FIN 30220: Macroeconomic
Analysis
The Short Term and Keynesian Economics
Classical economics and the “Long Run”
•
•
•
•
Optimal behavior by individuals
Competitive Markets
All prices are fully flexible
All markets are in equilibrium
w
p
LS
S Y 
r
r
Ms
P
r*
D
L
L
I
LS  LD
Y  C  I G
SI
Y  F  A, K , L 
Y
Capital markets
determine
expenditures
Y
L
L
Labor markets determine
total production/income
M D Y 
I
MD  MS
M
P
Money markets
determine prices
MV  PY
In a “classical world”, monetary
policy is very simple…
Or, in percentages
   %M  %Y   %V
i  r  e
%M  %V  %P  %Y
Inflation
r
S
I
The Fed takes the “real
economy” as a given and
chooses money supply to set
the inflation rate
Determined in capital
markets
Y  C  I G
SI
I
In a classical world, the Federal Reserve chairman would not be a very newsworthy
job…however try to do a Google news search.
Chairman of the Federal
Reserve from 1987 to 2006
17,800 Results
Chairman of the Federal
Reserve from 2006 to 2014
57,000 Results
Current Chairman of the
Federal Reserve
1,150,000 Results
They must be a little more important that the classical world would suggest!
% Deviation from Trend
Real Interest Rate vs. M2
Correlation = -.20
It seems that increasing the money supply lowers the interest rate
% Deviation from Trend
M2 Money Supply vs. GDP
Correlation = .25
It seems that increasing the money supply has a positive effect on GDP
Keynesian economics and the “Short Run”
•
•
•
Optimal behavior by (most) individuals
The price level is fixed
Not all markets in equilibrium
Y
Y
r
Ms
P
S Y 
r
L
r*
MD  MS
I
MD M
P
Money Markets
determine the
interest rate (price
level is fixed)
S, I
w
p
LS
C  I G Y
Capital markets
determine output
(employment) via
expenditures
LD
L
Labor markets
determine real
wages
Why are prices fixed in the short run?
For other companies
there are strategic
reasons for not
changing prices
continuously
For some
companies, it is
costly to
continually
change prices
Product Group
Average time between price
changes (months)
Cement
13.2
Steel
13.0
Chemicals
12.8
Glass
10.2
Paper
8.7
Rubber Tires
8.1
Petroleum
5.9
Truck Motors
5.4
Plywood
4.7
Non-Ferrous Metals
4.3
Household Appliances
3.6
*Source: Dennis W. Carlton, “The Rigidity of Prices, American Economic
1986, pp. 637-658
Review, September
Imagine that we have an initial equilibrium.
MS
P
r
S Y 
r
r*
M M
D
S
M
P
I
SI
C  I Y
S, I
Now, suppose that the Fed increases the money supply. In a
classical world, the price level would increase. However, if prices
are fixed…
If the interest rate falls to bring the money market into equilibrium, the
capital market is out of equilibrium.
r
MS
P
S Y 
r
r*
M M
D
S
M
P
I
S, I
S
<
I
C  I Y
In a Keynesian world, the economy is demand determined. That is, the
economy supplies whatever is demanded. In this case higher demand raises
production
Higher production has two effects
• Higher production (which means higher income) raises savings
• Higher production (which means higher income) raises money demand
r
MS
P
S Y 
r
r*
S Y 
M d Y 
M M
D
S
M
P
I
S =I
S, I
C I Y
In a Keynesian world, the economy is demand determined. That is, the
economy supplies whatever is demanded. In this case higher demand raises
production
Note that the current level of output is higher than it would be at the initial
equilibrium (i.e. the labor market is out of equilibrium).
r
MS
P
r*
S Y 
r
S Y 
MD  MS
Ls
w
p
M d Y 
M
P
w
p
I
S =I
C I Y
Ld
S, I
L
L
L
Y   Y 
This would be an economy that is
overemployed
Again, imagine that we have an initial equilibrium.
r
MS
P
S Y 
r
r*
I
M
P
MD  MS
S, I
C  I Y
Now, suppose that we get a random decline in investment
(Keynes call this “animal spirits”)
The interest rate needs to decline to bring demand back in line with supply
Price level falls
r
MS
P
S Y 
r
r*
M M
D
S
M
P
I
SI
S, I
C  I G Y
In a Classical world, the economy is supply determined. In this case a
decline in prices increases the real value of money which lowers the
interest rate
In a Keynesian world, the price level can’t adjust.
MS
P
r
S Y 
r
r*
M M
D
S
M
P
I
I
<
S
S, I
C  I Y
Because output is greater than expenditures, output drops
Lower output decreases savings and lowers money demand
r
S Y 
MS
P
S Y 
r
r*
M d Y 
MD  MS
M
P
I
SI
S, I
C I Y
Because output is greater than expenditures, output drops
Note that the current level of output is lower than it would be at the initial
equilibrium (i.e. the labor market is out of equilibrium).
MS
P
r
S  Y  S Y 
r
r*
M M
D
S
Ls
w
p
M d Y 
M
P
w
p
I
Ld
S, I
S =I
C I Y
L
L
 Y  Y 
This would be an economy that is
underemployed
We need a more compact way of representing this…
L
We need to identify an equilibrium relationship between current GDP and
the interest rate in the capital market. All else equal, a rise in current GDP
will raise savings which lowers the interest rate.
r
r
r
S Y 
r
S Y 

S Y
r
IS
I
S, I
Y
Y
Y
Y
We call this equilibrium relationship the IS curve
We need to identify an equilibrium relationship between current GDP and
the interest rate in the money market. All else equal, a rise in current GDP
will raise money demand which raises the interest rate.
r
Ms
P
r
LM
r
r
r

Md Y
M d Y 
M d Y 
M
P
Y
Y
Y
Y
We call this equilibrium relationship the LM curve
Now, we can repeat the previous analysis. Suppose that the Fed increases
the money supply. In a classical world, the price level would increase.
However, of prices are fixed…
r
MS
P
S Y * 
r
LM
r
r*
M d Y * 
M
P
I
S =I
C I Y
IS
S, I
Y
*
*
An increase in the money supply would push down
the interest rate for any level of GDP. This moves the
LM curve down
Y
The new Keynesian (short term) equilibrium has a higher level of GDP
(which results in higher savings and higher money demand)
r
MS
P
S Y * 
r
LM
r
S Y ' 
r*
M d Y ' 
MD  MS
M
P
I
S =I
C  I Y '
IS
S, I
Y'
Y
The new classical (long term) equilibrium has a no effect on GDP but has
higher prices
r
MS
P
S Y * 
r
LM
r
r*
M d Y *
MD  MS
M
P
I
S = I
C  I Y *
IS
S, I
Y
Y*
Higher prices lowers the real supply of money which
raises the LM curve back to its original position
Or, as in the “Animal Spirits” example…a drop in investment demand
changes the GDP/interest rate relationship in the capital market
MS
P
r
S Y * 
r
LM
r
r*
M d Y * 
M M
D
S
M
P
I
S =I
C  I  Y*
IS
S, I
Y
*
This drop in investment demand lowers the capital
market interest rate…IS shifts down
Y
The new Keynesian (short term) equilibrium has a lower level of GDP
(which results in lower savings and lower money demand)
MS
P
r
S Y * 
r
LM
r
r*
M d Y ' 
M M
D
S
I
M
P
IS
S, I
S =I
C  I Y '
Y'
Y
The new classical (long term) equilibrium has no effect on GDP but lowers prices
MS
P
r
r*
S Y * 
r
M d Y * 
M M
D
S
M
P
LM
r
I
IS
S, I
S =I
Y
*
C  I  Y*
The fall in prices raises the real supply of money
which lowers the interest rate in the money market
(LM shifts down)
Y
What about labor markets? We can represent labor markets as the FE (Full
Employment) curve. Note that interest rates have no effect on labor supply or
demand.
w
p
Ls
r
FE
w
p
Ld
L
L
Y
Y
Y
L
L
Y
Now, lets put it all together….suppose that the Federal reserve increases the
money supply
MS
P
r
S Y 
r
w
p
Ls
w
p
r*
M d Y 
M M
D
S
I
M
P
Ld
S, I
S =I
C  I Y
r
FE
L
Y 
LM
r*
IS
Y
Y
L
Now, lets put it all together….suppose that the Federal reserve increases the
money supply
MS
P
r
S Y 
r
w
p
Ls
w
p
r*
M d Y 
M M
D
S
I
M
P
Ld
S, I
S =I
C  I Y
r
FE
L
Y 
LM
r*
IS
Y
L
Y
With prices fixed, the
rise in money supply
lowers the interest
rate (LM shifts down)
Now, lets put it all together….suppose that the Federal reserve increases the
money supply
MS
P
r
S Y 
r
S Y 
M d Y 
M M
S
Ls
w
p
r*
D
w
p
I
M
P
S, I
S =I
C I Y
r
FE
L
LM
IS
Y
L
L
Y   Y 
r*
Y
Ld
Y
The new short term
(Keynesian) equilibrium
has higher GDP and
lower interest rates
(above equilibrium
employment)
Now, lets put it all together….suppose that the Federal reserve increases the
money supply
MS
P
r
S Y 
r
S Y 
w
p
Ls
w
p
r*
M d Y 
M M
D
S
I
M
P
S, I
S =I
C  I Y
r
FE
Ld
L
L
Y 
LM
The long term (Classical)
equilibrium has higher
prices (equilibrium
employment)
r*
IS
Y
Y
Now, lets put it all together….suppose we get a drop in investment demand
MS
P
r
S Y 
r
w
p
Ls
w
p
r*
M d Y 
M M
D
S
I
M
P
Ld
S, I
S =I
C  I Y
r
FE
L
Y 
LM
r*
IS
Y
L
Y
With prices fixed, the
drop in investment
lowers the interest
rate (IS shifts down)
Now, lets put it all together….suppose we get a drop in investment demand
MS
P
r
S Y 
r
S Y 
w
p
Ls
w
p
r*
M d Y 
M M
D
S
I
M
P
S, I
S =I
C I Y
L
LM
r*
IS
Y
L
L
 Y  Y 
FE
r
Ld
Y
Y
The new short term
(Keynesian) equilibrium
has lower GDP and
lower interest rates
(below equilibrium
employment)
Now, lets put it all together….suppose we get a drop in investment demand
MS
P
r
S Y 
r
w
p
Ls
w
p
r*
M M
D
S
I
M
P
S, I
S =I
C I Y
r
Ld
L
L
Y 
FE
r*
LM
The long term (Classical)
equilibrium has lower
prices and lower interest
rates (equilibrium
employment)
IS
Y
Y
What about the productivity shocks from real business cycle theory? Suppose we have a
temporary drop in productivity.
r
MS
P
S Y 
r
w
p
Ls
w
p
r*
M d Y 
S
M
MD 
P
I
M
P
S, I
S =I
C  I Y
r
FE
L
Y 
LM
r*
IS
Y
Ld
Y
L
The drop in productivity creates a decline in full employment output
r
MS
P
S Y 
r
w
p
Ls
w
p
r*
M d Y 
I
M
P
Ld
S, I
L
L
 Y  Y 
FE
r
LM
r*
IS
Y
Y
Y
L
The drop in GDP (lowering current income) lowers savings while the decline in
MPK lowers investment
S Y 
MS
P
r
S Y 
r
w
p
Ls
w
p
r*
M d Y 
I
M
P
The drop in
savings due to
the decline in
income would
move the
economy here
Ld
S, I
L
Y 
FE
r
L
Y 
LM
The drop in
investment by
itself would
move the
economy here
r*
IS
Y
Y
Y
L
The drop in GDP lowers current income which lowers money demand.
S Y 
MS
P
r
S Y 
r
w
p
Ls
w
p
r*
M d Y 
M M
D
S
M d Y 
I
M
P
Ld
S, I
S =I
C  I Y
FE
r
L
 Y  Y 
LM
r*
IS
Y
Y
L
Y
L
What about the supply shocks from real business cycle theory. Suppose we have
a temporary drop in productivity.
S Y 
S
M
P
r
S Y 
r
w
p
Ls
w
p
r*
M d Y 
M M
D
S
I
M
P
Ld
S, I
S =I
C  I Y
FE
r
L
 Y  Y 
LM
r*
IS
Y
Y
L
L
Y
The new short term
(Keynesian) equilibrium has
GDP and interest rates
falling (above the new
equilibrium employment)
What about the supply shocks from real business cycle theory. Suppose we have
a temporary drop in productivity.
S Y 
S
r
M
P
MS
P
S Y 
r
w
p
Ls
r*
w
p
M d Y 
M M
D
I
M
P
Ld
S, I
S =I
C I Y
S
FE
r
L
Y 
LM
The long term (Classical)
equilibrium has higher
prices and higher interest
rates (equilibrium
employment)
r*
IS
Y
L
Y
What about the supply shocks from real business cycle theory. Suppose we have
a permanent drop in productivity.
MS
P
r
S Y 
r
w
p
Ls
w
p
M d Y 
r*
M M
D
S
The drop in
productivity creates a
decline in full
employment output
(FE) and lowers
investment (IS)
I
M
P
S, I
S =I
C I Y
FE
r
L
LM
IS
Y
L
 Y  Y 
r*
Y
Ld
Y
Its possible for the
Classical and
Keynesian solutions
to coincide with no
price change
necessary
L
We can also do IS-LM-FE analysis numerically…
Y  5,000
r
FE
LM
M 
r  .5  .02Y  .25 
 P
r*
IS
Y
*
Y
Y  9,000  1,000r
First, we need to find the long run equilibrium for this economy. For this, we can
temporarily ignore the LM sector…
Y  5,000
r
The FE curve represents long run
output…plug this into the IS curve
FE
r4
Y  9,000  1,000r  5,000  9,000  1,000r
4,000  1,000r
r4
IS
Y  5,000
Y
Now that we know the interest rate and output, we can add the money market
Plug in values for
output and the
interest rate
M 
r  .5  .02Y  .25 
 P
r
FE
LM
M 
4  .5  .025,000   .25 
 P
r4
M
 386
P
IS
Y  5,000
Y
Now, any value for
money supply implies a
unique price level
M  850
P  2.2
Now, solve for real
money
So, we have the economy’s long run equilibrium…now, lets give the economy a
shock!
Y  5,000
r
M  850
P  2.2
FE
LM
M 
r  .5  .02Y  .25 
 P
r4
IS
Y  5,000
Y
Y  9,000  1,000r
Let’s increase the money supply
by $10B
On impact, this shock only effects the money market…initially, the price level is
fixed
M  860
P  2.2
r
FE
M
 391
P
LM
r  .5  .025,000  .25391  2.75
r4
r  2.75
Assuming that output remained at 5,000,
the interest rate would need to drop to
2.75% to get people willing to hold the extra
cash
IS
Y  5,000
Y
In the short run, we find an interest rate where both money demand = money
supply and where demand = supply (for goods & services)
r
FE
r  .5  .02Y  .25391
LM
Y  9,000  1,000r
r4
r  3.94
r  2.75
Plug one into the other
to solve for r
IS
Y  5,000 Y '  5,060
Y
r  .5  .029000 1000r   .25391
r  3.94
Now, find Y
This would be the short term
equilibrium…
Y  9,000 1,0003.94  5,060
Eventually, we need to return to the long run production level given by the FE
sector…to accomplish this, a price increase will lower the real value of money
and bring interest rates back up
r
To return demand back to
5,000, r = 4%
FE
M 
r  .5  .02Y  .25 
 P
LM
Long run output is 5,000
r4
r  3.94
r  2.75
M 
4  .5  .025,000   .25 
 P
IS
Y  5,000 Y '  5,060
Y
M
 386
P
This would be the short term
equilibrium…
P  2.23
M  860
Let’s try another one….suppose FE increases.
Y  5,000
r
M  850
P  2.2
FE
LM
M 
r  .5  .02Y  .25 
 P
r4
IS
Y  5,000
Y
Y  9,000  1,000r
Suppose GDP increases by
10%
….again, prices are initially fixed
M  850
P  2.2
Y '  5,500
r
FE
 850 
r  .5  .025,500  .25
  14
2
.
2


LM
The interest rate would need to rise
to 14% to clear the money market
r  14
r4
r  3.5
5500  9,000  1,000r  r  3.5
IS
Y  5,000 Y '  5,500
Y
The interest rate would need to fall
to 3.5% to clear the goods market
Now what???
In the short run, nothing happens (IS/LM)
M  850
P  2.2
Y '  5,500
r
An increase in the real value of
money will bring the interest rate
down
FE
LM
r  14
M 
3.5  .5  .025,500   .25 
 P
r4
r  3.5
IS
Y  5,000 Y '  5,500
Y
M
 428
P
M  850
P  1.98
A price level of 1.98 will lower the
interest rate to 3.5%
Let’s try one more…how about a demand shock.
Y  5,000
r
M  850
P  2.2
FE
LM
M 
r  .5  .02Y  .25 
 P
r4
IS
Y  5,000
Y
Y  9,000  1,000r
Consider a shock that (at the
initial interest rate), increases
expenditures by 10%
Let’s try one more…how about a demand shock (for example, a
rise in investment demand).
M  850
P  2.2
New IS Curve
Y  9,500  1, 000r
r
r  4.5
FE
LM
5,000  9,500  1,000r  r  4.5
r4
Given the demand shock, the interest rate
would need to rise to 4.5% to keep
demand at 5,000
IS
Y  5,000 Y  5,500
Y
Again, in the short run, we look to where IS and LM intersect…
r
r  4.5
r  4.47
r4
r  .5  .02Y  .25386
FE
LM
Y  9,500  1,000r
M  850
P  2.2
Plug one into
the other to
solve for r
r  .5  .029500 1000r   .25386
r  4.47
IS
Y  5,000 Y  5,500
Y  5,030
Now, find Y
Y
Y  9,500 1,0004.47  5,030
Again, it will be a change in the price level that returns us to capacity
r
r  4.5
r  4.47
r4
M  850
P  2.2
An decrease in the real value of
money will bring the interest rate up
to 4.5%
FE
LM
M 
4.5  .5  .025,000   .25 
 P
IS
Y  5,000 Y  5,500
Y  5,030
Y
M
 384
P
M  850
P  2.21
A price level of 2.21 will raise the
interest rate to 4.5%