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Unformatted text preview: 1 Old Keynesian analysis Here, we will quickly look at so-called old Keynesian analysis of macroeconomy. This was a mainstream model of macroeconomics starting 1930s until 1960s. As was explained in Chapter 1, one fundamental problem of this approach is that it models the relationships of aggregate variables (such as GDP and consumption) directly and it is not based on individuals decisions. As a result, it cannot incorporate the factors such as individuals change in expectations. The old Keynesian analysis consists of two components: (i) IS-LM analysis and (ii) AS- AD analysis. We will study them in turn. As we will see, IS-LM analysis can be considered as a part of AS-AD model. 1.1 IS-LM model The IS-LM model describes the macroeconomy by two equations. Each of them represents a relationship between the real interest rate ( r ) and GDP ( Y ). 1.1.1 IS curve The IS curve represents the demand for output. As we learned in Chapter 2, the output is demanded as either as consumption ( C ), investment ( I ), government spending ( G ), or net export ( NX ). Thus, the following has to hold: Y = C + I + G + NX. (1) We also learned that the output is equal to income. Income has to be consumed ( C ) or saved ( S ). Therefore, Y = C + S (2) holds. Combining (1) and (2), and canceling out C , we obtain S = I + G + NX. We take G and NX as given from outside, and consider them as constant numbers. We assume that people save more when they have more income. We represent this relationship by denoting the saving as an increasing function of Y : S ( Y ). We also assume that firms invest less when the real interest rate is higher. This can be understood by the fact that often firms have to borrow money to make an investment. When they make a decision for investment, they compare the real interest rate (cost) and the profitability of the investment (benefit). When the real interest 1 rate is very high, only investments with very high profitability are made. Thus, the investment is a decreasing function of r : I ( r ). Now we have the IS curve: S ( Y ) = I ( r ) + G + NX. (3) Since G and NX are constants, the IS curve represents a relationship between r and Y . The name IS curve comes from the fact that it represents the relationship between investment ( I ) and saving ( S ). In the graph (see Figure 1), it is a downward-sloping curve. 1.1.2 LM curve The LM curve represents the equilibrium in the market for money. It is reasonable to think that people demand money after adjusting for the price level: that is, if the price level is 100 times larger, the money demand is 100 times larger. Thus, we will consider the demand andtimes larger, the money demand is 100 times larger....
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- Spring '10