6 AD/AS/ IS-LM Model Flashcards
What is the classical economic theory of economic fluctuations?
Classical economic theory:
- Money and inflation has been about the long run two building blocks
- Classical dichotomy - seperate variables into real and nominal variables
- Monetary neutrality:
- Changes in money supply affect nominal variables, but not real variables
- Could examine determinants of real variables, like real GDP and unemployment, without reference to nominal variables like money and prices
What are the assumptions of short run fluctuations?
- Money neutrality no longer appropriate
Real and nominal variables highly intertwined
e.g. changes in money supply temporarily push real GDP away from long run trend, need new short run model
Why is AD curve downward sloping
Wealth effect C;
- Decrease price level increases real value, consumers spend more, AD increases
Interest rate effect I;
- Decrease in price, reduce real interest rate - real money balances (supply increases) making the interest rate drop
- required to induce households to increase money demand, demand again equal to supply
-Stimulates spending on investment goods and increases AD
Exchange rate ffect:
- Fall in UK price level reduces IR as above
-Pound depreciates - NCO rises as well as supply of £ on forex markets
- Stimulates UK exporting and supress imports
- Increase net exports thus AD
What causes a shift in AD
Exogenous changes in C, I, G or NX
C:
- changes how much people want to consume - changes in patience or savings preferences
I:
- change in how firms want to invest at given price level
- Better technology or increase in money supply
G:
- Policy makers change G at given price level
- Building new stuff
NX:
- e.g. sudden change in NER
What is the LRAS?
In long run, depends on capital,labour,resource and technology
- Price doesnt affect long run determinants so output the same regardless of price level
In long run, classical dichotomy holds:
- Real and nominal variables independent
- Real variables cannot be influenced by a nominal one
LRAS curve vertical line positioned at natural rate of output
- All existing factors fully utilised
Unemployment at natural rate
Long run:
- output depends on labour, K, resources and technology for turning inputs into output - because the quantity supplied doesnt depend on overall price level, vertical at natural rate of output
What shifts LRAS?
Change in natural rate of output
Labour:
- population
- Labour market
Capital - link to productivity
Change in natural resources
Change in technological knowledge - innovation
How does AS act in the short run?
Short run upward sloping
- Increase in overall level of prices in economy tends to raise supply and the converse is true
- Causes contract int he SRAS curve - quantity of output falls due to the fall in price level - positive relationship due to sticky wages, sticky prices, or misperception
Theories explaining why AS curve slopes upwrads:
- Sticky wages
- Sticky price
-Misperceptions
These all based on market imperfections - difference between expected and actual
SRAS:
- prices above expected price level, output rises above its natural rate
- Prices fall below expected price level, output falls below its natural rate
WHat is the sticky wage theory? Why does this imply upward slope?
Nominal wages slow to adjust to changing economic conditions e.g. since labour contracts fixed
Nominal wages based on expected prices, dont respond immediately when actual price level is different from what was expected - adjust with lag
Implies real wage is firms marginal cost of labour:
P(actual) < P(expected)
- real wages higher than firms expect so actual MC greater than expected, firms cut production costs and lay off workers, output falls
P(actual) > P(expected)
- Real wages now lower than firms expected so firms increase production and output increases
What is sticky price theory
prices slow to adjust in short term e.g. menu costs
Implies upward sloping SRAS - princes are firms MR
- Prices lower than expected actual revenue lower than expected so firms forced to cut production, reducing AS of goods and services
- Prices higher than expected firms will instead increase output
WHat is the misperceptions theory
Change in overall price level temporarily misleads suppliers about price changes
Implies upward sloping SRAS:
- Suppose prices below expected level. If indivudal firms interpret fall in price level as fall in prices, they misperceive their MR and reduce production
- Opposite is true if general price level above expectations
What is the function of supply?
Y(supply) = Y(natural) + a((P(actual) - P(expected)
In the long run, P (actual) = P(expected) and so the long run supply is Y(natural)
What is long run equilibrium
Where AD and AS meet
- Economy reaches point where expected price level adjusted to equal actual price level and so short run AS cuve crosses the point as well
What is the IS-LM model
Split into Investment saving curve: relationship between IR and income that ensures equilibrium in goods market
Liqudity money:
- Relationship between IR and income representing equilibrium
Assumption:
- General price level of economy constant (model of short run)
Implications:
- Only quantities and rate of interest varies to clear market, nt prices
- Reasonable description of short run - prices are fixed or costly to change
How do interest rates affect the goods market
C:
- Household spending depend on interst
- Higher interest mean higher return on savings, hence households save more, consume less
I:
- Firms investment decisions based on borrowing costs
- Higher interest impleies high cost, hence firms drop less investment - investment drops at high investment level
How to draw investment savings curve
Page 27
Shows equilibrium for different interest levels
- Negative relationship between interest rate and national income
- Derived form the keynesian cross - figure on the left
What is keynesian cross
C+I+G+NX is planned expenditure - what people will buy
Increasing in income (MPC - how much more bought for every unit increase in income)
Equilibrium where actual production is equal to the planned expenditure
What is liquidity preference:
Money market depends on:
- Value of transactions in economy - higher income Y associated to higher level of transactions, hence more money needed
- Preference for liquid assets - high interest makes prospect of holding money less appealing, household sshift towards less liquid assets and demand less money
Money demand curve declining in interest rate
Money supply assumed to be constant (Exogenous)
WHat is the liquidity money curve
SHows interest rate that clear the money market for each level of income
It slopes up (positive between interest rates and incomes)
Page 27
What does equilibrium of the two models show? how does this relate to AD
level where interst rate and incomes such that both markets in equilibrum at the same time
- COmbines IS and LM curve in single graph
Again on page 27
IS curve: equilibrium level of interest rate and income in goods market
LM curve: equilibrium level of interest rate and income in money market
AD curve shows us relationship between general and aggregate price levels and national income/output
IS-LM can derive AD:
- Gives us equilibrium interest rate and income for given price level
- Consider a higher price level P1
- Real money supply decreases due to higher price level
- Shifts LM to the left, as MS shifts left causing LM to shift left:
The economy shifts to a new equilibrium with higher interest rates and lower income - this corresponds to two differnt points on the AD curve - higher price level associated to lower levels of output
