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1. Learning Outcomes
After studying this module, you shall be able to

To understand need to incorporate dynamics of inflation in AD AS schedules.

To understand the derivation of AD curve using Inflation modified IS-LM
framework.
To comprehend the notion of overall equilibrium in the economy under inflation.
To understand the long run steady state incorporating expected inflation.
To identify the impacts of demand side shocks which affect AD curve.
To identify the impacts of supply side shocks affecting AS curve.

2. Introduction

In the earlier module you have seen the derivation of expectation augmented aggregate
demand AD and aggregate supply AS , Phillips curve and expectation augmented Phillips
curve and the relationship between actual rate of unemployment , natural rate of
unemployment and inflation rate .

In the real world, the prices are continuously rising therefore to study dynamics of
inflation we need to generalize IS-LM model to incorporate rising inflation .As a result
we need to derive Aggregate demand and aggregate supply under dynamics of inflation
and then study the long-run equilibrium condition.

In the long run an economy would settle down to a specific combination of interest rate,
income and inflation. The only point of argument that exists is the time it would take to
obtain the equilibrium. Keynesian stream of thought would propose a long- time for
economy to reach long run equilibrium while New-Classical argue that the economy is
so adjustable that it would settle to its long run equilibrium very fast . One common
factor in both the schools of thought is that they both believe in the concept of
equilibrium

An unplanned movement in inventories would bring about an equilibrium in inventories,

leading to changes in output and employment. This adjustment mechanism occurs
whenever there is short run equilibrium condition. In the long run AS schedule
becomes vertical as AS plays no role in determining income. This would effectively
imply that fiscal or monetary policies play no role in determining income in long- run .An
explanatory Monetary Policy would not be able to lower nominal interest and increase
output.
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Module 34: Dynamics in AD -AS Model: Stability and Convergence to Long
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This module would incorporate the dynamics of inflation in aggregate demand AD and
aggregate supply AS , thus describe the mechanism by which long run equilibrium and
stability and equilibrium is attained .The module would go through the implications of
demand side shocks and supply side shocks

3. AD Schedule under Dynamics of Inflation

In order to study dynamics of inflation we need to study IS LM model which is
modified to capture persistent inflation .IS curve represents the goods market equilibrium
.The goods market equilibrium is represented by the situation where leakages from
national income in form of Savings and Taxes are equated to injections into national
expenditure in the form of Investment and Government Expenditure.

Let sum of savings and taxes i.e. ( S+T) be represented by R and sum of investment and
government expenditure i.e ( I+G ) be represented by T . Also assume natural log of R be
lnR and natural log of T be lnT .

Since savings depend on real income and investment depends on real income and real
interest rates, their functional relationship in terms of natural log can be written as
follows:

0 1

e
2 3 lny 4( i

e
where ( i ) is in terms of levels not logs . It is the gross inflation rate of return , r is
e
is expected rate of return or nominal rate of interest i can be
e
.

In equilibrium, leakages are equal to injections implying savings and taxes are set equal
to investment and government expenditure .This gives the relationship between income
and interest rates. Therefore the IS schedule would look like:

3.1 IS Curve: Goods Market Equilibrium

e
0 1( i-

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0 2 - 0 1 - 3 1 4 1 - 3 ) . Since the coefficient of i is 1 , the

slope of IS curve is - 1 1 3 .
This implies that the response of savings to income be larger than that of investment to
income .All the points lying on the right hand side of IS curve are points representing
excess supply in the goods market while points lying on left hand side are the points of
excess demand in the goods market .All the points on the IS curve are the points where
the goods market is in the equilibrium.

An increase in expected inflation would leave the slope of IS curve same but will shift the
IS schedule outwards. This change in goods market gets reflected in Aggregate Demand
schedule as the aggregate demand schedule denotes those combinations of real income
and real interest rate where both goods and money market are in equilibrium.

FIG 1: Shift in IS Schedule

Let Y represent natural log of real income.

0 : measures exogenous components of aggregate demand

0 which means a change in exogenous variables like change in fiscal

policy would bring about changes in IS schedule and further affects AD curve .This
implies a rise in government expenditure will shift IS schedule outwards without
changing its slope.

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3.2 LM Curve: Money Market Equilibrium

LM curve on the other hand reflects money market equilibrium. It deals with asset
markets at a point in time .In money market equilibrium, demand for money is given by

Md = KY hi

Rewriting the above equation in natural log form

m- 2lny 3

where , m : natural log of nominal supply of money

p : natural log of price level

Opportunity cost of holding real cash balances depends on nominal rate of interest i

Let µ be the rate of growth of nom

balances grow at the rate of µ -

As a result LM schedule can be written as

µ- -p ) ( m- p )-1

( m- p )-1 : real money demand in the last period so that right hand side of above
equation denotes growth of real balances .

Substituting real demand equation in the above equation we get

µ- 2lny 3i (m-p)-1

The money market would be in the steady state where the real cash balances are constant
2 3 . Therefore the LM curve would be positively sloped.
All the points lying above the LM curve depict points of excess supply while points lying
below the LM curve represent points of excess demand. All the points on the LM curve
are the points where money market clears i.e money market is in the equilibrium.

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FIG 2: Money Market Equilibrium

In order to look for the equilibrium of both goods market and money market, we plot
both IS and LM schedules. Based on the Keynesian assumption that interest rates respond
to money market and national income responds to goods market , one can understand the
mechanism through which the economy will settle down at the equilibrium where IS and
LM schedules intersect at point E in Fig 3 .Point E provides the corresponding
equilibrium level of interest rates i* and income Y * .

FIG 3: General Equilibrium

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Keeping expected rate of inflation constant the following will happen

1. An expansionary Fiscal Policy with unchanged inflationary expectations, would

shift IS schedule outwards to IS as a result both income and interest would rise.
This is depicted by a new equilibrium E'.
2.
fall in interes

Both the above impacts are only explaining the way the policy instruments are
incorporated in the model and provide a misleading picture if expected rate of
e
is kept constant w

3.3 Aggregate Demand Schedule

We can now use the IS-LM schedules to derive an aggregate demand ( AD ) schedule. To
derive AD schedule we express IS curve as interest rates in terms of real income as given
below and further substitute for i in the LM equation.

e
IS schedule: i = 0 Y +
1

LM Schedule: µ- 2 lny 3 i ( m-p )-1

Using the i from the IS schedule as above and substituting in LM schedule and
rearranging we get

d e
= µ + ( m-p )-1 - 2 + 3]Y + 3 0 3
1 1

Yd : It is defined as natural log of real income represented by lny .It is written as Y d to

indicate
Aggregate Demand AD

From the above relationship AD schedule defines a negative relation between rate of
d
( aggregate demand ) .An increase in rate of inflation reduces the real
quantity of money in economy creating excess demand in money market . This would

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Module 34: Dynamics in AD -AS Model: Stability and Convergence to Long
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further make nominal interest rate to rise. With expected rate of inflation held constant,
real interest rate also rises reducing investment and hence aggregate demand.

FIG 4: Aggregate Demand Function

Further, a change in Fiscal Policy will shift the AD schedule without changing its slope.
(m-p)-1 i.e the real money demand in the last period will keep changing so long as rate of
growth of money and rate of inflation are not equal. An increase in expected rate of
e 3 e
. At any given level of
3
. Therefore the expected inflation pursues actual
inflation.

4. AS Schedule under Dynamics of Inflation

AD
output Y.

Y appropriate with production conditions in labor market. This involves two key
components like an aggregate production function indicating total output produced by
labor input. Secondly, it reflects labor market supply and demand conditions relating
labor supply and demand to rate of inflation.

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Module 34: Dynamics in AD -AS Model: Stability and Convergence to Long
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4.1 Production Function

It is defined as the relationship between the output produced and the inputs used . A
specific form of production function can be assumed as

Ys 5 6l 7

where Ys is the natural log of the real output supplied , it is equal to lny s, n is the natural
5 , 6 7 are
defined as positive parameters . The above production function is in the form of Cobb
Douglas production function.

Considering the short run equilibrium, the amount of capital is considered to be fixed or
given exogenously, as a result production function can be written as

Ys 8 6 l

8 5 7 k . Therefore production function in the short run is a relationship

between Ys and n that is a relationship between output supplied and amount of labor
supplied . This relationship is repres 8 6.
7 times the increase in
capital.

FIG 5: Aggregate Supply Function

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4.2 Labor Market

The labor market again has two components demand side and supply side .The demand
for labor is inversely proportional to real wage rate. The labor demanded by firms
depends negatively on real wage rate.

l 9 10 ( w-

where w p is the natural log of real wa 9 10 are defined as positive

parameters the labor demand schedule is inversely related to real wages . Since wages
and prices are rising continuously, the labor demand schedule can incorporate rates of
changes in form of:

l - l-1 10 [w w-1 - ( p p-1

The above can be written as

l = l-1 - 10 ( w

l-1 is the labor demand in the previous period and w = ( w w-1 )

The amount of labor will rise only if wages are greater than rate of inflation i.e w
.This imply that the real wages would be falling over time .When w
will be constant l=l-1

4.3 Aggregate Supply Schedule:

The aggregate supply schedule which is a relationship between rate of inflation and
income can be obtained by taking the difference in one lag period of the production
function in Eq 10.

Ys = Ys-1 6 (l l-1

Substituting change in demand for labor in two periods in the above equation that is Eq
13 we obtain

Ys = Ys-1 6 10 (w

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The above equation indicates that an increase in inflation rate with given wage rate would
reduce the real wages and increase demand for labor given by the parameter 10. This
demand for labor would produce more output as measured by the parameter 6 , implying
more production in the current period as compared to last year .

Ys>Ys-1

This results in positive relationship between rate of growth of real output Y s and rate of
inflation 4 4 6 10

The labor market is considered to be in the equilibrium w

growth of real wages is equal to rate of growth of prices , then amount of labor demand in
this period is same as labor demanded in the last year . This further means that the output
as given by Eq 10
Ys 8 6 l w i.e. rate of inflation and rate of growth of real
wages. Therefore aggregate supply curve is vertical as shown in the figure below.

FIG 6: Long-Run Aggregate Supply

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Module 34: Dynamics in AD -AS Model: Stability and Convergence to Long
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5. Overall Equilibrium under Dynamics of Inflation

A complete overall Equilibrium is a state when the goods market is in equilibrium,

money market is also in the equilibrium thus the aggregate demand derived from this
situation intersects with the aggregate supply schedule to give the equilibrium level or
combination of inflation rate and real income.

The complete macro-economic model can be represented by the following set of

equations.

1. Goods market is in equilibrium as reflected by IS curve

IS Schedule : Yd 0 1( i- e
)

2. Money market equilibrium as reflected by LM curve .

LM Schedule: µ- 2 lny 3 i ( m-p )-1

3. Aggregate supply as given by

AS Schedule: Ys = Ye - 4
e

4. Equilibrium Conditions

Y = Ys = Y d

The above overall system of equilibrium is depicted in the graph as below

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Module 34: Dynamics in AD -AS Model: Stability and Convergence to Long
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FIG : 7 (a)Overall Equilibrium

FIG: 7 (b) Equilibrium through AD & AS

The intersection of IS LM curve determine equilibrium level of income y and nominal

interest rate i , this is shown in Fig 7 part a .On the other hand the final intersection of AD
and AS schedules can easily be observed in Fig 7 part b . The equilibrium income so
derived by the connection established between the two graphs implies that it is same.

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Module 34: Dynamics in AD -AS Model: Stability and Convergence to Long
Run Steady State
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From IS schedule indicating goods market equilibrium we can read real interest rate. As a
result we would be able to derive an overall equilibrium, from demand side which
includes both goods market equilibrium and money market and from the supply side.
Thus, an intersection of aggregate demand AD curve and aggregate supply or AS curve at
point E results in equilibrium values of 0 (inflation) and (real income) y0which
reflects overall equilibrium of the economy.

6. Long run Equilibrium under Dynamics of Inflation

In the long run, an economy is left to itself would settle down with a specific
combination of interest rate, real income and rate of inflation. . Both the schools of
thought New classical and Keynesian agree on notion of equilibrium but differ in their
opinion when it comes to the point of time taken in adjustment. Keynesians argue that it
takes long time for adjustments and reach a long run equilibrium therefore it is
necessary intervene using fiscal and monetary policies.

While New Classical economists argue that the economy is quite adjusting and it will
attain a long-run equilibrium. In the short run, the economy attains an equilibrium given
by the following equation.

y = yd = ys

e
or y = ye

If there arises discrepancy between output demanded and supplied then an undesired
movement in the inventories will take place bringing about further changes in the output
and employment .This process is assumed to be completed every time there exists short
run equilibrium.
Labor market may not be in the equilibrium in the short run but in the long run, it
definitely attains equilibrium .The equilibrium is attained at real wage constant where
labor supply is equal to demand .When expectations of inflation are fulfilled, there is no
incentive to make any further adjustments in the economy, the economy will attain a
stationary state.
e
In the long , stating that expected inflation is same as current
inflation .AS schedule becomes vertical implying output is determined independent of
demand as shown in Fig 8 .In the long run , given y or the real income ,

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Module 34: Dynamics in AD -AS Model: Stability and Convergence to Long
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e
IS schedule is given by : i = 0 y +
1
e

From the above we get real money supply ( m-p ) and a real rate of interest is obtained

e
i- 0 ye 1

observe that

1. Output is determined by AS schedule.

2. Inflation is equal to given rate of growth.
3. Money supply and interest is determined by location of IS curve.
4.

As a result long

Y = Yd = Y s = Y e
e

0 ye 1

Fig 8 (a ) Long Run Equilibrium

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Module 34: Dynamics in AD -AS Model: Stability and Convergence to Long
Run Steady State
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Fig 8 (b) Long Run Aggregate Supply

It should be noticed that aggregate demand AD plays no role in determining income in

the long run as shown by part b of Fig 8. It further indicates that the stabilizing policies
of demand management like fiscal or monetary policies play no role in determining
output or income in long run .This equilibrium condition can only be affected if there
are shocks either from demand side or supply side .Let us now consider the situations of
demand side shocks in the economy as well as supply side shocks.

7. Demand Side Shocks: Aggregate Demand or AD Shocks

A demand shock occurs when factors influence the aggregate demand curve .An
expansionary Monetary Policy in IS LM framework would lower nominal rate of
interest and increase output, but this will not occur in the long run equilibrium .An
increase in rate of growth of money from µ0 to µ1 will shift LM curve outwards to LM' as
shown in Fig. 9 but in long- run equilibrium the rate of inflation must equal higher money
supply growth rate, µ1. Hence the IS curve must shift to intersect the new LM curve and
attain Ye as the equilibrium. As a result interest rates should be higher by the amount of
increase in rate of growth of money supply.
e
= 0 does not change, this would imply real
interest rate will not change. The real money supply initially increased as µ 1
curve starts retreating as rate of inflation exceeds the rate of growth in money supply
.Therefore the central banks started with larger growth of money supply but the economy
ended with lower value of cash balances . This is the only real variable that has been
affected by growth rate of money supply.

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Module 34: Dynamics in AD -AS Model: Stability and Convergence to Long
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FIG 9: Long Run Equilibrium: IS-LM

In the long run equilibrium rate of inflation must be equal to higher money supply µ 1 .
e
IS curve would therefore shift = µ1inorder to attain equilibrium at ye . Interest is
higher by the amount of increase in rate of growth of money supply. The real money
supply increases initially when since µ1
result rate of inflation exceeds rate of growth of money supply .

Finally one can conclude that initially Central Bank started with larger growth of money
but the economy ended with lower value of real cash balances.

8. Supply Side Shocks: Aggregate Supply or AS Shocks

A supply shock occurs when at every wage rate the supply of labor falls. This can occur
due to the factors like increase in non- wage income or an increase in preference for
leisure. This shock shifts AS schedule to AS ' that is towards left hand side .The output
would consequently fall to y1e

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Module 34: Dynamics in AD -AS Model: Stability and Convergence to Long
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Fig 9(b): Aggregate Supply Shock

FIG 10: Aggregate Demand Shift

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Module 34: Dynamics in AD -AS Model: Stability and Convergence to Long
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If AD curve does not shift or reduces then this would lead to excess demand and further
increasing the rate of inflation. However rate of money supply has not changed , rate of
inflation must remain same as before and as a result AD will shift towards left to AD '
.This new aggregate demand curve AD ' intersects with AS ' schedule leading to new
equilibrium E'' as shown in fig 10 . As a result of this AS shock, LM curve is also
affected. The supply shock of reduced labor supply, output or income would be lower and
this will result in fall in transactional demand for money .This means for some time rate
of inflation remains higher than rate of growth of money in order to reduce the value of
money .The final equilibrium E'is achieved, both and i- e will be higher .This higher real
interest rate will reduce some amount of aggregate demand resulting in lower equilibrium
output.

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Module 34: Dynamics in AD -AS Model: Stability and Convergence to Long
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9. Summary

d
1.
(aggregate demand) .An increase in rate of inflation reduces the real quantity of
money in economy creating excess demand in money market. This would further
make nominal interest rate to rise. With expected rate of inflation held constant,
real interest rate also rises reducing investment and aggregate demand.

5. Aggregate supply schedule shows the combinations of rate of inflation

income ys appropriate with production conditions in labor market. This involves
two key components like an aggregate production function indicating total output
produced by labor and capital input. Secondly, it reflects labor market supply and
demand conditions relating labor supply and demand to rate of inflation.

6. An intersection of aggregate demand AD curve and aggregate supply or AS curve

results in equilibrium values of (inflation) and (real income) y .which reflects
overall equilibrium of the economy.

4 In the long run, an economy is left to itself would settle down with a specific
combination of interest rate, real income and rate of inflation. Both the schools of
thoughts New classical and Keynesian agree on notion of equilibrium but differ in
their opinion when it comes to the point of time taken in adjustment.

5 In the long run equilibrium rate of inflation is equal to expected rate of inflation
e
AS schedule becomes vertical implying output is determined independent
of demand. AD plays no role in determining real income y .Therefore the demand
management policies namely fiscal and monetary policies play no role in
determining income in long run.

6. Supply shock occurs when at every wage rate the supply of labor falls. This can
occur due to the factors like increase in non- wage income or an increase in
preference for leisure. This shock shifts AS schedule to AS ' that is towards left
hand side .The output would consequently fall to y 1e

ECONOMICS Paper 4: Basic Macroeconomics

Module 34: Dynamics in AD -AS Model: Stability and Convergence to Long
Run Steady State