The IS/LM Model, Part A

assumptions

The IS/LM model is the most frequently used tool of macroeconomic analysis.

assumptions:

- wages and prices rapidly adjust to bring markets into equlibrium
- actors
  - 1. firms
      1. produce and sell output
        invest in capital goods and hire workers
    2. households
      1. supply labor and receive wages and capital income
        purchase output
    3. government
      1. makes purchases and transfer payments
        collects taxes
        determines money supply
- no international trade
- 3 markets
  - 1. goods market - for the output produced by firms
    2. labor market
    3. asset market - consumer savings are held in the form of financial and real assets

supply side of the goods market

The amount of output firms produce depends on the quantity of inputs they use. A production function gives the amount of output that can be produced using any given quantities of capital and labor.

Y = AF(K,N)

where

Y = real output

A = productivity

K = capital

N = labor

F = function relating Y to K and N

The U.S. economy is described well by Y = AK0.3N0.7

We can graph the production function as a relationship between K and Y, with N held constant

- upward sloping
- diminishing marginal returns to capital
- slope is the marginal product of capital (MPK)

We can graph the production function as a relationship between N and Y, with K held constant

- slope is the marginal product of labor
- shifts of the production function are called supply shocks

labor market

The demand for labor depends on the

1. marginal product of labor
2. real wage

The supply of labor depends on

1. demographic factors
2. the real wage

shifts of the labor demand curve

- anything that affects MPN

shifts of the labor supply curve

- demographic changes
- wealth
- expected future real wage

the FE line

Full-employment output is the level of output that firms supply when the labor market is in equilibrium.

Let N* = equilibrium level of employment and Y* = full-employment output. Y* is the level of output supplied when the labor market is in equilibrium. So,

Y* = AF(K,N*).

Anything that changes N*, A, or the production function will change Y*. For example, an adverse supply shock like an oil price rise causes the production function to shift down and the MPN to fall. So, both N* and Y* will decrease.

The FE line shows combinations of real income (Y) and the real interest rate (r) for which the labor market is in equilibrium. The FE line is vertical at the full-employment level of output, Y*. All points on the FE line are points of labor market equilibrium.

shifts of FE line

- adverse supply shock
- change in NS
- change in K

demand for goods and services

With no international trade, the demand for goods and services consists of (1) the desired consumption of households, (2) desired investment of firms, and (3) government spending.

The goods market is in equilibrium when Y = Cd + Id + G.

Equivalently, the goods market is in equilibrium when desired national saving (Sd) equals desired investment (Id).

determinants of Sd

- current income
- expected future income
- expected real interest rate
- wealth
- government purchases
- taxes determinants of Id

1. expected future MPK
2. corporate taxes
3. expected real interest rate

- shifts of saving curve
- shifts of investment curve

the IS curve

The IS curve tells us what value of the real interest rate clears the goods market for any given value of real income. It shows combinations of Y and r for which the goods market is in equilibrium. Sd equals Idat all points along the IS curve.

The IS curve is downward sloping because higher Y leads to higher Sd which requires a lower r to bring the goods market into equilibrium.

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