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The Classical Model versus the Keynesian Model of Income and

Interest Rate Determination

Classical Keynesian

goods market I(r) = S(r) I(r) = S(Y)

or I(r) = Y - C(r) or I(r) = Y - C(Y)

money market M = kPY M = kPY + L(r)

production function Y = Y(N, K ) Y = Y(N, K)

W W W W
labour market D( )  S( ) N (P)N (P)
D S
P P

Three major differences:

(1) no induced consumption induced consumption
(consumption as a (positive “feedback”
residual decision after between C and Y)
saving)
reflecting behaviour of different income groups?
feedback CYBERNETICS

(2) no multiplier effect multiplier effect

important implications for autonomous expenditure

including G

(3) “classical dichotomy ” interaction between the

between the goods and goods and the money
the money markets markets

*Read Brian Morgan, chapter 2.

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National Income Determination and the Wealth Effect: the IS-LM

Model

The IS-LM model is a behavioural model with an identity and separate

functions for key variables, some of which are endogenous (determined
within the model) while others are exogenous (not determined by the
model and therefore assumed to be independent).

IS

(1) IS curve: the equilibrium locus of the goods market, tracing out the
relationship between income Y and interest rate r.
YC+I+G (identity)
C = c0 + c(Y – T) (endogenous)
T = t0 + tY (endogenous)
G= G (exogenous)
I = i0 – fr (endogenous)

By substitution
Y = c0 + c[Y – (t0 + tY)] + i0 – fr + G

   G  Y[1  c(1  t)]

r = c 0 ct 0 i 0 (IS curve without wealth effect)
f

1 f
Y= (c 0  ct 0  i 0  G) - r
1  c(1  t) 1 - c(1 - t)
(IS curve without wealth effect)
1 1
Multiplier: 
1  c(1  t) 1 - c  ct

When tax is imposed lump-sum, i.e. T = to:

Y=C+I+G
= c0 + c(Y – t0) + i0 – fr + G
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   G  Y(1  c)
r = c 0 ct 0 i 0
f

1 f
Y= (c 0  ct 0  i 0  G) - r
1 c 1- c

1 1
Multiplier: , which is greater than . So lump-sum tax
1 c 1 - c  ct
produces a larger multiplier.

(2) Wealth augmented consumption function:

C = co + c (Y – T) + jW
1 1  c(1  t)
working out: r = (c0  ct0  i0  G  jW) - Y
f f

1 f
Y= (c0  ct0  i0  G  jW)- r
1 c(1 t) 1 c(1 t)
(IS curve with wealth effect)

LM

(2) LM curve: the equilibrium locus of the money market, tracing

out the relationship between income Y and interest rate r.

Neglecting the price and the Pigou (price) Effect

Ms  Md (identity—equilibrium condition)
Md = hY – lr + gW (endogenous)
Ms = M (exogenous)
1 h
r=  M Y (LM curve without wealth effect)
l l

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1 l
Y= M r (LM curve without wealth effect)
h h

Adding the wealth effect to the money demand

Function:

Md = hY – lr + gW

g 1 h
r= W M Y (LM curve with wealth effect)
l l l

1 g l
Y= M W r (LM curve with wealth effect)
h h h

LM LM’

Pigou Effect
Wealth
Wealth Effect
Effect

IS IS’

Saving the inadequacy

of Keynesian effect in
face of wage rigidity

IS-LM equilibrium with wealth effect

1 1  c(1  t) g 1 h
(c 0  ct 0  i 0  G  jW) - Y= W  M  Y
f f l l l

 h 1  c(1  t)  1 1 g
l   Y = (  
c ct 0 i 0  G  j W)  M - W
 f  f 0 l l

hf  l[1  c(1  t)] 1 1 g

Y = (c 0  ct 0  i 0  G  jW)  M - W
lf f l l

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lf 1
Y= (c  ct 0  i 0  G  jW) +
hf  l[1  c(1  t)] f 0

lf 1 lf g
M- W
hf  l[1  c(1  t)] l hf  l[1  c(1  t)] l

Y* =
l
(c  ct 0  i 0  G  jW) -
hf  l[1  c(1  t)] 0

f f
gW + M
hf  l[1  c(1  t)] hf  l[1  c(1  t)]

LM’’

LM’
LM

IS’
IS

Y*’’ Y* Y*’

The relative effectiveness of fiscal versus monetary policy (i.e. the

relative size of the fiscal multiplier versus the monetary multiplier)

depends on the size of l  f ?

Repeat: the multiplier is a kind of damped positive feedback.