ISLM Analysis Part IV: Policy Tools (Fiscal and Monetary) Keynesian Framework

1. ISLM Analysis Part IV: Policy Tools (Fiscal and Monetary) The Keynesian Framework According to John Hicks and Alvin Hansen Roger W. Garrison 2010

2. S S Seq Y I i i i LM ieq ieq IS MSPEC Yeq Y Ieq I MT MT Y MSPEC

3. S+T S I+G I

4. S+T I+G i G I+G I

5. S+T S S+T Y I+G i G I+G

6. S+T bT S+T S = -a + (1-b) Y S = -a - (1-b)T + (1-b)Y S = -a + (1-b)(Y-T) (1-b)T Y - a - (1-b)T

7. S+T S+T Y I+G i I+G

8. S+T S+T (S+T)eq Y I+G i i i LM ieq ieq IS MSPEC Yeq Y (I+G)eq I+G MT MT Y MSPEC

9. We focus on just two of the quadrants of ISLM to show how a fiscal stimulus in the form of increased government spending is weakened by a countermovement in investment spending. i i LM ieq IS Yeq Y (I+G)eq I+G

10. With ISLM analysis, we can show that fiscal stimuli don’t have the same strength as they did in the simple Keynesian modes. That’s because government spending crowds out investment spending. Any such “crowding out” offsets the magnitude of the stimulus dollar-for dollar. Suppose the MPC in Macrovia is 0.75, implying a spending multiplier of 4. And suppose that income is $1,200 below its full-employment level. How much additional spending would drive the economy to full employment a. in the simple Keynesian framework? b. in the ISLM framework? i i LM I+G I+G’ IS IS’ 1200 300 I+G Y Yfe 880 80 Crowding Out Crowding out (ΔI) may amount to 80, in which case the net stimulus would be only 220. And the actual increase in income would be 880.

11. 1200 First, we assume no crowding out. 900 300 Y = C + I + G Once we know the actually magnitude of the crowding out, we can show how it manifests itself even in the simple Keynesian model.

12. Then we allow for crowding out. 300 Y = C + I + G 80 The result is a net increase in I+G of 220. The reduction of investment spending in the amount of 80 accompanies the government spending of 300.

13. 880 660 220 Y = C + ( I + G) The simple Keynesian multiplier applies to (ΔI + ΔG).

14. Suppose we observe a sharp increase in the fetish-based component of the demand for money. Can you identify the resulting changes in the equilibrium levels in the economy’s monetary sector? S+T S+T (S+T)eq Y I+G i i i LM ieq ieq IS MSPEC Yeq Y (I+G)eq I+G MT MT Which of the two sector-equilibrium curves shifts and in which direction does it shift? Can you identify the resulting changes in the equilibrium levels in the economy’s real sector? Y MSPEC

15. With the equation of exchange in play, some of the transactions balances are drawn into speculative balances. How would adopting the hard-drawn version of Keynes’s theory have affected the results? S+T S+T (S+T)eq Y I+G i i i LM ieq ieq IS MSPEC Yeq Y (I+G)eq I+G MT MT The interest rate would have risen higher, and income would have fallen farther. These transactions balances are freed up as income spirals downward. Y MSPEC

16. Are all the behavioral magnitudes driven back to their original levels? What policy tool is most appropriate for re-establishing the original interest rate and level of income? S+T S+T (S+T)eq Y I+G What policy would be most appropriate if prices, wages, and the interest rate all responded to surpluses and shortages like your micoeconomics professor suggested they do? i i i LM LM ieq ieq IS MSPEC Yeq Y (I+G)eq I+G MT MT No. The increased demand for M SPEC is accommodated by a dollar-for-dollar increase in supply. Should the policy be expansionary or contractionary? MONETARY POLICY Y MSPEC

17. ISLM Analysis Part IV: Policy Tools (Fiscal and Monetary) The Keynesian Framework According to John Hicks and Alvin Hansen Roger W. Garrison 2008