Wednesday, December 14, 2011

IS-LM and the Price Level

One criticism that is sometimes made about the IS-LM model is that it neglects the price level. The determinates of the model are the real interest rate and GDP; but the price level IS present in the framework. In the LM function that represents the necessary levels of (r) and (Y) that clear the market for real money balances, the supply function in the market is the real, as opposed to the nominal, money supply.

What this means is that a change in the price level, that is to say deflation or inflation, will shift LM either up or down. The real money supply is defined as M/P, where M is the nominal money supply and P the price level. A fall in P, that is to say deflation, leads to a smaller denominator and hence a larger real money supply. Inflation, that is to say a rise in P, leads to a larger denominator and hence a smaller real money supply. Recall that an increase in the real money supply relative to money demand causes the LM curve to shift to the right; a decrease causes a leftward shift.

This mechanism, where changes in the price level change the real money supply and hence the position of the LM curve, is the mechanism that theoretically allows the LM to reach FE equilibrium without a change in the nominal money supply, that is to say monetary policy. If the IS-LM intersection is left of IS-FE (the interest rate compatible with full employment), a then there will be downward pressure on prices: workers will accept lower nominal wages, and firms will cut nominal prices to move pilled-up inventory. This decrease in P then causes M/P to expand and shift the LM curve to the right until FE is reached. If IS-LM is to the right of IS-FE, then nominal wages and prices will rise (i.e. inflation) and M/P will contract until LM is once again at FE. So the price level does factor into our IS-LM analysis; its just hidden in the LM curve.

But what are the implications for Eurozone policy?

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