Download ISLM: Part I: The Real Sector

ISLM Analysis
Part I: The Real Sector
The Keynesian Framework
According to John Hicks and Alvin Hansen
Roger W. Garrison
2010
S
S
(1 – b)
1
1
-a
1
Y
i
I
I
According
Macroeconomic
In Keynes’s
to vision,
Keynes,
equilibrium
investment
savingfor
depends
adepends
whollyupon
private
primarily
income
economy
onand
“animal
income
requires
spirts.”
alone.
that saving
equal
investment.
I”only
is antoaequilibrium
In
But
particular,
investment
S =also
– aThat
+depends,
(1is,– “S
b)Y,=ifwhere
a> minor
0 and extent,
0 <condition.
b <on
1. the rate of interest.
The demand for investment funds in highly interest inelastic.
With “animal spirits” in play, the whole curve moves around on its own.
Suppose the interest
rate is relatively low.
S
borrowing
income
is
How much saving
and investment
would
required
people
to finance
have
would
this
to
the business
earn
to
willing
community
to
level
of be
investment?
save
this amount?
be willing
to undertake? i
S
Y
i
I
So, now we have one
possible combination
of the interest rate
iLOW
and total income.
Y
I
So far, we have one equilibrium condition (in orange) and two behavioral
relationships (in blue). Together, these three relationships imply a particular
relationship between the interest rate and the economy’s total income.
This relationship is revealed by tracing out the implications of a low interest
rate, a high interest rate, and a middling interest rate.
Suppose the interest
rate is relatively high.
S
incomeis
borrowing
How much saving
would
and
required
investment
people
to finance
have
would
this
to
earnbusiness
the
to
willing
community
to
level
of be
investment?
save
be
willing
this amount?
to undertake? i
iHIGH
Now we have
another possible
combination of the
iLOW
interest rate and
total income.
S
Y
Y
i
I
I
So far, we have one equilibrium condition (in orange) and two behavioral
relationships (in blue). Together, these three relationships imply a particular
relationship between the interest rate and the economy’s total income.
This relationship is revealed by tracing out the implications of a low interest
rate, a high interest rate, and a middling interest rate.
Suppose the interest
rate is a middling rate.
S
borrowing
saving
is
How much income
and investment
required
would
people
to finance
have
would
this
to
the business
earn
to
willing
community
to
level
of be
investment?
be willing
save
this amount?
to undertake? i
Now we have a third iHIGH
possible combination i
MID
of the interest rate
iLOW
and total income.
S
Y
i
I
IS
Y
I
Soline
A
far,passing
we havethrough
one equilibrium
these three
condition
points (two
(in orange)
would have
and two
been
behavioral
enough)
represents all(in
relationships
combinations
blue). Together,
of thethese
interest
three
rate
relationships
and total income
imply athat
particular
are
consistent with
the equality
of investment
saving, given
theincome.
relationships
relationship
between
the interest
rate and and
the economy’s
total
that
investment
behavior
and saving
This describe
relationship
is revealed
by tracing
out thebehavior.
implications of a low interest
rate,
a high interest
andthe
a middling
rate.this curve, I = S.)
Accordingly,
we call rate,
this line
IS curve.interest
(All along
S
If the middling rate of
interest just happens to
be the equilibrium rate, Seq
the level of total income
that corresponds to that
rate is the equilibrium
i
level of income.
iHIGH
Equilibrium levels of
ii
saving and investment MIDeq
are similarly identified. iLOW
S
Y
I
i
IS
Yeq Y
Ieq
I
WARNING: “Equilibrium” in income-expenditure analysis means only that
income gets spent---or, equivalently (for a wholly private economy), saving
gets invested. It does not mean that the work force is fully employed or that
the economy’s potential output is being realized. Keynes believed that some
“unemployment equilibrium” was the norm for a wholly private economy.
If the income-expenditure S
equilibrium just happens
to be consistent with full Seq
employment, then the
labor force will be
experiencing a supplyi
and-demand equilibrium.
Keynes
But
Keynes’s
assumed
supplythat
ieq
and-demandinreckoning
movements
total
of the labor
income
faithfully
market
reflect
differs
the
movements
importantly
in from
the
AlfredofMarshall’s.
level
employment.
S
W
S
Y
i
LABOR
INCOME
D
I
N
IS
Yeq Y
Ieq
I
Wholly dismissive
Marshall
would observe
of the that
classical
the wage
economists’
rate hastheorizing
adjusted to
about
the prevailing
the distribution
supply-and-demand
of
income among thefor
factors
labor.of production, Keynes assumed a “fixed structure
Keynes
of
industry”
would
whose
observe
levelthat,
of utilization
give the varies
supplydirectly
of laborwith
andthe
theemployment
going wage of
rate,
the current
labor.
And with
levelthe
of wage
expenditures
rate given,
justchanges
happensintototal
be high
income
enough
are directly
to cause the
resulting demand
proportional
to changes
for labor
in the
to clear
employment
the laborofmarket.
labor.
According to Keynes, the S
demand for investment
funds is subject to a
Seq
sudden, unpredictable S'eq
collapse. The collapse
(the leftward shift in the
i
demand curve) upsets
both the labor market’s
supply-and-demand
ieq
equilibrium and the
macroeconomy’s incomeexpenditure equilibrium.
S
(1 – b)
W
ΔI
1
ΔY
S
Y
i
D
ΔI
I
N
1
ΔY = (1 – b) ΔI
IS
Y'eq Yeq Y
I'eq Ieq
I
The
magnitude
shift
in thebehavior,
ISincurve
is aIS
multiple
of thetomagnitude
With
thewe
change
inthe
investment
the
curveashifts
the left. of
Finally,
note of
that
the
decrease
income
reflects
corresponding
the
shift
ininthe
demand
Here,
thewage
simple
decrease
theexperiences
demandforforinvestment
And funds.
with
the
going
rate
persisting,
The
economy
alabor.
downturn
in which
lower
levels
of Keynesian
income,
multiplier
is in
play.
Andare
note
thata with
an unchanged
rate of
interest, the
the
labor market
is experiencing
persistent
(Marshallian)
disequilibrium.
investment,
and
saving
established.
equilibrium
level
ofitincome
also changes
in accordance with the simple
Keynes
would
call
“unemployment
equilibrium.”
Note that the interest rate, If only by assumption, remains unchanged.
Keynesian multiplier.
S
According to Keynes,
people’s saving behavior
is unlikely to change.
Seq
And fortunately so. In the
Keynesian framework,
increased saving has bad
i
consequences.
A decision to save more
ieq
is represented by an
upward shift in the saving
function.
S
ΔThrift
W
S
Y
ΔY
i
−1
ΔY = (1 – b) ΔThrift
D
I
N
IS
Y'eqYeq Y
Ieq
I
Finally,
IfThe
thegreater
oldweequilibrium
note
volume
that of
the
rate
saving
decrease
of interest
would
instill
be
income
borrowed
prevails,
reflects
then
by athe
the
corresponding
business
economy’s
community
reaction
only
decrease
if the in
rate
the
ofdemand
interest
for
were
labor.
lower.
As happened in the case of a fall in
to increased
saving
is a fall
income.
investment
an increase
in thriftrelationship
reduces
spending
causes
thethe
IfAnd
wewhatever
call andemand,
upward
the eventual
shift
of consequences
the saving
of the increased
a changeand
saving,
in thrift,
thethen
old
IS
labor
toshift
experience
persistent
(Marshallian)
corresponding
in theThe
ISacurve
is given
multiplier---which is
curve market
is no longer
valid.
new
one
lies
tobyitsthe
left.thriftdisequilibrium.
simply the negative of the spending multiplier. (Thrift means not spending.)
A decision to classical
According
save more S
thinking,
is
represented
people’s
in two
saving
behavior ways---by
different
is subject an
to
Seq
change.shift
upward
Andinnot
the saving
surprisingly,
function
and,those
at the same
changes
time,
by aimpinge,
rightwardin shift
the
i
firsttheinstance,
in
supply ofonloanable
the
market for loanable
funds.
funds---which entails
ieq
both
the demand for
We’re now depicting the classical
view in the Keynesian
loanable
funds framework.
and the
supply of loanable funds.
S
ΔThrift
W
S
Y
i
D
I
ΔIN
IS
Yeq Y
Ieq
I
Finally,
The
Notice,
Consistent
greater
we
though,
note
with
volume
that
that
pre-Keynesian
of
with
ansaving
increase
the new
is thinking,
willingly
inlower
saving
equilibrium
borrowed
saving
and the
andby
consequent
rate
investment
theofbusiness
interest,
increase
arethe
community
brought
initial
in
because
level
investment
into balance
of income
thewill
rate
byredirect
isaof
consistent
market-driven
interest
production
iswith
sufficiently
change
anplans
income-expenditure
away
inlower.
the from
rate
Equilibrium
of
producing
interest.
equilibrium.
in the
consumer
And,loanable
ofA
funds
functional
goods
course,
market
and
given
loanable-funds
toward
isthis
re-established.
producing
critical market
function
investment
keeps
ofwith
thethe
interest
economy
rate,
from
it is
total
essential
spiraling
demand
that
downward
forthe
But
agoods.
shift
inBut
thethe
saving
function
and
a
ininterest
labor
response
need
rate
not
tobean
change.
allowed
increase
(However,
to in
seek
saving.
the
market
economy’s
equilibrium.
growth
rate
will increase.)
movement
along
the
demand
forits
loanable
funds,
the
old IS
curve
is no longer
valid. The new one lies to its left.
ISLM Analysis
Part I: The Real Sector
The Keynesian Framework
According to John Hicks and Alvin Hansen
Roger W. Garrison
2010