QUESTION

(i).Critically appraise the IS-LM and the AD-AS models as analytical tools in explaining the macro-economy (the business cycle).

In preparing your essay, please think about the following:

• The theoretical structure to the IS-LM and AD-AS models
• How well do the models explain fluctuations in economic activity such as recessions and boom periods?

What are the weaknesses of these models

SOLUTION

1. Introduction

The IS-LM and the AD-AS model have played a crucial role in the determination and evolution of macro-economic theory over the past decades. The IS-LM and the AD-AS model remain the core and the introductory level of understanding any macro-economic theory. Through this paper we evaluate and analyse the history of the IS-LM and the AD-AS models. We also analyse the practicality of the models as well as highlight the strengths and weaknesses of both.

2. History of the IS-LM model

The first exemplar of the IS-LM model was introduced by Hicks in 1937, a means for establishing a clear relationship between the Keynesian theory general equilibrium model and the classical theory established earlier. The IS-LM was a mathematical establishment of the classical model which led to the further evolvement of both the Keynesian and the classical theories. Hicks interpreted the Keynesian model had three aggregate markets which were the money , capital and the goods markets and the labour market to some extent which helped in the determination of the equilibrium in the short run. The evolvement of the IS-LM model began in the late 1930’s but the model was continuously refined and came to its current state by the 1950’s. The success of the IS-LM model in explaining the general macro-economic state at that time can be attributed to

1. The monitory stability of the economies at that time with respect to prices and wage rates, which justified the assumptions of fixed wage rate and prices in the short run.

2. Slow shifts in the supply curve which were equivalent to the supply curves in the short run.

3. The substantial structural stability of the 2 curves assumed which contributed to the stability of the IS-LM model.

The IS-LM model consolidated its position in the 1950’s and was often used for descriptive purposes to understand the macroeconomic behaviour of the economy. Many economic theorists believe that the IS-LM model was a simplistic representation of the aggregate demand of the economy and cannot be used to explain overall macro-economic behaviour until the model further evolved with the introduction of the Phillip’s curve.

(Vercelli, 1999 Pages 3-13 and King, 1999 Pages 45-50)

Despite the weaknesses the IS-LM is an integral part of economic theory; let us undertake the general study and derivation of the IS-LM model.

3. Derivation of the IS-LM model and the Equilibrium

3.1 Goods Market Equilibrium(IS)

The IS-LM model is based on a certain set of assumption, assuming the IS-LM model for a two sector economy.

I.          The price level is constant

II.          At a given price level the firms are willing to pay the price demanded

III.          In the short run the supply curve is perfectly elastic until the full employment level is reached.

Let us derive the IS-LM model graphically

Figure 1: Graphical Presentation of the IS-LM model

Let us assume in Quadrant 1 there is an Investment in the economy at the rate of R1 at the level of investment I1, In Quadrant 2 the Saving = Investment along the 45 degree line, Quadrant 3 depicts that Saving is equal to Investment when the Saving level is S1 at Income level Y1 therefore in Quadrant 4 the goods market equilibrium is established. Suppose that the rate of interest increases to R2 in Quadrant 2, then in Quadrant 3 Savings equals investment when the saving level is S2 at Income level Y2, Therefore in Quadrant 4 yet another condition for goods market equilibrium is established. Joining both the points we obtain a downward sloping IS curve where the goods market is in Equilibrium at the rate of interests R1 and R2.

3.2 Money Market Equilibrium (LM)

The money market equilibrium is established when the demand for money the supply of money and assuming that the supply of money is fixed by the monitory authorities of the country.

Therefore according to the Keynesian theory the demand for money can be divided into 2 broad categories firstly the transaction demand of money which is determined by the level of income, therefore the transaction demand of money is the direct function of income level Mt(Y). Secondly, the other demand of money is a speculative demand of money which is determined by the rate of interest Msp(R).

The total demand for money

Where Mt(Y) is the transaction demand of money and Msp(R) is the speculative demand for money.

The money market equilibrium is Money Demand (Md) = Money Supply (Ms)

Deriving the LM curve now graphically,

Figure 2: Graphical derivation of the LM curve

In the above figure the money supply curve Ms is a vertical i.e. it is determined exogenously, the money market equilibrium is established where the demand for money equals the supply of money, Thus the demand for money Md(Y1) equals the Ms at the level of interest R1 , Suppose that the income level increases to Y1 the demand for money then the money market equilibrium is established at the rate of interest R2. Correspondingly joining the points at the income levels Y1 and Y2 corresponding to R1 and R2 we obtain an upward sloping LM curve.

3.3 Equilibrium in Goods and Money Market (IS-LM Equilibrium)

From the above analysis we can conclude that all points along the IS curve is the representation of the goods market equilibrium, and all points on the LM curve represent the money market equilibrium. Therefore combining the 2 we can obtain the general equilibrium in the market. Thus, the general equilibrium is established at the point of intersection of the IS-LM curves which determines the equilibrium level of income and output at Y0 at the rate of interest R0.

Figure 3: IS-LM Equilibrium

(Vanita, Pages 213-217, 2009, Ghosh, et al, Pages 170-174, 2009)

3.4 Shift in the IS –LM Curves

3.4.1 Shift in the IS

The shift in the IS curve is caused by either a change in the level of investment in the economy or the saving. The rightward or the leftward shift depends of the increase or decrease in the level or investment and saving.

3.4.2 Shift in the LM

Since the supply of money is exogenously determined by the monitory authorities of the countries therefore the shift in the LM is caused by the shift in the aggregate demand of money. Similarly the rightward or the leftward shift is determined by either an increase or decrease in the Aggregate demand for money.

Let us understand the situation by assuming a hypothetical situation where both the IS-LM curves shift. Suppose the aggregate demand for money increases this causes the income levels to increase thus causing a rightward shift of the LM curve, similarly if the level of Investment increases in the economy it causes the rightward shift of the aggregate demand curve and is reflected by the rightward shift of the LM curve. The shifts in both the curves cause the equilibrium level of output and interest rate to remain the same. This is explained graphically below,

Figure4: Shift in the IS-LM curves

(Aggarwal et al, Pages 213-217, 2009)

The simultaneous shift causes the expansion of output from Y1 to Y2 and the rate of interest to remain constant at R1.

Therefore for the achievement of full employment level of output in the long run the output (government spending) will have to expand to the level until the equilibrium is established at the same interest rate of R1, this is called crowing out

4. Expansionary Fiscal and Monitory Policy

The shifts in the IS-LM curves can be caused by mainly 2 methods the adoption of an expansionary fiscal or monitory policy.

4.1 Expansionary Fiscal Policy

A fiscal expansion is caused by an increase in the government spending to provide the required fiscal impetus to the economy. As the government spending( G) increases as a component of the aggregate demand there is an increase in the aggregate demand and subsequently a rightward shift of the IS curve.

Figure 5: Effects of an Expansionary Fiscal Policy

The expansionary fiscal policy undertaken causes the IS curve to shift to the right i.e. from IS1 to IS2 this causes the output expansion from Y1 to Y2 as well as an increase in the rate of interest from R1 to R2. Therefore the fiscal expansion leads to an expansion in output but the increase in the rate of interest also causes the reduction of investment.

Therefore for the achievement of full employment level of output in the long run the output (government spending) will have to expand to the level until the equilibrium is established at the same interest rate of R1, this is called crowing out.

4.2 Expansionary Monitory Policy

An expansionary monitory undertaken by the government to increase money supply in the economy to stimulate the growth of the economy causes an increase in the aggregate supply of money which causes the rightward shift of the LM curve.

Figure 6: Effects Expansionary Monitory Policy

The monitory stimulus causes the LM curve to shift to the right from LM1 to LM2; this is accompanied with the expansion of output from Y1 to Y2 at a lower rate of interest R2 which is less than the earlier equilibrium rate of R1.

5. Derivation of Aggregate Demand and Supply Curve from IS-LM

With the government undertaking both expansionary fiscal and monitory the aggregate Demand curve can be effectively derived using the IS-LM model.

5.1 Derivation of Aggregate Demand curve with the expansionary fiscal policy

A fiscal expansion is caused by an increase in the government spending to provide the required fiscal impetus to the economy. As the government spending( G) increases as a component of the aggregate demand there is an increase in the aggregate demand and subsequently a rightward shift of the IS curve.

Figure 7: Effects of an Expansionary Fiscal Policy and derivation of the Aggregate Demand Curve

The expansionary fiscal policy undertaken causes the IS curve to shift to the right i.e. from IS1 to IS2 this causes the output expansion from Y1 to Y2 as well as an increase in the rate of interest from R1 to R2. Therefore the fiscal expansion leads to an expansion in output but the increase in the rate of interest also causes the reduction of investment.

The expansionary fiscal policy causes an expansion of the aggregate demand curve and shifts it from AD1 to AD2 with a expansion in the output with a reduction in the price levels which gives a downward sloping aggregate demand curve.

5.2 Derivation of the Aggregate Demand curve with an Expansionary Monitory Policy

An expansionary monitory undertaken by the government to increase money supply in the economy to stimulate the growth of the economy causes an increase in the aggregate supply of money which causes the rightward shift of the LM curve. The monitory stimulus causes the LM curve to shift to the right from LM1 to LM2; this is accompanied with the expansion of output from Y1 to Y2 at a lower rate of interest R2 which is less than the earlier equilibrium rate of R1.

Figure 8: Expansionary Monitory Policy and the derivation of the Aggregate Demand curve

The expansionary monitory policy undertaken causes the output to expand from Y1 to Y2 as the LM curve shifts to the right the price level drops from P1 to P2 giving a downward sloping aggregate demand curve.

(Dwivedi, 2010, Pages 325 – 340)

5.3 Derivation of the Aggregate Supply Curve

There has been a lot of debate on the nature of the aggregate supply curve in long run among economic theorist. The classical and the Keynesian Economists assume contrasting views on the nature and the shape of the aggregate supply curve. On the one hand the according to the classical theory the long run aggregate supply curve is assumed to be perfectly inelastic. This is based on the very basic assumption adopted by the classical economists that the economy operates at the full employment level.

Figure 9 : Long run AS curve according to the classical theory.

The arguers of the Keynesian theory have a totally opposite and a contrasting view on the theory , they believe that the market is moving toward the achievement of the full employment level of output , and therefore in the long run the price level is assumed to be constant and the output levels  can be maximised at the given output levels.

(Dwivedi , 2010 , Pages 325-350)

In the short run however in the IS-LM economic theory the supply curve is assumed to be perfectly elastic and the constant price level assumption is made , In the long run however the aggregate demand curve perfectly inelastic at the full employment level of output. Therefore to obtain equilibrium the long run and the short run supply curve intersect with the aggregate demand curve at the same point.

Figure 10: Derivation of equilibrium using AD-AS model

(Wesley,2005 Page 12)

Therefore the IS-LM model is used to derive the AD and AS curves, which in turn enable to determine the general equilibrium at the full employment levels of output. Thus, the IS-LM and the AD-AS models do effectively explain the concepts of output and expansion and macro-economic theory, many researchers have pointed out certain limitations in the models. These limitations have been discussed below.

6. Limitations of the IS-LM model

There have been some inherent weaknesses that have been built in the IS-LM model which do not make it the most appropriate model for the determination of full employment levels of output, price and equilibrium. Many concerns have been expressed over the years over the usability and the practicality of the model.

1. Firstly, the IS-LM model assumes that the prices are fixed maintains a rigid price level. However many economists argue that the price levels in an economy do not remain fixed and are subject to change in the over a period of time owning inflationary concerns.
2. Secondly, the model is unable to distinguish between real and nominal interest rates . Therefore the model adopts a very simplistic view on interest rates which is not a real reflector of the macro economic conditions or the true nature of the economy at a given period of time.
3. Thirdly, Economists argue that the model is unable to distinguish between different asset classes. As then IS-LM model makes use only of the nominal interest rates and ignores the real interest rate, therefore the model categorises all assets within 2 categories of bonds and money. The model ignores other categories of asset classes such T-bills and other financial instruments.
4. Fourthly, the model assumes a fixed stock of capital in the short run. This assumption is however too simplistic and almost unrealistic. Therefore many economists have objected to this assumption particularly in the analysis of the IS-LM models. In a business cycle even in the short run the stock of capital keeps on changing and does not remain constant moreover, it does not include the rational expectation and therefore reduces the practicality of the model.

Despite its many weaknesses the IS-LM model has been a milestone on the evolution of the macro economic theory and has been effectively been able to explain certain, macro characteristics of policy making effectively over a period of time. But owning to the simplistic nature of the model and unreal expectations some prefer the AD-AS model over the IS-LM, but that model also has some weaknesses.

(Mc Cullum , et al ,1997 Pages 4-8)

7. Limitation of the AD-AS Model

The AD-AS model is somewhat preferred over the IS-LM framework, but however the AD-AS model is also derived from the IS-LM framework to determine the general equilibrium of the economy. There have been significant criticisms to the AD-AS model particularly from the 1990’s onwards. There are certain inherent weaknesses in the AD-AS framework

1. Firstly, many argue that the model is logically inconsistent. This is because of the fact that the AD curve id usually derived using one method .However the AS curve, there have been many versions which have been considered which may be labour costs; sticky price and costs .These specify the inconsistency in the determination of the AS curve.
2. Secondly, there has been ignorance of the cost plus measures, The AD-AS model have ignored the cost plus measures. The AD-AS model does not begin with the equilibrium in the labour markets and but rather with the determination of the output. It ignores wage rates and the importance of wage rate, employment levels and the output produced.
3. Thirdly, the models adopt a price determination which is not consistent with the level of output and therefore can be described as sticky price. The sticky price nature of the prices assumed in the model implies that the prices are assumed to be somewhat constant and therefore are not subject to change according market conditions and expectations.
4. Fourthly, the model ignores the inflationary pressures that are exerted on the prices. The model adopts a deflationary view and also concludes that prices eventually fall in the short run, this view has been scrapped by most economists and most believe that prices do not fall and the model is incompetent to include the inflation component in the determination equilibrium price and output.

(Moseley, 2011, Pages 1-7)

8. Conclusion

Despite the existence of in consistencies in both the IS-LM and the AD-AS models, both the models have dominated macro-economic theory. Both the models have been used effectively explain and determine full employment equilibrium in the long run. The main weakness associated with the models is the simplistic approach adopted by the models ignoring g certain critical factors in both the short run, despite the rigid assumptions the models have been effective in the evolution of macro-economic theory. Most economists believe that the AD-AS is a better determinant of the general equilibrium but the weaknesses in the model cannot be ignored. The models have effectively evolved over a period of time and now include factors such as real interest rates, inflationary concerns and the importance of expectation in macro-economic theory.

9. References

• King, Robert G. “The New IS-LM Model: Language, Logic, and Limits.” Federal Reserve Bank of Richmond Economic Quarterly 1.1 (2009): 45-50. Print.
• Vercelli, Alessandro . “The evolution of IS-LM models: empirical evidence and theoretical presuppositions n. 246.” university Searams 1.1 (1999): 3-13. www2.depfid.unisi.id. Web. 28 Apr. 2012.
• Aggarwal, Vanita. Macroeconomics theory and Policy.. DElhi: Pearson , 2008. Print.
• Dwivedi, D. Macroeconomics, 3E. New Delhi: Tata Mc Grawhill, 2010. Print.
• Aggarwal, Vanita, and Deepashree Aggarwal. Macroeconomics theory and Policy.. DElhi: Pearson , 2008. Print.
• Ghosh, Chandana, and Chandana Ghosh. Macroeconomics. New Delhi: PHI Learning Private Limited, 2011. Print.
• Mc Callum, Bernett, and Edward Nelson. “An optimizing IS-LM specification for monitory policy and business cycle analysis.” NBER Working Series Paper 1.1 (1997): 4-8. Print.
• General Equilibrium in the Complete IS-LM Model.” demidova.myweb.uga.edu. N.p., n.d. Web. 27 Apr. 2012. <http://demidova.myweb.uga.edu/Lecture
• Moseley, Fred . “Criticisms of Aggregate Demand and Aggregate Supply: Mankiw’s Presentation.” Mount Holyoke College 1.1 (2011): 1-7. Print.

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