Keynes: Useful Economics for the World Economy by Peter Temin

Author:Peter Temin [Temin, Peter]
Language: eng
Format: epub, pdf
Publisher: The MIT Press
Published: 0101-01-01T00:00:00+00:00

Figure 6.1

The IS-LM diagram.

Figure 6.1 looks like figure 4.1, but the labels are different. As in figure 5.1, the horizontal axis represents national production or GDP, often represented by economists as Y. The vertical axis represents the interest rate. There is no distinction between the real interest rate and the nominal interest rate as prices are assumed constant.

The IS curve represents equilibrium points in the markets for goods and services. It is an extension of figure 5.1, making investment a function of the interest rate. As the interest rate falls, investment rises. Investment will now be higher than saving. Production and income will rise until savings are again equal to investment.

The LM curve represents equilibrium in the money market. The LM curve shows different combinations of the interest rate and GDP where wealth holders are content to hold a given quantity of money and there are no pressures for the interest rate to change. As GDP rises, the demand for money rises. The interest rate must rise to ensure equilibrium in the money market.

The IS curve shows different combinations of the interest rate and national product where savers and investors are content, and at which firms do not wish to change their level of production. The LM curve shows different combinations of the interest rate and national income where wealth holders are content to hold a given quantity of money. Where the curves cross, both groups are content, and there is no pressure to change either the interest rate or GDP.

The equilibrium in figure 6.1 is based on the preferences of separate groups of people, as in figure 4.1. In this case, the same people or business firms may be making investments and holding money, but we think of these two activities as separate. As we explained in chapter 1, we can think of Robinson Crusoe as both a producer and a consumer; here, however, we think of these businessmen and women separately as they make separate decisions. Turning to consumers in figure 6.1, we can think of consumers as making two decisions as well. They decide how much of their income to save—that is, how much of their income not to consume—and whether they want to hold their savings in money or bonds.

How does this IS-LM analysis change the argument for fiscal expansion in the last chapter? Figure 5.3 described the multiplier effect of a fiscal expansion when the interest rate remained unchanged. This conclusion needs to be modified when the interest rate is free to change.

An increase in government spending appears as a shift to the right of the IS curve in figure 6.1. As GDP rises, the demand for money rises too (for added transactions) and people will sell bonds. This will drive down the price of bonds, increasing the rate of interest. That has two effects. The rise in the interest rate reduces the liquidity demand for money and keeps the economy on the LM curve. The rise

Download

Copyright Disclaimer:
This site does not store any files on its server. We only index and link to content provided by other sites. Please contact the content providers to delete copyright contents if any and email us, we'll remove relevant links or contents immediately.