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A clarification of the IS curve and the aggregate demand curve
ALAN RABIN Uniuersity
of Tennessee, Chattanooga
DAN BIRCH Tennessee Valley
Authority
A Clarification of the IS Curve and the Aggregate Demand Cutve* This paper clarifies the current textbook interpretations of the IS curve and the aggregate demand (AD) curve. Most macroeconomic textbooks portray the IS curve as representing equilibrium in the product, goods, or commodity market. This paper illustrates that in flexible-price models the IS curve does not necessarily portray equilibrium in the goods market because the textbooks introduce two contradictory it will be shown that, contrary to popular notions of equilibrium. Furthermore, textbook usage, the AD curve, which is derived from the IS-LM framework, is not the economy’s effectioe demand curve for goods.
1. Equilibrium in the Goods Market’ It is interesting to observe the inconsistency that occurs among the major macro textbooks as their authors attempt to define equilibrium in the goods market as a point on the IS curve. The inconsistency arises when these texts later claim that there is goodsmarket disequilibrium if the economy is on an AD curve (and hence an IS curve) but not on an AS curve.’ For example, Shapiro (p. 38) claims:
*The authors would like to thank an anonymous referee for his or her helpful comments. ‘We will use the term “goods market” to refer to the market for goods, commodities, or products. The following lists some of those textbooks which allow for flexible prices and still claim that the IS curve represents equilibrium in the goods market: Branson (1979), Dombusch and Fischer (1978), Edgmand (1979), Elliott (1979), Glahe (1977), Gordon (1978), K ennedy (1979), McKenna (1977), Petersen (1978), and Shapiro (1978). ‘The AD curve is the locus of points (commonly graphed in the price-real-income plane) of intersection of an IS curve with several different LM curves (each LM curve corresponds to a different price). Each intersection of an LM curve with the IS curve yields one point on the AD curve. The aggregate supply (AS) curve is upward sloping and represents the desired supply of goods by firms. We assume here that the aggregate supply curve has some price elasticity. This curve could be drawn vertically to portray the classical position. The AS curve is usually derived from a production function and labor supply and demand functions. Such an AS curve is consistent with firms’ desires for profit maximization.
Journal Copyright
of
Macroeconomics, 0 1982 by Wayne
Spring State
1982, Vol. University
4, No. Press.
2, pp.
233-238
233
Alan
Rabin and Dan Birch
The intersection between the aggregate curves indicates the price level or the average price at which there is equality between the aggregate quantity of goods and services supplied and demanded. As in the case of a single commodity, at any price level higher or lower than that given by this intersection, there is disequilibrium. Similarly,
Edgmand
(p. 254) claims:
At any other price level [besides that given by the intersection of the AD and AS curves], either an excess demand for goods and services or an excess supply exists. In other words, the current macro texts first claim that there is goods-market equilibrium on an IS and AD curve. And then they later claim that to have goods-market equilibrium, the economy must be at the intersection of the AD and AS curves. Hence, we have two contradictory notions of equilibrium in the goods market. How can we resolve this dilemma? First, we might define equilibrium in the goods market as a point on the IS curve. Thus, even if the economy were not at an intersection of the AD and AS curves, there would be goods-market equilibrium if it were on an AD curve (and hence an IS curve). However, the labor market would not be in equilibrium, leading to pressure for change in the nominal wage. Alternatively, we might define equilibrium in the goods market as the intersection of the AD and AS curves. Then if the economy were represented by a point on an AD curve but not on an AS curve, there would not be equilibrium in the goods market. The major point here is that desired supply is not taken into consideration by the IS curve. For example, firms may be selling all of their output; actual output, therefore, may equal aggregate demand (the economy is represented by a point on the IS curve). Yet, at the given price level firms may desire to supply a greater quantity of goods. In this situation there is a notional excess supply of goods. By the above definition the goods market is not in equilibrium. 3 In this view, what then does the IS curve repre‘Patinkin (p. 321) states: ‘The nature of both these dynamic pressures requires further clarification. Consider first the point G. Even though this point is not marked by an excess of output-firms are selling all they are producing-it is marked by an excess of supply. That is, despite the fact that firms have decreased their actual output to Y,, the fact remains that the optimum output they desire to Supply at the real wage rate (w/p) -should the market be tilling to absorb this 234
Clatifwation
of the IS Curve
sent if it does not represent equilibrium in the goods market? Acthe IS curve simply represents all comcording to its derivation, binations of income and interest rates for which planned saving (plus taxes) equals planned investment (plus government expenditures). That is, on an IS curve, the level of income (actual output) is equal to the level of planned expenditure. We conclude that one cannot accept both conflicting definitions of equilibrium. If one adopts a definition of equilibrium in the goods market as a point on the IS curve, then one must forego the interpretation of equilibrium as a point of intersection of the AD and AS curves. Similarly, if one adopts the latter definition, then one must forego the former.4
2. The AD Curve The AD curve is derived in macro texts as the locus of points of intersection of an IS curve with several different LM curves (each LM curve corresponds to a different price). Yet, this AD curve is defined or interpreted in the following macro textbooks as the economy’s effective demand curve: Branson (p. 67, 69), Dernburg and McDougall (p. X34), McKenna (p. 225, 248), Glahe (p. 13), Dombusch and Fischer (p. 19, 369), and Shapiro (pp. 37-38). Dernburg and McDougall (p. 184) provide this explicit interpretation of the AD curve: However, the meaning that demand is the level of output price levels. Therefore, the be thought of as an ordinary and services with respect to economy as a whole, rather
we will now give to aggregate (income) demanded at different aggregate demand function may schedule of demand for goods price except that it refers to the than to an individual market.
output-is still Y,,. In other words, since the real wage rate has, by assumption, remained unchanged, so has the vertical commodity supply curve. Hence at the point G there is an excess of desired over actual supply equal to Y,Y, units of commodities. This manifests itself as an excess in the productive capacity of firms. And this idle capacity continues to induce firms to lower their prices in an attempt to increase their volume of sales and thereby return to the optimum output designated by their commodity supply curve.” ‘We thank an anonymous referee for pointing out to us that it is not patently obvious which is the more desirable definition of equilibrium in the goods market. Here we have chosen to present the alternative definitions, leaving it to the reader to choose whichever he or she is more comfortable with. 23.5
Alan Rabin and Dan Birch We shall now show that if one derives the AD curve from IS and LM analysis, then it is incorrect to define or interpret the AD curve as the economy’s effective demand curve. In Figure 1, suppose the economy is represented by point 2, a point on the AS curve but off the AD curve. Given price level Pi, actual income (output) is represented by Y,. The goods market is not in equilibrium since the economy is not on an AD curve. The question now arises: What is the economy’s effective demand for goods? Is it represented by point I? That is, can we say that the excess supply of goods in the economy is represented by the horizontal distance between points 1 and 2? The answer to both questions is no, for the AD curve is drawn such that desired expenditure equals actual output at every point on the curve. Thus, point 1 represents the economy’s desired expenditure on (effective demand for) goods, Y,, assuming that output (income) is equal to Y,. But in this case, output is given by Y,.1 Hence the economy’s effective demand for goods cannot be represented by point 1. How then can we represent the economy’s effective demand for goods? First, such a curve would be constrained by income
Figure
1.
Price I
AD I \
AS
Real 236
Income
Clarification
of the IS Curve
(output).5 Second, for each level of income there would be a unique effective demand curve. 6 Thus, there exists a whole family of effective demand curves (one for each level of income). We conclude that the AD curve is not the economy’s effective demand curve for goods. Rather, the AD curve simply gives the combinations of price and real income for which planned expenditure exactly equals income and demand for money equals supply of money. Consequently, we cannot determine from the AD curve the economy’s effective demand for goods when price and actual output are represented by a point off the AD curve.’
3. Conclusion In the flexible-price model, the IS curve does not necessarily represent equilibrium in the goods market. In this model, such an equilibrium may be portrayed by considering both the AD curve and the AS curve. Most macroeconomic textbooks are inconsistent in their interpretation of goods-market equilibrium. Finally, the AD curve is not the economy’s effective demand curve for goods. Recdoed: November, 1979 Final version received: September,
1981
References Branson, William H. Macroeconomic Theory and Policy. New York: Harper & Row, 1979. and James M. Litvak. Macroeconomics. New York: Harper and Row, 1981. Clower, R.W. “The Keynesian Counter-revolution: A Theoretical Appraisal. ” In The Theory of Interest Rates. F. H. Hahn and F. Brechling, eds. International Economic Association Series. New York: Macmillan, 1965. ‘See Clower (1965) for a discussion of income-constrained or effective demand curves. ‘In the above example, given the economy is at Y,, the effective demand curve is not represented by AD. Rather, the effective demand curve will lie somewhere between points 1 and 2 (given output Y,). ‘It is interesting to note that Branson (pp. 127, 129) and Branson and Litvak (p. 126) not only define the AD curve incorrectly, but also use the AD curve illegally. That is, they state that when the economy is at some point off the AD curve (but on an AS curve), the excess demand (or excess supply) is equal to the horizontal distance to the AD curve. 237
Alan Rabin and Dan Birch Demburg, Thomas F. and Duncan M. McDougall. Macroeconomics. New York: McGraw-Hill, 1976. Dombusch, Rudiger and Stanley Fischer. Macroeconomics. New York: McGraw-Hill, 1978. Edgmand, Michael R. Macroeconomics: Theory and Policy. Englewood Cliffs: Prentice-Hall, 1979. Elliott, Jan Walter. Macroeconomic Analysis. Cambridge: Winthrop Publishers, 1979. Glahe, Fred R. Macroeconomics Theory and Policy. New York: Harcourt Brace Jovanovich, 1977. Gordon, Robert J. Macroeconomics. Boston: Little, Brown, 1978. Kennedy, Peter E. Macroeconomics. Boston: Allyn and Bacon, 1979. McKenna, Joseph P. Aggregate Economic Analysis. Hinsdale: Dryden Press, 1977. Patinkin, Don. Money, Interest, and Prices. New York: Harper and Row, 1965. Petersen, Wallace C. Income, Employment and Economic Growth. New York: W.W. Norton, 1978. Shapiro, Edward J. Macroeconomic Analysis. New York: Harcourt Brace Jovanovich, 1978.
238
of Tennessee, Chattanooga
DAN BIRCH Tennessee Valley
Authority
A Clarification of the IS Curve and the Aggregate Demand Cutve* This paper clarifies the current textbook interpretations of the IS curve and the aggregate demand (AD) curve. Most macroeconomic textbooks portray the IS curve as representing equilibrium in the product, goods, or commodity market. This paper illustrates that in flexible-price models the IS curve does not necessarily portray equilibrium in the goods market because the textbooks introduce two contradictory it will be shown that, contrary to popular notions of equilibrium. Furthermore, textbook usage, the AD curve, which is derived from the IS-LM framework, is not the economy’s effectioe demand curve for goods.
1. Equilibrium in the Goods Market’ It is interesting to observe the inconsistency that occurs among the major macro textbooks as their authors attempt to define equilibrium in the goods market as a point on the IS curve. The inconsistency arises when these texts later claim that there is goodsmarket disequilibrium if the economy is on an AD curve (and hence an IS curve) but not on an AS curve.’ For example, Shapiro (p. 38) claims:
*The authors would like to thank an anonymous referee for his or her helpful comments. ‘We will use the term “goods market” to refer to the market for goods, commodities, or products. The following lists some of those textbooks which allow for flexible prices and still claim that the IS curve represents equilibrium in the goods market: Branson (1979), Dombusch and Fischer (1978), Edgmand (1979), Elliott (1979), Glahe (1977), Gordon (1978), K ennedy (1979), McKenna (1977), Petersen (1978), and Shapiro (1978). ‘The AD curve is the locus of points (commonly graphed in the price-real-income plane) of intersection of an IS curve with several different LM curves (each LM curve corresponds to a different price). Each intersection of an LM curve with the IS curve yields one point on the AD curve. The aggregate supply (AS) curve is upward sloping and represents the desired supply of goods by firms. We assume here that the aggregate supply curve has some price elasticity. This curve could be drawn vertically to portray the classical position. The AS curve is usually derived from a production function and labor supply and demand functions. Such an AS curve is consistent with firms’ desires for profit maximization.
Journal Copyright
of
Macroeconomics, 0 1982 by Wayne
Spring State
1982, Vol. University
4, No. Press.
2, pp.
233-238
233
Alan
Rabin and Dan Birch
The intersection between the aggregate curves indicates the price level or the average price at which there is equality between the aggregate quantity of goods and services supplied and demanded. As in the case of a single commodity, at any price level higher or lower than that given by this intersection, there is disequilibrium. Similarly,
Edgmand
(p. 254) claims:
At any other price level [besides that given by the intersection of the AD and AS curves], either an excess demand for goods and services or an excess supply exists. In other words, the current macro texts first claim that there is goods-market equilibrium on an IS and AD curve. And then they later claim that to have goods-market equilibrium, the economy must be at the intersection of the AD and AS curves. Hence, we have two contradictory notions of equilibrium in the goods market. How can we resolve this dilemma? First, we might define equilibrium in the goods market as a point on the IS curve. Thus, even if the economy were not at an intersection of the AD and AS curves, there would be goods-market equilibrium if it were on an AD curve (and hence an IS curve). However, the labor market would not be in equilibrium, leading to pressure for change in the nominal wage. Alternatively, we might define equilibrium in the goods market as the intersection of the AD and AS curves. Then if the economy were represented by a point on an AD curve but not on an AS curve, there would not be equilibrium in the goods market. The major point here is that desired supply is not taken into consideration by the IS curve. For example, firms may be selling all of their output; actual output, therefore, may equal aggregate demand (the economy is represented by a point on the IS curve). Yet, at the given price level firms may desire to supply a greater quantity of goods. In this situation there is a notional excess supply of goods. By the above definition the goods market is not in equilibrium. 3 In this view, what then does the IS curve repre‘Patinkin (p. 321) states: ‘The nature of both these dynamic pressures requires further clarification. Consider first the point G. Even though this point is not marked by an excess of output-firms are selling all they are producing-it is marked by an excess of supply. That is, despite the fact that firms have decreased their actual output to Y,, the fact remains that the optimum output they desire to Supply at the real wage rate (w/p) -should the market be tilling to absorb this 234
Clatifwation
of the IS Curve
sent if it does not represent equilibrium in the goods market? Acthe IS curve simply represents all comcording to its derivation, binations of income and interest rates for which planned saving (plus taxes) equals planned investment (plus government expenditures). That is, on an IS curve, the level of income (actual output) is equal to the level of planned expenditure. We conclude that one cannot accept both conflicting definitions of equilibrium. If one adopts a definition of equilibrium in the goods market as a point on the IS curve, then one must forego the interpretation of equilibrium as a point of intersection of the AD and AS curves. Similarly, if one adopts the latter definition, then one must forego the former.4
2. The AD Curve The AD curve is derived in macro texts as the locus of points of intersection of an IS curve with several different LM curves (each LM curve corresponds to a different price). Yet, this AD curve is defined or interpreted in the following macro textbooks as the economy’s effective demand curve: Branson (p. 67, 69), Dernburg and McDougall (p. X34), McKenna (p. 225, 248), Glahe (p. 13), Dombusch and Fischer (p. 19, 369), and Shapiro (pp. 37-38). Dernburg and McDougall (p. 184) provide this explicit interpretation of the AD curve: However, the meaning that demand is the level of output price levels. Therefore, the be thought of as an ordinary and services with respect to economy as a whole, rather
we will now give to aggregate (income) demanded at different aggregate demand function may schedule of demand for goods price except that it refers to the than to an individual market.
output-is still Y,,. In other words, since the real wage rate has, by assumption, remained unchanged, so has the vertical commodity supply curve. Hence at the point G there is an excess of desired over actual supply equal to Y,Y, units of commodities. This manifests itself as an excess in the productive capacity of firms. And this idle capacity continues to induce firms to lower their prices in an attempt to increase their volume of sales and thereby return to the optimum output designated by their commodity supply curve.” ‘We thank an anonymous referee for pointing out to us that it is not patently obvious which is the more desirable definition of equilibrium in the goods market. Here we have chosen to present the alternative definitions, leaving it to the reader to choose whichever he or she is more comfortable with. 23.5
Alan Rabin and Dan Birch We shall now show that if one derives the AD curve from IS and LM analysis, then it is incorrect to define or interpret the AD curve as the economy’s effective demand curve. In Figure 1, suppose the economy is represented by point 2, a point on the AS curve but off the AD curve. Given price level Pi, actual income (output) is represented by Y,. The goods market is not in equilibrium since the economy is not on an AD curve. The question now arises: What is the economy’s effective demand for goods? Is it represented by point I? That is, can we say that the excess supply of goods in the economy is represented by the horizontal distance between points 1 and 2? The answer to both questions is no, for the AD curve is drawn such that desired expenditure equals actual output at every point on the curve. Thus, point 1 represents the economy’s desired expenditure on (effective demand for) goods, Y,, assuming that output (income) is equal to Y,. But in this case, output is given by Y,.1 Hence the economy’s effective demand for goods cannot be represented by point 1. How then can we represent the economy’s effective demand for goods? First, such a curve would be constrained by income
Figure
1.
Price I
AD I \
AS
Real 236
Income
Clarification
of the IS Curve
(output).5 Second, for each level of income there would be a unique effective demand curve. 6 Thus, there exists a whole family of effective demand curves (one for each level of income). We conclude that the AD curve is not the economy’s effective demand curve for goods. Rather, the AD curve simply gives the combinations of price and real income for which planned expenditure exactly equals income and demand for money equals supply of money. Consequently, we cannot determine from the AD curve the economy’s effective demand for goods when price and actual output are represented by a point off the AD curve.’
3. Conclusion In the flexible-price model, the IS curve does not necessarily represent equilibrium in the goods market. In this model, such an equilibrium may be portrayed by considering both the AD curve and the AS curve. Most macroeconomic textbooks are inconsistent in their interpretation of goods-market equilibrium. Finally, the AD curve is not the economy’s effective demand curve for goods. Recdoed: November, 1979 Final version received: September,
1981
References Branson, William H. Macroeconomic Theory and Policy. New York: Harper & Row, 1979. and James M. Litvak. Macroeconomics. New York: Harper and Row, 1981. Clower, R.W. “The Keynesian Counter-revolution: A Theoretical Appraisal. ” In The Theory of Interest Rates. F. H. Hahn and F. Brechling, eds. International Economic Association Series. New York: Macmillan, 1965. ‘See Clower (1965) for a discussion of income-constrained or effective demand curves. ‘In the above example, given the economy is at Y,, the effective demand curve is not represented by AD. Rather, the effective demand curve will lie somewhere between points 1 and 2 (given output Y,). ‘It is interesting to note that Branson (pp. 127, 129) and Branson and Litvak (p. 126) not only define the AD curve incorrectly, but also use the AD curve illegally. That is, they state that when the economy is at some point off the AD curve (but on an AS curve), the excess demand (or excess supply) is equal to the horizontal distance to the AD curve. 237
Alan Rabin and Dan Birch Demburg, Thomas F. and Duncan M. McDougall. Macroeconomics. New York: McGraw-Hill, 1976. Dombusch, Rudiger and Stanley Fischer. Macroeconomics. New York: McGraw-Hill, 1978. Edgmand, Michael R. Macroeconomics: Theory and Policy. Englewood Cliffs: Prentice-Hall, 1979. Elliott, Jan Walter. Macroeconomic Analysis. Cambridge: Winthrop Publishers, 1979. Glahe, Fred R. Macroeconomics Theory and Policy. New York: Harcourt Brace Jovanovich, 1977. Gordon, Robert J. Macroeconomics. Boston: Little, Brown, 1978. Kennedy, Peter E. Macroeconomics. Boston: Allyn and Bacon, 1979. McKenna, Joseph P. Aggregate Economic Analysis. Hinsdale: Dryden Press, 1977. Patinkin, Don. Money, Interest, and Prices. New York: Harper and Row, 1965. Petersen, Wallace C. Income, Employment and Economic Growth. New York: W.W. Norton, 1978. Shapiro, Edward J. Macroeconomic Analysis. New York: Harcourt Brace Jovanovich, 1978.
238