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Economist / Macro / Aggregate Demand & Supply

Aggregate Demand & Supply

The IS-LM Model

The IS-LM model shows how the goods market and money market jointly determine the interest rate and output in the short run, holding the price level fixed.

The IS Curve (Goods Market)

The IS curve represents equilibrium in the goods market. Total output (Y) equals aggregate expenditure: consumption, investment, government spending, and net exports.

Y=C(Y−T)+I(r)+G+NX(ε)Y = C(Y - T) + I(r) + G + NX(\varepsilon)

Investment depends negatively on the real interest rate (r). When r rises, borrowing costs increase and investment falls, reducing output. This makes the IS curve downward-sloping in (Y, r) space.

  • Expansionary fiscal policy (↑G or ↓T) shifts IS right → higher Y at every r
  • Contractionary fiscal policy (↓G or ↑T) shifts IS left

The LM Curve (Money Market)

The LM curve represents equilibrium in the money market. The real money supply (M/P) must equal real money demand L(Y, i), which rises with output and falls with the nominal interest rate.

MP=L(Y,i)\frac{M}{P} = L(Y, i)

Higher output increases money demand, pushing up the interest rate. This makes the LM curve upward-sloping in (Y, i) space.

  • Expansionary monetary policy (↑M) shifts LM right → lower r at every Y
  • Contractionary monetary policy (↓M) shifts LM left
xychart-beta
    title "IS-LM Equilibrium"
    x-axis "Output (Y)" 0 --> 100
    y-axis "Interest Rate (r)" 0 --> 100
    line "IS" [80, 60, 40, 20, 0]
    line "LM" [0, 25, 50, 75, 100]

The intersection of IS and LM gives the short-run equilibrium (Y*, r*) for a given price level. Fiscal policy shifts IS; monetary policy shifts LM.

Limitations

The basic IS-LM model assumes a fixed price level, no inflation expectations, and a closed economy. The Mundell-Fleming model (see open-economy.md) extends it to open economies, and the AD-AS framework below relaxes the fixed-price assumption.

From IS-LM to Aggregate Demand

The aggregate-demand (AD) curve shows the total quantity of goods and services demanded at each price level. It is derived by varying P in the IS-LM model:

  1. An increase in P reduces the real money supply M/P
  2. The LM curve shifts left
  3. Equilibrium Y falls
  4. Tracing (P, Y) pairs yields the downward-sloping AD curve

Three mechanisms reinforce the negative relationship between P and Y:

  • Wealth effect (Pigou effect): higher P reduces the real value of wealth → consumption falls
  • Interest-rate effect (Keynes effect): higher P raises money demand → interest rates rise → investment falls
  • Exchange-rate effect (Mundell-Fleming): higher P raises domestic interest rates → currency appreciates → net exports fall

Aggregate Supply

Long-Run Aggregate Supply

The long-run aggregate-supply (LRAS) curve is vertical at potential output (Y*). In the long run, the classical dichotomy holds: nominal variables (price level, money supply) do not affect real variables (output, employment). Output is determined by real factors: labor, capital, natural resources, and technology.

Short-Run Aggregate Supply

The short-run aggregate-supply (SRAS) curve slopes upward. Three theories explain why output deviates from potential in the short run:

  • Sticky-wage theory: nominal wages adjust slowly. A higher price level lowers real wages → firms hire more → output rises
  • Sticky-price theory (menu costs): firms are slow to adjust prices. A higher price level raises firms’ relative prices → they increase output
  • Worker-misperception theory: workers confuse nominal wage changes with real wage changes. A higher price level leads them to supply more labor

All three theories imply that the SRAS equation can be written as:

Y=Y∗+α(P−Pe)Y = Y^* + \alpha (P - P^e)

When the actual price level exceeds the expected price level, output rises above potential.

Shocks and Adjustment

Supply Shocks

A negative supply shock (e.g., oil price spike, pandemic) shifts SRAS left: output falls and the price level rises — stagflation. A positive supply shock (e.g., technological breakthrough) shifts SRAS right: output rises and prices fall.

Demand Shocks

A negative demand shock (e.g., drop in consumer confidence) shifts AD left, creating a recessionary gap (Y < Y*). A positive demand shock creates an inflationary gap (Y > Y*). Over time, if no policy response occurs, expectations adjust and the economy self-corrects back to potential output.

Fiscal and Monetary Policy

Multiplier Effect and Crowding-Out

An increase in government spending has two competing effects on AD:

  • Multiplier effect: each dollar of government spending raises income, which raises consumption, further raising income — amplifying the initial impact
  • Crowding-out effect: higher government spending raises money demand and interest rates, reducing private investment — dampening the initial impact

The net effect depends on the slope of the LM curve and the sensitivity of investment to interest rates.

Automatic Stabilizers vs. Discretionary Policy

  • Automatic stabilizers: tax and transfer systems that automatically smooth the business cycle (progressive income tax, unemployment insurance) — no legislative delay
  • Discretionary policy: deliberate changes in spending or taxes — subject to recognition, implementation, and impact lags

Supply-Side Economics

Supply-side policies aim to shift LRAS right by improving incentives to work, save, and invest. The Laffer curve illustrates the relationship between tax rates and tax revenue: beyond a certain rate, further increases reduce revenue by discouraging economic activity.