MACROECONOMICS IIB

Keynesian Model
1
Keynesian Model
2
1. Simple Keynesian Model
2. Keynesian IS-LM model
3. Keynesian AD-AS Model
i. Flexible Wage
ii. Fixed Wage
4. Keynesian IS-LM & AD-AS

AD
AS
P
Y
Y*
1. The Simple Keynesian Model

3
a. Equilibrium Output
b. Aggregate Expenditure/Spending
c. Equilibrium Income
d. Exports & Imports
4
(a) Equilibrium Output
Assumptions:
all factors of production are owned by households;
all output is produced by private sector firms and
government buys from private firms and does not
produce any output itself;
closed economy, therefore GDP=GNP and National
Income (GNI) is equal to GDP (purchases of current
goods and services); and,
the aggregate price level is fixed and therefore all
variables are real and all changes are real changes.
5
AGGREGATE DEMAND

Keynesian Model aggregate output (supply) equals aggregate
expenditure (demand), i.e.
Y = E (1)
Accordingly in equilibrium:
Y = E = C + I + G (2)
Assumed balanced budget, i.e. G-T = 0
An identity exists between output and expenditure, i.e.:

Y C + S + T (3)
Key concept of the Keynesian models is expectations and is
critical because it allows the Model to handle the discrepancy
that can occur between planned and actual or realized
outcomes.
Keynes placed special emphasis on the difference between
planned (I) and actual or realized investment (I
r
) by private
firms. Thus:
Y = C + I
r
+ G (4)

6
From Eq. 3 & 4,
S + T = I + G (5)
Similarly using Eq. 2 & 4
I
r
= I (6)

Given the assumptions, there are 3 alternative ways of
expressing equilibrium in the simplified Keynesian
Model:
Y = C + I + G (2)
S + T = I + G (5)
I
r
= I (6)
where I
r
actual/realized investment;
I planned/desired investment

7
How planned and realized inventory invest can
differ?
Y > E (7)
C + I
r
+ G > C + I + G
I
r
> I
i.e. actual inventories are larger than planned;
I
r
-I is the unintended inventory accumulation.
Alternatively,
E > Y (8)
C + I + G > C + I
r
+ G
I > I
r
i.e. desired inventories are larger than the realized;;
I I
r
is the unintended inventory shortfall.
8
(b) Aggregate Expenditure/Demand (AD)
AD in the Keynesian Model comprises 3 components:
i - consumption (C);
ii - investment (I); and,
iii - government spending (G).
i Consumption
C accounts for 60 - 70% of AD. Keynes believed C was a
stable function of disposable income (Y
d
) , i.e. after tax
income (Y
d
= Y-T).
Other factors can influence C, e.g. expected in Y or
wealth as well as expected price changes.
In summary, C is induced by changes in the level of
income, i.e. if income goes up C goes up and visa versa.


9
Figure 1: Keynesian
Consumption Function
b represents the
marginal propensity to
consume (MPC) or the
slope of the C function
relative to disposable
income.
b = C/Y
d
(10)
Figure 2: Keynesian
Saving Function

In the Keynesian Model, the C function can be
expressed as:

C=a+bY
d
(9)

where a>0; 0<b<1
C
Y
d
Slope = b
C = a + bY
d
Y
d
C
S
Y
d
Y
d
S
S = -a + (1- b)Y
d
10
Keynes assumed that any in Y
d
would be split between C
and S, i.e. the in C would be less than the in Y
d
.
For individual households, MPC varies according to income
level. Thus the rich have a lower MPC than the poor.
Y
d
forms an accounting identity with C and S as follows:
Given: (3)
then: (11)
The savings function:
S = -a + (1-b)Y
d
(12)
The marginal propensity to save (MPS) , i.e. the in S for a
unit in disposable income as
S/Y
d
= 1 b (13)



T S C Y + +
S C T Y Y
D
+
11
ii Investment I= I(r, )

Highly Volatile.
I is an autonomous variable that changed not in response
to Y but for other reasons.
The two factors determine the level of I - the interest
rate (r) and expected business condition, i.e. the
expectation of earning a profit/future expectations of
profitability (
e
).
There is uncertainty information in the future.
Expectation always change according to changes in the
economy situation as a response of new information.

Investment I= I(r, ), cont
The r measured the direct or indirect cost of
financing a project, i.e. investing.
The anticipated profit to be earned was calculated
relative to the cost of funds that must be paid to
undertake the project.
There are great uncertainties concerning I. Some
uncertainties are subject to probabilistic
calculation; other are consider true uncertainty,
i.e., there are risks involved.
The willingness to accept these risks was summed
up as animal spirits by Keynes.

12
13
iii Government Spending and Taxes
Keynes assumed that government spending and taxation
were not direct functions of income, i.e. they are
autonomous not induced variables of Y.

(c) Equilibrium Income
First form of the condition for an equilibrium level of
income is:
Y = E = C + I + G (2)
- Y is the endogenous variable to be determined.
- Autonomous or exogenous variables: a, I, G & T which
do not vary with income.
Consumption, is dependent or induced by changes in
disposable income, i.e.
C = a + bY
d
(9)

or
C = a + bY bT

14
Substituting Eq.9 in 2, we get:
(14)

The Equilibrium Income is shown in Figure 3a & 3b.
The intersection of Aggregate Expenditure (AE) Curve and
the 45
0
line indicates where equilibrium will be achieved
(A in Fig.3).
Any point above A and the AE curve indicates that DD
exceeds output and business inventories will be run down
forcing the system back to equilibrium.
Any point below A and the AE curve indicates that AD is
less that existing output and inventories will be built up
forcing the system back into equilibrium.


) (
1
1
G I bT a
b
Y + +

=
15
Figure 3: Determination of
Equilibrium Income
Y = E = C + I + G
(2)
) 9 ( bT bY a bY a C
D
+ = + =
) (
1
1
) 1 (
G I bT a
b
Y
G I bT a b Y
G I bT a bY Y
G I bT bY a Y
G I C Y
+ +

=
+ + =
+ + =
+ + + =
+ + =
(14)
45
0
C,I,G
Y
C = a + Y
d
E = C + I + G
A
I + G
b
b
a bT + I + G
a-bT
Y
1 Y
a. Aggregate Expenditures
I + G
I + G
S + T
Y
C,I,G,T
Y
1 Y
1-b
b. Investment, Government spending, Saving, and Taxes
( )
( )
b
b
T
Y
T b
b
Y
b G
Y
G
b
Y
b mps I
Y
I
b
Y
I Y b
Y b S

=
A
A
A

= A

=
A
A
A

= A

= =
A
A
A

= A
A = A
A =
1
) (
1
1
1
1
1
1
1
1 1
1
1
1
1
16
Keynes introduced one of his most important additions to
economic thinking the multiplier.
(1/1-b) is the aggregate expenditure multiplier where b = MPC.
If b <1 then the denominator is <1 and when divided into 1
will generate a number (the multiplier) that is >1. i.e. any
change in autonomous spending, especially usually more
unstable investment will lead to a larger change in output
equilibrium.
In equilibrium, it is assumed that I + G = S + T. If there were no
government this would mean that I =S for equilibrium.
One of Keynes criticisms of the Classical Model was that the
loanable funds doctrine was not necessarily true.
On the one hand individuals might, due to fear and insecurity,
hold cash without investing it. On the other, firms might be
unwilling to invest as much as consumers are willing to save.
This potential instability of I lay at the heart of Keynes call for
an interventionist government.


17
The effect of the multiplier at work due to an increase in
autonomous spending, specifically an increase in I can be
seen in Fig.4.
The I shifts the AE curve upwards by the I but
equilibrium output increases by more than I. In effect
income by I which then consumption (C) because
part of Y is spent (specifically b Y).
Therefore
Y = I + C may be expressed as
Y C = I, and, assuming tax collection is fixed,
then for equilibrium:
S = I (15)
Thus with T and G fixed, to restore equilibrium S must
enough to balance I.

18
As and using Eq. 15
and, therefore,
(16) or


The same result will occur for G. Thus,
, and, (17)

There is a difference, however, with respect to a change in
taxes, i.e. T (Fig. 5).
or, (18)

Given that changes in G or T can affect equilibrium income they
can be used as conscious tools of macroeconomic policy to
offset undesirable changes in I. In Fig. 6, we can see that a
drop in I can be offset by increasing G.


( ) Y b S A = 1
( ) I Y b A = A 1
b mps I
Y

= =
A
A
1
1 1
I
b
Y A

= A
1
1
G
b
Y A

= A
1
1
b G
Y

=
A
A
1
1
T b
b
Y A

= A ) (
1
1
b
b
T
Y

=
A
A
1
19
Figure 4: Effect of an
Increase in Autonomous
Investment on Equilibrium
Income
45
0
C,I,G
Y
E
0
= C + I
0
+ G
0
E
1
= C + I
1
+ G
0
A
I
b
b
a bT
0
+ I
1
+ G
0
a bT
0
+ I
0
+ G
0
a. Aggregate Expenditures
I
1
+ G
0

S + T
0
Y
C,I,G,T
1-b
b. Investment, Government spending, Saving, and Taxes
B
C
Y
1
Y
0
I
0
+ G
0
I
A
I
0
+ G
0
I
1
+ G
0
Y
0
Y
1
B
20
Figure 5: Effect of an
Increase in Taxes on
Equilibrium Income
45
0
C,I,G
Y
(C + I + G)
1
(C + I+ G)
0
A
-bT
b
b
a bT
0
+ I
1
+ G
0
a bT
1
+ I
0
+ G
0
a. Aggregate Expenditures
I
1
+ G
0

S + T
0
Y
C,I,G,T
1-b
b. Investment, Government spending, Saving, and Taxes
B
Y
1
Y
0
I
A
I
0
+ G
0
Y
0
Y
1
B
S + T
1
21
Figure 6: An Example of
Fiscal Stabilization Policy
45
0
C,I,G
Y
E
0
= C + I
1
+ G
0
E
1
= (C + I
1
+ G
0
) = (C + I
1
+ G
0
)


A
-I
b
b
a. Aggregate Expenditures
I
1
+ G
0

S + T
0
Y
C,I,G,T
1-b
b. Investment, Government spending, Saving, and Taxes
B
C
Y
0
I
0
+ G
0
-I
A
I
1
+ G
0
I
1
+ G
0
= I
1
+ G
1
Y
0
B
+G
Y
Y
+G
Changes in government
spending (G) and
Taxes (T) is a fiscal policy
instrument to
Stabilize income (Y), full
employment
(u=2-3%) and reducing
inflation (=0-3%).
22
(d) Exports & Imports (Open Economy)
Assuming X stands for exports and Z for imports the
national income and expenditure equation can be
specified as follows:
Y = E = C + I + G + X Z (19)
Exports - sales of current domestic production to
foreigners. Thus, it is part of AD.
Imports, are purchases made from foreigners and not
from current domestic production. Therefore, they
represent a reduction in DD for domestic goods and
services and are subtracted from AD.
What is equilibrium in an open economy? Assuming G
and I are autonomous of changes in Y; C is induced by
changes in Y, i.e.
C = a + bY (20)



23
What determines exports and imports?
In the case of exports, DD is autonomous - it is determined
by foreign income not domestic; by the exchange rate and
international prices, not domestic.
In the case of imports - they depend on Y, i.e. induced by
Y, i.e.
Z = u + vY (21) where
u - autonomous level of imports;
v - the marginal propensity to import, i.e. the percentage of
additional income spent on imports.
If Z is induced by Y and C is induced by Y then any in Y
will be split between consumption of domestically produce
or imported goods and services. Starting with:
Y = E = C + I + G + X Z (19)


24
substituting C = a + bY and Z = u + vY into Eq. 19, we
obtain:
(22)
Ignoring T, and compare Eq. 22 with the closed economy
equation:
(23)
The higher the propensity to import (v) the lower the
multiplier.
This reduces the effects of changes in autonomous
expenditures, e.g. G.
Imports act as a leakage from the system. The more
leakage the less leverage is available to government,
monetary authorities and domestic forces to effectively
exercise macro-economic policies.

( )
( ) u x G I a
v b
Y + + + +
+
=
1
1
( )
( ) G I a
b
Y + +

=
1
1



2. The Keynesian Model (cont'd)
25
(e) Money & Interest Rates
i. Demand for Money
ii. Investment
iii. Theory of Interest
iv. Equilibrium
r
M/P
M
d
=L(r,Y)
M
s
= M/P
M
d
<M
s
M
d
>Ms
r*
r
1
r
2
26
Money-Income Transmission
The Keynes Effect (Money Income Transmission Mechanism):
| |
)
`

|
|
+ | | | P AD
C
I
r P B M
durables
B
d s
Money is not neutral (in the short run), and there is no dichotomy.
Some modern Keynesians argue for long-run neutrality, but short-
run nonneutrality.
Changes in the money supply affect the real sector through the
interest rate channel.
MS r I y
KEYNESIAN IS-LM
-The Role of Money
Money plays an important role on the level of economics
activities
M
S
r I AD Y (causality)
27
e) Money & Interest Rates
In Classical Model, money and the cost of money (the interest rate) have
no real effect. Prices increased or decreased (including the price of
money) but real output did not change. The AS curve was vertical
(perfectly inelastic).
Real demand (as opposed to the demand for money) was given by
Says Law: supply creates its own demand.
What happens in the Keynesian Model?

Theory of Interest Rate
Assumptions:
Financial asset money and bond
Define money supply M1 = currency in circulation (CC) + Deposits (D)
All alternatives financial assets is homogeneous

Wealth: Wh = B + M, M
d
= M
d
t
+ M
d
s

Equilibrium: Bd = Bs and M
d
= M
s

If M
d
> M
s
: Sell bon P
b
r M
d
M
d
= M
s

1. Demand for Money

Assumed that supply of money (M
1
) is fixed by the
monetary authorities.
The demand for money in the Keynesian Model, is
different from Classical Model.
Assuming income can be held either as money, spent or
converted into interest earning assets (bonds), there
were 3 main reasons for holding money as cash:
i) transaction demand : M
d
t
= f (Y)
ii) precautionary demand : M
d
p
= f(Y)
iii) speculative demand : M
d
s
= f (r)
iv) total demand : M
d
= L (r, Y)

28
29
i) Transactional Demand
Money would be held as a medium of exchange for use in
transactions. Transactional DD vary positively with the volume of
transactions (T
D
) and income was assumed to be a good measure of
T
D
.
There are brokerage and other fees associated with buying bonds
(assume - the real rate of return being r and stands for fees), the
higher the interest rate the higher the final rate of return and so
individuals and households are more likely to reduce their
transactional DD for money as the interest rate rises.
In conclusion, T
D
varies positively with income and negatively with
the rate of interest.
ii) Precautionary Demand
Individuals always have a DD for cash on hand to meet emergencies
medical or repairs. Keynes assumed the amount of precautionary
DD (P
D
) would vary positively with income. To simplify the analysis
it will be assumed that P
D
can be subsumed under T
D
as an
unexpected transaction demand for money.


30
iii) Speculative Demand
Keynes argued that given uncertainties about future interest rates
and the relationship between interest rates and price of bonds
(specifically capital loss or gain on their value) meant that there
would be times when individuals would hold on to cash.
If you buy a bond today you are committing part of your income to
something that will pay a given rate of interest say r
1
. The price of
the bond is sometimes called its yield measured by the purchase
price say $1,000 and its coupon or interest rate is, say 5%.
If tomorrow the interest increases to r
2
say 10% - you will lose (r
2

r
1
). Furthermore, if you try and sell your old bond its price must be
decreased to yield an effective rate of r
2
.
The difference in what you paid for the bond and the price at which
you must sell it to generate an effective yield of r
2
is called a capital
loss.
31
Keynes argued that the uncertainty lead some individuals to
hold onto cash in order to earned a higher rate tomorrow and
avoid capital losses. And vice versa, if interest rates were
expected to fall then speculative demand for money would fall
as higher yielding bonds are purchased today in the hope both
of a lower interest rate tomorrow and the chance of capital
gains.
Keynes assumed that different individuals had different views
about future change in the interest rate.
Each had preconceptions of what was the normal rate of
interest. Those who thought the normal rate was higher than
todays rate would tend to have a higher S
D
; those who thought
the normal rate was less than todays rate would have a lower
S
D
.
32
At very low current rates most individuals will have a high S
D

in anticipation that rates will rise tomorrow and to avoid capital
losses.
If enough individuals hold on to cash a liquidity trap is
reached. This is the point at which the demand for money
(liquidity) is perfectly elastic with respect to the interest
rate. This is reflected in Fig. 7, where the curve tends to flatten
out at the bottom.
In liquidity trap, any in the money supply yields no fall in the
interest rate. Such a situation arises when the yield on income
earning assets is so low that the risk of holding such assets is so
high (capital losses if rates rise) that investors prefer to hold on
to any in the money supply in liquid form.

The speculative Demand for Money: Keynesian explanation
Individuals will hold all wealth in money if they expect r in
future is low.
M
d
=c
0
+c
1
(Y)-c
2
(r )

Return on money M= zero
Expected return on B = r + expected capital gain
or
= r expected capital loss
r > r
c
Wh=B M
d
= 0
r < r
c
Wh=M B = 0

33
34
Figure 7: Individual & Aggregate
Speculative Demand Curves for
Money
M
d
s
Wh - M
d
t
r
c
r
n
r

M
d
s

a. Speculative Demand for Money (Individual)
M
d
s
r

M
d
s

b. Aggregate Speculative Demand for Money
According to Keynes, individual was assumed to have preconceived view of
the normal interest rates (r
n
). If r > r
n
, r is expected to fall. At that level of r,
bond will be more preferred than money as asset. M
d
s
is zero and holding
bond is equal Wh-M
d
t
If r r
n
, r is expected to increase. Holding B will cause capital loss. So that,
all the holding wealth in money, and B= 0
Alternatively,
r will cause capital loss (P
b
) on the bond that have been purchased. On
the other hand, if r, bond purchased earlier will experience capital gain
(Pb). At this lower interest rate (r), investor sell the bond at higher price
and obtained capital gain.
M
d
= L (Y , r )
M
d
= c
0
+ c
1
Y- c
2
r
M
s
r
M
s
M
d
< M
s
excess supply of money
Buy Bond Bd ( P
b
) r
Expected capital loss (r ) - M
d
M
d
=M
s

Disequilibrium in goods markets and money market will cause depression on
r and Y to changes.

35
36
iv) Total Demand
Total demand for money in the Keynesian Model or M
D
= T
D
+ P
D
+
S
D
where T
D
and P
D
vary positively with income and negatively with
respect to interest rate while S
D
does not vary with income but
negatively with respect to interest rates.
Taken together we can say:
M
d
= L(Y, r) (24)
If we assume the function is linear, then
M
d
= c
o
+ c
1
Y c
2
r (25)
where c
1
>0, c
2
>0 and
c
0
is the minimum amount of cash that must be held; c
1
is the in
money demanded per unit in income and c
2
is the in money
demanded per unit in the interest rate.
Assuming linearity, the total demand for money is downward
sloping relative to the rate of interest (Fig.8).

37
Figure 8:
Money demand curve
0 ) , ( <
A
A
=
r
M
r y L M
d
d
r

M
d

L(r,Y)
r
1
r
2
M
d
1
M
d
2
Money demand curve
38
The money demand curve takes the following form:


The money demand curve is downward sloping with
respect to the interest rate. However, changes in
income will lead to shifts in the money demand curve.
Two important factors concerning the money demand
function relate to interest and income elasticities.
The interest elasticity of money demand describes
how the demand for money varies with respect to
changes in the interest rate.

( ) r Y L M
d
, =
0 <
A
A
r
M
d
Interest elasticity of money demand
39
It is the ratio of the percentage change in money demand and
the percentage change in interest rates:


If , then money demand is interest inelastic.
Changes in interest rates generate less than proportional
changes in money demand. Consequently, the money demand
schedule will be relatively steep.
If , then money demand is interest elastic. Changes
in interest rates generate more than proportional changes in
money demand and the money demand schedule will be
relatively flat. (Fig. 9)
r
M
d
M
r
d
A
A
=
%
%
c
1 0 > >
d
M
r
c
1 <
d
M
c
40
r

M
d

L
1
(r,Y)
r
1
r
2
M
d
1
M
d
2
L
2
(r,Y)
a
b c
Interest inelastic money demand
Interest elastic money demand
M
d
3
Figure 9: Interest elasticity of money demand
Income elasticity of money demand
41
The income elasticity of money demand describes how
money demand reacts to changes in income:


This elasticity does not determine the slope of the curve, but
rather how far it will shift following a change in income.
If , then money demand is said to be
inelastic. This means that a given change in income will
produce a smaller than proportionate change in money
demand (L
1
L
2
). (Fig. 10)

If , then money demand is income elastic changes
in income produce larger than proportionate changes in
money demand. The shift in the money demand curve will
be relatively large following a change in income (L
1
L
3
).
Y
M
d
M
Y
d
A
A
=
%
%
c
1 0 < <
d
M
Y
c
1 >
d
M
Y
c
Figure 10: Income elasticity of money demand
42
r
r
Money Demand M
d
1
M
d
2
M
d
3
L
1
L
2
L
3



M
S
/P = real money supply / supply of real balances
P real balance

money supply is taken to be exogenously determined and
controlled by the monetary authority / central bank.
money supply does not depend on either r or y and is a
policy instrument which can be changed at the behest of
the authorities.

43
Supply of Money
Equilibrium in the Money Market
M
D
= M
S
(Figure 12)
44
r

M
d

M
d
=L(r,Y)
r
1
a
Figure 12: Equilibrium in Money Market
M
d
1
M
s

45
Ambiguity in the Money Market
In the classical model:
M
s
= M
0
(exogenous)
M
d
= M
d
(Y)
We used these relationships to create the AD curve.
In Keynes model:
M
s
= M
0
(exogenous)
M
d
= L(Y,r)
M
s
= M
d

M
0
= L(Y,r) is the money market outcome.
46
Keynesian Money Market
M
0
= L(Y,r) is the equilibrium in the money market.
There is not one single variable that can change to
clear the market. There are two!
The money market cannot tell us alone what the
supply and demand for money will be.
Money is not dichotomous.
The Keynesian Model (cont'd)

47
(f) IS-LM Model
1. Money Market Equilibrium : LM
(i) Slope of the LM Curve
(ii) Shift of the LM Curve
2. Product Market Equilibrium : IS
(i) Slope of the IS curve
(ii) Shift of the IS curve
3. Equilibrium: relationship between r & Y when both
goods market & money market achieve equilibrium
simultaneously.
r
r
0
Y
0
Y

IS
LM
48
f) The IS-LM Model

The IS-LM Model is the Keynesian method to
determine simultaneous equilibrium in the
commodity (output) and money market, two
assumptions must be made:
policy variables are assumed fixed, i.e., M
s
, G, T;
and,
other autonomous or exogenous factors are
assumed fixed, e.g., business expectations about
investment.


49
1. Money Market Equilibrium (LM)
Keynesian M
d
: transactional, precautionary and speculative DD
components.
Transactional DD varies positively with the level of income, i.e.
the higher the level of income, the higher the transactional
DD. Transaction DD also varies inversely with the interest rate,
i.e., the higher the rate of interest the greater the opportunity
cost of holding cash.
L
T
= f(Y, r) (+, -)
Speculative DD varies inversely with the r , i.e. the higher the r
the lower the level of speculative DD.
L
S
= f(r) (-)
Accordingly, M
d
can be generically expressed as
M
d
= L(Y, r) (+, -) (27)


50
Alternatively, expressed in linear form:
M
d
= c
o
+ c
1
Y c
2
r (28)
where c
o
> 0
,
c
1
> 0 and c
2
> 0

Given the assumptions, what combinations of r
and Y will result in equilibrium of M
d
and M
s
0
?
In linear terms:
M
s
0
= M
d
= c
0
+ c
1
Y c
2
r (29)
Y = 1/c
1
[M-c
0
+c
2
r]

51
Fig. 13 illustrates the equilibrium in the money market given
M
s
0
and different levels of Y(0, 1, 2).
At Y
0,
equilibrium is achieved at r
0
. If Y to Y
1
then L
T
but
with a fixed money supply this increased DD raises the price of
money, i .e., r from r
0
to r
1
. in interest reduces L
S
and also
lowers the L
T
at any given level of Y (opportunity cost i leading
to improved cash management practices reducing L
T
).
Equilibrium is re-established when the increased L
T
resulting
from an in Y is exactly offset by the decline in L
S
and L
T

caused by the in r .
By varying Y we can deduce a series of points (A, B, C) where,
given a fixed money supply and in Y, a new equilibrium interest
rate will exist (r
o
, r
1
, r
2
).
These points (Y, r) can then be plotted to generate the LM curve
(Fig. 13b) that trace equilibrium conditions in the money market.

52
r
r
r
1
r
1
r
3
r
0
r
0
r
3
LM
M Y
M
s
0
M
d
(Y
0
)
M
d
(Y
1
)
M
d
(Y
3
)
A
A
B
B
C
C
Y
0
Y
1
Y
2
Figure 13: Equilibrium Positions in the Money
Market and the LM Schedule
53
Two additional policy-relevant questions need be answered.
(i) What is the slope of the LM curve steep or gentle?
(ii) What causes the LM curve to shift?

(i) Slope of the LM Curve: c
1
& c
2

The slope of the LM curve reflects the change in r caused by an in Y, i.e.
r/Y = c
1
/ c
2
.
2 factors affect the slope: the value of c
1;
and the elasticity of DD for money,
specifically the value of c
2
.
First, from eq. 28, M
d
= c
o
+ c
1
Y c
2
r.
M
d
= c
1
(Y)

where c
1
is a parameter of the in money demand per unit in income or
income elasticity of money demand
Given a fixed M
S
, r the must raise enough to offset this income-induced in
the M
d
.
The higher c
1
(M
d
is income elastic), the larger will be the required in r to
re-equilibrate the money market, ; the smaller c
1
(M
d
is income inelastic), the
lower the necessary in r.
Alternatively, the higher the value of c
1
the steeper will be the slope of the LM
curve; the lower the value of c
1
the LM curve is flatter .
The value of c
1
, however, is relatively stable determined by institutional
factors, e.g., payment periods and technology.

d
M
Y
c
54
b
c
a
M/P
r
1
r
2
r
3
L(r,Y
0
)
L(r,Y
1
)
L(r,Y
2
)
I
n
t
e
r
e
s
t

R
a
t
e

Money Demand
a
b
c
Y
Y
1
Y
2
r
1
r
2
r
3
r

Figure 14: The Income Elasticity of money demand
1 <
d
M
Y
c
1 >
d
M
Y
c
55
Second, the response of M
d
to a change in r (or the interest
elasticity of the demand for money ).
An in r the opportunity cost of holding money causing a
reduction in speculative and transactional demand.
In eq. 28, we know that
M
d
= c
o
+ c
1
Y c
2
r
M
d
= -c
2
(r)
where c
2
measures the change in M
d
for a change in r (-c
2
=
M
d
/r).
Fig. 15a shows M
d
with a very low elasticity (steep) (measured
in absolute value, i.e. ignoring the negative sign associated with
c
2
). (money demand were interest inelastic). (LM curve steeper)
This means c
2
is relatively low meaning that a relatively small
increase in Y will require a large increase in r to reduced
speculative and transactional DD to compensate for the
income-induced increase in M
d
.
Alternatively if the M
d
is very interest-elastic (gentle) as in Fig.
13b then c
2
is relatively large and only a small change in r is
required. (LM curve flatter)


d
M
r
c
56
r
r
r
1
r
1
r
3
r
0
r
0
r
3
LM
M Y
M
s
0
M
d
(Y
0
)
M
d
(Y
1
)
M
d
(Y
3
)
Y
0
Y
1
Y
2
Figure 15: Interest Elasticity of Money Demand and the Slope of the LM Curve
c
1
(Y
2
-Y
1
)
r
0
LM
r
Y M
r
r
0
r
1
r
1
r
3
r
3
Y
0
Y
1
Y
2
M
s
0
M
d
(Y
0
)
M
d
(Y
1
)
M
d
(Y
3
)
c
1
(Y
2
-Y
1
)
a. Low Interest Elasticity of Money Demand
b. High Interest Elasticity of Money Demand
57
b
c
a
M/P
r
1
r
2
r
3
L(r,Y
0
)
L(r,Y
1
)
L(r,Y
2
)
I
n
t
e
r
e
s
t

R
a
t
e

Money Demand
a
b
c
Y
Y
1
Y
2
r
1
r
2
r
3
r

Figure 16: The interest elasticity of money demand
L(r,Y
1
)
L(r,Y
2
)
LM
LM
Two special (Extreme) cases
58
(i) If the demand for money perfectly interest inelastic
, then c
2
=0.

This means that Eq. 28 reduces to: M
d
= c
o
+ c
1
Y,
i.e., the demand for money is simply a function of
Y.
This is the situation in the Classical Model.
Accordingly, the demand for money will not change
in response to changing interest rates and the LM
curve will be vertical (Fig. 17), or,
M
d
= M
s
0
= c
0
+c
1
Y and:

Y = (M
s
0
c
0
)/c
1
(30)

58
0 =
d
M
r
c
59
(ii) If the demand for money is perfectly elastic (approaching
infinity) with respect to changes in the interest rate, then c
2
=

Keynes believed that at very low r, L
T
would be very high
because the opportunity cost of holding cash will be low and the
danger of future capital losses high, i.e., if one buys a bond at a
very low r and rates then increase, the price of the bond must
be reduced to generate a yield equal to the now higher prevailing
rate of interest.
This situation is called the liquidity trap where changes in the r
has little or no impact on M
d
.
This situation exists only at very low levels of r and accordingly
we must change from a linear to a curvilinear expression of both
M
d
and LM curves (Fig. 16 or 17).
This means that the slope of these curves is not constant but
rather varies according to the level of the r.
Where and when a liquidity trap can occur is a matter of heated
policy debate.

=
d
M
r
c
60
Figure 17: Perfectly interest
Inelastic money
demand
Figure 18: Perfectly interest
elastic money
demand
LM
LM
Y
Y
r

r

LM Schedule, the Classical Case
61
LM
M
d
(Y
0
)
M
d
(Y
1
)
M
d
(Y
2
)
M
d
(Y
0
)
M

M
s
0
r
0
r
1
r
2
r
3
Y

r

r

r
3
r
2
r
1
r
0
Y
3
Y
2
Y
0
Y
1
Figure 19: Keynesian Liquidity Trap
a. The Money Market
b. The LM Curve
62
(ii) Shift in the LM Curve
Next, consider changes in two exogenous factors: (1) a fixed
money supply and (2) a change in liquidity preference, i.e.,
changes to the set of institutional conditions defining payment
period and technology as well as the climate of the times.

(1) A change in the money supply M
s

It has been assumed M
s
is fixed exogenously by the monetary
authorities. For whatever reasons the authority changes the
money supply (Fig. 18). We know:
M
s
0
= M
d
= c
0
+ c
1
Y c
2
r (29)
solving for r
(29a)

or the LM curve with intercept c
0
/c
2
-1/c
3
(M
s
0
) and slope
(c
1
/c
2
)Y.



63
M
s
1
M
s
0
LM
0
LM
1
M
d
(Y
0
)
r
0
r
1
r
1
r
0
Y
1
Y
0
Y

M

r

r

a

a

b

b

c

( )
M
c c
c
s
0
2 2
0
1

( )
M
c c
c
s
1
2 2
0
1

Figure 20: Shift in the LM Curve with an Increase

in the Quantity of Money
a. The Money Market
b. LM Curve
64
Given the money supply (M
s
0
) is a component of the intercept
then an or in M
s
will cause the intercept to move up or
down.
Furthermore, because of the minus sign the intercept will move
in the opposite direction, i.e., an in M
s
causes the intercept
to drop (Fig. 18).
If Y is fixed, then an in M
s
means more money is held as cash
at every level of interest. If Y is allowed to vary then the
existing rate of interest r
0
can be maintained only if Y increases
from Y
0
to Y
1
.

Next, consider a change in the M
d
function:

M
d
= c
0
+ c
1
Y c
2
r.

The parameters (c
0
, c
1
& c
2
) are established in an institutional
manner, i.e., routinized patterns of behaviour.
If everyone is confident that today will continue smoothly into
tomorrow these parameters will tend to remain relatively
constant. But if confidence breaks down then their values will
tend to change.

65
If there is concern about a significant increase in
interest (and the accompanying concern about capital
losses) there will be a tendency to hold more money,
i.e., at every current rate of interest more money will
be held shifting the M
d
up to the right (Fig. 21). In
response the LM curve, at each rate of interest, will
tend to shift to the left reflecting a greater demand for
liquidity at each interest rate.

Similarly, if there are changes in the payment habits
and technology, there can be a change in the amount
of money held at each interest rate, e.g., introduction
of ATM, credit and debit cards reduce the amount of
money held at each interest rate reflecting better cash
management.

66
M
s
0
LM
0
LM
1
M
d
(Y
0
)
r
0
r
1
r
1
r
0
Y
1
Y
0
Y

M

r

r

a

b

c

a. The Money Market
b. LM Curve
M
d
(Y
1
)
Figure 21: Shift in the LM Curve with a Shift in the Money
Demand Function
67
2. Product Market (IS)
Equilibrium in the product market occurs when:
Y = C + I + G, (2) or, alternatively,
I + G = S + T (9)
Assuming that there is no government sector , thus
equilibrium condition is:
I(r) = S(Y) (30)
i.e. investment as a function of the r (negatively sloped)
equals savings (positively sloped) as a function of Y ( Fig.
22).
At a given level of r, there is a corresponding level of I and
for that level of I there is a corresponding level of savings
associated with a specific level of Y.
Taking r from and Y from Fig. 22a, we can plot the IS curve
showing levels of r and Y at which I(r) = S(Y) as in Fig. 22b.



68
Y

Y

Y
2
Y
1
Y
1
Y
2
Y
0
Y
0
r
0
r
1
r
2
r
0
r
1
r
2
b

a

c

r

r

I(r)
S
IS
S(Y)
I
0
=S
0
I
1
=S
1
I
2
=S
2
b. The IS Curve
a. Investment and Saving Curves
Figure 22: Construction of the IS Curve (T=G=0)
I

I
0
I
1
I
2
69
i) Slope of the IS Curve
Two factors determine the slope of the IS curve: (1) the interest-elasticity
of investment DD ; and (2) MPS or multiplier
(1) The interest elasticity of investment
If I is very responsive to changes in the r then the slope of the I function
will tend to be gentle or flatter as shown in I in Fig. 21a. The interest
elasticity of investment is relatively high compared to I.
Thus, the slope of the IS curve will be gentler or flatter the higher the
interest-elasticity of I.
The I function become steeper the lower the interest-elasticity of I DD
or I is interest inelastic and therefore IS curve will be steeper.
(2) The multiplier
The MPS (the inverse of MPC) determines the slope of the savings
function (Fig. 21b).
The higher the MPS, (the lower the MPC), the steeper the savings
function, the smaller the multiplier and vice versa.
As the size of the multiplier (k gets larger), in I following a fall in the
r will generate a larger effect on equilibrium output, hence the IS curve
also becomes flatter.

70
Y

Y

Y
2
Y
1
Y
1
Y
2
Y
0
Y
2
r
1
r
2
r
1
r
2
b

a

c

r

r

I
S
IS
S(Y)
I
2
=S
2
I
1
=S
1
I
2
=S
2
b. The IS Curve
a. Investment Curve
Figure 23: Interest Elasticity of Investment and the Slope of the IS Curve
I

I
2
I
1
I
2
b. Saving Curve
I
IS
Two Special Cases
71
Two important IS curves are shown next.
When the investment demand curve is perfectly
inelastic , changes in the interest rate fail to
alter investment, hence the IS curve is vertical.

Likewise, when investment is perfectly elastic
with respect to the interest rate, small
changes in the interest rate generate very large
responses in investment, so the IS curve becomes
horizontal.
71
( ) 0 =
I
r
c
( ) =
I
r
c
72
IS
IS
r

r

Y

Y

(a) Interest insensitive investment (b) Perfectly Elastic Investment
73
ii) Shift of the IS Curve
(1) Change in the investment function
At a given point in time business has a marginal efficiency of I
schedule that tells it the cut off point for project I at any level
of r.
If the marginal efficiency of I changes, for example, new
technologies the anticipated rate of return of projects , then
the I schedule must be recalculated, resulting in a shift in the
IS curve to the right reflecting the increased level of I at each
possible level of r.
(2) Government spending (G) and taxing (T).
With government sector, the equilibrium conditions change to:
I(r) + G = S(Y-T) + T (31)
Thus S is a function of disposable income.


74
To derive the IS curve with an active government
sector we begin with the I function that is
downward sloping with respect to the r
complemented by government spending which is
autonomously determined ( Fig. 24a).
Similarly, the S function is shifted to right by the
amount of taxes subtracted from gross Y .
In both cases G and T are assumed autonomous fixed
amounts that do not vary, in the first instance (G) with
the r , and in the second (T) with Y .
Using the two modified curves [(I+G) and S(Y-T)] we can
calculate the level of r at which I will equal S and the
corresponding level of Y to plot the IS curve (Fig. 24).
What will be the effect if government decides to
change G or T?

75
Y

Y

Y
2
Y
1
Y
1
Y
2
Y
0
Y
0
r
0
r
1
r
2
r
0
r
1
r
2
b

a

c

r

r

I(r)+ G
S
IS
S(Y)
I
0
+G=S
0
+T

c. The IS Curve
a. Investment +Government Spending
Figure 24: IS Curve with the Addition of a Government Sector
I

I
0
+G

I
1
+G
I
2
+G
I(r)
I
1
+G=S
1
+T

I
2
+G=S
2
+T

b. Saving +Taxes
76
(i) If G is increased, the combined I + G curve shifts to the right
(Fig. 25a).
Equilibrium will require an equally higher in S + T that can
only be provided if Y from Y
o
to Y
1
(Fig. 25b).
Assuming G does not crowd out I (i.e. government
borrowing on the bond market) then the existing rate of
interest (r
0
) can be maintained if Y so increases.
This means at each level of r the IS curve shifts to the right
from IS
0
to IS
1
and at r
0
from Y
0
to Y
1
.
But what is the relationship between G and Y? It will be:
Yr
0
= G(1/1-b) (32)
where [(1-b)=MPS], or rather, 1 minus the MPC and (1/1-b)
is the autonomous expenditure multiplier.


77
Y

Y

Y
1
Y
1
Y
0
Y
0
r
0
r
1
r
0
r
1
b

a

r

r

I(r)+ G
1
S
IS
S(Y)
I
0
+G
1
=S
0
+T
0
c. The IS Curve
a. Investment +Government Spending
Figure 25: IS Curve with an Increase in Government Spending
I

I
0
+G
0
I
0
+G
1
I(r)+G
0
b. Saving +Taxes
I
0
+G
0
=S
0
+T
0
IS
1
G(1/1-b)
78
(ii) What happens if T changes?
A tax does not directly affect the I function (Fig. 25a). Instead
it cuts into savings shifting the savings function to the left (Fig.
23b).
To maintain the existing rate of interest (r
0
), Y must from Y
0
to
Y
1
.
This shifts the IS curve to the left (Fig. 25c). Again, by how
much?
By the tax multiplier Yr
0
= T(-b/1-b).

(iii) What will be the effect if autonomous I function change, for
instance, I increases?
In Fig. 22 if we replace G with I, we have the same effect.
That is, the I+G function shifts to the right and income must grow
if the existing rate of interest (r
0
) is to be maintained and the IS
curve will shift to the right.
And by how much, by the autonomous expenditure multiplier:
Yr
0
= I(1/1-b)


79
Y

Y

Y
1
Y
1
Y
0
Y
0
r
0
r
0
b

a

r

r

S
S(Y-T
0
)+T
0
c. The IS Curve
a. Investment +Government Spending
Figure 26: Shift in the IS Curve with an Increase in Taxes
I

I
0
+G
0
I(r)+G
0
b. Saving +Taxes
I
0
+G
0
=S
0
+T
0
=S
1
+T
1

IS
1
(T
1
)

T(-b/1-b)
S(Y-T
1
)+T
1
IS
0
(T
0
)

3. Equilibrium: IS-LM Model
80
A general equilibrium model is one where all markets
(in this case, it will be the goods and money markets)
are in equilibrium simultaneously.
The equilibrium level of Y and r for an economy is
found at the intersection of the IS and LM schedules
(Fig.24).
That it is an equilibrium towards which it will gravitate
(assuming autonomous or exogenous factors are
constant) is demonstrated in Fig.25.


81
r

Y

IS
LM
E
Y
0
r
0
Figure 27: IS and LM Curves Combined
82
r

Y

IS
LM
E
A

Figure 28: Adjustment to Equilibrium in the IS-LM Curve Model
C

B

D

XS
M
XS
0
XS
0
XS
M
XD
M
XD
0
XD
0
XD
M
Comparative Statics
83

The term comparative statics refers to the idea of
comparing different equilibria. In analysing the
consequences of a particular policy or shock on
the economy, all we have to do is compare the
equilibrium before and afterward.

In this section, we will focus on assessing the
effectiveness of expansionary monetary and fiscal
policies on the level of equilibrium output.
Fiscal policy will imply IS curve shifts, whereas
monetary policy will shift the LM schedule.
Fiscal Policy
84
Fiscal policy refers to the level of government
spending (G) and taxation (T).

From the construction of the IS curve, we know
that any factor other than a change in interest
rates that leads to a change in autonomous
expenditures will shift the IS schedule.

An expansionary fiscal policy would suggest a rise
in government spending (G), or a fall in taxation
(T) both will produce a rightward shift in the IS
curve.
85
r

Y

IS
0
LM
1
Y
0
r
0
Figure 28: Effects of an Increase in Government Spending
2
3
r
1
Y
1
Y
2
IS
1
b
G

A
1
1
b
G

A
1
1 in output (Y
1
-Y
2
)
crowding out effect
0% Crowding Out
There are two scenarios when there will be no
crowding out effect of fiscal policy.
If the IS curve is vertical, then an in government
spending will shift the IS curve to the right.
When the IS curve is vertical, it implies that
investment is completely interest inelastic .
This means that changes in the interest rate have no
effect whatsoever on investment even though the
interest rate rises, it will not crowd out investment
and reduce output.
( ) 0 =
I
r
c
86
87
LM
IS
0
IS
1
r

Y

Y
0
Y
1
r
0
r
1
( ) 0 =
I
r
c
0% Crowding Out
0% Crowding Out
The second scenario where there is no crowding out is
when the LM curve is horizontal.
This arises when the DD for money is perfectly interest
elastic . An in government spending will not
generate any in r . So, even if I were interest elastic,
there will be no crowding out effect.
The question is though: how much must interest rates rise
in order to induce the public to sufficiently reduce their DD
for money?
When the money DD schedule is perfectly interest elastic,
then the answer is by a miniscule amount. This is why the
LM curve is horizontal. And, with no rise in interest rates,
there will be no reduction in I or crowding out.
=
d
M
r
c
88 88
89
LM
IS
0
IS
1
r

Y

Y
0
Y
1
r
0
r
1
0% Crowding Out
=
d
M
r
c
100% Crowding Out
The rise in output brought on by the fiscal expansion is
completely reversed by the crowding out effect.
Following an increase in government spending, the
level of output will return to the point from which it
started.
Again, there are two situations where 100% crowding
out would occur.
The first is when the IS curve is horizontal. A
horizontal IS curve implies that investment is perfectly
interest elastic , so only small increases in
investment will produce large falls in investment.
Output will therefore fall back to due to the most
miniscule increases in interest rates.
( ) =
I
r
c
90
91
LM
IS
0
, IS
1
r

Y

Y
0
Y
1
r
0
100% Crowding Out
( ) =
I
r
c
100% Crowding Out
92
The second case is when the LM curve is vertical.
When the LM curve is vertical, it implies that the DD for
money is completely inelastic with respect to interest rates
.

When output rises and the DD for money, there will be
excess DD in the money market. Removing this excess DD
would require an in r . However, because the DD for
money is completely insensitive to r , this would not work
even at exceptionally high r .
The only way equilibrium in the money market can be
restored is if output falls back to the original level. To
achieve this, r must rise sufficiently so that enough I is
crowded out ( ).
0 =
d
M
r
c
I G A = A
93
LM
IS
0
IS
1
r

Y

Y
0
Y
1
r
0
r
1
100% Crowding Out
0 =
d
M
r
c
Overview of Fiscal Policy
94
The effects of fiscal policy on the economy will be
greater when:
(i) The interest elasticity of investment is lower,
implying that the IS curve is steeper. In this
case, interest rate rises will produce less
crowding out.
(ii) The interest elasticity of money demand is
higher, implying that the LM curve is flatter.
When output increases, smaller rises in interest
rates will arise from the money market, again
reducing the size of the crowding out effect.
Overview of Fiscal Policy
95
(iii) The lower the income elasticity of money demand,
the flatter the LM schedule and the more effective a fiscal
expansion becomes. Any in output results in a
smaller shift in money DD and therefore less upward
pressure on the r .
(iv) As the multiplier becomes larger, any change in
autonomous expenditure will produce a larger shift in the IS
schedule. It must also be considered that the IS curve will
become flatter, indicating that any subsequent crowding
out
of I will produce a larger reduction in output.
However, as long as crowding out is less than 100%, the
larger the multiplier, the greater the effect of fiscal policy
on equilibrium output.

95
Other factors causing shifts in the IS Curve
96
If we wanted to show what impact changes in
autonomous consumption or investment (other than
that induced by interest rate changes) or a tax cut had
on the economy we would simply shift the IS curve.

We also know that the effects of such actions on the
equilibrium values of output and interest rate will
depend on the slopes of the IS and LM schedules.


Monetary Policy
97
The LM curve will shift with changes in the money
supply.

Monetary policy refers to changes in either the
quantity (the money stock) or the price (interest rate)
of money. By controlling one of these, the government
can hope to exert some control over the economy.

An expansionary monetary policy could consist of an
increase in the money supply. Weve seen that this
would lead to a downward shift in the LM schedule.
98
LM
0
IS

r

Y

Y
0
Y
1
r
0
r
2
Expansionary Monetary Policy
r
1
1

2

3

LM
1
Expansionary Monetary Policy
99
A monetary expansion reduces the interest rate
which in turn stimulates investment.
For the policy to work in producing higher output,
both these two processes must be working.
The success of this policy will obviously depend on
how changes in the money supply change the
interest rate and then how investment responds to
a change in the interest rate. Considering these two
elements, we can see that the success of monetary
policy is inherently linked to the slopes of the IS and
LM curves.
Effective Monetary Policy
100
There are two cases where monetary policy is extremely
effective in raising the level of output.

When the M
d
is perfectly inelastic with respect to the interest
rate, the LM curve will be vertical.

An in the money supply would lead to a position of excess
supply in the money market. For equilibrium to be restored,
money DD must . The conventional way to do this is to
reduce the r this encourages households to substitute out of
bonds and into cash. It also stimulates I . When the M
d
is
interest inelastic, a large fall in the r will not produce any
substitution effect. Therefore, the only way to eliminate excess
supply is through the output . Output must by a more
substantial amount because the fall in interest rate is
ineffective in raising money demand.
101
LM
0
IS

r

Y

Y
0
Y
1
r
0
Effective Monetary Policy: Vertical LM curve
r
1
1

2

LM
1
0 =
d
M
r
c
Effective Monetary Policy
102
The second case is where investment is perfectly
interest elastic, which describes the situation when
the IS curve is horizontal.
A small reduction in interest rates is all that is required
to generate a very large increase in investment and
therefore output.
103
LM
0
IS

r

Y

Y
0
Y
1
r
0
Effective monetary policy: Horizontal IS curve
LM
1
( ) =
I
r
c
Ineffective Monetary Policy
104
The cases where monetary policy fails to output
are the opposite of those stated above.

Firstly, when the LM curve is horizontal, we know that
this refers to the situation of a liquidity trap.

The demand for money is perfectly interest elastic, so
any in the money supply would fail to put
downward pressure on the interest rate. If no
reduction in interest rate is achieved, then there is
nothing on which investment can bite and the level of
output will remain unchanged.
105
LM

IS

r

Y

Y
0
r
0
Ineffective Monetary Policy: Horizontal LM Curve
=
d
M
r
c
Ineffective Monetary Policy
106
Second, even if an in the money supply is
successful in reducing the interest rate, it will only
lead to an in output if extra investment is then
forthcoming.
When investment is interest inelastic, the IS curve will
be vertical.

An in the money supply may be successful in
reducing the interest rate, but because investment is
completely unresponsive to this, output will again
remain unchanged.
107
LM
0
IS

r

Y

Y
0
r
0
Ineffective Monetary Policy: Vertical IS Curve
r
1
LM
1
( ) 0 =
I
r
c
Overview of Monetary Policy
108
From what we have just investigated, we can conclude that
monetary policy is more successful when:
Investment is interest elastic: the IS curve is flatter because
any change in interest rates generates a proportionally greater
change in investment
The demand for money is interest inelastic. This means that
the LM curve is steeper. Here, any change in the money
supply has greater effects on the equilibrium interest rates,
i.e., a change in the money supply generates a larger vertical
shift in the LM schedule.
The higher the multiplier, the flatter the IS curve. This implies
that the response of output to any change in investment
induced by a change in interest rates will be greater.
What policy do we use? Keynesians vs. Classicists
109
Keynesian economists believe:
Bonds are very close substitute to holding money, so the interest
elasticity of money demand is high and the LM curve is relatively
flat.
Investment is relatively interest inelastic. Investment is more
likely to be determined by things such as animal spirits, so the IS
curve is relatively steep.
It should be clear that fiscal policy will be much more successful
than monetary policy in influencing output. The crowding out
effect of a fiscal expansion would be fairly small. Monetary
policy would be relatively ineffective as an increase in the money
supply would only exert a small amount of downward pressure on
interest rates, and investment is insensitive to interest rate
changes.
110
LM

IS

r

Y

Keynesian View
Classicists View
111
Classical economists believe:
Money demand is interest inelastic, as the main reason
for holding money is for transactions purposes, so the
LM curve is fairly steep.
Investment is interest sensitive, hence the IS curve is
relatively flat.
Given this view of the world, it is now the case that
monetary policy is preferable. A monetary expansion
would exert strong downward pressure on interest rates
and this will be successful in stimulating extra
investment, which is highly sensitive to interest rates.
Fiscal policy, on the other hand, would be very limited
due to significant crowding out effects.
112
LM

IS

r

Y

Classicists View
Keynes vs. the Classicists Once Again
113
Classicists: We have seen in the Neoclassical IS-LM
model that attempting to use monetary or fiscal
policies to control the economy is futile. The
Classical economists believe that markets clear
quickly; therefore, if there is any position of excess
demand or supply, it will be the case that wages
and prices adjust quickly. The use of these policies
will only be of use in the very short run. The only
long run consequence of the policy will be to
increase the price level. The governments best
course of action is not to interfere in the economy,
as it will only have very limited effects on output
and will just be inflationary.

113
Keynes vs. the Classicists Once Again
114
Keynesians: The Keynesian viewpoint is opposite to
this. The reason comes down to how long is the
long run. Keynesians accept that in the long run,
output will return to its full employment level. But,
if this adjustment is slow, then the short run may
be a significant period of time. The government
will then look at active monetary and fiscal policy
as being useful. The famous quote which sums up
the position well goes: in the long run we are all
dead emphasizing the importance of the short
run.

114
Monetary & Fiscal Policy Multipliers in the IS-LM Model
115
When monetary & fiscal policy variables change, how the equilibrium
level of income is changed.

A. The Effects of MP & FP on Income
The equilibrium values of income (Y
0
) and interest rate (r
0
) in the IS-LM
curve model is given by:






( )
( )
(
(

+ + +
(

+
=

0
2
1
2 1 1
0
/ 1
1
c M
c
i
bT G I a x
c c i b
Y
s
(1)
r c Y c c M M
d s
2 0
1
+ = =
0 ;
2 1
> c c
(2)
( )
( )
( )
(

|
.
|

\
|
+ + +

+
=

bT G I a
c
c
M c
c
b
x
c c i b
r
s
2
1
0
2 2 1 1
0
1
/ 1
1
Fiscal Policy
1.




2.





Y T A A
116
Y G A A
(3)
( )
G
c c i b
Y A
+
= A
2 1 1
/ 1
1
( )
0
/ 1
1
2 1 1
>
+
=
A
A
c c i b G
Y
( )
( ) T b
c c i b
Y A
+
= A
2 1 1
/ 1
1
( )
0
/ 1
1
2 1 1
<
+
=
A
A
c c i b T
Y
(4)
117
Monetary Policy










Y M
s
A A
( )
s
M
c
i
c c i b
Y A
|
|
.
|

\
|
+
= A
2
1
2 1 1
/ 1
1
( )
0
/ 1
1
2
1
2 1 1
>
|
|
.
|

\
|
+
=
A
A
c
i
c c i b M
Y
s
( )
|
|
.
|

\
|
+
=
A
A
1 1 2
1
1 c i c b
i
M
Y
s
or
(5)
118
The IS Curve and Policy Effectiveness
The Slope of IS curve:


where i
1
measures the interest sensitivity of investment demand. If i
1
is large
(small), investment demand is interest-sensitive (-insensitive) and IS curve is
flat (steep).
Compare the i
1
in equation (3) & (6), we see that as i
1
in (3)
becomes smaller, becomes larger.
That is, as investment becomes less sensitive to the interest and
the IS curve becomes steeper, FP becomes more effective.
If i
1
goes to zero, equation (3) reduces to , the multiplier of
simple Keynesian model.



( )
1
1
i
b
Y
r
IS

=
A
A
(6)
G
Y
A
A
( ) b 1
1
Monetary policy multiplier



as i
1
in (5) gets smaller (the IS curve becomes steeper), the
numerator in (5) becomes proportionately smaller. Thus, the
value of the expression declines.
The lower the interest elasticity of investment, the steeper the IS
curve, and the less effective is MP
In the extreme case, where i
1
is zero (vertical IS curve), the value
in (5) goes to zero, and the MP becomes completely ineffective.




( )
|
|
.
|

\
|
+
=
A
A
1 1 2
1
1 c i c b
i
M
Y
s
119
(5)
The LM Curve and Policy Effectives
The Slope of LM curve:

where c
2
measures the interest sensitivity of money demand. If c
2
is large
(small), meaning that money demand is interest-sensitive (-insensitive), the LM
curve will be relatively flat (steep). This outcome follows because the expression
in (7) decreases in values as c
2
becomes larger.


As c
2
becomes smaller, the second term in the denominator in (3)
becomes larger. Thus, the whole expression becomes smaller.
The lower the interest sensitivity of money demand, the steeper is the
LM curve and the less effective is the FP.
In the extreme case in which c
2
approaches zero, the denominator in (3)
becomes extremely large, the whole expression goes to zero. As the LM
curve becomes vertical, FP becomes completely ineffective.




( )
0
/ 1
1
2 1 1
>
+
=
A
A
c c i b G
Y
120
2
1
c
c
Y
r
LM
=
A
A
(7)
(3)
Monetary policy multiplier



As c
2
becomes smaller, the denominator of (5) becomes smaller,
and the expression becomes larger.
The less sensitive money demand is to the interest rate, the
steeper is the LM curve and the more effective is MP.
If c
2
is zero, equation (5) reduces to 1/c
1
. The LM curve is
vertical, and the equilibrium income will increase by the full
amount of the horizontal shift in the LM curve as the money
supply increases.
( )
|
|
.
|

\
|
+
=
A
A
1 1 2
1
1 c i c b
i
M
Y
s
121
(5)
122
Relative Monetary & Fiscal Policy Effectiveness and the Slope of the
IS and LM Curves
Monetary Policy
IS Curve LM Curve
Steep Ineffective Effective
Flat Effective Ineffective
Fiscal Policy
IS Curve LM Curve
Steep Effective Ineffective
Flat Ineffective Effective


( ) b
G

A
1
1
( ) b
G

A
1
1
123
Fiscal Policy Effects & the Slope of the IS Curve
LM
0

IS
0

IS
1

r
0

r
1

r
Y
0

Y
1

( ) b
G

A
1
1
Y Y
LM
0

r
0

Y
0
Y
1

LM
0

IS
0

IS
1

Y
r
r
0

r
1

Y
0
Y
1

a. Steep IS Curve
b. Flat IS Curve
c. Vertical IS Curve
IS
0

IS
1

Fiscal Policy Effects & the Slope of the LM Curve
( ) b
G

A
1
1
( ) b
G

A
1
1
124
r
r
0

r
1

Y
0
Y
1

r
1

r
0

Y
0
Y
1

IS
0

IS
1

LM
0

r
0

r
1

Y
0
=Y
1

LM
0

IS
0

IS
1

IS
0

IS
1

LM
0

Y
r
Y
r
Y
( ) b
G

A
1
1
a. Flat LM Curve b. Steep LM Curve
c. Vertical LM Curve
Monetary Policy Effects & the Slope of LM Curve
125

r
0

r
1

r
0

r
0


r
1

r
1

Y
0
Y
0


Y
0


Y
1

Y
1


Y
1


IS
0

IS
0

IS
0

LM
0

LM
0

LM
0

LM
1

LM
1

LM
1

1
c
M A
1
c
M A
1
c
M A
a. Flat LM Curve
b. Steep LM Curve
c. Vertical LM Curve