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ISLM Analysis Part I: The Real Sector The Keynesian Framework According to John Hicks 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 S S (1 – b) 1 1 -a 1 Y i I I According to vision, investment depends primarily onand Macroeconomic equilibrium for a wholly private economy In Keynes’s Keynes, saving depends upon income spirts. ” That + (1 = I” iswhere requiresalone. =alsoequal–investment. aa>minor extent, < 1. the “animal that saving is, “S b)Y, an equilibrium 0 < b on In particular, S – a depends, if only to But investment 0 and rate of interest. condition. funds in highly interest inelastic. The demand for investment With “animal spirits” in play, the whole curve moves around on its own.

S Suppose the interest rate is relatively low. How much incomeis saving required to S Suppose the interest rate is relatively low. How much incomeis saving required to finance would people borrowing andhave this level be to earn toof willing investment would investment? to save this the business i amount? community be So, now we have willing to one possible undertake? combination of i. LOW the 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 by tracing out the implications of a This relationship is revealed income. low interest rate, a high interest rate, and a middling interest rate.

S Suppose the interest rate is relatively high. How much incomeis saving required to S Suppose the interest rate is relatively high. How much incomeis saving required to finance borrowing and would people have this level be investment willing to earn toof would investment? the business to save this i community be amount? have i. HIGH Now we willing topossible another undertake? of combination i. LOW the 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 by tracing out the implications of a This relationship is revealed income. low interest rate, a high interest rate, and a middling interest rate.

S Suppose the interest rate is a middling rate. How much saving is income S Suppose the interest rate is a middling rate. How much saving is income would people required to finance borrowing andhave to earn to be this level of willing investment would to save this investment? the business i amount? have community be a i. HIGH Now we willing to third possible i. MID undertake? of combination i. LOW the interest rate and total income. S Y i I IS Y I So far, we have one equilibrium condition (in orange) and been A line passing through these three points (two would havetwo behavioral relationships (in blue). Together, these three enough) represents all combinations of the interest rate and total relationships imply a particular the equality of investment and income that are consistent withrelationship between the interest rate and the economy’s total income. out the implications of a saving, given the is revealed bythat describe investment behavior This relationships tracing and interest behavior. interest rate, and a middling interest rate. low saving rate, call this line the IS curve. (All along this curve, Accordingly, we a high

If the middling rate of S interest just happens to be the equilibrium Seq If the middling rate of S interest just happens to be the equilibrium Seq rate, the level of total income that corresponds to that i rate is the equilibrium level of i. HIGH Equilibrium levels income. iieq MID of saving and investment are i. LOW similarly identified. 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

S S If the incomeexpenditure equilibrium just Seq W happens to be S consistent S S If the incomeexpenditure equilibrium just Seq W happens to be S consistent with full LABOR Y D I INCOME employment, then i i N the labor force will be experiencing a Keynes assumed But Keynes’s supply-and-demand ieq that movements in supply-and. IS equilibrium. total income demand reckoning faithfully reflect the of the labor market Ieq Y I movements in the differs importantly level of dismissive of the that the wage rate hastheorizing to the from Alfred Wholly employment. Marshall would observe classical economists’ adjusted about Marshall’s. the distribution of income among labor. prevailing supply-and-demand forthe factors of production, Keynes would observe that, give the supply of labor and theof assumed a “fixed structure of industry” whose level utilization varies the current the employment of labor. And with going wage rate, directly with level of expenditures just happens the wage enough to cause the total income are for labor to be highrate given, changes inresulting demand directly to

S According to Keynes, S the demand for investment funds is Seq (1 – S According to Keynes, S the demand for investment funds is Seq (1 – b) ΔI W subject to a sudden, S'eq 1 S unpredictable D Y I collapse. The i i N collapse (the leftward ΔY ΔI 1 ΔY = (1 – b) ΔI shift in the demand curve) upsets both ieq IS the labor market’s supply-and-demand I'eq Ieq Y'eq Y I equilibrium and the macroeconomy’sin investment behavior, the a multipleshifts to The the changethat the decrease in income reflects Withmagnitude of the shift in the IS curve is IS curvea of the Finally, we note income-expenditure in the demand for investment funds. magnitude of the shift in a downturn in which lower levels of the left. corresponding decrease The economy experiences the demand for labor. And with the equilibrium. Here, the simple persisting, the laborestablished. going wage rate Keynesian multipliermarket is experiencing income, investment, And note that withis inunchanged rate of a and saving are an play. interest, the equilibrium level of income Keynes would in it persistentthe interest rate, If only by assumption, remains (Marshallian) disequilibrium. also changes call Note that accordance withequilibrium. ” “unemployment the simple Keynesian multiplier. unchanged.

According to Keynes, S people’s saving behavior is unlikely Seq to change. And fortunately According to Keynes, S people’s saving behavior is unlikely Seq to change. And fortunately so. In the Keynesian i framework, increased saving has bad consequences. ieq S ΔThrift W S Y ΔY i − 1 ΔY = (1 – b) ΔThrift IS D I N A decision to save more is represented Ieq Y'eq eq Y Y I by an upward shift in the saving function. of saving would still borrowedthen the Finally, we volume If the old equilibrium rate of interest income reflects the The greaternote that the decrease in be prevails, by a corresponding decrease if the rate of interest were happened economy’s reaction onlyin the demand is labor. Aslower. business communityto increased saving fora fall income. in wewhatever a fall in investment demand, of the increased in If the case upward shift of the saving relationship a change And call anof the eventual consequences an increase in thrift reducesthethe corresponding shift in valid. The new given by toa thrift, then old IS and causes the labor IS curve experience its saving, spending curve is no longer the market tois one lies the persistent (Marshallian) disequilibrium. thrift left. multiplier---which is simply the negative of the spending

ISLM Analysis Part II: The Monetary Sector The Keynesian Framework According to John Hicks 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 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 He later concluded that the interest rate exchange. 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

Keynes had once considered himself to be a “classical” economist. With Marshall, he believed 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 Keynes was left with puzzles: exchange. 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

According to Keynes, the interest rate has little or no influence on people’s willingness According to Keynes, the interest rate has little or no influence on people’s willingness to save. But it has a great KEYNES’S LIQUIDITY-PREFERENCE THEORY OF influence, he claims, on the preferred INTEREST form of saving. Do people put their savings at interest (e. g. by buying bonds) or do they keep their savings liquid (by Income alone determines consumption holding money)? 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 + b. Y 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. 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 six. When the last coupon is month intervals. redeemed, the $1, 000 is returned to the bond holder. So, the buyer pays $1, 000 in 1872. He gets back $1, 000 in 1902. And he gets $30 biannually for 30 years. He can sell the bond any time he wants. $30 $30 $30 $30 $30 $30 $30 $30 $30 $30 $30 $30 $30 $30 $30

Suppose that a few years after you bought this bond, market rates of interest Suppose that a few years after you bought this bond, market rates of interest are significantly higher than 6%. lower than 6%. At that point, the $1, 000 -bondbe someone might able to buy a as bond 4% or 3%. rate might be 9%low asor a 12% bonds would bonds six. These $1, 000 have a would have a coupon value of $45 and month coupon value of $20 or $60, $15, respectively. You could easily sell your 6% still sell your 6% bond, but you would be able to bond, and you have to offer it at a price considerably OUTLOOK: sell. From a 1993 OECDless than it at a price considerably $1, 000. United States, higher than $1, 000. long-term In the 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

i MSPEC Keynes portrayed each saver as facing a choice between holding his savings i MSPEC Keynes portrayed each saver as facing a choice between holding his savings liquid or holding longterm bonds. The savers’ preferences in this regard determine both the demand for money (liquidity) and the demand The choices (between money and for earning assets (bonds) hinge critically on beliefs about future movements in the interest rate. 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 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. If the current rate is sufficiently i MSPEC high, savers will lock themselves into high long-term bond rate and there will be no speculative holdings of money. sufficiently low, If the current rate is 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, The speculative demand for money is unique to Keynesian macroeconomics and, according to some, is the sine qua non of Keynesianism. This special demand curve is non- IN i TE R RM EG E IO DIA N TE CLASSICAL REGION EXTREME KEYNESIAN REGION MSPEC linear and has three identifiable regions: In rates of interest so highthat At the “intermediate region, ” the low that quantity of one believes they virtually no money holdings are demanded varies inversely likely to go still higher, the with the lower, the rate of interest. speculative demand for money is becomes perfectly elastic. In perfectly inelastic and is co- this “extreme Keynesian region, ” This incident with the vertical axis. all additions to the money so named is the “classical region, ”supply are simply hoarded. because 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 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 wellfounded. 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 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. To determine the particular rate of i interest that actually prevails, we take into account the money supply, which is set by the central bank. The rate of interest adjusts to its MS ieq MSPEC 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 marketclearing rate of interest.

If the demand for money holdings stays put for the time being, we can If the demand for money holdings stays put for the time being, we can note the inverse relationship According rate and between the interestto Keynes: the demand for“The interest rate is rate of money holdings. To determine the particular what it i is because it is expected interest that actually prevails, weto be other than what it is. If it take into account the moneyother isn’t expected to be supply, which iswhat it is, the central than set by there is bank. The rate of nothing toadjusts to it is interest tell us why its MS ieq what it is. The organ that MSPEC equilibrium secretes eqhas been the value (i it ), where preferred level of moneyyet amputated and holdings somehow it supply. is equal Dennis Robertsonto the moneystill exists, the (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 marketclearing rate of interest.

Suppose that people’s propensity to hoard strengthens—meaning that their demand for money to hold Suppose that people’s propensity to hoard strengthens—meaning that their demand for money to hold increases. Note that the increased demand is i MS i’eq ieq MSPEC 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. However, if the central bank wants to re-establish the preexisting rate of interest, it can increase the money supply, moving the money holders along their money-demand curves.

i ieq MS MS MSPEC With an economy performing at fullemployment without inflation, Keynes i ieq MS MS MSPEC 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 If the central bank could rate of interest. 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 So, why does it matter that the interest rate increases with a strengthening of hoarding i MS propensities? i’eq ieq MSPEC It matters because a change in the interest rate has an impact on the real sector of the S S Seq W S I i i N 1 Suppose the economy is in an incomeΔI ΔY = (1 – b) expenditure equilibrium and is ieqperforming at full employment without inflation. ΔY IS labor demand is just That is, ΔI strong enough to clear the labor market Ieq Y I at the going wage Y D An increase in money demand raises the rate of interest and takes this fullyemployed 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 S S Seq i ieq i MS MS MSPEC ieq Y I i IS Yeq Y Ieq I People behave manipulating the money By continuouslyfetishistically toward money, sometimes wanting to hoard supply so as to keep the interest rateit. If the central bank matches bank can nip from changing, the centraltheir hoarding propensities by supplying additional in the bud any recession (or inflation) that quantities of money, the economy will be would otherwise be associated with the

S S Seq W S i i MS ieq MSPEC Y i D I S S Seq W S i i MS ieq MSPEC Y i D I N IS Yeq Y Ieq I We begin again with the economy in an income-expenditure equilibrium and performing at full employment without inflation. We assume away the problem of hoarding and show monetary

Suppose the animal S spirits are on the wane, causing Seq investors to cut Suppose the animal S spirits are on the wane, causing Seq investors to cut back S'eq on their borrowing of investment funds. i i MS ieq MSPEC S W W S Y ΔY i 1 ΔY = (1 – b) ΔI S D D I N ΔI N IS Y'eq Y I'eq I In the absence of any shift in the income is IS curve of the The the change the decrease behavior, reflects a shifts be Withmagnitude ofin investment in IS curvethe a recession canto Finally, note that the fiscal-policy levers, the multiple countered magnitude of monetary the demand forfor labor. Andby the left. by the shift inpolicy. Though strictly which funds. levels correspondinghas experienced demand investment lower the The economy decrease in the a downturn in limited with shapewage demand for note thatan increaseis experiencing Here, thetherate persisting, savingwithis inunchanged rate of a And money, are an play. going of simple Keynesianthe labor market in the money of income, investment, and multiplier established. supply can(Marshallian) level of income Keynes the economy interest, thelower the rate of interest andalso changes in it equilibrium disequilibrium. move would call persistentthe interest rate, which continues to match the money Note that down along withequilibrium. ” accordance the IS curve. Keynesian multiplier. “unemployment the simple supply to the speculative demand for money, remains

The classical economists Keynes’s hard-drawn version wrote: of the monetary sector gives no play The classical economists Keynes’s hard-drawn version wrote: of the monetary sector gives no play to the equation of MV = PQ, where Q also exchange. The whole story is represents real income—i. e. , about the supply of money Q = Y/P. and the speculative demand Since Q = The interest = Y. for money. Y/P, then PQ rate, which balances supply So, we can write MV = Y, against demand is a purely which applies, Keynes monetary phenomenon. insisted, only to the transactions demand for money. MT And so, MTVT = Y or MT = Y / VT Keynes recognized that the But Keynes did recognize transactions velocity of another component of the money, for money. The demandlike the velocity of money in the classical transactions demand formulation, is fairly stable. money (MT) depends VT is more or less constant. primarily on income and not so much on the interest rate. This means that MT is It is this component (MTRANS linearly related to Y. MT = Y / —or simply MT) that can be VT graphs as a straight line analyzed in terms of the that emanates from the equation of exchange. origin and has a slope of 1/ V T. 1 VT Y

MT is one component of the demand for money. The other component is MSPEC. MT is one component of the demand for money. The other component is MSPEC. took the two components to be Keynes additive. That is, the total demand for money (MD) is equal to MSPEC plus MT. [Or simply: MD = MSPEC + MT] i MSPEC MT MS MT 1 MSPEC Simply written: MS = MD. So, MS = MSPEC + MT, where MS is controlled by the central bank. 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. 1 S The monetary sector is in equilibrium when money supply equals money demand. Y

The two (additive) demands for money together with the equilibrium condition imply possible combinations 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 i LM MT MSPEC MT 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 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 i LM MT MSPEC MT 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 The Keynesian Framework According to John Hicks and Alvin Hansen S Seq W S i i 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 ISLM Analysis Part I: The Real Sector The Keynesian Framework According to John Hicks and Alvin Hansen Roger W. Garrison 2008