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