The Keynesian Framework According to John Hicks and Alvin Hansen

1. ISLM Analysis Part III: The Monetary Sector (with MV=PQ in play) The Keynesian Framework According to John Hicks and Alvin Hansen Roger W. Garrison 2010

2. S S Seq Y I i i i MS MS ieq ieq IS MSPEC Yeq Y Ieq I Keynes’s hard-drawn version of the monetary sector gives no play to the equation of exchange. The whole story is about the supply of money and the speculative demand for money. The interest rate, which balances supply against demand is a purely monetary phenomenon. But Keynes did recognize another component of the demand for money. The transactions demand for money (MTRANS—or simply MT) depends primarily on income and not so much on the interest rate. It is this component (MT) that can be analyzed in terms of the equation of exchange.

3. Y/P = Q The equation of exchange in the classical model. (MV)0 P MT MT The equation of exchange in the ISLM model. So, how is MT graphed as a function of Y? Y = PQ

4. The classical economists wrote: MV = PQ, where Q also represents real income—i.e., Q = Y/P. Since Q = Y/P, then PQ = Y. So, we can write MV = Y, which applies, Keynes insisted, only to the transactions demand for money. And so, MTVT = Y or MT = Y/VT Keynes recognized that the transactions velocity of money, like the velocity of money in the classical formulation, is fairly stable. VT is more or less constant. This means that MT is linearly related to Y. MT = Y/VT graphs as a straight line that emanates from the origin and has a slope of 1/VT. MT 1 VT Y

5. Y/P = Q The equation of exchange in the classical model. (MV)0 P MT MT The equation of exchange in the ISLM model. So, how is MT graphed as a function of Y? 1 VT Y = PQ

6. MT is one component of the demand for money. The other component is MSPEC. The monetary sector is in equilibrium when money supply equals money demand. Simply written: MS = MD. So, MS = MSPEC + MT, where MS is controlled by the central bank. Keynes took the two components to be additive. That is, the total demand for money (MD) is equal to MSPEC plus MT. [Or simply: MD = MSPEC + MT] i This equilibrium condition graphs as a straight line with a vertical intercept of MS, a horizontal intercept of MS and a slope of negative one. MSPEC MT MT 1 VT MS 1 1 Y MSPEC MS

7. The money supply is managed by the central bank, i.e, the Federal Reserve. So, the Fed can increase or decrease MS, as deemed necessary. MT is one component of the demand for money. The other component is MSPEC. The monetary sector is in equilibrium when money supply equals money demand. Simply written: MS = MD. So, MS = MSPEC + MT, where MS is controlled by the central bank. Keynes took the two components to be additive. That is, the total demand for money (MD) is equal to MSPEC plus MT. [Or simply: MD = MSPEC + MT] As in the case of the hard-drawn version of Keynes’s model, changes in MS can influence both income and the interest rate. i This equilibrium condition graphs as a straight line with a vertical intercept of MS, a horizontal intercept of MS and a slope of negative one. MSPEC MT MT 1 VT Y MSPEC

8. The two (additive) demands for money together with the equilibrium condition imply possible combinations of income and the interest rate that are consistent with equilibrium in the monetary sector. The line connecting the possible equilibrium points is called the LM curve—with L (liquidity) representing the demand for money and M representing money supply. i i LM MSPEC Y MT MT Y MSPEC

9. The two (additive) demands for money together with the equilibrium condition imply possible combinations of income and the interest rate that are consistent with equilibrium in the monetary sector. The line connecting the possible equilibrium points is called the LM curve—with L (liquidity) representing the demand for money and M representing money supply. i i LM MSPEC Y MT MT Y MSPEC

10. S S The Keynesian Framework According to John Hicks and Alvin Hansen Seq W S Y LABOR INCOME I D i i i LM N ieq ieq IS MSPEC Yeq Y Ieq I MT MT This is the Hicks-Hansen, fixed-price, eight-quadrant diagrammatical exposition of Keynesian Macroeconomics. Y MSPEC

11. S S The Keynesian Framework According to John Hicks and Alvin Hansen Seq Y I i i i LM ieq ieq IS MSPEC Yeq Y Ieq I MT MT The speculative demand for money, which reflects the “fetish of liquidity” is similarly unstable. A strengthening or weakening of the fetish generates a mirror-image movement of the LM curve. Watch. The “animal spirits” that govern investment demand can wax and wane, causing amplified movements in the IS curve. Waxing spirits can result in inflation; waning spirits can result in unemployment. Watch. Y MSPEC

12. S S The Keynesian Framework According to John Hicks and Alvin Hansen Seq Y I i i i LM ieq ieq IS MSPEC Yeq Y Ieq I MT MT “Animal spirits” and the “fetish of liquidity” can interact, setting both the IS curve and the LM curve in motion. Fine tuning such a macroeconomy with fiscal and monetary policy is the ultimate “mission incredible.” Watch. Y MSPEC

13. S S The Keynesian Framework According to John Hicks and Alvin Hansen Seq Y I i i i LM Liquidity Trap Stagnation Thesis ieq ieq IS MSPEC Yfe Y Ieq I MT MT Even without “animal spirits” and the “fetish of liquidity,” monetary policy may not be able to lift the economy out of recession. The obstacles come in the form of the “Liquidity Trap” and the “Stagnation Thesis.” Y MSPEC

14. ISLM Analysis Part III: The Monetary Sector (with MV=PQ in play) The Keynesian Framework According to John Hicks and Alvin Hansen Roger W. Garrison 2010