of Economic Perspectives, vol. 3,
no. 3 pp. 79-90.
• Miller, Marcus; Salmon, Mark When Does Coordination Pay? Journal of Economic Dynamics and Control, July-Oct.
1990, v. 14, iss. 3-4, pp. 553-69
• Mundell R. A (1962) Capital mobility and stabilisation policy under fixed and flexible exchange rates,
• Canadian Journal of Economic and Political Science, 29, 475-85.
• Nordhaus WD (1994) Policy Games: Co-ordination and Independence in Monetary and Fiscal Policies, Brookings
Papers in Economic Activities, pp. 139-216.
• Phillips A W. (1958) The relation between unemployment and the rate of change of money
• wage rates in the United Kingdom, 1861-1957.
• Phelps E. S. (1968) Money wage dynamics and labour market equilibrium, Journal of
• Political Economy, 76 , 678-711.
• Sebastian E (1986) Are Devaluations Contractionary? Review of Economics and Statistics, vol. 68, 3, 501-508.
• G.K.Shaw, M. J. McCrostie and D. Greenaway (2001) Macroeconomics: Theory and Policy in the UK, Blackwell.
• Shaw, McCrostie and Greeenaway (2001) Macroeconomics Theory and Policy in the UK, Blackwell.
• Taylor Mark (1995) The Economics of Exchange Rates, Journal of Economic Literature, March, vol 33, No. 1, pp.
13-47.

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