UNIT 1

NEOCLASSICAL KEYNESIAN
SYNTHESIS
 1.1 HICKS HANSEN IS -LM Functions
Principal Task - Provide Synthesis -integrate the Real & Monetary sectors

● Main Contribution of the model is a simple kind of graphic presentation

● This graphic version was first developed by J.R. Hicks and popularized by
Alvin Hansen- hence Hicks Hansen analysis
● Two functions are used in the graphical analysis
● Curves are labelled as IS and LM curves- commonly known as IS -LM
Model
Determinants of equilibrium
In a Two Sector Model

Goods market equilibrium - The level of income at which there was equality
between saving and Investment

Money market equilibrium defined by an equality between the supply of and

demand for money- giving us the equilibrium interest rate
Equilibrium levels of Income
Upper panel - shows equilibrium level of income
C+I2
Y 1 if Investment is I1 and that depends on
certain rate of interest
C+I1

Income Y1 Y2 S

I2

I1
Equilibrium Levels of Interest Rate
Given money supply ms
Rate md2 ms
and demand md1
rate on interest is r 1
Of md1
A higher income level means different
transactions demand- thereby will
Int r2
indicate different interest rate
r1

Money
Simultaneous Determination Of Equilibrium IS LM Model

We cannot determine Equilibrium Income level without rate if interest

And also the Interest rate cannot be determined without a knowledge of the
level of income

Simultaneous Solution of the two equilibrium Values - HICKS HANSEN

The Goods Market-
Determinants of equilibrium

Equilibrium in the
Goods market
Y = C+ I
S =I
Assumption
I is function of interest rate
C & so S is a function of Income alone
Equations - Goods Market
Consumption Function C =c (Y)
Investment Function I= i ( r)
Equilibrium Condition
y=c(Y) + i(r)

Savings function S= s(Y)

Investment Function I= i ( r)
Equilibrium Condition s(Y) =i(r)

We shall follow the S, I approach for

the diagrammatic analysis
 Derivation of the IS Curve
Part A Part B

45’ line from origin

Investment Spending schedule
Planned investment needs to be same as savings
Investment spending varies inversely with measured along Y axis
interest rate

Part D

Part C IS Curve

Saving Function Derived from other panels

6% rate of interest- I =20, S =20 then Y =120

Savings Varies directly with income
r=5%, I = 30 S= 30 Y=140 another point on IS
Disequilibrium
Suppose income =140 and r= 6% Suppose Y= 120 and r =5%

Investment will be lower due high interest Investment

Therefore S >I Saving

Point E

Left of the Is Curve

Right of the IS Curve I>S

S>I
Equilibrium in the
Money market
Money market equilibrium

ms =md

Keynesian demand for money

Transaction dd - m t = k(Y)

Speculative dd - msp = h(r)

Total Demand md = m t + msp

md= k(Y) + h(r)

mS = exogenous

mS = ma

i.e determined by the monetary authorities

Ms(nominal stock. P stable
Equilibrium in the Money market
Three equations to cover the money market

Demand for money md= k(Y) + h(r)

Supply of Money mS = ma

Equilibrium condition ms =md

To be precise it gives us the equilibrium interest rate for any given

value of level of income (Y) and real money balances. In drawing
LM curve, real money balances are assumed to be constant.

Thus LM curve describes money market equilibrium for different

values of income and rate of interest, given a fixed value of real
money balances (M/P). Thus, given the real money balances
(M/P), we can obtain a rate of interest for different values of
income.
Derivation of the LM Curve
Part A
Speculative demand schedule
Investment spending varies inversely with interest
rate
Part C
Transactions demand Function
Amount required for transactions demand at
each level of income on the assumption of k =1/2
Part B
Shows a total money supply of 100
Held in either transactions or speculative balances
Part D
LM Curve
Derived from other panels
6% rate of interest- 40 for speculative balances
From the total money supply of 100 deducting speculative
balances will 60 for transactions consistent with Y =120 (part
C)
Bring together Y =120 r=6% one point on the LM curve
Lower Interest 5% Speculative balance 50, transaction bal 50,
Income 100 another equilibrium point
 Disequilibrium
Point E
Income level of 120
Money demand = supply
only if r=6% but as r=5%
Demand for speculative
Purpose is higher md >ms
All points to the right of
LM curve exhibit the same.

Point F
Opposite of the
previous situation
ms>md
 Two Market Equilibrium- Goods & Money Markets
Only one Combination of Y and r at which the
demand for goods equals the supply of
goods and the supply of money equals the
demand for money

Equilibrium income and rate of interest

Intersection of IS and LM curves
Y = 120 and r = 6%
All other points indicate disequilibrium

Goods Market Money Market

Space I I<S, (C+I)<Y md <ms

Space II I<S, (C+I)<Y md >ms

Space III I >S, (C+I)>Y md >ms

Disequilibrium to Equilibrium
Disequilibrium Four quadrants

I>S, - rise in income

md >ms rise in interest rate

Further Understanding - IS & LM
IS
● What determines the slope of the IS curve?
○ Negative slope- higher interest rate investment- agg dd-
income
○ Steepness- smaller the multiplier and less sensitive
investment spending is to changes in the interest rate, the
steeper the IS curve
● What determines the position of the IS curve, given its
slope, and what causes the curve to shift?
○ Increase in level of autonomous spending
LM
● What determines the slope of the LM curve?
○ Greater responsiveness m\of the demand for
money to income as measured by k, and lower
responsiveness to the interest
○ From the coefficient of income k/h, we can know whether LM
curve is steep or flat. If demand for money is not much
sensitive to level of income, then k will be small. Therefore, in
case of small k (i.e. low sensitivity of interest with respect to
changes in income), small change in interest rate is required to
offset a small increase in money demand caused by a given
increase in income.
● What determines the position of the LM curve,
given its slope, and what causes the curve to
shift?
○ Real supply of money
Equilibrium - Income and Interest rate