Nouriel Roubini and David Backus
Lectures in Macroeconomics
Chapter 9. The IS/LM Model
Note: The Figures for this Chapter are currentlymissing. They will be posted soon.Money market is in equilibrium. If money demand does not depend on the interest rate, then we can write the LM equation as M/P = L(Y). For any given level of real balances M/P, there is only one level of income at which the money market is in equilibrium. Thus, the LM curve is vertical.
Keynesian versus Classical Theory: Why Money MayAffect the Level of Output
Saving and Investment Once More (The IS Curve)
Money and the Rate of Interest (the LM Curve)
Demand-Side Equilibrium
Application: The 1981-2 Recession
The Role of Animal Spirits
Application: Bolivian Stabilization
Application: Is Saving Good for the Economy?
Application: Who Should Make Monetary Policy?
Summary
We've spent a few lectures going through the Classical theory (Chapters5, 6, 7),which I think captures many of the important features of the macroeconomyvery well: the effects of productivity changes on output, real wages, andemployment; the relations among saving, investment, government spending,and real interest rates; and the connections between money growth, inflation,and exchange rates. These are all things that we observe in macroeconomiclife. But there are also a few aspects of the macroeconomy that don't mesheasily with this theoretical setup. To some extent that's unavoidable:theory is simplification, and that means you lose some of the complexityof the real world when you boil it down to a small number of graphs orequations. I think the benefits far exceed the costs, in the sense thatthe theory gave us a fairly simple and unified way of thinking about abroad range of issues.
The Keynesian theory takes many of the elements used in the Classicaltheory, but adds to them the premise that prices do not clear markets inthe short run. Instead, prices have a life of their own, with the pricelevel or its rate of change subject to considerable inertia (think of arunaway truck, if you like metaphors). This sounds plausible on the faceof it, and we've often argued that (say) adjustments in the labor marketmight take some time. What makes this theory interesting, however, is notthat the premise is plausible, but that this one modification changes someof the theory's short-run predictions in dramatic ways.
Perhaps the most important change concerns the effect of higher moneygrowth on interest rates. In the Classical theory, you'll recall, highermoney growth leads to higher inflation and thus, other things equal, highernominal rates of interest. But if you read the newspaper, you get the clearidea that higher money growth lowers interest rates. Over the last sixmonths of 1991, for example, the Fed loosened monetary policy (higher moneygrowth) in order to lower interest rates and combat the recession. I thinkit's pretty unlikely that Greenspan and his colleagues got this wrong (althoughwe may be facing inflation some time down the road). Think of yourselfdriving a car with the gas pedal reversed: you'd have to have an IQ belowroom temperature not to figure this out pretty quick. So if Greenspan isnot mistaken, the Classical model must be getting the direction wrong.As I said before, the data seem to indicate that the long-run effect ofmoney growth on interest rates is just as the Classical theory predicts,but the data also suggest that the short-run effect is the opposite. Figure1 gives you some idea of the typical dynamic response of interest ratesto money growth. What we need, then, is some way of thinking about thisshort-run effect.
For this reason and others, we're going to spend some time looking ata second theory, which we label Keynesian. The Keynesian and Classicaltheories are often presented as competitors. I'd say that's exactly wrong.They choose different simplifications of a complex reality. Which is betterdepends on the issues you want to think about. Roughly speaking, the Classicaltheory is better for long-run properties and the Keynesian theory is betterfor the short run. (To be honest, this is really too simple: the Classicaltheory does a better job on the effects of oil price shocks even in theshort run, for example.) Of course, what we really need is a combinationof the two theories. If we had another term we could do this, but I thinkyou'd find that this is a lot of effort and that we can guess many of theproperties of this hybrid model without making such a large investmentof our time.
So on to the Keynesian theory. This theory was developed by the Britisheconomist and man about town John Maynard Keynes in the middle of the 1930s,when it seemed as if the economies of the Western World were stuck in anendless Depression (a term that means recession, only worse).
We've seen in the postwar period that growth rates of real output goup and down, but that the downs never last very long (check the data fromthe first chapter). Well the Depression seemed to go on a long time, andKeynes thought a different theory was called for. We'll look at a characterizationof his theory due to John Hicks, another British economist and one of thefirst Nobel prize winners in economics. (Keynes died before the prize wasestablished.) This version is referred to as the IS/LM model, since itis based on the IS and LM curves. We'll see what those are momentarily.
The starting point, as we've noted, is to give prices a life of theirown. Quantities are then determined by the 'demand' for output (who buysit), rather than 'supply' (who makes it), as it is in the Classical theory.The difficulty in getting, say, monetary policy to affect output in theClassical theory is that output is determined by the supply side: the productionfunction, the labor market, and the stock of capital. What Keynes did,essentially, was to erase these parts of the model and proceed withoutthem. You can imagine that this leads to some strange possibilities (canwe get more output without more inputs?), but Keynes thought it might notbe a bad idea in the short run, despite its long run anomalies. His famouscomment to classical critics was that it's the short run that matters:'In the long run we're all dead.'.The plan, then, is to develop the 'demand'side of our model.
Keynesian versus Classical Theory: Why Money May Affectthe Level of Output
As seen in Chapter 6, according to the ClassicalTheory, monetary policy has no effects on the level of real economic variables(such as output, consumption, savings, investment and the real interestrate). In the Classical Theory it is assumed that all prices and (nominal)wages are perfectly flexible both in the short-run and the long-run. Then:
1. An increase in the level of the money supply M will increase proportionallythe price level P (and the level of the exchange rate S in an open economy)with no real effects.
2. An increase in the rate of growth of the money supply will increaseproportionally the rate of inflation , the nominal interest rate (and therate of currency depreciation) and will have no real effect on Y, C, I,r.
The basic idea of the Keynesian Theory (IS/LM model) is that prices(and nominal wages) are not flexible in the short-run: they do not clearmarkets in the short-run. In other terms, there is inertia in the settingof prices (especially when the economy is operating below full capacity/full employment). The rationale of assuming that prices are sticky isthat firms and businesses do not change the prices of the goods they sellon a continuous basis: for example, the New York Times has been sellingfor 60 cents for a number of years in spite of changes in demand, supplyand costs of production. Similarly, producers and sellers of many goodschange the price at which the goods are sold only infrequently. This simplemodification of the assumption about price flexibility changes dramaticallythe implications of the effects of monetary policy: monetary policy willhave real effects on output in the short-run. We will see in this chapterwhy.
An important issue related to this non-neutrality of money is the behaviorof central banks and monetary policy. During recessions, the Fed expandsthe level and/or growth rate of the money supply to reduce interest ratesand stimulate economic activity. What is the logic of such a policy ? Ifthe world was working according to the Classical Theory in the short-run,such Fed policy would have no real effects and will only increase inflation.Figure 1 shows the effects of an increase in the rate of growth of moneyin the Classical model. An increase in the rate of growth of money leadsto an immediate proportional increase in the inflation rate, in the nominalinterest rate with no effects on the real interest rate and the level ofoutput. Money is neutral both in the short-run and the long-run.
However, empirical evidence shows that an increase in the rate of growthof the money supply has very different effects in the short-run from thosepredicted by the Classical Theory. The response in reality is more similarto that shown in Figure 2: higher money growth reduces the nominal andreal interest rate in the short run and leads to an increase in the rateof inflation only slowly over time. The reduction in the real interestrate, in turn, leads to a short-run increase in investment, consumptionand the level of output. To understand why monetary policy has effectssimilar to those shown in Figure 2, we have to look at the Keynesian Theorywhere prices adjust slowly (with inertia) in the short-run.
So to summarize the differences between Classical Theory and KeynesianTheory:
1. In the Classical Theory, quantities (output) are determined by the'Supply' of output (who makes it) that depends on technology (the productionfunction) and the equilibrium in the labor market. 'Aggregate Demand' affectsonly the price level: so monetary policy affects only prices. The leftpart of Figure 3 presents a graphical representation of the classical theory.Given the equilibrium in the labor market, the level of output (aggregatesupply) is given and is independent of the price level; this is representedby the vertical curve AS in the right side of Figure 3. On the same graphwe present the aggregate demand for goods (AD) that is a negative functionof the price level; in fact, a reduction of the price level increases realincome and leads to an increase in demand. The position of the AD curvedepends on the other determinants of aggregate demand: an increase in governmentspending G or a reduction in taxes T lead to a shift to the right (an increase)of the aggregate demand function. Similarly, an increase in the money supply,increases the real money balances (M/P), reduces the interest rate andleads to an increase in investment and consumption, two major componentsof aggregate demand. The figure shows that, in the classical theory, anyincrease in aggregate demand induced by an increase in the money supplydoes not affect the level of output: it only leads to an increase in theprice level from P to P'.
2. In the Keynesian Theory, it is assumed that the economy is not operatingat full employment. Since some machines and workers are unemployed, thesupply of output can be increased without an increase in the price level.This is represented by an horizontal aggregate supply function AS, as inFigure 4: at the given price level that is fixed (sticky) in the short-run,the supply of output is fully elastic. In this Keynesian model, quantities(output) are determined by the 'Demand' for output (who buys it), i.e.by the aggregate demand for goods AD. Since prices are sticky (in the short-run)an increase in aggregate demand (generated by an increase in money M orgovernment spending G) will not affect the price level in the short run.Instead, it will lead to an increase in the level of output from Y to Y'.This is shown in the right hand side of Figure 4.
Where is the increase in output coming from in the Keynesian Theory.The Keynesian theory with fixed prices is mute on this point: as long asthere are unemployed resources and production is below capacity, it isassumed that firms are willing to increase output when demand goes up withoutincreasing prices. Figure 5 shows a variant of the Keynesian model thatgives some consideration to the supply decisions of firms and explainswhy they might be willing to increase production when demand goes up. Inthis Neo-Keynesian variant, nominal wages (W) rather than goods pricesare sticky in the short run. If the nominal wage is too high, given thelevel of goods prices, we get unemployment as the demand for labor is belowthe supply of labor at the initial real wage (W/P1). The employmentlevel N1 is then determined by the demand for labor and outputis equal to Y1. An increase in the price level from P1to P2 reduces the real wage to (W/P2), increasesthe demand for labor to N2 and increases the supply of outputto Y2. So the aggregate supply AS is a positive function ofthe price level as opposed to the vertical AS curve of the classical theoryand the horizontal AS curve of the fixed-price keynesian theory. In thisNeo-Keynesian variant, an increase in the money supply leads to an increasein aggregate demand (shown in the bottom panel of Figure 5). This increasein demand leads to an increase in the price level; this, in turn, reducesthe real wage (W/P), increases the demand for labor and leads to an increasein the supply of output. As shown in the bottom part of Figure 5, an increasein aggregate demand leads both to an increase in the level of output andan increase in the price level. So, money is non-neutral in the sense thatit affects real output but an increase in M also leads to price inflation.
In general the Keynesian Theory is more valuable for short-run analysis('In the long-run we're all dead') while the Classical Theory is more valuablefor long-run analysis where prices and wages adjust. We will now describein more detail the Keynesian Theory.
Saving and Investment Once More (The IS Curve)
You'll recall that one of the components of the Classical model is a relationbetween saving and investment:S= Sp(r,Y-T) - (G-T) = Sp +Sg=I(r) + CA
where Sp is saving by households (private savings), I isnew investment in physical capital, and G-T is the government deficit (negativepublic savings). As before, let's start by omitting the foreign sector(CA=0), so that the equilibrium condition is
Sp(r,Y-T) - (G-T) = Sp +Sg = I(r).
In the earlier theory Y was given by technological factors and the equilibriumin the labor market; here we want to allow Y to change in response to changesin monetary and fiscal policy, as well as other factors. What we need isnot a new relation, but a different graphical representation of the samesaving and investment relation, which we'll call the IS curve.
The IS curve summarizes equilibrium in what we'll now call the goodsmarket. It's what we called the financial market earlier, but goods makea better story in the present context, as you'll see. Recall that thisequation can be thought of as supply and demand for goods, obvious whenwe express it as aggregate supply equal to aggregate demand (that is thesum of C, I and G):
Ys = Yd = C + I + G
or as supply and demand for funds in capital markets, as when we write
Sp - (G-T) = I
where Sp is equal to Y-C-T. The two equations represent thesame information in different ways. Now what we want, to get an analysisof the effects of monetary and fiscal policy on output and interest rates,is a graph with r and Y on the axes. This is a more complex curve thanwe've seen before, but it makes what follows easier, since we can put theentire theory in one diagram.
Here's what we do. In our former diagram in Chapter 5 we equated Sp-(G-T)with I for given values of Y, G, T and other variables that affect thepositions of the S and I curves. This gives us, as illustrated in Figure6, a single equilibrium point, labeled A in the diagram where r= r'; thispoint is for a particular value of Y, say Y = 1000. We can draw this pointin the diagram to the right that relates r to Y, also labeled A.
This same experiment can be done for other values of Y, for exampleY = 1500. For this value of Y the saving curve shifts to the right as higherincome leads to higher private savings, and we have the equilibrium conditionat point B at which r is lower and equal to r'. If we plot B on the seconddiagram we have a point that is southeast of A. If we continue this forall possible values of Y, we trace out a downward sloping line in the seconddiagram. This line gives us all the combinations of r and Y that are consistentwith equilibrium in the goods and financial markets. The curve is downwardsloping because, given the initial point A where S=I, an increase in incomeleads to an increase in savings and causes an excess supply of savingsin the financial market. Then, in order to restore the equilibrium in thefinancial market, we need a fall in the interest rate: this fall reducessavings, increases the investment rate and leads savings to become againequal to investment.
There is an alternative explanation of the downward slope of the IScurve, based on the fact that this curve represents also the equilibriumbetween aggregate supply of goods and aggregate demand. Aggregate demandis made of three components:
G = exogenous value
C = c0+ b (Y-T) - a r
I = i0- d r
Here we assume that government spending G is exogenously chosenby the government.
Private consumption C depends on three factors. First, thereis some exogenous (autonomous) level of private consumption (defined byc0) even at zero levels of disposable income. Second, consumptiondepends on disposable income (Y-T) according to the parameter 'b'that represents the marginal propensity to consume: i.e.if b=0.8,when income goes up by a dollar, consumption goes up by 80 cents. Third,consumption is a negative function of the interest rate r; as interestrates go up, consumers will save a larger fraction of their income andconsume a smaller fraction of their income.
Private investment I depends on two factors: first, there issome exogenous (autonomous) level of private investment (defined by i0)that does not depend on the level of interest rates. Second, investmentis a negative function of the interest rate: as the interest rate becomeshigher, firms (who borrow to buy capital goods) are less likely to investin new capital goods. The parameter 'd' represents the sensitivity of investmentto changes in the interest rate.
Now let us see why the IS curve represents the equilibrium in the goodsmarket. Suppose that the initial point A in Figure 7 is one where, giventhe initial income Y' and interest rate r', aggregate demand is equal toaggregate supply. Then, suppose that we maintain the same initial interestrate r' and increase income/output from Y' to Y'; in terms of the Figurewe move from the point A to the point X. This increase in output Y willlead to an excess supply of goods: in fact an increase in output of onedollar by definition increases the supply of goods by one dollar but increasesthe demand for goods only by 'b', the marginal propensity to consume income(say 80 cents if b=0.8). So, point X must be a point of disequilibriumin the goods market: aggregate supply is above aggregate demand (Ys> Yd) at X. Then, we need to do something to restore theequilibrium in the goods market. A fall in the interest rate will do thatsince a fall in r to the level r' leads to an increase in investment demandand an increase in consumption demand. So as we move from point X to pointB, we restore the equilibrium in the goods market: at B demand for goodswill be equal to to the higher supply of goods Y'. So to summarize: startingfrom an equilibrium, an increase in Y leads to an excess supply of goods;then, a fall in interest rate is required to stimulate aggregate demand(C and I) and restore the equilibrium in the goods market. Note that pointsabove the IS curve represent points where aggregate supply is above aggregatedemand (Ys > Yd) and savings are greater than investment(S>I); while points below the IS curve are points where (Ys <Yd) and (S<I). Obviously, points along the IS curve representcombination of values of Y and r such that aggregate demand is equal toaggregate supply (Ys = Yd) and savings are equalto investment (S=I).
Formally, the IS curve is derived as follows. Equate aggregate supplyand aggregate demand:
Y = C + I + G = [c0+ b (Y-T) - a r] +[ i0- d r]+ G
Then solve for Y as a function of r to get:
Y = [(c0+ i0 + G - bT)/(1-b)] - (a + d)/(1-b)r
Since the slope coefficient -(a+d)/(1-b) is negative, the equation aboverepresents a negative relation between Y and r, i.e. the IS curve.
As with all our curves, there are some changes that are incorporatedin movements along the curve and others that involve shifts of the curve.The latter are those that are held fixed during our derivation of the IScurve and include changes in G , T and the autonomous components of consumptionand investment (i.e. changes in c 0and i0). We'llconsider these in turn.
The effect of an increase in government spending G. Let's seehow a change in the exogenous government spending G leads to a shift tothe right of the entire IS curve: intuitively, a higher G will spur theeconomy and shift the IS curve out. Lets us start at point A' in the leftside Figure 8 where S=I and aggregate demand is equal to aggregate supplyat the initial level of income Y' and r' and the initial G'; the same pointA' is represented by the IS' curve in the right side of Figure 8. Whathappens when we increase G from G' to G'? In the left hand diagram theI(r) curve remains the same while the the national supply of savings isreduced as public savings fall with the increase in G. This reduction innational savings leads, for the initial income Y', to a higher rate ofinterest r'. That means that the point A' shifts to A', which is aboveA'. So, in the right side of Figure 8, the original point A' is not anymorean equilibrium point as G is higher; the new equilibrium in the goods/capitalmarket is at point A' that is on a different new IS curve. This will betrue for all points on the IS curve for exactly the same reason: they allshift up. In fact, for any level of initial income Y, a higher G leadsto lower savings and higher interest rates. So the IS' curve shifts upor, what amounts to the same thing, shifts to the right to the new IS'curve in the right side of Figure 8.
The shift in the IS curve to IS' following an increase in G can alsobe seen in Figure 9. Given the initial G', the point E in the old IS' curverepresents a point where aggregate supply is equal to aggregate demand.When G increases to G', given the initial Y' and r', we get an increasein aggregate demand with no change in aggregate supply (as Y is fixed atpoint E). So point E is now a point of excess demand for goods since Gis higher than before. In order to restore the equilibrium in the goodsmarket, we can do two things. We can either move from point E to pointE' where the interest rate is higher and equal to r': the higher interestrate r' reduces aggregate demand and restores the equilibrium betweendemand and supply at the initial output level Y'; so point E' is a pointon the new IS curve. Alternatively, if r remains constant at the initiallevel r', the excess demand at point E is eliminated via an increase inoutput from Y' to Y'; this is represented by a movement from E to E'where E' is a point on the new IS' curve (that corresponds to the higherG').
The effect of an increase in taxes T. You might guess that thisshifts the IS curve to the left or down and you'd be right as shown inFigure 10, but it's a little more complicated than the first example. Supposewe start from an initial equilibrium point A' represented both in the leftand right hand sides of Figure 10: at point A', given the initial G' andT', demand for goods is equal to supply for goods and S=I. An increasein taxes T (from T' to T') has the following effects. First, it leadsto an increase in public savings (a reduction in the budget deficit) thatcauses a shift to the right of the curve S representing total nationalsavings. This is the movement of the curve from A' to B in the left sideof Figure 10. However, the increase in taxes reduces disposable income(Y-T) and causes a reduction in private savings; this is the shift of thesavings curve from B to A' in the left side of Figure 10. On net, theincrease in taxes leads to a increase in national savings for the samereasons explained in Chapter 5; an increase in taxes by one dollar increasespublic savings by one dollar but reduces private savings only by the marginalpropensity to save out of income. Such marginal propensity to save is (1-b)<1,i.e. one minus the marginal propensity to consume. For example if b=0.8,the marginal propensity to save is (1-b)=0.2; so a fall in disposable incomeof one dollar (because of higher taxes) reduces private savings by 20 cents.Since private savings fall less than the increase in public savings, totalsavings go up as shown by the move of the savings function S from the pointA' to the point A'. At A' the higher savings cause a reduction in theinterest rate and an increase in national investment. The right hand sideof Figure 10 shows this change in taxes as a shift of the IS curve. Theinitial point A' on the old IS curve is not an equilibrium as higher Tmeans higher savings while investment is still unchanged. Therefore a fallin the interest rate from r' to r' is required to increase investmentand restore the equilibrium in the capital market. At point A' in theright hand side of Figure 10, we get this new equilibrium on a new IS curvedenoted as IS'. This shift will be true for all points on the IS curvefor exactly the same reason: they all shift down. In fact, for any levelof the initial income Y, a higher T leads to higher savings and lower interestrates. So the IS curve shifts down or, what amounts to the same thing,shifts to the left to the new IS' curve in the right side of Figure 10.
The shift in the IS' curve to IS' following an increase in T can alsobe seen in Figure 11. Given the initial T, the point E in the old IS curverepresents a point where aggregate supply is equal to aggregate demand.When T increases to T', given the initial Y' and r', we get an fall inaggregate demand (as lower disposable income leads to lower private consumption)with no change in aggregate supply (as Y is fixed at point E). So pointE is now a point of excess supply for goods since T is higher than beforeand consumption C is lower. In order to restore the equilibrium in thegoods market, we can do two things. We can either move from point E topoint E' where the interest rate is lower and equal to r': the lower interestrate r' increases aggregate demand (C and I) and restores the equilibriumbetween demand and supply at the initial output level Y'; so point E' isa point on the new IS curve. Alternatively, if r remains constant at theinitial level r', the excess supply of goods at point E is eliminated viaan reduction in output from Y' to Y'; this is represented by a movementfrom E to E' where E' is a point on the new IS curve (that correspondsto the higher T). Note that a fall in Y reduces supply more than demand(as the marginal propensity to consume 'b' is less than unity); so, ithelps to reduce the excess supply of goods.
Money and the Rate of Interest (the LM Curve)
The second element of our theory is the money market. As seen in Chapter8, the equilibrium in the money market isM/P = L(i, Y) = L (r, Y)
where M is the amount of currency supplied to the public by the Fed(previously called MS in Chapter 6). Note that, in the Keynesian theorythe price level is fixed so that we can assume that there is no differencebetween the nominal and the real interest rate (i.e. r and i are equal).As we discussed in Chapter 8, the Fed affects the level of interest ratesby choosing the amount of currency via open market operations. As in Chapter8, the equilibrium in the money market is shown in the top panel of Figure12; r (or i) is determined at the point where the real money supply M/Pis equal to the real money demand L.
We can now express this equilibrium in the money market as a new relationbetween the real interest rate r and real output Y, given values of M andP; we will call this relation the LM curve. We derive this relation inmuch the same way we did for the IS curve. Start with supply and demandfor money for a given initial value of Y. We can graph this, as done inthe bottom panel of Figure 12, in a diagram with r on the vertical axisand the quantity of real money supplied or demanded on the horizontal axis.Real money supply is fixed since M and P are given (that is, outside thetheory). Real money demand L is a downward sloping line. The equilibrium,labeled A, can be drawn as a point in the right hand diagram (also labeledA) as a combination of the initial Y' and the initial equilibrium r'.
Now try a different, higher value of Y, Y' greater than the initialY'. This results in greater demand for money (more transactions) and ashift up of the L curve: at any level of the interest rate the demand formoney is higher since income is higher. This increase in money demand leadsto a higher rate of interest r', labeled point B in both sides of thediagram. Thus higher output is associated with a higher interest rate alongthe equilibrium curve for the money market, labeled the LM curve. So theLM curve represents the combination of values of Y and r such that thereal demand for money is equal to the real supply of money (L=M/P).
This upward slope of the LM curve makes sense. As shown in Figure 13,starting from an initial equilibrium point A on the LM curve, a higherY leads to a higher demand for money; since the supply of money is given,to restore the equilibrium in the money market we need an increase in theinterest rates that reduces the money demand back to the fixed real moneysupply. In other terms, starting from an equilibrium point A, an increasein Y (shown as a movement from point A to point X) leads to an increasein the demand for money and an excess demand for money in the money market(L>M/P). Then, to bring back the demand for money to the lower exogenouslevel of the real money supply (M/P), we need an increase in the interestrate, i.e. a movement from point X to point B. At B, the equilibrium inthe money market equilibrium is restored. Note that points below the LMcurve are points of excess demand for money (L>M/P) as higher output and/orlower interest rates raise the demand for money above its supply; whilepoints above the LM curve are points of excess supply of money (M/P>L).Points along the LM curve are points where real money demand is equal toreal money supply (L=M/P).
The LM curve summarizes equilibrium in the money market for given valuesof M and P. Changes in any of these variables leads to a shift of the curve.The most important of these is a change in M. You might guess that an increasein M shifts the LM curve to the right or down (raises output or lowersthe interest rate), as shown in Figure 14. That's exactly right, as wenow show. Suppose you start from an initial equilibrium in the money marketat point A in both sides of Figure 14; the initial output, money supplyand price level are Y', M' and P'. The equilibrium A is represented bythe interest rate r' and the level of output Y' in the right side of thefigure. If M increases from M' to M', this shifts the supply of moneyfunction in the left hand diagram of Figure 14 to the right. The resultis a lower equilibrium real interest rate, given the initial value of Y,Y'. In the right hand side diagram, this appears as a shift down from pointA' to point A'. The new point is labeled A' in both diagrams. So, anincrease in the money supply leads to an excess supply of money, giventhe initial values of r and Y. Then ,we need a reduction of r (given thelevel of Y) to increase the demand for money to the new higher level ofthe money supply. So, the equilibrium is restored on a new LM curve ata point A' where output is still the same Y' and r has fallen from r'to r'. This increase in the money supply will reduce the interest rateat any level of output Y. In fact, if we started from a different initialY, say Y' (before the shift in M), we would be on a point like B' on theoriginal LM curve. Then, an increase in M would still lead to a reductionin the interest rate. So, an increase in M is represented by a shift downwardto the right of the entire LM curve from LM' to LM'. An additional wayof seeing the shift in the LM is as follows. An increase in M leads toan excess supply of money (M/P > L) at the initial levels of r and Y. Then,to restore the equilibrium in the money market, you need either a lowerr (for given Y) to increase the money demand to the higher supply or ahigher Y (for given r) to increase the money demand to the higher levelof M. Either way, the LM shifts to the right.
Demand-Side Equilibrium
The equilibrium in the Keynesian model consists of intersecting the ISand LM curves, as in Figure 15. Points of intersection are combinationsof r and Y (Y' and r' in the figure) such that we have equilibrium in themarkets for both goods (the IS curve) and money (the LM curve). We callthis the demand side since it involves how much output is demanded (throughconsumption, investment, and government spending), rather than how theoutput is produced (the production function, you'll note, plays no parthere).The interesting aspects of this model concern the policy experiments.Note first the effects on r and Y of an increase in the money supplyM, considered in Figure 16 . We saw in above in Figure 14 that thisleads to a shift of the LM curve to the right. The initial equilibrium(before the increase in M) is at point A where r=r', Y=Y' and the LM curveis represented by LM'. Now, the central bank increases the money supplyfrom M' to M'. Given the initial level of output Y' and interest rater', the increase in the money supply lead to an excess supply of moneyand a shift of the LM curve from LM' to LM'. The equilibrium will movefrom A to B where r is lower at r' and Y is higher at Y'. Let us seehow the adjustment from A to B occurs. Initially, the level of output isfixed at Y' and the increase in M leads to a reduction in the interestrate. Given the initial money demand (for given Y'), the interest ratehas to fall from r' to rx to clear the money market; since assetprices adjust faster than goods markets, it makes sense to think that inthe short-run output is unchanged and the entire burden of equating moneydemand and money supply falls on the interest rate. Now, the increase inM caused the interest rates to fall at the much lower level rx representedby the move from point A to point B in the right panel of Figure 16. Notethat this is fall in both the nominal and real interest rate since pricesand inflation are held fixed. Since real interest rates are lower, thecomponents of aggregate demand more sensitive to interest rates start toincrease: firms increase investment by buying more capital goods whilehouseholds reduce savings and start to consume more (especially big itemssuch as cars, home appliances and other durable goods whose demand is sensitiveto interest rates). In turn, this increase in aggregate demand leads firmsto produce more as in a Keynesian model aggregate supply is determinedby the aggregate demand for goods; so output starts to increase from Y'to Y'. Note that, while the interest rate falls on impact following theincrease in the money supply, over time it starts to increase even if atthe new equilibrium B, the interest rate is at a level r' that is lowerthan its pre-monetary shock level r'. The reason for the increase in rfrom rx to r' in the transition from C to B is simple: as outputstarts to increase, the demand for money will increase too. Since the moneysupply is now fixed at its new higher level M', the increase in moneydemand pushes up the interest rate. So, r initially falls from r' to rxbut then crawls back up to r'. In the new short-run equilibriumB, output is higher and the (nominal and real) interest rate is lower.Thus we have delivered on one of our objectives: to have a theory in whichmore money leads to lower interest rates and higher output. The mechanism,if you stop to think about it, is liquidity: the Fed changes the compositionof its debt, raising the fraction of debt in the form of cash. This makesfinancial markets more liquid and, for a period of time, drives down interestrates. This, in turn, stimulates aggregate demand and leads to an increasein production, output and income.
Over longer periods of time, of course, we might expect that an increasein M would lead the classical effects to take over: inflation and nominalinterest rates would rise. You can see this long-run effect by workingthrough the effects of an increase in P on the LM curve in Figure 17. Ifthe initial output level Y' was equal to the full employment output, theincrease in output to Y' puts the economy in a overheated state whereoutput and demand are above the long-run potential level of output. Therefore,the price level starts to increase as bottlenecks in production and increasesin wages lead to positive inflation. As the price level P starts to increase,the real money supply M/P falls; in fact, the nominal money supply is nowgiven at M' while P is now increasing over time. This reduction in thereal money supply leads to a leftward shift in the LM curve. In fact, theposition of the LM curve depends on the levels of M and P; and an increasein P is equivalent to a fall in M since the position of the LM curve dependson the ratio M/P. Therefore over time, as prices increase, the LM curveshifts back eventually to where it was before the monetary shock; as thisbackward shift in the LM occurs, the interest rate starts to increase,the demand for goods starts to fall and output falls back towards its fullemployment level Y'. In the long-run, the initial increase in the moneysupply has not effects on output and the interest rate and its only effectis an increase in the price level, as predicted by the Classical theory.But in the short run, say 6 to 18 months, the Keynesian model seems appropriate.Figures 16-17 put these two effects together: initially the Keynesian 'liquidity'effect dominates, but later on the Classical theory takes over, as inflationcatches up with the increase in the money supply.
Another policy change we consider is a rise in government spendingG, shown in Figure 18. Note that, since a reduction of taxes T hasthe same effect on the IS curve as an increase in government spending G,the policy experiment we consider (an increase in G) has similar effectas a reduction in T. In fact, both fiscal policy changes lead to a higherbudget deficit; here we assume that this budget deficit is financed byissuing bonds. In Figure 18, we show the short-run effects of this fiscalexpansion. We know from the analysis above (and Figure 9) that an increasein G leads to a shift of the IS curve up to the right, from IS' to IS'.Before the increase in G, the equilibrium was at point A; the new equilibriumis at point B where both output and the interest rate are higher. Let ussee why a fiscal expansion leads to these effects. Starting from an equilibriumA, an increase in government spending leads to an increase in aggregatedemand; initially this leads to an excess demand for goods but since outputis demand determined, the increase in demand soon leads to an increasein supply. Therefore, output starts to increase from Y' towards Y'. Notethat, as output goes up, the interest rate starts to increase from r' tor'. The reasons why the interest rate goes up are two: first, as incomegoes up the demand for money increases; but since the supply of money isconstant, the increase in the demand for money must lead to an increasein the interest rate. Second, since the higher budget deficit is bond-financed,the increased supply of bonds by the government must lead to a fall intheir price and an increase in interest rates; agents will hold these extragovernment bonds only if their return is higher. Therefore, as output increasesfrom Y' to Y', the interest rate goes up from r' to r'. Note that thedifference between expansionary monetary and fiscal policy, then, is thatone lowers interest rates, the other raises them; both of them lead toan increase in output. Note also that, in the case of a fiscal expansion,the increase in the interest rate leads to a 'crowding-out' of privateinvestment. In fact, as interest rates go higher, private investment tendsto fall leading to a smaller increase in output than would have occurredif interest rates had not gone up. This can be seen by observing that,if the interest rate had remained constant at r', the shift in the IS curveto IS' would have led to an increase in output from Y' to Yx ;instead, the actual increase in Y is only from Y' up to Y' since the increasein interest rates leads to an fall in private investment (the crowding-outeffect). This is similar to the Classical theory where higher budget deficitslead to higher interest rates and lower investment (see Chapter 5).
As in the case of a monetary expansion, the effects described aboveare only short-run. Since in the long-run output is determined by supplyfactors, a fiscal expansion cannot permanently increase output above itslong-run full employment level. This transition from the short run to thelong run is described in Figure 19. Suppose that the initial Y' was thefull employment output. Then, in the short-run the fiscal expansion leadsto an overheating of the economy as output Y' is above its full employmentlevel. This excess demand for goods, in turn, will cause over time somepositive inflation. As the price level goes up, the real money supply M/Pwill fall (since M is exogenously given and P is increasing); this fallin real money balances leads to a shift to the left of the LM curve thatstarts to move from LM' to LM'. As the LM shifts back, the interest ratewill tend to rise from r' to r''. This increase in interest rates, inturn, leads to a reduction in aggregate demand, especially demand for investmentand durable goods. This fall in aggregate demand, in turn, leads to a fallin output. So, the output level starts to shrink from Y' back to its originalfull employment level Y'. The increase in prices terminates when outputis back to its full employment level and the excess demand for goods iseliminated. The new equilibrium is at point C where interest rates areeven higher than in the short-run. That makes sense: since output is backto its initial level while G is at a higher level, the goods market clearsthrough a permanent reduction in the components of demand that are interestsensitive, i.e. investment and consumption of durable goods (Y =C + ¯I + G).So, you get a long-run crowding-out of investment. Note that this permanentlong-run crowding-out of investment can be avoided if, over time, the increasedbudget deficit (caused by the increased G) is financed by an increase intaxes T. If an increase in taxes occurs, the IS curve shifts from IS'back to the original IS' and the long run equilibrium is not at point Cbut back at point A. In this new long-run equilibrium, there is no crowding-outof investment as the interest rate falls back to the original r'. However,since Y is constant to its full employment level Y' while G is at a higherpermanent level G', there must be a full crowding-out of private consumption;in fact, the higher taxes reduce disposable income and lead to a permanentreduction in C (again Y = ¯C+ I + G).
In summary, in the short-run since prices of goods are fixed the Keynesianeffects are at work and both a monetary and fiscal expansion lead to higheroutput. However, if output ends up being higher than its full employmentlevel, over time the price level will start to increase and the long-runeffects of these monetary and fiscal expansions is identical to the implicationsof the Classical theory. Money cannot affect the long run level of realvariables such as output, C, I and the real interest rate. For concernsfiscal policy, government spending and budget deficits cannot affect thelevel of long-run output but may affect its composition between consumption,investment and G.
Application: The 1981-2 Recession
If you were older, you might recall the 1981-2 recession, the deepest recessionof the postwar period. This recession was unusual in a number of respects.For one thing, it coincided with extremely high rates of interest, whereasin most recessions (think of 1990-92) we see low rates of interest. Thisrecession was also interesting for establishing Henry Kaufman, an NYU graduateand current chairman of Stern's Board of Overseers, as the preeminent interestrate forecaster on Wall Street for most of the 1980s, and for spurringthe growth of fixed income derivative assets, like options on treasurybonds.Let's start with the background. As we entered 1979, the US economywas limping along with slow growth and inflation in the range of 10-12percent a year; see Figure 20. Carter had just appointed Paul Volcker chairmanof the Federal Reserve with orders to eliminate inflation. Over the nextthree years we experienced the most severe recession of the postwar periodand inflation fell to about 4 percent, where it stayed for most of the1980s.
What happened? I think the simplest sensible interpretation of the datais that the Fed adopted a policy of very tight money. We can think of theshort-run effects as being a leftward shift of the LM curve, which raisesinterest rates and lowers output. In the top panel of Figure 21 we seea sharp drop in money growth in 1980, and the middle panel shows that thisresulted in a similar drop in real balances, M/P, that lasted for severalyears. The final panel illustrates the impact on short-term rates of interest:the 3-month tbill rate and the federal funds rate (the rate at which banksborrow and lend from each other on a daily basis, which we'll discuss ina few weeks). For the only time in the postwar period we saw 3-month treasurybill yields well above ten percent, which is exactly what we'd expect froma sharp leftward shift of the LM curve.
Here's where Kaufman comes in. Rates peaked in the fall of 1979 at around14 percent, then fell under 10 in early 1980. At this point most forecastersregarded the high rates of late 1979 as a freak occurrence that was unlikelyto happen again. Kaufman argued the opposite, and predicted that Volcker'stight money policy would drive rates up again. Kaufman turned out to beright when everyone else was wrong, and thus established himself as oneof the most influential men on the Street. Curiously, his own firm (SalomonBrothers) reportedly didn't believe him at the time.
This is an example, I think, of where sound economic reasoning (andprobably a fair amount of luck) turned out to be useful. In forecasting,if patterns between variables were the same from one business cycle tothe next, all you'd need to forecast is a summary of these patterns. Butin 1981-82 we saw something that didn't fit past experience: high interestrates in a recession. Economic theory was useful because we could use thesame framework to examine the effects of policies that have never beentried, like the Volcker disinflation. Thus theory helps us to make predictionsabout events that lie outside our range of experience.
If we follow this period along a couple more years, we see, I think,that elements of the Classical theory come to bear. After a couple yearsof tight money, we see in Figure 20 that inflation fell from about 12 percentin early 1980 to 4 percent in mid-1982. If we compare Figure 21, we seethat nominal interest rates declined along with inflation. So I think thisepisode illustrates both the short-run Keynesian effects of Volcker's tightmoney policy and the longer-run Classical effects, too.
There's another aspect of this situation that relates to financial markets.If you glance at interest rates over the 1979-81 period you can see thatthey had more sudden changes than we'd seen ever before in the postwarperiod. There was a lot more uncertainty about interest rates and bondprices. Now think what this means for a financial business---say one thatborrows short and lends long, like a typical commercial bank. If interestrates rise sharply then the prices of long bonds fall (think about thisif it seems mysterious). The company is stuck with assets that have declinedin value and face higher interest rates on their borrowing: in short, they'vebeen squeezed by the rise in interest rates.
A friend of mine made a large amount of money (by academic standards)explaining to a money-center bank how to hedge itself against such risks.What you do is buy a put on government bonds, so that if the bonds fallthe put rises in value to compensate. This advice turned out to be extremelyvaluable in the early 1980s. Events like this helped to spur the growthof such markets as options on government bonds, and 'fixed income derivatives'are still pretty hot in the financial community.
Animal Spirits and Self-Fullfilling Recessions
In this section, we will explore the idea that changes in the households'and firms' optimism and confidence about the economy (animal spirits) canlead to self-fulfilling recessions or economic booms even if the fundamentaldeterminants of income and interest rates have not changes. Suppose thatsuddenly households and firms become more pessimistic about the futureof the economy. This change is the market mood or confidence may occureven if there has been no change in the current fundamentals. For example,households may start to cut consumption even if the the level of theirdisposable income is unchanged and the level of interest rate is unchanged.This reduction in consumption (in spite of the constancy of the determinantsof consumption, disposable income and interest rates) may occur if thereis an event that makes households more pessimistic about their future income.For example, when Iraq invaded Kuwait in the summer of 1990, the U.S. economystarted to go into a recession. Why ? Part of the story is that householdswere nervous about the future effects of the invasion on the economy andstarted to cut their consumption spending in spite of the fact that theircurrent incomes and interest rates were unchanged. This exogenous reductionin consumption led to a fall in aggregate demand; in turn, this fall inaggregate demand led to a fall in production that resulted in the recessionof 1991-1992. In other terms, an exogenous change in consumer confidenceabout the future of the economy led to a self-fullfilling recession. Householdsstarted to consume less because they were worried about their future income;according to the conventional lore, in 1990-91 people were staying at homeand following the Kuwait crisis on CNN rather than going out and spendingtheir incomes. In turn, this initial concern about future incomes led toa fall in consumption that caused the recession that was being feared inthe first place. Similar changes in optimism, investors's mood (otherwisecalled by Keynes 'animal spirits') and consumer confidence may leadto changes in the firms' investment demand even if fundamental determinantsof investment (such as real interest rates) have not changed. Firms maysuddenly become concerned about the future of the economy and this changein firms' animal spirits may or may not be related to actual changes inthe current state of the economy. If this change in firms' sentiment occurs,they may start to cut their investment (their purchases of plant and equipment).This fall in investment demand, in turn, leads to a fall in aggregate demandand a self-fullfilling fall in output. I.e. a recession may end up occurringjust because consumers and firms start to believe that a recession mightbe occurring in the future.
How can we formalize the idea of self-fullfilling changes in outputdue to animal spirits in the context of out IS/LM model? You remember thatwhen we derived above the consumption and investment demand functions wesaid that these functions depend on fundamental variables such as Y-T andr for consumption and r for investment. However, we also argued that thereare some components of consumption and investment that are exogenous andwe called such autonomous components c0 and i0; theseautonomous components of aggregate demand are those that are affected byanimal spirits as they lead to changes in C or I even if there are no changesin fundamentals (Y-T or r). Formally, the consumption and investment functionsare:
C = c0+ b (Y-T) - a r
I = i0- d r
Real Money Balance
Lets us then consider the effects on the IS curve of exogenous changesin the autonomous components of consumption and investment. A reductionin either c0 or i0 represents a reduction in someexogenous component of aggregate demand. Therefore, if initially the economywas in equilibrium, such exogenous fall in demand is exactly equivalentto other types of exogenous reductions in aggregate demand, such as anexogenous fall in government spending G. We know from the previous analysisthat a fall in government spending leads to a shift of the IS curve downto the left. Therefore, an exogenous change in the autonomous componentsof consumption or investment (due to animal spirits) will also be representedby an exogenous shift downward to the left of the IS curve. This case ofa recession caused by animal spirits is then described in Figure 22. Beforethe change in the investors' and consumers' mood, the equilibrium is atpoint A where output is at Y' and the interest rate is at r'. Then, anincrease in agents' pessimism about the economy leads to a fall in exogenousdemand even if the fundamentals Y and r are still unchanged; in turn, thisleads to a shift to the left of the IS curve from IS' to IS'. This fallin aggregate demand then leads to a fall in output/income as firms startto cut production in response to the fall in demand. The ensuing fall inincome further reduces aggregate demand and exacerbates the initial fallin output. The economy starts to contract and output falls from Y' to Y'.As output falls, the interest rate falls as well: the lower investmentdemand reduces the demand for loans and borrowing pushing down the interestrate. Also, the fall in output reduces the demand for money and leads,for given supply of money, to a fall in the interest rate. Over time theeconomy moves from point A to point B and the economy falls into a recession.
This is in part the story of the 1990-1991 recession. Of course, thesechanges in animal spirits were not the sole cause of that recession asmonetary policy and external shocks played also an important role. However,the discussion above suggests that animal spirits can play a role in theobserved business cycles in the economy. An exogenous increase in optimism(higher consumer and firms' confidence) can lead an economy out of a recession;conversely, an exogenous fall in consumer and investors confidence canlead to a self-fullfilling contraction in economic activity. A recessionmay occur just because many people start to believe that it may be occurring!
Application: Bolivian Stabilization
Bolivia in the mid-1980s suffered from rates of inflation in excess of1000 percent per year. On the advice of Jeffrey Sachs of Harvard, theyadopted one of the cleanest examples of an orthodox stabilization: fiscalbudget balance, slower money growth, and market-oriented policies. Whatwe saw was a dramatic fall in the inflation rate, as you might predictfrom the Classical theory. We also saw a substantial decline in output,as the Keynesian theory predicts for the short run. This suggests thatthe kinds of price inertia we're talking about are also present at veryhigh rates of inflation (which should tell you why it's so hard to getrid of inflation once you get it). Sachs remarked on the latter: 'WhenI came, Bolivia was a poor country with very high inflation. Now Boliviais simply a poor country.'
Application: Is Saving Good for the Economy?
There's an old joke that if you ask twelve economists a question, you getthirteen answers: one from each, plus two from Keynes. Saving is a goodexample of this. We saw in the Classical theory that saving was good forthe economy: a high saving rate translated into higher investment, growthin the stock of capital, and increases in output and wages. This predictionwas backed up by data: countries that save the most also tend to investthe most and grow the fastest.The Keynesian story is just the opposite. A higher saving rate (theratio of S to Y) is also a lower consumption rate, since saving and consumptionsum to after-tax income. In terms of the IS/LM diagram, we can think ofan increase in the saving rate as a leftward shift in the IS curve, which(in the theory) reduces output. The story is that if individuals decideto consume less, this hurts firms, who are trying to sell, and leads themto lay people off. This is a demand side story in the sense that we aretalking about who demands, or buys, goods, rather than how they are produced.I think the story has some merit.
So who is right? Like our analysis of monetary policy, I think it'sa little of both: the Keynesian theory fits the short term, but over periodslonger than a couple years saving clearly raises output (ie, the Classicaltheory is the best guide). For example, the short-run effect of a reductionin budget deficits (via a cut in spending G or an increase in taxes T)may be recessionary according to the Keynesian model; however, over time,the cut in the budget deficit lead to a fall in real interest rates, lesscrowding-out and an increase in private investment. Over time, this increasein investment leads to a larger capital stock and an increase in potentialand actual output. So, while the short run effects of a fiscal contractionmay be recessionary, the long-run effects are likely to be expansionary.This tradeoff between short and long term objectives is one of the toughissues facing policymakers. On the whole, I tend to worry that short termthinking has led to policy with poor long term consequences. Businessmenface some of the same problems: when bonuses are tied to annual performance,there may be little gain to adopting policies with long term benefits.(Keller, in Rude Awakening, makes this point over and over aboutthe corporate culture at GM.)
Application: Who Should Make Monetary Policy?
The Volcker disinflation of 1979-1982, and countless other examples, makesit clear that the short run and long run effects of monetary policy aremuch different. In the short run, monetary expansion lowers interest ratesby increasing the level of liquidity in financial markets. In the longrun, faster money growth raises inflation and thus raises nominal interestrates, with no effect on the real rate. Experience suggests that if thecentral bank is too closely connected to the government, short run considerationswill dominate with possible adverse consequences in the longer term (unnecessarilyhigh inflation). As a result, many countries give the central bank someautonomy, much as we do for the judiciary. Eg, US Supreme Court Justicesare appointed for life, and members of the Board of Governors of the FederalReserve System are appointed for 14 year terms (we'll discuss the FederalReserve System in more detail later on). This gives elected officials control,in the longer term, over monetary policy, but insulates monetary policyfrom day-to-day politics.Over the last decade or so, there has been increasing pressure in Congressto make the Fed more 'accountable.' Articles in the Wall Street Journaland elsewhere note that monetary policy is made by people who have notbeen elected, suggesting that perhaps they should be.
Should the Fed be more accountable to Congress? The evidence seems tobe that in those countries with more independent central banks, inflationhas been lower and unemployment hasn't been much different. In this sense,independence may be a good idea. That's generally the recommendation tohigh inflation countries: deny the fiscal authority access to the printingpresses by making the central bank independent. The low inflation ratesof Germany are surely the result of an extremely independent Bundesbank,which doesn't seem to have affected them adversely in other respects. Germanoutput growth, for example, has been as good as any European country inthe postwar period. It's strange, then, that Congress would then arguethat Fed independence is bad for the US. It's hard, too, to resist a furthercheap shot at Congress: would you rather put monetary policy in the handsof the Greenspan and Co., or the people who brought you the S&L fiasco?
Summary
- The central idea of the Keynesian theory is that prices, or inflation rates,have a great deal of inertia: they do not respond immediately to changesin economic conditions or policy. That allows monetary policy to influencethe real rate of interest and output in the short run.
- The IS curve summarizes equilibrium in the goods market. It's downwardsloping in the diagram. Increases in G shift it to the right/up. [Writedown the equation and draw the graph.]
- The LM curve summarizes equilibrium in the market for money. It's upwardsloping in the diagram. Increases in M shift it to the right and down.[Write down the equation and draw the graph.]
- Equilibrium in the IS/LM model is represented by the intersection of theIS and LM curves. Increases in G raise Y and r. Increases in M raise Ybut lower r.
- The 1981-2 recession illustrates the impact of monetary policy in the shortrun, and how elements of both the Keynesian and Classical theories showup in applications.
- Stabilizations of hyperinflations suggest that 'price inertia' may be relevantthere, too.
- Finally, autonomy of the central bank may improve its performance by insulatingit from short term political pressures.
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