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The Keynesian Framework and the ISLM Model

The Keynesian Framework and the ISLM Model. Determination of Output. Keynesian ISLM Model assumes price level is fixed Aggregate Demand Y ad = C + I + G + NX Equilibrium Y = Y ad Consumption Function C = a + ( mpc  Y D ) Investment 1. Fixed investment

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The Keynesian Framework and the ISLM Model

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  1. The Keynesian Framework and the ISLM Model

  2. Determination of Output Keynesian ISLM Model assumes price level is fixed Aggregate Demand Yad = C + I + G + NX Equilibrium Y = Yad Consumption Function C = a + (mpcYD) Investment 1. Fixed investment 2. Inventory investment Only planned investment is included in Yad

  3. Consumption Function

  4. Assume G = 0, NX = 0, T = 0 Yad = C + I = 200 + .5Y + 300 = 500 + .5Y Equilibrium: 1. When Y > Y*, Iu > 0 Y to Y* 2. When Y < Y*, Iu < 0 Y to Y* Keynesian Cross Diagram

  5. Expenditure Multiplier

  6. Analysis of Figure 3: Expenditure Multiplier I = + 100 Y/I = 200/100 = 2 1 Y = (a + I)  1 – mpc A = a + I = autonomous spending Conclusions: 1. Expenditure multiplier = Y/A = 1/(1 – mpc) whether change in A is due to change in a or I 2. Animal spirits change A

  7. The Great Depression and the Collapse of Investment

  8. Role of Government

  9. Analysis of Figure 5: Role of Government G = + 400, T = + 400 1. With no G and T, Yd = C + I = 500 + mpc Y = 500 + .5Y, Y1 = 1000 2. With G, Y= C + I + G = 900 + .5Y, Y2 = 1800 3. With G and T, Yd = 900 + mpc  Y – mpc T = 700 + .5Y, Y3 = 1400 Conclusions: 1. GY; TY 2. G = T = + 400, Y 400

  10. NX = +100, Y/NX = 200/100 = 2 = 1/(1 – mpc) = 1/(1 – .5) Role of International Trade

  11. Summary: Factors that Affect Y

  12. IS Curve IS curve 1. iINX, Yad, Y Points 1, 2, 3 in figure 2. Right of IS: Y > YadY to IS Left of IS: Y < YadY to IS

  13. LM curve 1. Y, Md, i Points 1, 2, 3 in figure 2. Right of LM: excess Md, i to LM Left of LM : excess Ms, i to LM LM Curve

  14. ISLM Model Point E, equilibrium where Y = Yad (IS) and Md = M s (LM ) At other points like A, B, C, D, one of two markets is not in equilibrium and arrows mark movement towards point E

  15. Monetary and Fiscal Policy in the ISLM Model

  16. Shift in the IS Curve 1. C: at given iA, Yad, YIS shifts right 2. Same reasoning when I, G, NX, T

  17. 1. Ms: at given YA, i in panel (b) and (a) LM shifts to the right Shift in the LM Curve from a Rise in Ms

  18. Shift in the LM Curve from a Rise in M d 1. M d: at given YA, i in panel (b) and (a) LM shifts to the left

  19. 1. M s: i, LM shifts right Yi Response to an Increase in Ms

  20. 1. G or T: Yad, IS shifts right Yi Response to Expansionary Fiscal Policy

  21. Summary: Factors that Shift IS and LM Curves

  22. Effectiveness of Monetary and Fiscal Policy 1. M d is unrelated to ii, M d = M s at same YLM vertical 2. Panel (a): G, IS shifts right i, Y stays same (complete crowding out) 3. Panel (b): M s, Y so M d, LM shifts right iY Conclusion: Less interest sensitive is M d, more effective is monetary policy relative to fiscal policy

  23. 1. IS unstable: fluctuates from IS' to IS'' 2. i target at i*: Y fluctuates from YI' to YI'' 3. M target, LM = LM*: Y fluctuates from YM' to YM'' 4. Y fluctuation is less with M target Conclusion: If IS curve is more unstable than LM curve, M target is preferred Ms vs. i Targets When IS Unstable

  24. 1. LM unstable: fluctuates from LM' to LM'' 2. i target at i*: Y = Y* 3. M target: Y fluctuates from YM' to YM'' 4. Y fluctuation is less with i target Conclusion:If LM curve is more unstable than IS curve, i target is preferred Ms vs. i Targets When LM Unstable

  25. Panel (a) 1. Ms, LM right to LM2, go to point 2, i to i2, Y to Y2 2. Because Y2 > Yn, P, M/P, LM back to LM1, go back to point 1 Panel (b) 1. G, IS right to IS2, go to point 2 where i = i2 and Y = Y2 2. Because Y2 > Yn, P, M/P, LM left to LM2, go to point 2', i = i2` and Y= Yn. The ISLM Model in the Long Run

  26. P, M/P, LM shifts in, Y Points 1, 2, 3 Deriving AD Curve

  27. At given PA, IS shifts right: Y in panel (b) AD shifts right in panel (a) Shift in AD from Shift in IS

  28. At given PA, LM shifts right: Y in panel (b) AD shifts right in panel (a) Shift in AD from Shift in LM

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