because we are on the IS curve.

But we are still

at a point to the right of the LM curve, so the
demand for money exceeds the supply of money.
Therefore, a force is at work to push up the interest rate and the next movement may be along
the arrowfrom B to C. At C there is still an excess
demand for money, which again tends to push
up the inlerest rate as indicated by the vertical
arrow originating at C. However, at C there is an
excess supply of goods, "thich tends to reduc
the income level as shown by the horizontal arrow
originating at C. These forces may on balance
cause the economy to move along the path
described by the arrow running from C to D. At
0, the forces are the same as at C; the result is
a movelTocnt of the same kind. The combination
of income level and interest rate may change in
this way over time until finally the system reaches
that one combination of Y and r at which both
markets clear. Although the several discrete
steps traced out here help reveal the-underlying
process at work, the actual process would be a
continuous one in which Y and r might move
along a path like that indicated by the dashed
line running from A to 0 and then to the intersection of the two curves.
Instead of starting at A, we could start at any
other disequilibrium point in Figure 12-6 and
trace the movement of Y and r toward the single
pair of equilibrium values in the same way. No
matter what disequilibrium point one starts with,
all one need do is (1) identify whether I > S, 1<
S, or I = S, or in terms of aggregate spending
whether (C + !) > Y, (C + I) < Y, or (C + I) =
Y, which te!ls whether Y will tend to rise, fall, or
remain unchanged; (2) identify whether md > ms'
md < ms' or md = ms' which tells whether r will
tend to rise, tall, or remain unchanged; and (3)
establish the direction of movement at the Y, r
combination indicated by the forces found to be
at work in (1) and (2). For example, starting with
any point in Space I such as E, forces tend to
reduce both the income level and the interest
rate. The reader may trace the discrte steps
from E thrOi !gh H, which are different In direction
but exactly symmetrical with those from A through

..

D. As was shown for themovement-from-A.t6 the

intersection, the continuous;pa.th-th_at;t~~ ~
omy might follow fro~ E to H and then to the
intersection is indicated by a dashed line. Once
at the intersection. the combination of Y and ,
provides equilibrium in both markets; the income
level and the interest rate will remain unchanged
until the existing equilibrium is upset by a shift in
the IS or LM curve. or in both.8

E5-LM Equilibrium and the

Aggregate Demand Curve

In th~simple classical theory of Chapter 9, the
aggregate demand curve was derived from the
quantity of money and appeared graphically as
a downward sloping curve (rectangular hyperbola). Given the classical theory's conclusion
that the aggregate supply curve is a perfectly
inelastic line situated at the full employment level
of output, the intersection of the AD curve with
the AS curve did no more than determine the
price level of the full employment output.
The model being constructed in this chapter
includes the opposite extreme for the AS curvethat is. one that is perfectly elastic up to the full
employment level of output but perfectly inelastic
at that level. This kind of AS curve is shown in
Part B of Figure 12-7. The present model also
assumes that the economy operates below the
full employment level of output-that
is, along the
perfectly elastic portion of the AS curve. Some

8 Although it is quite illuminating to trace the path followed by Y and' as we have done here. the IS-LM model
, now before us does not in itself reveal that Y and , will
follow the path here described or any other particular path
from an initial disequilibrium position like A or E. As briefly
explained in Chapter 3. to trace the process of change in
the values of a model's variables from one period to
another can be done only with a dynamic model. The
IS-LM model isnot dynamic, but completely static. It identifies the values the variables must exhibit in order that
there be equilibrium. but it does not show the sequence
- of changes by which these values will be reached if we
start off with any values eltler than Ihese equilibrium

values.