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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