CHAPTER SUMMARY
1. The IS-LM model represents the three main markets of the economy—the labor market, the goods market, and the asset market—simultaneously, in a diagram that has the real interest rate on the vertical axis and output on the horizontal axis.
Although the IS-LM model was originally developed by Keynesians, it may be used to illustrate both classical and Keynesian analyses of the economy.2. In the IS-LM model, equilibrium in the labor market is represented graphically by the full-employment, or FE, line, which is vertical at full-employment output. Factors that raise full-employment output shift the FE line to the right, and factors that reduce fullemployment output shift the FE line to the left.
3. For any level of output, the IS curve shows the value of the real interest rate that clears the goods market. The IS curve slopes downward because higher output leads to more desired saving and thus a lower goods- market-clearing real interest rate. For constant output, any change that reduces desired national saving relative to desired investment increases the real interest rate that clears the goods market and shifts the IS curve up and to the right. Equivalently, for constant output, any change that increases the aggregate demand for goods increases the real interest rate that clears the goods market and shifts the IS curve up and to the right.
4. For any level of output, the LM curve identifies the real interest rate that equates the quantities of money supplied and demanded and thus clears the asset market. The LM curve slopes upward because an increase in output raises money demand, implying that a higher real interest rate is needed to clear the asset market. With output fixed, any change that reduces the money supply relative to money demand increases the real interest rate that clears the asset market and causes the LM curve to shift up and to the left.
5. General equilibrium in the macroeconomy occurs when all markets are in equilibrium. Graphically, the general equilibrium point is where the IS curve, the FE line, and the LM curve intersect. Price level adjustments push the economy toward general equilibrium. Specifically, changes in the price level, P, change the real money supply, M∕P, which causes the LM curve to shift until it passes through the point at which the FE line and the IS curve intersect.
6. A temporary adverse supply shock causes the general equilibrium levels of the real wage, employment, output, consumption, and investment to fall, and the general equilibrium levels of the real interest rate and price level to increase.
7. A change in the money supply is neutral if it leads to a proportional change in the price level but doesn't affect real variables. In the IS-LM model, money is neutral after prices have adjusted and the economy has returned to general equilibrium.
8. The aggregate demand-aggregate supply (AD-AS) model is based on the IS-LM model and in fact is equivalent to it. However, the two models allow us to focus on the behavior of different macroeconomic variables: The IS-LM model is most useful for studying the relationship between the real interest rate and the level of output, whereas the AD-AS model focuses on the relationship between the price level and the level of output.
9. The aggregate demand (AD) curve relates the aggregate quantity of output demanded—the level of output at the intersection of the IS and LM curves—to the price level. An increase in the price level reduces the real money supply and shifts the LM curve up and to the left, thereby reducing the aggregate quantity of output demanded. Because an increase in the price level reduces the aggregate quantity of goods demanded, the aggregate demand curve slopes downward. Factors that increase the aggregate quantity of output demanded at a given price level, such as increases in government purchases or the money supply, shift the AD curve up and to the right.
10. The aggregate supply curve relates the quantity of output supplied to the price level. In the short run, the price level is fixed and firms supply whatever level of output is demanded, so the short-run aggregate supply (SRAS) curve is horizontal. In the long run, after prices and wages have fully adjusted and all markets are in equilibrium, firms produce the profit-maximizing level of output. Hence, in the long run, aggregate output, Y, equals its full-employment level, Y. In the long run, firms supply Y regardless of the price level, so the long-run aggregate supply (LRAS) curve is a vertical line at Y = Y.
11. Classical macroeconomists argue that prices and wages adjust rapidly in response to changes in supply or demand. This argument implies that, following shocks or changes in policy, the economy quickly reaches its general equilibrium, represented by the IS-LM-FE intersection or, equivalently, by the intersection of the AD and LRAS curves. In contrast, Keynesian macroeconomists argue that prices and wages adjust slowly enough that the economy can remain away from its general equilibrium (long-run equilibrium) for a prolonged period of time. Keynesians agree with classicals, however, that eventually prices and wages fully adjust so that the economy reaches its general equilibrium.
12. Classicals and Keynesians agree that money is neutral in the long run, after the economy has reached its general equilibrium. Because classicals believe that long-run equilibrium is reached quickly, they dismiss the short-run equilibrium in which money is not neutral as essentially irrelevant. Keynesians, who believe that it may take several years for the economy to reach general equilibrium, ascribe much more importance to the short-run period in which money is not neutral.
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