A Simple Overview of Keynesian, Monetarist and
New Classical and New Keynesian Approaches to
Analysis of short run fluctuations
IS 2
LM 3
LM 2
LM 1
IS 1
M o d els I, II, IIIA IIIB
Interest
rate, i
Macroeconomic Themes: 2
1
Summary of Four Macro Models in the above Figure
G overnm ent expenditure rises IS 1 shifts to IS 2. Im pact on
output according to four different m acroeconom ic m odels.
M odel I is sim ple K ey nesian m odel for the real sector.
G ood m arket equilibrium is given by the dow nw ard sloping
IS curve because low er interest rate stim ulates the
aggregate dem and.
M odel II includes m oney m arket. It is given by upw ard
sloping L M function w hich show s m oney m arket
equilibrium w ith the rising level of dem and for m oney as
incom e rises. T his includes interest rate feedback.
M odels I and II are K ey nesian and new K ey nesian m odels.
M odel IIIA includes a price feedback. W hen A D rises price
also rises. It reduces real balances and there is less dem and
for output. T his is the m onetarist proposition in the short
run.
M odel IIIB m onetarist proposition in the long run and N ew
C lassical m odel w ith rational expectation.
Macroeconomic Themes: 2
2
IS-LM and Aggregate Demand and Aggregate Supply
Analysis
IS 2
LM 3
LM 2
LM 1
IS 1
M o d els I, II, IIIA IIIB
Interest
rate, i
Y0
y1
y2
y3
LAS
SAS
P rice level
Macroeconomic Themes: 2
Y0
y1
y2
3
Specification of the IS-LM
Model
C onsum ption:
D isposable incom e:
Investm ent:
C  a  bY d
Y d  Y T
(1)
(2)
(3)
I r   I  q  r
0
D em and for real balances: M  kY    r (4)
P
N ational incom e identity: Y  C  I  G
(5)
Macroeconomic Themes: 2
4
Equilibrium in Model I: Keynesian Multiplier
P ut equation (2) into (1), then use the resulting equation for C
and the investm ent (3) into (5) and solve for Y (M odel I).
a  bT  I  qr  G
0
Y
(6)
1 b
T his is goods m arket equilibrium or the IS curve according to
H icks (1933).
It is a dow nw ard sloping line:
 Y   q  0 ; and
r
1 b
 1  b Y  a  bT  I  G

0
r 
q
In term s of saving investm ent identity : Y  C  G  I  r  ; w hen
incom e rises saving is greater than investm ent, the interest rate
should fall to accom m odate an increase in investm ent.
Macroeconomic Themes: 2
5
Crowding out of Investment:
Equilibrium with Interest Rate Feedback
T he m oney m arket equilibrium , L M curve, is
provided by equation (5) and exogenously fixed
real m oney supply
M  kY    r
P
or

r  1  kY  M
 
P





(7)
r k
L M is an upw ard sloping line  y    0
Macroeconomic Themes: 2
6
Equilibrium with Price Feedback:
Model III: Aggregate Demand





1
a  bT  I  q   kY  M

0
P

Y
1 b




 
G
,
S olve for Y as
a  bT  I  q M  G
0
P
Y
1  b  q k
(8)
Macroeconomic Themes: 2
7
Response of Output to the Fiscal and Monetary
Policy
Y  
b
0;
q
T
1 b  k

 Y  q   0 and
 M 1 b  q k

Y 
1
0
q
 G 1 b  k

Macroeconomic Themes: 2
8
Parametric Specifications for Model I, II and III
a
150
b
0 .8
T
50
G
60
I0
50
q
10
M
150
P
1
k
0 .8
n
3000
r-fo r
m o d e l1
P ric e
change
0 .0 5
Macroeconomic Themes: 2
2
9
Macroeconomic equilibrium without and with
interest and price feedback
Y
G-Multipler
Consumption
Tax
G-Spending
Investment
Saving
Interest rate
Price level
Model 1
1097.5
5
988
50
60
49.5
59.5
0.05
1
Model 2
1087.993
4.934211
980.3947
50
60
47.59868
57.59868
0.240132
1
Macroeconomic Themes: 2
Model 3 Model 4
1086.349
1085
4.934211 4.934211
979.0789
978
50
50
60
60
47.26974 47.2654
57.26974
57
0.273026 0.27346
3
3.25
10
Simple Model of Aggregate supply
Y  L
L abo u r d em an d co n sisten t w ith m ax im isatio n o f p ro fit:
1
L  1 W  1
 P










S in ce lab ou r d em and is eq u al to th e labou r su p ply in
eq u ilib riu m
A gg reg ate su pp ly :

Y  1 W  1 ;  Y  0
 P
P










th e ag g reg ate su pp ly
is u p w ard slop in g .
Macroeconomic Themes: 2
11
Parametric Specification for the
Labour Market
a
b
c
d
phi
Note
5487.50
0.50
3841.25
0.50
0.75
5439.97
0.50
3841.25
0.50
0.75
a=y*5
5431.74
0.50
3841.25
0.50
0.75
5425.00
0.50
3841.25
0.50
0.75
b=y*3.5
Macroeconomic Themes: 2
12
A Numerical Illustration of the Determination
of Employment and the real wage rates in
above models
a
b
c
d
phi
Output
Employment
Real wage
Price level
Nominal wage
Labour Market
5487.50
0.50
0.00
0.50
5487.50 5439.97 5431.74 5425.00
0.50
0.50
0.50
0.50
3841.25 3841.25 3841.25 3841.25
0.50
0.50
0.50
0.50
0.75
0.75
0.75
0.75
Model 1 Model 2 Model 3 Model 4
1097.50 1087.99 1086.35 1085.00
11320.68 11190.13 11167.58 11149.10
1646.25 1598.72 1590.49 1583.75
1.00
1.00
1.00
1.00
1646.25 1598.72 1590.49 1583.75
Macroeconomic Themes: 2
13
Can you suggest other forms of
Supply Curves?
R eferen ces:
1.
2.
3.
H icks, J. R .(1937): M r. K eynes and the "C lassics"; A S uggested Interpretation,
E con
1937.
M ankiw N .G . (1989) R eal B usiness cycle: A N ew K eynesian P erspective, Journal of E con
P erspectives, vol. 3, no. 3 pp. 79-90.
L ucas, R obert Jr. and Sargent, A fter K eynesian M acroeconom ics, Spring 1979, Federal
R eserve B ank of M o nneapolis Q uarterly R eview .
Macroeconomic Themes: 2
14