1995 version

Prof. Humberto Barreto1 Introduction: This brief work is designed to provide additional ammunition for the student in the ongoing war against IS/LM confusion and ignorance. The author has claimed in his Notes on Macroeconomic Theory (1995) that, There should be no mystery or uncertainty surrounding the IS/LM analysis at this point. IS/LM curves are simply a short-cut to finding the equilibrium values for income and interest rate. There are two equations and two unknownsÑwhat simpler strategy than to put them on one graph could be devised? (p. 52) The author still worries, however, that the student is memorizing the equilibrium condition, IS=LM generates Ye, without really understanding why the condition works. Most students are unable to explain why setting IS equal to LM generates the equilibrium level of output. I have, on rare occasion, heard a student give the following explanation: "Along the IS curve the goods market is in equilibrium; along the LM curve the money market is in equilibrium. Therefore, for both markets to be in equilibrium, the system must be on both curves. This only occurs at the intersection of the curves." That's pretty good, and it's the explanation I used in Notes on Macroeconomic Theory; but I still worry that there is too little understanding and too much memorization. I very much want to get across true, complete comprehension of this fundamental macro tool known as the IS/LM graph. To do this, I undertake a detailed analysis of the meaning of equilibrium in the IS/LM Model in the pages that follow.

1 The author wishes to thank Professors Frank Howland and John Naylor for their many

(many!) useful comments and suggestions.

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The Equilibration Process: In struggling with the problem of teaching the student why the intersection of the IS and LM curves yields the general equilibrium solution to the interest rate and output variables, I wondered why students are able to understand quickly how a market equilibrates. The typical student knows that D=S generates the Pe, Qe combination that we seek. He also knows, however, the process by which such a solution is reached. From the first course in economics he is taught that any price above the equilibrium price generates a surplus which forces suppliers to cut prices in order to sell their inventories. On the other hand, a P below Pe results in a shortage and upward pressure on the price as consumers bid up the price. When asked why the intersection of S and D yields Pe, the typical student responds with this story. The student hasn't memorized that S=D generates Pe, he has learned that there is an "equilibration process" at work. The microeconomist's story of how equilibrium is attained provides the key to teaching the concept of equilibrium price in a single market. Note how the presentation proceeds: (1) define equilibrium as no tendency to change, (2) pick a value and see if it has a tendency to change, and, (3) if it does, describe the forces that lead to change and point out the direction of the change. This explanation is understood by the vast majority of students. Simply put, as a means to communicate an idea, it really works! When asked why S=D generates the Pe, the typical response is built around the notion that forces are at work that will drive the price to a certain value. No attempt is made at repeating a memorized conditionÑas is usually the case when the question concerns equilibrium output in a macro model. The next step is obvious: if it works for explaining the equilibration process in a single market, let's apply it to explain why IS=LM yields Ye. By following the three steps outlined above, we hope to get the same spectacular results in terms of understanding the IS/LM graph that we get in microeconomics. LetÕs do it!

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Step (1): Defining equilibrium As in microeconomics, equilibrium is defined as no tendency to change. In general, an endogenous...