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Econ 309: Savings and Social Security. Keynesianism: The IS-LM Model. Keynes wrote The General Theory of Employment, Interest, and Money in 1936 The IS-LM model was developed by John Hicks for the Econometric Conference at Oxford, September, 1936

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keynesianism the is lm model
Keynesianism: The IS-LM Model
  • Keynes wrote The General Theory of Employment, Interest, and Money in 1936
  • The IS-LM model was developed by John Hicks for the Econometric Conference at Oxford, September, 1936
  • One of many attempts to make the General Theory more accessible, formal
    • Hicks later became disillusioned with IS-LM and was ambivalent about receiving the Nobel Prize for it in 1972
keynesianism the is lm model1
Keynesianism: The IS-LM Model



  • IS curve: Y = C(Y-T) + I(r) + G
  • LM curve: M/P = L(r, Y)





keynesianism is lm curve
Keynesianism: IS-LM curve
  • IS curve: Y = C(Y-T) + I(r) + G
    • Assumption: Consumption is a functional of “disposable income” (marginal propensity to consume) and nothing else
    • Assumption: Investment is a function of interest rates (though it can be exogenously shifted by “animal spirits”)
    • Government spending does not affect either investment or consumption directly
  • LM curve: M/P = L(r, Y)
    • People have a liquidity preference, demanding more money and less
keynesianism the is lm model2
Keynesianism: The IS-LM Model
  • Implications for policy
    • Fiscal policy: An increase in government spending pushes the IS curve outward and raises GDP (if Y<Ymax)
    • Monetary policy: An increase in the money supply pushes LM outward and raises GDP
  • “Crowding out”: expansionary fiscal policy drives up interest rates and causes a fall in investment that partially offsets its effects
  • Question: What if Y=Ymax?
savings in keynes
Savings in Keynes
  • IS curve: Y = C(Y-T) + I(r) + G
    • Consumption, C, is a function of disposable income, Y-T
    • Savings is the residual of disposal income after consumption, i.e. S = Y – T - C(Y-T)
    • Savings behavior does not involve any thought for the future!
  • What is the effect of a fall in the savings rate? C rises, and GDP rises
basic monetarism
Basic Monetarism
  • The equation of exchange: MV=PT, where
    • M = money supply
    • V = velocity of money
    • P = price level
    • T = volume of real transactions (i.e., real GDP)
  • If V is constant (a major assumption), then:
    • Monetary policy (interpreted as raising M) can increase real GDP, but might only increase inflation
    • No obvious interpretation for fiscal policy
  • “The triumph of monetarism”: in recent years (until 2009), economists have usually advocated monetary policy rather than fiscal policy
the solow model of long run growth
The Solow Model of Long-Run Growth


  • Yt = f(Kt), dY/dK > 0, d2Y/dK2 < 0
  • Kt+1 = (1-n-d)Kt + sYt





savings in solow
Savings in Solow
  • As in the standard Keynesian model, savings is exogenously fixed
  • What is the effect of a fall in the savings rate? The long-run growth rate falls
  • IS-LM plus Solow: Savings are bad in the “short run,” good in the “long run”???
digression ethics and discount rates
Digression: Ethics and discount rates
  • Economists assume that people “discount the future”
  • Revealed preference says:
    • The future really is worth less than the present, if people systematically treat it so
    • It is not irrational to discount the future
    • Ordinary people find this view hard to accept
  • Exponential vs. hyperbolic discounting:
    • If discounting is exponential, people’s behavior is “time-consistent”
    • If discounting is hyperbolic, people have time-inconsistent preferences
  • Given economic growth, is it clear that people really do discount the future?
gokhale social security and savings
Gokhale: Social Security and Savings
  • Gokhale’s explanations for the decline in the savings rate:
    • Government redistribution of income from younger cohorts to older cohorts
    • A rise in the consumption propensities of older cohorts due to annuitization of incomes
the decline in us savings rates
The decline in US savings rates
  • (go to Gokhale, p. 7/320)
  • Between 1950 and 1995, savings rate dropped from 11.5% to 3.4%
  • Continued falling after that, to 0% or less, before rising sharply in 2008/09
us savings rates 2000 2009
US savings rates, 2000-2009

net national savings rate
Net national savings rate

Savings rate equals one minus consumption rate minus government spending rate