AD-AS Short Run

Building the short run AD-AS

model from the IS-LM
framework

Theory of Short Run Fluctuations

The IS curve is generated
from the Keynesian Cross and
the LM curve is generated
from the market for real
money balances.

Keynesian
Cross

IS
Curve
IS-LM
Model

Money
Market

AD
Curve

LM
Curve

Now we will generate the AD

curve from IS-LM and use
short run and long run
models of AS to explain short
run economic fluctuations.

AD-AS
Model
AS
Curve

Short-run
Fluctuations
Explanation

Fiscal Policy and the IS curve (government expenditure)

An increase in government purchases

shifts the IS curve to the right.

The IS curve shifts to the

right by G/(1-MPC),...

Y=C(Y-T)+I(r)+G
M/P=L(r,Y)

...IS
...LM

LM

...and the interest rate.

r2
r1

which raises income...

IS2
IS1
Y1

Y2

Fiscal Policy and the IS curve (government expenditure)

A decrease in taxes shifts the IS curve

to the right.

The IS curve shifts to the

right by TxMPC/(1MPC),...

Y=C(Y-T)+I(r)+G
M/P=L(r,Y)

...IS
...LM

LM

...and the interest rate.

r2
r1

which raises income...

IS2
IS1
Y1

Y2

Fiscal Policy and the IS curve

(tax changes)

Note that government expenditure has a

larger effect than does the same change in

taxes.

Y=C(Y-T)+I(r)+G
M/P=L(r,Y)

...IS
...LM

Monetary Policy and the LM curve

An increase in the money supply

shifts the LM curve to the right,...

Y=C(Y-T)+I(r)+G
M/P=L(r,Y)
r

...and lowers the interest rate.

LM1

...IS
...LM

LM2

r1
r2

which raises income...

IS1
Y1 Y2

Monetary and Fiscal Policy Interactions

if the money
supply is held
constant, the
LM curve stays
the same.

How the economy

responds to a tax
increase depends on
the response of the
money supply.

LM1

The interest
rate and
output fall.

IS1
IS2

Monetary and Fiscal Policy Interactions

if to hold the
interest rate constant,
the money supply
contracts.

How the economy

responds to a tax
increase depends on
the response of the
money supply.

Only output
falls.

LM2

LM1

IS1
IS2

Monetary and Fiscal Policy Interactions

if to hold
income
constant, the
money supply
expands.

How the economy

responds to a tax
increase depends on
the response of the
money supply.

Only the

interest rate
falls.

LM1

LM2

IS1
IS2

IS-LM as a theory of Aggregate Demand

r

LM(P2)

A higher price level P shifts the

LM curve upward

LM(P1)

lowering income Y.
IS1

We now allow price

level to vary in the ISLM model. This

provides a theory for
the position and
slope of the AD
curve.

Y2
P

Y1

The AD curve
summarizes the
relationship between
P and Y.

P2
P1
AD
Y2 Y1

IS-LM as a theory of Aggregate Demand

LM(P1)

A monetary expansion shifts the

LM curve outward

increasing income Y.

IS1
Y1

If we hold price

constant we can see

the effects of monetary
and fiscal policy on AD
via IS-LM.

LM(P1)

Y2

Increasing AD at any
given price level.

P1
AD2
AD1
Y1 Y2

IS-LM as a theory of Aggregate Demand

r

LM(P1)

A fiscal expansion shifts the IS

curve outward

IS2
IS1

increasing income Y.

Y1

Y2

Increasing
AD at any
given price
level.

P1
AD2
AD1
Y1

Y2

IS-LM and AD-AS the Short Run and the Long Run
Now lets add short-run and long-run
AS to our IS-LM and AD models.
Assume the economy is operating
below full employment output.

LRAS

LM(P1)

LM(P2)

As price falls money demand

decreases and the LM curve
shifts out.

2
IS

In the short run price is fixed at P1

and equilibrium is at point 1.

In the long run price falls to P2,

quantity demanded increases, and
equilibrium moves to point 2. This
is characterized by a shifting
SRAS curve.

P1
P2

SRAS1

1
2

AD1

Long run equilibrium is achieved

at point 2.

SRAS2

The Algebra of the IS-LM theory of AD

The algebra behind the system is a bit tedious.

But, by solving the LM curve for r and

plugging into the IS curve which contains r on
the right hand side you obtain the IS-LM
equilibrium condition or AD curve.

The Algebra of the IS-LM theory of AD

The IS curve boils down to

ac 1
b
d
Y

G
T
r
1 b 1 b
1 b 1 b

r (e / f )Y (1/ f ) M / P
The LM curve boils
down to

z (a c)
z
zb
d
M
Y

G
T
1 b
1 b
1 b
(1 b)[ f de /(1 b)] P
Plugging r into the IS
curve and solving for Y
yields

Conclusions

In this section we derived the AD curve via the IS-

LM equilibrium condition. We looked at fiscal and

monetary policy effects on the IS-LM model. We
looked at the shifting effects that monetary and
fiscal policies have on the AD curve and used the
IS-LM model with the AD-AS model to explain short
run and long run changes to the economy.