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3.3.3 The complete model and the role of fiscal and monetary policy

Equilibrium in both the goods and money markets is simultaneously attained

where the IS and LM curves intersect, that is, at reYe in Figure 3.2. Two points

are worth emphasizing. First, the intersection of the two curves in Figure 3.2

represents the only value of the rate of interest and income which is consistent

with equilibrium in both markets. Second, if the level of income is below

that of full employment, then both fiscal and monetary policy have a potentially

important role to play in stabilizing the economy. We now briefly

review what determines the relative effectiveness of fiscal and monetary

policy in influencing aggregate demand and therefore the level of output and

employment.

In Figure 3.3, the economy is initially in equilibrium at r0Y0 (the intersection

of IS0 and LM) at less than full employment. Expansionary fiscal policy

(for example, an increase in government expenditure) shifts the IS curve

outwards to the right, from IS0 to IS1, and results in an increase in both the

equilibrium rate of interest (from r0 to r1) and the equilibrium level of income

(from Y0 to Y1). As spending and income increase, the transactions and precautionary

demand for money increase, which, with a fixed money supply,

results in an increase in the rate of interest. The rise in the rate of interest in

turn leads to a reduction in private sector investment spending, the extent of

which depends on the interest elasticity of investment. Readers should verify

Figure 3.3 Expansionary fiscal policy

for themselves that fiscal policy will be more effective in influencing aggregate

demand and therefore the level of output and employment (i) the more

interest-elastic is the demand for money; that is, the flatter is the LM curve,

and (ii) the less interest-elastic is investment; that is, the steeper is the IS

curve. In the limiting cases of (i) a vertical LM curve (classical range) fiscal

expansion will have no effect on income, as the rise in the rate of interest will

reduce private investment by an amount identical to the increase in government

expenditure; that is, complete (100 per cent) crowding out or the so-called

‘Treasury View’; and (ii) a horizontal LM curve (liquidity trap) fiscal expansion

will result in the full multiplier effect of the simple Keynesian 45° or

cross model.

In Figure 3.4, the economy is again initially in equilibrium at r0Y0 (the

intersection of LM0 and IS) at less than full employment. Expansionary

monetary policy shifts the LM curve downwards to the right, from LM0 to

LM1, and results in a fall in the equilibrium rate of interest (from r0 to r1) and

an increase in the equilibrium level of income (from Y0 to Y1). Within the

orthodox Keynesian transmission mechanism the strength of monetary policy

depends on (i) the degree to which the rate of interest falls following an

increase in the money supply; (ii) the degree to which investment responds to

a fall in the rate of interest; and (iii) the size of the multiplier. Readers should

verify for themselves that monetary policy will be more effective in influenc108

Figure 3.4 Expansionary monetary policy

ing aggregate demand and therefore the level of output and employment (i)

the more interest-inelastic is the demand for money; that is, the steeper is the

LM curve, and (ii) the more interest-elastic is investment; that is, the flatter is

the IS curve. In the limiting (extreme Keynesian) cases of either (i) a horizontal

LM curve (liquidity trap) or (ii) a vertical IS curve (that is, where investment

is completely interest-inelastic) the transmission mechanism breaks down

and monetary policy will have no effect on the level of income.

From the above discussion it should be evident that, while both fiscal and

monetary policy can, in normal circumstances, be used to influence the level

of output and employment, the relative effectiveness of these two policy

instruments depends on the structural parameters of the model, that is, the

relative slopes of the IS and LM curves. Within the orthodox Keynesian

approach, the demand for money has traditionally been viewed as being

highly responsive to changes in the rate of interest (generating a relatively flat

LM curve), while investment has been taken as being fairly unresponsive to

changes in the rate of interest (generating a relatively steep IS curve). Indeed,

there was early empirical support for orthodox Keynesianism associated with

the elasticities of the IS and LM curves, with Klein referring to its ‘solid

empirical basis’ (see Klein, 1968, pp. 65–6, pp. 71–2) – a basis, we hasten to

add, which became increasingly questionable in the early 1960s. In these

circumstances disturbances from the real side of the economy (that is,

stochastic shifts in the IS curve) tend to dominate changes in income. Furthermore,

fiscal policy is generally preferred as it is relatively powerful,

while monetary policy is relatively weak. At this point the reader should note

that by the end of the 1950s the belief in the efficacy of fiscal policy relative

to monetary policy was much stronger among British as compared to American

Keynesians.

This analysis can also be summarized in algebraic terms. In what follows it

is assumed that the price level is fixed when the economy is at less than full

employment. Aggregate real expenditure (E) is equal to an autonomous component

(A), a component dependent on real income (cY) and an interest-sensitive

component (ar).

E A cY −ar (3.1)

Equilibrium in the goods market occurs where the aggregate demand for and

aggregate supply of goods are equal.

E Y (3.2)

Turning to the money market, the demand for real money balances (M/P) has

a component dependent on real income (mY) and an interest-sensitive component

(br).

M

P

mY −br (3.3)

The supply of nominal money balances is assumed to be exogenously determined

(Ms ). Equilibrium in the money market occurs where the demand for

and supply of money are equal.

M

P

M

P

s (3.4)

Rearranging these relationships and solving the system for Y gives:

Y

c

a

b

m

A

m

b

a

c

M

P

s





1

1

1

(1 )

(3.5)

Within this framework, orthodox Keynesians can be characterized as low a

and high b people. Reference to equation (3.5) reveals that, where the ratio

a/b is small, (i) disturbances from the real side of the economy tend to

dominate changes in income, and (ii) fiscal policy is relatively powerful with

the autonomous expenditure multiplier tending to 1/1 – c, while monetary

policy is relatively weak with the money multiplier tending to zero. These

central distinguishing beliefs of orthodox Keynesians were noted earlier, in

section 3.2.

The orthodox Keynesian faith in the effectiveness of fiscal policy has been

challenged by, among others, monetarists who typically argue that in the long

run ‘pure’ fiscal expansion (that is, expansion without any accommodating

changes in the money supply) will result in the crowding out or replacement

of components of private expenditure with relatively minor effects on aggregate

demand, the level of income and employment. A number of reasons as to

why crowding out can occur in the IS–LM framework have been put forward

in the literature, which do not rely on the demand for money being perfectly

interest-inelastic (a vertically sloped LM curve), including expectations and

wealth effects (see Carlson and Spencer, 1975). In what follows we outline

the Keynesian response which reasserted the importance of fiscal policy (see

Blinder and Solow, 1973) focusing on the wealth effects of a bond-financed

increase in government expenditure. This analysis involves an extended version

of the Keynesian IS–LM model incorporating the government budget

constraint.

The top panel of Figure 3.5 depicts the conventional IS–LM model and the

lower panel the government budget position determined by the relationship

between government expenditure (G), which is assumed to be independent of

income, and tax receipts (T), which are endogenous to the level of income. At

Y0 (the intersection of IS0 and LM) both the goods and money markets are in

equilibrium and the government budget is balanced (G0 = T); that is, a stable

equilibrium position prevails. Suppose the authorities now seek to raise the

level of income and employment by increasing their expenditure. An increase

in government expenditure shifts the IS curve outwards to the right, from IS0

to IS1, and the government expenditure function downwards, from G0 to G1.

At Y1 (the intersection of IS1 and LM) there is a budget deficit equal to AB. As

long as the deficit persists, the authorities will have to issue more bonds,

which will lead to an increase in private sector wealth (owing to increased

bond holdings) and an increase in private consumption expenditure and the

demand for money. If the wealth effect on consumption (which shifts the IS

curve further outwards to the right, as indicated by the arrows) outweighs that

on the demand for money (which shifts the LM curve upwards to the left),

then in the long run bond-financed fiscal expansion will result in income

increasing to Y2, where the deficit will be removed; that is, crowding out will

be absent. Furthermore, if increased interest payments arising from bond

finance are taken into account (shifting the government expenditure function

downwards beyond G1), income will have to rise above Y2 in order to balance

the government budget. It is evident therefore that incorporating wealth

Figure 3.5 The government budget constraint and bond-financed fiscal

expansion

effects and the government budget constraint into the IS–LM model makes a

bond-financed increase in government expenditure potentially very effective

in raising the level of income and employment.

One particular objection to the predictions of this analysis concerning the

efficacy of fiscal policy worth commenting on is that which derives from

what has come to be known as the Ricardian debt equivalence theorem (see,

for example, Buchanan, 1976; Dimand, 2002a). In short, this theorem states

that the burden of government expenditure on the private sector is equivalent

whether it is financed by an increase in taxation or by bond sales. The sale of

government bonds places a burden on the private sector involving a future tax

liability in order to meet interest payments on and, where the bonds are not

perpetuities, redemption of the bonds. Assuming the private sector takes this

future tax liability fully into account, government bonds will be not regarded

as net wealth. Future tax liabilities will be discounted and their present value

will be perceived to exactly offset the value of the bonds sold. Barro’s (1974)

influential paper presents an elegant exposition of the controversial view that

government bonds should not be regarded as net wealth. In these circumstances

it would make no difference whether the government sold bonds or

raised taxes to finance expenditure, as selling bonds will not affect the private

sector’s wealth. The private sector would merely react to a bond-financed

increase in government expenditure by saving more in the present period in

order to meet future tax liabilities. In other words the effect of an increase in

government expenditure will be the same whether it is financed by increased

taxation or bond sales, in line with the so-called ‘balanced-budget’ multiplier

(see Shaw, 2002). A bond-financed increase in government expenditure will

only be more effective than a tax-financed increase in expenditure if government

bonds are regarded as net wealth.

Several arguments have been raised against the Ricardian debt equivalence

theorem and in what follows we briefly mention two of the main criticisms of

it. The reader is referred to Tobin (1980a) and Feldstein (1982) for accessible

and critical discussions of the Ricardian doctrine and its implications, and to

Barro (1989b) for a spirited defence against the main theoretical objections

that have been raised to the approach. First, if the future tax liability arising

out of bond-financed fiscal expansion falls on a future generation, then it can

be argued that the present generation will be wealthier. Barro has argued,

however, that the existence of bequests implies that the present generation

will raise their saving so as to increase their bequests to their children in

order to pay for the future tax liability. Barro’s argument that the existence of

bequests implies concern by parents about the tax burden their children will

face has itself been subjected to a number of criticisms. For example, it is

open to debate as to whether or not all parents will be so far-sighted, or

concerned enough, to take into account the expected tax liability of their

children. Second, given imperfect capital markets, government bonds may be

regarded as net wealth. The rate of interest the government pays on bonds

establishes the magnitude of the future tax liability. If, as a result of the

government having more favourable access to capital markets than individuals,

the rate of interest is less than the discount rate appropriate to the private

sector when estimating the present value of the future tax liability, government

bonds will be regarded as net wealth. In this situation a bond-financed

increase in government expenditure will increase private sector wealth and

consumption, and be more expansionary that a tax-financed increase in government

expenditure.

Before moving on and making use of the IS–LM framework to discuss the

Keynes v. Classics debate on the issue of ‘underemployment equilibrium’,

we should note that over the years the IS–LM model has stirred up a considerable

amount of controversy. Reflecting on the theoretical developments of

the early post-war period, Modigliani (1986) has identified the ‘Keynesian

system’ as resting on four building-blocks: the consumption function; the

investment function; the demand for and supply of money; and the mechanisms

for determining the movement of prices and wages. Following Hicks’s

(1937) effort to model the first three of Modigliani’s ‘building blocks’, other

major contributions to our understanding were made in the 1940s and 1950s

by Keynesian economists, including those by Modigliani (1944), Modigliani

and Brumberg (1954), Patinkin (1956), Phillips (1958) and Tobin (1958). By

the early 1960s, following the publication of Phillips’s (1958) influential

article, the mainstream macroeconomic model was one which could be described

as a Hicks (1937)–Hansen (1949) IS–LM model, augmented by a

Phillips curve relationship. The MPS–FMP macroeconometric model (based

on an extended IS–LM model) constructed by Modigliani and his associates

in the 1960s is probably the best practical example of the consensus position

during this era (Beaud and Dostaler, 1997; Blaug, 1997).

While a majority of economists (see, for example, Patinkin, 1990a; and the

Tobin interview at the end of this chapter) accepted the Hicksian inspired IS–

LM model as an accurate representation of the essence of Keynes’s thinking

in the General Theory, a vocal minority of ‘Keynesians’ view the IS–LM

model as a distortion or ‘bastardization’ of Keynes’s ideas (see Leijonhufvud,

1968; Robinson, 1975; Davidson, 1994). Interestingly, Dimand (2004) has

recently shown, using evidence from Keynes’s lecture notes compiled by

Rymes (1989) that Keynes himself used a similar IS–LM type of general

equilibrium system of equations to express his new ideas in his lectures

during Michaelmas Term of 1933 as well as a 1934 draft of the General

Theory. Monetarists such as Friedman, Brunner and Meltzer also ‘dislike’ the

IS–LM framework. Bordo and Schwartz (2003) attribute this negative view

to the model’s narrow definition of investment and its narrow view of monetary

influences. Nevertheless, even if the IS–LM model no longer forms the

foundation of graduate macro courses (now dominated by dynamic general

equilibrium theorizing), as it did until the mid-1970s, the model still forms a

major input into most mainstream intermediate macroeconomics textbooks

such as Blanchard (2003), Dornbusch et al. (2004), Gordon (2000a) and

Mankiw (2003). Readers interested in recent controversies and discussions

surrounding the origin, development and persistence of the IS–LM model

should consult King (1993), Young (1987), Young and Zilberfarb (2000),

Young and Darity (2004), Barens and Caspari (1999), De Vroey (2000),

Backhouse (2004), Colander (2004), Dimand (2004), and Snowdon (2004a).

We now turn to consider the Keynesian belief that the economy can take a

long time to return to full employment after being subjected to some disturbance.

This involves a discussion of the debate on underemployment

equilibrium and in what follows we examine the circumstances under which

the IS–LM model will fail to self-equilibrate at full employment.