text book name here mitchell and wray 2013 16 the is-lm...

Text Book Name Here Mitchell and Wray 2013

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16 The IS-LM Analysis

Chapter Outline 16.1 Introduction to The Concept of Equilibrium

16.2 The Money Market – Demand, Supply and Equilibrium

16.3 Derivation of LM Curve

16.4 The Product Market – Equilibrium Output

16.5 Derivation of IS Curve

16.6 Policy Analysis in IS-LM Framework

16.7 Introducing the Price Level – The Keynes and Pigou Effect

16.8 Why We Do Not Use The IS-LM Framework

16.8 Limitations of IS-LM Analysis

This Chapter is about IS-LM analysis, a framework we also reject outright. However, during the current crisis, it has been used by notable economists who have held it out as an approach that still has relevance. In that vein we have decided to include it as a separate chapter even though, at first, we had excluded it from the book.

However, we don’t go the next step and derive and utilise the full AD-AS model that flows from the IS-LM approach and is the main organising framework for the orthodox exposition.


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16.1 Introduction to The Concept of Equilibrium

Soon after the publication of Keynes’s General Theory, British economist J.R. Hicks published an article that attempted to integrate the insights he felt were useful in the General Theory with those of the so-called “Classics” that Keynes had opposed. We discussed the debate between Keynes and the Classics in Chapter 15.

The so-called Neo-classical synthesis that emerged and dominated macroeconomic thinking, particularly the textbook expositions, was built on the work of J.R. Hicks and his IS-LM model (see box for more discussion).

The IS and LM curves are the equilibrium relationships pertaining, respectively, to the product (goods) market (investment = saving) and the money market (demand for money (liquidity preference) equals money supply).

The representation of the goods market equilibrium in terms of simple equality between investment and saving reflected the historical period that the model was developed – the simplifying assumption was that we would gain essential insights into income determination by assuming a closed economy without government.

The IS equation was subsequently extended to allow for the impact of governments and net exports on aggregate demand.

The income-expenditure model we considered in Chapter 12 allowed the interest rate to impact on investment and hence aggregate demand and output in the goods market. The interest rate was considered to be determined by the equality of money demand and supply in the money market.

The IS-LM approach thus was built on the interdependence of the equilibrium states in the two markets. The general IS-LM approach showed how the equilibrium solution for output (employment) and the interest rate was simultaneous. We needed to know what the interest rate was to solve the level of income and the level of income to solve the interest rate.

In an analytical sense, there were two unknowns – output and the interest rate – and two equations to allow us to solve the unknowns.

The IS-LM model is an early example of a general equilibrium model that remains fashionable in mainstream economics.


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16.2 The Money Market – Demand, Supply and Equilibrium


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16.3 Derivation of The LM Curve

We assume that the price level is constant. The IS-LM model allows us to introduce price level changes but at present we are operating in real terms.

Money market equilibrium requires that the demand for money equals the supply. We use the term money demand to refer to the willingness to hold cash balances as part of a wealth portfolio.

The demand for money – or as Keynes called it – the liquidity preference – is a function of the level of income and the interest rate.

Three motives have been identified for holding liquid balances (money) in preference to other assets:

Transactions Motive – people need money to engage in daily transactions. Thus the demand for liquidity will be some proportion of total national income.

Precautionary Motive – at times major events occur that need to be resolved through transactions – for example, maintaining a cash balance to pay for engine repairs on a car. This motive also tends to vary with national income as the higher is the level of economic activity, the higher are the overall transactions.

Speculative Motive – Keynes contribution, which we considered in Chapter 15 was to highlight that money is not simply a means of exchange. People used money in times of uncertainty over movements in interest rates. They have a choice between holding money which earns no interest return or purchasing an interest-bearing asset, which has less liquidity. Keynes juxtaposed the decision to hold money or bonds. If the interest rate is expected to rise, the price of bonds falls and capital losses would be expected. So at lower interest rates more people would prefer to hold money than take a chance that they would lose should they invest in bonds. Alternatively, if the interest rate falls, the price of bonds rises and capital gains would be enjoyed. At higher interest rates, more people will form the view that rates will fall rather than rise and the liquidity preference will be lower.

The other way of thinking about the impact of interest rates is to realise that the opportunity cost of holding money rises when interest rates are higher because holding money negates the alternative of holding an interest-earning asset.

Figure 16.1 shows the liquidity preference function for a range of income levels. The nominal rate of interest is on the vertical axis and the volume of money demand is on the horizontal axis.

The money demand curve (L) is downward sloping with respect to the interest rate and shifts outwards at higher income levels (Y1 < Y2).

The higher is the interest rate, the lower will be the demand for liquidity, other things equal. However, at any interest rate, the higher is the level of national income, the higher will be the demand for money.

The money demand curve is smooth and non-linear because of diversity of opinion. For example, as interest rates rise, wealth holders progressively form the view that they have reached their maximum. Eventually everybody adopts the same expectation.

The money supply (Ms) is assumed to be controlled by the central bank via the monetary base and the money multiplier determines the quantity of money supplied for a given base.

We can thus capture that assumption as a vertical line. The intersection of the money demand and money supply curves determines the interest rate.

This is faithful to Keynes departure from the Classics who considered the interest rate to mediate saving and investment (that is, a real variable). Keynes noted that the nominal interest rate was a monetary variable determined by the demand for liquidity and the supply of money available.


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Figure 16.1 Money Market Equilibrium

If the national income level was Y0 then the intersection of the relevant liquidity preference function and the money supply line would generate an interest rate of i0 – Point A.

What would happen if income rose to Y1?

At the current interest rate i0 there would now be an excess demand for liquidity (measured by the segment AB) and this would lead to the interest rate rising until the excess demand was eliminated at C (i1) given that the money supply would be fixed.

What would happen if the central bank increased the money supply?

Figure 16.2 shows the impact of an increase in the money supply from Ms1 to Ms1.

At national income level Y0 and Ms1, the interest rate is i0 and the money market is in equilibrium at Point A.

If the money supply rises to Ms2 then there is an excess supply of money at i0 (measured by the segment AB) and the interest rate would drop until is reached i2 – Point D, where the demand for money is again equal to the money supply.

You can also see that if we start at Point A and the national income level rose to Y1 the interest rate could be held constant at i0 if the central bank accommodates the increased demand for money at the higher income level by increasing the money supply to Ms2.

C

B A

L (i, Y0)

L (i, Y1) i0

i1

MS1

Money Demand (L) and Money Supply (Ms)

Interest Rate (i)


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Figure 16.2 The Impact of An Increase in The Money Supply From Ms1 to Ms2

We are now in a position to derive the LM curve which shows all combinations of income and interest rates that are consistent with money market equilibrium.

Figure 16.3 shows the derivation of the LM curve. From the money market diagram, the Points A, B and C represent equilibrium states where money demand equals money supply for different levels of income.

Each equilibrium point is thus a unique combination of income and interest rates.

We can translate this understanding to a new graph (right-hand panel) where national income (Y) is on the horizontal axis and the interest rate (i) is on the vertical axis.

If we trace the respective equilibrium points across into the income-interest space diagram we get a series of points that are consistent with money market equilibrium.

The intersection of all those points is the LM curve.

MS2

C

B A

L (i, Y0)

L (i, Y1) i0

i1

Interest Rate (i)

i2

MS1

D

Money Demand (L) and Money Supply (MS)


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Figure 16.3 The LM Curve

Advanced Material: John Hicks on His IS-LM Framework

John Richard Hicks – was a British economist who “invented” the IS-LM general equilibrium macroeconomic framework.

In his 1937 article published in Econometrica – Mr. Keynes and the “Classics”; A Suggested Interpretation – Hicks sought to provide an interpretation of Keynes’ General Theory within a single diagram – the IS-LL model. As the model became popularised and standard macroeconomic textbook fare, the terminology became IS-LM to describe the product market equilibrium (IS) and the money market equilibrium (LM).

The IS-LM model was designed to demonstrate how the determination of total real output was dependent on the interdependent outcomes in the product and money markets.

Hicks said he “invented a little apparatus” (the IS-LM framework) to bring together Keynesian and Classical economics into an integrated model.

By the 1970s, Hicks started to sign his academic papers John Hicks rather than J.R. Hicks, which reflected his growing sense of rejection of his earlier work.

In 1975, to formalise is transition away from his earlier views, he wrote (Page 365):

J.R. Hicks … [is] … a “neoclassical” economist now deceased … John Hicks … [is] … a non-neo-classic who is quite disrespectful towards his “uncle”.

The issue was that he began to realise that the static equilibrium IS-LM model left out the key contribution of Keynes – the importance of time and endemic uncertainty.

For example, in the IS-LM model the current flow of investment is meant to be sensitive to interest rate changes in the same period, which is one way in which the money market outcome influences the product market equilibrium. But investment in any period is largely pre-determined by decisions made in previous periods.

In 1980, Hicks wrote that he rejected the way in which is little apparatus had been deployed by economists and the policy interpretations they had drawn from it.

He said (1980: 139):

The IS-LM diagram, which is widely, but not universally accepted as a convenient synopsis of Keynesian theory, is a thing for which I cannot deny that I have some responsibility. It first saw the light in a paper of my own, “Mr. Keynes and the Classics” (1937) … I have, however, not concealed that, as time has gone on, I have myself become dissatisfied with it … [the] … diagram

Interest Rate (i)

Interest Rate (i)

Money Demand and Supply

Income (Y)

C

B

A A

B

C

Y2 Y1 Y0

i2 i2

i1 i1

i0 i0

L (i,Y2)

L (i,Y1)

L (i,Y0)

MS1 LM Curve


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is now much less popular with me than I think it still is with many other people …

By way of conclusion, he wrote (1980: 152-153):

I accordingly conclude that the only way in which IS-LM analysis usefully survives — as anything more than a classroom gadget, to be superseded, later on, by something better – is in application to a particular kind of causal analysis, where the use of equilibrium methods, even a drastic use of equilibrium methods, is not inappropriate. I have deliberately interpreted the equilibrium concept, to be used in such analysis, in a very stringent manner (some would say a pedantic manner) not because I want to tell the applied economist, who uses such methods, that he is in fact committing himself to anything which must appear to him to be so ridiculous, but because I want to ask him to try to assure himself that the divergences between reality and the theoretical model, which he is using to explain it, are no more than divergences which he is entitled to overlook. I am quite prepared to believe that there are cases where he is entitled to overlook them. But the issue is one which needs to be faced in each case.

When one turns to questions of policy, looking toward the future instead of the past, the use of equilibrium methods is still more suspect. For one cannot prescribe policy without considering at least the possibility that policy may be changed. There can be no change of policy if everything is to go on as expected-if the economy is to remain in what (however approximately) may be regarded as its existing equilibrium. It may be hoped that, after the change in policy, the economy will somehow, at some time in the future, settle into what may be regarded, in the same sense, as a new equilibrium; but there must necessarily be a stage before that equilibrium is reached. There must always be a problem of traverse. For the study of a traverse, one has to have recourse to sequential methods of one kind or another.

The last point was telling. While the intersection of given IS and LM curves might reflect conditions now, the other points on the respective curves are what John Hicks called “theoretical constructions” (1980: 149) and “surely do not represent, make no claim to represent, what actually happened”.

Note that at interest rate, i0, the LM curve is flat and becomes steeper at higher interest rates. What does that mean? The horizontal segment of the LM curve relates to the presence of the liquidity trap, which was named by English economist Dennis Robertson, who in the 1930s, worked closely with J.M. Keynes at Cambridge University.

The liquidity trap arises at some minimum interest rate (which could be zero) where everybody forms the view that the only direction for interest rates is up. The equivalent expectation is that everybody considers that capital losses will be incurred on bond portfolios because when interest rates rise, bond prices fall.

The result is that once interest rates reach this minimum level, all people will prefer to hold any new money in the form of cash instead of bonds.

In Chapter 15 of The General Theory of Employment, Interest and Money, Keynes said (1936: 207):

There is the possibility … 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 … 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.

As we will see when we consider policy analysis within the IS-LM framework, the existence of a liquidity trap renders monetary policy ineffective as a counter-stabilising tool.

Monetary policy is characterised in this framework as the central bank manipulating the money supply and when the interest rate is at i0 in Figure 16.3, increasing the money supply would have no impact on interest rates or the price of bonds. In other words, monetary policy changes cannot alter the level of national income.

In a liquidity trap, a rise in the money supply leads to an equal rise in the demand for money and as a result the interest rate does not change. We will consider this in more detail later in the Chapter.

The LM curve is upward sloping at higher levels of income because as national income rises, the demand for money increases and at each given money supply, the interest rate has to rise to ration the excess money demand and retain money market equilibrium.


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The slope of the LM curve is steeper:

§ The more sensitive the demand for money (transactions and precautionary motives) is to national income changes. Thus, small changes in national income lead to large changes in excess money demand at a given money supply level. The rise in interest rates to restore money market equilibrium, other things equal, has to be larger as a consequence.

§ The less sensitive the speculative demand for money is to changes in interest rates. Thus, for a given excess demand for money, the interest rate increase that is required to restore money market equilibrium is larger.

While the horizontal LM curve (liquidity trap case) is one extreme, the other extreme is sometimes referred to as the Classical Case, which describes a vertical LM curve.

The Classical case arises from a demand for money function which is not sensitive to the interest rate. In other words, money is considered to be a means of exchange only and the speculative demand for money (which renders the overall demand for money sensitive to interest rates) is ignored.

In these cases, the demand for money shifts outwards when income rises and inwards when it fall. As a consequence there is only one national income level consistent with money market equilibrium for a given money supply and the LM curve is vertical.

In the Appendix to this Chapter we derive an analytical solution to the IS-LM framework for advanced studies, which show the impact of these two sensitivities (elasticities).

Shifts in the LM curve arise from changes in the money supply. Refer back to Figure 16.2, which showed that for a given money demand curve, interest rates fall when the money supply rises. The reasoning was that at a given money market equilibrium combination of interest rates and income, a rise in the money supply generates an excess supply of money, which requires interest rates to fall to stimulate the demand for money sufficiently to absorb the extra money.

In terms of the LM curve, this means that at higher levels of money supply, equilibrium interest rates will be lower at each income level which translates into a shift outwards in the LM. The opposite occurs when the money supply falls.

The LM curve can also shift if there is an autonomous change in liquidity preference, which means the money demand rises (falls) at each income level depending on whether the preference for liquidity rises (falls).

For example, if people become more pessimistic about the future they may use increased cash holdings as a haven from uncertainty. This will lead to an outward shift in the money demand curve so that for a given money supply, interest rates will be higher at each income level.


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16.4 The Product Market – Equilibrium Output


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16.5 Derivation of The IS Curve

The IS curve shows all combinations of interest rates and income where the product (goods) market is in equilibrium. So unlike the simple income-expenditure model we developed in Chapter 12, the IS curve framework requires us to incorporate information about the money market (interest rates) in our understanding of equilibrium in the product market.

In Chapter 12 we developed the real expenditure model of income determination. From the National Accounting framework we know that total expenditure (E) in the domestic economy in any particular period can be expressed as:

(16.1) E = C + I + G + (X – M) Equation (16.1) is identical to Equation (12.2). As it stands, Equation (16.1) is an accounting statement by dint of the definitions and sources of aggregate spending.

The equilibrium level of national income (Y) is determined by aggregate expenditure, such that Y = E. The task of Chapter 12 was then to understand the behaviour of each of the expenditure components in Equation (16.1) and theorise how they interact to determine national income.

At that stage we assumed that firms in aggregate plan a fixed volume of investment spending in each period. We were concerned at that stage of the text in tracing out the implications of changes in autonomous (exogenous) components of expenditure (investment, government, exports etc) on national income via the multiplier process.

However, in Chapter 2, we develop a more detailed model of investment spending, which allows us to take into account the impact on capital formation of changes in interest rates.

As a preview, we assume that rather than being exogenous, total investment spending is influenced, in part, by expectations of future economic conditions and the interest rate.

Business firms are continually forming expectations about future output. Firms have to make resource commitments (working capital, labour etc) well in advance of realisation (sales) and so the scale of production at any point in time reflects the guesses they make in a highly uncertain world.

Further, for given expectations about future sales and revenue, a firm’s investment decisions will also be influenced by the cost of capital goods, which, in turn, will be affected by the interest rate.

If interest rates rise, the cost of funds necessary to invest in new capital equipment rises and so marginal projects (relative to expected revenue) may become unprofitable. In other words, investment is likely to be an inverse function of the interest rate, other things being equal.

In other words, we might hypothesise that total investment is given as:

(16.2) I = b1 – b2i where b1 is an autonomous component of investment and b2 is the interest-rate sensitivity of investment to interest rate changes.

The higher is b2, the more investment will decline (rise) for a given interest rate rise (fall).

The IS-LM framework retains the insight of Keynes that planned savings is a positive function of national income. A more detailed analysis of the General Theory would also reveal that Keynes considered that the interest rate might also influence consumption spending (via wealth impacts). Further, the purchase of consumer durables such as white goods, which might require access to consumer credit.

However, for now, to keep the argument simple, we assume that the interest rate only impacts on investment.

In Chapter 12 we assumed that firms in the economy are quantity-adjusters and so prices are fixed in the short-term. Figure 12.7 brought together the 45o aggregate supply curve with the aggregate demand curve (E). It showed that equilibrium national income occurs when the Aggregate Demand Function cuts the 45o line.

At this point, the aggregate demand expectations formed by the firms, which motivated their decisions to supply – Y* – are consistent with the planned expenditure – E* – by consumers, firms, government and the external economy.

Figure 16.4 augments Figure 12.7 by adding in the impact of Equation (16.2) – that is, allowing investment to be inversely impacted by interest rate changes.


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Figure 16.4 Product Market Equilibrium and Interest Rate Changes

The total expenditure curve, E = C + I + G + NX is drawn from a given interest rate. The lower the interest rate (i0 < i1), the higher in investment (and total spending) at all income levels. As a consequence, the total expenditure curve shifts upwards.

When interest rates rise, the total expenditure curve would shift downwards, other things equal.

Point A in Figure 16.4 shows the product market equilibrium associated with an interest rate of i0. So we know that the combination of income level, Y*0 and interest rate level, i0 is an equilibrium combination in the product market.

What happens if the interest rate was to rise to i1? Total investment would decline at all income levels and the total expenditure curve would shift downward from E0 to E1.

The excess supply at the prior income level leads firms to cut back output and employment and national income falls. A new product market equilibrium occurs when E*1 = Y*1.

So the combination of income level, Y*1 and interest rate level, i1 is an equilibrium combination in the product market.

We thus have two combinations of interest rates and income levels which are consistent with product market equilibrium. Clearly we could trace out the impact of many interest rate changes and thus many equilibrium combinations of interest rates and income.

The IS curve is the line that joins all the equilibrium combinations of interest rates and national income. Figure 16.5 shows this derivation.

A

B

Y*0 Y*1

E*1

E*0

National Income

E0 = C + I + G + NX, at i0

E1 = C + I + G + NX, at i1

Tota

l Exp

endi

ture


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Figure 16.5 The Derivation of The IS Curve

Point A is one product equilibrium where the interest rate is i0 and total expenditure is E0 generating total national income of Y0.

In the right-hand panel where the interest rate is on the vertical axis and national income is on the horizontal axis, point A shows the combination of the interest rate and income which produce the product market equilibrium shown in the left-hand pane.

If interest rates fell to i1, total expenditure rises to E1 as a result of the higher investment expenditure, which leads to a rise in national income via the expenditure multiplier. Point B shows the new product market equilibrium at (i1, Y1).

We could examine the impact of any number of interest rate changes on product market equilibrium in the left panel and subsequently map these points into the right panel. The result would be the IS curve.

The IS curve therefore is a series of points corresponding to equilibrium combinations of national income and interest rates in the product market.

It is clear that in the IS-LM framework, the money market impacts on the product market through the impact of interest rate changes on investment. The change in income results from the initial response of investment to an interest rate change then being multiplied through the expenditure system via induced consumption and leakages to taxation and imports.

In other words, the total change in income that follows a change in the interest rate depends on the values of the expenditure multiplier and the sensitivity of investment to interest rate changes.

What factors will shift the IS curve? First, any increase (decrease) in autonomous spending shifts IS up (down) because for a given interest rate, the equilibrium level of national income rises (falls) when autonomous spending rises (falls).

The magnitude of the shift up or down in the IS resulting from a rise (fall) in autonomous spending is determined by the magnitude of the change in autonomous spending and the size of the expenditure multiplier.

For a given change in autonomous spending, the shift in the IS curve will be larger the larger is the value of the expenditure multiplier.

The slope of the IS curve represents this overall sensitivity of national income to interest rate changes. The larger is the expenditure multiplier and the larger is the sensitivity of investment to interest rate changes the flatter the IS curve.

This is because for a given change in interest rates, the initial response of investment spending will be larger the more responsive it is to the cost of capital, other things being equal.

In turn, a given change in investment will generate a larger (smaller) change in national income the larger (smaller) is the value of the expenditure multiplier.

Expe

nditu

re

Income (Y) Y1 Y0

E1

E0 A

B E1 at i1

E0 at i0

Interest Rate (i)

Income (Y) Y1 Y0

i0

i1

A

B

IS Curve


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If current period investment is very unresponsive to a change in the current interest rate, then the IS curve will be very steep. It is argued by economists who consider time to be an important consideration in economic analysis that investment spending plans are based on expectations of future revenue streams that were formed in past periods.

The current period’s flow of investment spending reflects these past decisions. The time it takes to evaluate different projects, design the appropriate necessary capital equipment, source funding and then implement the capital infrastructure suggests that current investment spending will be relatively insensitive to current changes in interest rates.

We discuss this topic more in Chapter 22.

It should be clear from this discussion that changes in the tax rate (t), which impact on the value of the expenditure multiplier will also impact on the slope of the IS curve. For example, a rise in the tax rate will cause the IS curve to become steeper because it reduces the value of the expenditure multiplier – a larger leakage from the expenditure system.

Similarly, a rising saving propensity or propensity to import, which means that there are larger leakages from the expenditure system each time income changes, will lead to a steeper IS curve.


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16.6 Policy Analysis in the IS-LM framework

The intention of the IS-LM framework is to bring the product market and money market outcomes into a single diagram so that we can simultaneously determine the equilibrium value of national income and the interest rate. In doing so, it recognises the interdependency between these markets, a point that Keynes demonstrated clearly.

What happens in one market impacts on the other market, which then leads to feedback loops and new equilibrium outcomes in each.

The IS-LM framework thus conceives of a general equilibrium defined as the interest rate and income level that generates simultaneous equilibrium in the both the product and money markets.

In a graphical form, this equilibrium position corresponds to the intersection of the IS and LM curves. In the Advanced Material Box we derive the algebra corresponding to this general equilibrium.

Figure 16.6 shows the IS-LM solution for equilibrium income and interest rates, Y*, i*. Two things are worth noting. The vertical blue line at YFE, denotes a full employment national output level. In other words, at this output level all available labour and capital are being productively deployed.

The IS-LM joint equilibrium thus can occur at levels of income which are below full employment in the labour market. This is consistent with Keynes’ insight that the capitalist monetary system has a tendency to reach under-full employment steady states which need to be shocked by policy interventions.

At Y* and i*, business firms are selling as much as they expected to sell and have no incentive to expand production and employment. The desire for liquidity by firms and households is also being fully met by the available supply of money.

This under-full employment equilibrium can be reached at interest rates above the minimum rate, where the economy enters a liquidity trap.


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Figure 16.6 General IS-LM Equilibrium

[THE FOLLOWING ADVANCED MATERIAL MAY BE IN A BOX WITHIN THE CHAPTER TEXT OR PRESENTED AS A SEPARATE APPENDIX AT THE END OF THE CHAPTER]

IS Curve

LM Curve

Interest Rate (i)

Income (Y) YFE

i0

i*

Y*


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Advanced Material: The IS-LM Algebra

The formal IS-LM model for a simplified open economy begins with the following relationships.

Product Market

(1) Y = C + I + G + X – M National income identity

(2) C = C0 + cYd Consumption function

(3) Yd = Y – T Disposable income

(4) T = tY Tax revenue (proportional tax rate, t)

(5) I = I0 – bi Investment function

(6) G = G Government spending

(7) M = mY Import function

Product Market Equilibrium

The product market equilibrium can be solved as a relationship between GDP (Y) and the interest rate (i) given the autonomous spending aggregates and the value of the multiplier.

Substituting Equations (2) to (7) into (1) we get:

(10) Y = C0 + cY – ctY + I0 – bi + G + X – mY Rearranging gives the equation for the IS curve:

(11) Y = α(A– bi) where α = 1/(1 – c(1 – t) + m), the expenditure multiplier and A is the autonomous spending component, C0 + I0 + G + X.

The slope of the IS curve is given by αb, so the larger the multiplier (α) and the sensitivity of investment to interest rates (b), the flatter will be the slope because the response of national income to a given interest rate will be larger.

Money Market Equilibrium

The money market equilibrium is given by the equality of money supply and money demand.

(12) Ms = kY – hi Which produces the LM curve where Y is a function of i:

(13) Y = (1/k)Ms + (h/k)i The slope of the LM curve is given by (h/k), so the larger the sensitivity of the demand for money to interest rates (h) and the smaller the sensitivity to income (k), the flatter will be the slope because for a small change in interest rates, a much larger change in national income will be required to maintain the equality between the demand for money and the given money supply.

Equation (13) can also be written with i as a function of Y:

(14) i = (k/h)Y – (1/h)Ms


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General Equilibrium

A state of general equilibrium in this context is defined as the interest rate and income level that generates simultaneous equilibrium in the both the product and money markets.

This equilibrium position corresponds to the intersection of the IS and LM curves.

To solve for the equilibrium level of national income we can substitute Equation (14) into the IS curve equation (11) to give:

(15) Y = α[A- (b/h)(kY - Ms)] Solving for equilibrium Y gives:

(16) Y = ∝

!!∝!"!A+ !

!M!

Equation (16.16) indicates that equilibrium income is determined by autonomous spending (A), which includes the fiscal policy parameter (G) and the money supply (Ms).

We use the solution in Equation (16.16) to solve for the equilibrium interest rate:

(17) i = !!

!

!!∝!"!A− !

!!∝!"M!

Equation (17) tells us that the equilibrium interest rate is determined by autonomous spending (A) and the money supply (Ms).

Some economists use Equation (16.15) to define a fiscal policy multiplier, which indicates the change in national income for a given change in government spending, if the money supply is held constant.

The fiscal policy multiplier is given by the coefficient on autonomous spending A in Equation (15). You will note that this is different to the expenditure multiplier, α because it takes into account the interest rate impacts of rising income on investment spending that emanate from the shifts in the demand for money in the money market.

The simple expenditure multiplier is derived on the assumption that interest rates do not change when national income rises.

Similarly, a monetary policy multiplier can be derived, which shows the increase in national income for a given change in the money supply, if government spending and tax rates are held constant.

This is given by the coefficient on MS in Equation (15). Note though that this assumes that monetary policy is conducted through the central bank exercising its assumed control over the money supply. This is one of the flaws of the IS-LM framework when applied to the real world – the central bank does not have control over the money supply and the assumed money multiplier does not exist in any form other than as an ex post, non-causal accounting statement.

Posted on Friday, August 16, 2013 by bill

The IS-LM framework is used within the mainstream approach to analyse the impact of fiscal and monetary policy changes on output (income) and interest rates, and by implication, employment.

Monetary policy is represented by the assumed capacity of the central bank to alter the money supply. Inherent in this approach is the view that central banks manipulate base money (reserves) which are then transmitted into a broader money supply via the money multiplier mechanisms.

In Chapter 9, we demonstrated how this view of central bank operations is not a valid representation of the real world and that in fact, the central bank has little control over the money supply and conducts monetary policy principally via its capacity to set the short-term interest rate. However, for the purposes of this Chapter, to ensure we render the IS-LM approach faithfully, we assume the money supply is exogenous and under the control of the central bank.

Monetary policy changes are thus represented in the IS-LM framework by shifts in the LM curve.


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Figure 16.2 showed that if the central bank increases the money supply, the interest rate falls at the current national income level. This is because at the existing interest rate, there is an excess supply of money and the interest rate has to fall to stimulate an increased demand for money.

The interest rate continues to fall until the demand for money is again equal to the increased money supply and money market equilibrium is restored.

In terms of the LM curve, this means that at higher levels of money supply, equilibrium interest rates will be lower at each income level which translates into a shift outwards in the LM curve. The opposite occurs when the money supply falls.

The LM curve shifts to the right when the money supply rises and shifts to the left when the money supply contracts.

Figure 16.7 shows the impacts of expansionary monetary policy. At some existing monetary policy stance captured by LM1 the equilibrium combination of the interest rate and national income is i*1, Y*1. Point A shows the equilibrium position where LM1 cuts the IS curve.

The central bank decides that the output gap (measured by the difference between the full employment national income level, YFE and the current national income level, Y*1) is intolerable (given the implied mass unemployment that would be associated with such a deficiency in output) and they increase the money supply.

The LM curve shifts to LM2, which drives down interest rates (to stimulate a higher demand for money). The new equilibrium is at Point B, with the equilibrium combination of the interest rate and national income at i*2, Y*2.

The rising income results from the positive impact on investment of the lower interest rates (represented by the movement along the IS curve from A to B). The more sensitive is investment spending to interest rate changes, the more expansionary the monetary policy change will be.

Note, that in this case, monetary policy would not be able to achieve full employment because the economy would encounter a liquidity trap (at i0) before full employment was restored.

A contractionary monetary policy could be represented in Figure 16.7 by a shift in the LM curve from LM2 to LM1. This would drive interest rates up and national income down.

The falling income results from the negative impact on investment of the higher interest rates (represented by the movement along the IS curve from B to A). The more sensitive is investment spending to interest rate changes, the more contractionary the monetary policy change will be.


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Figure 16.7 Expansionary Monetary Policy

Expansionary monetary policy drives the interest rate down and national income up. Contractionary monetary policy drives the interest rate up and national income down.

The extent of the expansion or contraction depends on the slope of the IS curve. The steeper the IS curve the less effective are monetary policy changes with respect to income changes.

Fiscal policy changes could be implemented by discretionary changes in government spending or the tax rate. We have learned that a rise in government spending shifts the IS curve to the right because for a given interest rate, the equilibrium level of national income rises when autonomous spending rises.

Similarly, a fall in government spending shifts the IS curve to the left because for a given interest rate, the equilibrium level of national income falls when autonomous spending falls.

The magnitude of the shift up or down in the IS curve resulting from a rise (fall) in autonomous spending is determined by the magnitude of the change in autonomous spending and the size of the expenditure multiplier.

For a given change in autonomous spending, the shift in the IS curve will be larger, the larger is the value of the expenditure multiplier.

IS

A

B

LM1 LM2

YFE Y*2 Y*1

i*2

i*1

i0

Income (Y)

Interest Rate (i)


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The IS curve shifts to the right when government spending rises and shifts to the left when the government spending falls.

Figure 16.8 depicts an expansionary fiscal policy change (increase in government spending). At some existing fiscal policy stance captured by IS1 the equilibrium combination of the interest rate and national income is i*1, Y*1. Point A shows the equilibrium position where IS1 cuts the LM curve.

The treasury decides that the output gap (measured by the difference between the full employment national income level, YFE and the current national income level, Y*1) is intolerable (given the implied mass unemployment that would be associated with such a deficiency in output) and they increase government spending in order to stimulate aggregate demand.

The IS curve shifts to IS2 which creates a new equilibrium at Point B, with the equilibrium combination of the interest rate and national income at i*2, Y*2.

You will note that both the interest rate and national income are higher. The rising national income arises because at higher levels of aggregate demand, firms produce more output (and hire more workers).

How do we explain the higher interest rates? Within the IS-LM framework, the rising national income that follows the increased aggregate demand, increases the transactions demand for money. With the money supply fixed, the rising demand for money creates an excess demand for money at the original equilibrium interest rate (i*1) and rising interest rates motivate people to hold less cash. This is because the opportunity cost of holding wealth in the form of cash rises when interest rates rise.

You will note that if the interest rates had not increased, the expansion in income would have been greater than the shift from Y*1 to Y*2.


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Figure 16.8 Expansionary Fiscal Policy

The final change in aggregate demand is thus less than the initial ΔG. How do we explain this?

The rising interest rates impact negatively on private investment which offsets some of the increase in government spending. In the policy debates this impact is referred to as financial crowding out. The rising interest rates that follow the increase in government spending, crowd out other interest sensitive components of aggregate demand (in this case, private investment).

Note that fiscal policy could achieve full employment (at Point C) if the government kept increasing government spending such that the IS curve shifted to ISFE.

The extent of the financial crowding out depends on the slope of the LM curve. The steeper is the LM curve the less expansionary will fiscal policy be and the larger is the crowding out effects.

This is demonstrated in Figure 16.9. From an initial equilibrium at Point A, a fiscal stimulus (shifting IS curve to IS2) would increase national income to Y*2 and interest rate would rise to i*2 with the flatter LM curve (LM1) at the new equilibrium point, B1.

With a steeper LM curve (LM2), for the same fiscal stimulus (shifting IS curve to IS2), the new equilibrium point, B2 clearly involves a lower equilibrium income outcome and a higher equilibrium interest rate than occurred at Point B1.

The extent of the financial crowding out is higher with LM2 than LM1.

IS1 IS2

ISFE

LM

C

B

A i*1

i*2

i0

Y*1 Y*2 YFE Income (Y)

Interest Rate (i)


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What explains this difference? The LM curve is steeper the more sensitive the demand for money (transactions and precautionary motives) is to national income changes and the less sensitive the speculative demand for money is to changes in interest rates.

Thus, small changes in national income lead to large changes in excess money demand at a given money supply level and the rise in interest rates to restore money market equilibrium, other things equal, has to be larger as a consequence. Additionally, for a given excess demand for money, the interest rate increase that is required to restore money market equilibrium is larger.

An extreme position is complete financial crowding out and this would occur if the LM curve was vertical. In this situation a given rise in government spending, for example, would be exactly offset by a decline in investment as the interest rate rose.

In that situation, fiscal policy would be totally ineffective.

We should note that financial crowding out is not confined to fiscal policy changes exclusively. Any of the autonomous spending components, which can shift the IS curve and increase national income, trigger the money market mechanisms that see interest rates rise and interest-sensitive components of aggregate demand stifled.

Figure 16.9 Fiscal Policy and Financial Crowding Out

Note that the other extreme position would be a horizontal LM curve at some given interest rate. In this case there would be no financial crowding out and the fiscal stimulus to aggregate demand would be fully translated into changes in national income.

We will return to this extreme position when we discuss endogenous money theories later in the Chapter.

IS1 IS2

LM1

LM2

B2

B1

A

Y*1 Y*2

i*1

i*2

Income (Y)

Interest Rate (i)


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An expansionary fiscal policy change increases national income and interest rates.

The rise in national income is less than the change in government spending because the higher interest rates crowd out private investment.

The extent of the financial crowding out depends on the slope of the LM curve. The steeper is the LM curve, the less expansionary will fiscal policy be and the larger is the crowding out effects.

There is complete crowding out when the LM curve is vertical and zero crowding out when the LM curve is horizontal.


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16.7 Introducing the Price Level - The Keynes and Pigou Effects

Our derivation of the IS-LM framework initially assumed that the price level was fixed and all changes in output were real. This is consistent with the simple income-expenditure model developed in Chapter 12 where the focus was on the manner in which output and employment responds to changes in aggregate demand.

We assumed that firms were willing to supply whatever was demanded up to full capacity without changing their prices. In this vein, we also treated the nominal and real interest rate has being interchangeable.

In this section we consider how changes in the price level impact on output and interest rates.

The price level is introduced into the IS-LM framework as an exogenous variable, that is, determined outside of the interest rate-income equilibrium defined by the intersection of the IS and LM curves. There are several complications involved in adopting this assumption which we will abstract from for the sake of simplicity.

The income-expenditure model developed in Chapter 12, which underpins the derivation of the IS curve was defined in real terms. Thus, the expenditure components – consumption, investment, government spending and net exports – are all measured in constant prices.

We would expect the IS curve therefore to be invariant to changes in the general price level given that households, firms, government and the external sector have made decisions regarding real expenditures.

However, to date our analysis of the money market has fudged the question of the price level. The demand for money is a demand for real balances, motivated by the need to make transactions for the exchange of goods and services which we have just noted are defined in real terms.

But, the money supply is specified in nominal terms – an amount of dollars – and forms the unit in which all the other variables are accounted.

The real value of a given stock of money on issue, however, varies with the price level. For a given stock of dollars on issue, the real value is higher when the price level is lower, and, vice versa.

For example, assume that the money supply on issue is $1000 billion and the price index is 1. The real value of the money supply would be $1,000 billion.

Now if the price level rose by 5 per cent the price index would be 1.05 and the real value of the money supply would drop to $952.4 billion.

This means that users of the currency have less available in real terms to use for purchases and speculative holdings.

The same contraction in real value of the money supply could arise if the price level was unchanged (that is, the index remained at 1) and the nominal money supply fell to $952.4 billion.

In other words, the real value of the money supply can fall if the price level rises (for a given nominal money stock) or if the nominal money stock falls (for a given price level).

Alternatively, the real value of the money supply can rise if the price level falls (for a given nominal money stock) or if the nominal money stock rises (for a given price level).

Within the logic of the IS-LM framework, it is clear that if the price level rises and reduces the real value of the money supply, the interest rate will rise because at the previous equilibrium interest rate, there will now be a shortage of real balances relative to the demand for them.

The introduction of the general price level modifies our LM curve derivation. If a rising price level (with a constant nominal money stock) is equivalent in real terms to a declining nominal stock of money (at constant prices) then we can capture this impact via shifts in the LM curve.

The LM curve shifts to the left when the price level is higher, other things equal, and to the right when the price level is lower.


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Posted on Friday, August 30, 2013 by bill

Figure 16.10 depicts a family of LM curves with each individual curve corresponding to a different price level (P0 is the highest price and P3 is the lowest price).

The introduction of the price level now means that the interest rate-income equilibrium is now contingent on the price level. If there is a different price level, the equilibrium changes as noted.

This means that within this framework, the national income equilibrium can shift without any change in monetary or fiscal policy settings if the price level changes.

Figure 16.10 The Keynes Effect

This observation was central to the debates between Keynes and the classical economists during the 1930s, which we examined in detail in Chapter 15.

Assume that the economy is currently at Point A, where the interest-rate is i0 and national income is Y0. The general price level is P0.

The full employment output level is at YFE, so that the current equilibrium corresponds to what Keynes would refer to as a underemployment equilibrium.

At Point A, the product and money markets are in equilibrium but there is an output gap and there would be mass unemployment in the labour market as a consequence.

IS

A

BA

LM (P1)

LM (P0)

YFE Y0

iLT

i0

i1

Income (Y)

Interest Rate (i)

CA

LM (P2)

LM (P3)

Y1 YL


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Keynes considered this to be the general case for a monetary economy and depicted the neo-classical model as a special case in which the equilibrium that emerged was also consistent with full employment. For Keynes, a monetary economy could be in equilibrium at any level of national income.

The neo-classical response to this was that unless we impose fixed wages on the model, the persistent mass unemployment would eventually lead to falling nominal wages and prices.

While this might not lead to a fall in the real wage (if nominal wages and prices fall proportionately), which would negate the traditional neo-classical route to full employment via marginal productivity theory, the fact remains that the lower price level increases real balances in the economy.

The reasoning that follows is that the reduction in prices leads to a decline in the transaction demand for money at every level of income because goods and services are now cheaper.

With the nominal stock of money fixed, the expansion of real balances combined with a decline in the demand for liquidity, results in a decline in the rate of interest.

As long as future expectations of returns are not affected adversely by the deflationary environment, the reduction in the rate of interest, stimulates investment spending, which leads to increased aggregate output and income via the multiplier effect.

As long as there is an output gap, deflation will continue and the interest rate will continue to fall until the economy is at full employment.

The link between real balances and the interest rate was referred to as the Keynes effect.

In terms of Figure 16.10, the LM curve shifts outwards as the price level falls and the rising investment is depicted as a movement along the IS curve.

For example, if the price level fell to P1, the LM curve would shift and a new IS-LM equilibrium would result at Point B, with the interest rate at i1 and national income is Y1. Under the circumstances depicted this is not a full employment level of national income.

As a result of this observation, the neo-classical economists argued that an underemployment equilibrium was a special case when wages and prices were fixed given that flexible prices could reduce the output gap and unemployment via LM curve shifts.

The view that Keynes’ underemployment equilibrium was a special case of the more general flexible price model became known as the Neo-classical synthesis. This approach recognised that aggregate demand drove income and employment (the so-called Keynesian contribution) but that the economy would tend to full employment if wages and prices were flexible (the Classical contribution).

Note that the capacity of the Keynes effect to deliver output and employment gains is limited. If there is a liquidity trap (iLT) then the maximum expansion in national income that is possible via falling prices would be YL at Point C (where the IS curve intersects with the flat segment of the LM curve.)

At that point, there would still be unemployment and if wages and prices were flexible and behaved according to the Classical labour market dynamics, the price level would continue to fall, say to P3.

The LM curve would continue to shift out but there would be no further expansion in national income beyond YL because the increase in real balances would not reduce the interest rate below iLT.

The classical route to full employment thus would require the full employment level of national income to lie at a point where the intersection of the IS-LM curves produced an equilibrium interest that was equal to or above iLT.

The Keynes effect is so-named because the expansion that follows a reduction in the price level occurs through a rise in aggregate demand – first, through the interest=rate stimulus to investment, and, second, through the standard expenditure multiplier inducing higher consumption expenditure.

However, as we learned in Chapter 15, Keynes did not support wage and price cuts as a way to achieve full employment. He considered the social consequences of wage cuts to be unacceptable and instead advocated increasing the nominal money supply as the way to increase real balances.

But the limits to expansion posed by the possible existence of a liquidity trap dissuaded Keynes from considering the Keynes effect to being a plausible route to full employment.

There are several other arguments that militate against a reliance on the Keynes effect for achieving full employment.


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Keynes’ General Theory, – Chapter 19 – which is devoted to the impacts of money wage changes on aggregate demand – presented several such arguments.

Among other impacts, Keynes argued that lower money wages and prices will lead to a redistribution of real income (FIND PAGE NUMBERS):

(a) from wage-earners to other factors entering into marginal prime cost whose remuneration has not been reduced, and (b) from entrepreneurs to rentiers to whom a certain income fixed in terms of money has been guaranteed.

He concluded that the impact of “this redistribution on the propensity to consume for the community as a whole” would probably be more “adverse than favourable”.

Moreover, falling money wages will have a (FIND PAGE NUMBERS):

… depressing influence on entrepreneurs of their greater burden of debt may partly offset any cheerful reactions from the reduction of wages. Indeed if the fall of wages and prices goes far, the embarrassment of those entrepreneurs who are heavily indebted may soon reach the point of insolvency, — with severely adverse effects on investment.

Overall, Keynes concluded that there was “no ground for the belief that a flexible wage policy is capable of maintaining a state of continuous full employment”.

The debt-deflation argument was also recognised by other economists such as Irving Fisher in 1933, Michal Kalecki in 1944 and Hyman Minsky in 1982).

The Classical view proposed an additional mechanism that could generate full employment as long as wages and prices were flexible.

The so-called – Pigou effect – was named after Keynes’ principal antagonist at Cambridge University, Arthur Pigou, whose work exemplified the Treasury View during the Great Depression. The Pigou effect is also known as the Real Balance effect.

While the Keynes effect worked via interest rate responses to changing real money balances then stimulating investment, the Pigou effect was based on the view that falling prices would stimulate consumption expenditure.

It was argued that the real value of household wealth rose as prices fell and this reduced the need to save. As a result the consumption function shifted upwards (higher levels of consumption at each income level) and this would shift the IS curve outwards.

Figure 16.11 captures the Pigou effect. Note we abstract from any impacts on the LM curve of the falling price level to highlight the shifting IS curve.

If we start from an initial underemployment equilibrium at i0 and Y0 with the price level at P0. The argument is that wage and price levels would fall given the output gap (Y0 < YFE) and this would increase real wealth balances and stimulate consumption, thus pushing the IS curve outwards and leading to an expansion in national income.

Eventually, if prices were sufficiently downwardly flexible, the economy would achieve full employment at i2 and YFE, with the lower price level, P2.

You will note that unlike the Keynes effect, whose effectiveness was limited by the possibility of encountering a liquidity trap, the expansionary possibilities of the Pigou effect are unlimited.


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Figure 16.11 The Pigou Effect

The introduction of the Pigou effect provided a theoretical device to combat Keynes’ argument that when aggregate demand was deficient (relative to the full employment level), wage and price flexibility would not guarantee full employment.

However, studies have rejected its practical importance. Wealth effects, where identified in the empirical research literature, have been shown to be small and insufficient to resolve a major recession.

IS(P2) IS(P1) IS(P0)

LM Curve

Income (Y) YFE Y1 Y0

iLT

i0

i1

i2

Interest Rate (i)


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16.8 Why We Do Not Use The IS-LM Framework

There have been many critiques of the IS-LM framework over the years. Many have concentrated on whether the approach is a faithful representation of Keynes’ General Theory, as was its initial purpose. Even its originator John Hicks accepted that it was not a valid depiction of Keynes’ theories (see box).

Other critiques have concentrated on issues relating to its static nature and the fact that it can tell us nothing about what happens when the economy is not in equilibrium.

A third focus of objection relates to its denial of the realities of central bank operations and the way in which the commercial banks function.

In this section, we focus on the last two of these lines of attack.

The Endogeneity of The Money Supply

The supply side is the simpler of the two since the money supply is regarded as fixed by some external agent (the ‘policymaker’) and independent of the rate of interest.

First, the IS-LM analysis relies on the assumption that the money supply is “exogenous”, that is, controlled by the central bank and thus, independent of the demand for funds.

The underlying theory supporting this assumption centres on the money multiplier, which we examine in detail in Chapter 20. The assumption is that the central bank is in control of the so-called monetary base (MB) (the sum of bank reserves and currency at issue) and the money multiplier m transmits changes from the base into changes in the money supply (M).

By setting the size of the monetary base, it is thus asserted that the central bank controls the money supply, as is depicted in the derivation of the LM curve.

As we will learn in Chapter 20, this conceptualisation of the monetary operations of the system are not remotely applicable to the real world.

A senior official in the US Federal Reserve Bank of New York, A.D. Holmes identified what he called “operational problems in stabilising the money supply” as far back as 1969:

The idea of a regular injection of reserves … suffers from a naive assumption that the banking system only expands loans after the System (or market factors) have put reserves in the banking system. In the real world, banks extend credit, creating deposits in the process, and look for the reserves later. The question then becomes one of whether and how the Federal Reserve will accommodate the demand for reserves. In the very short run, the Federal Reserve has little or no choice about accommodating that demand; over time, its influence can obviously be felt.

The reality, which we will analyse in detail in Chapter 20, is that the central bank sets the so-called official, policy or target interest rate. This is the rate at which they are prepared to provide funds to the banking system on an overnight basis.

This rate then determines the interbank rate that banks apply a margin to, which determines the cost of loans. The interbank rate is just the rate that banks lend to each other to ensure the payments system is stable on a daily basis.

The cost of loans influences the demand for them from private borrowers. Banks then lend to credit-worthy borrowers by creating deposits. The banks then seek the necessary reserves to ensure the withdrawals from the deposits are honoured by the payments system.

While the banks can get the necessary reserves from alternative sources, the central bank supplies reserves on demand to ensure there is financial stability and that they can maintain control of their policy interest rate.

If there is a shortage of reserves, then the competition in the interbank market between the banks for funds will drive up the short-term interest rate above the policy rate and the central bank would lose control of its policy rate. In these cases, the central bank will always supply reserves at the policy rate to maintain control over its policy settings.

Alternatively if there are excess reserves, the banks will try to loan them to other banks at discounted rates and the short-term interest rate would drop to zero. Hence the central bank will either drain the excess by selling interest-bearing government debt or it will pay a return on the excess reserves that eliminates the interbank competition.


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These operations tell us that:

• Bank loans create deposits – that is, banks react to the demand for credit from borrowers rather than on-lending deposits.

• The demand for credit depends on the state of economic activity and the level of confidence in the future.

• Bank lending is not constrained by reserve holdings. The reserves are added on demand by the central bank where needed.

• Rather than driving the money supply, the monetary base responds to the expansion of credit by the banks.

• This process means the money supply is endogenously determined and the central bank has no real capacity to maintain any quantity targets.

The fact that the money supply is endogenously determined means that the LM will be horizontal at the policy interest rate. All shifts in the interest rates are thus set by the central bank and funds are supply on demand elastically at that rate. In this case, shifts in the IS curve would not impact on interest rates.

From a policy perspective this means the simple notion that the central bank can solve unemployment by increasing the money supply is flawed.

If the central bank tries to increase reserves in a discretionary manner this would only result in excess reserve holdings and push the overnight interest rate to zero without actually increasing the money supply. To avoid this the central bank would have pay the policy rate on those excess reserves.

Unemployment is typically the result of a high liquidity preference – people want to hold cash rather than spend it – given uncertainties about the future. In those cases the demand for loans collapses and the banks become more cautious in who they will loan funds to for fear of losses. Under these conditions, there is no way for the central bank to simply increase the supply of money to raise aggregate demand.

In the global financial crisis, central banks have been adding massive volumes of reserves to the banking system via the so-called quantitative easing programs, which we analyse in detail in Chapter 20. The demand for funds was so subdued that credit expansion also slowed dramatically and the banks were content to hold vast quantities of low-interest bearing reserves.

Expectations and Time

From blog 6 Sep 13

Consider the role of the investment function in the derivation of the IS curve. Investment is said to be dependent on the interest rate (cost of funds) and, perhaps, output (via the accelerator affect).

While the IS-LM approach of John Hicks tried to represent what he saw as the key elements of Keynes’ General Theory, it clearly left out issues relating to uncertainty and probability that Keynes saw as being crucial in the way long-term expectations were formed. Chapter 12 of the General Theory was devoted to this topic.

In the General Theory (1936: 149-50), Keynes wrote:

The outstanding fact is the extreme precariousness of the basis of knowledge on which our estimates of prospective yield have to be made. Our knowledge of the factors which will govern the yield of an investment some years hence is usually very slight and often negligible. If we speak frankly, we have to admit that our basis of knowledge for estimating the yield ten years hence of a railway, a copper mine, a textile factory, the goodwill of a patent medicine, an Atlantic liner, a building in the City of London amounts to little and sometimes to nothing; or even five years hence.

Thus the decision to invest is dependent on the “state of long-term expectation”, which is ignored in the static IS-LM approach.

Investment, among other key economic decisions, is a forward-looking process, where firms form guesses about what the state of aggregate demand will be in the years to come.


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It is necessarily such because the process of creating new capital stock is lengthy and involves a number of separate decisions – type of product to produce, nature of capital required to produce it, design, access supply and ordering, and quantum – are all separated in time.

The investment spending today is the result of decisions taken in some past periods about what the state of the world will be today and into the future. Investment spending is not a tap that is turned on or off when current interest rates change.

The psychological factors that are crucial for comprehending the decision to consume (marginal propensity to consume); the decision to invest (marginal efficiency of capital); and the determination of the labour market bargain (implicit in the IS-LM approach) are abstracted from in the derivation of the equilibrium – what are essentially dynamic process with complex feedback loops are frozen in time by the need to derivate static IS and LM curves.

The failure to include the crucial role of expectations and historical time means that IS-LM framework is reduced to presenting a general equilibrium static solution that has little place in a dynamic system where uncertainty is a key driver in economic decision-making.

The last word in this Chapter will go to the original architect of the IS-LM approach, John Hicks, who reflected on his creation and the way it had been subsequently used in a 1981 article in the Journal of Post Keynesian Economics:

I accordingly conclude that the only way in which IS-LM analysis usefully survives—as anything more than a classroom gadget, to be superseded, later on, by something better—is in application to a particular kind of causal analysis, where the use of equilibrium methods, even a drastic use of equilibrium methods, is not inappropriate. I have deliberately interpreted the equilibrium concept, to be used in such analysis, in a very stringent manner (some would say a pedantic manner) not because I want to tell the applied economist, who uses such methods, that he is in fact committing himself to anything which must appear to him to be so ridiculous, but because I want to ask him to try to assure himself that the divergences between reality and the theoretical model, which he is using to explain it, are no more than divergences which he is entitled to overlook. I am quite prepared to believe that there are cases where he is entitled to overlook them. But the issue is one which needs to be faced in each case.

When one turns to questions of policy, looking toward the future instead of the past, the use of equilibrium methods is still more suspect. For one cannot prescribe policy without considering at least the possibility that policy may be changed. There can be no change of policy if everything is to go on as expected—if the economy is to remain in what (however approximately) may be regarded as its existing equilibrium. It may be hoped that, after the change in policy, the economy will somehow, at some time in the future, settle into what may be regarded, in the same sense, as a new equilibrium; but there must necessarily be a stage before that equilibrium is reached. There must always be a problem of traverse. For the study of a traverse, one has to have recourse to sequential methods of one kind or another.


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References:

Fisher, I. (1933)

Hicks, J.R. (1937) ‘Mr. Keynes and the “Classics”; A Suggested Interpretation’, Econometrica, 5(2), April, 147-159. Available at http://www.jstor.org/stable/1907242.

Hicks, John (1975) ‘Revival of Political Economy: The Old and the New’, The Economic Record, The Economic Society of Australia, 51(135), September, 365-67.

Hicks, John (1980)’”IS-LM”: An Explanation’, Journal of Post Keynesian Economics, 3(2): 139–154. Available at: http://www.jstor.org/stable/4537583.

Hicks, J. (1981) 'IS-LM: “An Explanation”', Journal of Post Keynesian Economics, 3(2) (Winter, 1980-1981), 139-154.

Holmes, A (1969) 'Operational Constraints on the Stabilization of Money Supply Growth. In Controlling Monetary Aggregates', Federal Reserve Bank of Boston, 65-77.

Kalecki, M. (1944)

Keynes, J.M. (1936) The General Theory of Employment, Interest and Money, Harcourt, Brace and Company, and printed in the U.S.A. by the Polygraphic Company of America, New York.

Minsky (H) (1982)

text book name here mitchell and wray 2013 16 the is-lm...

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