Download Chapter 24 The Keynesian Framework Chapter 25 The IS-LM World

Chapter 24
The Keynesian Framework
Chapter 25
The IS-LM World
Keynesian Theory
Advocates active role of the federal government in correcting economic problems
Manipulate money supply to adjust interest rates to induce borrowing or decrease
borrowing
Looks at the short-run--sees immediate problem, fix it now, rather than let it fix itself
Liquidity Preference Theory - Market rate of interest is determined by
demand/supply of money balances.
Demand of Money
Transaction
Precautionary
Speculative
+
f(y)
f(r)
Since:
+
−
D m = f (Y , r )
If MS increases then either income increases or interest rates drop.
Supply of Money
Fed basically determines supply
Few uncontrollable factors
(1) banks lending
(2) public's preference for cash
Letting D=S then solve for interest rate:
+
r= f (
Y
−
,M ,
•
+
P
)
e
Liquidity Trap: At some point rates will not drop further. At this point no one would trade
money for bonds.
Keynesian Focus
Focus on aggregate spending as the variable that must be adjusted through adjusting
interest rates:
ie. Excessive inflation--Keynesians see it as excessive spending (demand-pull
inflation) so they would manipulate money supply to raise interest rates to
decrease spending
Focus on ensuring low unemployment
Keynesians vs Monetarists
Break with Quantity Theory (Monetarists):
1. Since interest rates change when MS change, the rigid proportional link
between money and income is broken.
2. If the demand for money depends on interest rates, then velocity is a function
of interest rates which implies income no longer proportional to change in
money supply.
Reaction to Recession:
Keynesians immediately increase money supply to drive rates lower (later
inflation)
Monetarists allow lack of spending in economy to lower rates gradually
Keynesians assume that the quantity of loanable funds does not change when monetary supply is
adjusted (reduced/increased) Monetarists and Rational Expectations suggest that when money
supply is increased, inflationary expectations rise which cause a higher demand for loanable
funds This shifts the demand curve which could offset the shift in the supply curve caused by the
monetary policy decision. If both demand and supply shift equally, no change occurs in the
interest rate would occur and business investment would not change
FOMC decision reflect both Monetarists and Keynesian viewpoints. In addition, their political
affiliation tends to be related to their viewpoints--those appointed by a democratic president tend
to favor loose monetary policy while those appointed by a republican president tend to favor
tighter monetary policies.
Development of the IS/LM Curve
Keynesian Theory
Economy has 2 sectors: (1) financial and (2) real.
Financial sector described by demand and supply equations for money.
-
Financial Sector (LM)
- Liquidity Preference Theory
- Transaction & Precautionary Demand for Money
- LP = DM
DM
-
+
= f (Y )
Speculative Demand for Money
LP = DM =
−
DM = f ( i )
-
Total Demand for Money
LP = DM =
+
−
DM= f (Y, i)
-
Supply of Money
Determined by Fed
+ +
SM= f (R,i)
-
Equilibrium
SM = DM
_
+
+
i = f ( R ,Y , P )
Ignoring price expectations: The relationship between interest rate and aggregate nominal
income is the LM function.
Financial sector is in equilibrium at all points along the LM function.
Without changes in reserves, an increase in income will result in an increase in interest
rates.
-
Real Sector (IS)
-
Components: Y = C + I + G
Consumption
- C = f (Y)
- C=a+b Y
b=marginal propensity to consume
b<1 for all periods but exceptional periods
Ignoring government spending:
Y=C+S
S = Y - C = Y - (a+b Y) = -a+(1-b) Y
marginal propensity to save (1-b)
reacts inversely to
the marginal propensity to
consume (b)
- Savings when consider taxes
- S = f (Y-T)
- Wealth effect
+
C = f (W )
−
W = f (i)
+
C = f (Y ,
S
=
−
+
i, W )
+
+
+
f ( Y , i ,W )
-
Investment - Buildup of Capital goods
planned savings = planned investment
−
I = f (i)
-
-
Government spending
- independent of r, prices, Y
Total Spending
−
+
i = f (Y , G )
All points on the IS curve the real sector is in equilibrium.
Market Rate : IS=LM
Deflationary Gap--close by increasing money supply
Inflationary Gap--close by decreasing money supply
Strength of Monetary Policy
-
Stabilization policy involves shifting either IS or LM Curve
Measured by the resulting change in nominal income per dollar change in mo ney supply
-
Change in income produced by a shift in the LM curve depends on
- Size of the shift
- Slope of the LM curve
- Slope of the IS curve
-
LM Shifts
LM Shifts
Demand for LP increases, LM shifts left
Demand for LP increases, LM shifts left
Money Supply increases, LM shifts right
-
Slope of LM Curve
LM Slopes
- Greater sensitivity LP has to r change
- (flatter the LP curve) the flatter is the LM curve
- The less sensitive LP is to income (flatter the LP curve the flatter is the LM
curve)
- Vertical LM
- Horizontal LM---Liquidity Trap
- Fiscal policy dictates the income
- Bottom of deep recessions
- Fed is pegging interest rates
IS Shifts
- IS Shifts
-
Increase investment or Gov't spending, IS shifts right
Increase taxes, shift IS left
IS Slopes
- Slope of IS Curves
Greater sensitivity of I to r change (flatter I curve), the flatter the IS curve
- Greater MPS (more income sensitive the S curve), the steeper the IS curve
.
IS/LM Summary:
Shifts:
Increase demand £or Speculative Money LM shifts left
Increase demand £or Transaction Money LM shifts left
Increase money supply LM curve shifts right
Increase Investment or Gov't spending shift IS to right
Increase Taxes shift IS to left
Increase in MPS shift IS to left
Slopes:
Greater sensitive LPs is to interest change's (flatter LPs curve) the
flatter is the LM curve and shifts LM right
Less sensitive LPt is to income (flatter LP t curve) the flatter is the
LM curve and shifts LM right
Highly interest sensitive I (flatter curve) the flatter the IS and
shifts IS left.
Greater MPS (more income sensitive) the steeper the IS and shifts IS
left
Policy Effectiveness:
Steeper LM---More Effective Monetary Policy
Flatter IS----More Effective Monetary Policy
Steeper IS----More Effective Fiscal Policy
Flatter LM---More Effective Fiscal, Policy
Money Multiplier Summary:
1+C+0
K =
rd +rt (t)+ro(o)+c+e
IF c increases, k decreases, money supply decreases
IF t increases, k decreases, money supply decreases
IF r.r. increases, k decreases, money supply decreases
IF e increases, k decreases, money supply decreases
IF o increases, k increases, money supply increases
Points on the IS-LM Curves
-
Transmission Mechanism
Lags
Recognition
Action
Impact
-
Policy Impact
Monetary Policy strong
Steep LM
Flat IS
Fiscal Policy strong
Steep IS
Flat LM
Points off the ISLM Curve
Crowding Out Effect
Expansive Action--Crowd Out
Restrictive Action--Crowd In