Chapter 16 – The IS-LM Framework<\/strong><\/p>\n [PREVIOUS MATERIAL HERE IN PARTS 1 to 4]<\/p>\n 16.6 Introducing the price level<\/strong><\/p>\n Our derivation of the IS-LM framework initially assumed that the price level was fixed and all changes in output were real. This is consistent with the simple income-expenditure model developed in Chapter 12 where the focus was on the manner in which output and employment responds to changes in aggregate demand.<\/p>\n We assumed that firms were willing to supply whatever was demanded up to full capacity without changing their prices. In this vein, we also treated the nominal and real interest rate has being interchangeable.<\/p>\n In this section we consider how changes in the price level impact on output and interest rates.<\/p>\n The price level is introduced into the IS-LM framework as an exogenous variable, that is, determined outside of the interest rate-income equilibrium defined by the intersection of the IS and LM curves. There are several complications involved in adopting this assumption, which we will abstract from for the sake of simplicity.<\/p>\n The income-expenditure model developed in Chapter 12, which underpins the derivation of the IS curve was defined in real terms. Thus, the expenditure components – consumption, investment, government spending and net exports – are all measured in constant prices.<\/p>\n We would expect the IS curve therefore to be invariant to changes in the general price level given that housholds, firms, government and the external sector have made decisions regarding real expenditures.<\/p>\n However, to date our analysis of the money market has fudged the question of the price level. The demand for money is a demand for real balances, motivated by the need to make transactions for the exchange of goods and services which we have just noted are defined in real terms.<\/p>\n But, the money supply is specified in nominal terms – an amount of dollars – and forms the unit in which all the other variables are accounted.<\/p>\n The real value of a given stock of money on issue, however, varies with the price level. For a given stock of dollars on issue, the real value is higher when the price level is lower, and, vice versa.<\/p>\n For example, assume that the money supply on issue is $1000 billion and the price index is 1. The real value of the money supply would be $1,000 billion.<\/p>\n Now if the price level rose by 5 per cent the price index would be 1.05 and the real value of the money supply would drop to $952.4 billion.<\/p>\n This means that users of the currency have less available in real terms to use for purchases and speculative holdings.<\/p>\n The same contraction in real value of the money supply could arise if the price level was unchanged (that is, the index remained at 1) and the nominal money supply fell to $952.4 billion.<\/p>\n In other words, the real value of the money supply can fall if the price level rises (for a given nominal money stock) or if the nominal money stock falls (for a given price level).<\/p>\n Alternatively, the real value of the money supply can rise if the price level falls (for a given nominal money stock) or if the nominal money stock rises (for a given price level).<\/p>\n Within the logic of the IS-LM framework, it is clear that if the price level rises and reduces the real value of the money supply, the interest rate will rise because at the previous equilibrium interest rate, there will now be a shortage of real balances relative to the demand for them.<\/p>\n The introduction of the general price level modifies our LM curve derivation. If a rising price level (with a constant nominal money stock) is equivalent in real terms to a declining nominal stock of money (at constant prices) then we can capture this impact via shifts in the LM curve.<\/p>\n The LM curve shifts to the left when the price level is higher, other things equal, and to the right when the price level is lower.<\/p>\n Figure 16.10 depicts two different LM curves at different price levels (P1<\/sub> > P0<\/sub>).<\/p>\n The introduction of the price level now means that our interest rate-income equilibrium is now contingent on the price level. If there is a different price level, the equilibrium changes as noted.<\/p>\n This means that within this framework, the national economy equilibrium can shift without any change in monetary or fiscal policy if the price level changes.<\/p>\n
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