Transcript Intermediate Macroeconomics

Orthodox
Keynesianism:
IS-LM Model
Intermediate Macroeconomics
ECON-305 Spring 2013
Professor Dalton
Boise State University
Purposes
1.
2.
3.
4.
Review the IS-LM Model
Consider effectiveness of monetary
and fiscal policy in terms of model
Discuss original Phillips Curve model
and importance to orthodox
Keynesian analysis
Summarize central propositions of
orthodox Keynesianism
Recurrent Themes

Controversy over self-equilibrating
properties of modern capitalist
economies

Role and efficacy of activist
government monetary and fiscal
policy
Distinguishing Beliefs
1.
Economy is inherently unstable

Subject to erratic shocks originating
in business confidence
2. Economy is weakly selfequilibrating

Forces that return economy to full
employment are slow and unrobust
Distinguishing Beliefs
3. Aggregate Demand determines
aggregate output and
employment

government can intervene to assure
sufficient AD
4. Fiscal policy preferable to
monetary policy

More predictable, direct and faster
Development of IS-LM



J.R. Hicks, “Mr. Keynes and the
Classics: A Suggested Interpretation,”
Econometrica (April, 1937)
F. Modigliani, “Liquidity Preference
and the Theory of Interest and
Money,” Econometrica (January, 1944)
Popularized by A. Hansen and P.
Samuelson
IS-LM Model

IS curve represents equilibrium in the
goods market


name derives from Investment = Saving
equilibrium condition
LM curve represents equilibrium in the
money market

name derives from Liquidity preference
(Md) = Money Supply equilibrium
condition
IS Curve: The Goods Market
 Closed
economy, no
government
 E = C + I; Y = C + S
 In equilibrium, E = Y
C+I=C+S
I=S
IS Curve: The Goods Market
Expenditure Approach
 C = CA + cY
0<c<1
 I = IA – ar
 A = CA + IA
 E = A + cY - ar
C
C = CA + cY
r
r0
I = IA - ar
CA
Y
I
E=Y
I0
E = A + cY - ar
E
C = CA + cY
I0
CA
Ye
Y
Equilibrium and Inventories
Suppose actual income is Y0.
At Y0, E > Y0.
E=Y
E
E = A + cY -ar
E
Y0
Y0
Ye
Y
Inventories of firms are
being depleted below
desired levels – “unplanned
inventory reductions.”
This sends signals to firms
to expand production.
Output and income rise
toward Ye.
As Y increases, so does E.
Equilibrium and Inventories
Suppose actual income is Y1.
At Y1, E < Y1.
E=Y
E
E = A + cY -ar
Y1
E
Ye
Y1
Y
Inventories of firms are
rising above desired levels –
“unplanned inventory
accumulation.”
This sends signals to firms
to reduce production. Output
and income fall toward Ye.
As Y decreases, so does E.
Equilibrium and the Multiplier
Begin at E0 and output is
at equilibrium Ye.
E=Y
E1 = A + cY -ar Now suppose E increases
E
E0 = A + cY -ar
Ye
Y e’
Y
to E1.
Why?
At Ye, E1 > Ye.
Unplanned inventory
reductions will lead firms
to increase output.
As output increases so
will expenditures. We
end up at Ye’.
How much will Y change
due to the change in E?
Equilibrium and the Multiplier
∆E = ∆Y
∆E = ∆A + c∆Y
∆Y = ∆A + c∆Y
∆Y - c∆Y = ∆A
∆Y (1 – c) = ∆A
∆Y = ∆A/(1 – c)
The multiplier equals (1/1 - c)
Adding Government

Government can purchase goods (G),
make transfer payments (TR), and tax
income (tY).

Households now consume out of
disposable income (Yd), which
includes net transfers after taxes.

Total expenditures (AD) now includes
government purchases (G).
System with Government
E=C+I+G
C = CA + cYd
Yd = Y + TR – tY
T = TR – tY
If government runs a deficit G > T
If government runs a surplus G < T
System with Government
E=C+I+G
C = CA + cTR + c(1-t)Y
E = CA + cTR + c(1-t)Y + IA – ar + G
Let AG = CA + cTR + IA + G
E = AG + c(1-t)Y - ar
Introducing government shifts E up
and flattens the E curve
Why?
Sources and Changes in
Expenditures
E = CA + cTR
CA
E
TR
E
IA
E
r
E
G
E
t
E
c
E
+ c(1-t)Y + IA – ar + G
What changes will change
the slope of the E curve?
∆t or ∆c will change slope
What is the expenditure
multiplier after introducing
taxes?
the new expenditure
multiplier is [1\(1-c)(1-t)]
Deriving the IS Curve
I
E=Y
I = IA - ar
E = CA + cTR + c(1-t)Y + G
r1
r0
r
I0 I1
E
Y0
r=r
Y1
Y
r
r0
r1
r
IS
Y0
Y1
Y
IS Curve

r0

r1
IS
The IS curve is the
locus of r & Y
where goods
market is in
equilibrium
IS curve is
steeper…


Y0
Y1
Y
the smaller is the
multiplier
the more interestinelastic is
investment
IS Curve

r0
IS curve shifts
for changes
in…
CA
 IA
 TR
 G
 t
 c

r1
IS
Y0
Y1
Y
IS Curve

r0

r1
IS
Y0
Y1
Y

To the right of IS
curve there is ES
in goods market
To the left of IS
curve there is ED
in goods market
∆Y = ∆G *
multiplier
LM Curve: The Money Market
 Money
demand
 Transactions
demand ... f(Y)
 Precautionary demand … g(Y)
 Speculative demand … (r v. re)
 The
alternative to holding
money is holding securities
(bonds)
LM Curve: The Money Market
 Demand
for financial wealth
Md/P + Bd = Wn/P
 Stock of financial wealth
Ms/P + Bs = Wn/P
where B = bonds
Wn = total financial wealth
LM Curve: The Money Market
 In
equilibrium,
Md/P + Bd = Wn/P = Ms/P + Bs
Md/P + Bd = Ms/P + Bs
or
(Md/P - Ms/P) + (Bd – Bs) = 0
when the money market is in equilibrium, so
too, is the bond market.
LM Curve: The Money Market
Md/P = mY – br
Ms/P is exogenously determined
(perfectly inelastic?)
r
r0
Ms/P
Md/P = mY0 - br
M/P
r
Ms/P
Ms2/P
r1
r2
r0
Md/P = mY1 - br
Md/P = mY1 - br
Md/P = mY0 - br
M/P




An increase in Y increases Md/P and increases r
An increase in Ms reduces r at a given Y
An increase in re increases Md/P and increases r at
given Y
An increase in P reduces both Ms/P and Md/P. What
happens to r at given Y?



if ∆(Ms/P) > ∆(Md/P), then r rises
if
∆(Ms/P)
< ∆(Md/P),
then r falls
Why?
Because
the change
in the money supply has to be
d/P), then
if ∆(Ms/P)
“split”
= ∆(M
between
three
r stays
usesthe
in same
demand (consumption,
money balances, and securities).
Deriving the LM Curve
r=r
r
LM
r1
r0
r
r1
r0
Y0
Y1
Y
MdT
MdT1
Md/P = kY
Ms/P
Md/P (Y0)
Md/P (Y1)
M/P
LM Curve

r
LM
r1

r0
The LM curve is
the locus of r & Y
where the money
and bond markets
are in equilibrium
LM curve is
steeper…

Y0
Y1
Y

the greater the
income elasticity
of Md
the smaller is the
interest elasticity
of Md
LM Curve

r
LM
LM curve shifts
for changes
in…
Ms
 P
 re

r1
r0
Y0
Y1
Y
LM Curve

r
LM

r1

r0
Y0
Y1
Y
To the right of LM
curve there is ED
in money market
To the left of LM
curve there is ES
in money market
∆Y because of
∆Ms depend on
the interest
elasticity of Md;
∆Y larger the
more inelastic is
Md
The Liquidity Trap
r
Ms0/P
Ms1/P

Md/P
rmin
M/P
r
LM

LM

rmin

Y0
Y
At sufficiently low r
(expected when Y < YF),
the Md/P becomes
perfectly elastic because
everyone expects r to
rise. (Bond prices are so
high that everyone
expects bond prices to
fall.)
In the liquidity trap the
LM curve becomes
horizontal over the
relevant range of output.
In the liquidity trap, an
increase in Ms has no
affect on r.
So the relevant portion of
the LM curve remains
horizontal.
What did Keynes think of
his liquidity trap idea?
“There is the possibility, for the reasons discussed above,
that, after the rate of interest has fallen to a certain level,
liquidity-preference may become virtually absolute in the
sense that almost everyone prefers cash to holding a debt
which yields so low a rate of interest. In this event the
monetary authority would have lost effective control over
the rate of interest. But whilst this limiting case might
become practically important in future, I know of no
example of it hitherto. Indeed, owing to the unwillingness
of most monetary authorities to deal boldly in debts of
long term, there has not been much opportunity for a test.
Moreover, if such a situation were to arise, it would mean
that the public authority itself could borrow through the
banking system on an unlimited scale at a nominal rate of
interest.”
- Keynes, General Theory, p. 207
The most striking examples of a complete breakdown of
stability in the rate of interest, due to the liquidity function
flattening out in one direction or the other, have occurred
in very abnormal circumstances. In Russia and Central
Europe after the war a currency crisis or flight from the
currency was experienced, when no one could be induced
to retain holdings either of money or of debts on any
terms whatever, and even a high and rising rate of interest
was unable to keep pace with the marginal efficiency of
capital (especially of stocks of liquid goods) under the
influence of the expectation of an ever greater fall in the
value of money; whilst in the United States at certain dates
in 1932 there was a crisis of the opposite kind—a financial
crisis or crisis of liquidation, when scarcely anyone could
be induced to part with holdings of money on any
reasonable terms.
- Keynes, General Theory, p. 207
IS-LM Analytics
IS-LM Equilibrium

r
LM
LM”
LM’
r*
IS’ 
IS” 
IS
Y*
YF
Y
r*, Y* is the equilibrium
combination of the
interest rate and real
output that brings
about equilibrium in
the goods and money
(and bond) markets.
Suppose Y* < YF.
Full employment can
be achieved by shifting
either IS or LM, or
both, to the right.
IS-LM Equilibrium

r
LM
LM’
r*

IS’
IS
Y*
YF
Y
IS will shift to the
right if CA, IA, TR,
G or c increase,
or if t decreases.
LM will shift to
the right if Ms
increases or P or
re decrease.
IS-LM Equilibrium

r
LM
r’
LM’ 
r*
IS’
r’’

IS
Y*
YF
Y
Policy options are
to increase G,
reduce t, or
increase Ms.
Fiscal policy options
will shift IS to the
right and increase r
and Y.
Monetary policy will
shift LM to the right
and reduce r while
increasing Y.
Policy Effectiveness

Fiscal policy will be more effective…


The flatter the LM curve (more interest elastic is Md).
The steeper the IS curve (less interest elastic is I).
LMs
r
r
LM
rs
LMf rs
rf
r*
rf
r*
ISf’
IS’
IS
Y* Ys
Yf
ISs
Y
Y* Yf Ys
ISs’
Y
ISf
Policy Effectiveness

Monetary policy will be more effective…


The steeper the LM curve (less interest elastic is Md).
The flatter the IS curve (more interest elastic is I).
LMs
LMs’
r
LM
r
LMf
LMf’
LM
r*
r*
rf
rs
rf
rs
ISf
IS
Y* Yf Ys
ISs
Y
Y*
Ys
Yf
Y
Orthodox Keynesian View

r

LM
r’
r*

IS’
IS
Y*

YF
Y
Demand for money
is interest elastic
Investment demand
is interest inelastic
The LM curve is flat
and the IS curve is
steep
Fiscal Policy is
more effective
than monetary
policy
Policy Effectiveness




During the 1950s several studies sought to
determine the interest elasticity of
investment demand and the interest
elasticity of money demand.
The early studies supported the Orthodox
Keynesian view that investment demand was
inelastic and monetary demand was elastic.
The empirics supported the notion that
fiscal policy was more effective than
monetary policy.
This empirical support, however, became
increasingly questionable by the early
1960s.
The Crowding Out Argument


On theoretical grounds, the early 1960s saw
a questioning of the effectiveness of “pure”
fiscal policy (fiscal policy unaccompanied by
accommodating changes in the money
supply).
The argument: “Higher interest rates from
expansionary fiscal policy crowd out private
spending sensitive to the interest rate,
limiting the effectiveness of fiscal policy.”
The Crowding Out Argument
r
(G–T)
r1
r0
I1
I0
When government
runs a deficit, and
SLF
the interest rate
rises, private
demand for
loanable funds to
use for
consumption and
DLF + (G–T) investment falls.
The effects of fiscal
policy are smaller
DLF
than expected by
S, I
the IS-LM model.
The Keynesian Response

The Keynesian response to the
“crowding out argument” focuses
on the wealth effects of bondfinanced government
expenditures

Blinder and Solow, “Does Fiscal Policy
Matter?,” Journal of Public Economics
(November 1973)
The Keynesian Response
LM
r
r1
r0
IS
Y0 Y1
T1
G,T
G1 -T1
IS’
Y
Go
G1
T
Begin in equilibrium r0, Y0 with
a balanced budget G0 = T.
Desire to increase Y, so
increase G to G1.
The IS curve shifts to the right,
increasing Y to Y1and
providing T1 to finance part
of the deficit.
Deficit equals G1-T1.
Government must issue
additional bonds. The bonds
represent additional private
sector wealth which
increases consumption and
demand for money.
The Keynesian Response
LM
r
r1
r0
IS
Y0 Y1 Y2
IS’
Y
Go
G1
G,T
T
The effect of higher
consumption is to shift the
IS curve further to the right.
The effect of higher money
demand is to shift the LM
curve to the left.
If the consumption effect
outweighs the money
demand effect, income will
continue to rise until Y2 and
the deficit will be reduced to
zero.
Debt Equivalence Theorem



Barro, “Are Government Bonds Net Wealth?”
Journal of Political Economy (Nov./Dec. 1974).
The burden of government spending is the
same whether it is financed by an increase in
taxation or by bonds.
Borrowing reflects a future tax liability which
if fully taken into account exactly offsets the
value of the bonds in households wealth.
Government Bonds are not net
wealth!
Is Debt Equivalent to Taxes?



Are households farsighted?
Do households take into account future tax
liabilities that will fall on their heirs?
Government has privileged access to
loanable funds so the interest rate at which
government borrows is less than the
interest rate at which future taxes are
discounted.
Government bonds are net wealth
Underemployment Equilibrium
LM0
r
W/P
ESL
SL
The General Case:
Rigid Money Wages
(W/P)0
r0
DL
IS
Y
Y=Y
Y
Y0
Y
L
Y
Y= f(L)
L0 < LF
L
Start in IS-LM
quadrant.
Initial equilibrium at
r0, Y0.
If money wages are
rigid, there is no
guarantee that W,
given P consistent with
LM0, is consistent with
labor market clearing.
The labor market can
get stuck at less than
full employment.
Underemployment Equilibrium
LM0
r
LM1
r0
r1
W/P
ESL
(W/P)0
(W/P)1
DL
Y
Y=Y
Y0 YF
Y
The General Case:
Introduce Flexible Wages
The ESL cause W to fall,
reducing prices of output.
IS
Y
SL
L
Y
Y= f(L)
L0 LF
L
In terms of IS-LM, as P
falls, the real money
supply (Ms/P) increases,
causing the LM curve to
shift to the right.
The LM shift to the right
reduces r and increases I,
increasing Y.
The increase in E
moderates P decreases,
so W fall > P fall; (W/P)
fall.
Underemployment Equilibrium
LM0
r
LM1
r0
r1
W/P
ESL
(W/P)0
(W/P)1
DL
Y
Y=Y
Y0 YF
Y
The General Case:
Introduce Flexible Wages
This story is the “Keynes
Effect” story.
IS
Y
SL
L
But Keynes denied that
the “Keynes Effect” would
be sufficient to restore YF.
Why?
Y
Y= f(L)
L0 LF
L
1. Liquidity trap (r
wouldn’t fall)
2. Interest-inelastic
Investment (Investment
wouldn’t increase enough)
Unemployment & Liquidity Trap
LM0 LM1 W/P
r
ESL
SL
(W/P)0
r0
The ESL cause W to fall,
reducing prices of
output.
DL
IS0
Y
Y=Y
Y
Y0 YF
Y
Flexible Wages and
Liquidity Trap
L
Y
Y= f(L)
L0 LF
L
In terms of IS-LM, as P
falls, the real money
supply (Ms/P) increases,
causing the LM curve to
shift to the right.
The LM shift to the
right, however, fails to
reduce r because
households and firms
add the additional real
money supply to their
cash balances.
Unemployment & Liquidity Trap
LM0 LM1 W/P
r
ESL
SL
(W/P)0
r0
(W/P)1
IS0
DL
IS1
Y
Y=Y
Y
Y0 YF
Y
L
Y
Y= f(L)
L0 LF
L
Flexible Wages and
Liquidity Trap
Since r does not fall,
investment does not
increase, AD is
unchanged.
Wages fall at the same
rate as prices, so the real
wage does not change and
the ESL remains.
Full employment can be
achieved by increasing G
or reducing t, increasing
expenditures, shifting the
IS curve.
The increase in AD raises
prices, reducing the real
wage to clear the market.
Interest Inelastic Investment
YF LM
0
r
W/P
LM1
r0
IS0
IS1
SL
ESL
The ESL cause W to fall,
reducing prices of
output.
(W/P)1
DL
Y
Y=Y
Y
(W/P)0
ESL
L
Y
Flexible Wages and
Interest Inelastic
Investment
Y= f(L)
In terms of IS-LM, as P
falls, the real money
supply (Ms/P) increases,
causing the LM curve to
shift to the right.The LM
shift to the right reduces
r and increases I,
increasing Y.
But r can’t fell below
zero, since r is the
reward for parting with
liquidity.
Y0
Y
L0 LF
L
Persistent
underemployment
equilibrium.
Summary
Orthodox
Keynesian IS-LM
Orthodox Keynesian IS-LM
1.
2.
3.
Rigidity of nominal wages prevent
adjustment to full employment.
If nominal wages are flexible, reductions in
wages and prices fail to restore full
employment unless the Keynes effect is
operative.
If liquidity trap or interest-inelastic
investment exists, the Keynes Effect is
short-circuited and the economy, left to
itself, fails to restore full employment.
Orthodox Keynesian IS-LM
Keynes failed to provide a general
theory of unemployment; his argument
rests on special cases (nominal wage
rigidity, liquidity trap, or severe interestinelastic investment).
Wealth Effects:
Real Balance and
Pigou Effects
“Classical” Economics Redux
r
ESL
W/P
(W/P)0
B
SL
A
DL
Y
Y=Y
Y
Y0 YF
Y
L
Y
Y= f(L)
L0 LF
L
Patinkin, Money,
Interest and Prices
(1956)
Unemployment is not
an equilibrium, but a
disequilibrium one
which occurs even when
W and P are flexible.
AD falls as W and P falls
(balanced) and firms
forced off DL curve from
A to B.
But as P falls, real
money balances
increase, people feel
wealthier, and CA and IA
increase directly. Falling
prices and higher real
spending move the
economy back to full
employment.
“Classical” Economics Redux
r
r0
r1
W/P
ESL
LM0
(W/P)0
IS1
B
IS0
Y=Y
Y0 YF
Suppose some shock
occurs (expected
profitability falls) shifting
IS to left, reducing Y.
A
DL
Y
Y
SL
Y
L
Y
Y= f(L)
L0 LF
Start at full employment
(IS0, LM0, r0, YF, LF, (W/P)0).
L
Reduced AD cause a
balanced fall in prices and
wages.
Firms and workers are
forced off DL and SL.
Falling prices cause a
higher value of money
balances, increasing wealth
and shifting the IS curve
back to the right through
higher consumption and
investment spending.
Full employment is
restored.
Pigou Effect



Patinkin’s argument concerning the “real balance
effect” indirectly revives the Pigou effect argument.
Pigou had argued that reduced prices increase
wealth and increase AD, so that the Keynes Effect
of a shifting LM curve was accompanied by a
shifting IS curve to restore full employment, and
that even if the Keynes Effect was inoperative,
wealth effects restore equilibrium.
Harry Johnson: “The Pigou effect finally disposes of
the Keynesian contention that underemployment
equilibrium does not depend upon the assumption
of wage rigidity. It does.”
Criticisms of Pigou Effect




Falling prices might lead to expectations of
further declines in prices, postponing
consumption and delaying return to full
employment.
Falling prices might lead to firms delaying
investment, believing recession will
continue, and delay return to full
employment.
How does Pigou effect change wealth?
Currency (outside money), Bank credit
(inside money), government bonds?
Empirical evidence for Pigou effect is weak.
The Neoclassical Synthesis



By mid-1960s, economists widely accepted
the “neoclassical synthesis.”
Keynes was wrong in terms of theory.
Keynesian economics was a special case of
the more general classical theory (wage
rigidity).
Keynes was right in terms of policy.
Slow Keynes and Pigou effect adjustments
mean that activist government policy is
necessary.
Open Economy
IS-LM
Open Economy


Late 1950s and early 1960s saw
increasingly liberalized (freer) trade and
capital movements
IS/LM extended to cover open economies




E = Y = C + I + G + (X-Im)
Exports (X) and Imports (Im)
Mundell, “Capital Mobility and Stabilization
Policy under Fixed and Flexible Exchange
Rates, Canadian Journal of Economics and
Political Science (Nov. 1963)
Fleming, “Domestic Financial Policies under
Fixed and under Floating Exchange Rates,”
IMF Staff Papers (Nov. 1962)
Open Economy IS




E = Y = C + I + G + (X-Im)
Exports (X) and Imports (Im)
X = h(YW, ePD/PF, z)
Im = j(Y, ePD/PF, z )
where
YW = world income, e = exchange rate,
PD = domestic price level, PF = foreign
price level, and z = vector of other
determinants (tastes, quality, delivery
dates, etc.)
Net exports (X-Im) rise as world income increases,
domestic income falls, exchange rate falls, domestic
price level falls or foreign price level rises.
Balance of Payments

Balance of Payments - payments that flow
between a country and the rest of the world.
It is determined by a country’s exports and
imports of goods and services and the flow
of financial capital and transfers.


Current account records transfers of goods and
services.
Capital account (broad) accounts for capital
transfers, trade of nonfinancial assets and
financial assets and liabilities


Financial account v. capital account (narrow)
X + Ki = Im + Ko
or
(X – Im) = Ko - Ki
(X – Im) + (Ki - Ko) = 0
Balance of Payments
Definitions

Balance of Payments Surplus :


Payments made by a country are less than
payments received a the country
Generally occurs when a trade surplus exists


Exports > Imports
Balance of Payments Deficit :


Payments made by a country are greater than the
payments received by a country
Generally occurs when a trade deficit occurs

Exports < Imports
Open Economy LM

Fixed exchange rate regime




Central bank committed to buy and sell foreign
exchange for domestic currency at a fixed rate
BP surplus leads to central bank buying foreign
currency – increasing domestic Ms (LM shifts
right)
BP deficit leads to central bank selling foreign
currency – decreasing domestic Ms (LM shifts left)
Floating exchange rate regime

Exchange rate adjusts to clear foreign exchange
market – balance payments always zero
BP Curve

r
BP

The locus of all r,Y
combinations that yield
a balance of payments
equilibrium.
Positively sloped

Y

Increases in Y that
worsen current account
have to be accompanied
by increases in r to
improve the capital
account
Points above BP curve are
BP surplus, points below
BP curve are BP deficit
BP Curve

BPimmobile
r
BP
BPmobile

Y 
Slope depends on
marginal propensity to
import and interest
elasticity of international
capital flows
BP curve is flatter the
smaller the marginal
propensity to import and
the more interest-elastic
are capital flows
Limiting cases


Complete capital
immobility
Perfect capital mobility
BP Curve
r
BP0
BP1
Y
The BP curve shifts to
the right if net
exports increase
Net exports increase if
world income
exchange rate
domestic prices
foreign prices
Mundell-Fleming Model
LM0
r
BP0
IS0
LM curve typically steeper
than BP curve (capital
flows more interest
elastic than the demand
for money).
What is effect of monetary
and fiscal policy under
different exchange rate
Y
regimes?
Mundell-Fleming Model
LM0
r
B
r1
r0
C
A
IS0
Y0
Fixed Exchange Rate
Regime
LM1
BP0
Y1
IS1
Y
Begin in equilibrium, r0,Y0
Expansionary fiscal policy shifts
IS to right
Move from A to B
Balance of payments surplus
Central bank must expand MS
to maintain fixed exchange
rate
Long-run equilibrium occurs at
C
Mundell-Fleming Model
LM0
r
Fixed Exchange Rate
Regime
LM1
B
r0
A
C
IS0
Y0
Y1
In extreme case of perfect
capital mobility,
interest rates would not
rise and fiscal policy
becomes fully effective
BP0
IS1
Y
Mundell-Fleming Model
Fixed Exchange Rate
Regime
LM0
r
BP0
LM1
r0
A
C
B
IS0
Y0
Y
Begin in equilibrium, r0,Y0
Expansionary monetary policy
shifts LM to right
Move from A to B
Balance of payments deficit
Central bank must reduce MS to
maintain fixed exchange rate
Long-run equilibrium occurs at C
Monetary policy is ineffective
regardless of capital mobility
Mundell-Fleming Model
Flexible Exchange Rate
Regime
LM0
r
BP1
BP0
B
r1
r0
A
C
IS1
IS0
Y0 Y1
IS2
Y
Begin in equilibrium, r0,Y0
Expansionary fiscal policy shifts
IS to right
Move from A to B
Balance of payments surplus
causes exchange rate to rise,
shifting BP curve to left
IS curve also shifts to left as net
exports decline
Long-run equilibrium occurs at C
Fiscal policy is less robust under
flexible exchange rates
Mundell-Fleming Model
Flexible Exchange Rate
Regime
LM0
r
B
r0
BP0
A
C
IS0
Y0
IS1
Y
In extreme case of perfect
capital mobility,
interest rates would not
rise and fiscal policy
becomes fully
ineffective
Mundell-Fleming Model
Flexible Exchange Rate
Regime
LM0
r
r1
r0
LM1
A
BP0
BP1
C
B
IS1
IS0
Y0
Y1
Y
Begin in equilibrium, r0,Y0
Expansionary monetary policy
shifts LM to right
Move from A to B
Balance of payments deficit
causes exchange rate to fall,
shifting BP to right
IS curve shifts to right as net
exports rise
Long-run equilibrium occurs at C
Monetary policy is more effective
than fiscal policy
Mundell-Fleming Model
LM0
LM1
r
Flexible Exchange Rate
Regime
B
r0
BP0
A
C
IS0
Y0
Y1
IS1
Y
In extreme case of perfect
capital mobility,
interest rates would not
rise and monetary
policy becomes fully
effective
The Phillips Curve
Original Phillips Curve

Phillips, “The Relation Between
Unemployment and the Rate of Change of
Money Wage Rates in the United Kingdom,
1861-1957,” Economica (Nov. 1958)


Fisher, “I Discovered the Phillips Curve,” Journal
of Political Economy, (March/April 1973) [1926]
Phillips found an inverse relationship
between unemployment and the rate of
change of money wages

Data for 1948-1957 fit closely the earlier period
1861-1913
Original Phillips Curve

dW

2%
2.5%
5.5%
PC
U

Phillips’ discovered
relationship suggested a
long-run trade-off between
money-wage inflation and
unemployment
Implied permanently low
levels of unemployment
could be achieved by
tolerating permanently high
levels of inflation
Provided explanation of
inflation missing in IS-LM
model
Development of Phillips Curve
Empirical front
Search for stable
relationship in other
countries
dW

2%
2.5%
5.5%
PC
U
Samuelson and Solow,
“Analytical Aspects of
Anti-Inflation Policy,”
AER (May 1960)
Development of Phillips Curve
Theoretical front
Development of
theoretical grounds
dW

2%
2.5%
5.5%
PC
U
“The Relationship
Between
Unemployment and
the Rate of Change of
Money Wage Rates in
the U.K. 1862-1957: A
Further Analysis,”
Economica (Feb. 1960)
Theoretical Grounding

Lipsey argued:
there exists a positive linear relationship
between dW and ED for labor
 there exists a negative non-linear
relationship between EDL and
unemployment rate
 assumes the time it takes to move from
disequilibrium to equilibrium wage the
same regardless of size of EDL


therefore lower initial W, the higher the dW
Theoretical Grounding
W
We
W1
W2
SL
EDL
a
a
b
b
DL
L
dW
e
dW2
ESL
dW1
a
b
(DL – SL)/ DL
U
Linking to IS-LM
r
C
LM1
LM0

B
A
IS
YF Y1
Y
IS1



dP


dP1
B
A
YFC Y1
Y
The level of output depends
on the level of employment
and prices set as mark-up over
wage costs
U = g(L); Y = f(L)
dP = dW – productivity growth
Begin at full employment and
zero inflation (A)
Increase in AD shifts IS curve
to the right, price inflation of
dP1 occurs (B)
As prices increase real money
supply falls, shifting LM to left
until full employment is
restored (C)
Orthodox
Keynesianism
Central Propositions


First Proposition: Modern capitalism
subject to periodic recessions caused
by deficiency of aggregate demand.
Recessions are undesirable departures
from full employment.
Second Proposition: The economy can
be in one of two situations – a
demand-constrained Keynesian regime
or a full-employment supplyconstrained classical regime.



Third Proposition: Unemployment of
labor is a major feature of a Keynesian
regime and unemployment is
involuntary.
Fourth Proposition: Deviations from
full employment need to be corrected,
can be corrected and therefore should
be corrected.
Fifth Proposition: In modern
capitalism, wages and prices are not
perfectly flexible; changes in AD will
have real effects on output and
employment.


Sixth Proposition: Business cycles are
asymmetrical fluctuations around
trend long-run full-employment
growth.
Seventh Proposition: Policy-makers
face a non-linear tradeoff between
inflation and unemployment.


Eighth Proposition: Some Keynesians
favor the use of incomes policies
(wage and price controls) to help
guide the economy to full employment
and price stability.
Ninth Proposition: Keynesian
economics is an economics of the
short-run; it does not apply to longrun growth and development (though
it is recognized some policies can be
more favorable to long run growth).
Algebraic
Summary of Basic
IS-LM Model
Algebra of the
Basic IS-LM Model
E = A + cY – ar
E=Y
Md/P = mY – br
Md/P = M/P
Rearranging and solving for Y yields:
Y=
A
+
1 – [c – (a/b)m]
M/P
m + (b/a)(1-c)
As a → 0 and b →∞
Y = [A / (1-c )] + [(M/P) / ∞] = A / (1-c)
Y
Y
Y
Y
= A + cY – ar
– cY = A – ar
(1-c) = A – ar
= (A – ar)/(1-c)
M/P = mY - br
let Z = M/P
mY – Z = br
(mY - Z)/b = r
Substitute the value of r from the right-side into the left-side equation
Y = A – a[(mY - Z)/b] / (1-c)
Multiply both top and bottom by b
Y = (bA – amY + aZ) / b(1-c)
Multiply both sides by b(1-c)
b(1-c)Y = bA – amY + aZ
Collect Y
b(1-c)Y + amY = bA + aZ
Factor out Y
Y [b(1-c) + am] = bA + aZ
Divide both sides by b(1-c) + am
Y = bA/[b(1-c) + am] + aZ/[b(1-c) + am]
Y = bA/[b(1-c) + am] + aZ/[b(1-c) + am]
Factor out b from 1st term on right and factor out a from 2nd
term on right
Y = {bA/b[(1 – c) + (a/b)m]} + {aZ/a[(b/a)(1-c) + m]
Cancel
Y = A/[(1 – c) + (a/b)m] + Z/[(b/a)(1-c) + m]
Rearrange
Y = A/[1 – (c – (a/b)m] + Z/[m + (b/a)(1-c)]
Replace Z with M/P
Y=
A
1 – [c – (a/b)m]
+
M/P
m + (b/a)(1-c)