GRIPS Macroeconomics II

Fall II Semester, 2016

Lecture 5: IS-LM and AD-AS (1)
Junichi Fujimoto
December 14, 2016

The IS-LM Diagram and the AD Curve

1.1 Equilibrium in the Goods Market and the Money Market

The combination of Y and r, for which both the goods market and the money market are in equilibrium, is given
by the intersection of the IS curve and the LM curve.
r

LM

IS

Y*

Figure 1: The IS-LM Diagram

1.2 The IS-LM Diagram and the AD curve

The Keynesian AD curve is derived from the IS-LM diagram as in Figure 2. First, take two dierent price levels,
P1 and P2 (P1 > P2 ). As we saw before, other things equal, the LM curve with a larger M
P will lie more to the
right, so the LM curve with P = P2 lies to the right of the LM curve with P = P1 . Next, from the intersections of
these LM curves with the IS curve, nd the corresponding values of Y , Y1 and Y2 . Finally, by connecting the two
points (P1 , Y1 ) and (P2 , Y2 ), we obtain the downward sloping AD curve.

The Short Run Equilibrium: When

is Constant

First, let us consider the case in which the price level P is completely rigid in the short run, such that P is constant.
This implies that the SRAS is horizontal. In this case, we need only the IS-LM diagram to analyze the eect of
scal and monetary policies on income and the interest rate.

M
)
P1
M
LM ( )
P2

LM (

IS

Y1

Y2

P1
P2

AD
Y1

Y2

Figure 2: The IS-LM Diagram and the AD Curve

LM

r2
r1
IS 2
IS1

Y1

Y2
1

1 MPC

Figure 3: Increase in Government Purchases

2.1 Fiscal Policy: Government Purchases

Suppose the government increases government purchases by G. As we studied the last time, this shifts the IS
curve to the right by 1M1 P C G (see Figure 3). This increases Y , which in turn increases money demand. Then
the interest rate rises, which decreases investment. Thus, the ultimate rise in Y is smaller than 1M1 P C G.
2.2 Fiscal Policy: Taxes

Suppose the government reduces taxes by T . As we studied the last time, this shifts the IS curve to the right
MP C
by 1M
P C T (see Figure 4). As with the case of government purchases, this increases Y , which in turn increases
money demand. Thus the interest rate rises, which decreases investment. Thus the ultimate rise in Y turns out to
MP C
be smaller than 1M
P C T . Moreover, compared to the increase in government purchases of the same magnitude,
the rightward shift of the IS curve is smaller with tax reduction, hence the eect on Y is also smaller.
2.3 Monetary Policy

Suppose the government increases the money supply by M . This shifts the LM curve to the right as in Figure 5,
and lowers the interest rate. The fall in the interest rate increases investment, and accordingly, increases Y .
2.4 The IS-LM Diagram and the AD Curve

In all of 2.12.3 above, the IS-LM analysis tells us that following the government policy, Y increases for a given P .
Thus, the AD curve shifts to the right. Suppose the initial price level is P1 . Then since, by assumption, the price
level is xed at P1 in the short run (i.e., the SRAS curve is horizontal at P1 ), as shown in Figure 6, only Y rises as
the economy moves to the new equilibrium.

The Short Run Equilibrium: When

is not Constant

When the SRAS curve is upward sloping, scal and monetary policies cause changes in P , even in the short run.
We can again use the IS-LM and the AD-AS diagrams to analyze how the equilibrium of the economy changes.
As an example, let us consider the case in which the government increases the money supply as in 2.3; let M1 , P1
denote, respectively, the initial money supply and the price level, and M2 denote the new level of money supply.
As we have already seen, such an expansionary monetary policy shifts the LM curve to the right. This time,
however, such a policy also changes P , so we need to also consider this eect. To do so, we must combine the IS-LM
3

LM

r2
r1
IS 2
IS1

Y2

Y1

MPC
T
1 MPC

Figure 4: Decrease in Taxes

LM 1
LM 2

r1
r2
IS

Y1

Y2

Figure 5: Increase in the Money Supply

P1

SRAS

AD2

AD1

Y1

Y2

Figure 6: The IS-LM Diagram and the AD-AS diagram (When P is Constant)
1
analysis with the AD-AS analysis. First, as shown in Figure 7, the LM curve shifts to the right from LM ( M
P1 ) to
0
2
LM ( M
P1 ), and intersects with the IS curve at Y = Y2 . Accordingly, the AD curve shifts to the right from AD1 to
AD2 . However, as we observe from the AD-AS diagram, the value of Y in the new equilibrium, Y2 , is smaller than
0
Y2 . In the IS-LM diagram, this is explained by the leftward shift of the LM curve, following the rise in P from P1
M2
2
to P2 , from LM ( M
P1 ) to LM ( P2 ). After all, the equilibrium values of P and Y change from (P1 , Y1 ) to (P2 , Y2 ).

The Long Run Equilibrium

We can also analyze, by using the IS-LM diagram, the long run eects of scal and monetary policies. Suppose
initially the price level is P1 , the money supply is M1 , and Y equals its long run level, Y . Suppose now that the
government increases the money supply to M2 . Then, in the short run, the LM curve shifts to the right, and so
the AD curve also shifts to the right, as in Figure 8. However, in the long run, the price level rises from P1 to P2 ,
which shifts the LM curve back to where it originally was; accordingly, the equilibrium income returns to Y .
Note that for the LM curve to return to where it was, it must be that

M1
M2
=
,
P1
P2
so when M doubles, P doubles as well. Thus, in the long run, the classical dichotomy holds in the Keynesian model.
Practice Questions

1. Suppose the government increases government purchases. Using the IS-LM diagram and the AD-AS diagram,
explain how the price level P , national income Y , and the real interest rate r changes: (1) in the short run
(assume the SRAS is upward sloping), and (2) in the long run.
2. Suppose people began to hold more cash following system problems in banks, and as a result, demand for real
money balances rose autonomously by M d /P (i.e., equal rise in money demand, independent of the interest
rate and income). Assume P is constant, and respond to the following questions.
(a) Show that the LM curve shifts to the left (or equivalently, upwards).
(b) Answer what the size of the horizontal shift of the LM curve depends on, besides M d /P .
(c) Answer what the size of the vertical shift of the LM curve depends on, besides M d /P .
(d) How does the equilibrium Y change ? How does the interest sensitivity of investment I aect the size of
change in Y ?

LM (

M1
)
P1

M2
)
P2
M
LM ( 2 )
P1

LM (

IS

Y1 Y2

'

SRAS

P2
P1

AD2
AD1

Y1 Y2

'

Figure 7: The IS-LM Diagram and the AD-AS Diagram (When P is not Constant)

LM (

M2
M1
) = LM (
)
P2
P1
LM (

M2
)
P1

IS

LRAS

P2
P1

AD2

AD1

Y*

Figure 8: The IS-LM Diagram and the AD-AS Diagram (Long Run Equilibrium)