Chapter 11: Macroeconomic Equilibrium (IS-LM, AD-AS)

The IS-LM and AD-AS models are the most powerful tools for analyzing how macroeconomic policies affect national income, interest rates, and prices.

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1. IS-LM Model (Short-run analysis, Fixed Prices)

(1) IS Curve (Product Market Equilibrium)

• Definition: Combinations of interest rate (r) and national income (Y) that clear the product market.
• Characteristic: As interest rates fall, investment increases, leading to higher income, so the curve is downward-sloping.
• Shift: Moves to the right when government spending increases or investment increases.

(2) LM Curve (Money Market Equilibrium)

• Definition: Combinations of interest rate (r) and national income (Y) that clear the money market.
• Characteristic: As income rises, money demand increases, pushing up interest rates, so the curve is upward-sloping.
• Shift: Moves to the right (down) when the money supply increases.

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2. Policy Effects and Crowding-out

1. Expansionary Fiscal Policy ($G \uparrow$): Rightward shift of IS curve $\rightarrow$ Increase in income, rise in interest rates.
2. Crowding-out Effect: When government spending increases, interest rates rise, which in turn reduces private investment. This reduces the overall increase in income.
3. Expansionary Monetary Policy ($M \uparrow$): Rightward shift of LM curve $\rightarrow$ Increase in income, fall in interest rates.

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3. AD-AS Model (Includes price changes)

(1) Aggregate Demand (AD)

• Represents the relationship between price (P) and income (Y), and is downward-sloping. As prices fall, the real value of assets rises, increasing income (Pigou effect).

(2) Aggregate Supply (AS)

• Classical (Long-run): A vertical line. (Regardless of price, the economy is always at its potential output level)
• Keynesian (Short-run): Upward-sloping or horizontal. (Due to nominal wage rigidity, an increase in prices leads to more production)

(3) Changes in Equilibrium and Stagflation

• Stagflation: A worst-case scenario where the AS curve shifts to the left (e.g., due to rising raw material prices), causing prices to rise while income decreases (unemployment rises).

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Key Checklist

• What do we call the phenomenon where an increase in government spending leads to higher interest rates and a reduction in private investment? (Answer: Crowding-out effect)
• In which direction does the LM curve shift when the money supply increases? (Answer: Right/Down)
• Which curve likely shifted if both prices and income are rising simultaneously? (Answer: Rightward shift of the AD curve)
• Why is the Long-Run Aggregate Supply (LRAS) curve vertical?