ISLM Analysis Part I: The Real Sector The Keynesian Framework According to John Hicks and Alvin Hansen Roger W. Garrison 2010

(1 – b) Y I I SS Macroeconomic equilibrium for a wholly private economy requires that saving equal investment. That is, “S = I” is an equilibrium condition. According to Keynes, saving depends upon income and income alone. In particular, S = – a + (1 – b)Y, where a > 0 and 0 < b < 1. In Keynes’s vision, investment depends primarily on “animal spirts.” But investment also depends, if only to a minor extent, on the rate of interest. The demand for investment funds in highly interest inelastic. i With “animal spirits” in play, the whole curve moves around on its own. -a 1 1 1

How much borrowing and investment would the business community be willing to undertake? How much income would people have to earn to be willing to save this amount? Y Y i I I SS i So far, we have one equilibrium condition (in orange) and two behavioral relationships (in blue). Together, these three relationships imply a particular relationship between the interest rate and the economy’s total income. This relationship is revealed by tracing out the implications of a low interest rate, a high interest rate, and a middling interest rate. Suppose the interest rate is relatively low. i LOW How much saving is required to finance this level of investment? How much So, now we have one possible combination of the interest rate and total income.

How much income would people have to earn to be willing to save this amount? Y Y i I I SS i So far, we have one equilibrium condition (in orange) and two behavioral relationships (in blue). Together, these three relationships imply a particular relationship between the interest rate and the economy’s total income. This relationship is revealed by tracing out the implications of a low interest rate, a high interest rate, and a middling interest rate. Suppose the interest rate is relatively high. i LOW How much borrowing and investment would the business community be willing to undertake? How much saving is required to finance this level of investment? How much Now we have another possible combination of the interest rate and total income. i HIGH

This relationship is revealed by tracing out the implications of a low interest rate, a high interest rate, and a middling interest rate. How much borrowing and investment would the business community be willing to undertake? How much saving is required to finance this level of investment? How much income would people have to earn to be willing to save this amount? Accordingly, we call this line the IS curve. (All along this curve, I = S.) A line passing through these three points (two would have been enough) represents all combinations of the interest rate and total income that are consistent with the equality of investment and saving, given the relationships that describe investment behavior and saving behavior. Y Y i I I SS IS i So far, we have one equilibrium condition (in orange) and two behavioral relationships (in blue). Together, these three relationships imply a particular relationship between the interest rate and the economy’s total income. Suppose the interest rate is a middling rate. i LOW How much Now we have a third possible combination of the interest rate and total income. i HIGH i MID

Y Y i I I SS IS i WARNING: “Equilibrium” in income-expenditure analysis means only that income gets spent---or, equivalently (for a wholly private economy), saving gets invested. It does not mean that the work force is fully employed or that the economy’s potential output is being realized. Keynes believed that some “unemployment equilibrium” was the norm for a wholly private economy. If the middling rate of interest just happens to be the equilibrium rate, the level of total income that corresponds to that rate is the equilibrium level of income. i LOW i HIGH i MID Equilibrium levels of saving and investment are similarly identified. i eq Y eq I eq S eq

Marshall would observe that the wage rate has adjusted to the prevailing supply-and-demand for labor. Keynes would observe that, give the supply of labor and the going wage rate, the current level of expenditures just happens to be high enough to cause the resulting demand for labor to clear the labor market. Wholly dismissive of the classical economists’ theorizing about the distribution of income among the factors of production, Keynes assumed a “fixed structure of industry” whose level of utilization varies directly with the employment of labor. And with the wage rate given, changes in total income are directly proportional to changes in the employment of labor. But Keynes’s supply- and-demand reckoning of the labor market differs importantly from Alfred Marshall’s. Keynes assumed that movements in total income faithfully reflect the movements in the level of employment. i eq Y Y i I I SS IS i If the income-expenditure equilibrium just happens to be consistent with full employment, then the labor force will be experiencing a supply- and-demand equilibrium. Y eq I eq S eq N W S D LABOR INCOME

(1 – b) ΔIΔI And note that with an unchanged rate of interest, the equilibrium level of income also changes in accordance with the simple Keynesian multiplier. Note that the interest rate, If only by assumption, remains unchanged. With the change in investment behavior, the IS curve shifts to the left. The economy experiences a downturn in which lower levels of income, investment, and saving are established. The magnitude of the shift in the IS curve is a multiple of the magnitude of the shift in the demand for investment funds. Here, the simple Keynesian multiplier is in play. 1 (1 – b) ΔY =ΔY = ΔIΔI ΔYΔY i eq Y Y I I SS IS i According to Keynes, the demand for investment funds is subject to a sudden, unpredictable collapse. The collapse (the leftward shift in the demand curve) upsets both the labor market’s supply-and-demand equilibrium and the macroeconomy’s income- expenditure equilibrium. Y eq I eq S eq i S' eq Y' eq I ' eq ΔIΔI N W S D Finally, we note that the decrease in income reflects a corresponding decrease in the demand for labor. And with the going wage rate persisting, the labor market is experiencing a persistent (Marshallian) disequilibrium. Keynes would call it “unemployment equilibrium.” 1

The greater volume of saving would be borrowed by the business community only if the rate of interest were lower. If the old equilibrium rate of interest still prevails, then the economy’s reaction to increased saving is a fall income. −1 (1 – b) ΔT hrift ΔY =ΔY = ΔYΔY i eq Y Y I I SS IS i According to Keynes, people’s saving behavior is unlikely to change. And fortunately so. In the Keynesian framework, increased saving has bad consequences. A decision to save more is represented by an upward shift in the saving function. Y eq I eq S eq i Y' eq ΔT hrift N W S D And whatever the eventual consequences of the increased saving, the old IS curve is no longer valid. The new one lies to its left. If we call an upward shift of the saving relationship a change in thrift, then the corresponding shift in the IS curve is given by the thrift multiplier---which is simply the negative of the spending multiplier. (Thrift means not spending.) Finally, we note that the decrease in income reflects a corresponding decrease in the demand for labor. As happened in the case of a fall in investment demand, an increase in thrift reduces spending and causes the labor market to experience a persistent (Marshallian) disequilibrium.

The greater volume of saving is willingly borrowed by the business community because the rate of interest is sufficiently lower. Equilibrium in the loanable funds market is re-established. Notice, though, that with the new lower equilibrium rate of interest, the initial level of income is consistent with an income-expenditure equilibrium. A functional loanable-funds market keeps the economy from spiraling downward in response to an increase in saving. Finally, we note that an increase in saving and the consequent increase in investment will redirect production plans away from producing consumer goods and toward producing investment goods. But the total demand for labor need not change. (However, the economy’s growth rate will increase.) But with a shift in the saving function and a movement along the demand for loanable funds, the old IS curve is no longer valid. The new one lies to its left. ΔT hrift ΔIΔI i eq Y Y I I SS IS i According to classical thinking, people’s saving behavior is subject to change. And not surprisingly, those changes impinge, in the first instance, on the market for loanable funds---which entails both the demand for loanable funds and the supply of loanable funds. Y eq I eq S eq i A decision to save more is represented in two different ways---by an upward shift in the saving function and, at the same time, by a rightward shift in the supply of loanable funds. Consistent with pre-Keynesian thinking, saving and investment are brought into balance by a market-driven change in the rate of interest. And, of course, given this critical function of the interest rate, it is essential that the interest rate be allowed to seek its market equilibrium. N W S D We’re now depicting the classical view in the Keynesian framework.

ISLM Analysis Part I: The Real Sector The Keynesian Framework According to John Hicks and Alvin Hansen Roger W. Garrison 2010