27 Keynesian Economics

and IS–LM Analysis

N eo-classical orthodoxy had held that markets, including labour markets, cleared without government
involvement in both the short run and the long run. The Great Depression of the 1930s across Europe
and the United States saw millions of people losing their jobs, and unemployment remained at high levels
throughout the decade.
In 1936, economist John Maynard Keynes published a book entitled The General Theory of Employ-
ment, Interest, and Money, which attempted to explain short-run economic fluctuations in general and the
Great Depression in particular. Macroeconomics as a separate path of economic research stemmed from
the experiences of the Great Depression. Keynes was not the first to question classical paradigms; recall
how Mitchell and Burns’ work on business cycles was being carried out some several years before the
Great Depression. Keynes picked up this tradition and helped create interest in the analysis of aggregate
phenomena.
Keynes’ primary message was that recessions and depressions can occur because of inadequate
aggregate demand (AD) for goods and services. Keynes had long been a critic of classical economic
theory because it could explain only the long-run effects of policies. A few years before The General
Theory, Keynes had written the following about classical economics:
The long run is a misleading guide to current affairs. In the long run we are all dead. Economists
set themselves too easy, too useless a task if in tempestuous seasons they can only tell us that
when the storm is long past, the ocean will be flat.
Keynes’ message was aimed at policymakers as well as economists. As the world’s economies suffered
with high unemployment, Keynes advocated policies to increase AD, including government spending on
public works. Keynes argued for the necessity of short-run interventions in the economy. The focus on
monetary and supply-side policies as the main ways of controlling the economy in most developed coun-
tries in Europe had largely consigned Keynesian demand management to the economic history books.
However, the Financial Crisis and subsequent recession of 2007–9 reignited the debate about the role of
Keynesian economics in macro policy. Keynes’ contribution to economic thinking is widely acknowledged
and it is valuable to have some insight into Keynesian economics. This chapter will begin this process.

The Keynesian Cross

Classical economics placed a fundamental reliance on the efficiency of markets and the assumption that
they would clear. At a macro level, this meant that if the economy was in disequilibrium and unemploy-
ment existed, wages and prices would adjust to bring the economy back into equilibrium at full employ-
ment. Full employment is defined as a point where those people who want to work at the going market
wage level are able to find a job. Any unemployment that did exist would be classed as voluntary unem-
ployment. The experience of the Great Depression of the 1930s brought the classical assumptions under
closer scrutiny; the many millions suffering from unemployment could not all be volunteering to not take
jobs at the going wage rates, so some must, therefore, be involuntarily unemployed. We have also seen
that prices can be sticky, meaning markets may not always adjust to clear surpluses and shortages quickly.

614

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 CHAPTER 27 KEYNESIAN ECONOMICS AND IS–LM ANALYSIS 615

full employment a point where those people who want to work at the going market wage level are able to find a job

Planned and Actual Spending

Fundamental to Keynesian analysis is the distinction between planned and actual decisions by households
and firms. Planned spending, saving or investment refers to the desired or intended actions of firms
and households. A publisher, for example, may plan to sell 10,000 copies of a textbook in the first six
months of the year; an individual may plan to go on holiday to Turkey in the summer and save up to finance
the trip; a person may intend to save €1,000 over the year to put towards paying for a wedding next year.

planned spending, saving or investment the desired or intended actions of households and firms

Actual spending, saving or investment refers to the realized, ex post (after the event) outcome. The
publisher may only sell 8,000 copies in the first six months and so has a build-up of stock (inventories) of
2,000 more than planned; the holidaymaker may fall ill and is unable to go on holiday and so their actual
consumption is lower than planned (whereas actual saving is more than planned because they have not
spent what they intended); and the plans for saving for the wedding may be compromised by the need to
spend money on repairing a house damaged by a flood.

actual spending, saving or investment the realized or ex post outcome resulting from actions of households
and firms

Planned and actual outcomes, therefore, might be very different. Keynes suggested that there was no
reason why equilibrium national income would coincide with full employment output. Wages and prices
might not adjust in the short run because of sticky wages and prices, and so the economy could be at
a position where the level of demand in the economy was insufficient to bring about full employment.
The mass unemployment of the 1930s could be alleviated, he argued, by governments intervening in the
economy to manage demand to achieve the desired level of employment.

The Equilibrium of the Economy

We have seen that a country’s GDP (which we will refer to as national income), is divided among four
components: consumption spending, investment spending, spending by government and net exports.
Imagine a situation where, at every point, total expenditure in the economy given by C 1 I 1 G 1 NX
was exactly the same as national income. We could represent this in diagrammatic form as a 45 degree
line such as the ones in panels (a) and (b) in Figure 27.1.
In panels (a) and (b), the 45 degree line connects all points where consumption spending (actual
expenditure) would be equal to national income (planned expenditure). This line can be thought of as the
equivalent of the capacity of the economy – the aggregate supply (AS) curve.
TheC 1 I 1 G 1 NX line is a function of income – in other words, spending depends on income. If income is
higher, spending will also be higher and so the C 1 I 1 G 1 NX line has a positive slope. The vertical intercept
of the C 1 I 1 G 1 NX line, given as E0 , is termed autonomous spending or autonomous expenditure.
This is the component of expenditure which does not depend on income/output – government spending
being a key element of this expenditure.

autonomous spending or autonomous expenditure spending which is not dependent on income/output

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616 PART 12 Short-run economic fluctuations

Figure 27.1
Deflationary and Inflationary Gaps
The 45 degree line shows all the points where consumption spending equals income. The vertical intercept of the expenditure line
shows autonomous expenditure. The economy is in equilibrium where the expenditure line, C 1 I 1 G 1 NX, cuts the 45 degree line.
In panel (a) this equilibrium is lower than full employment output (Yf ) at Y1 ; there is insufficient demand to maintain full employment
output. The government would need to shift the expenditure line up to C 1 I 1 G 1 NX1 to eliminate the deflationary gap. In panel (b)
the equilibrium is higher than full employment output – the economy does not have the capacity to meet demand. In this case the
government needs to shift the C 1 I 1 G 1 NX line down to C 1 I 1 G 1 NX 2 to eliminate the inflationary gap.

Total
45°
expenditure C + I + G + NX1

Deflationary gap

C + I + G + NX
E1

E0

Y1 Yf National income
(a)

Total 45°
expenditure C + I + G + NX

Inflationary gap
C + I + G + NX2
E0

E1

Yf Y1 National income
(b)

Where actual spending is equal to planned spending is the short-run equilibrium of the economy. Note
that the use of the term ‘equilibrium’ in this context does not mean the ‘best’ or ‘desired’ equilibrium –
it is simply a point where actual spending is equal to planned spending. The economy is in equilibrium
where the C 1 I 1 G 1 NX line cuts the 45 degree line. This is referred to as the Keynesian cross. In
panel (a) the economy is in equilibrium at a national income of Y1 . However, full employment national
income is at Yf . Actual spending of C 1 I 1 G 1 NX in panel (a) gives an equilibrium which is less than
that required for full employment output (Yf ). At the equilibrium Y1 there is spare capacity in the economy –
some resources are not being used to their full extent, capital may be underused and unemployment
will exist. This is the equivalent to an economy being at a point inside its production possibilities frontier.
The difference between full employment output, and the expenditure required to meet it, is termed the
deflationary gap (you may sometimes see this also referred to as the output gap). Expenditure needs
to rise to C 1 I 1 G 1 NX1 to eliminate the deflationary gap, which is the vertical distance between actual
spending and spending necessary to achieve full employment.

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 CHAPTER 27 KEYNESIAN ECONOMICS AND IS–LM ANALYSIS 617

deflationary gap or output gap the difference between full employment output and expenditure when expenditure is
less than full employment output

In panel (b) the C 1 I 1 G 1 NX line cuts the 45 degree line at an output level Y1 , which is higher
than full employment output, Yf . In this situation the economy does not have the capacity to meet actual
spending. This will trigger inflationary pressures. The difference between full employment output and the
expenditure line here is called the inflationary gap. Actual spending needs to be reduced to eradicate
the inflationary gap and the C 1 I 1 G 1 NX line needs to be reduced to C 1 I 1 G 1 NX 2 to bring the
economy to an equilibrium where actual spending equals full employment output.

inflationary gap the difference between full employment output and actual expenditure when actual expenditure is
greater than full employment output

Demand Management The deviations in the business cycle in Keynesian analysis are primarily due to
demand-side factors. The principle behind Keynesian economics is, at its heart, very simple and intuitive.
Downturns in economic activity occur because firms fail to sell all the goods and services they planned
to sell. If customers (and of course we are not only talking about final consumers but also about other
businesses as customers of firms) are not buying as many goods and services, firms will not need to pro-
duce as many and so cut back production as stocks rise. If production is cut back then firms do not need
as many workers and either do not replace workers when they retire, make some workers redundant, or
lay off workers by reverting to shorter working weeks or even ceasing production temporarily for a time
period. Unemployment rises, and the cause is due to demand deficiency. The affected workers now see a
fall in their incomes and so cut back on spending which exacerbates the problem.
The cause of a fall in consumption in the first place is often difficult to pinpoint. It could be due to
confidence and expectations; it could be due to the way in which the public respond to news items (the
more the news media refer to the possibility of slowdown or recession, it might become a self-fulfilling
prophecy); or it could be due to a change in patterns of consumption with some firms seeing a decline
in demand for their goods while others see an increase, but the structural change causes a disruption in
demand. Workers who are made redundant from the declining industries may not have the skills to move
to jobs being created in the growth industries, and, as a result, regardless of the wage rate, they remain
unemployed.
Keynes argued that governments can use the tools of fiscal and monetary policy, and in particular fiscal
policy, to influence demand in the economy and reduce deflationary and inflationary gaps. Taxation is a
leakage from the circular flow of income but can be manipulated by the government. Equally, government
can vary its own expenditure, and the combinations of changes in tax and government spending can be
used as levers to manage demand to bring the economy into equilibrium at a point nearer to full employ-
ment output. If the value of full employment output, the amount the economy is capable of producing if
all existing resources are used fully (planned spending), is €1 trillion, for example, but actual spending is
only €800 billion, the deflationary or output gap would be €200 billion. The government might introduce
policy levers which lead to a cut in taxes and a boost to government spending to generate this additional
€200 billion in spending. The use of these levers has some interesting features, which we will describe in
the next section.

Self Test Why might actual spending differ from planned spending?

If planned spending in an economy is €500 billion but actual spending is €400 billion, is there an inflationary gap
or a deflationary gap? Explain.
What might the government do in this situation to bring spending more in line with full employment output?

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618 PART 12 Short-run economic fluctuations

The Multiplier Effect

The C 1 I 1 G 1 NX line is referred to as the expenditure function. Planned expenditure is dependent on
the level of consumption, plus investment, plus government spending plus net exports and can be written:

E 5 C 1 I 1 G 1 NX

Actual expenditure/output (remember that expenditure is one way of measuring output – these two things
are the same) will be denoted as (Y ). The economy will be in equilibrium when planned expenditure is
equal to actual expenditure ( E 5 Y ).
The positive slope of the expenditure function implies that planned spending rises as income rises.
What determines the slope of the expenditure function has important policy implications. When a gov-
ernment makes a purchase, say it enters into a contract with a construction company for €10 billion to
build a new nuclear power station, that purchase has repercussions. The immediate impact of the higher
demand from the government is to raise employment and profits at the construction company (which
we shall call Nucelec). Nucelec, in turn, must buy resources from other contractors to carry out the job
and so these suppliers also experience an increase in orders. Workers at these firms see higher earnings
and the firms’ owners see higher profits; they respond to this increase in income by raising their own
spending on consumer goods. As a result, the government purchase from Nucelec raises the demand
for the products of many other firms in the economy. Because each euro spent by the government can
raise the AD for goods and services by more than a euro, government purchases are said to have a
multiplier effect on AD.

multiplier effect the additional shifts in aggregate demand that result when expansionary fiscal policy increases income
and thereby increases consumer spending

The multiplier effect continues even after this first round. When consumer spending rises, the firms
that produce these consumer goods hire more people and experience higher profits. Higher earnings and
profits stimulate consumer spending once again, and so on. Thus there is positive feedback as higher
demand leads to higher income, which in turn leads to even higher demand. Once all these effects are
added together, the total impact on the quantity of goods and services demanded can be much larger than
the initial impulse from higher government spending.
The multiplier effect arising from the response of consumer spending can be strengthened by the
response of investment to higher levels of demand. For instance, Nucelec might respond to the higher
demand for building services by buying more cranes and other mechanized building equipment. In this
case, higher government demand spurs higher demand for investment goods. This positive feedback from
demand to investment is sometimes called the investment accelerator.

Case Study The Accelerator Principle

The accelerator principle relates the rate of change of AD to the rate of change in investment. To produce
goods, a firm needs equipment. Imagine that a machine is capable of producing 1,000 tablet computers per
week. Demand for tablet computers is currently 800. A rise in demand for tablet computers of up to 200 is
capable of being met without any further investment in new machinery. However, if the rate of growth of
demand continues to rise, it may be necessary to invest in a new machine.

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 CHAPTER 27 KEYNESIAN ECONOMICS AND IS–LM ANALYSIS 619

Imagine that in year 1, demand for tablet computers

rises by 10 per cent to 880. The business can meet this
demand through existing equipment. In year 2, demand
increases by 20 per cent and is now 1,056. The existing
capacity of the machine means that this demand can-
not be met, but the shortage is only 56 units, so the firm
decides that it might increase price rather than invest
in a new machine. In year 3, demand rises by a further
25 per cent. Demand is now 1,320, but the machine is
only capable of producing a maximum of 1,000 tablet
computers. The firm decides to invest in a new machine.
The manufacturers of the new machine will therefore
see a rise in their order books as a result of the increase
in demand. An increase in demand of 25 per cent has
led to an ‘accelerated’ rise in investment of 100 per cent.
Investment is a component of AD, so economists are
interested in the way investment adjusts to changes in
demand in the economy. As this brief example shows, Increases in demand do not always mean
the relationship between an increase in demand and an that investment in productive capital is
increase in investment is not a simple one. increased.

A Formula for the Spending Multiplier

A little algebra permits us to derive a formula for the size of the multiplier effect that arises from consumer
spending. An important number in this formula is the marginal propensity to consume – the fraction
of extra income that a household consumes rather than saves. For example, suppose that the marginal
propensity to consume is 3 4. This means that for every extra pound or euro that a household earns, the
household spends 3 4 of it and saves 14 . The marginal propensity to save (MPS) is the fraction of extra
income that a household saves rather than consumes. With an MPC of 3 4, when the workers and owners
of Nucelec earn €10 billion from the government contract, they increase their consumer spending by
3 3 €10 billion, or €7.5 billion. (You should see from the above that MPC 1 MPS 5 1. The formula below
4
can also be expressed in terms of the MPS.)

marginal propensity to consume the fraction of extra income that a household consumes rather than saves
marginal propensity to save the fraction of extra income that a household saves rather than consumes

To gauge the impact on spending of a change in government purchases, we follow the effects step by
step. The process begins when the government spends €10 billion, which implies that national income
(earnings and profits) also rises by this amount. This increase in income in turn raises consumer spending
by MPC 3 €10 billion, which in turn raises the income for the workers and owners of the firms that pro-
duce the consumption goods. This second increase in income again raises consumer spending, this time
by MPC 3 (MPC 3 €10 billion). These feedback effects go on and on.

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620 PART 12 Short-run economic fluctuations

To find the total impact on the demand for goods and services, we add up all these effects:

Change in government 5 €10 billion

purchases
First change in consumption 5 MPC 3 €10 billion
Second change in consumption 5 (MPC )2 3 €10 billion
Third change in consumption 5 (MPC )3 3 €10 billion
• •
• •
• •
Total change in demand 5 (1 1 MPC 1 MPC 2 1 MPC 3 1 … ) 3 €10 billion

We can write the multiplier using ‘…’ to represent a pattern of similar terms as follows:

Multiplier 5 (1 1 MPC 1 MPC 2 1 MPC 3 1 …)

This multiplier tells us the demand for goods and services that each euro of government purchases
generates.
To simplify this equation for the multiplier, recall from your school algebra that this expression is an
infinite geometric series. For x between 21 and 1:

1 1 x 1 x 2 1 x 3 1…

The sum of this series as the number of terms tends to infinity, is given by:
1
12 x
In our case, x 5 MPC . Thus:
1
Multiplier(k ) 5
(1 2 MPC )

We have said that the MPC 1 MPS 5 1 so the multiplier can also be expressed as:

1
Multiplier(k ) 5
(MPS )

1
For example, if the MPC is 3 4, the multiplier is . In this case, the €10 billion of government spending
 3
1 2 
 4
generates €40 billion of demand for goods and services.
This formula for the multiplier shows an important conclusion: the size of the multiplier depends on
the marginal propensity to consume. While an MPC of 3 4 leads to a multiplier of 4, an MPC of 12 leads to a
multiplier of only 2. Thus a larger MPC means a larger multiplier. To see why this is true, remember that the
multiplier arises because higher income induces greater spending on consumption. The larger the MPC,
the greater the induced effect on consumption and the larger the multiplier. The MPC determines the
slope of the consumption element of the planned expenditure function.

Other Applications of the Multiplier Effect

Because of the multiplier effect, a euro of government purchases can generate more than a euro of AD.
The logic of the multiplier effect, however, is not restricted to changes in government purchases. Instead,
it applies to any event that alters spending on any component of planned expenditure – consumption,
investment, government purchases or net exports.

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 CHAPTER 27 KEYNESIAN ECONOMICS AND IS–LM ANALYSIS 621

For example, suppose that a recession overseas reduces the demand for Ireland’s net exports by
€1 billion. This reduced spending on Irish goods and services depresses Ireland’s national income, which
reduces spending by Irish consumers. If the MPC is 3 4 and the multiplier is 4, then the €1 billion fall in net
exports means a €4 billion contraction in output.
As another example, suppose that a stock market boom increases households’ wealth and stimu-
lates their spending on goods and services by €2 billion. This extra consumer spending increases national
income, which in turn generates even more consumer spending. If the MPC is 3 4 and the multiplier is 4,
then the initial impulse of €2 billion in consumer spending translates into an €8 billion increase in AD.
The multiplier is an important concept in macroeconomics because it shows how the economy can
amplify the impact of changes in spending. A small initial change in consumption, investment, government
purchases or net exports can end up having a large effect on AD and, therefore, on the economy’s produc-
tion of goods and services.

Withdrawals from the Circular Flow The amount spent in each successive round of spending is termed
‘induced expenditure’. The multiplier showed how the eventual change in income would be determined by
the size of the MPC and the MPS. The higher the MPC the greater the multiplier effect.
However, in an open economy with government, any extra €1 is not simply either spent or saved,
some of the extra income may be spent on imported goods and services or go to the government in
taxation – withdrawals from the circular flow. Withdrawals (W ) from the circular flow are classed as
endogenous as they are directly related to changes in income. Withdrawals are saving (S ), taxation (T )
and imports (M ).
We must also take into consideration injections into the circular flow of income. Governments receive
tax revenue (a withdrawal from the circular flow), but uses it to spend on the goods and services they
provide for citizens (an injection into the circular flow); firms earn revenue from selling goods abroad
(exports) which are an injection into the circular flow; and firms use savings (a withdrawal) as a source of
funds to borrow for investment (an injection). Injections into the circular flow are exogenous – they are
not related to the level of output or income – and are investment (I ), government spending (G ) and export
earnings (X ).
The slope of the expenditure line as a whole, therefore, will be dependent on how much of each extra
€1 is withdrawn. For each additional €1 of income, some will exit the circular flow of income in taxation,
some through savings and some through spending on imports. The marginal propensity to taxation (MPT)
is the proportion of each additional €1 of income taken in taxation by the government and the marginal
propensity to import (MPM), the proportion of each additional €1 of income spent on goods from abroad.
When we take into consideration the fact that each extra €1 in income is not disposable income, i.e. not
all available for consumption, the multiplier effect when considering the marginal propensity to withdraw
(MPW) will be much lower than if we were simply considering the MPC alone in any increase in income.
We can restate the formula for the multiplier (k ) in an open economy with a government as:
1
K 5
(MPS 1 MPT 1 MPM )

Or:
1
K 5
(MPW )

The size of the MPW will determine the slope of the expenditure line: the steeper the slope of the expend-
iture line the greater the size of the multiplier, as shown in Figure 27.2.

Equilibrium of Planned Withdrawals and Injections

Seeing the economy from the perspective of withdrawals and injections is helpful to understand how
demand management might work. Let us start with the national income identity:
Output ; Expenditure ; Income

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622 PART 12 Short-run economic fluctuations

Figure 27.2
The Slope of the Expenditure Line and Changes in Autonomous Expenditure
Panel (a) shows a relatively shallow expenditure line which would mean that the marginal propensity to withdraw would be high and
the value of the multiplier would be relatively low. Using the Greek letter delta ( D ) to mean ‘change’, the impact on national income
( DY ) of a change in government spending ( DG) would be more limited in comparison to the effect as shown in panel (b), where the
expenditure line is much steeper reflecting a higher value of the multiplier where the MPW was relatively low. In this case it takes a
smaller rise in government spending to achieve the same increase in national income.

Total 45°
expenditure C + I + G + NX1

C + I + G + NX
ΔG
E1

E0

Y1 Yf National income

ΔY
(a)

Total 45°
expenditure C + I + G + NX1

C + I + G + NX

ΔG
E1

E0

Y1 Yf National income

ΔY
(b)

Recall that in a closed economy S 5 I with savings a withdrawal and investment an injection. We can
extend this analysis to state that in equilibrium, in an open economy with a government, planned with-
drawals would equal planned injections:
Planned S 1 T 1 M 5 Planned I 1 G 1 X

At this point all the output being produced by the economy would be ‘bought’ by households and firms.
However, if actual withdrawals are greater than planned injections, then the economy would be expe-
riencing a deficiency in demand. For example, assume that full employment output (Yf ) is €120 billion.
Withdrawals are a function of income; assume that S , T and M have the following values:
S 5 0.1Y
T 5 0.2Y
M 5 0.2Y

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 CHAPTER 27 KEYNESIAN ECONOMICS AND IS–LM ANALYSIS 623

So if income increased by €1, savings would change by 0.1 3 1 5 10 cents and so on. Now assume that
investment is €20 billion, government spending is also €20 billion and the value of exports is €10 billion.
Given these figures the equilibrium level of national income would be:
Planned S 1 T 1 M 5 Planned I 1 G 1 X
0.1Y 1 0.2Y 1 0.2Y 5 20 1 20 1 10
0.5Y 5 50
This implies that:
Y 5 100

This equilibrium is below the level of full employment output by €20 billion. The government could manage
demand to achieve full employment output in different ways. It could increase its spending by €10 billion
and through the multiplier effect see Y rise to €120 billion.
Planned S 1 T 1 M 5 Planned I 1 G 1 X
0.1Y 1 0.2Y 1 0.2Y 5 20 1 30 1 10
0.5Y 5 60
This implies that:
Y 5 120

In an open economy, the government might not simply target full employment but might wish to reduce
net exports. For example, assume Yf 5 €120 billion, the value of exports is given as €10 billion, but the
value of imports would be 0.2Y and so would be €24 billion (0.2 3 120). If the government wanted to
reduce net exports to zero it might cut government spending, but change tax rates so that the MPT
increases. If government spending was cut to 5 and the marginal propensity to tax raised to 0.4 then the
government could achieve zero net exports:
Planned S 1 T 1 M 5 Planned I 1 G 1 X
0.1Y 1 0.4Y 1 0.2Y 5 20 1 5 1 10
0.7Y 5 35

This implies that:

Y 5 50

It is clear that the policy to reduce net exports has had a severe effect on national income. One of the
features of demand management is that it is possible for governments to use fiscal policy to achieve
desired output levels, but there will be consequences for other areas of the economy which may have
more long-term effects.
If government sets policy to achieve a reduction in unemployment through boosting the economy, then
net exports would fall and the country would be running a trade deficit (NX , 0 ). Recall that trade influ-
ences net capital outflow and the exchange rate. Changes in the exchange rate affect the competitiveness
of firms in the economy and so even though the government might reduce unemployment, its policy
causes longer-term effects which might cause it to have to alter policy to deal with these effects (such as
a currency crisis), which in turn might reduce income and increase unemployment again.

The IS and LM Curves

The Keynesian cross gives us a picture of the economy in short-run equilibrium. (Note, if you access a
copy of Keynes’ General Theory you might be surprised to see a complete absence of Keynesian cross
diagrams. The use of these diagrams was developed by later economists to help portray Keynes’ ideas.)
In equilibrium, planned expenditure equals income (E 5 Y ). This equilibrium is referred to as equilibrium
in the goods market. We have also seen how equilibrium in the money market is given by the inter-
section of the demand for money and the supply of money. At this point, we consider the concept of
real money balances – what money can actually buy or the real value of money, given by the ratio of the
M
money supply (M ) to the price level P , .
P
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624 PART 12 Short-run economic fluctuations

M
real money balances what money can actually buy given the ratio of the money supply to the price level
P

The goods market and the money market are both interrelated with the linking factor being the
interest rate. Following Keynes’ analysis of the goods market and the money market (via the liquidity
preference theory which we will look at in more detail later in the book), Nobel Prize winning economist,
John Hicks, developed a theory that described the links between the two and showed how changes
in both fiscal and monetary policy could be analyzed. The framework for this analysis is known as the
IS–LM model.
IS–LM describes equilibrium in these two markets and together determines a general equilibrium in
the economy. General equilibrium in the economy occurs at the point where the goods market and money
market are both in equilibrium at a particular interest rate and level of income. The remainder of this
chapter will provide an introduction to the IS–LM model. The model forms the basis of many intermediate
courses in macroeconomics, although some have argued that it is now outdated and fails to represent
how the modern economy works, particularly since the Financial Crisis of 2007–9. We will look at an alter-
native representation of the model that seeks to take into account some of these objections. Regardless
of the debates about the validity of the model, it does represent a useful way of understanding how the
goods and money markets interact and, as an exercise in analytical thinking, is helpful in seeing the effects
of monetary and fiscal policy on the macroeconomy.
IS stands for investment and saving; LM stands for liquidity and money. The link between these two
markets is the rate of interest (i ).

The IS Curve
The IS curve shows the relationship between the interest rate and level of income (Y ) in the goods
market. In Figure 27.3, panel (a) shows the Keynesian cross diagram from Figure 27.2, with equilibrium
point a where the expenditure line C 1 I 1 G 1 NX , crosses the 45 degree line. Panel (b) shows the IS
curve. On the vertical axis is the rate of interest and on the horizontal axis is output (national income).
The equilibrium point a in panel (a) is associated with a rate of interest i1. This is plotted as point a* on
panel (b). If interest rates fall then the expenditure line shifts upwards to the left and there will be a new
equilibrium point b where the expenditure line C 1 I 1 G 1 NX1 crosses the 45 degree line. This is plotted
as b* on panel (b), showing the equilibrium of the goods market at a lower interest rate associated with a
higher level of national income. If we connect these two points we get the IS curve. The curve connects
all possible points of equilibrium in the goods market associated with a particular interest rate and level of
national income.
The IS curve shows an inverse relationship between the interest rate and output – a fall in interest rates
leads to a rise in income and vice versa. The rise in income will be dependent on the size of the interest
rate change and the size of the multiplier. The slope of the IS curve is determined by the responsiveness
of consumption and investment (C 1 I ) to changes in interest rates. This is important because it leads to
different outcomes; where economists tend to disagree is the extent to which C 1 I are responsive to
changes in interest rates rather than any disagreement about the validity of the relationship of C 1 I and
the interest rate. The more responsive C 1 I are, the flatter the IS curve.

Shifts in the IS Curve Shifts in the IS curve come about as a result of changes in autonomous expend-
iture. If, for example, government spending rises, this occurs independent of any change in interest
rates. A rise in autonomous spending would be associated with a shift in the IS curve to the right – the
prevailing interest rate would now be associated with a higher level of income. Equally, if autonomous
spending fell, then the IS curve would shift to the left, showing a lower level of income at the prevailing
interest rate.

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 CHAPTER 27 KEYNESIAN ECONOMICS AND IS–LM ANALYSIS 625

Figure 27.3
The IS Curve
The IS curve is derived from the Keynesian cross diagram and shows all possible points of equilibrium in the goods market associated
with a particular interest rate and level of income. In panel (a) initial equilibrium is where the C 1 I 1 G 1 NX line crosses the
45 degree line at point a. This point is plotted on the IS curve as point a∗. An increase in C 1 I 1 G 1 NX to C 1 I 1 G 1 NX1 shows a
new equilibrium point in the goods market, b, which is plotted on the IS curve as b∗. These two points are connected to form the
IS curve.

Interest rate

Total
45° C + I + G + NX1
expenditure
b
i1 a*
C + I + G + NX
E1 a i2 b*

E0

IS

Y1 Y2 National income Y1 Y2 National income

(a) (b)

The LM Curve
The LM curve shows all points where the money market is in equilibrium given a combination of the rate
of interest and national income. In Figure 27.4, panel (a) shows the money market with the demand for
money inversely related to the interest rate. The money supply is shown as a vertical line and it is assumed
that the money supply is fixed by the central bank. Equilibrium in the money market is where the demand
for money (Dm ) curve intersects the money supply curve (Ms ), at point a in panel (a) at interest rate i1, and
a quantity of real money balances M. Panel (b) shows the LM curve with the interest rate on the vertical
axis and national income on the horizontal axis. The equilibrium point, a, in the money market is plotted
as point a* in panel (b). Increases in income will have an effect on the demand for money and assuming
the money supply is fixed, will affect the equilibrium interest rate. Assume that national income rises; the
demand for money curve in panel (a) would shift to the right to Dm1, indicating that the public wish to hold
higher money balances at all interest rates. At the prevailing interest rate the demand for money is now
higher than the supply of money and so the interest rate would rise. The new equilibrium in the money
market is given as point b and this is plotted on the LM diagram as point b*. If we connect the two points
we get the LM curve. The LM curve plots all combinations of interest rates and national income where
the money market is in equilibrium.
The LM curve has a positive slope showing that an increase in income is associated with an increase
in the interest rate and vice versa. The slope of the LM curve will be dependent on the responsiveness of
the demand for money to changes in interest rates. Again, the extent of this relationship is often a point
of disagreement among economists.

Shifts in the LM Curve The LM curve can shift if the central bank expands or contracts the money supply
(we will say more about how this might happen later in the chapter). Assuming income is held constant,
a rise in the money supply (for example), will cause interest rates to fall and a new equilibrium will be
reached at a given level of income. This would be associated with a shift of the LM curve downwards to the
right showing a new combination of income and interest rate at which the money market is in equilibrium.

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626 PART 12 Short-run economic fluctuations

Figure 27.4
The LM Curve
The LM curve shows all points where the money market is in equilibrium given a combination of the rate of interest and national
income. In panel (a), the money market is in equilibrium where the demand for money (Dm ) equals the supply of money (Ms ) at point a.
This point is plotted on the LM curve in panel (b) as point a∗. An increase in the demand for money causes a shift of the curve to the
right to Dm1 with a new equilibrium point of b. This is plotted on panel (b) as point b∗ and the points connected to form the LM curve.

MS Interest LM
Interest
rate rate

i2
b b*
i2

i1 a*
i1 a
Dm1

Dm

M Quantity of real Y1 Y2 National income

money balances
(a) (b)

General Equilibrium Using The IS–LM Model

Equilibrium is found where the IS curve intersects the LM curve. Remember that any point on either curve
describes a point of equilibrium in the goods market and the money market at a rate of interest and level of
national income. In Figure 27.5, the point where the IS curve intersects the LM curve gives a point where
both markets are in equilibrium at an interest rate i e and a level of national income Ye . Hence it follows that
at this point planned expenditure equals actual expenditure (E 5 Y ), and the demand for money equals the
supply of money Dm 5 Ms .

Figure 27.5
General Equilibrium LM
Equilibrium in the economy is found Interest rate
where the IS curve intersects with the
LM curve. At this point both the goods
market and the money market are in
equilibrium at a particular interest rate, ie ,
and level of national income, Ye.

ie

IS

Ye National income

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 CHAPTER 27 KEYNESIAN ECONOMICS AND IS–LM ANALYSIS 627

Having established this general equilibrium, we can use the model to analyze the impact of fiscal and
monetary policy changes in an attempt to stabilize the economy and how these two policies are inter-
related. Further analysis of both policies will be covered later in the book but this uses our basic model
of IS–LM. The detail of IS–LM analysis is beyond the scope of this book; however, the remainder of this
chapter will introduce some of the key implications of the model.

The Effect of a Change in Fiscal Policy

Assume that the government chooses to increase spending to boost economic activity. This increase in
autonomous expenditure shifts the IS curve to the right as shown in panel (a) of Figure 27.6. The result is
that national income will rise but there will also be an increase in interest rates. A similar outcome would
occur if the government chose to cut taxes as the means of boosting the economy. The result of either
policy would be dependent on the MPW and the size of the multiplier. The opposite would occur if the
government chose to cut spending or increase taxes – national income and interest rates would both fall.

Figure 27.6
The Effects of Fiscal and Monetary Policy
In panel (a), a rise in government spending shifts the IS curve to the right resulting in a new equilibrium with a higher interest rate
and level of national income. In panel (b), an increase in the money supply would shift the LM curve to the right and a new equilibrium
would result in a lower interest rate and higher level of national income.

LM
Interest
rate Interest LM
rate
LM1
i1

ie ie

i1

IS1
IS IS
Ye Y1 National income Ye Y1 National income

(a) (b)

The Effect of a Change in Monetary Policy

If the central bank decided to expand the money supply the LM curve would shift to the right to LM1 as
shown in panel (b) of Figure 27.6. The new equilibrium would lead to a lower interest rate and a higher
level of national income. The reverse outcome would occur if the central bank tightened monetary policy
by reducing the money supply.

Fiscal and Monetary Policy Interactions In reality, central banks do not act totally in isolation of gov-
ernment, even if they are independent. Central banks will be aware of what governments are doing. The
Bank of England and the ECB have a responsibility to maintain price stability, and this may be reflected in
the form of a target for inflation. Central banks will be monitoring the effect of fiscal policy changes on the
economy and how these changes might affect inflationary pressures. These inflationary pressures can be
influenced by the central bank’s control over short-term interest rates through the rate at which it lends
to the financial system. Governments may wish to implement fiscal policy with the aim of influencing
unemployment, for example. Such a policy may have effects on inflationary pressures which the central
bank wants to nullify.

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628 PART 12 Short-run economic fluctuations

Let us assume that the government reduces taxation to encourage more people to take jobs in the
economy or to increase spending through consumers having more disposable income. The IS curve would
shift to the right as shown in Figure 27.7 and national income and interest rates would rise. If the central
bank wants to keep interest rates constant, it must expand the money supply. By doing so, the LM curve
shifts to the right to LM1, national income would rise further than if the central bank had not acted, to Y2 ,
and the interest rate will remain at its initial level. If the bank had not altered the money supply, then the
effects of the reduction in tax would have been partially offset by a rise in interest rates, which would have
curbed spending.

Figure 27.7
Maintaining Interest Rates Constant LM
Interest
Following a Shift in the IS Curve rate
A shift in the IS curve to the right would,
LM1
without central bank action, lead to a rise in
the interest rate and in national income. If the
central bank wants to maintain the interest rate,
it must increase the money supply and shift the
ie
LM curve to the right. The result would be to
maintain the interest rate at ie , but the increase
in national income would be greater than if the
central bank had not acted.

IS1
IS
National income
Ye Y1 Y2

If government had increased taxes, then the IS curve would shift to the left and both national income
and interest rates would fall. If the central bank wants to keep interest rates constant it must reduce the
money supply, and the result would be that the fall in national income would be compounded. If the central
bank wanted to avoid this outcome, it could expand the money supply and interest rates would fall. This
would help to offset the shift in the IS curve and reduce the impact on national income.

From IS–LM To Aggregate Demand

It is a short step from using this model to the AD and AS model that we will use to analyze changes in the
M
economy later in the book. Remember that the supply of real money balances is given by . Assume the
P
average price of a unit of output in the economy is €10 and the money supply is €100. The supply of real
100
money balances is 5 10, that is, at the current price level the supply of money in the economy can
10
buy 10 units of output. If the average price of a unit of output in the economy rises to €20 and the money
100 
supply is constant, real money balances will fall to 5 units  5 5  . This fall in the supply of real money
 20 
balances shifts the LM curve to the left as shown in panel (a) of Figure 27.8. The result is that interest
rates rise and national income falls. There is, therefore, an inverse relationship between the price level and
national income. The AD curve is derived by plotting the relationship between national income and the
price level as shown in panel (b) of Figure 27.8. The AD curve slopes downwards from left to right because
of the inverse relationship between the price level and national income.

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 CHAPTER 27 KEYNESIAN ECONOMICS AND IS–LM ANALYSIS 629

Figure 27.8
Deriving the Aggregate Demand Curve
In panel (a) a rise in the price level reduces real money balances and shifts the LM curve to the left to LM1 . This leads to a rise in the
equilibrium interest rate to i1 and a fall in national income from Y0 to Y1 . The inverse relationship between the price level and national
income is plotted in panel (b). A rise in the price level from P0 to P1 leads to a fall in national income from Y0 to Y1 . The aggregate
demand curve slopes downwards from left to right.

1. A rise in the price

level reduces real
money balances and
shifts the LM curve to
Interest the left. Price
LM1
rate level
3. The aggregate
demand curve AD
shows the inverse
LM
relationship between
the price level and
national income.
i1 P1

i0 P0

IS AD

2. The shift in the LM Y1 Y0 National income Y1 Y0 National income

curve raises the
equilibrium interest (a) (b)
rate and lowers
national income.

Shifts in the Aggregate Demand Curve If we assume the price level remains constant, a change in
national income in the IS–LM model will result in a shift in the AD curve. Changes in both fiscal and mon-
etary policy, assuming a given constant price level, will cause the AD curve to shift. If the government
imposes an austerity package which seeks to cut government spending and raise taxes at a given price
level, the IS curve will shift to the left and national income will fall. At the given price level, AD in the econ-
omy will now be less and the AD curve will shift to the left as shown in panel (a) of Figure 27.9.
If the central bank expands the money supply (possibly through a programme of asset purchasing or
quantitative easing), the LM curve will shift to the right and national income will rise. At the given price
level, the AD curve will shift to the right showing a higher level of national income at the given price level
as shown in panel (b) of Figure 27.9.
A loosening of fiscal policy (increased government spending and/or lower taxes) and a reduction in the
money supply (a tightening of monetary policy) will have the opposite effects from those described in
Figure 27.9.

Criticisms of IS–LM, and the Romer Model

This short introduction to IS–LM analysis and the effect of changes in fiscal and monetary policy helps
to highlight a number of important issues that you may start to consider as your study of economics
moves to the next level. The effects of changes in fiscal and monetary policy are dependent on a number
of factors related to the slope of the IS and LM curves, their relative position, and how far each shifts in

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630 PART 12 Short-run economic fluctuations

response to changes in policy. It is entirely possible that a change in fiscal policy can be countered by a
change in monetary policy that leaves national income unchanged. The potential outcomes are many, and
economists try to pinpoint more accurately what changes in policy will mean for the economy as a whole.
This means conducting research to quantify such changes. The outcome of such research will be depend-
ent on the value of variables that economists input into their models and on the relative strength of factors
affecting the variables in the model.

Figure 27.9
Shifts in the Aggregate Demand Curve as a Result of Monetary and Fiscal Policy
Panel (a) represents a situation where the government tightens fiscal policy, which shifts the IS curve to the left and reduces national
income. At a given price level, the AD curve shifts to the left and a lower level of national income is associated with the given price level.
Panel (b) represents a situation where the central bank loosens monetary policy, which causes the LM curve to shift to the right and
lowers the interest rate. At the given price level, the AD curve shifts to the right with a higher level of national income.

Interest rate Price level

LM

i0
P0
i1

IS
IS1 AD1 AD

Y1 Y0 National income Y1 Y0 National income

(a)

LM
Interest rate Price level

LM1

i1

i0 P0

AD1
IS AD
Y0 Y1 National income Y0 Y1 National income
(b)

One example of how the model has developed is the role which microeconomic analysis plays in under-
standing the macroeconomy. Some economists argue that microeconomic principles cannot be divorced
from the macroeconomy. We have seen how changing economic conditions may lead to wages and prices

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 CHAPTER 27 KEYNESIAN ECONOMICS AND IS–LM ANALYSIS 631

adjusting at different rates and markets being slow to clear as a result. If national income falls, for exam-
ple, the assumption might be that prices and wages in the economy would also fall to help bring markets
back into equilibrium. Sticky wages and prices may lag behind the reduction in economic activity as firms
may be forced into trying to maintain cash flow rather than seeking to expand market share. As prices are
sticky, sales fall and firms cut back output, which further impacts on economic activity.
Professor Mankiw was one of the economists who helped to reconcile the idea of sticky prices and
menu costs with rational behaviour in his paper, ‘Small Menu Costs and Large Business Cycles: A Macro-
economic Model of Monopoly’, published in The Quarterly Journal of Economics in 1985. The debate over
IS–LM has continued and has generated large amounts of valuable and interesting research which has
helped build our understanding of the economy as a whole. It still has its critics, however.
Indeed, one such disagreement focuses on a central assumption of the model itself. Some higher edu-
cation institutions have questioned the value of teaching IS–LM at all, because they argue that the world
is now a very different place from the one Hicks knew back in the 1930s when he first developed Keynes’
ideas. One of the major criticisms is that central banks no longer control the money supply, but instead
set interest rates. Attempts to control the money supply have proved to be difficult and so targeting the
interest rate is seen as being a more viable option to achieving policy objectives.
We have seen how central banks set interest rates through open market operations. If the central bank
wishes to reduce interest rates, its traders will be instructed to buy bonds. Banks and financial institutions
who sell these bonds will receive funds in return which will effectively expand the money supply. This in
turn shifts the LM curve to the right and interest rates fall. If the central bank increases interest rates, the
opposite occurs; traders will be instructed to sell bonds and thus take funds out of the banking system,
reducing the money supply. The LM curve shifts to the left and interest rates rise.

The IS–MP Model One of Professor Mankiw’s close colleagues, David Romer (indeed they are more
than simply colleagues given that each was best man at the other’s wedding), has suggested an approach
termed the IS–MP model, which attempts to build on the IS–LM model to reflect how central banks and
the economy work today. The assumption in the model is that central banks adjust the money supply as
outlined above to generate the interest rate that they want. The interest rate is adjusted in accordance
with the inflation target that the central bank is working with or, as is the case with the Bank of England,
has been set by the government.
In the IS–LM model the money supply is assumed to be exogenous (determined by factors outside
the model). In the IS–MP model, the monetary policy reaction function is exogenous. Romer assumes
that when output rises, the central bank increases interest rates to dampen inflationary pressures; and
it reduces interest rates when output falls to maintain the price level at its target. National income is a
positive function of the interest rate, therefore. Romer plots this upwards sloping relationship as the MP
curve. The MP function is assumed to be exogenous, but in reality both the money supply and the MP
function can and do change in response to economic activity and events.
The MP function takes into account the fact that central banks now target inflation and set interest
rates to achieve this goal rather than simply assuming government (or a central bank) sets the money
supply and that interest rates adjust to balance this supply of money with the demand for money. Crucially,
Romer suggests that changes in inflation can cause a shift in the MP curve. If the central bank increases
interest rates, the money supply will fall, which will affect the price level and expectations on inflation.
Equally, if the central bank cuts interest rates the money supply will rise and expectations on inflation will
also change as a result.
It is at this point where the microeconomic element of the analysis takes on some importance. Expec-
tations of price changes may not match the reality because of the extent of price stickiness. If we assume
that prices are completely sticky (i.e. the price level is fixed), they will not change when the money supply
changes. Expectations on inflation will, therefore, be zero. If the money supply rises then the supply of
M
real money balances, , also rises and is greater than the demand for real money balances. As the money
P
market is now out of equilibrium, we might expect the interest rate to fall, but it could also be that the
level of income could rise, or a combination of the two might occur. There will be a movement along the
IS curve and a fall in interest rates will be accompanied by a rise in national income. This implies that the
central bank can directly control the real interest rate by adjusting money supply appropriately to achieve
the interest rate it desires.

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632 PART 12 Short-run economic fluctuations

If prices adjusted instantaneously then a change in the money supply would not affect the supply of real
M
money balances because the ratio would hold as before at the rate of interest and level of income; in
P
other words, the money market would remain in equilibrium. There would be no movement along the IS
curve and the central bank would not be able to affect the real interest rate.
In reality, prices are not fixed, but the speed with which prices adjust to changes in economic condi-
tions will vary – some will adjust relatively quickly, others will take much longer and will be sticky. These
sticky prices will influence the ratio of the money supply to the price level (the supply of real money bal-
ances) and so there may be some expectations of inflation which will exist in the economy because M will
rise by a greater proportion than P . An increase in the money supply will raise expected inflation and vice
versa. If prices are sticky, then an increase in the nominal money supply will cause the money market to
move out of equilibrium but expected inflation will affect the real interest rate. The nominal interest rate
may have to be higher as a result.
The extent to which prices are sticky, therefore, has an important influence on the way in which a cen-
tral bank can influence the interest rate to achieve its inflation targets. Such an analysis raises interesting
questions when interest rates are reduced as was the case in response to the Financial Crisis and the
global recession in 2007–9. The UK, Europe and the United States saw their central banks reducing inter-
est rates to historically low levels. To reduce interest rates, the central bank instructs its traders to buy
bonds and the money supply will rise. Increases in the money supply may be associated with an increase
in the price level; indeed, some economists expressed alarm at the scale of quantitative easing conducted
by central banks and predicted accelerating inflation. In times where economic activity is restrained, how-
ever, expectations of inflation may remain subdued and the money market may remain out of equilibrium
as a result. The reason is that at these low interest rates people are willing to hold a greater amount of real
money balances without any change in interest rate or output – after all, the interest rate cannot fall much
further. This is the liquidity trap and may imply that monetary policy can have little effect on stimulating
economic growth.

Self Test Draw diagrams to show the effect on interest rates and the level of national income of: (a)
a decision by the government to raise taxes to cut a public deficit; and (b) a decision by a central bank to
increase interest rates.

Keynesianism Post Crisis

The Financial Crisis of 2007–9 reignited the debate about the value of Keynesian demand management
policies. A number of countries introduced fiscal stimulus packages in the wake of the Financial Crisis.
This led to questions about the benefits of such packages and even whether they amount to a stimulus.
In late 2008 the EU announced a fiscal stimulus package of €200 billion. In the UK the Chancellor of the
Exchequer had to admit that government borrowing might reach £175 billion, and be 79 per cent of GDP
in 2013–14 (in the latter part of 2012 it stood at 73 per cent of GDP). In the United States the package was
reported to be $800 billion; meanwhile, China was reported to be injecting $585 billion and Japan $275
billion. Critics argued that such packages were not enough to bridge the output gap that had widened in
most economies. In the United States, for example, the gap between potential and actual GDP was esti-
mated by some economists at around $2 trillion. Other criticisms of fiscal stimulus packages suggested
that they were not really what they seemed to be, and if they were, then they would not bring the benefits
that were claimed for them because of crowding out.
For example, in a study of the EU stimulus package in February 2009, David Saha and Jakob von
Weizsäcker said, ‘It should be recognized that the likely real impact on aggregate demand in the near
future may well be more limited than suggested by the headline figures’ (aei.pitt.edu/10549/1/UPDATED-
SIZE-OF-STIMULUS-FINAL.pdf). In their analysis of the fiscal stimulus in Italy, announced as €80 billion,
Saha and Weizsäcker conclude that the stimulus was not a stimulus at all, but a fiscal tightening a­ mounting
to €0.3 billion. In parts of Europe there were concerns that any major fiscal stimulus package would put
pressure on the public debt and affect the stability of the euro, around which so much of the future pros-
perity of the EU lies.

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 CHAPTER 27 KEYNESIAN ECONOMICS AND IS–LM ANALYSIS 633

One of the concerns about any fiscal stimulus is the extent to which it creates real wealth. Govern-
ments may spend more money, but on what? If the money is spent on public works – the building of
new schools, hospitals, roads and so on, then surely this would boost AD? To an extent it would, but how
is this additional spending to be financed? To raise the money governments will either tax their citizens
more or increase borrowing. Additional spending on the construction of a new road may put money into
the pockets of construction companies and its workers, but to fund this the government must tax other
wealth producers, thus offsetting some of the benefits of the stimulus. If the spending goes on additional
benefits for those who become unemployed, then critics argue that the government is not contributing
to wealth creation; these individuals may be supported in times of hardship and may spend their benefits
on food and other goods, but they are not actually generating any wealth in return for the benefits they
receive. Indeed, Keynes himself acknowledged that there were limitations to stimulus packages. In an
article in The Times newspaper in the UK in 1937, a year after The General Theory was published, he wrote:
But I believe that we are approaching, or have reached, the point where there is not much advantage
in applying a further general stimulus at the centre … It follows that the later stages of recovery
require a different technique. To remedy the condition of the distressed areas ad hoc measures are
necessary. The Jarrow marchers were, so to speak, theoretically correct … We are in more need
today of a rightly distributed demand than of a greater aggregate demand.
Structural changes in the economy might require more long-term investment if improvements in unem-
ployment prospects and growth are to be achieved.
If governments must borrow more, then crowding out may emerge. In this scenario, the government is
competing with the private sector for funds. Since the supply of loanable funds is finite, if governments take
more of these funds it is argued that there will be less available for the private sector. If it is also assumed
that the private sector uses such investment funds more efficiently than the public sector, then not only do
fiscal stimulus packages crowd out private investment, they divert investment funds to less productive uses.

Krugman and Crowding In While this view is accepted by some economists, there are those that sug-
gest that extraordinary times call for extraordinary action. One such proponent of this view was Paul
Krugman. Krugman consistently argued that the depth of the Financial Crisis and global recession was
such that a fiscal stimulus was necessary to get out of a liquidity trap and would lead to ‘crowding in’. A
liquidity trap occurs when monetary policy is insufficient to generate the economic stimulus necessary to
get out of recession. In the United States and the UK, for example, interest rates were lowered by the Fed
and the Bank of England to near zero; the Bank of Japan’s key interest rate stood at 0.1 per cent in August
2009 while the ECB had rates at 1 per cent.
Krugman argued that private investment is a function of the state of the economy and, given the
depth of the global recession, investment had plummeted. Investment, therefore, in this situation, was
more responsive to product demand than to the rate of interest. If governments applied appropriate fiscal
stimuli, this would improve the state of the economy and thus encourage private sector investment. As
private sector investment increases, this improves productive potential and helps bring economies out of
recession. Far from crowding out, Krugman argued, the fiscal stimulus would lead to crowding in.
Critics of this view suggest that increased government spending will crowd out private investment to
an extent, and so any fiscal stimulus must take into account the loss of the benefits of that private invest-
ment in assessing the success of such a policy. The success of a stimulus package in putting economies
on a sounder footing and bringing benefits to future generations would be highly dependent on the type
of spending carried out by governments worldwide. Spending on new schools and transport infrastructure
may improve the future productive potential of the economy and tackle the structural problems that exist
in some economies as referred to above.
However, the issues of rent seeking and logrolling have to be taken into consideration. Rent seek-
ing occurs where decisions are made leading to resource allocation that maximizes the benefit to the
­decision-maker at the expense of another party or parties, and logrolling is where decisions may be made
on resource allocation to projects that have less importance, in return for the support of the interested
party in other decision-making areas. In both cases, it is argued that resource allocation is not as effi-
cient as that carried out by the private sector, and this must be taken into consideration in assessing the
­benefits of public sector spending as a result of any stimulus package.

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634 PART 12 Short-run economic fluctuations

Conclusion
There is still much debate on Keynesian approaches in macroeconomics in addition to the debate on the
value and relevance of the IS–LM model. What is not in much doubt is that an understanding of the rela-
tionship between the goods market and the money market is a useful way of developing a broader under-
standing of analyzing the economy as a whole. This short introduction to such analysis provides some
pointers to the IS–LM model and to some of the issues that economists are debating. Depending on the
university that you attend, a greater or lesser emphasis may be placed on the IS–LM model. Having some
awareness of the model does help to develop a focus on the important connections between the money
supply, interest rates and economic activity.

Summary
●● Keynes developed The General Theory as a response to the mass unemployment which existed in the 1930s.
●● He advocated governments intervene to boost demand through influencing aggregate demand.
●● The Keynesian cross diagram shows how the economy can be in equilibrium when E 5 Y .
●● This equilibrium may not be sufficient to deliver full employment output, and so the government can attempt to
boost demand to help achieve full employment.
●● John Hicks developed Keynes’ ideas in the form of the IS–LM model, which shows general equilibrium in the
economy.
●● The IS (investment–saving) curve shows all points of equilibrium in the goods market at a particular interest rate
and level of national income.
●● The LM (liquidity–money supply) curve shows points where the money market is in equilibrium at particular rates
of interest and level of national income.
●● General equilibrium occurs where the IS curve intersects the LM curve. At this interest rate and level of national
income, both the goods market and money market are in equilibrium.
●● Fiscal policy and monetary policy can cause shifts in the IS and LM curves bringing about new equilibrium
­positions. The outcome will depend on a variety of factors including the response of consumption and i­ nvestment
to changes in interest rates and the public’s response to holding monetary balances as a result of a change in
interest rates.
●● There have been criticisms that the IS–LM model does not represent the way monetary policy is conducted in
modern economies.
●● Economists have developed new models to incorporate the changes in policy.

In the News

Keynesianism
Keynesianism has been subject to much debate over the years. To what extent is the idea that demand management
in a period of economic stagnation a recipe for stimulating economic growth once again? The standard argument
is that in times of recession when unemployment is high and rising, government should step in, cut taxes and boost
its own spending to kick-start the economy and get it moving. It is often noted that the US President Franklin D.
Roosevelt’s administration was one of the first governments to try to boost aggregate demand via the New Deal.
However, as economic historian, Brian Domitrovic, argues, the policy did not bring down unemployment significantly
even after six years of the policy.

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 CHAPTER 27 KEYNESIAN ECONOMICS AND IS–LM ANALYSIS 635

Instead, Domitrovic argues that it was the Second World War that really laid to rest the spectre of the Great
Depression. Similarly, he notes that post-war recessions in the United States were partly solved by wars in Korea and
Vietnam. The reason is that governments can spend very large sums of money on military hardware, which generates
jobs and boosts aggregate demand. Is going to war the ultimate weapon of Keynesian demand management to solve
problems of sluggish economic growth and unemployment? Domitrovic argues that government spending on war can
be viewed as ‘a jobs programme’ and refers to this as a ‘Keynesian injustice’.
Other Keynesian injustices which Domitrovic argues exist include government spending programmes on welfare
programmes, housing, and social and health policies, all of which fail and leave an ‘underclass’ in society which gov-
ernment can claim are the architects of their own problems given the financial stimulus the government has provided.
‘Our problems would not exist if you did not throw up insuperable problems to your own success’, chides Domitrovic.
Keynesian injustice number three is the emphasis on aggregates which Domitrovic argues masks the credit
which should be given to entrepreneurs who succeed in business. Domitrovic cites Jean Baptiste Say’s definition
of entrepreneurs as ‘those people who see what people need before they themselves do, and get to work provid-
ing it’. Keynesian demand management with
its emphasis on ‘aggregates’ does not suffi-
ciently recognize the importance of the free
market and individual incentives in generating
economic growth. Domitrovic notes:
The great art critic Hilton Kramer once
said of Picasso, some years after his
death, that he was ‘the artist we will have
studied and lived with – and argued about
and, at times, even been a little sickened
by’. So may it be said of Keynes and his
movement that still dogs us as we try to
overcome the government soaked eco-
nomic sluggishness of the twenty first
century. John Maynard Keynes – highly revered by some, criticized by others.

Critical Thinking Questions

1 Domitrovic suggests that the New Deal did not solve the problem of unemployment in the pre-war United States
and that it was war that created jobs. What evidence is there to support this view?
2 Critique the argument that a cut in taxes and an increase in government spending can help kick-start the econ-
omy in a period of stagnant economic growth.
3 Do you agree that spending on welfare programmes is not an efficient way of attempting to boost aggregate
demand and economic growth?
4 Are Keynesianism and entrepreneurship incompatible? Explain.
5 Critically evaluate the view by Domitrovic on Keynesianism and his quote that the ‘movement still dogs us…’.
Reference: The Injustices of Keynesianism. Brian Domitrovic. www.forbes.com/sites/briandomitrovic/2018/05/15
/the-injustices-of-keynesianism/#48cf203e481e, accessed 17 January 2019.

Questions for Review

1 Distinguish between planned expenditure and actual expenditure.
2 Draw a Keynesian cross diagram to show the effects of a rise in autonomous expenditure on an economy operating
below full employment output.

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636 PART 12 Short-run economic fluctuations

3 What is meant by the terms: inflationary gap and deflationary gap?

4 What is the marginal propensity to consume?
5 Why does the MPC 1 MPS 5 1?
6 What is the multiplier? Can the multiplier be negative as well as positive? Explain.
7 Explain how the marginal propensity to withdraw affects the outcome of a rise in autonomous expenditure.
8 Use diagrams to describe how the IS and LM curves are derived.
9 Using the IS–LM model, explain the effect on the economy of a reduction in autonomous expenditure resulting from a
cut in public spending by the government.
10 A central bank wishes to reduce inflationary expectations by increasing interest rates. Use the IS–MP model to analyze
the effect on the economy of such a move.

Problems and Applications

1 What, according to Keynes, was the main reason why recessions and depressions occurred? As a result of identifying
this key reason, what did Keynes suggest was an appropriate policy repose?
2 Explain, using an appropriate diagram, how a deflationary gap can occur and how this gap can be eliminated.
3 Suppose economists observe that an increase in government spending of €10 billion raises the total demand for goods
and services by €30 billion.
a. If these economists ignore the possibility of crowding out, what would they estimate the MPC to be?
b. Now suppose economists allow for crowding out. Would their new estimate of the MPC be larger or smaller than
their initial one? Explain your answer.
4 Suppose the government reduces taxes by €2 billion, that there is no crowding out and that the MPC is 0.75.
a. What is the initial effect of the tax reduction on AD?
b. What additional effects follow this initial effect? What is the total effect of the tax cut on AD?
c. How does the total effect of this €2 billion tax cut compare to the total effect of a €2 billion increase in government
purchases? Why?
5 Assume the economy is in equilibrium. Analyze the effect of a cut in autonomous expenditure on economic activity and
the level of unemployment. You should use a diagram to help illustrate your answer.
6 What does the IS curve show? What does the LM curve show?
7 What determines the slope of the IS curve? What determines the slope of the LM curve? In relation to your answer to
these questions, explain why these determinants can be a source of disagreement among economists.
8 Use the IS–LM model to explain the following:
a. The government institutes significant cuts in public expenditure.
b. The central bank institutes an asset purchasing facility (quantitative easing) which expands the money supply by
€300 billion.
c. The central bank fears that inflationary pressures are rising and increases interest rates.
d. The government increases taxation to try to reduce a large budget deficit.
9 Assume that a period of deflation leads to a rise in the supply of real money balances. Explain the effect of this change
on the economy using the IS–LM model and then what effect it would have on AD and why.
10 Do you think that Keynes’ ideas still have some relevance today? Explain.

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