113-1The IS-LM/AD-AS Model:A General Framework for Macroeconomic Analysis,Part 313-2Agenda• Price Adjustment and the Attainment of General Equilibrium13-3General equilibrium in the AD-AS modelYPSRASLRASPY*AD13-4Disequilibrium in the AD-AS model• Equilibrium in the AD-AS model:¾ If the economy is NOT in general equilibrium, economic forces will work to restore general equilibrium in both the IS-LM and AD-AS models.213-5Price Adjustment and General Equilibrium• Price adjustment in the IS-LM and AD-ASmodels:¾ An increase in government purchases,¾ An increase in the real money supply,¾ A short-run adverse supply shock, and¾ A long-run adverse supply shock.13-6Price Adjustment and General Equilibrium• An increase in government purchases:¾ In Year 0, the economy is in general equilibrium.• Denote the general equilibrium level of output by Y*.13-7An increase in government purchasesrYYPAD0SRAS0LRASFELM0IS0Y*0Y*0P0r013-8Price Adjustment and General Equilibrium• An increase in government purchases:¾ In Year 1, government purchases increase.• Assume Ricardian equivalence does NOT hold.• An increase in government purchases shifts both the ISand AD curves to the right.313-9Price Adjustment and General Equilibrium• An increase in government purchases:¾ In Year 1, the increase in government purchases increases output but leaves the price level unchanged.• Short-run equilibrium is at:– The intersection of the IS and LM curves, and – The intersection of the AD and SRAS curves.• The labor market is temporarily out of equilibrium.– Employment has increased.– The unemployment rate has declined.13-10Price Adjustment and General Equilibrium• An increase in government purchases:¾ In Year 2, the price level begins to rise. • In Year 2, the SRAS curve shifts up because of excess aggregate demand in Year 1, i.e., Y1> Y*.–How far the SRAS curve shifts up depends on the explicit price adjustment process for the economy.– Generally it is a multiyear process dependent on the amount of excess aggregate demand.13-11Price Adjustment and General Equilibrium• An increase in government purchases:¾ In Year 2, the price level begins to rise. • A higher price level reduces the real money supply, Ms/P.– Alternatively, the purchasing power of the nominal money supply, Ms, has been reduced.• A lower real money supply shifts the LM curve to the left, raising the real interest rate.13-12Price Adjustment and General Equilibrium• An increase in government purchases:¾ In Year 2, the price level begins to rise. • A higher real interest rate will:– Reduce interest-sensitive spending, – Reduce output and employment, and – Raise the unemployment rate.413-13Price Adjustment and General Equilibrium• An increase in government purchases:¾ In Year 3, the price level continues to adjust up. • In Year 3, the SRAS curve shifts up because of any excess aggregate demand in Year 2, i.e., Y2> Y*.– Because excess aggregate demand in Year 2 is less than in Year 1, the upward shift of the SRAS in Year 3 will be smaller than in Year 2.13-14Price Adjustment and General Equilibrium• An increase in government purchases:¾ In Year 4 and beyond, this process continues until general equilibrium is re-established in both the IS-LM and AD-AS models.• Output will be at its full-employment level.– Employment will be at its full-employment level.– The unemployment rate will be at its natural level.• The price level will be permanently higher.13-15Price Adjustment and General Equilibrium• An increase in government purchases:¾ Once general equilibrium has been re-established:• Output is back at its full-employment level.• The real money supply is lower.– Because of the increase in the price level.• The real interest rate is higher.• The composition of output has changed.13-16Price Adjustment and General Equilibrium• An increase in the real money supply:¾ In Year 0, the economy is in general equilibrium.513-17An increase in the money supplyrYYPAD0SRAS0LRASFELM0IS0Y0Y0P0r013-18Price Adjustment and General Equilibrium• An increase in the real money supply:¾ In Year 1, the nominal money supply increases.• An increase in the nominal money supply shifts both the LM and AD curves to the right.• The increase in the real money supply increases output but leaves the price level unchanged.13-19Price Adjustment and General Equilibrium• An increase in the real money supply:¾ In Year 2, the price level will begin to rise.• In Year 2, the SRAS curve shifts up because of excess aggregate demand in Year 1, i.e., Y1> Y*.–How far the SRAS curve shifts up depends on the explicit price adjustment process for the economy.– Generally it is a multiyear process dependent on the amount of excess aggregate demand.13-20Price Adjustment and General Equilibrium• An increase in the real money supply:¾ In Year 2, the price level will begin to rise.• A higher price level reduces the real money supply, Msss/P.– Alternatively, the purchasing power of the nominal money supply, Ms, is reduced.• A lower real money supply shifts the LM curve to the left, raising the real interest rate.613-21Price Adjustment and General Equilibrium• An increase in the real money supply:¾ In Year 2, the price level will begin to rise.• A higher real interest rate will:– Reduce interest-sensitive spending, – Reducing output and employment, and – Raise the unemployment rate.13-22Price Adjustment and General Equilibrium• An increase in the real money supply:¾ In Year 3, the price level continues to adjust.• In Year 3, the SRAS curve shifts up because of any excess aggregate demand in Year 2, i.e., Y2> Y*.– Because excess aggregate demand in Year 2 is less than in Year 1, the upward shift of the SRAS curve in Year 3 will be smaller than it was in Year 2.13-23Price Adjustment and General Equilibrium• An increase in the real money supply:¾ In Year 4 and beyond, this process continues until general equilibrium is re-established in both the IS-LM and AD-AS models.• Output will be back at its full-employment level.– Employment will be back at its full-employment level.– The unemployment rate will be back at its natural rate.• The price level will be permanently higher.13-24Price Adjustment and General Equilibrium• An increase in the real money supply:¾ Once general equilibrium has been re-established:• Output is back at its full-employment level.• The real money