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IS-LM Model and AD-AS Model in Keynesian Theory
1. Introduction
📌 The IS-LM model and the AD-AS model are two essential tools in Keynesian macroeconomics, used to analyze equilibrium in the goods and money markets and to understand macroeconomic fluctuations.
✔ The IS-LM Model explains short-run equilibrium in an economy by linking the goods market (IS curve) and the money market (LM curve).
✔ The AD-AS Model extends Keynesian ideas to show how aggregate demand (AD) and aggregate supply (AS) determine output and prices in the economy.
🚀 Why are these models important?
✔ Help policymakers understand recessions, inflation, and government policy effects.
✔ Show how monetary and fiscal policies influence interest rates, output, and employment.
✔ Provide insight into the short-run and long-run behavior of the economy.
2. The IS-LM Model (Investment-Savings & Liquidity-Money Model)
The IS-LM Model (developed by John Hicks and Alvin Hansen) describes equilibrium in the goods and money markets.
IS Curve: Equilibrium in the Goods Market
✔ The IS curve represents equilibrium in the goods market, where investment (I) = savings (S).
✔ Derived from the Keynesian Cross Model, where: Y=C+I+G+NXY = C + I + G + NX
Where:
✔ YY = National income/output
✔ CC = Consumption
✔ II = Investment
✔ GG = Government spending
✔ NXNX = Net exports
🔹 Slope of the IS Curve:
✔ Downward sloping: Higher interest rates (rr) reduce investment (II), lowering output (YY).
✔ Shifts in IS Curve:
- Expansionary fiscal policy (higher GG, lower taxes) shifts IS right.
- Contractionary fiscal policy shifts IS left.
LM Curve: Equilibrium in the Money Market
✔ The LM curve represents equilibrium in the money market, where money demand (Md) = money supply (Ms).
✔ Derived from Keynes’ liquidity preference theory: Md=L(Y,r)Md = L(Y, r)
Where:
✔ LL = Liquidity demand function
✔ YY = Income (higher YY → higher money demand)
✔ rr = Interest rate (higher rr → lower money demand)
🔹 Slope of the LM Curve:
✔ Upward sloping: Higher income (YY) increases money demand, raising interest rates (rr).
✔ Shifts in LM Curve:
- Monetary expansion (higher MsMs) shifts LM right, lowering rr.
- Monetary contraction shifts LM left, raising rr.
IS-LM Equilibrium: Determining Output and Interest Rates
✔ The intersection of IS and LM curves determines equilibrium output (Y∗Y^*) and interest rate (r∗r^*).
🔹 Policy Implications:
✔ Fiscal policy (changing G or taxes) shifts the IS curve.
✔ Monetary policy (changing money supply) shifts the LM curve.
✔ Liquidity trap: If interest rates are very low, monetary policy becomes ineffective (LM is horizontal).
🔹 Limitations of the IS-LM Model:
✔ Short-run model, does not consider inflation.
✔ Assumes fixed prices (does not explain supply-side issues).
✔ Over-simplifies expectations and investment behavior.
3. AD-AS Model (Aggregate Demand – Aggregate Supply Model)
The AD-AS Model extends Keynesian analysis to show how output and price levels are determined in the short run and long run.
Aggregate Demand (AD) Curve
✔ Represents total demand for goods and services in the economy: AD=C+I+G+NXAD = C + I + G + NX
🔹 Why is AD downward sloping?
✔ Wealth Effect: Lower prices increase real wealth → higher consumption.
✔ Interest Rate Effect: Lower prices reduce interest rates → higher investment.
✔ Exchange Rate Effect: Lower prices depreciate currency → higher net exports.
🔹 Shifts in AD Curve:
✔ Expansionary fiscal/monetary policy → AD shifts right (higher YY, higher prices).
✔ Contractionary policy → AD shifts left (lower YY, lower prices).
Aggregate Supply (AS) Curve
✔ Shows how much output producers are willing to supply at different price levels.
Short-Run Aggregate Supply (SRAS)
✔ Upward sloping: Prices and wages are sticky, so higher prices increase output.
✔ Shifts in SRAS:
- Higher wages, input costs, or supply shocks shift SRAS left.
- Higher productivity or lower input costs shift SRAS right.
Long-Run Aggregate Supply (LRAS)
✔ Vertical: In the long run, output depends on technology, capital, labor (not prices).
✔ Shifts in LRAS: Economic growth (higher capital, better technology) shifts LRAS right.
AD-AS Equilibrium: Determining Output and Inflation
✔ Short-run equilibrium: Where AD = SRAS (determines short-run output and price level).
✔ Long-run equilibrium: Where AD = LRAS (economy at full employment).
🔹 Effects of Policy Changes:
✔ Expansionary policy (higher G, lower taxes, more money supply):
- AD shifts right, increasing output and inflation.
✔ Contractionary policy: - AD shifts left, reducing inflation but lowering output.
🔹 Stagflation (Cost-Push Inflation):
✔ Negative supply shock (e.g., oil crisis) shifts SRAS left → higher inflation and lower output.
✔ Keynesian model suggests fiscal stimulus, but it can worsen inflation.
4. Comparing IS-LM and AD-AS Models
| Feature | IS-LM Model | AD-AS Model |
|---|---|---|
| Focus | Short-run interest rate & output | Output & price level |
| Markets | Goods & Money markets | Aggregate economy |
| Key Variables | Interest rate (rr), Output (YY) | Price level (PP), Output (YY) |
| Policies | Monetary & Fiscal policies affect interest rates & output | Monetary & Fiscal policies affect output & inflation |
| Inflation | Assumed fixed prices | Prices adjust |
5. Conclusion
✔ The IS-LM model explains short-run equilibrium in interest rates and output, focusing on monetary and fiscal policy effectiveness.
✔ The AD-AS model extends Keynesian analysis to inflation and long-run growth, explaining economic fluctuations and policy trade-offs.
✔ Both models remain crucial tools for macroeconomic analysis and policymaking.