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The IS-curve in the AS-AD model

The IS-curve is not affected by P in the AS-AD model

We can define an IS-curve in the AS-AD model in exactly the same way as in the IS-LM model: it will give us all combinations of R and Y where the goods market is in equilibrium, that is, where aggregate demand is equal to GDP, YD(Y, R) = Y.

Since P does not affect any part of the goods market, P will not affect the IS curve. The IS curve in the AS-AD model is exactly the same as IS-curve in the IS-LM model.

The LM-curve in the AS-AD model

The LM-curve will shift upwards (downward) when P is increases (decreases) in the AS-AD model is moved

The LM-curve in the AS-AD model is slightly more complicated as P will affect the demand for money. In the IS-LM model, the LM-curve is defined as all combination of R and Y where the money market is in equilibrium, that is, where the demand for money is equal to the supply of money, MD(Y, R) = MS.

In the AS-AD model, the LM-curve shows all combinations of R and Y, where the money market is in equilibrium for a given P. For a given P, we can still draw the LM curve in the AS-AD model just as we did in the IS-LM model. For a given P, there are different combinations of R and Y where the money market is in equilibrium. But for another given P, another set of combinations of R and Y will be associated with equilibrium in the money market. This means that the LM-curve will shift when P changes.

Money market diagram with different prices.

Fig. 13.3: Money market diagram with different prices.

1. First consider the top left figure. The demand curve for money, M, is drawn for Y = 100 and P = 10. The equilibrium interest rate is R = 5%.

2. Y = 100 and R = 5% will provide us with a point on the LM1 curve to the right.

3. Now suppose that P increases to 20. We know that the demand for money will increase and the curve will shift to the right (to M ).

4. We see that R = 5% and Y = 100 is no longer an equilibrium in the money market.

5. To the left you see that R = 7% will be an equilibrium when Y = 100 for P = 20.

6. R = 7% and Y = 100 must be on a new LM curve (LM2) associated with the higher price P = 20.

There is an LM curve for P = 10 (LM1) and an LM curve for P = 20 (LM2). The important thing to remember is that in the AS-AD model, there is one LM-curve for each value of P. When P increases, the LM curve will shift to a new curve which will be above the old one. The reason, again, is that R must increase when P increases to keep the money market in equilibrium.

Equilibrium in both the goods and in the money market

If both the goods - and the money markets are to be in equilibrium... ...if P increases, Y must fall and R increase ... ...if P decreases, Y must increase and R fall

For a given P, we can use the IS and the LM curves to find the equilibrium values of interest rate and GDP. However, we can also figure out how the equilibrium values of R and Y depend on P.

How P affects the equilibrium in the goods and money market.

Fig. 13.4: How P affects the equilibrium in the goods and money market.

LM1 is the LM curve when P = 10, while LM2 is the LM curve when P = 20. LM2 is above LM1 as explained in the previous section. If Y1 and R1 are the equilibrium values when P = 10 and Y2 and R2 are the equilibrium value when P = 20, we see that Y2 < Y and that R2 > R .

We may draw the following conclusion. When prices increase, GDP must fall and interest rates must increase if both the goods and the money market is to be in equilibrium. The economic intuition is something like this

1. When P increases, the demand for money increases

2. When MD increases, the interest rate increases

3. When R increases, investments fall

4. When I falls, GDP falls

Of less importance is the following point: when GDP falls in step 4, MD will fall slightly - although not as much as it increased in step 1. Therefore, the interest rate will decline somewhat compared to the level in step 2.

More importantly, we no longer have a unique equilibrium from the money market and the goods market. Since there is a unique LM curve for each value of P, there is an equilibrium (in both markets) for each value of P.

The AD curve

The AD curve shows all combinations of P and Y where the goods and the money markets are both in equilibrium. The AD curve slopes downwards.

From the section above, we know that Y must fall if P increases if we want both markets to remain in equilibrium. In this section we derive the exact relationship between Y and P when both markets are in equilibrium.

Derivation of the AD curve.

Fig. 13.5: Derivation of the AD curve.

We can illustrate our derivation using the diagram above.

1. First select P = 10 and P2 = 20 in the lower diagram.

2. Draw the IS curve in the upper diagram and two LM curves - the one corresponding to P = 20 must be above the one for P = 10.

3. Identify the resulting GDP in the upper graph for both prices - the highest level of GDP is associated with the lower of the prices.

4. Extend these levels of GDP to the lower graph. This will result in two points in the lower graph.

5. Keep on doing this with other prices. The resulting downward sloping curve in the lower graph is called the AD-curve.

Keep in mind that both the goods market and the money market is in equilibrium at all points on the AD curve. Therefore, the AD-curve alone cannot identify to which point the economy will move.

The AD curve is the aggregate demand

The AD curve is the aggregate demand as a function of P when the goods and money market are both in equilibrium

The AD curve shows not only the equilibrium combinations of P and Y - it also shows the aggregated demand as a function of P when both markets are in equilibrium. This follows from the equilibrium condition in the goods market which requires aggregate demand to be equal to GDP. When we change P, the AD curve will tell us the response of Y and therefore also the response of YD. You may therefore use the AD curve to find the aggregate demand for different prices under the condition that both markets are in equilibrium.

Initially, this may seem like a contradiction. In section 12.2.3, we claimed that the only endogenous variables that affect aggregate demand where R and Y. Specifically, we stated that P does not affect YD as long as we kept the R and Y fixed.

• If we start in equilibrium and change P but keep R and Y constant, YD will not change but we will not longer be in equilibrium in the money market.

• If we require both markets to be in equilibrium, R and Y must change when P changes.

• Specifically, R must fall and Y must increase when P decreases if both markets are to be in equilibrium.

• Since YD depends positively on Y and negatively on RtYe will then increase.

• Thus, YD increases when P falls when both markets remain in equilibrium and there is no contradiction.

 
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