|The core of this section was the development of two closely-related
models. The first was the IS-LM model, the second the AS-AD model. Each
of these models is useful for different purposes.
|The IS-LM model is a nothing more than a neat way to
keep track of two equilibirum conditions that must be satisfied at all
points in time. The first is money market equilibrium: money supply must
equal money demand. For any given values of money supply and the price
level, money market equilibrium requires that a certain relationship between
the nominal interest rate and national income be satisfied. This relationship
is summarized by the LM curve. The second is goods market equilibrium,
which is to say that the national income accounting identity, Y=C+I+G,
must always be satisified. You should also recall that when Y=C+I+G, it
is also true that national saving equals national investment. Thus, the
goods market equilibrium is that S=I. For given values of government expenditure,
taxes, and expected inflation, goods market equilibrium requires that another
relationship between the nominal interest rate and national income
be satisfied. This relationship is summarized by the IS curve.
|When plotted on a graph with i and Y on
the axes, we showed that the LM curve has a positive slope while the IS
curve has a negative slope. The economy has to lie on the LM curve for
the money market to be in equilibrium and it has to lie on the IS curve
for the goods market to be in equilibrium. There is only one point, the
intersection of the two curves, where both sectors of the economy are in
equilibrium. We also showed how these curves shift when policies change.
Whenever they shift, the intersection point changes, so the IS-LM model
is a neat way to work out the effects of policy changes on the nominal
interest rate and output.
|The AS-AD model extends the IS-LM by allowing for price
changes. The IS-LM curves were combined into a single curve plotted on
a graph with price and output on the axes. This we called the Aggregate
Demand curve. We then developed a concept of aggregate supply which depended
on price expectations, and we introduced the concept of adapative expectations
to model how price expectations develop over time. The AS-AD model provides
a bridge between the short-run analysis of the Keynesian IS-LM model where
prices are fixed, and the Classical AS-AD model, where prices are fully
flexible. In developing this model, we concluded that (i) the IS-LM model
is an appropriate tool to assess how policy changes might affect the economy
over a time horizon of 6 to 9 months, (ii) the Keynesian AS-AD model is
an appropriate tool to assess how policy changes might affect the economy
over a time horizon of 9 months to 4 or 5 years, and (iii) the classical
model with a vertical AS curve is an appropriate tool to analyze how policies
introduced today will affect how the economy will look in 5 years or more.
|We have tried to develop three specific skills in using
these models. The first is to be able to calculate the effects of policy
changes mathematically. The reason for this is that many of you may come
across occasions when the question you want to study involves extending
the basic model to introduce a new policy variable or some new factor than
influences the economy. Problem set 3 was concerned with giving you practice
at this skill. You were asked to modify the basic model and explain how
the economy is predicted to behave in the new version of the model. Adapting
the basic models to new questions is difficult to do without mastering
the mathematical approach.
|The second skill is to use the models as a guiding framework
to help you explain in a non-technical fashion how the economy will respond
to a policy change. This is what I call conversational macroeconomics.
I have tried to push this skill by getting you to explain verbally why
the intersection moves in the way that it does. We saw repeated instances
of this skill set in the applications we looked at: German unification,
the Clinton-Greenspan policy mix, the macroeconomic effects of 9/11, and
|The third skill is to use the IS-LM model as a guide
in interpreting data. This is what I call forensic macroeconomics. You
are presented with some data on the behavior of the economy, perhaps as
it is sliding into a recession. Your boss wants to know what is causing
the recession. By studying what has happened to interest rates or to prices,
you are able to pinpoint which part of the economy is causing the recession.