Question

Use IS- LM model to analyze the US recession in 2001 :

+ What US followed to remedy the recession

+ Use IS- LM model to analyze the effects of the remedies

Answer 1

The AD-AS model is a standard tool in macroeconomic analysis. AD represents the aggregate demand, whereas AS stays for aggregate supply. This is explained to students when the macroeconomic theory is introduced, often preceded by the IS-LM model (with fixed prices). Indeed, in an introductory course on macroeconomics, when organized starting from the analysis of the short-run to proceed with the medium- and then the long-run analysis of economic growth, one firstly is taught the IS-LM model, and then the AD curve can be constructed on this basis, corresponding to anl IS-LM modelwith flexible prices. Based on the Phillipurve, which is on the inverse relationship between (wage) inflation and unemployment, typically assuming a constant mark-up, the AS curve is introduced, and the AD-AS model can be used for the macroeconomic analysis of the medium run.In its simplest form, the AD-AS model is represented as the interaction between two linear curves, though nonlinear relationships are quite commonly employed. In general, however, we have a downward sloping AD and an upward sloping AS.1Depending on expectations, policy makers can (or cannot) exploit the trade-off between unemployment and inflation because of the different time intervals implied by the adjustment toward the equilibrium. In the extreme (but included in the textbook AD-AS model) case of “rational expectations,” when the agents know the model and are able to anticipate the decisions of policy makers, the AS is vertical at the potential level of output (as if the adjustment was instantaneous), and the AD only determines the price level. The unemployment rate that corresponds to the equilibrium output is the NAIRU (Non-Accelerating Inflation Rate of Unemployment). According to this model, only movements of the AS influence the macroeconomic equilibrium in the long run, whereas a monetary or a fiscal expansion just leads to more inflation, thus suggesting that “structural reforms” are needed to reduce unemployment (i.e., the NAIRU), whereas the Keynesian tools of macroeconomic policy are ineffective (or can have an impact that is limited to the short run). As for stabilization, in such a “natural” equilibrium setting, monetary policy is considered as the primary tool to promote macroeconomic stability and, in general, a growth-enhancing environment [1]. However, neither monetary policy nor fiscal policy aimed at managing the aggregate demand is taught to be useful in affecting the “natural” macroeconomic equilibrium, for example, the NAIRU.

However, it is unlikely that rational expectations are a good approximation of real agents' behavior; thus an upward sloping AS curve seems to be a better representation of the macroeconomic reality, and the sustain of aggregate demand through fiscal or monetary policy can be effective, at least along the adjustment process (thus depending on how long the system takes to go back to the equilibrium). In other words, people are able to adapt, at least partially, to policy changes, but not instantaneously. Adaptive expectations of some sort should be assumed to describe a relatively slow and possibly incomplete adjustment.