From notes for PA854 (before AD-AS chapter), to be discussed tomorrow:
Assume the price level is sticky in the short run with respect to aggregate demand, but responds quickly to cost-push shocks:
The elevated oil price (see this post) then induces a leftward shift in the LM curve (gray arrow), raising borrowing costs.
Output declines from Y0 to Y1, as interest rates rise. In reality, policy rates are likely to be set higher than they otherwise would have been.
Note that this is an old fashioned interpretation of central bank as targeting the money supply. One could reinterpret as an interest rate target, where the interest rate is targeted, but reacts positively to the price level.
An obvious question is whether the IS curve should shift out in response to an increase in government (defense) expenditures. The answer depends on whether production can be ramped up quickly to replace expended munitions (probably not, as we’re at capacity), or more importantly whether the war entails “boots on the ground”. Current betting on Polymarket indicates 42% probability by year’s end. For the moment, I assume no ground forces in Iraq for an extended period.
We’re in a period of great uncertainty with respect to the conduct of economic policy writ broadly, as well as geopolitical risk (see here). How can we interpret this in a simple IS-LM model. We can’t unless we augment the model. The obvious place is investment; relying on empirical work (e.g., Baker, Bloom and Davis), restate the investment equation as:
Elevated uncertainty (see here) then implies slowing investment, shifting in the IS curve (dark gray arrow).
Output then falls to Y2.
