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OVERVIEW
hte
Model: Fi e
Price Lev
The next part of the chapter analyzes the separate and combined effects of increases in investment and the money supply on the income level
and the interest rate. The conclusions reached
through the use of the I5-LM tool differ from
those reached when the goods and monetary
aspects of the analysis were considered separately. For example, the simple Keynesian multipliers developed for the two-sector economy In
Chapter 5 are now seen to apply only when
events in the monetary sector are such that the
interest rate remains constant as aggregate
spending for goods and services changes.
The same sort of general analysis is carried
out in the next part of the chapter for changes in
government spending and taxation. Here again
the simple government spending and tax multipliers presented in Chapter 6 are found to apply
only when the monetary authority acts to maintain
a constant interest rate.
234------~----...::...-----------
The last part of the chapter turns to the questic1nof the elasticities of the IS and LM functions,
and to the closely related Question of the effectiveness of monetary and fiscal policies. The elasticities of the two functions are analyzed to clarify
the difference between the extreme version of the
classical theory-which
argues that only monetary policy can be effective in raising the income
level-and the extreme version of the Keynesian
theory-which
argues that only fiscal policy can
be effective. On the basis of this analysis, the LM
function, if it is assumed to vary from perfect inelasticity at one extreme to perfect elasticity at the
other, can be divided into a segment consistent
with classical theory, a segment consistent with
Keynesian theory, and an intermediate segment
lying between the extreme versions of the two theories.
236
and investment. At the level of Y at which S = I,
the leakage from the income stream into S is
exactly offset by I. Money market equilibrium is
defined by an equality between the supply of and
the demand for money-m s = m d-the condition
that gave us the equilibrium interest rate. In other
words, at the interest rate at which ms = md there
is money market equilibrium.2
The particular level of income at which there
is goods market equilibrium depends in part on
conditions in the money market. The particular
interest rate at which there is money market equilibrium depends in part on conditions in the
goods market. For a preliminary look at what is
involved, let us briefly review the simplest possible Keynesian model as shown in Figure 12-1 .
Given the C + I, curve in Part A and the Sand
I, curves in Part B, the equilibrium level of Y is Y,.
If investment depends at all on the interest rate,
the C + I, curve in Part A and the I, curve in
Part B must have been drawn on the assumption
of some particular interest rate. Other things
being equal, a lower interest rate would indicate
a different position for the C + I curve-say
C
~
+ 12instead of C + I,-and a different position
for the I curve-say
/2 instead of I,. This, in turn,
would indicate a different equilibrium income
level, Y2 instead of Y,. Figure 12-1, however, does
not reveal what the interest rate may be-it
assumes some rate and proceeds from there.
FIGURE 1~1
Equilibrium Levels of Income
EquDibrium
in the Goods
Market
mlZ
rz r----
r, '-"--m'l
Tn
FIGURE 1.1~
C(Y)
I(r)
= C(Y) + I(r)
S(Y)
=
=
I(r)
I(r)
See also F. Modigliani, "Liquidity Preference and the Theory of Interest and Morley," in FA. Lutz and L.w. Mints,
,005 . Reaoings in Monetary Theory, Irwin, 1951, partlculcirlypp. 190-206.
S
I
100 -
____
1_
40
Saving Function
S(Y)
Saving Inv8strnenl
5 c- I
Equality
I
I
I
I
IS
I
I
----------
IE
-1--------
----------:rF
'l
I
I
I
I
I
I
I
I
I
I
I
I
I
I
I
!
40
80
120
,I
--
160
200
20
1 __
40
60
Investment Function
I
I(r)
FIGURE 12~
Goods Market ~quilibrium
5, ~
240----------------------rC~H~APTED:mR;-:lWE~iVCLVE
exceeds Y. In other words. the aggregate spending on goods exceeds the aggregate output of
goods.
Equilibrium
in the Money
Market
Equilibrium in the money market requires an
equa1ity between the supply of and the demand
for money. The Keynesian theory of the demand
for money makes the transactions demand (here
combined with the precautionary demand) a
direct function of the income level alone. orm,
= k(Y) . .It makes the speculative demand an
inverse function of the interest rate alone. or msp
= h(r). Total demand for money is md = mr +
ms = k(Y) + h(r). The supply of money ms is
determined outside the model--it is exogenous.
This may be written ms = mar in which m8 is simply the am0unt of money that exists, an amount
determined by the monetary authorities. (The
monetary authorities determine only the nominal
stock of money, Ms. but with P assumed to be
stable. determination of Ms also determines ms')
This .gives us three equations to cover the money
market:
Demand for money: md = k(Y)
Supply of money: ms = mil
Equilibrium condition: md = ms
h(r)
m,
I
100
I
1
60
------
ms
= $100
---------1I
I
!
I
I
I
I
J..
_j
80
Transactions Demand
mt
;
10 ~-
Supply of Money
m.
k(Y)
mr +
msp
I
I
I
I
I
I
I
Fi
---------tI
I
I
-1-----------
I
I
I
I
I
I
I
I
I
I
Speculative Demand
m.p
FIGURE 1;1..4
Money Market EquWbrium
h(r)
Two ..Market
"Ir
10
"-
81-
"IV
I
q-----------
I
III
I
) I-
__ I
1.
4L:
.1
80
._.
~c:
_-L-
1CJ
200
, __
v
;l4q
FIG1JP..J: 12 5
Equilibrium in 'the Goods and
Money Markets
9
From Disequilibrium to
Equilibrium
Every possible combination of Y and r in Figure
12-5 other than that given by the intersection of
the IS and LM curves is one at which there is
disequilibrium in the goods market, the money
market, or both. All those combinations that do
not lie on either the IS or the LM curve fall into
this last category. Because all such combinations
do not lie on a line, they necessarily jie in one of
the four areas identified by the Roman numerals
I through IV As we saw earlier, any combination
of Y andr that lies anywhere to the right of the IS
curve is a combination at which S > I and Y >
(C + I). The opposite is true for any combination
of Y and r anywhere to the left of the IS curve.
Similarly, any combination of Y and r anywhere
to the right of the LM curve is a combination at
which md > ms' The opposite is true for any combination to the left of the LM curve. Accordingly,
each of the four spa~s may be distinguished
from the other three in terms of the relationships
between the supply of and demand for goods
and betweenthe
supply of and demand for
money for any-'combination of Y and r that falls
within that space:
In Space
In Space
In Space
In Space
I:
II:
III:
IV:
Goods Market
f < S, (C + I) < Y
1< S, (C + I) < Y
I> S, (C + I) > Y
I> S, (C + I) > Y
Money
Market
md < ms
md> ms
md> ms
md < ms
From the analysis of the goods market considered in isolation, we know that a situation in
which' I > S or (C + I)
Y will lead to a rise in
income and vice versa. From the analysis of the
money market considered in isolation, we know
that a situation in which m d > m s will lead to a rise
in the interest rate and vice versa. What we now
have in the four spaces laid out in Figure 12-5
are various combinations of IS and LM disequi.Iibrium situations. Because we know the direction
in which the income .level tends to move in
. response to an excess supply or excess demand
:>
FIGURE 12-6
Possible Paths of Movement to
Equilibrium in the Goods an4
Money Markets
..
8 Although it is quite illuminating to trace the path followed by Y and' as we have done here. the IS-LM model
, now before us does not in itself reveal that Y and , will
follow the path here described or any other particular path
from an initial disequilibrium position like A or E. As briefly
explained in Chapter 3. to trace the process of change in
the values of a model's variables from one period to
another can be done only with a dynamic model. The
IS-LM model isnot dynamic, but completely static. It identifies the values the variables must exhibit in order that
there be equilibrium. but it does not show the sequence
- of changes by which these values will be reached if we
start off with any values eltler than Ihese equilibrium
values.
i
12
r-
4,
2 ,-
IS
'-
...
-'
40
160
80
200
240
A
P
AS
AD
4
3
2
"'~
1
i.
40
80
.........
120
160
200
240
FIGURE 127
The IS-LM Curves and the
Aggregate Demand Curve
ular IS and LM curves, and it is from the intersection of this pair of curves that the AD curve is
derived in the present model. To derive the AD
curve, we make one final assumption-that
neither the IS nor the LM curve shifts with changes
in the price level. This assumption enables us to
postpone dealing with some major complications
until Chapter 13.
With this 3ssumption, whatever the price level
might be-1, 2, 3, 4, or any other level in Part B
of Figure 12-7-the IS and LM curves remain in
the position shown in Part A. Therefore, corresponding to each possible price level on the vertical axis of Part B, we have the same pair of IS
and LM curves and the same equilibrium figure
of 120 for the output level found in Part A. The
AD curve shows the toial amount of goods
demanded at various price levels, but on the
present assumption that amount is a constant
120. Therefore, the aggregate AD c.urve is perfectly inelastic at the output level of 120, as
shown in Part B. Throughout the balance of this
chapter we will assume that the IS andLM curves
do not shift with the price level; therefore all of
the AD curves will be perfectly inelastic. However, these AD curves can shift :to the right or the
left, and we next look at some of the factors that
will produce such shifts.
q,.;mges in Aggregate
Demand_ _'
,...---
.,-
//
.c
Is
A Change in Investment
Among the various possibilities, a shift in the
investment curve is one of the most important.
Suppose a change in an underlying factor-for
-example, an improvement in business expectations-causes
this'curve to shift $20 to the right
at each rate~of interest. In Part A of Figure 12-8,
the original curve is labeled I, and the new one
12, In Figure 12-3, an IS curve was derived graphically from the investment and saving curves
given there. Similarly, in Figure 12-8, a separate
IS curve may be derived from each of the investment curves in combination with the given saving
curve. In Part D, the IS, and IS2 curves are based
on the I, and 12 curves, respectively. At each
interest rate, IS2 lies $40 to the right of IS,. In
other words, at each interest rate the level of
income at which S = I is now $40 greater than
it was before the shift in the investment schedule.
This follows from the fact that, with an increase
of $20 in investment, income must rise by $40 to
induce an increase of $20 in saving, given that
the MPS is 1/2. This is nothing more than the
simple multiplier in action, ~ Y(1 /MPS~/, which
gives us $40 = 2' $20.
, The original equilibrium was earlier -found at
Y pf $120 and r of 6 percent. Here it is shown
a@ain by the intersection of IS, and L,M in Part D
of Fig'Jre 12-8. As before, this gives us the AD,
curve positioned at Y of $120 in Part E. The LM
curve here is the sa\Tle as the one derived in Figure 12-4. The new equilibrium that results from
the shift in the investment curve is at Y of $140
and r of 7 percent (an 'increase of one percent-
'3'
S
100
80
l-
S-
I
I
100
80 \-
6d-
::
40
t
!
I
20
I
I
r-
l~_l.-__
,---------..J _l.
I
I
--1..--_1 _...L __
..l...--.
120
200
160
--
---_
.....L..-..__...L
__
..._L..
60
80
__
100
2 ~.
I[
..__
~
.....L..-. _
20
.L_
40
..
_.L_ ..._L
60
80
.__
L.-..._.
100
_ ..
.l-
....1.- __ .....
160
200
FIGURE 128
A Change in Investment and the Change in Aggregate Demapd
'(
...
__.
A Change
in th'e Money Supply
As a second illustration of a shift in the AD curve,
assume a $20 increase in the money supply. This
shifts the ms curve in Part B of Figure 12-9 from
its original position of mS1 to the new position
ms2. With no change in the speculative demand
function or the transactions demand function, the
$20 increase in ms shifts the LM function rightward by $40 at each rate of interest, or from LM 1
to LM2. What lies behind this may be seen as
follows. Equilibrium between md and ms requires
a rise in Y sufficient to absorb the ms increase of
$20 in transactions balances, ml, if the interest
rate is assumed to be given. Because mt = k(Y),
we ' .J.veY = m,lk and ~ Y = tun,lk. Accordingly,
with k given as 0.5, a Y must be $40 to produce
a new equilibrium between md and ms at each
jntere~t rate.
249
.....J
-1- -+ - - - - - - - - - - -
__
40
10
I
I
I
I
I
-L __L.L__
L_--.L
80
,
40 t-
120
..L.._
160
..._._
200
8~
6~
I
I
I
I
.~
2 ~
I
,
I(
40
80
i -
l----l- L. __ l
120
......L.
160
200
.l-...,
.L
20
40
L
60
_ ... .c.
80
L.
100
L.
120 msp
"
-';
.'
_.,
"
FIGURE 12-9
A G p :Inthe Money Supply and the Change in Aggregate Demand
I
I
I
I
2
I'- __----.--L-_-----l-..._-L ,I
o.
40
80
120
--.L
IS,
----.--L-
160
200
240
AD2
AS
A
AD,
A Simultaneous Increase
in Investment and
the Money Supply
A
Now suppose that the two increases we have discussed separately occur simultaneously. The rise
in the investment function moves the IS curve
from IS, to IS2, and the rise in the money supply
moves the LM curve from LM, to LM2, as shown
in Part A of Figure 12-10. The result is a shift in
the equilibrium position from Y of $120 and r of
6 percent to Y of $160 and r of 6 percent. The AD
curve of Part B correspondingly shifts from its
position at Y of $120 to a position at Y of $160. A
rise in investment spending, with no change in
the money supply, produces a rise in income that
is dampened by a rise in the interest rate resulting from it. If the money supply increases by just
the amount necessary to prevent this rise in the
interest rate, the full i'ncome-expansionary effect
of the rise in investmeAt will be realized. The
increase in Y from $120 to $160, with an increase
in investment of $20 and an MPC of 1/2, is just
the result we found in the simple Keynesian
FIGURE 12-10
Effect on Aggregate Demand of a
Simultaneous Increase in
Investment and the Money
Supply
model in Chapter 5. Now we see that this result
will be realized only if an appropriately expansionary monetary policy-here
an increase in ms
of $20-is
pursued to prevent what otherwise
would be a rise in the interest rate and consequently a smaller rise in the income level.
The effects of shifts in other functions may be
traced in the same way. For example, an increase
in "thrift," which appears as an upward shift in the
, Government Spending,
Taxation, and Aggregate
Demand,
_
Once government spending and taxation have
been added to the model, the equilibrium condition S = I in the goods market foi' a two-sector
economy becomes S + T = I + G for a threesector economy. This simply means that the
aggregate spending for goods and aggregate
output of goods will be equal when the sum of
the diversions, S + T, from the real income
stream is just matched by the sum of compensating injections, I + G, into the real..'income
stream. Alternatively, the equilibrium condition in
the goods market may be expressed as Y =
C + I + G. The equilibrium condition in the
money'market is md = ms' as before.
As in the first fiscal model of Chapter 6. both
government purchases of goods and services
and net tax receipts'are assumed to be independent of the level of income. Part A of Figure 12-11
shows $20 9f :government purchases added.
to the investment .schedule- of Figure 12-3.
'Bec.~use these Pwchases are also regarded
as independent of the interest rate, the I + G
curve lies $20 to the right of the I curve at all
interest rates. Whatever the interest rate, the sum
of I -+- G will be $20 greater than I alone. In termsof its'effecton Y,a dollar of G is no different from
, a dollar of I. Adding $20 of G therefore shifts the
S+T
100
I
!
:: f
60 ~
!
40
20
401-----~----
IrI1.__ .__
_1.
40
______
.Ll_L__~____----.L..
00
20!-- --
I
I
I I
..1...- .
r---
lW
100
200
I
,
,
I
I
I I I
I I
45.__'-_....L1_L
I I
I
20
40
' __
60
..l- ._
----L __..
80
100
r
I
10 \--
6,
i
4 ~-
i,
2
rI+~
IL
120
130
.....L.
__
20
i_.
40
..l-
..l_.
60
80
.1.__...
100
f ~ 160
'"
:\
140
Effect on Aggregate
fiGURE 12-1 i
D'emand of Changes in Government
and Taxation
Spending
equal to the expansion in the size of the budgetwill be dampened by the tendency for the interest
rate to rise with the rise in income. In other words,
a fiscal policy designed to produce a rise in
income while maintaining a balanced bUdget will
produ~e the maximum possible income increase
only if it is accompanied by an expansionary
monetary policy that prevents what otherwis~
might be a rise in the interest rate and a consequent reduction in private investment spending.
We have seen that a rise in the income level
m'ay be expected from an expansion in G with no
change in T and even from an expansion in G
that is matched by T. The third possibility, of
course, is a reduction in Twith no reduction in G,
a commonly cited example of which was the tax
cut of 1964. This major reduction cut federal tax
receipts about 10 percent below what they other~
wise would have been; in contrast. the more
recent anti-reCE:fssionary Tax Reduction Act' of
1975 reduced receipts about 5 percent below
what they otherwise would have been. Figure
12-11 may bE?used to illustrate an aspect of the
1964 tax cut much discussed at the Jime.-SUppose the original equilibrium is definedf/by)the
intersection of 153 and LM at Y otl$)3(j,~'nd
of
6.5' percent; this is the equilibriurl consistent with
1 + G of Part A and 52 + T ~f ParVJ. of Figure
12-11. With no change in G ~ ~Jax cut of $20,
the I + G curve remains ~
~crthe 52 + T
curve shifts downward to.8,. 't'fis'in turn causes
the 15 curve to shift from 153 'to 152, But the full
expansionary effect of the tax cut-a rise in Y
from $130 to $150-is not realized because the
interest rate rises. Therefore, in judging the prospective effectiveness of the 1964 tax cut, one
consideration was whether or not the expected'
increase in aggregate spending would be smaller
than otherwise obtainable due to adverse monetary effects, In President Johnson's words, ,''It
would be self-defeating to cancel the,stimulus,of
tax reduction by tightening money. Monetary and
debt policy should be directed toward maintainjng interest rates and credit conditions that
encourage private investment.,,14 The model In
1's.'
254
Figure 12-11 is far tOb simple.to come to grips
with the questions' involved, but it suggests. in
very general terms, that what is called-for is an
incre~~e in the money supply. This' Jncrease.
should be"sufficient to shift the LM cu~e to the
right 'by the amount necessary to s.ecure the
greater rise in income-from
$130 to $"1~~that
will follow f(om the increase in aggregate spending to be exp~cted at ,a stable interest rate.
~Itpough we will not go beyond the simple
model in which both G and T are assumed to be
independent of Y, the- IS-LM analysis of Figure
12-11 may be elaborated by introducing more
realistic fiscal assumptions. In Part C, for example. T may be treated as a function of Y, and the
effects of this more realistic fiscal assumption on
the..Y, r equilibrium combination may readily be
tr~ced. This . model will show how the potential
income-expansionary
effect of, say, a rise in
investment. spending may be restrainec.by both
a rise in the interest rate and a rise in tax receipts
as income expands. Although it adds something
to the simpler model of this section, like any other
model of this kind it will again bring out our principal conclusion: An increase in aggregate
spending-whether
it is the result of a shift in the
investment function. consumption function, or a
change in government spending or taxation-will
not produce the effect on income ~uggested by
the crude multipliers in earlier ch~ers.
When
,
we recognize the r<>leplayed by money and interest, we see how an otherwise greater expansion
of income suggested by crude multipliers may
be prevented by the rise in the interest rate that
may accompany a rise in income.
!
L.
'I
t.L_L
FIGtJRE 1:112
ion? In our simplified version of the classical theory, money is demanded only for transactions
purposes. Therefore, in Figure 12-4, classical
theory assumes that the speculative demand for
money is zero at each inter~st rate. In effect.
Part A of that figure vanishes. If the total money
supply given in Part B is $100. that $100 will be
held in transactions balances or msp = 0 and ms
=: tnr With k of 1/2 in Part C. the LM curve of
Part 0 becomes a perfectly vertical line at the
income level of $200. if the public holds, money
only for transactions purposes and if it holds
money balances equal to one-half of a period's
income, money market equiiibrium is found at an
. income level of $200 at all interest rates. 15
With the exception of the perfectly. inelastic
section-the
so-called classical range-it would
not be altogether incorrect to include the remainder of the LM function in the Keynesian range.
However, because of Keynes' emphasis on the
ineffectiveness of monetary policy, the Iiquiditytrap section alone has been identified. as the
Keynesian range. Within this range, monetary
policy is completely ineffective; therefore .. this
range most closely fits Keynes' emphasis.
The IS function as derived in Figure 12-3
slopes downward to the right. Its elasticity
depends on the responsiver:'ess of investment ./
spending to changes in the interest rate and on
the magnitude.of the mUltiplier. If the investment
spending schedule is perfectly inelastic (indipating that investment sRending is completely
tnsensitive to the interest rate). the IS curve
derived in Part 0 will' be perfectly inelastic.
regardless of the magnitude of the multiplier. If,
on the other hand, the investment demand
schedule shows some elasticity, as se~ms to be
the case, the IS curvewili be- more ela,stic, the
lower the MPS. The lower the MPS, the higher will
be the mutliplier and the greater will be _the
change in income for any increase in investment
resulting from a fall in the interest rate. Part A of .
Figure 12-13 shows three pairs of IS curves, each
''''The graphic derivation of a perlect!V inelastic
curve is shoM1 in Chsptei 13 on p. 268.
LM
Y4
A
P
AD3
,
AD,
AD2
ADs
AD4
AS
I
PI
...
r, equilibrium
FIGURE 1213
16 Although
the present model contains a classical element in the form of the perfectly inelastic range of the LM
curve, the model is essentially Keynesian because it
shows that the equilibrium level of output may be below
it-Ie level consistent with full employment. Remember from
Chapter 9 that the simple classical model with its assumption of perfect wage and price flexibility yields a perfectly
inelastic AS curve, which is located at the full employment
ievel of output. This makes the full employment level of
output the only equilibrium level, a result altogether different from that found in Figures 12-12 and 12-13. Further
. comparisons between the classical and Keynesian models"
in terms of the IS-U.If framework will be presented in the
following chapter.
.:0
example, it does not matter Wh~eh r the IS function is th~ el.a~ticIS1 or the inelasti IS"1.17
The liqUidity trap is an extre e case that
could occur only during a dee depression, if
even then. A prosperous economy and a liquidity
trap do not go hand in hand. Because the pure
As we will see, the elasticity of the IS function does
::>ecomerelevaAt elsewhere, but not in the Keynesian
ange.
17
"
-.
The Intennediate Range Finally, let us examine the equilibrium of Y2, r2, as defined by !.he
intersection of /S2 and LM1 in Part A of Figu~e
12-12. Here again we see that some increase in the
money supply will shift the LM1 function to LM2.
In the Keynesian range, this increase in the
money supply left both Y and r unchanged
because that total increase was absorbed in
speculative balances at the existing interest rate. -.
In the classical range, this increase in the money ,
supply raised Y by the amount necessarY to
absorb the full increase in transactions balances.
This worked itself out through the interest rate
reduction that raised spending by the amount
needed to produce the required rise in income.
In the intermediate range, however, the increase
in the money supply is partially absorbed in both
speculative and transactions balances. The level
of income rises, but by an amount less than that
which would require the full increase in the
money supply for transactions purposes.
For example, suppose that the increase in the
money suppiy is $20 and k is 1/2. Although the
resultant shift in the LM function is $40, here the
rise in income (Y3 - Y2) is only ha~fthat amount.