Understanding Macroeconomic Models in Macroeconomics

In this segment, you will learn about the two economic models that are imperative to understanding the broader economy and which will help you understand macroeconomics better. These are the Aggregate Demand–Aggregate Supply (AD-AS) model and the Investment-Savings and Liquidity Preference–Money Supply (IS-LM) model.

 First, let’s take a look at the AD-AS model. Aggregate Demand refers to the total demand for goods and services in an economy. Aggregate Supply refers to the total supply of goods and services produced in an economy.

So, essentially, the AD-AS model helps in understanding the relationship between aggregate demand and aggregate supply. It shows how spending in an economy (AD) relates to production in an economy (AS) and, thus, helps in determining the macroeconomic equilibrium, which indicates the real GDP and price levels. 

Some features of the AD-AS model include the following:

• It is similar to a simple market demand and supply model but takes a broader view of the economy, which helps governments or economists interpret the economy better and, thus, make better decisions. 
• It helps in understanding how the economy functions during a recession when demand declines in the long run and also helps understand whether there could be a supply shock or whether a supply shock already exists. 
• It tells you how supply adjusts itself in the long run to match the reduction in demand in order to reach an optimal price level and vice versa.
• The understanding of aggregate demand and aggregate supply helps governments make policy decisions, and it also helps explain why governments take certain policy decisions. Governments make policy decisions such as those related to growth, unemployment and economic fluctuations.

Economic fluctuations, be it the great depression of the 1930s, the stagflation of 1930s or the great recession of 2008-09 can be explained through the help of the AD/AS model. Even the COVID-19 pandemic-induced recession has its roots in the falling aggregate supply and aggregate demand. 

Now, in the next video, you will learn about the IS-LM model. 

So, in the video, you were presented with a simplified view of the Investment-Savings and Liquidity Preference-Money Supply (IS-LM) model. 
 

The IS-LM model helps you understand the relationship between interest rates and output in an economy. The point at which these two slopes meet indicates the short-run equilibrium between output and interest rates. Simply put, it tells us how investments and savings relate to liquidity preference and money supply. Liquidity preference refers to people’s preference for holding liquid assets over illiquid, long-term investments. 
 

Simply put, the IS-LM model tells you that:

• As interest rates decrease, there is a decrease in people’s preference for saving as they will earn a lower return on that money. This leads to more money being injected into the economy as people spend more. This leads to a higher demand, which in turn boosts economic activity, leading to higher output. So, the IS curve slopes upwards.
• As interest rates increase, there is a decrease in people’s preference for spending, which means there is leakage from the economy as people prefer to save more in order to earn a higher interest on their money. This leads to a decrease in demand, which in turn decreases the output. So, the IS curve slopes downwards. 
• As money supply decreases in an economy, there is an increase in interest rates. Since the money supplied in the economy is less, there would be a greater number of people who would want to access that money. This in turn would lead to a higher interest being charged for borrowing that money. Consequently, the LM curve slopes upwards.
• As money supply increases in an economy, the need to compete for it is less, and this leads to lower interest rates. This situation occurs when people start spending, which in turn increases the circulation of money in the economy. Consequently, the LM curve slopes downwards.

Additional Learning

Read this document if you would like to know about the applications of the IS-LM model.