KeynesianAll - 1 Old Keynesian analysis Here we will...

Info icon This preview shows pages 1–3. Sign up to view the full content.

View Full Document Right Arrow Icon
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
Image of page 1

Info icon This preview has intentionally blurred sections. Sign up to view the full version.

View Full Document Right Arrow Icon
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 and supply for the “real balance” M/P , where M is the amount of money and P is the price level.
Image of page 2
Image of page 3
This is the end of the preview. Sign up to access the rest of the document.

{[ snackBarMessage ]}

What students are saying

  • Left Quote Icon

    As a current student on this bumpy collegiate pathway, I stumbled upon Course Hero, where I can find study resources for nearly all my courses, get online help from tutors 24/7, and even share my old projects, papers, and lecture notes with other students.

    Student Picture

    Kiran Temple University Fox School of Business ‘17, Course Hero Intern

  • Left Quote Icon

    I cannot even describe how much Course Hero helped me this summer. It’s truly become something I can always rely on and help me. In the end, I was not only able to survive summer classes, but I was able to thrive thanks to Course Hero.

    Student Picture

    Dana University of Pennsylvania ‘17, Course Hero Intern

  • Left Quote Icon

    The ability to access any university’s resources through Course Hero proved invaluable in my case. I was behind on Tulane coursework and actually used UCLA’s materials to help me move forward and get everything together on time.

    Student Picture

    Jill Tulane University ‘16, Course Hero Intern