The Keynesian macroeconomic approach has many advantage over the new-Keynesian-micro- foundation approach; Simplicity: graphical presentation always simple compared with the numerical analysis in the microanalysis. The micro-analysis are useless in understanding some macro phenomena such as the demand for money. In contrast the micro foundation of the the macroeconomic analysis has many advantages over the traditional Keynesian analysis; Welfare analysis is not possible in the macro- analysis. Intertemporal utility analysis Testing the Recardian Equivalence notion.
The main distinction of the Keynesian model compared to the classical model and to some extent, the new Keynesian models is the rigidity of wages. Classical assumed that prices and wages are flexible, so market clears at any monetary shocks. Keynes assumed rigidity so monetary shocks reduce real income, enlarge the mark-up, high employment and output, so monetary expansion affect real output. Using the IS-LM model; the AD curve is driven at different levels of prices. The AS curve is vertical in the classical model (Why?), while it is positive function of price level in the Keynesian model.
The LM curve represents different combinations of output and interest rates that lead to equilibrium in the money market(i.e. M d = M s ) for a given price level. M d = f(P,i,Y)………thus the demand for real assets; M d /P = f(i,Y)………F i 0 i Y M SPECULATIVE M TRANSACTIO N LM Since f(.)is negative in i and positive in transaction, then in Y, the first derivative w.r.t Y is positive in the i,Y space. As any monetary model, it assumes that financial assets available are perfect substitute.
THE IS CURVE SHOWS THE OUTPUT-INTEREST RATE COMBNATIONS SUCH THAT PLANNED AND ACTUAL EXPENDITURES ON OUTPUT ARE EQUAL I Y S i IS 45 O E=E(Y, i - e, G, T) where: 0 0, E T <0 In equilibrium; E=Y this depict the famous Keynesian cross(?) thus Y=E(Y, i - e, G, T) For any increase in interest rates planned expenditure fall and then income fall to the level where actual and planned expenditures are equal. Thus the IS curve slopes down
At the intersection of the IS-LM curves market clears for a given P, e and G. Derivation of AD Curve i y IS P=1P=1 P =p* LM(i,y) LM ` (i,y) AD y P AD ` Relaxing constancy of P; when P increases demand for money increases to restore Real Balance M d /P. So interest rates increase reduces investment and market clears at a lower Y. While monetary policy shocks (P changes) moving along AD curve, Fiscal policy shifts AD curve; when G increased, AD shifts rightward
The impact of aggregate demand changes on output and/or price level depend on aggregate supply curve AS: Inelastic supply curve implies only price level changes ( as the classical assumed) and vice a visa that implies incomplete adjustment of nominal prices introduces a new channel through which shocks affect output. Nominal stickiness in prices are frequently common in the short-term, thus changes in demand at a given price level affects output.
Classical Macroeconomics: (1) Equilibrium P Y P* Y* AS AD Y Y* r IS r* L L* W/P Ls LdLd (W*/P*) L* L Y Y=f(L) LM
Classical Macroeconomics: (2) Monetary Policy P Y P1P1 Y* AS AD 1 Y Y* r IS r* L L* W/P Ls LdLd (W*/P*) L* L Y Y=f(L) P2P2 AD 2 LM 1 LM 2 Y1Y1
Classical Macroeconomics: (3) Fiscal Policy P Y P1P1 Y* AS AD 1 Y Y* r IS 1 r* L L* W/P Ls LdLd (W*/P*) L* L Y Y=f(L) P2P2 AD 2 LM 1 LM 2 Y1Y1 IS 2
Keynesian Macroeconomics: (1) Aggregate Supply Ls LdLd W/P P P Y Y LdLd Ls AS AS ` W/P 1 W/P 3 W/P 2 P1P1 P2P2 P3P3 Y1Y1 Y2Y2 Y3Y3 L1L1 L2L2 L3L3 L* W`< WW`< W W`/P 1 W`/P2 W`/P3 L` 1 L` 2 L` 3 L`*
Keynesian Macroeconomics: (2) Equilibrium P Y PkPk YkYk AS AD Y YkYk r IS rkrk L LkLk W/P LdLd (W/P k ) LkLk L Y Y=f(L) LM
Keynesian Macroeconomics: (3) Monetary Policy P Y P1P1 Y1Y1 AS AD 1 Y Y1Y1 r IS r1r1 L LkLk W/P LdLd W/P 2 W/P 1 L1L1 L Y Y=f(L) LM 1 AD 2 Y2Y2 P2P2 LM 2 LM ` 1 Y2Y2 Y`1Y`1 L2L2 Y1Y1 Y2Y2
Keynesian Macroeconomics: (4) Fiscal Policy P Y P1P1 Y1Y1 AS AD 1 Y Y1Y1 r IS 1 r1r1 L L1L1 W/P LdLd W/P 2 W/P 1 L1L1 L Y Y=f(L) LM 2 AD 2 Y2Y2 P2P2 LM 1 Y2Y2 Y`1Y`1 L2L2 Y1Y1 Y2Y2 IS 2 L2L2 Y`1Y`1 r2r2
Keynesian Macroeconomics: (5) A fall in the money wage P Y P2P2 Y1Y1 AS(W) AD Y Y1Y1 r r1r1 L L1L1 W/P LdLd W ` /P 2 W ` /P 1 L1L1 L Y Y=f(L) LM(P 1 ) Y2Y2 P1P1 Y2Y2 L2L2 Y1Y1 Y2Y2 IS 1 L2L2 r2r2 AS(W ` ) LM(P 2 )
The Open Economy Extension In the IS-LM model, aggregate demand is a function of the real exchange rate, disposal income, and the real interest rate; D(EP*/P,Y - T,R - e ) = C(Y - T, R - e ) + G + CA(EP*/P,Y- T, R - e ) To find the IS curve of R and Y combinations s.t. the aggregate demand equals the output, the G term dropped for simplicity; solving for E using UIP condition; R=R* +(E-E e )/ E E = Ee Ee /(1+R-R* ) Where expected inflation is a function of actual output and full employment output, then e = e (Y-Y f )
Under the above assumptions, the goods market equilibrium exist when; Y= D[EP*/P,(1+R-R*),Y - T,R - e (Y-Y f )] The above equation indicates that a fall in nominal interest rate raises aggregate demand through two channels; (1) Given the expected exchange rate fall, foreign absorption increases (2) interest rate fall improves consumption and investment. In closed economy, only the second channel may affect total spending.
The open economy model need assumptions related to exchange rate regime and interest rate determinations; The Mundell-Fleming Model Also assume perfect capital mobility, thus i =i* Y=E(Y, i* - e, G, T, P*/P) M/P=L(i*, Y) Y LM IS = Assuming fixed exchange rate regime, thus = IS shifts( due to G increases ) would increase output at a given price level. Vertical LM curve implies that IS shifts( due to G increases ) has no effect on output and reflected entirely on exchange rate