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# THE IS-LM FRAMEWORK I

Soon after the publication of Keyness General Theory, British economist J.R. Hicks published
an article that attempted to integrate the insights he felt were useful in the General Theory with
those of the so-called Classics that Keynes had opposed. We discussed the debate between
Keynes and the Classics in Chapter 15.

The so-called Neo-classical synthesis that emerged and dominated macroeconomic thinking,
particularly the textbook expositions, was built on the work of J.R. Hicks and his IS-LM model
(see box for more discussion).

The IS and LM curves are the equilibrium relationships pertaining, respectively, to the product
(goods) market (investment = saving) and the money market (demand for money (liquidity
preference) equals money supply).

The representation of the goods market equilibrium in terms of simple equality between
investment and saving reflected the historical period that the model was developed the
simplifying assumption was that we would gain essential insights into income determination by
assuming a closed economy without government.

The IS equation was subsequently extended to allow for the impact of governments and net
exports on aggregate demand.

The income-expenditure model we considered in Chapter 12 allowed the interest rate to impact
on investment and hence aggregate demand and output in the goods market. The interest rate was
considered to be determined by the equality of money demand and supply in the money market.

The IS-LM approach thus was built on the interdependence of the equilibrium states in the two
markets. The general IS-LM approach showed how the equilibrium solution for output
(employment) and the interest rate was simultaneous. We needed to know what the interest rate
was to solve the level of income and the level of income to solve the interest rate.

In an analytical sense, there were two unknowns output and the interest rate and two
equations to allow us to solve the unknowns.

The IS-LM model is an early example of a general equilibrium model that remains fashionable in
mainstream economics.

## 16.2 The LM Curve

We assume that the price level is constant. The IS-LM model allows us to introduce price level
changes but at present we are operating in real terms.

Money market equilibrium requires that the demand for money equal the supply. We use the term
money demand to refer to the willingness to hold cash balances as part of a wealth portfolio.
The demand for money or as Keynes called it the liquidity preference is a function of the
level of income and the interest rate.

Three motives have been identified for holding liquid balances (money) in preference to other
assets:

Transactions motive people need money to engage in daily transactions. Thus the
demand for liquidity will be some proportion of total national income.

Precautionary motive at times major events occur that need to be resolved through
transactions for example, maintaining a cash balance to pay for engine repairs on a car.
This motive also tends to vary with national income as the higher is the level of economic
activity, the higher are the overall transactions.

## Speculative motive Keynes contribution, which we considered in Chapter 15 was to

highlight that money is not simply a means of exchange. People used money in times of
uncertainty over movements in interest rates. They have a choice between holding money
which earns no interest return or purchasing an interest-bearing asset, which has less
liquidity. Keynes juxtaposed the decision to hold money or bonds. If the interest rate is
expected to rise, the price of bonds falls and capital losses would be expected. So at lower
interest rates more people would prefer to hold money than take a chance that they would
lose should they invest in bonds. Alternatively, if the interest rate falls, the price of bonds
rises and capital gains would be enjoyed. At higher interest rates, more people will form
the view that rates will fall rather than rise and the liquidity preference will be lower.

The other way of thinking about the impact of interest rates is to realise that the opportunity cost
of holding money rises when interest rates are higher because holding money negates the
alternative of holding an interest-earning asset.

Figure 16.1 shows the liquidity preference function for a range of income levels. The nominal
rate of interest is on the vertical axis and the volume of money demand is on the horizontal axis.

The money demand curve (L) is downward sloping with respect to the interest rate and shifts
outwards at higher income levels (Y1 < Y2).

The higher is the interest rate, the lower will be the demand for liquidity, other things equal.
However, at any interest rate, the higher is the level of national income, the higher will be the
demand for money.

The money demand curve is smooth and non-linear because of diversity of opinion. For example,
as interest rates rise, wealth holders progressively form the view that they have reached their
maximum. Eventually everybody adopts the same expectation.

The money supply (Ms) is assumed to be controlled by the central bank via the monetary base
and the money multiplier determines the quantity of money supplied for a given base.
We can thus capture that assumption as a vertical line. The intersection of the money demand and
money supply curves determines the interest rate.

This is faithful to Keynes departure from the Classics who considered the interest rate to mediate
saving and investment (that is, a real variable). Keynes noted that the nominal interest rate was a
monetary variable determined by the demand for liquity and the supply of money available.

## Figure 16.1 Money Market Equilibrium

If the national income level was Y0 then the intersection of the relevant liquidity preference
function and the money supply line would generate an interest rate of i0 Point A.

## What would happen if income rose to Y1?

At the current interest rate i0 there would now be an excess demand for liquidity (measured by
the segment AB) and this would lead to the interest rate rising until the excess demand was
eliminated at C (i1) given that the money supply would be fixed.

What would happen if the central bank increased the money supply?

If the national income level was Y0 then the intersection of the relevant liquidity preference
function and the money supply line would generate an interest rate of i0 Point A.

## What would happen if income rose to Y1?

At the current interest rate i0 there would now be an excess demand for liquidity (measured by
the segment AB) and this would lead to the interest rate rising until the excess demand was
eliminated at C (i1) given that the money supply would be fixed.
What would happen if the central bank increased the money supply?

Figure 16.2 shows the impact of an increase in the money supply from Ms1 to Ms1.

At national income level Y0 and Ms1, the interest rate is i0 and the money market is in equilibrium
at Point A.

If the money supply rises to Ms2 then there is an excess supply of money at i0 (measured by the
segment AB) and the interest rate would drop until is reached i2 Point D, where the demand for
money is again equal to the money supply.

You can also see that if we start at Point A and the national income level rose to Y1 the interest
rate could be held constant at i0 if the central bank accommodates the increased demand for
money at the higher income level by increasing the money supply to Ms2.

We are now in a position to derive the LM curve which shows all combinations of income and
interest rates that are consistent with money market equilibrium.

Figure 16.3 shows the derivation of the LM curve. From the money market diagram, the Points
A, B and C represent equilibirium states where money demand equals money supply for different
levels of income.

Each equilibrium point is thus a unique combination of income and interest rates.

We can translate this understanding to a new graph (right-hand panel) where national income (Y)
is on the horizontal axis and the interest rate (i) is on the vertical axis.
If we trace the respective equilibrium points across into the income-interest space diagram we
get a series of points that are consistent with money market equilibrium.

## Advanced material: John Hicks on his IS-LM Framework

John Richard Hicks was a British economist who invented the IS-LM general equilibrium
macroeconomic framework.

In his 1937 article published in Econometrica Mr. Keynes and the Classics; A Suggested
Interpretation Hicks sought to provide an interpretation of Keynes General Theory within a
single diagram the IS-LL model. As the model became popularised and standard
macroeconomic textbook fare, the terminology became IS-LM to describe the product market
equilibrium (IS) and the money market equilibrium (LM).

The IS-LM model was designed to demonstrate how the determination of total real output was
dependent on the interdependent outcomes in the product and money markets.

Hicks said he invented a little apparatus (the IS-LM framework) to bring together Keynesian
and Classical economics into an integrated model.

By the 1970s, Hicks started to sign his academic papers John Hicks rather than J.R. Hicks,
which reflected his growing sense of rejection of his earlier work.

In 1975, to formalise is transition away from his earlier views, he wrote (Page 365):

J.R. Hicks [is] a neoclassical economist now deceased John Hicks [is] a non-
neo-classic who is quite disrespectful towards his uncle.

The issue was that he began to realise that the static equilibrium IS-LM model left out the key
contribution of Keynes the importance of time and endemic uncertainty.

For example, in the IS-LM model the current flow of investment is meant to be sensitive to
interest rate changes in the same period, which is one way in which the money market outcome
influences the product market equilibrium. But investment in any period is largely pre-
determined by decisions made in previous periods.

In 1980, Hicks wrote that he rejected the way in which is little aparatus had been deployed by
economists and the policy interpretations they had drawn from it.

## He said (1980: 139):

The IS-LM diagram, which is widely, but not universally accepted as a convenient synopsis of
Keynesian theory, is a thing for which I cannot deny that I have some responsibility. It first saw
the light in a paper of my own, Mr. Keynes and the Classics (1937) I have, however, not
concealed that, as time has gone on, I have myself become dissatisfied with it [the]
diagram is now much less popular with me than I think it still is with many other people

## By way of conclusion, he wrote (1980: 152-153):

I accordingly conclude that the only way in which IS-LM analysis usefully survives as
anything more than a classroom gadget, to be superseded, later on, by something better is in
application to a particular kind of causal analysis, where the use of equilibrium methods, even a
drastic use of equilibrium methods, is not inappropriate. I have deliberately interpreted the
equilibrium concept, to be used in such analysis, in a very stringent manner (some would say a
pedantic manner) not because I want to tell the applied economist, who uses such methods, that
he is in fact committing himself to anything which must appear to him to be so ridiculous, but
because I want to ask him to try to assure himself that the divergences between reality and the
theoretical model, which he is using to explain it, are no more than divergences which he is
entitled to overlook. I am quite prepared to believe that there are cases where he is entitled to
overlook them. But the issue is one which needs to be faced in each case.

When one turns to questions of policy, looking toward the future instead of the past, the use of
equilibrium methods is still more suspect. For one cannot prescribe policy without considering at
least the possibility that policy may be changed. There can be no change of policy if everything
is to go on as expected-if the economy is to remain in what (however approximately) may be
regarded as its existing equilibrium. It may be hoped that, after the change in policy, the
economy will somehow, at some time in the future, settle into what may be regarded, in the same
sense, as a new equilibrium; but there must necessarily be a stage before that equilibrium is
reached. There must always be a problem of traverse. For the study of a traverse, one has to have
recourse to sequential methods of one kind or another.
The last point was telling. While the intersection of given IS and LM curves might reflect
conditions now, the other points on the respective curves are what John Hicks called theoretical
constructions (1980: 149) and surely do not represent, make no claim to represent, what
actually happened.

References:

Hicks, J.R. (1937) Mr. Keynes and the Classics; A Suggested Interpretation, Econometrica,

Hicks, John (1975) Revival of Political Economy: The Old and the New, The Economic
Record, The Economic Society of Australia, 51(135), September, 365-67.

## THE IS-LM FRAMEWORK II

Figure 16.3 shows the derivation of the LM curve. From the money market diagram, the Points
A, B and C represent equilibrium states where money demand equals money supply for different
levels of income.

Each equilibrium point is thus a unique combination of income and interest rates.

We can translate this understanding to a new graph (right-hand panel) where national income (Y)
is on the horizontal axis and the interest rate (i) is on the vertical axis.

If we trace the respective equilibrium points across into the income-interest space diagram we
get a series of points that are consistent with money market equilibrium.

## The intersection of all those points is the LM curve.

Figure 16.3 The LM Curve

Note that at interest rate, i0, the LM curve is flat and becomes steeper at higher interest rates.
What does that mean? The horizontal segment of the LM curve relates to the presence of the
liquidity trap, which was named by English economist Dennis Robertson, who in the 1930s,
worked closely with J.M. Keynes at Cambridge University.

The liquidity trap arises at some minimum interest rate (which could be zero) where everybody
forms the view that the only direction for interest rates is up. The equivalent expectation is that
everybody considers that capital losses will be incurred on bond portfolios because when interest
rates rise, bond prices fall.

The result is that once interest rates reach this minimum level, all people will prefer to hold any
new money in the form of cash instead of bonds.

In Chapter 15 of the The General Theory of Employment, Interest and Money, Keynes said
(1936: 207):

There is the possibility that, after the rate of interest has fallen to a certain level, liquidity-
preference may become virtually absolute in the sense that almost everyone prefers cash to
holding a debt which yields so low a rate of interest. In this event the monetary authority would
have lost effective control over the rate of interest Moreover, if such a situation were to arise,
it would mean that the public authority itself could borrow through the banking system on an
unlimited scale at a nominal rate of interest.

As we will see when we consider policy analysis within the IS-LM framework, the existence of a
liquidity trap renders monetary policy ineffective as a counter-stabilising tool.

Monetary policy is characterised in this framework as the central bank manipulating the money
supply and when the interest rate is at i0 in Figure 16.3, increasing the money supply would have
no impact on interest rates or the price of bonds. In other words, monetary policy changes cannot
alter the level of national income.
In a liquidity trap, a rise in the money supply leads to an equal rise in the demand for money and
as a result the interest rate does not change. We will consider this in more detail later in the
Chapter.

The LM curve is upward sloping at higher levels of income because as national income rises the
demand for money increases and at each given money supply, the interest rate has to rise to
ration the excess money demand and retain money market equilibrium.

## The slope of the LM curve is steeper:

The more sensitive the demand for money (transactions and precautionary motives) is to
national income changes. Thus, small changes in national income lead to large changes in
excess money demand at a given money supply level. The rise in interest rates to restore
money market equilibrium, other things equal, has to be larger as a consequence.

The less sensitive the speculative demand for money is to changes in interest rates. Thus,
for a given excess demand for money, the interest rate increase that is required to restore
money market equilibrium is larger.

While the horizontal LM curve (liquidity trap case) is one extreme, the other extreme is
sometimes referred to as the Classical Case, which describes a vertical LM curve.

The Classical case arises from a demand for money function which is not sensitive to the interest
rate. In other words, money is considered to be a means of exchange only and the speculative
demand for money (which renders the overall demand for money sensitive to interest rates) is
ignored.

In these cases, the demand for money shifts outwards when income rises and inwards when it
fall. As a consequence there is only one national income level consistent with money market
equilibrium for a given money supply and the LM curve is vertical.

In the Appendix to this Chapter we derive an analytical solution to the IS-LM framework for
advanced studies, which show the impact of these two sensitivities (elasticities).

Shifts in the LM curve arise from changes in the money supply. Refer back to Figure 16.2, which
showed that for a given money demand curve, interest rates fall when the money supply rises.
The reasoning was that at a given money market equilibrium combination of interest rates and
income, a rise in the money supply generates an excess supply of money, which requires interest
rates to fall to stimulate the demand for money sufficiently to absorb the extra money.

In terms of the LM curve, this means that at higher levels of money supply, equilibrium interest
rates will be lower at each income level which translates into a shift outwards in the LM. The
opposite occurs when the money supply falls.
The LM curve can also shift if there is an autonomous change in liquidity preference, which
means the money demand rises (falls) at each income level depending on whether the preference
for liquidity rises (falls).

For example, if people become more pessimistic about the future they may use increased cash
holdings as a haven from uncertainty. This will lead to an outward shift in the money demand
curve so that for a given money supply, interest rates will be higher at each income level.

## 16.3 The IS curve

The IS curve shows all combinations of interest rates and income where the product (goods)
market is in equilibrium. So unlike the simple income-expenditure model we developed in
Chapter 12, the IS curve framework requires us to incorporate information about the money
market (interest rates) in our understanding of equilibrium in the product market.

In Chapter 12 we developed the real expenditure model of income determination. From the
National Accounting framework we know that total expenditure (E) in the domestic economy in
any particular period can be expressed as:

(16.1) E = C + I + G + (X M)

## Equation (16.1) is identical to Equation (12.2). As it stands, Equation (16.1) is an accounting

statement by dint of the definitions and sources of aggregate spending.

The equilibrium level of national income (Y) is determined by aggregate expenditure, such that
Y = E. The task of Chapter 12 was then to understand the behaviour of each of the expenditure
components in Equation (16.1) and theorise how they interact to determine national income.

At that stage we assumed that firms in aggregate plan a fixed volume of investment spending in
each period. We were concerned at that stage of the text in tracing out the implications of
changes in autonomous (exogenous) components of expenditure (investment, government,
exports etc) on national income via the multiplier process.

However, in Chapter 2, we develop a more detailed model of investment spending, which allows
us to take into account the impact on capital formation of changes in interest rates.

As a preview, we assume that rather than being exogenous, total investment spending is
influenced, in part, by expectations of future economic conditions and the interest rate.

Business firms are continually forming expectations about future output. Firms have to make
resource commitments (working capital, labour etc) well in advance of realisation (sales) and so
the scale of production at any point in time reflects the guesses they make in a highly uncertain
world.
Further, for given expectations about future sales and revenue, a firms investment decisions will
also be influenced by the cost of capital goods, which, in turn, will be affected by the interest
rate.

If interest rates rise, the cost of funds necessary to invest in new capital equipment rises and so
marginal projects (relative to expected revenue) may become unprofitable. In other words,
investment is likely to be an inverse function of the interest rate, other things being equal.

## In other words, we might hypothesise that total investment is given as:

(16.2) I = b1 b2i

## where b1 is an autonomous component of investment and b2 is the interest-rate sensitivity of

investment to interest rate changes.

The higher is b2, the more investment will decline (rise) for a given interest rate rise (fall).

The IS-LM framework retains the insight of Keynes that planned savings is a positive function of
national income. A more detailed analysis of the General Theory would also reveal that Keynes
considered that the interest rate might also influence consumption spending (via wealth impacts).
Further, the purchase of consumer durables such as white goods, which might require access to
consumer credit).

However, for now, to keep the argument simple, we assume that the interest rate only impacts on
investment.

In Chapter 12. we assumed that firms in the economy are quantity-adjusters and so prices are
fixed in the short-term. Figure 12.8 brought together the 450 aggregate supply curve with the
aggregate demand curve (E). It showed that equilibrium national income occurs when the
Aggregate Demand Function cuts the 450 line.

At this point, the aggregate demand expectations formed by the firms, which motivated their
decisions to supply Y* are consistent with the planned expenditure E* by consumers,
firms, government and the external economy.

Figure 16.4 augments Figure 12.8 by adding in the impact of Equation (16.2) that is, allowing
investment to be inversely impacted by interest rate changes.
Figure 16.4 Product market equilibrium and interest rate changes

The total expenditure curve, E = C + I + G + NX is drawn from a given interest rate. The lower
the interest rate (i0 < i1), the higher in investment (and total spending) at all income levels. As a
consequence, the total expenditure curve shifts upwards.

When interest rates rise, the total expenditure curve would shift downwards, other things equal.

Point A in Figure 16.4 shows the product market equilibrium associated with an interest rate of
i0. So we know that the combination of income level, Y*0 and interest rate level, i0 is an
equilibrium combination in the product market.

What happens if the interest rate was to rise to i1? Total investment would decline at all income
levels and the total expenditure curve would shift downward from E0 to E1.

The excess supply at the prior income level leads firms to cut back output and employment and
national income falls. A new product market equilibrium occurs when E*1 = Y*1.

So the combination of income level, Y*1 and interest rate level, i1 is an equilibrium combination
in the product market.

We thus have two combinations of interest rates and income levels which are consistent with
product market equilibrium. Clearly we could trace out the impact of many interest rate changes
and thus many equilibrium combinations of interest rates and income.
The IS curve is the line that joins all the equilibrium combinations of interest rates and national
income. Figure 16.5 shows this derivation.

GRAPH TO COME.

Conclusion

## PART 3 next week Policy Analysis and Critique

Saturday Quiz

The Saturday Quiz will be back again tomorrow. It will be of an appropriate order of difficulty
(-:

Mondays Blog

I am going to be in some very remote locations for the next three days (Kakadu National Park)
and I might not get to file a blog on Monday. We will see.

## This entry was posted in MMT Textbook. Bookmark the permalink.

US National Accounts economy plodding along due to fiscal drag
Saturday Quiz August 3, 2013

1. Dirk says:

## Here are some more comments.

The liquidity trap arises at some minimum interest rate (which could be zero) where
everybody forms the view that the only direction for interest rates is up. The equivalent
expectation is that everybody considers that capital losses will be incurred on bond
portfolios because when interest rates rise, bond prices fall.

I heard that many times, but still: a \$100 dollar bond with an interest rate of zero held to
maturity at rising interest rates incurs no capital loss. Depending on accounting rules a
temporary loss will show up but if you are not forced to make position than there is no
problem. Mentioning Ponzi finance in the IS/LM chapter is probably out of bounds, but I
think that this would be where Minsky comes in to support Keynes.

In a liquidity trap, a rise in the money supply leads to an equal rise in the demand for
money and as a result the interest rate does not change. We will consider this in more
detail later in the Chapter.

A rise in the money supply also leads to an equal rise in the demand for money when you
have a vertical supply curve (like in your previous post), but here the interesting thing to
note is that it is absorbed fully by the speculative motive.

E = C + I + G + NX

best,
Dirk

## IS-LM FRAMEWORK III

We thus have two combinations of interest rates and income levels which are consistent with
product market equilibrium. Clearly we could trace out the impact of many interest rate changes
and thus many equilibrium combinations of interest rates and income.

The IS curve is the line that joins all the equilibrium combinations of interest rates and national
income. Figure 16.5 shows this derivation.
Figure 16.5 The derivation of the IS curve

Point A is one product equilibrium where the interest rate is i0 and total expenditure is E0
generating total national income of Y0.

In the right-hand panel where the interest rate is on the vertical axis and national income is on the
horizontal axis, point A shows the combination of the interest rate and income which produce the
product market equilibrium shown in the left-hand pane.

If interest rates fell to i1, total expenditure rises to E1 as a result of the higher investment
expenditure, which leads to a rise in national income via the expenditure multiplier. Point B
shows the new product market equilibrium at (i1, Y1).

We could examine the impact of any number of interest rate changes on product market
equilibrium in the left panel and subsequently map these points into the right panel. The result
would be the IS curve.

## The IS curve therefore is a series of points corresponding to equilibrium combinations of

national income and interest rates in the product market.

It is clear that in the IS-LM framework, the money market impacts on the product market
through the impact of interest rate changes on investment. The change in income results from the
initial response of investment to an interest rate change then being multiplied through the
expenditure system via induced consumption and leakages to taxation and imports.

In other words, the total change in income that follows a change in the interest rate depends on
the values of the expenditure multiplier and the sensitivity of investment to interest rate changes.
What factors will shift the IS curve? First, any increase (decrease) in autonomous spending shifts
IS up (down) because for a given interest rate, the equilibrium level of national income rises
(falls) when autonomous spending rises (falls).

The magnitude of the shift up or down in the IS resulting from a rise (fall) in autonomous
spending is determined by the magnitude of the change in autonomous spending and the size of
the expenditure multiplier.

For a given change in autonomous spending, the shift in the IS curve will be larger the larger is
the value of the expenditure multiplier.

The slope of the IS curve represents this overall sensitivity of national income to interest rate
changes. The larger is the expenditure multiplier and the larger is the sensitivity of investment to
interest rate changes the flatter the IS curve.

This is because for a given change in interest rates, the initial response of investment spending
will be larger the more responsive it is to the cost of capital, other things being equal.

In turn, a given change in investment will generate a larger (smaller) change in national income
the larger (smaller) is the value of the expenditure multiplier.

If current period investment is very unresponsive to a change in the current interest rate then the
IS curve will be very steep. It is argued by economists who consider time to be an important
consideration in economic analysis that investment spending plans are based on expectations of
future revenue streams that were formed in past periods.

The current periods flow of investment spending reflects these past decisions. The time it takes
to evaluate different projects, design the appropriate necessary capital equipment, source funding
and then implement the capital infrastructure suggests that current investment spending will be
relatively insensitive to current changes in interest rates.

## We discuss this topic more in Chapter 22.

It should be clear from this discussion that changes in the tax rate (t), which impact on the value
of the expenditure multiplier will also impact on the slope of the IS curve. For example, a rise in
the tax rate will cause the IS curve to become steeper because it reduces the value of the
expenditure multiplier a larger leakage from the expenditure system.

Similarly, a rising saving propensity or propensity to import, which mean that there are larger
leakages from the expenditure system each time income changes, will lead to a steeper IS curve.

## 16.4 General Equilibrium in the IS-LM framework

The intention of the IS-LM framework is to bring the product market and money market
outcomes into a single diagram so that we can simultaneously determine the equilibrium value of
national income and the interest rate. In doing so, it recognises the interdependency between
these markets, a point that Keynes demonstrated clearly.

What happens in one market impacts on the other market, which then leads to feedback loops
and new equilibrium outcomes in each.

The IS-LM framework thus conceives of a general equilibrium defined as the interest rate and
income level that generates simultaneous equilibrium in the both the product and money markets.

In a graphical form, this equilibrium position corresponds to the intersection of the IS and LM
curves. In the Advanced Material Box we derive the algebra corresponding to this general
equilibrium.

Figure 16.6 shows the IS-LM solution for equilibrium income and interest rates, Y*, i*. Two
things are worth noting. The vertical green line at YFE, denotes a full employment national output
level. In other words, at this output level all available labour and capital are being productively
deployed.

The IS-LM joint equilibrium thus can occur at levels of income which are below full
employment in the labour market. This is consistent with Keynes insight that the capitalist
monetary system has a tendency to reach under-full employment steady states which need to be
shocked by policy interventions.

At Y* and i*, business firms are selling as much as they expected to sell and have no incentive to
expand production and employment. The desire for liquidity by firms and households are also
being full met by the available supply of money.

This under-full employment equilibrium can be reached at interest rates above the minimum rate,
where the economy enters a liquidity trap.
Figure 16.6 General IS-LM Equilibrium

## [THE FOLLOWING ADVANCED MATERIAL MAY BE IN A BOX WITHIN THE CHAPTER

TEXT OR PRESENTED AS A SEPARATE APPENDIX AT THE END OF THE CHAPTER]

## Advanced material: The IS-LM algebra

The formal IS-LM model for a simplified open economy begins with the following relationships.

Product Market
Product Market Equilibrium

The product market equilibrium can be solved as a relationship between GDP (Y) and the
interest rate (i) given the autonomous spending aggregates and the value of the multiplier.

## Substituting Equations (2) to (7) into (1) we get:

(10) Y = C0 + cY ctY + I0 bi + G + X mY

## Rearranging gives the equation for the IS curve:

(11) Y = (A bi)

where = 1/(1 c(1 t) + m), the expenditure multiplier and A is the autonomous spending
component, C0 + I0 + G + X.

The slope of the IS curve is given by b, so the larger the multiplier () and the sensitivity of
investment to interest rates (b), the flatter will be the slope because the response of national
income to a given interest rate will be larger.

## Money Market Equilibrium

The money market equilibrium is given by the equality of money supply and money demand.

(12) Ms = kY hi

## Which produces the LM curve where Y is a function of i:

(13) Y = (1/k)Ms + (h/k)i

The slope of the LM curve is given by (h/k), so the larger the sensitivity of the demand for
money to interest rates (h) and the smaller the sensitivity to income (k), the flatter will be the
slope because for a small change in interest rates, a much larger change in national income will
be required to maintain the equality between the demand for money and the given money supply.

## (14) i = (k/h)Y (1/h)Ms

General Equilibrium

A state of general equilibrium in this context is defined as the interest rate and income level that
generates simultaneous equilibrium in the both the product and money markets.

## This equilibrium position corresponds to the intersection of the IS and LM curves.

To solve for the equilibrium level of national income we can substitute Equation (14) into the IS
curve equation (11) to give:

## Solving for equilibrium Y gives:

(16)

Equation (16) indicates that equilibrium income is determined by autonomous spending (A),
which includes the fiscal policy parameter (G) and the money supply (Ms).

We use the solution in Equation (16) to solve for the equilibrium interest rate:

(17)

Equation (17) tells us that the equilibrium interest rate is determined by autonomous spending
(A) and the money supply (Ms).

Some economists use Equation (15) to define a fiscal policy multiplier, which indicates the
change in national income for a given change in government spending, if the money supply is
held constant.

The fiscal policy multiplier is given by the coefficient on autonomous spending A in Equation
(15). You will note that this is different to the expenditure multiplier, because it takes into
account the interest rate impacts of rising income on investment spending that emanate from the
shifts in the demand for money in the money market.

The simple expenditure multiplier is derived on the assumption that interest rates do not change
when national income rises.

Similarly, a monetary policy multiplier can be derived, which shows the increase in national
income for a given change in the money supply, if government spending and tax rates are held
constant.

This is given by the coefficient on Ms in Equation (15). Note though that this assumes that
monetary policy is conducted through the central bank exercising its assumed control over the
money supply. This is one of the flaws of the IS-LM framework when applied to the real world
the central bank does not have control over the money supply and the assumed money multiplier
does not exist in any form other than as an ex post, non-causal accounting statement.

## [TO BE CONTINUED IN PART 3]

Conclusion

PART 4 next week Complete Chapter POLICY ANALYSIS IN THE CONTEXT OF THE
CURRENT CRISIS (HOW THE IS-LM IS BEING USED BY SOME TO ANALYSE THE
CRISIS), PIGOU AND KEYNES EFFECTS AND CRITIQUE OF FRAMEWORK.

Saturday Quiz

The Saturday Quiz will be back again tomorrow. It will be of an appropriate order of difficulty
(-:

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Media coverage of unemployment and defictis during current election campaign
Saturday Quiz August 10, 2013
3 Responses to The IS-LM Framework Part 3

1. Dirk says:

## Friday, August 9, 2013 at 19:52

Hi,

I like the green full employment line. Another possibility would be to draw the LM curve
vertical, but then you would have to talk about crowding out, which is nonsense. Your
solution is superior.

We thus have two combinations of interest rates and income levels which are consistent
with product market equilibrium.

There are actually two equilibrium conditions which are fulfilled simultaneously: I=S and
income=expenditure. This might be confusing for students because some books use one
condition, some the other.

There is an alternative way to show the derivation of IS and LM curve which is a little bit
more informative, I think. You draw a 4 quadrant schedule, with the IS curve in the NE.
On the axis you have i (N), Y (E), I (W) and S (S). The investment function goes into the
NW, S=I into SW and the savings function into SE. For the LM diagramm, you keep i
(N) and Y (E) but then add Ls (W) and Lt (S). In the NW you draw the speculative
demand, in the SE the transaction demand for money. In the SW you draw a line so that

2. juanbeard says:

## Saturday, August 10, 2013 at 6:01

(11) Y = (A bi)

where = 1/(1 c(1 t) + m), the expenditure multiplier and A is the autonomous
spending component, C0 + I0 bi + G + X.

## Im not sure here. Is autonomous spending A=C0 + I0 bi + G + X ? or just A=C0 + I0 +

G + X and we substract bi out of it in eq 11? If not is substracted twice and makes no
much sense.

3. bill says:

## Dear juanbeard (at 2013/08/10 at 6:01)

You are correct it was a cut-and-paste error. Thanks for the scrutiny.

IS-LM FRAMEWORK IV
The IS-LM framework is used within the mainstream approach to analyse the impact of fiscal
and monetary policy changes on output (income) and interest rates, and by implication,
employment.

Monetary policy is represented by the assumed capacity of the central bank to alter the money
supply. Inherent in this appraoch is the view that central banks manipulate base money (reserves)
which are then transmitted into a broader money supply via the money multiplier mechanisms.

In Chapter 9, we demonstrated how this view of central bank operations is not a valid
representation of the real world and that, in fact, the central bank has little control over the
money supply and conducts monetary policy principally via its capacity to set the short-term
interest rate. However, for the purposes of this Chapter, to ensure we render the IS-LM approach
faithfully, we assume the money supply is exogenous and under the control of the central bank.

Monetary policy changes are thus represented in the IS-LM framework by shifts in the LM
curve.

Figure 16.2 showed that if the central bank increases the money supply, the interest rate falls at
the current national income level. This is because at the existing interest rate, there is an excess
supply of money and the interest rate has to fall to stimulate an increased demand for money.

The interest rate continues to fall until the demand for money is again equal to the increased
money supply and money market equilibrium is restored.

In terms of the LM curve, this means that at higher levels of money supply, equilibrium interest
rates will be lower at each income level which translates into a shift outwards in the LM curve.
The opposite occurs when the money supply falls.

The LM curve shifts to the right when the money supply rises and shifts to the left when the
money supply contracts.

Figure 16.7 shows the impacts of expansionary monetary policy. At some existing monetary
policy stance captured by LM1 the equilibrium combination of the interest rate and national
income is i*1, Y*1. Point A shows the equilibrium position where LM1 cuts the IS curve.

The central bank decides that the output gap (measured by the difference between the full
employment national income level, YFE and the current national income level, Y*1) is intolerable
(given the implied mass unemployment that would be associated with such a deficiency in
output) and they increase the money supply.
The LM curve shifts to LM2, which drives down interest rates (to stimulate a higher demand for
money). The new equilibrium is at Point B, with the equilibrium combination of the interest rate
and national income at i*2, Y*2.

The rising income results from the positive impact on investment of the lower interest rates
(represented by the movement along the IS curve from A to B). The more sensitive is investment
spending to interest rate changes the more expansionary the monetary policy change will be.

Note, that in this case, monetary policy would not be able to achieve full employment because
the economy would encounter a liquidity trap (at i0) before full employment was restored.

A contractionary monetary policy could be represented in Figure 16.7 by a shift in the LM curve
from LM2 to LM1. This would drive interest rates up and national income down.

The falling income results from the negative impact on investment of the higher interest rates
(represented by the movement along the IS curve from B to A). The more sensitive is investment
spending to interest rate changes the more contractinoary the monetary policy change will be.

## Figure 16.7 Expansionary Monetary Policy

Expansionary monetary policy drives the interest rate down and national income up.
Contractionary monetary policy drives the interest rate up and national income down.

The extent of the expansion or contraction depends on the slope of the IS curve. The steeper the
IS curve the less effective are monetary policy changes with respect to income changes.

## Fiscal policy changes could be implemented by discretionary changes in government spending or

the tax rate. We have learned that a rise in government spending shifts the IS curve to the right
because for a given interest rate, the equilibrium level of national income rises when autonomous
spending rises.

Similarly, a fall in government spending shifts the IS curve to the left because for a given interest
rate, the equilibrium level of national income falls when autonomous spending falls.

The magnitude of the shift up or down in the IS resulting from a rise (fall) in autonomous
spending is determined by the magnitude of the change in autonomous spending and the size of
the expenditure multiplier.

For a given change in autonomous spending, the shift in the IS curve will be larger, the larger is
the value of the expenditure multiplier.

The IS curve shifts to the right when government spending rises and shifts to the left when the
government spending falls.

Figure 16.8 depicts an expansionary fiscal policy change (increase in government spending). At
some existing fiscal policy stance captured by IS1 the equilibrium combination of the interest rate
and national income is i*1, Y*1. Point A shows the equilibrium position where IS1 cuts the LM
curve.

The treasury decides that the output gap (measured by the difference between the full
employment national income level, YFE and the current national income level, Y*1) is intolerable
(given the implied mass unemployment that would be associated with such a deficiency in
output) and they increase government spending in order to stimulate aggregate demand.

The IS curve shifts to IS2 which creates a new equilibrium at Point B, with the equilibrium
combination of the interest rate and national income at i*2, Y*2.

You will note that both the interest rate and national income are higher. The rising national
income arises because at higher levels of aggregate demand, firms produce more output (and hire
more workers).

How do we explain the higher interest rates? Within the IS-LM framework, the rising national
income that follows the increased aggregate demand, increases the transactions demand for
money. With the money supply fixed, the rising demand for money creates an excess demand for
money at the original equilibrium interest rate (i*1) and rising interest rates motivate people to
hold less cash. This is because the opportunity cost of holding wealth in the form of cash rises
when interest rates rise.

You will note that if the interest rates had not have increased, the expansion in income would
have been greater than the shift from Y*1 to Y*2.

## Figure 16.8 Expansionary Fiscal Policy

The final change in aggregate demand is thus less than the initial G. How do we explain this?

The rising interest rates impact negatively on private investment which offsets some of the
increase in government spending. In the policy debates this impact is referred to as financial
crowding out. The rising interest rates that follow the increase in government spending, crowd
out other interest sensitive components of aggregate demand (in this case, private investment).

Note that fiscal policy could achieve full employment (at Point C) if the government kept
increasing government spending such that the IS curve shifted to ISFE.

The extent of the financial crowding out depends on the slope of the LM curve. The steeper is the
LM curve the less expansionary will fiscal policy be and the larger is the crowding out effects.
This is demonstrated in Figure 16.9. From an initial equilibrium at Point A, a fiscal stimulus
(shifting IS curve to IS2) would increase national income to Y*2 and interest rate would rise to i*2
with the flatter LM curve (LM1) at the new equilibrium point, B1.

With a steeper LM curve (LM2), for the same fiscal stimulus (shifting IS curve to IS2), the new
equilibrium point, B2 clearly involves a lower equilibrium income outcome and a higher
equilibrium interest rate than occurred at Point B1.

The extent of the financial crowding out is higher with LM2 than LM1.

What explains this difference? The LM curve is steeper the more sensitive the demand for money
(transactions and precautionary motives) is to national income changes and the less sensitive the
speculative demand for money is to changes in interest rates.

Thus, small changes in national income lead to large changes in excess money demand at a given
money supply level and the rise in interest rates to restore money market equilibrium, other
things equal, has to be larger as a consequence. Additionally, for a given excess demand for
money, the interest rate increase that is required to restore money market equilibrium is larger.

A extreme position is complete financial crowding out and this would occur if the LM curve was
vertical. In this situation a given rise in government spending, for example, would be exactly
offset by a decline in investment as the interest rate rose.

## In that situation, fiscal policy would be totally ineffective.

We should note that financial crowding out is not confined to fiscal policy changes exclusively.
Any of the autonomous spending components, which can shift the IS curve and increase national
income, trigger the money market mechanisms that see interest rates rise and interest-sensitive
components of aggregate demand stifled.
Figure 16.9 Fiscal policy and financial crowding out

Note that the other extreme position would be a horizontal LM curve at some given interest rate.
In this case there would be no financial crowding out and the fiscal stimulus to aggregate
demand would be fully translated into changes in national income.

We will return to this extreme position when we discuss endogenous money theories later in the
Chapter.

An expansionary fiscal policy change increases national income and interest rates.

The rise in national income is less than the change in government spending because the higher
interest rates crowd out private investment.

The extent of the financial crowding out depends on the slope of the LM curve. The steeper is
the LM curve the less expansionary will fiscal policy be and the larger is the crowding out
effects.

There is complete crowding out when the LM curve is vertical and zero crowding out when the
LM curve is horizontal.

## 16.6 Introducing the price level

Our derivation of the IS-LM framework initially assumed that the price level was fixed and all
changes in output were real. This is consistent with the simple income-expenditure model
developed in Chapter 12 where the focus was on the manner in which output and employment
responds to changes in aggregate demand.

We assumed that firms were willing to supply whatever was demanded up to full capacity
without changing their prices.

In this vein, we also treated the nominal and real interest rate has being interchangeable.

In this section we consider how changes in the price level impact on output and interest rates.

## [TO BE CONTINUED IN PART 5]

Conclusion

PART 5 next week Introducing the Price Level to the Analysis PIGOU AND KEYNES
EFFECTS AND CRITIQUE OF FRAMEWORK.

Saturday Quiz

The Saturday Quiz will be back again tomorrow. It will be of an appropriate order of difficulty
(-:

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The opportunities for the unemployed in Australia are deteriorating
Saturday Quiz August 17, 2013

1. Steve says:

## Friday, August 16, 2013 at 14:52

The rising interest rates impact negatively on private investment which offsets some of
the increase in government spending.
Not if the government spending increased the returns from private investment more than
the increase in the interest rate. Eg new infrastructure spending etc..

2. Andrew says:

## Saturday, August 17, 2013 at 9:38

Steve,

All the gaping holes you or I could point out in the IS-LM framework Bill has pointed
out numerous times before. He is including it in his textbook because it is widely used in
the current debate and he believes it is important for students to understand it. I am sure
he will have a section with critique and analysis.

3. Dirk says:

## Monday, August 19, 2013 at 7:21

Hi,

In terms of the LM curve, this means that at higher levels of money supply, equilibrium
interest rates will be lower at each income level which translates into a shift outwards in
the LM curve. The opposite occurs when the money supply falls.

This could be described in more proper language which reflects that money supply is
being pushed around as a policy variable. The last sentence makes money supply a player
on its own, maybe better would be: The opposite occurs when the money supply is
decreased (by the central bank).

The central bank decides that the output gap (measured by the difference between the
full employment national income level, YFE and the current national income level, Y*1)
is intolerable (given the implied mass unemployment that would be associated with such
a deficiency in output) and they increase the money supply.

A deficiency in output does not have to be mass unemployment, it could start a stage
below with some unemployment. IS/LM is (normally) not shown to apply only in a
depression.

The IS curve shifts to the right when government spending rises and shifts to the left
when the government spending falls.

A little below you mentioned changes in the tax rate. These should be mentioned in the
above section again. Also, it might be interesting to add a quick discussion of policy
effectiveness (tax cuts vs fiscal stimulus maybe in an additional box?).
best,

IS-LM FRAMEWORK V

Our derivation of the IS-LM framework initially assumed that the price level was fixed and all
changes in output were real. This is consistent with the simple income-expenditure model
developed in Chapter 12 where the focus was on the manner in which output and employment
responds to changes in aggregate demand.

We assumed that firms were willing to supply whatever was demanded up to full capacity
without changing their prices. In this vein, we also treated the nominal and real interest rate has
being interchangeable.

In this section we consider how changes in the price level impact on output and interest rates.

The price level is introduced into the IS-LM framework as an exogenous variable, that is,
determined outside of the interest rate-income equilibrium defined by the intersection of the IS
and LM curves. There are several complications involved in adopting this assumption, which we
will abstract from for the sake of simplicity.

The income-expenditure model developed in Chapter 12, which underpins the derivation of the
IS curve was defined in real terms. Thus, the expenditure components consumption,
investment, government spending and net exports are all measured in constant prices.

We would expect the IS curve therefore to be invariant to changes in the general price level given
that housholds, firms, government and the external sector have made decisions regarding real
expenditures.

However, to date our analysis of the money market has fudged the question of the price level.
The demand for money is a demand for real balances, motivated by the need to make
transactions for the exchange of goods and services which we have just noted are defined in real
terms.

But, the money supply is specified in nominal terms an amount of dollars and forms the unit
in which all the other variables are accounted.

The real value of a given stock of money on issue, however, varies with the price level. For a
given stock of dollars on issue, the real value is higher when the price level is lower, and, vice
versa.

For example, assume that the money supply on issue is \$1000 billion and the price index is 1.
The real value of the money supply would be \$1,000 billion.
Now if the price level rose by 5 per cent the price index would be 1.05 and the real value of the
money supply would drop to \$952.4 billion.

This means that users of the currency have less available in real terms to use for purchases and
speculative holdings.

The same contraction in real value of the money supply could arise if the price level was
unchanged (that is, the index remained at 1) and the nominal money supply fell to \$952.4 billion.

In other words, the real value of the money supply can fall if the price level rises (for a given
nominal money stock) or if the nominal money stock falls (for a given price level).

Alternatively, the real value of the money supply can rise if the price level falls (for a given
nominal money stock) or if the nominal money stock rises (for a given price level).

Within the logic of the IS-LM framework, it is clear that if the price level rises and reduces the
real value of the money supply, the interest rate will rise because at the previous equilibrium
interest rate, there will now be a shortage of real balances relative to the demand for them.

The introduction of the general price level modifies our LM curve derivation. If a rising price
level (with a constant nominal money stock) is equivalent in real terms to a declining nominal
stock of money (at constant prices) then we can capture this impact via shifts in the LM curve.

The LM curve shifts to the left when the price level is higher, other things equal, and to the right
when the price level is lower.

Figure 16.10 depicts two different LM curves at different price levels (P1 > P0).

The introduction of the price level now means that our interest rate-income equilibrium is now
contingent on the price level. If there is a different price level, the equilibrium changes as noted.

This means that within this framework, the national economy equilibrium can shift without any
change in monetary or fiscal policy if the price level changes.
Figure 16.10 IS-LM Equilibrium and the General Price Level

This observation was central to the debates between Keynes and the classical economists during
the 1930s, which we examined in detail in Chapter 15.

Assume that the economy is currently at Point A, where the interest-rate is i1 and national income
is Y*. The general price level is P1.

Point B is the full employment output level so that the current equilibrium is what Keynes would
refer to as a underemployment equilibrium.
At Point A, the product and money markets are in equilibrium but there is an output gap and
there would be mass unemployment in the labour market.

Keynes considered this to be the general case for a monetary economy and depicted the neo-
classical model as a special case in which the equilibrium that emerged was also consistent with
full employment. For Keynes, a monetary economy could be in equilibrium at any level of
national income.
The neo-classical response to this was that unless we impose fixed wages on the model, the
persistent mass unemployment would eventually lead to falling nominal wages and prices.

While this might not lead to a fall in the real wage (if nominal wages and prices fall
proportionately), which would negate the traditional neo-classical route to full employment via
marginal productivity theory, the fact remains that the lower price level increases real balances in
the economy.

The reasoning that follows is that the reduction in prices leads to a decline in the transactions
demand for money at every level of income because goods and services are now cheaper.

With the nominal stock of money fixed, the expansion of real balances combined with a decline
in the demand for liquidity, results in a decline in the rate of interest.

As long as future expectations of returns are not affected adversely by the deflationary
environment, the reduction in the rate of interest, stimulates investment spending, which leads to
increased aggregate output and income via the multiplier effect.

As long as there is an output gap, deflation will continue and the interest rate will continue to fall
until the economy is at full employment.

The link between real balances and the interest rate was referred to as the Keynes effect.

In terms of Figure 16.10, the LM curve shifts outwards as the price level falls and the rising
investment is depicted as a movement along the IS curve. The new equilibrium is Point A.

## This observation then led to neo-classical economists to consider the possibility of an

underemployment equilibrium as a special case when wages and prices were fixed.

The view that Keynes underemployment equilibrium was a special case of the more general
flexible price model became known as the Neo-classical synthesis. This approached recognised
that aggregate demand drove income and employment (the so-called Keynesian contribution) but
that the economy would tend to full employment if wages and prices were flexible (the Classical
contribution).

There are several arguments against the view that a Keynes effect will be sufficient to generate
full employment.

Keynes General Theory, Chapter 19 which is devoted to the impacts of money wage changes
on aggregate demand.

Among other impacts, Keynes argued that lower money wages and prices will lead to a
redistribution of real income (FIND PAGE NUMBERS):
(a) from wage-earners to other factors entering into marginal prime cost whose remuneration has
not been reduced, and (b) from entrepreneurs to rentiers to whom a certain income fixed in terms
of money has been guaranteed.

He concluded that the impact of this redistribution on the propensity to consume for the
community as a whole would probably be more adverse than favourable.

## Moreover, falling money wages will have a (FIND PAGE NUMBERS):

depressing influence on entrepreneurs of their greater burden of debt may partly offset any
cheerful reactions from the reduction of wages. Indeed if the fall of wages and prices goes far,
the embarrassment of those entrepreneurs who are heavily indebted may soon reach the point of
insolvency, with severely adverse effects on investment.

Overall, Keynes concluded that there was no ground for the belief that a flexible wage policy is
capable of maintaining a state of continuous full employment.

The debt-deflation argument was also recognised by other economists such as Irving Fisher in
1933, Michal Kalecki in 1944 and Hyman Minsky in 1982).

Conclusion

## PART 6 next week CRITIQUE OF FRAMEWORK.

Saturday Quiz

The Saturday Quiz will be back again tomorrow. It will be of an appropriate order of difficulty
(-:

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A new breed of economics graduates is needed (did I say desperately)
Saturday Quiz August 24, 2013

1. Dirk says:

## Friday, August 23, 2013 at 22:40

Hi,

(a) from wage-earners to other factors entering into marginal prime cost whose
remuneration has not been reduced, and (b) from entrepreneurs to rentiers to whom a
certain income fixed in terms of money has been guaranteed.

This is page 262 in my copy, the other quote is from page 263.

Why not include the Pigou effect, too? It would only be one additional paragraph.

best,
Dirk

2. Phil says:

## Friday, August 23, 2013 at 22:51

Bill, I was hoping you might be able to help me with these questions:

1. You argue that government spending comes before taxation and borrowing, but how
can this be the case if the Treasury is not allowed to borrow directly from the Central
Bank? In this situation, for the Treasury to get a positive balance in its account at the CB
it has to tax or sell bonds to the non-government. So how can the government spend
first in this situation?

2. How does government deficit spending increase demand overall if government bonds
are sold to non-banks?

If the government deficit spends \$100 then this increases demand, but if it simultaneously
sells a \$100 bond, doesnt this reduce potential spending by the (non-bank) bond buyer
by the same amount?

If I buy a government bond, my net financial wealth doesnt change but the amount of
money I have to spend decreases by the amount of the bond. Doesnt the bond sale
remove as much money from the economy as the deficit spending adds, if the bond is
sold to a non-bank (thus reducing bank deposits)?

Many thanks,

Phil.

## Saturday, August 24, 2013 at 0:24

You argue that government spending comes before taxation and borrowing, but how can
this be the case if the Treasury is not allowed to borrow directly from the Central Bank?

Government tends to have an infinite intra-day overdraft at the central bank as do all
other central bank holders. They then clear that by the end of the day. The prohibition,
such that it is, is on having negative balances over night.

Think of it that the government spends at 11am, taxation is collected at midday and the
bond selling happens at 2pm with what is left.

Reality is a lot more dynamic than that, but this mental model is useful to understand how
it works.

If I buy a government bond, my net financial wealth doesnt change but the amount of
money I have to spend decreases by the amount of the bond.

But your assets do not change. And you wouldnt have swapped it for a bond if you
didnt intend to save.

Remember that spending causes taxation which reduces the need for bonds. Spending
essentially means that the government gets its money for free. So it is only excess
saving over investment that causes a need to issue bonds in the first place.

Essentially there is an amount of liquidity in the system that the central bank ensures is
sufficient for transactions to clear via the banking sector. So you can always get cash
when you need it. Thats the fundamental principle of a dynamic currency.

4. Phil says:

## Government tends to have an infinite intra-day overdraft at the central bank

Does this happen in the US? Do you have any evidence that the Treasury gets intra-day
overdrafts from the Fed?

5. Phil says:

## Saturday, August 24, 2013 at 0:55

But your assets do not change. And you wouldnt have swapped it for a bond if you
didnt intend to save.

Ok, but how does government spending increase demand overall if each increase in
government spending is matched by an equal decrease in private sector spending (i.e.
6. lxdr1f7 says:

## Saturday, August 24, 2013 at 0:55

1. You argue that government spending comes before taxation and borrowing, but how
can this be the case if the Treasury is not allowed to borrow directly from the Central
Bank? In this situation, for the Treasury to get a positive balance in its account at the CB
it has to tax or sell bonds to the non-government. So how can the government spend
first in this situation?

Government tends to have an infinite intra-day overdraft at the central bank as do all
other central bank holders. They then clear that by the end of the day. The prohibition,
such that it is, is on having negative balances over night.

## So because of an overdraft facility at the cb the government is able to spend before it

taxes? It doesnt seem as if most of the money comes into circulation that way.

It appears as if private bank lending which accounts for most of the money supply places
money into circulation for the gov to tax without government spending first. Bank lends
100 to someone, that money circulates and some of it becomes tax. After the bank lends it
can borrow reserves to fulfil its RR. Maybe the gov has to issue treasuries so the banks
can use in exchange for reserves but the government doesnt have to spend first.

7. Phil says:

## So you can always get cash when you need it.

Do you mean you can always sell a government bond if you want to? But then doesnt
someone else have to decide to save?

## Saturday, August 24, 2013 at 5:54

Do you mean you can always sell a government bond if you want to? But then doesnt
someone else have to decide to save?

The dealers in government bonds have to make a market. So you can guarantee that they
will want to save. And that guarantee is back-stopped by the central bank which has to
ensure there is sufficient liquidity for the transaction to complete and bonds are
swapped for cash where necessary to make sure that happens.

Its all smoke and mirrors in a fiat currency system with a load of money men creaming
off a living via all these pointless transactions.
9. Neil Wilson says:

## Saturday, August 24, 2013 at 6:11

Maybe the gov has to issue treasuries so the banks can use in exchange for reserves but
the government doesnt have to spend first.

## What do you buy the treasuries with?

If the bank has an overdraft with the central bank, it would need to extend that overdraft
to buy the treasuries in order to borrow reserves from the central bank.

You cant buy treasuries with bank money. It has to be central bank money.

The current system may be controlled by the commercial banks, but we havent yet got to
the point where the Treasury is giving gifts of Treasuries to commercial banks.

Ultimately you have to do a reserve add to match a reserve drain if you have an enforced
zero boundary.

## Saturday, August 24, 2013 at 9:18

that guarantee is back-stopped by the central bank which has to ensure there is sufficient
liquidity for the transaction to complete and bonds are swapped for cash where
necessary to make sure that happens.

The central bank has to supply enough reserves to maintain its target base interest rate,
but it doesnt have to intervene in the secondary treasury market in any way, does it? I
dont see why you say the central bank has to get involved.

Also dont treasury dealers buy treasuries to sell them on? They dont buy them to hold
them and save.

## Saturday, August 24, 2013 at 11:54

So isnt the equation better stated that private bank lending leads to taxation? The private
banks lend first create taxes and then later fulfil their reserve and treasury obligations.
The only reason treasuries are required is for exchanging into reserves. But for example
in Australia there is no reserve requirements so this doesnt apply at all.

## 12. Neil Wilson says:

Saturday, August 24, 2013 at 12:20

So isnt the equation better stated that private bank lending leads to taxation?

You cant pay taxation unless there is some central bank money in the system to pay it
with. And a government that is taxing but not spending has no need to issue bonds since it
has no deficit.

As I said ultimately you have to have a reserve add before you can do a reserve drain if
you have an enforced zero bound (ie no overnight central bank overdrafts allowed).
Whether there is a reserve requirement is irrelevant for the point.

To pay taxes a bank must transfer central bank reserves to the Treasury. So the bank has
to obtain reserves to clear the overdraft. And that means, transitively, some non-
government sector product must be transferred to the government sector in return for
those reserves, or the government sector has to gift a non-government entity those
reserves. Both of which are government spending.

## Saturday, August 24, 2013 at 12:29

The central bank has to supply enough reserves to maintain its target base interest rate,
but it doesnt have to intervene in the secondary treasury market in any way, does it?

A system short of reserves is generally supplied with reserves by the central bank repoing
treasuries. Thats intervening in the secondary market since it is reducing the overall free
supply of treasuries.

Also dont treasury dealers buy treasuries to sell them on? They dont buy them to hold
them and save.

They do, but not necessarily instantly. A market maker ensures that the market is liquid
by providing a liquidity buffer. That means they provide a saver of last resort function.
You can always sell to the market maker even if there isnt necessarily a matching buyer
at that point in time. And the spread between the bid and offer price compensates the
market makers for the risk of providing that saver of last resort function.

## Saturday, August 24, 2013 at 12:34

You cant pay taxation unless there is some central bank money in the system to pay it
with. And a government that is taxing but not spending has no need to issue bonds since it
has no deficit.
In the example of Australia when it was running surplusses and had little debt the gov
issued bonds just to underpin the operation of monetary system. In order to underpin the
payment system without reserve requirements only a small amount of treasuries is
needed.

## Saturday, August 24, 2013 at 22:30

A system short of reserves is generally supplied with reserves by the central bank
repoing treasuries. Thats intervening in the secondary market since it is reducing the
overall free supply of treasuries.

Ok but I dont see how the central banks decisions regarding the base interest rate have
anything to do with whats going on in the secondary treasury market per se.

You can always sell to the market maker even if there isnt necessarily a matching buyer
at that point in time.

But in the end someone other than a dealer has to buy the treasury, as the dealers
intention is in most cases not to hold on to the treasuries indefinitely. What happens if
everyone tries to sell their treasuries at the same time? Im guessing the prices collapse
and interest rates shoot up.

IS-LM FRAMEWORK VI

Figure 16.10 depicts a family of LM curves with each individual curve corresponding to a
different price levels (P0 is the highest price and P3 is the lowest price).

The introduction of the price level now means that the interest rate-income equilibrium is now
contingent on the price level. If there is a different price level, the equilibrium changes as noted.

This means that within this framework, the national income equilibrium can shift without any
change in monetary or fiscal policy settings if the price level changes.
Figure 16.10 The Keynes Effect

This observation was central to the debates between Keynes and the classical economists during
the 1930s, which we examined in detail in Chapter 15.

Assume that the economy is currently at Point A, where the interest-rate is i0 and national income
is Y0. The general price level is P0.

The full employment output level is at YFE, so that the current equilibrium corresponds to what
Keynes would refer to as a underemployment equilibrium.

At Point A, the product and money markets are in equilibrium but there is an output gap and
there would be mass unemployment in the labour market as a consequence.

Keynes considered this to be the general case for a monetary economy and depicted the neo-
classical model as a special case in which the equilibrium that emerged was also consistent with
full employment. For Keynes, a monetary economy could be in equilibrium at any level of
national income.

The neo-classical response to this was that unless we impose fixed wages on the model, the
persistent mass unemployment would eventually lead to falling nominal wages and prices.
While this might not lead to a fall in the real wage (if nominal wages and prices fall
proportionately), which would negate the traditional neo-classical route to full employment via
marginal productivity theory, the fact remains that the lower price level increases real balances in
the economy.

The reasoning that follows is that the reduction in prices leads to a decline in the transactions
demand for money at every level of income because goods and services are now cheaper.

With the nominal stock of money fixed, the expansion of real balances combined with a decline
in the demand for liquidity, results in a decline in the rate of interest.

As long as future expectations of returns are not affected adversely by the deflationary
environment, the reduction in the rate of interest, stimulates investment spending, which leads to
increased aggregate output and income via the multiplier effect.

As long as there is an output gap, deflation will continue and the interest rate will continue to fall
until the economy is at full employment.

The link between real balances and the interest rate was referred to as the Keynes effect.

In terms of Figure 16.10, the LM curve shifts outwards as the price level falls and the rising
investment is depicted as a movement along the IS curve.

For example, if the price level fell to P1, the LM curve would shift and a new IS-LM equilibrium
would result at Point B, with the interest rate at i1 and national income is Y1. Under the
circumstances depicted this is not a full employment level of national income.

## As a result of this observation, the neo-classical economists argued that an underemployment

equilibrium was a special case when wages and prices were fixed given that flexible prices could
reduce the output gap and unemployment via LM curve shifts.

The view that Keynes underemployment equilibrium was a special case of the more general
flexible price model became known as the Neo-classical synthesis. This approach recognised that
aggregate demand drove income and employment (the so-called Keynesian contribution) but that
the economy would tend to full employment if wages and prices were flexible (the Classical
contribution).

Note that the capacity of the Keynes effect to deliver output and employment gains is limited. If
there is a liquidity trap (iLT) then the maximum expansion in national income that is possible via
falling prices would be YL at Point C (where the IS curve intersects with the flat segment of the
LM curve.

At that point, there would still be unemployment and if wages and prices were flexible and
behaved according to the Classical labour market dynamics, the price level would continue to
fall, say to P3.
The LM curve would continue to shift out but there would be no further expansion in national
income beyond YL because the increase in real balances would not reduce the interest rate below
iLT.

The classical route to full employment thus would require the full employment level of national
income to lie at a point where the intersection of the IS-LM curves produced an equilibrium
interest that that was equal to or above iLT.

The Keynes effect is so-named because the expansion that follows a reduction in the price level
occurs through a rise in aggregate demand first, through the interest=rate stimulus to
investment, and, second, through the standard expenditure multiplier inducing higher
consumption expenditure.

However, as we learned in Chapter 15, Keynes did not support wage and price cuts as a way to
achieve full employment. He considered the social consequences of wage cuts to be unacceptable
and instead advocated increasing the nominal money supply as the way to increase real balances.

But the limits to expansion posed by the possible existence of a liquidity trap dissuaded Keynes
from considering the Keynes effect to being a plausible route to full employment.

There are several other arguments that militate against a reliance on the Keynes effect for
achieving full employment.

Keynes General Theory, Chapter 19 which is devoted to the impacts of money wage changes
on aggregate demand presented several such arguments.

Among other impacts, Keynes argued that lower money wages and prices will lead to a
redistribution of real income (FIND PAGE NUMBERS):

(a) from wage-earners to other factors entering into marginal prime cost whose remuneration has
not been reduced, and (b) from entrepreneurs to rentiers to whom a certain income fixed in terms
of money has been guaranteed.

He concluded that the impact of this redistribution on the propensity to consume for the
community as a whole would probably be more adverse than favourable.

## Moreover, falling money wages will have a (FIND PAGE NUMBERS):

depressing influence on entrepreneurs of their greater burden of debt may partly offset any
cheerful reactions from the reduction of wages. Indeed if the fall of wages and prices goes far,
the embarrassment of those entrepreneurs who are heavily indebted may soon reach the point of
insolvency, with severely adverse effects on investment.

Overall, Keynes concluded that there was no ground for the belief that a flexible wage policy is
capable of maintaining a state of continuous full employment.
The debt-deflation argument was also recognised by other economists such as Irving Fisher in
1933, Michal Kalecki in 1944 and Hyman Minsky in 1982).

The Classical view proposed an additional mechanism that could generate full employment as
long as wages and prices were flexible.

The so-called Pigou effect was named after Keynes principal antagonist at Cambridge
University, Arthur Pigou, whose work exemplified the Treasury View during the Great
Depression. The Pigou effect is also known as the Real Balance effect.

While the Keynes effect worked via interest rate responses to changing real money balances then
stimulating investment, the Pigou effect was based on the view that falling prices would
stimulate consumption expenditure.

It was argued that the real value of household wealth rose as prices fell and this reduced the need
to save. As a result the consumption function shifted upwards (higher levels of consumption at
each income level) and this would shift the IS curve outwards.

Figure 16.11 captures the Pigou effect. Note we abstract from any impacts on the LM curve of
the falling price level to highlight the shifting IS curve.

If we start from an initial underemployment equilibrium at i0 and Y0 with the price level at P0.
The argument is that wage and price levels would fall given the output gap (Y0 < YFE) and this
would increase real wealth balances and stimulate consumption, thus pushing the IS curve
outwards and leading to an expansion in national income.

Eventually, if prices were sufficiently downwardly flexible, the economy would achieve full
employment at i2 and YFE, with the lower price level, P2.

You will note that unlike the Keynes effect, whose effectiveness was limited by the possibility of
encountering a liquidity trap, the expansionary possibilities of the Pigou effect are unlimited.
Figure 16.11 The Pigou Effect

The introduction of the Pigou effect provided a theoretical device to combat Keynes argument
that when aggregate demand was deficient (relative to the full employment level), wage and
price flexibility would not guarantee full employment.

However, studies have rejected its practical importance. Wealth effects, where identified in the
empirical research literature, have been shown to be small and insufficient to resolve a major
recession.

## 16.7 Why we do not use the IS-LM framework

There have been many critiques of the IS-LM framework over the years. Many have
concentrated on whether the approach is a faithful representation of Keynes General Theory, as
was its initial purpose. Even its originator John Hicks accepted that it was not a valid depiction
of Keynes theories (see box).

Other critiques have concentrated on issues relation to its static nature and the fact that it can tell
us nothing about what happens when the economy is no in equilibrium.
A third focus of objection relates to its denial of the realities of central bank operations and the
way in which the commercial banks function.

## The endogeneity of the money supply

The supply side is the simpler of the two since the money supply is regarded as fixed by some
external agent (the policymaker) and independent of the rate of interest.

First, the IS-LM analysis relies on the assumption that the money supply is exogenous, that is,
controlled by the central bank and, thus, independent of the demand for funds.

The underlying theory supporting this assumption centres on the money multiplier, which we
examine in detail in Chapter 20. The assumption is that the central bank is in control of the so-
called monetary base (MB) (the sum of bank reserves and currency at issue) and the money
multiplier m transmits changes from the base into changes in the money supply (M).

By setting the size of the monetary base, it is thus asserted that the central bank controls the
money supply, as is depicted in the derivation of the LM curve.

As we will learn in Chapter 20, this conceptualisation of the monetary operations of the system
are not remotely applicable to the real world.

A senior official in the US Federal Reserve Bank of New York, A.D. Holmes identified what he
called operational problems in stabilising the money supply as far back as 1969:

The idea of a regular injection of reserves suffers from a naive assumption that the banking
system only expands loans after the System (or market factors) have put reserves in the banking
system. In the real world, banks extend credit, creating deposits in the process, and look for the
reserves later. The question then becomes one of whether and how the Federal Reserve will
accommodate the demand for reserves. In the very short run, the Federal Reserve has little or no
choice about accommodating that demand; over time, its influence can obviously be felt.

## [Reference: Holmes, A (1969) 'Operational Constraints on the Stabilization of Money Supply

Growth. In Controlling Monetary Aggregates', Federal Reserve Bank of Boston, 65-77]

The reality, which we will analyse in detail in Chapter 20, is that the central bank sets the so-
called official, policy or target interest rate. This is the rate at which they are prepared to provide
funds to the banking system on an overnight basis.

This rate then determines the interbank rate that banks apply a margin to, which determines the
cost of loans. The interbank rate is just the rate that banks lend to each other to ensure the
payments system is stable on a daily basis.
The cost of loans influences the demand for them from private borrowers. Banks then lend to
credit-worthy borrowers by creating deposits. The banks then seek the necessary reserves to
ensure the withdrawals from the deposits are honoured by the payments system.

While the banks can get the necessary reserves from alternative sources, the central bank
supplies reserves on demand to ensure there is financial stability and that they can maintain
control of their policy interest rate.

If there is a shortage of reserves, then the competition in the interbank market between the banks
for funds will drive up the short-term interest rate above the policy rate and the central bank
would lose control of its policy rate. In these cases, the central bank will always supply reserves
at the policy rate to maintain control over its policy settings.

Alternatively if there are excess reserves, the banks will try to loan them to other banks at
discounted rates and the short-term interest rate would drop to zero. Hence the central bank will
either drain the excess by selling interest-bearing government debt or it will pay a return on the
excess reserves that eliminates the interbank competition.

## These operations tell us that:

Bank loans create deposits that is, banks react to the demand for credit from borrowers
rather than on-lend deposits.

The demand for credit depends on the state of economic activity and the level of
confidence in the future.

Bank lending is not constrained by reserve holdings. The reserves are added on demand
by the central bank where needed.

Rather than driving the money supply, the monetary base responses to the expansion of
credit by the banks.

This process means the money supply is endogenously determined and the central bank
has no real capacity to maintain any quantity-targets.

The fact that the money supply is endogenously determined means that the LM will be horizontal
at the policy interest rate. All shifts in the interest rates are thus set by the central bank and funds
are supply on demand elastically at that rate. In this case, shifts in the IS curve would not impact
on interest rates.

From a policy perspective this means the simple notion that the central bank can solve
unemployment by increasing the money supply is flawed.

If the central bank tries to increase reserves in a discretionary manner this would only result in
excess reserve holdings and push the overnight interest rate to zero without actually increasing
the money supply. To avoid this the central bank would have pay the policy rate on those excess
reserves.

Unemployment is typically the result of a high liquidity preference people want to hold cash
rather than spend it given uncertainties about the future. In those cases the demand for loans
collapses and the banks become more cautious in who they will loan funds to for fear of losses.
Under these conditions, there is no way for the central bank to simply increase the supply of
money to raise aggregate demand.

In the global financial crisis, central banks have been adding massive volumes of reserves to the
banking system via the so-called quantitative easing programs, which we analyse in detail in
Chapter 20. The demand for funds was so subdued that credit expansion also slowed
dramatically and the banks were content to hold vast quantities of low-interest bearing reserves.

Conclusion

## PART 7 next week FINALISE CRITIQUE OF FRAMEWORK.

Saturday Quiz

The Saturday Quiz will be back again tomorrow. It will be of an appropriate order of difficulty
(-:

## This entry was posted in MMT Textbook. Bookmark the permalink.

There is a class warfare and the workers are not winning
Saturday Quiz August 31, 2013

## 2. Neil Wilson says:

Friday, August 30, 2013 at 19:00

The reality, which we will analyse in detail in Chapter 20, is that the central bank sets
the so-called official, policy or target interest rate. This is the rate at which they are
prepared to provide funds to the banking system on an overnight basis.

I know this is later, but it does need to cover the width and depth of the discount window
and the effect (if any) of the collateral market.

I know there are lots of criticisms of the MMT approach because it doesnt appear to
address the issue of bank collateral or restrictions in the discount window. (I think the UK
being forced to introduce a direct discount window in 2008 for the first time is an
interesting case study).

3. bill says:

## Dear Neil Wilson (at 2013/08/30 at 18:14)

You knew which one was the highest, nest-ce pas? But thanks for pointing out the error.
Fixed now.

best wiwshes
bill

## Sunday, September 1, 2013 at 0:30

Bill,

Do you think that it might be worth pointing out that the more sophisticated New
Keynesians now recognise the flat LM curve?

E.g. David Romer (note especially the footnote where he says that no textbooks have
picked this up!)

http://elsa.berkeley.edu/~dromer/papers/JEP_Spring00.pdf

## Of course, the dinosaurs are still clueless in this regard:

http://fixingtheeconomists.wordpress.com/2013/08/24/tending-to-his-own-garden-has-
krugman-finally-turned-on-the-islm/

Best,
Phil

## Sunday, September 1, 2013 at 17:09

Do you think that it might be worth pointing out that the more sophisticated New
Keynesians now recognise the flat LM curve?

Not sophisticated enough to realise that the microfoundations quest is a fools errand
though.

The obsession with the so-called Lucas Critique reminds of the push for formal methods
in software development where everything had to be decomposed to mathematical logic
to prevent errors.

It sounded fabulous until you realised that there were perhaps two people in the entire
world who could do that and even then they made errors. So it didnt eliminate bugs any
better than the more ugly techniques but of course it would have excluded a lot of
people from the process of software development if the industry had made it a
requirement before letting them practice.

Now were smarter and realise that the limitation is the human capacity of the systems
architect and associated developers. We come up with something that might work, try it,
and then back it out if it causes unexpected dynamic effects. Fail early, fail often.

There should be a realisation from theoretical economists that they will not discover the
correct disaggregation and aggregation formulas because the structure they are looking at
is a dynamic self-feedback loop where any change alters the system fundamentally.
Nobody alive understands the deep truths and never will sufficiently without error
within the lifetime of the universe.

As Ive said before the approach of neo-classical economic theory always reminds me of
psychohistory in the Asimov Foundation series.

## IS-LM FRAMEWORK VII

Expectations and Time

Consider the role of the investment function in the derivation of the IS curve. Investment is said
to be dependent on the interest rate (cost of funds) and, perhaps, output (via the accelerator
affect).

While the IS-LM approach of John Hicks tried to represent, what he saw as the key elements of
Keynes General Theory, it clearly left out issues relating to uncertainty and probability that
Keynes saw as being crucial in the way long-term expectations were formed. Chapter 12 of the
General Theory was devoted to this topic.

## In the General Theory (1936: 149-50), Keynes wrote:

The outstanding fact is the extreme precariousness of the basis of knowledge on which our
estimates of prospective yield have to be made. Our knowledge of the factors which will govern
the yield of an investment some years hence is usually very slight and often negligible. If we
speak frankly, we have to admit that our basis of knowledge for estimating the yield ten years
hence of a railway, a copper mine, a textile factory, the goodwill of a patent medicine, an Atlantic
liner, a building in the City of London amounts to little and sometimes to nothing; or even five
years hence.

Thus the decision to invest is dependent on the state of long-term expectation, which is ignored
in the static IS-LM approach.

Investment, among other key economic decisions, is a forward-looking process, where firms
form guesses about what the state of aggregate demand will be in the years to come.

It is necessarily such because the process of creating new capital stock is lengthy and involves a
number of separate decisions type of product to produce, nature of capital required to produce
it, design, access supply and ordering, and quantum are all separated in time.

The investment spending today is the result of decisions taken in some past periods about what
the state of the world will be today and into the future. Investment spending is not a tap that is
turned on or off when current interest rates change.

The psychological factors that are crucial for comprehending the decision to consume (marginal
propensity to consume); the decision to invest (Marginal efficiency of capital); and the
determination of the labour market bargain (implicit in the IS-LM approach) are abstracted from
in the derivation of the equilibrium what are essentially dynamic process with complex
feedback loops are frozen in time by the need to derivate static IS and LM curves.

The failure to include the crucial role of expectations and historical time means that IS-LM
framework is reduced to presenting a general equilibrium static solution that has little place in a
dynamic system where uncertainty is a key driver in economic decision-making.

The last word in this Chapter will go to the original architect of the IS-LM approach, John Hicks,
who reflected on his creation and the way it had been subsequently used in a 1981 article in the
Journal of Post Keynesian Economics:
I accordingly conclude that the only way in which IS-LM analysis usefully survivesas
anything more than a classroom gadget, to be superseded, later on, by something betteris in
application to a particular kind of causal analysis, where the use of equilibrium methods, even a
drastic use of equilibrium methods, is not inappropriate. I have deliberately interpreted the
equilibrium concept, to be used in such analysis, in a very stringent manner (some would say a
pedantic manner) not because I want to tell the applied economist, who uses such methods, that
he is in fact committing himself to anything which must appear to him to be so ridiculous, but
because I want to ask him to try to assure himself that the divergences between reality and the
theoretical model, which he is using to explain it, are no more than divergences which he is
entitled to overlook. I am quite prepared to believe that there are cases where he is entitled to
overlook them. But the issue is one which needs to be faced in each case.

When one turns to questions of policy, looking toward the future instead of the past, the use of
equilibrium methods is still more suspect. For one cannot prescribe policy without considering at
least the possibility that policy may be changed. There can be no change of policy if everything
is to go on as expectedif the economy is to remain in what (however approximately) may be
regarded as its existing equilibrium. It may be hoped that, after the change in policy, the
economy will somehow, at some time in the future, settle into what may be regarded, in the same
sense, as a new equilibrium; but there must necessarily be a stage before that equilibrium is
reached. There must always be a problem of traverse. For the study of a traverse, one has to have
recourse to sequential methods of one kind or another.

## [Reference: Hicks, J. (1981) 'IS-LM: An Explanation', Journal of Post Keynesian Economics,

3(2)(Winter, 1980-1981), 139-154]