曼昆第10版讲义mankiw10e-irm-ch11

|CHAPTER11 AggregateDemandI:BuildingtheIS–LMModel

LectureNotes|

CHAPTER11

AggregateDemandI:BuildingtheIS–LMModel

NotestotheInstructor

ChapterSummary

Chapter11introducesstudentstotheIS–LMmodel.ThechapteristakenupprincipallywiththederivationoftheISandLMcurves,priortotheuseofthemodelinChapter12.

Comments

PresentationofIS–LMisgreatlyfacilitatedbythefactthatstudentshaveseenalloftheelementsalready.Thismakesitmucheasiertoteachthanwhenitistaughtpriortoalong-runmodel.TheamountoftimespentonthematerialinChapters11and12ispartlyamatteroftaste.ItprobablyrequiresthreelecturesataminimumtopresentbasicIS–LM(omittingdetaileddiscussionoftheGreatDepressionfromChapter12),althoughsomeinstructorsmightprefertospenduptosixlecturesonthismaterial.

WhenteachingtheIScurve,someinstructorsmayfindthatitispreferabletostartwiththeloanable-fundsderivationoftheIScurve.TheadvantageofthisapproachisthatitbuildsontheChapter3model:equilibriuminChapter3issummarizedby,whereisexogenous;theIScurveissimplygivenbyS(Y)=I(r),whereincomeisnowanendogenousvariable.TheKeynesiancrosscanthenbepresentedasaspecialcase.

UseoftheWebsite

ThemodelexercisesforChapter3canbeusedasanalternativewaytoderivetheIScurve.Studentscancalculateandgraphallofthe{r,Y}pairsconsistentwithgoods-marketequilibriumandalsoseehowchangesinexogenousvariablesshiftthiscurve.

Althoughthetextbookdoesnotspendalotoftimeonthemonetary/fiscalpolicydebate,thewebsitematerialcanbeusedtogothroughthestandardexercisesontherelativeefficacyofmonetaryandfiscalpolicyunderdifferentassumptionsontheparameters.

UseoftheEWebsite

UsetheEwebsitetodownloadannualdatafortheU.S.consumerpriceindexandthe1-yearand10-yearTreasuryyieldsoverthepast20years.ComputetherealinterestrateforeachoftheTreasuryyieldsbysubtractingCPIinflationfromeachyield.Discusshowrealinterestrateschangewithinflationintheshortruncomparedtowhatyouwouldexpectoverlongerperiodsoftime.

ChapterSupplements

Thischapterincludesthefollowingsupplements:

11-1 TheKeyFeaturesoftheIS–LMModel

11-2 Mr.KeynesandtheClassics:TheArtofModeling

11-3 TheIS–LMModel:ACriticalEvaluation

11-4 AdditionalReadings

LectureNotes

Introduction

Figure11-1

Wenowhaveabasicideaofhowtheeconomyfunctionsintheshortrun.Becauseintheshortrunpricesarenotcompletelyflexible,changesinaggregatedemandaffectoutput,notjustprices.Todevelopthisshort-runtheoryoftheeconomy,wemustnowconsideraggregatedemandandsupplyinmoredetail.ThischapterandthenextpresentamoredetailedanalysisofaggregatedemandbasedontheIS–LMmodel.ThismodelwasdevelopedbyJohnHicksinthe1930sasaninterpretationofJohnMaynardKeynes’sseminalwork,TheGeneralTheoryofEmployment,InterestandMoney,andisbasedonananalysisofequilibriuminthegoodsandmoneymarkets,supposingthatthepricelevelisfixed.WecaninterprettheIS–LMmodelintwodistinctways:first,asatheoryofGDPdetermination,supposingthatthepricelevelisfixed;second,asatheoryofaggregatedemandandsoaspartofanaggregatedemand–aggregatesupplymodel.

11-1 TheGoodsMarketandtheISCurve

ThebuildingblocksoftheIS–LMmodelarefamiliarfromearlieranalysis.TheISsideofthemodelsummarizesequilibriuminthegoodsmarketandisbasedpartlyontheclassicalmodelofChapter3;theLMsideofthemodelsummarizesequilibriuminthemoneymarketandsoisrelatedtotheanalysisofmoneyinChapter5.

Thebasicequationsummarizingequilibriuminthegoodsmarket,foraclosedeconomy,isfamiliar:

Y=C+I+G.

Asbefore,wesupposethat

C=C(Y–T)

I=I(r)

TheonlydifferencefromourearlieranalysisisthatwenolongersupposethatrealGDPisdeterminedonthesupplyside,sincethatistrueonlyinthelongrun.Butthisisfarfromaninnocuouschange.Previously,giventhatYwasfixedat,wewereabletousethismodeltodeterminetheequilibriuminterestrateintheeconomy.Now,therearedifferentcombinationsoftheinterestrateandthelevelofGDPthatareconsistentwithequilibrium.Writingequilibriumintermsoftheloansmarketgives

S(Y)=I(r).

Recallfromtheanalysisoftheclassicalmodelthat

Sp=Y–T–C

Sg=T–G

⇒S=Y–C(Y–T)–G.

Now,considerhowchangesinGDPchangesaving.AnincreaseinGDP(∆Y),fromthisequation,raisessavingdirectlyby∆YandlowersitbyanamountequaltoMPC×∆Y.Thus,thetotalchangeinsavingis

∆S=(1–MPC)∆Y>0.

Soanincreaseinincomeincreasestotalsaving,otherthingsbeingequal.Weknow,therefore,thatitdecreasestheinterestrate.Thus,wedrawtheconclusionthat,forequilibriumtoexistinthegoodsmarket,higherlevelsofGDPmustbeassociatedwithlowerinterestrates.

Wecantellthesamestoryanotherway.Supposethatinterestratesincrease.Thisdecreasesthelevelofinvestment.Inresponsetothisfallininvestmentdemand,firmsproducelessoutput.Nowrecallthecircularflow.Adecreaseinoutputleadsfirmstoemployfewerworkersandtousetheircapitallessintensively;hence,incomegoesdown.Inresponsetothedecreasedincome,householdsconsumeless.Thiseffectonconsumptionreinforcestheinitialeffect,sowegetthesameconclusion—higherinterestratesareassociatedwithloweroutputandviceversa.

WesummarizethisreasoningintermsoftheIScurve.Thisisdefinedas{r,Y}combinationssuchthatthegoodsmarket(equivalently,theloanable-fundsmarket)isinequilibrium.Thepreviousreasoningtellsusthatitslopesdownward.

TheKeynesianCross

AcommonmeansofderivingtheIScurve,basedonthesecondexplanationabove,isknownastheKeynesiancross.TheKeynesiancrossalsogivesusinsightsintohowfiscalpolicyaffectstheeconomy.Thekeyideaofthismodelisthatplannedexpendituremaydifferfromactualexpenditureiffirmsselllessormorethantheyanticipatedandsobuilduporrundowntheirinventory.Plannedexpenditureissimplytheamountthathouseholds,firms,andthegovernmentintendtospendongoodsandservices.Wewriteitas

PE=C+I+G.

Suppose,forthemoment,thattheinterestrateisfixedatrsothatthelevelofplannedinvestmentisexogenous[I(r)].Then,wecanwriteplannedexpenditureas

Figure11-2

Plannedexpenditureisthusanincreasingfunctionofincome.

Inequilibrium,plannedexpenditureequalsactualexpenditure,which,ofcourse,equalsGDP:

PE=Y.

WecangraphbothplannedandactualexpenditureagainstincometogettheKeynesiancrossdiagram.

Figure11-3

Theadjustmenttoequilibriumtakestheformofchangesininventory.Ifactualexpenditureexceedsplannedexpenditure,thismeansthatfirmsproducedtoomuch.Rememberthatinventoryinvestmentiscountedasexpenditure;itisasiffirmssellthegoodstothemselves.Actualexpenditureexceedsplannedexpenditurewhenfirmsaccumulateinventory.Inthiscircumstance,firmswouldcutbackontheirproduction,lesseningtheirinventoryaccumulationandsodecreasingactualexpenditure.Ananalogoussituationoccursifplannedexpenditureexceedsactualexpenditure.Inthiscase,firmsareunintentionallygettingridofinventory,givingthemanincentivetoincreaseproduction.Inpractice,wethinkthatthisadjustmenttakesplacerapidly,sowefocusuponthesituationwheretheeconomyisinequilibrium.

Figure11-4

Whathappensifplannedspendingincreases?Forexample,supposethatgovernmentspendingincreases.Thatwouldinducefirmstoproducemoreoutput.Recallingthecircularflow,thisimpliesthatworkersandownersoffirmsobtainmoreincomeandsoincreasetheirconsumption.Plannedspendingand,ultimately,outputgoupbymorethantheoriginalincrease

Figure11-5

ingovernmentspending.Toputitanotherway,governmentspendinghasamultipliereffectonoutputthroughthegovernment-purchasesmultiplier.

Whatistheeconomicsbehindthisprocess?Theanswercanbefoundinthecircularflowofincome.Anincreaseingovernmentpurchases(say,∆G=$1billion)directlyincreasesGDPbythesameamount.Firmshireworkerstoproducethisextraoutput,sowagesandprofits,henceincome,risebyanequalamount.ThisinducesextraconsumptionequaltoMPC×∆G(forexample,ifMPC=0.75,thenconsumptionincreasesby$750million).Thus,expenditures,whichoriginallyroseby∆G,nowriseby(1+MPC)∆G=$1.75billion.

Thestorydoesnotstophere.Sincethisadditionalconsumptionagainincreasesincome,consumptionrisesevenfurther,byanamountequaltoMPC×(MPC×∆G).Inthisexample,consumptionincreasesbyanadditional$563million.Andtheprocesscontinues.TheultimateincreaseinGDPisgivenby

∆Y=(1+MPC+MPC2+MPC3+...)∆G

=[1/(1–MPC)]∆G

⇒∆Y/∆G=1/(1–MPC).

Themultiplierhasacoupleofinterpretations—onebenign,theotherlessso.Fromoneperspective,wecanthinkaboutthemultiplierastellingusthatwehavethepowertousefiscalpolicytoaffecttheeconomydramaticallyintheshortrun.Thissuggeststhatfiscalpolicymightbeapotenttoolforstimulatingtheeconomyinarecession,forexample.ButanotherimplicationisthatfluctuationsinspendinghavemagnifiedeffectsonGDP.Thereasoningthatwehavejustconsideredwouldapplyequallywelliftheinitialchangewereanexogenousshocktoplannedinvestmentorconsumption.KeynessuggestedthatfluctuationsinGDPmightbecausedbyinitialfluctuationsininvestmentduetothecapriciousbehaviorofinvestors(whichhecalledtheiranimalspirits).

Figure11-6

JustasincreasesinspendingincreaseGDP,sodocutsintaxes.Themechanismissimilar:taxcutsincreasedisposableincomeandhencestimulateconsumption.Theonlydifferencecomesfromthefactthatataxcutof∆TincreasesconsumptioninitiallybyMPC×∆T.Thus,thetaxmultiplierequalsthegovernment-purchasesmultipliermultipliedby–MPC:

∆Y/∆T=–MPC/(1–MPC).

CaseStudy:CuttingTaxestoStimulatetheEconomy:

TheKennedyandBushTaxCuts

CutsinpersonalandcorporateincometaxeswereusedbyPresidentKennedytostimulatetheeconomyin1964,ontheadviceofhisCouncilofEconomicAdvisers.Theeconomygrewrapidlyinthewakeofthesecuts.Keynesianeconomiststhinkthatthisexperiencesupportstheidea,embodiedintheKeynesiancrossmodel,thattaxcutsstimulateaggregatedemandandboosttheeconomy.Taxcutsmayalsoincreasepeople’sincentivetosupplylabor,thusincreasingtheaggregatesupplyofgoodsandservices.

WhenGeorgeW.Bushproposedtaxcutsduringhiscampaignin2000,theeconomywasnearfullemployment,andsomeeconomistswereconcernedthatataxcutmightraiseaggregatedemandandspurinflation.ButcandidateBush’sadvisersarguedthatreductionsinmarginaltaxrateswouldincreaselaborsupplyandthusincreaseaggregatesupply.Aftertheelection,astheeconomybegantoweaken,PresidentBush’sadvisersbegantoutingthetax-cutproposalasawaytostimulatespendingandthusincreaseaggregatedemand.ThetaxcutthatfinallypassedinMay2001includeda“rebate”mailedtotaxpayersthatwasintendedtospeedupthestimulustotheeconomy.Asubsequenttaxcutin2003furtherstimulatedtheeconomy,turningarelativelyweakrecoveryintoamorerobustone.

CaseStudy:

IncreasingGovernmentPurchasestoStimulatetheEconomy:

TheObamaStimulus

PresidentObama’sstimulusplanfortheeconomywaspassedbyCongressandsignedintolawinFebruary2009.Theplan,whichtotalednearly$800billioninspendingandtaxcuts,representedaclassicKeynesian-styleresponsetotheworseningrecession.Economistsdebatedtheplan,inparticulartherelativelyheavieremphasisonspendingasopposedtotaxreductions.Injustifyingtheplan’slargerspendingcomponent,Obamaadministrationeconomistsarguedthatthemultiplierforgovernmentpurchaseswasabout50percentgreaterthanthemultiplierfortaxcuts.Someeconomistscriticizedtheplanasbeingtoosmall,giventhemagnitudeoftherecession.Theyarguedthatthestimulusspendingneededtobemuchlargerifitweretooffsettherecession.Othereconomists,however,doubtedwhethermoneyallocatedforspendingoninfrastructurewouldhaveimmediateeffectsontheeconomy.Theywereconcernedthatmuchofthespendingwouldnotoccurinthefirstyearandthattherecessioncouldwellbeoverbythen.Theseeconomistsgenerallyfavoredgreateremphasisontaxcutsthatmighthavemoreimmediateeffectsonhouseholds’incomeandthusspending.Theeconomyfinallydidrecoverfromtherecession,butmuchmoreslowlythantheObamaadministrationhadforecast.Whetherthisrepresentedafailureofthestimuluspolicyorsimplyarecessionmoreseverethaneconomistsinitiallybelievedremainsaquestionofdebate.

CaseStudy:UsingRegionalDatatoEstimateMultipliers

Keynesiantheorysuggeststhatchangesintaxesandgovernmentspendinghaveimportanteffectsonincomeandoutputfortheeconomy.Butinpractice,measuringtheeffectsontheeconomyfromfiscalpolicyisdifficultbecausethereisnosimplewaytocontrolforothereventsthatarealsoaffectingtheeconomy.Forexample,fiscalstimulusisoftenadoptedinresponsetoaweakeconomy,soitisdifficulttoseparatetheeffectsofstimulusfromtheeffectsofprolongedfalloutfromarecession.Recentstudieshaveattemptedtoaddressthisproblembyusingdatafromstatesorprovinceswithinacountry.Someregionalvariationingovernmentspendingisunrelatedtoothereventsaffectingregionaleconomies,allowingtheeconomicimpactofgovernmentspendingtobemorepreciselymeasured.

OnestudyconsidersvariationinU.S.federaldefensespendingatthestatelevelandcomputesitsimpactonstateGDP.AnotherstudyconsidersvariationinpublicinvestmentspendinginItalianprovincesasaresultofcrackdownsonorganizedcrime(investmentfallstemporarilyfollowingcrackdowns)andassessestheeffectonprovince-levelGDP.Bothstudiesfindgovernmentspendingmultipliersofabout1.5.

Theseestimatesmayoverstatethetruesizeofnationalgovernmentspendingmultipliersbecausethisspendingisfinancedwithtaxesatthenational,notregional,level,andsuchtaxeswoulddampenthestimuluseffects.Also,thenationalmultipliermaybesmallerbecausecentralbanksrespondtonationalratherthanregionalconditionsandmayoffsetsomeofthestimulusfromgovernmentspendingbyraisinginterestrates.Onefeature,however,thatwouldimplyalargernationalmultiplierisleakageofspendingintoimportsofgoodsandservices.Forastateorregion,importsfromotherstatesandregionsareamuchhigherpercentageofGDPthanareimportsfromabroadforanationasawhole.Leakageintoimportsreducesthemarginalpropensitytospendonregionallyproducedgoodsandservicesandtherebyreducesthesizeofthemultiplier.

TheInterestRate,Investment,andtheISCurve

Figure11-7

ThetransitionfromtheKeynesiancrossmodeltotheIScurveisachievedbynotingthatplannedinvestmentchangesiftherealinterestratechanges.TheKeynesiancrossanalysistellsusthatchangesinplannedinvestmentchangeGDP.Forexample,ifinterestratesincrease,plannedinvestmentfalls,andsodoesoutput.Thus,higherlevelsoftheinterestrateareassociatedwithlowerlevelsofoutput.

HowFiscalPolicyShiftstheISCurve

Figure11-8

ThepositionoftheIScurvedependsonfiscal-policyvariables.Increasesingovernmentspendingordecreasesintaxesincreasetheequilibriumlevelofoutputatanygiveninterestrate.ThustheyareassociatedwithoutwardshiftsintheIScurve.

11-2 TheMoneyMarketandtheLMCurve

TheTheoryofLiquidityPreference

Tounderstandthedeterminationofinterestrates,weturntothemoneymarket.Again,ourbuildingblocksarefamiliarfromtheclassicalmodel.Ourstartingpointistheconditionforequilibriuminthemoneymarket:

M/P=L(i,Y).

Accordingtothisequation,thedemandforrealbalancesequalstherealsupplyofmoneyM/P.Thedemandforrealbalances,asexplainedinChapter4,dependsonthelevelofGDPandthenominalinterestrate;thisisknownasthetheoryofliquiditypreference.Therealsupplyofmoneydependsonthenominalmoneysupply,whichisanexogenouspolicyvariable,andthepricelevel,whichisalsotakentobeexogenousintheIS–LMmodel.

RecallfromtheFisherequationthatthenominalinterestrateequalstherealinterestrateplustheexpectedinflationrate.Ifexpectedinflationiszero,i=r.Forsimplicity,wesupposeforthemomentthatthisisthecase,sowecanwrite

M/P=L(r,Y).

WereintroduceexpectedinflationinChapter12.

Figure11-9

JustastheIScurvegivesus{r,Y}combinationsconsistentwithequilibriuminthegoodsmarket,theLMcurvegivesus{r,Y}combinationsconsistentwithequilibriuminthemoneymarket.Toseehowthisworks,consideradiagramofthemarketformoney.NoticethatthedemandformoneyisafunctionofrandY.Increasesinrdecreasethedemandformoney;increasesinYincreasethedemandformoney.Thesupplyofanddemandformoneydeterminetheequilibriuminterestrate.Changesinthemoneysupplythereforeaffecttheequilibriuminterestrate.

CaseStudy:DoesaMonetaryTighteningRaiseorLowerInterestRates?

Figure11-10

Intheearly1980s,PaulVolcker,thechairoftheFederalReserve,slowedtherateofmoneygrowthinasuccessfulattempttodecreaseinflation.TheFisherequationteachesusthatlowerinflationtendstoreducenominalinterestratesinthelongrun.Ouranalysisofthemoneymarketrevealsthatwhenpricesaresticky,anti-inflationarymonetarypolicyreducesrealmoneybalancesandincreasesinterestratesintheshortrun.Botheffectsarevisibleinthe1980sdata.

Income,MoneyDemand,andtheLMCurve

Figure11-11

ThebasicanalysisoftheLMcurveisnowstraightforward.HigherGDPraisesthedemandformoney.Iftherealsupplyofmoneyisfixed,theninterestratesmustrisetobringthedemandformoneybackinlinewiththesupply.SohigherGDPisassociatedwithhigherinterestrateswhenthemoneymarketisinequilibrium.TheLMcurveslopesupward.

HowMonetaryPolicyShiftstheLMCurve

Figure11-12

ThepositionoftheLMcurvedependsontherealmoneysupply.AnincreaseintherealmoneysupplyforagivenlevelofGDPimplieslowerinterestrates.AnincreaseinthemoneysupplythusshiftstheLMcurvedownwardandconversely.

11-3 Conclusion:TheShort-RunEquilibrium

Figure11-13

Figure11-14

Supplement11-1,“TheKeyFeaturesoftheIS–LMModel”

Supplement11-2,“Mr.KeynesandtheClassics:TheArtofModeling”

Supplement11-3,“TheIS–LMModel:ACriticalEvaluation”

Finally,wecanputtogethertheISandLMcurvesandfindtheone{r,Y}combinationthatisconsistentwithequilibriuminboththegoodsandthemoneymarkets.SincepointsontheIScurveareconsistentwithequilibriuminthegoodsmarketandpointsontheLMcurveareconsistentwithequilibriuminthemoneymarket,thepointwherethetwocurvesintersectgivestheonecombinationoftherealinterestrateandGDPforwhichbothmarketsareinequilibrium.

Ifusedcarefully,IS–LMisasimplebutpowerfulmodelforunderstandingtheshort-runbehavioroftheeconomy;itisamodelthathelpsmanyeconomistsanswermacroeconomicquestions.Wemakemuchuseofitfromhereon.

ADDITIONALCASESTUDY

11-2 Mr.KeynesandtheClassics:TheArtofModeling

KeynesianeconomicswasbornwiththepublicationofTheGeneralTheoryofEmployment,InterestandMoney,byJohnMaynardKeynes.Intermsofitsimpactonthediscipline,thiswassurelyoneofthemostimportantbooksinthehistoryofeconomics.Yetforthemodernstudentofeconomics,itmakesfordifficultreading.Apparently,thiswasalsotrueforcontemporaryreaders:“ItwillbeadmittedbytheleastcharitablereaderthattheentertainmentvalueofMr.Keynes’sGeneralTheoryofEmploymentisconsiderablyenhancedbyitsatiricaspect.ButitisalsoclearthatmanyreadershavebeenleftverybewilderedbythisDunciad.”J.R.Hicks,“Mr.KeynesandtheClassics,”Econometrica5,no.2(April1937),reprintedinJ.Hicks,CriticalEssaysinMonetaryTheory(Oxford:OxfordUniversityPress,1967),126–42.

OnereasonwhyKeynes’sworkhadsuchimpactwasthattheNobelprize–winningeconomistJohnHicksfoundawaytotranslateKeynes’sideasintoasimpleandeasilyunderstooddiagram:theIS–LMmodel.IfKeynes’sbookwasoneofthemostinfluentialinthehistoryofeconomics,thenHicksmusttakemuchofthecredit.Compare,forexample,thefollowing:

Nowiftheinvestment-demandscheduleshifts,…incomewill,ingeneral,shiftalso.Buttheabove[saving/investment]diagramdoesnotcontainenoughdatatotelluswhatitsnewvaluewillbe;and,therefore,notknowingwhichistheappropriate[saving]curve,wedonotknowatwhatpointthenewinvestment-demandschedulewillcutit.If,however,weintroducethestateofliquidity-preferenceandthequantityofmoneyandthesebetweenthemtellusthattherateofinterestisr2,thenthewholepositionbecomesdeterminate….Thusthe[investment]curveandthe[saving]curvestellusnothingabouttherateofinterest.Theyonlytelluswhatincomewillbe,iffromsomeothersourcewecansaywhattherateofinterestis.J.M.Keynes,TheGeneralTheoryofEmployment,InterestandMoney(London:Macmillan,1936),181.

ThecurveIScanthereforebedrawnshowingtherelationbetweenincomeandinterestwhichmustbemaintainedinordertomakesavingequaltoinvestment.Hicks,CriticalEssaysinMonetaryTheory,135.

ItisatributetoHicks’smodelingskillsthatIS–LManalysissurvivestothisdayintextbooksandinjournalarticles.IthasbecomesuchastandardtoolthatwritersusuallydonotevenbothertociteHickswhenusingit.AndwhereassomecriticizethemodelandothersclaimthatitmisrepresentsKeynes’swork,itseemslikelytoendureasausefultoolforshort-runmacroeconomicanalysis.Hickscannothavesuspectedhisunderstatementwhenhewrotethat“inordertoelucidatetherelationbetweenMr.Keynesandthe‘Classics,’wehaveinventedalittleapparatus.Itdoesnotappearthatwehaveexhaustedtheusesofthatapparatus.”Ibid.,135.

ADVANCEDTOPIC

11-3 TheIS–LMModel:ACriticalEvaluation

TheIS–LMmodeloccupiesacuriouspositioninmodernmacroeconomics.Ithasbeenattheheartofmuchmacroeconomictheoryandpolicyfromitsinventionin1936tothepresent.Professionalmacroeconomistsinbusiness,government,andacademiautilizethemodeltohelpthemunderstandtheworld.Yet,atthesametime,manyprofessionaleconomists—particularlyacademics—havebecomeincreasinglyskepticalofitsusefulness.CriticsofIS–LMarguethatthemodelisflawedbecauseitisinherentlystatic,lacksmicroeconomicunderpinnings,anddoesnotprovideanadequatetreatmentofexpectations.Onesuchcritic,RobertKing,concludesthat“theIS–LMmodelhasnogreaterprospectofbeingaviableanalyticalvehicleformacroeconomicsinthe1990sthantheFordPintohasofbeingasporty,reliablecarforthe1990s.”R.King,“WilltheNewKeynesianMacroeconomistsResurrecttheIS–LMModel?”JournalofEconomicPerspectives7(Winter1993):67–82.

TheIS–LMmodelisstaticbecauseitmakesnoattempttoexplainthebehavioroftheeconomyovertime.Rather,themodelyieldsvaluesofcertainendogenousvariablesatapointintime,giventhevaluesofotherexogenouslyspecifiedvariables.InthesimpleIS–LMmodel,thereisnoattempttoanalyzehowtheendogenousvariablesevolveovertime,despitethatmanyoftheunderlyingrelationshipsinthemodelaremeanttocapturedecisionswithanexplicittimedimension.Forexample,theconsumptionfunctionismeanttoreflecttheconsumption–savingchoicesofhouseholds,andtheinvestmentfunctionisbasedonfirms’decisionstoundertakecurrentexpendituresintheanticipationoffuturebenefits.

OnewaytointroducedynamicsintoanIS–LMmodelistomakepriceadjustmentendogenous.MuchKeynesianmodelinginthe1960sand1970stookthisapproach.Theideawastoexplaintheadjustmentofwagesandpricesovertimebasedonsupplyanddemandinthelaborandgoodsmarkets.Forexample,ifoutputisaboveitsnaturalrate,thenunemploymentwillbebelowitsnaturalrate.Strongdemandforgoodsandlaborwouldthencausewagesandpricestorise.Inthissetting,theIS–LMmodelexplainsoutputatapointintime,giventhepricelevel,whilethespecificationofpriceadjustmentexplainshowpriceschange,givenpastvaluesofoutput.Suchanapproachwillbesuccessfulonlyifwecanadequatelycapturethecomplexitiesofpriceandwageadjustmentbysimple,adhocpriceandwageequations.Andthat,inturn,bringsusbacktothequestionofmicroeconomicunderpinnings.

ThesearchforsolidmicroeconomicfoundationsfortheIS–LMmodelhasbeengoingonsincetheearlydaysofKeynesianeconomics.Researchersinthe1950sand1960sprovidedmicroeconomicjustificationfortheconsumptionfunction,theinvestmentfunction,andthemoneydemandfunctionthatareusedintheIS–LMmodel.(MuchofthisworkisexplainedinPartVofthetextbook.)Morerecently,researchershaveanalyzedhowfirmssetpricesandwagesandhavethusdevelopedmuchbettermicrofoundationsforwageandpricestickiness(seeChapter14ofthetextbook).Asthisworkprogressed,however,itbecameevidentthatexpectationshaveacriticalinfluenceontheeconomy:anindividual’sdecisiononhowmuchtoconsumeandhowmuchtosavedependsonwhatheexpectshisfutureincometobe;afirm’sinvestmentdecisionsdependonexpectationsoffuturesales.Likewise,theprice-andwage-settingdecisionsoffirmsandworkersdependonexpectationsoffutureinflationandothervariables.

BecausetheIS–LMmodelisstatic,anticipationsoffutureeventscannotbehandledendogenously.Rather,theIS–LMmodeltreatsshiftsinexpectationsasexogenous.Iffirmsanticipatestrongdemandandsoincreaseinvestment,orifrisingconsumerconfidenceleadstoincreasedconsumption,thisshowsupintheIS–LMmodelasanexogenousoutward