Keynesian and Monetarists business cycle models and the Investment Savings Liquidity preference Money supply curves

​According to the Keynes theory, the source of fluctuations in the aggregate demand. The aggregate demand further varies due to changes mainly in investment. It occurs through the following process (shown in figure 1). The entrepreneurial expectations form the prospective yield (the expected income from the investment), which changes the marginal efficiency of capital (the rate of return on capital invested), thus changing the amount of capital investment in the economy. The capital investment (accelerator) then transfers the effect onto the aggregate demand (via multiplier i.e. changes in aggregate demand depends on the multiplier and the accelerator). (for more details you can watch this short video by marginal revolution university: click here). According to the Keynesians, government policies can help stabilize the demand.

To understand the policy: monetary and fiscal, implications on the aggregate demand, we will now peek into the IS-LM curves. The investment saving liquidity preference and money supply curve shows the relationship between the interest rates and the asset markets (real output and money markets). Thus, the intersection of IS and LM curves represent a "general equilibrium point" at which interest rates, money market and the product markets are at equilibrium. The IS-LM curve is plotted with real interest rates (r) on y-axis and real output (or national income, Y) on x-axis. (figure 2)

For the investment savings curve (IS), the independent variable is the interest rate and the dependent variable is the national income. The IS curve represents all the pairs of the level of real output (real GDP) and interest rates such that markets for goods and services are at equilibrium (i.e. demand for goods equals supply for goods or equivalently desired national savings equals desired investment). The IS curve is plotted with interest rate on the y-axis and output on the x-axis. 

Assuming consumer consumption behaviour as C = C(Y-T, r) with C positively correlated with disposable income and negatively correlated with real interest rate. Now we assume the firm investment behaviour I = I(r) with I negatively correlated with real interest rate. Further, we assume closed economy and so the aggregate demand function becomes the IS curve's equation i.e. Y = C(Y-T, r) + I(r) + G(exogenous). Derivating it we get, Y' = (1/(1-C1))*(C2+I1), where C1, C2 and I1 are changed in Y wrt disposable income, interest rate and investment respectively. The conclusion is that we observe the presence of a multiplier ( (1/1-C1) what was discussed earlier) and also that the IS curve is negatively sloped. Therefore, as discussed earlier, the increased fixed investment will lead to increased aggregate demand and it can be seen from the IS curve.

Now in the liquidity preference and money supply curve (LM), the independent variable is the income and the dependent variable is an interest rate. The LM curve shows the combination of interest rates and real output where the money market is in equilibrium. Thus, each point on the LM curve reflects a particular money market equilibrium (money demand equals money supply) situation, based on a particular level of income. 

The money market is represented by plotting nominal interest rates (i) against real money supply (M/P) at price level P. The equilibrium point in the money market is the intersection of the money supply and money demand (liquidity preference) curves. We assume that the central bank controls the money supply and also that it is perfectly inelastic wrt interest rates i.e. a vertical line. The liquidity preference curve or the money demand though depends on the transactions demand of money (level of income Y) and the speculative demand of money (interest rate r). Thus the equation for the LM curve is, M/P = L(i, Y). The LM curve is positively sloped.

In AS-AD model each point on the AD curve is the outcome of IS-LM model for aggregate demand Y at a particular price P. The AS curve is considered horizontal for short run (sticky prices) and vertical for the long run. Thus we can now understand how the policies would affect the IS-LM curve and subsequently the aggregate demand.

The monetarists had a quantity theory of money as their backbone. So, as per the theory, money supply multiplied by money velocity equals the nominal output. Monetarists believed that in the long run the amount of money in the economy would only lead to changes in the price level and not the real output, while in short run they agreed with price stickiness of Keynesians and claimed that it would lead to changes in the real output. Thus according to the monetarists, the un-necessary government intervention and the discretion of the monetary authorities in controlling the money supply leads to economic fluctuations.

​Want to read about more theories of business cycles read this blog article by economics discussion here or the Wikipedia here.

References:

1. Wikipedia

2. Slideshare, Ujjwal shanu, Motilal Nehru National Institute of technology accessed on October 16th, 2018

3. Goods market equilibrium article by Economics discussion, accessed on October 17th, 2018

Image sources:

1. Inspired from reference [6].

2. David Harvey's macroeconomics notes, Newcastle business school, accessed on October 17th, 2018