The business cycle fluctuations that are so pervasive in developed economies it tends to suggest that the economy is often not at its long run or natural equilibrium.
The principal theme of classical price theory that underlies the study of microeconomics is: If there is an imbalance between supply and demand in a competitive market, then prices change to clear the market or establish equilibrium. The simple Keynesian model is an application of the quantity adjustment paradigm. That is: If there is an imbalance between supply (output or production) and demand (expenditure), then producers will change the quantity of output produced.
QUANTITY ADJUSTMENT PARADIGM
In this section we will construct the Keynesian model of aggregate demand that shows how the quantity adjustment paradigm works. The model simply examines whether actual output—YS—and the desire to absorb output—planned aggregate demand, YD—are qual. If actual output differs from planned aggregate demand, then quantity adjustments bring the economy back to balance
THE PLANNED AGGREGATE DEMAND MODEL
Total real GDP is equal to the sum of these components. For convenience, we ignore the accounting inferences between Gross Domestic Product and national Income and call the sum simply real output or income. That is, total expenditure on all final goods and services is total real output or income, which we call Y :
Y = C + I + G + NX
The planned aggregate demand model can be used to demonstrate the Keynesian multiplier relationship. The model is highly simplified—there is no worry about price changes or capacity strains. The multiplier relationship is the effect on the quantity equilibrium of some outside or exogenous change that affects planned aggregate demand. The size of the government expenditure multiplier in our model depends on several parameters—the effects on C, T and NX of a change in income or the extent to which PAD changes when Y changes.
THE SIMPLE KEYNESIAN MULTIPLIER
The different components of planned aggregate demand—Cd, Id, NXd—are affected by many different things. The functional specifications shown above are simplifications that focus on the most important determinants of demand. In this section, we will provide a brief discussion of the determinants of aggregate demand.
DETERMINANTS OF AGGREGATE DEMAND
Modern theories of consumption demand emphasize that consumption expenditures are not only related to current income but are also affected by the household’s overall command over resources. That is, the wealth of the financial sector will influence its consumption plans. Wealth can be defined broadly to include actual assets held (financial assets, real estate, etc.) and also expected future income.
As noted earlier, investment expenditures are sensitive to the rate of interest. We will begin by showing why this is the case and then discuss other determinants of investment. Consider how a firm might evaluate an investment project that is expected to generate a stream of returns for some time into the future which we can denote as: RET1, RET2, RET3, …. We define the internal rate of return, IRR, on the project as the discount rate that equates the stream of future returns to the project’s cost:
- Foreign Sector:
The net exports component of planned aggregate demand depends first on the domestic and foreign income and second on the relative prices of foreign and domestic goods.
The Keynesian real sector equilibrium can be affected by a large number of economic, political and other phenomena.
Interest rates are important because they are the linkage between the real sector, the market for goods, and the financial sector, the market for money. In fact, there are two building blocks of the Keynesian approach—the quantity adjustment paradigm that underlies our discussion of Keynesian real sector equilibrium and the Keynesian emphasis on the short-run role of interest rates in the monetary sector.Thus, the emphasis here will be on the joint determination of output and interest rates and the short-run interactions between the real sector and the monetary sector.There will be different possible levels of output and interest rates—Y and R—for which the real sector will be in short-run equilibrium. That is, for some values the level of planned aggregate demand will be exactly equal to the level of output produced:
THE KEYNESIAN REAL SECTOR MODEL
The monetary sector equilibrium will be summarized by the LM curve. When the IS and LM curves are combined, we will be able to examine the interaction between the real and monetary sectors.
- IS curve: The interest rate is measured on the vertical axis and output is on the horizontal axis. Given the level of the other variables, called exogenous or determined elsewhere—G, T and e—there are different possible equilibria where planned aggregated demand (the right hand side of the equation) is equal to Y. This line, labeled IS, is a locus of points that represent real sector equilibrium. For each interest rate, it gives the level of equilibrium output. Of course, for a given IS curve, all the other exogenous factors that might affect PAD are held constant (i.e., G, T, e, and anything else that might affect demand).
The curve is called an IS curve because along this curve planned Investment is equal to planned saving. More generally, there is a real sector equilibrium where planned aggregate demand is equal to output or income.
- Properties of the IS Curve:
- IS curve slope: The slope of the IS curve is obtained by taking the total differential with the values of G, T and e held constant:
The slope of the IS curve is:
- Money Demand Function: Our specification of the money demand function or the demand for real money balances is:
That is, the demand for real money balances is a function of liquidity preference to use Keynes’ own terminology. Thus, we use the letter L to denote the money demand function. The arguments of the function, L (.), are the level of real income or output, Y, and the interest rate, R.
- Money Market Equilibrium:The supply of money or the stock in existence is determined by the interaction of the banking system and monetary policy.Equilibrium in the money market exists when the demand for money, liquidity preference—L(Y, R), is equal to the exogenous supply of real money balances .
- LM Curve : The different points of money market equilibrium are summarized by the LM curve in Figure. It is called the LM curve because liquidity preference (money demand) is equal to the real money supply.
- Properties of the LM Curve: The LM curve represents a set of money market equilibrium. That is, supply equals demand
- Equilibrium Adjustments:The excess money demand sets in motion financial asset sales as individuals try to re equilibrate their portfolios. These bond sales cause interest rates to rise which reduces money demand. Thus, interest rate adjustments are the mechanism that equilibrate the money market..
- SUMMARY OF THE IS-LM MODEL:
- IS Curve:
- Has a negative (downward) slope
- Is steep when PAD does not vary much with interest rates (investment is interest-inelastic)
- There is excess demand (supply) in the goods market to the left (right) of the IS curve.
- If there is excess demand or supply, horizontal movement toward the IS curve occurs as quantity adjustments eliminate the disequilibrium in the goods market.
- Government taxation and expenditure (fiscal) policy influences the position of the IS curve.
- Shifts outward (rightward) when there is an autonomous increase in PAD.
- LM Curve :
- Is steep when money demand does not vary much with interest (rates demand is interest inelastic).
- There is excess demand (supply) in money market to the right (left) of the LM curve.
- If there is excess demand or supply in the money market, vertical movement toward the curve occurs as interest rates change to eliminate the disequilibrium.
- Monetary policy operates through the real money stock (M/P) to position the LM curve.
- Shifts outward (rightward) when there is an autonomous increase in the real money stock (M/P).
Probably the most important application of the IS-LM model is for the analysis of the effects of monetary and fiscal policies. The purpose of this section is to examine the effects of policy changes with the model.
ANALYSIS OF MONETARY AND FISCAL POLICY
- Fiscal Policy: The increase in government expenditure which shifts the IS curve causes income to increase because of a production response to increased demand (the multiplier process). Increased income (and transactions) increases the demand for money, and interest rates rise from R1 and R2 in order to maintain money market equilibrium. Higher interest rates reduce investment and aggregate demand and constrain the multiplier-induced increases in output.
- Monetary Policy: The money markets equilibrate quickly when the money supply expands. Interest rates fall, and over time this leads to a gradual increase in investment expenditure and a multiplier expansion. The expansion of output increases money demand, which causes interest rates to rise. Monetarist economists often emphasize monetary policy and eschew fiscal policy.
THE KEYNESIAN MODEL IN THE OPEN ECONOMY
- Exchange Rates:
A major influence of the foreign sector on aggregate demand is through the influence of exchange rates on planned aggregate demand.
An appreciation (an increase in the exchange rate) will lead to an increase in real expenditures on imports and a decrease in real exports. Foreign goods will decline in relative price for Americans and the price of U.S. goods to foreigners will be relatively higher. Since net exports are exports less imports, we can write a function for net exports as :
NX = NX (Y, e)
- Monetary Policy in an Open Economy:
An expansionary monetary policy will tend to increase output (Y) and reduce interest rates (R).
As output and income increase, the demand for imports will go up. This effect is important because many imported consumer goods are highly income elastic. The demand for foreign exchange will lead to a depreciation of the dollar. Similarly, the fall in interest rates makes dollar denominated financial assets less attractive. If asset holders sell dollars and buy foreign financial assets, then the dollar depreciates.
- Fiscal Policy in an Open Economy:
A simple IS-LM analysis tells us that an expansionary fiscal policy leads to higher interest rates and a higher level of output.
To begin, the expansion of output and income leads to an increase in imports. A negative trade balance will put downward pressure on the exchange rate.
At the same time, the increase in interest rates makes dollar denominated financial assets more attractive and leads to a dollar appreciation. The fiscal policy expansion sets in motion forces for both depreciation and appreciation of the currency.