We are going to develop a representation of equilibrium in all three markets: Labor Goods and Assets. We can represent this graphically by graphing real interest rate versus output.

The FE Line: The Labor Market

Review from Chapter 3: Found equilibrium in the labor market where labor demand equals labor supply.

 

Equilibrium yielded the real wage and full employment level of employment (N). The production function determines the amount of output in the economy (Y= AF (K, N)). When the economy is at N it will produce the full employment level of output. ( Where everyone is working – only frictional and structural unemployment exist)

FE line: The full employment line is a vertical line at the full employment level of output. The economy will produce at full employment level of output regardless of the real interest rate. At every point along the FE line the labor market is in equilibrium.

Factors that shift the FE line:                Shifts the FE line          Reason

1) Beneficial Supply                        Right                    a) More output is produced with the same amount of labor
                                                                                  b) If MPN increases, labor demand increases and raises
                                                                                     employment

2) Increase in Labor Supply            Right                    Equilibrium employment rises raising full employment output

          3)  Increase in Capital Stock            Right                    More output is produced with the same amount of labor

The IS curve equilibrium in the Goods Market

IS curve, for level of output (Y) the IS curve shows the real interest rate for which goods market is in equilibrium.

When current income increases the saving curve shifted to the right in chapter 3, lowering the equilibrium level of real interest rates. The equilibrium level of interest rate is graphed with the level of income which will produce a downward sloping curve, the IS curve. The real interest rate is graphed on the vertical axis and the amount of output is graphed on the horizontal axis.

The graphs below represent the derivation of the IS curve. At point A the real interest rate is 8% and the level of income is 10,000. (in the graph on the right the combination of Y=10,000 and r = 8% will be the first point on the IS curve) At point B income has increased to 12,000 causing the real interest rate to decline to 6%. (creating the second point on the IS curve Y= 12,000 and r = 6%). At point C the level of income has increased to 14,000 and the equilibrium level of interest rate decreases to 4% creating a third point on the IS curve Y = 14,000 and r = 4%). The points on the IS curve are connected representing all combinations of income and the equilibrium interest rate which would have occurred at that level of income or the IS curve.

Factors that shift the IS curve:

Factors which will increase or decrease the level of saving or investment changing the equilibrium level of interest rate for each level of income.

For example an increase in wealth causes desired savings to fall at every level if income. The equilibrium level of interest rate will be higher at each level of income shifting the IS curve up at every level of income as shown in the graph below.

The LM Curve: Asset market Equilibrium

LM curve shows the real interest rate for which the asset market is in equilibrium (real money demand equals real money supplied.)

Review from chapter 7: If money market is the equilibrium the nonmonetary asset market is in equilibrium which implies that the bond market is in equilibrium.

    Structure of a bond (nonmonetary asset)

            Bond has two different prices the par value (amount paid at maturity) and the selling price. Example bond with par value
             of $100 which pays $10 in dividends each year, yields approximately 10% if the price falls to $90 you still receive $10
             in dividends every year(it is based on the par value) the yield you are receiving has increases to 11.1%

            The price of a bond will decrease as the yield increases and vice versa. For a given expected rate of inflation
             movements in the nominal interest rate are matched by movements in the real interest rate (the price of nonmonetary
             assets is also negatively related in the real interest rates).

Real Money demand for chapter 7 M^d/P=L(Y,r+π^e) As the real interest rate increase the amount of real money demanded will decrease( will hold more wealth in nonmonetary assets). This graph relationship—real money demand vs. real interest rate.

Real Money Supply is controlled by the Federal Reserve it is equal to M^s/P. When the Fed increases the nominal money supply through open market operations, reserve requirements or change in the discount rate M^s will increase causing the real money supply to increase. Real Money supply is represented by a vertical line.

The intersection of the real money supply and real money demanded curves determines equilibrium in the assets market( in the graph on the right the combination Y=10,000 r=%% will be the first point on the LM curve). At point B income increases to 12,000 the MD curve shifts up causing the real interest rate to increase to 7%( the second point on the LM curve is Y=12,000 r=&%). At point C income increases to 14,000 causing the real interest rate to increase to 9%( the third point on the LM curve would be Y=14% r =9%) the points on the LM curve are connected representing various levels of income and the equilibrium interest rate which would have occurred at each level of income.

Factors which shift the LM curve:

Things which change wither the amount of money demanded at each level of income, such as a change in expected inflation or changes from chapter 7 such as an increase in wealth or the risk of alternative assets…. Also, changes in the real money supply caused by changes in Federal reserve policy or a change in the price level.

Example:

An increase in the real money supply will shift the money supply to the right decreasing the equilibrium level of interest rate at each level of income, shifting the LM curve to the right.

General Equilibrium in the complete IS-LM model

General Equilibriul occurs when all three markets (labor goods and assets) are in equilibrium at the same time, also occurs when all three curves( IS,LM, and FE curves) intersect at the same point.

The general equilibrium will always occur at the intersection of the IS FE and the LM curves.

When all three markets are not in equilibrium at the same time then we assume that the asset market and goods mark determine the level of interest rates and output in the economy at the intersection of the IS and LM curves. There will then be an adjustment in the prices which moves the economy to the general equilibrium.

Speed and Adjustment:

The assets market is the quickest to adjust to change in the economy, sense financial markets are capable of responding quickly to changing economic conditions.

The good market is slower to react to non equilibrium conditions. This is due to the time it takes to build new products and develop new investment projects.

The labor market is the slowest to adjust, given that there are long term commitments in wages and hiring decisions.

General Adjustment process to a shock starting form general equilibrium:

1) The economy is in a short term equilibrium at the intersection of the IS and the LM curves following the shock. This will be short term equilibrium in the goods and assets markets, it is reached but the rapid adjustment of the assets market. It is reached by the rapid adjustment of the asset market.

2) This intersection will determine the amount of output which the economy is producing, it will temporarily be either below or above the full employment rate of output in the short run. At this point the goods and assets market will be in equilibrium, but the labor market will not.

3) The LM curve will adjust to bring all the markets to equilibrium at the same time , when the price responds to the good market.

a) If the economy is temporarily producing above full employment, the firms will temporarily supply excess demand for goods but can not continue this in the long run. (Remember they maximize profits when the labor market is in equilibrium, which it is not). The increase production will cause pressure to increase prices, which will decrease the real money supply, shifting the LM curve.

b) If the economy is currently producing below the full employment, the firms will temporarily produce less then they would like. (Remember they maximize profits when the labor market is in equilibrium, which it is not). The decrease in production will cause extra inventory, firms will start to decrease production and prices will fall increasing the real money supply shifting the LM curve toward general equilibrium.

Examples:

A temporary supply shock—will reduce the amount of full employment and the FE line will shift to the left. The intersection of the LM and IS curve will be to the right of the full employment level of output implying that output is temporarily above the full employment level.

Since the economy is temporarily producing above full employment level the prices will increase, decreasing the real money supply. As the real money supply decreases the LM curve shifts to the left along the IS curve until all markets are in the equilibrium again.

Example 2

A decrease in the money supply, will shift the LM curve to the left.

The new intersection of the IS and LM curve will be below the full employment level.

As inventories start to increase and the need for additional output decreases the price level and the LM curve will shift to the right as well as the real money supply increase. The economy will return to its full employment equilibrium level.

Classical vs. Keyesian Versions of the IS-LM model

1) How quickly does the economy reach the general equilibrium?

Classical- prices adjust quickly until supply equals demand. The classical model assumes that the economy will quickly reach its general equilibrium.

Keynesian- Wages and prices are slow to adjust therefore the price change does not occur quickly to bring the economy to general equilibrium.

2) What are the effects of monetary policy on the economy?

Neutrality of Money- Does the economy have any real effects on the economy? In the example before a change in the monetary policy will have no affect on the real variables in the long run.