Transcript Document

ISLM Analysis
Part I: The Real Sector
The Keynesian Framework
According to John Hicks and Alvin Hansen
Roger W. Garrison
2008
S
S
(1 – b)
1
1
-a
1
Y
i
I
I
According
Macroeconomic
In Keynes’s
to vision,
Keynes,
equilibrium
investment
savingfor
depends
adepends
whollyupon
private
primarily
income
economy
onand
“animal
income
requires
spirts.”
alone.
that saving
equal
investment.
I”only
is antoaequilibrium
In
But
particular,
investment
S =also
– aThat
+depends,
(1is,– “S
b)Y,=ifwhere
a> minor
0 and extent,
0 <condition.
b <on
1. the rate of interest.
The demand for investment funds in highly interest inelastic.
With “animal spirits” in play, the whole curve moves around on its own.
Suppose the interest
rate is relatively low.
S
borrowing
income
is
How much saving
and investment
would
required
people
to finance
have
would
this
to
the business
earn
to
willing
community
to
level
of be
investment?
save
this amount?
be willing
to undertake? i
S
Y
i
I
So, now we have one
possible combination
of the interest rate
iLOW
and total income.
Y
I
So far, we have one equilibrium condition (in orange) and two behavioral
relationships (in blue). Together, these three relationships imply a particular
relationship between the interest rate and the economy’s total income.
This relationship is revealed by tracing out the implications of a low interest
rate, a high interest rate, and a middling interest rate.
Suppose the interest
rate is relatively high.
S
incomeis
borrowing
How much saving
would
and
required
investment
people
to finance
have
would
this
to
earnbusiness
the
to
willing
community
to
level
of be
investment?
save
be
willing
this amount?
to undertake? i
iHIGH
Now we have
another possible
combination of the
iLOW
interest rate and
total income.
S
Y
Y
i
I
I
So far, we have one equilibrium condition (in orange) and two behavioral
relationships (in blue). Together, these three relationships imply a particular
relationship between the interest rate and the economy’s total income.
This relationship is revealed by tracing out the implications of a low interest
rate, a high interest rate, and a middling interest rate.
Suppose the interest
rate is a middling rate.
S
borrowing
saving
is
How much income
and investment
required
would
people
to finance
have
would
this
to
the business
earn
to
willing
community
to
level
of be
investment?
be willing
save
this amount?
to undertake? i
Now we have a third iHIGH
possible combination i
MID
of the interest rate
iLOW
and total income.
S
Y
i
I
IS
Y
I
Soline
A
far,passing
we havethrough
one equilibrium
these three
condition
points (two
(in orange)
would have
and two
been
behavioral
enough)
represents all(in
relationships
combinations
blue). Together,
of thethese
interest
three
rate
relationships
and total income
imply athat
particular
are
consistent with
the equality
of investment
saving, given
theincome.
relationships
relationship
between
the interest
rate and and
the economy’s
total
that
investment
behavior
and saving
This describe
relationship
is revealed
by tracing
out thebehavior.
implications of a low interest
rate,
a high interest
andthe
a middling
rate.this curve, I = S.)
Accordingly,
we call rate,
this line
IS curve.interest
(All along
S
If the middling rate of
interest just happens to
be the equilibrium rate, Seq
the level of total income
that corresponds to that
rate is the equilibrium
i
level of income.
iHIGH
Equilibrium levels of
ii
saving and investment MIDeq
are similarly identified. iLOW
S
Y
I
i
IS
Yeq Y
Ieq
I
WARNING: “Equilibrium” in income-expenditure analysis means only that
income gets spent---or, equivalently (for a wholly private economy), saving
gets invested. It does not mean that the work force is fully employed or that
the economy’s potential output is being realized. Keynes believed that some
“unemployment equilibrium” was the norm for a wholly private economy.
If the income-expenditure S
equilibrium just happens
to be consistent with full Seq
employment, then the
labor force will be
experiencing a supplyi
and-demand equilibrium.
Keynes
But
Keynes’s
assumed
supplythat
ieq
and-demandinreckoning
movements
total
of the labor
income
faithfully
market
reflect
differs
the
movements
importantly
in from
the
AlfredofMarshall’s.
level
employment.
S
W
S
Y
i
LABOR
INCOME
D
I
N
IS
Yeq Y
Ieq
I
Wholly dismissive
Marshall
would observe
of the that
classical
the wage
economists’
rate hastheorizing
adjusted to
about
the prevailing
the distribution
supply-and-demand
of
income among thefor
factors
labor.of production, Keynes assumed a “fixed structure
Keynes
of
industry”
would
whose
observe
levelthat,
of utilization
give the varies
supplydirectly
of laborwith
andthe
theemployment
going wage of
rate,
the current
labor.
And with
levelthe
of wage
expenditures
rate given,
justchanges
happensintototal
be high
income
enough
are directly
to cause the
resulting demand
proportional
to changes
for labor
in the
to clear
employment
the laborofmarket.
labor.
According to Keynes, the S
demand for investment
funds is subject to a
Seq
sudden, unpredictable S'eq
collapse. The collapse
(the leftward shift in the
i
demand curve) upsets
both the labor market’s
supply-and-demand
ieq
equilibrium and the
macroeconomy’s incomeexpenditure equilibrium.
S
(1 – b)
W
ΔI
1
S
Y
ΔY
i
1
ΔY = (1 – b) ΔI
D
I
N
ΔI
IS
Y'eq Yeq Y
I'eq Ieq
I
The
magnitude
shift
in thebehavior,
ISincurve
is aIS
multiple
of thetomagnitude
With
thewe
change
inthe
investment
the
curveashifts
the left. of
Finally,
note of
that
the
decrease
income
reflects
corresponding
the
shift
ininthe
demand
Here,
thewage
simple
decrease
theexperiences
demandforforinvestment
And funds.
with
the
going
rate
persisting,
The
economy
alabor.
downturn
in which
lower
levels
of Keynesian
income,
multiplier
is in
play.
Andare
note
thata with
an unchanged
rate of
interest, the
the
labor market
is experiencing
persistent
(Marshallian)
disequilibrium.
investment,
and
saving
established.
equilibrium
level
ofitincome
also changes
in accordance with the simple
Keynes
would
call
“unemployment
equilibrium.”
Note that the interest rate, If only by assumption, remains unchanged.
Keynesian multiplier.
S
According to Keynes,
people’s saving behavior
is unlikely to change.
Seq
And fortunately so. In the
Keynesian framework,
increased saving has bad
i
consequences.
A decision to save more
ieq
is represented by an
upward shift in the saving
function.
S
ΔThrift
W
S
Y
ΔY
i
−1
ΔY = (1 – b) ΔThrift
D
I
N
IS
Y'eqYeq Y
Ieq
I
Finally,
IfThe
thegreater
oldweequilibrium
note
volume
that of
the
rate
saving
decrease
of interest
would
instill
be
income
borrowed
prevails,
reflects
then
by athe
the
corresponding
business
economy’s
community
reaction
only
decrease
if the in
rate
the
ofdemand
interest
for
were
labor.
lower.
As happened in the case of a fall in
to increased
saving
is a fall
income.
investment
an increase
in thriftrelationship
reduces
spending
causes
thethe
IfAnd
wewhatever
call andemand,
upward
the eventual
shift
of consequences
the saving
of the increased
a changeand
saving,
in thrift,
thethen
old
IS
labor
toshift
experience
persistent
(Marshallian)
corresponding
in theThe
ISacurve
is given
multiplier---which is
curve market
is no longer
valid.
new
one
lies
tobyitsthe
left.thriftdisequilibrium.
simply the negative of the spending multiplier. (Thrift means not spending.)
ISLM Analysis
Part II: The Monetary Sector
The Keynesian Framework
According to John Hicks and Alvin Hansen
Roger W. Garrison
2008
Keynes had once considered himself to be a “classical” economist.
With Marshall, he believed that
1. the interest rate is determined in the loanable-funds market
and 2. money is to be analyzed in terms of the equation of exchange.
He later concluded that the interest rate wasn’t
doing its job—because saving was not affected by
the interest rate and investment was governed
exclusively (or, at least, primarily) by psychological
factors.
He also concluded that the equation of exchange
should be jettisoned (or, at least, should have
greatly diminished significance)—because it stood
in the way of our recognizing the impact that
monetary disturbances can have on the economy’s
real sector.
Keynes had once considered himself to be a “classical” economist.
With Marshall, he believed that
1. the interest rate is determined in the loanable-funds market
and 2. money is to be analyzed in terms of the equation of exchange.
Keynes was left with puzzles:
1. What job is the interest rate doing?
and 2. What replaces the equation of exchange?
Keynes’s then had s Road to Damascus conversion:
There is a single answer to both questions:
The supply and demand for money are brought into
balance by adjustments in the interest rate!
According to Keynes, the interest rate has little or
no influence on people’s willingness to save. But it
has a great influence, he claims, on the preferred
KEYNES’S LIQUIDITY-PREFERENCE THEORY OF INTEREST
form of saving. Do people put their savings at
interest (e.g. by buying bonds) or do they keep
their savings liquid (by holding money)?
Income alone determines consumption behavior.
Then, the interest rate (or rather, the expected
direction of movement in the interest rate) affects
the relative attractiveness of money and bonds.
Y
C = a + bY
B (if i is expected to fall)
S = -a + (1-b)Y
M (if i is expected to rise)
Suppose that a Railroad issues a 6%,
30 year, $1,000 bond in 1872.
The bond, which sells for $1,000, has
60 coupons attached, These coupons
are redeemable for $30 each at sixmonth intervals.
When the last coupon is redeemed, the
$1,000 is returned to the bond holder.
$30
$30
$30
$30
$30
$30
$30
$30
$30
$30
$30
$30
So, the buyer pays $1,000 in 1872.
$30
$30
$30
$30
$30
$30
He gets back $1,000 in 1902.
$30
$30
$30
$30
$30
$30
$30
$30
$30
$30
$30
$30
And he gets $30 biannually for 30 years.
$30
$30
$30
$30
$30
$30
He can sell the bond any time he wants.
$30
$30
$30
$30
$30
$30
$30
$30
$30
$30
$30
$30
$30
$30
$30
$30
$30
$30
$30
$30
$30
$30
$30
$30
But the selling price might be less than,
more than, or equal to $1,000. How so?
Suppose that a few years after you
bought this bond, market rates of
interest are significantly higher
lower than
than6%.
6%.
At that point, someone
the $1,000-bond
might be
rate
able
might
to
be asa 9%
buy
low bond
as 4%orora 3%.
12%These
bond. bonds
These
would have
$1,000
bonds
a six-month
would have
coupon
a coupon
value of
$20 orof$15,
value
$45respectively.
and $60, respectively.
You could still
easily
sellsell
your
your
6%6%
bond,
bond,
butand
you would have
be able
to offer
to sellit itatata aprice
price
considerably less
higher
than
than
$1,000.
$1,000.
From a 1993 OECD OUTLOOK:
In the United States, long-term
railroad-bond yields fell gradually
from about 5 per cent in 1880 to 4 per
cent at the turn of the century then
rose slightly.
$30
$30
$30
$30
$30
$30
$30
$30
$30
$30
$30
$30
$30
$30
$30
$30
$30
$30
$30
$30
$30
$30
$30
$30
$30
$30
$30
$30
$30
$30
$30
$30
$30
$30
$30
$30
$30
$30
$30
$30
$30
$30
$30
$30
$30
$30
$30
$30
$30
$30
$30
$30
$30
$30
$30
$30
$30
$30
$30
$30
Keynes portrayed each saver as facing a
choice between holding his savings liquid
or holding long-term bonds. The savers’
preferences in this regard determine both
the demand for money (liquidity) and the
demand for earning assets (bonds).
i
The choices (between money and bonds)
hinge critically on beliefs about future
movements in the interest rate.
MSPEC
In this connection, the demand for money
is a speculative demand (MSPEC) whose
magnitude is related, if only loosely, to
the current rate of interest.
If a high current rate of interest implies
that rates are likely to fall and a low
current rate implies that they are likely to
rise, then we get a downward-sloping
demand for speculative money holdings.
Keynes believed that the demand for
money holdings, i.e., for liquidity, is fairly
interest-rate elastic.
i
MSPEC
If the current rate is sufficiently high, savers
will lock themselves into high long-term
bond rate and there will be no speculative
holdings of money.
If the current rate is sufficiently low, savers
will abstain from buying bonds and will hold
all their savings liquid. The elasticity of
money demand becomes infinite.
The speculative demand for money is
unique to Keynesian macroeconomics
and, according to some, is the sine qua
non of Keynesianism.
CLASSICAL
REGION
This special demand curve is non-linear
and has three identifiable regions:
i
EXTREME
KEYNESIAN
REGION
MSPEC
In the
At
rates
“intermediate
of interest soregion,”
highthat
low
that
thevirtually
virtually
quantityno
noof
one believes
money
holdings
theydemanded
are likely to
varies
go still
inversely
lower,
higher,
the
with
speculative
thethe
ratespeculative
of interest.
demanddemand
for money
for money
is perfectlyperfectly
becomes
inelasticelastic.
and isInco-incident
this “extreme
with
the vertical region,”
Keynesian
axis. This
allisadditions
the “classical
to the
region,”supply
money
so named
are simply
because
hoarded.
in the classical
theory, there is no speculative demand for
money.
Complicating matters, the demand for
money holdings, like the demand for
investment funds, is unstable. While
investment is governed by “animal
spirits,” hoarding money is rooted in a
“fetish of liquidity.”
i
MSPEC
Expectations about which direction the
interest rate is likely to move are not at all
well-founded. The shifting and drifting
expectational winds can send the
demand for money holdings right and left
or up and down.
If the demand for money holdings stays
put for the time being, we can note the
inverse relationship between the interest
rate and the demand for money holdings.
i
To determine the particular rate of
interest that actually prevails, we take
into account the money supply, which is
set by the central bank.
MS
ieq
MSPEC
The rate of interest adjusts to its
equilibrium value (ieq), where the
preferred level of money holdings is
equal to the money supply.
This the hard-drawn Keynesian view,
where “forces of a different kind” (and not
the loanable-funds market) determine the
market-clearing rate of interest.
If the demand for money holdings stays
put for the time being, we can note the
inverse relationship between the interest
According
Keynes:
rate and the demand
for to
money
holdings.
i
“Theparticular
interest rate
To determine the
rate is
of what it
is because
it is expected
interest that actually
prevails,
we take to
be other than what it is. If it
into account the
money supply, which is
isn’t expected to be other
set by the central
thanbank.
what it is, there is
MS
ieq
MSPEC
nothing
to tellto
usitswhy it is
The rate of interest
adjusts
what it is. The organ that
equilibrium value
(ieq), where
the
secretes
it has been
preferred levelamputated
of money holdings
and yet is
somehow
it still exists, the
to the money
supply.
Dennisequal
Robertson
(1890−1963)
grin without the cat.”
This the hard-drawn Keynesian view,
where “forces of a different kind” (and not
the loanable-funds market) determine the
market-clearing rate of interest.
Suppose that people’s propensity to
hoard strengthens—meaning that their
demand for money to hold increases.
i
Note that the increased demand is not
automatically accommodated by an
increase in the money supply. Instead, the
rate of interest rises until people are
content to hold the existing money supply.
MS
i’eq
ieq
MSPEC
However, if the central bank wants to reestablish the pre-existing rate of interest,
it can increase the money supply, moving
the money holders along their moneydemand curves.
i
ieq
With an economy performing at fullemployment without inflation, Keynes
argued that changes in money demand be
accommodated by corresponding changes
in the money supply. He did not want
increased money demand to be choked off
by an increase in the rate of interest.
MS
MS
MSPEC
If the central bank could synchronize
movements in the money supply with
movements in money demand, the
interest rate would not need to change.
Note that successful synchronization
effectively transforms a perfectly inelastic
money supply into a perfectly elastic
money supply.
So, why does it matter
that the interest rate
increases with a
strengthening of
hoarding propensities?
i
S
S
Seq
W
S
Y
MS
i’eq
ieq
MSPEC
It matters because a
change in the interest
rate has an impact on
the real sector of the
economy.
D
I
i
i
N
1
Suppose the economy
is
ΔI in an incomeΔY =
(1 – b)
expenditure equilibrium and is performing at full
ieqemployment without inflation. That is, labor
IS enough to clear the labor
demand isΔYjust strong
ΔI
market at the going wage
Ieq
Yeq Y
I
An increase in money demand raises the rate of
interest and takes this fully-employed economy
into recession.
An accommodating increase in the money supply
undoes the damage.
S
S
Seq
i
ieq
i
MS
MS
MSPEC
ieq
Y
I
i
IS
Yeq Y
Ieq
I
People
behave fetishistically
money,
By
continuously
manipulatingtoward
the money
supply
sometimes
wanting
to hoard
If thechanging,
central bank
so
as to keep
the interest
rateit.from
the
matchesbank
theircan
hoarding
propensities
by supplying
central
nip in the
bud any recession
(or
additionalthat
quantities
of money,be
theassociated
economy will
inflation)
would otherwise
with
be spared
from
spiraling
depression.
the
unstable
demand
for into
money.
S
S
Seq
W
S
i
i
MS
ieq
ieq
MSPEC
Y
i
D
I
N
IS
Yeq Y
Ieq
I
We begin again with the economy in an incomeexpenditure equilibrium and performing at full
employment without inflation. We assume away
the problem of hoarding and show how monetary
policy can counter a waning of animal spirits.
S
Suppose the animal
spirits are on the wane,
causing investors to cut Seq
back on their borrowing S'eq
of investment funds.
i
i
MS
ieq
ieq
MSPEC
S
W
W
S
Y
ΔY
i
1
ΔY = (1 – b) ΔI
S
D D
I
N
ΔI N
IS
Y'eq Yeq Y
I'eq Ieq
I
In
The
themagnitude
absence
any
the
shift
fiscal-policy
in the
IS
levers,
curvethe
is
theaISrecession
multiple
ofcan
thetobe
magnitude
countered
of by
With
the
change
investment
behavior,
curve
shifts
the
left.
Finally,
note
thatofin
the
decrease
in
income
reflects
a corresponding
decrease
the
monetary
shift
inpolicy.
the has
demand
for
strictly
investment
funds.
by the
Here,
shape
the
ofpersisting,
simple
thelevels
demand
Keynesian
for
in the
demand
forThough
labor.
And
withalimited
the going
wage
rate
theincome,
labor
The
economy
experienced
downturn
in
which
lower
of
money,
increase
in the
money
lowerdisequilibrium.
therate
rateofofinterest,
interest
and
multiplier
in
play.
And
note
that supply
with
ancan
unchanged
the
market
isanis
experiencing
aare
persistent
(Marshallian)
Keynes
investment,
and
saving
established.
move
the
economy
down along
the
IS curve.
equilibrium
level
of income
also
changes
in accordance with the simple
would
call
it
“unemployment
equilibrium.”
Note that the interest rate, which continues to match the money supply to the
Keynesian multiplier.
speculative demand for money, remains unchanged.
The classical
Keynes’s
hard-drawn
economists
version
wrote:
of the
monetary sector gives no play to the
MV = PQ, where Q also represents
equation of exchange. The whole
real income—i.e., Q = Y/P.
story is about the supply of money
and theQ speculative
Since
= Y/P, then demand
PQ = Y. for
money. The interest rate, which
So, we can write MV = Y, which
balances supply against demand is
applies, Keynes insisted, only to the
a purely monetary phenomenon.
transactions demand for money.
Keynes
But
Keynes
recognized
did recognize
that theanother
component ofvelocity
transactions
the demand
of money,
for like
money.
the
velocity
The of
transactions
money in the
demand
for moneyformulation,
classical
(MT) depends
is fairly
primarily
on income
stable.
VT isand
more
notorsoless
much
constant.
on the
interest rate. It is this component
This means that MT is linearly
(MTRANS—or simply MT) that can be
related to Y. MT = Y/ VT graphs as
analyzed in terms of the equation
a straight line that emanates from
of exchange.
the origin and has a slope of 1/VT.
And so, MTVT = Y or MT = Y/VT
MT
1
VT
Y
MT is one component of the demand for money.
The other component is MSPEC.
The monetary sector is in
equilibrium when money
Keynes took the two components to be additive. supply equals money
That is, the total demand for money (MD) is equal demand.
to MSPEC plus MT. [Or simply: MD = MSPEC + MT]
Simply written: MS = MD.
i
So, MS = MSPEC + MT,
where MS is controlled by
the central bank.
MSPEC
MT
MS
This equilibrium condition
graphs as a straight line
with a vertical intercept of
MS, a horizontal intercept
of MS and a slope of
negative one.
MT
1
1
S
MSPEC
Y
The two (additive) demands for money
together with the equilibrium condition imply
possible combinations of income and the
interest rate that are consistent with
equilibrium in the monetary sector.
i
MT
i
MSPEC
MSPEC
MT
LM
Y
Y
The line connecting the
possible equilibrium points
is named the LM curve—
with L (liquidity)
representing the demand
for money and M
representing the money
supply.
The two (additive) demands for money
together with the equilibrium condition imply
possible combinations of income and the
interest rate that are consistent with
equilibrium in the monetary sector.
i
MT
i
MSPEC
MSPEC
MT
LM
Y
Y
The line connecting the
possible equilibrium points
is named the LM curve—
with L (liquidity)
representing the demand
for money and M
representing the money
supply.
S
The Keynesian Framework
According to John Hicks
and Alvin Hansen
S
Seq
W
S
i
i
ieq
ieq
MT
MSPEC
MT
Y
LM
i
LABOR
INCOME
D
I
N
IS
Yeq Y
Ieq
I
This is the Hicks-Hansen, fixed-price,
eight-quadrant diagrammatical
exposition of Keynesian
Macroeconomics.
MSPEC
Y
ISLM Analysis
Part I: The Real Sector
The Keynesian Framework
According to John Hicks and Alvin Hansen
Roger W. Garrison
2008