Egwald Economics: Macroeconomics

by

Elmer G. Wiens

Macroeconomics Theory, Testing, and Applications

Closed Canadian Economy Version | Open Canadian Economy Version | Comparative

Statics of the Canadian IS-LM Model

The Basic Keynesian IS-LM Model

Closed Canadian Economy Version

consumers | producers | money demand | government

product market | money market | economy equilibrium

Closed Canadian Economy Version

Macroeconomic Aggregates, Markets, and Agents.

Macroeconomics attempts to understand the behaviour of the whole economy by

analyzing the determination and interaction of such broad economic aggregates as
national income and product, consumers' expenditures and savings, producers' output of
products and producers' investment in capital, government revenues (taxes) and
expenditures, exports and imports, the level and composition (by age, sex, and region) of
employment, and the quantity of money in circulation.

In the basic IS-LM model, the behaviour of the economic agents - consumers, producers
(firms), and the government - is reconciled by the product and money markets. The
product market balances the demand for product by consumers, firms, and the government
with national income. The money market balances the demand for money by individuals
(consumers) and firms with the supply of money provided by the government and the
banks.

The equilibrium the IS-LM model obtains is the demand equilibrium for the economy. All
economic aggregates, including national income and the rate of interest adjust, so that the
demand for product equals national income, and the demand for money equals the supply
of money.

Many important macroeconomics aggregates (variables), such as the levels of prices and
wages, the volume of exports and imports, the pattern of foreign currency exchange rates,
the stock of capital, and the wealth of consumers are left out of the basic IS-LM model of
a closed economy. I also ignore the impact of the labour, bond, and stock markets on
macroeconomics aggregates. Consequently, the equilibrium rate of interest and level of
national income, plus the values of other macroeconomics aggregates produced by the IS-
LM model, reflect only the demand side of the economy.

Below, I specify the functions (equations) that describe the macroeconomics activities of
the economic agents: consumers' demand for product, private firms' demand for product,
and the government's collection of taxes, expenditures on product, and supply of money.

I set the values of the parameters of the macroeconomics functions to reflect the average
values of the macroeconomics aggregates of the Canadian economy during the years of
1998 - 2003. (Statistics Canada: Gross domestic product, income-based; Gross domestic
product, expenditure-based.) I express all aggregates in billions of dollars.
Consumers (Individuals).

The Consumer Expenditure Function.

The consumer expenditure function is a behavioural relation describing the demand for
consumer goods by individuals. I hypothesize that the expenditures of consumers, c, is a
function of disposable income, yd, and the rate of interest, r. Disposable national income
equals national income less taxes paid to the government.

c = c(yd, r)

c = c1 + c2*yd - c3*r + c4*r2

c1, c2, c3, c4 >= 0

For the Canadian economy I use:

c = 100 + 0.7*yd - 20*r + 0.5*r2

In the diagram below, I fixed (set) the rate of interest r at 3.35 yielding the demand for
consumption expenditures c as a function of disposable income yd. Consumers' demand
with the rate of interest r fixed is a linear function of yd.

c = c(yd) = 38.61 + 0.7*yd

Similarly, in the diagram below, I fixed disposable income at 789.46 yielding the demand
for consumption expenditures c as a function of the rate of interest r. Consumers' demand
with yd fixed is a quadratic function of r.

c = c(r) = 652.62 - 20*r + 0.5*r2

Producers (Firms).

The Private Firms' Investment Function.

The investment function is a behavioural relation describing the demand for investment
goods (investment in capital) by private firms. I hypothesize that the investment demand
of producers, i, is a function of national income, y, and the rate of interest, r.

i = i(y, r)

i = i1 + i2*y - i3*r + i4*r2

i1, i2, i3, i4 >= 0

For the Canadian economy I use:

i = 100 + 0.2*y - 40*r + 1.5*r2

In the diagram below, I fixed the rate of interest r at 3.35 yielding the demand for
investment goods i as a function of national income y. Producers' demand with the rate of
interest r fixed is a linear function of y.

i = i(y) = -17.17 + 0.2*y

Similarly, in the diagram below, I fixed national income at 980.08 yielding the demand for
investment goods i as a function of the rate of interest r. Producers' demand with y fixed is
a quadratic function of r.

i = i(r) = 296.02 - 40*r + 1.5*r2

Consumers and Producers.

The Money Demand Function.

The money demand function is a behavioural relation describing the demand for money
by individuals and firms. Individuals hold money for transactions purposes, to buy real-
goods and services, and as a store of wealth. As national income increases, individuals and
firms need more money on hand to pay for the increase in their purchases of goods and
services. I hypothesize that money demand, md, is an increasing function of national
income, y. As interest rates increase, holding interest bearing securities (bonds) becomes
increasingly more attractive than holding money. I hypothesize that money demand, md,
is a decreasing function of the rate of interest, r.

md = md(y, r)

md = m1 + m2*y - m3*r + m4*r2

m1, m2, m3, m4 >= 0

For the Canadian economy I use:

md = 75 + 0.23*y - 35*r + 1.5*r2

In the diagram below, I fixed the rate of interest r at 3.35 yielding the demand for money
md as a function of disposable income y. Money demand with the rate of interest r fixed is
a linear function of y.

md = md(y) = -25.42 + 0.23*y

Similarly, in the diagram below, I fixed national income at 980.08 yielding the demand for
money md as a function of the rate of interest r. Demand for money with national income
y fixed is a quadratic function of the rate of interest r.

md = md(r) = 300.42 - 35*r + 1.5*r2

The Government.

Revenues and the Tax Function.

The principal revenue sources for the federal government include income taxes,
consumption taxes, social security contributions, and investment income.

I hypothesize that value of government tax revenues, t, is a linear function of national

income, y.

t = t(y)

t = -t1 + t2*y

t1, t2 >= 0

For the Canadian economy I use:

t = -25 + 0.22*y = -25 + 0.22 * 980.08 = 190.62.

Disposable Income

Disposable national income, yd equals national income less taxes:

yd = y - (-25 + 0.22*y) = 25 + 0.78*y = 25 + 0.78 * 980.08 = 789.46.

Expenditures.

The principal expenditures of the federal government include expenditures on social

services, protection of persons and property, debt charges, resource conservation and
industrial development.
In this basic macroeconomic model, I fixed government expenditures g = 210 billion
dollars.
Money Supply.

The Bank of Canada is Canada's Central Bank. It serves as the bank for the Government
of Canada and Canada's chartered banks. The Bank of Canada controls the currency in
circulation in Canada, and influences the money supply by manipulating interest rates
(Summary of Key Monetary Policy Variables). For this basic IS-LM model, I define the
money supply as currency outside of banks + personal chequing accounts + current
accounts + a percentage of personal savings deposits and non-personal notice deposits. I
fixed the money supply ms = 200 billion dollars.
The Product (Commodity) Market Equilibrium.

The commodity markets equilibrate the demand and supply for consumer goods and
services, investment goods, and goods and services purchased by the government. I
aggregate the value of these products into one generic good.

The basic IS-LM model ignores the "supply side" of the economy - what quantities and
types of products firms produce, and what factors of production (labour, capital services,
and equipment and supplies) firms employ. I assume that the value of the supply of
products produced will adjust to meet the value of the demand for products —> aggregate
supply, AS = aggregate demand, AD.

Furthermore, expenditures on products become payments compensating the factors

(labour, capital, materials and supplies) that produced the output. Individuals, the ultimate
owners of these factors of production, dispose of the income obtained on consumer
expenditures, tax payments to the government, and savings.

The product market equilibrium occurs at the level of national income where AD = AS,
i.e., the level of income y where c + i + g = y. The diagram below depicts the equilibrium
where c + i + g crosses the line (in yellow) with a 45 degree angle with the y-axis.
The c + i + g curve as a function of r and y is:

c + i + g = 427.5 + 0.746*y - 60*r + 2*r2

The IS Curve.

Because the demand for consumer goods and the demand for producer goods vary
inversely with the rate of interest r, the c + i + g curve as a function of national income y
shifts upward as the rate of interest r decreases. Consequently, a lower rate of interest
requires a higher level of national income for equilibrium in the commodity market. The
locus of interest rates and national incomes implicit for equilibrium in the commodity
(product) market, an inverse relation between the rate of interest and national income is
called the IS curve.

Click to pop a new window with a graphical derivation of the IS curve.

The IS curve, y as a function of the rate of interest r, is:

y = 1683.07 - 236.22 * r + 7.87 * r2

The Money Market Equilibrium.

The Bank of Canada's key overnight policy interest rate influences the chartered banks'
prime interest rates (and the availability of money to lend to their best customers). Interest
rates adjust throughout the economy affecting investment and consumption demand, and
thereby the equilibrium national income of the IS-LM model of the demand side of
the economy, until the demand for money equals the supply of money. In the basic IS-LM
model, I assume the government sets the supply of money at a specific level. The diagram
below depicts the equilibrium where the demand for money curve intersects the vertical
supply of money line.
The LM Curve.

The demand for money is an increasing function of national income y. Therefore, the
demand for money curve, as a function of the rate of interest, shifts upwards with an
increase in national income. Consequently, a higher level of national income requires a
higher rate of interest for equilibrium in the money market. The locus of interest rates and
national incomes implicit for equilibrium in the money market, a direct relation between
the rate of interest and national income is called the LM curve.

Click to pop a new window with a graphical derivation of the LM curve.

The LM curve, y as a function of the rate of interest r, is:

y = 543.48 + 152.17 * r - 6.52 * r2

The IS-LM Demand Equilibrium.

The basic IS-LM economy is in equilibrium when national income, y, and the rate of
interest, r, are at levels consistent with equilibrium in both the product and money
markets.

Economy equilibrium occurs where the IS curve and the LM curve intersect.

As a review, I list the system of equations for the IS-LM model. Solving these equations
simultaneously, I obtain the values of the endogenous macroeconomics variables of the
model: the amount of output and national income, y, and the rate of interest, r.
 Product Market - IS Demand Equilibrium
Consumers c = 100 + 0.7*yd - 20*r + 0.5*r2
Producers i = 100 + 0.2*y - 40*r + 1.5*r2
Government Expenditures g = 210
Government Revenues t = -25 + 0.22*y
Consumer Disposable Income yd = y - (-25 + 0.22*y)
IS Curve c+i+g=y
Money Market - LM Demand Equilibrium
Consumers & Producers md = 75 + 0.23*y - 35*r + 1.5*r2
Money Supply ms = 200 ;
LM Curve md = ms

For this basic model of the Canadian economy, the equilibrium obtains where

y = 980.08, r = 3.35

The diagram below depicts the IS-LM economy equilibrium.

Economy Equilibrium Macroeconomic Variables and Aggregates

National Income: y 980.08
Rate of Interest: r 3.35
Disposable National Income: yd 789.46
Consumer Expenditures: c 591.23
Firm Investments: i 178.85
Government Expenditures: g 210
Government Revenue: t 190.62
Money Supply: ms 200
Consumer Savings: s = yd - c 198.23

The IS-LM Model's results versus the National Economic and Financial Accounts.

Comparing the model's results with the Statistics for the Canadian Economy reveals the
above IS-LM Model's limits and inadequacies. For example, the Federal Government
(Federal government revenue and expenditures), and the Canadian governments,
consoldiated, (Consolidated government revenue and expenditures) operated at a surplus
during the years 1999 to 2003. Many other factors inhibit the realism of the IS-LM
Model.

The Comparative Statics Of The Basic Keynesian IS-LM Model web page permits you to
adjust the parameters of the IS-LM Model. See if you can obtain more realistic results
(like running a government surplus without reducing national income).

IS/LM model
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The IS curve moves to the right, causing higher interest rates (i) and expansion in the
"real" economy (real GDP, or Y).

The IS/LM model is a macroeconomic tool that demonstrates the relationship between
interest rates and real output in the goods and services market and the money market. The
intersection of the IS and LM curves is the "General Equilibrium" where there is
simultaneous equilibrium in all the markets of the economy[1]. IS/LM stands for
Investment Saving / Liquidity preference Money supply.

Contents
[hide]

• 1 History
• 2 Formulation
o 2.1 IS schedule
o 2.2 LM Schedule
• 3 Shifts
• 4 References
• 5 Related Models
• 6 See also

• 7 External links
 History
The IS/LM model was born at the Econometric Conference held in Oxford during
September, 1936. Roy Harrod, John R. Hicks, and James Meade all presented papers
describing mathematical models attempting to summarize John Maynard Keynes'
General Theory of Employment, Interest, and Money. Hicks, who had seen a draft of
Harrod's paper, invented the IS/LM model (originally using LL, not LM). He later
presented it in "Mr. Keynes and the Classics: A Suggested Interpretation".[2]

Hicks later agreed that the model missed important points from the Keynesian theory,
criticizing it as having very limited use beyond "a classroom gadget", and criticizing
equilibrium methods generally: "When one turns to questions of policy, looking towards
the future instead of the past, the use of equilibrium methods is still more suspect."[3] The
first problem was that it presents the real and monetary sectors as separate, something
Keynes attempted to transcend. In addition, an equilibrium model ignores uncertainty –
and that liquidity preference only makes sense in the presence of uncertainty "For there is
no sense in liquidity, unless expectations are uncertain."[4] A shift in the IS or LM curve
will cause change in expectations, causing the other curve to shift. Most modern
macroeconomists see the IS/LM model as being at best a first approximation for
understanding the real world.

Although disputed in some circles and accepted to be imperfect, the model is widely used
and seen as useful in gaining an understanding of macroeconomic theory. It is used in the
popular U.S. college macroeconomics textbook by Gregory Mankiw, and many others.

Formulation
The model is presented as a graph of two intersecting lines in the first quadrant.

The horizontal axis represents national income or real gross domestic product and is
labelled Y. The vertical axis represents the nominal interest rate, i.

The point where these schedules intersect represents a short-run equilibrium in the real
and monetary sectors (though not necessarily in other sectors, such as labor markets):
both product markets and money markets are in equilibrium. This equilibrium yields a
unique combination of interest rates and real GDP.

IS schedule

The IS schedule is drawn as a downward-sloping curve with interest rates as a function of

GDP (Y). The initials IS stand for "Investment and Saving equilibrium" but since 1937
have been used to represent the locus of all equilibria where total spending (consumer
spending + planned private investment + government purchases + net exports) equals an
economy's total output (equivalent to real income, Y, or GDP). To keep the link with the
historical meaning, the IS curve can represent the equilibria where total private
investment equals total saving, where the latter equals consumer saving plus government
saving (the budget surplus) plus foreign saving (the trade surplus). Either way, in
equilibrium, all spending is desired or planned; there is no unplanned inventory
accumulation (i.e., no general glut of goods and services).[5] The level of real GDP (Y) is
determined along this line for each interest rate.

Thus the IS schedule is a locus of points of equilibrium in the "real" (non-financial)

economy. Given expectations about returns on fixed investment, every level of interest
rate (i) will generate a certain level of planned fixed investment and other interest-
sensitive spending: lower interest rates encourage higher fixed investment and the like.
Income is at the equilibrium level for a given interest rate when the saving that
consumers choose to do, out of this income equals investment (or, more generally, when
"leakages" from the circular flow equal "injections"). A higher level of income is needed
to generate a higher level of saving (or leakages) at a given interest rate. Alternatively, the
multiplier effect of an increase in fixed investment raises real GDP. Both ways explain
the downward slope of the IS schedule. In sum, this line represents the line of causation
from falling interest rates to rising planned fixed investment (etc.) to rising national
income and output.

In a closed economy, the IS curve is defined as: ,

where Y represents income, C(Y − T) represents consumer spending as a function of
disposable income (income, Y, minus taxes, T), I(r) represents investment as a function of
the real interest rate, and G represents government spending. In this equation, the level of
G (government spending) and T (taxes) are presumed to be exogenous, meaning that they
are taken as a given. To adapt this model to an open economy, a term for net exports
(exports, X, minus imports, M) would need to be added to the IS equation. An economy
with more imports than exports would have a negative net exports number.

LM Schedule

The LM schedule is an upward-sloping curve representing the role of finance and money.
The initials LM stand for "Liquidity preference and Money supply equilibrium". As
such, the LM function is the equilibrium point between the liquidity preference function
and the money supply function (as determined by banks and central banks).

The liquidity preference function is simply the willingness to hold cash balances instead
of securities. For this function, the interest rate (the vertical) is plotted against the
quantity of cash balances (or liquidity, on the horizontal). The liquidity preference
function is downward sloping. Two basic elements determine the quantity of cash
balances demanded (liquidity preference) - and therefore the position and slope of the
function:

• 1) Transactions demand for money: this includes both a) the willingness to hold
cash for everyday transactions as well as b) as a precautionary measure - in case
of emergencies. Transactions demand is positively related to real GDP
(represented by Y). This is simply explained - as GDP increases, so does spending
 and therefore transactions. As GDP is considered exogenous to the liquidity
preference function, changes in GDP shift the curve. For example, an increase in
GDP will, ceteris paribus (all else equal), move the entire liquidity function
rightward in proportion to the GDP increase.
• 2) Speculative demand for money: this is the willingness to hold cash as an asset
for speculative purposes. Speculative demand is inversely related to the interest
rate. As the interest rate rises, the opportunity cost of holding cash increases - the
incentive will be to move into securities. As will expectations based on current
interest rate trends contributes to the inverse relationship. As the interest rate rises
above its historical value, the expectation is for the interest rate to drop. Thus the
incentive is to move out of securities and into cash.

The money supply function for this situation is plotted on the same graph as the liquidity
preference function. Money supply is determined by the central bank decisions and
willingness of commercial banks to loan money. Though the money supply is related
indirectly to interest rates, in the short run, money supply in effect is perfectly inelastic
with respect to nominal interest rates. Thus the money supply function is represented as a
vertical line - it is a constant, independent of the interest rate GDP and other factors.
Mathematically, the LM curve is defined as M / P = L(r,Y), where the supply of money is
represented as the real money balance M/P (as opposed to the nominal balance M), with P
representing the price level, equals the demand for money L, which is some function of
the interest rate and the level of income.

Holding all variables constant, the intersection point between the liquidity preference and
money supply functions constitute a single point on the LM curve. Recalling that for the
LM curve, interest rate is plotted against the real GDP whereas the liquidity preference
and money supply functions plot interest rates against quantity of cash balances), that an
increase in GDP shifts the liquidity preference function rightward and that the money
supply is constant, independent of GDP - the shape of the LM function becomes clear. As
GDP increases, the negatively sloped liquidity preference function shifts rightward.
Money supply, and therefore cash balances, are constant and thus, the interest rate
increases. It is easy to see therefore, that the LM function is positively sloped.

Shifts
One hypothesis is that a government's deficit spending ("fiscal policy") has an effect
similar to that of a lower saving rate or increased private fixed investment, increasing the
amount of aggregate demand for national income at each individual interest rate. An
increased deficit by the national government shifts the IS curve to the right. This raises
the equilibrium interest rate (from i1 to i2) and national income (from Y1 to Y2), as shown
in the graph above.

From the point of view of quantity theory of money, fiscal actions that leave the money
supply unchanged can only shift aggregate demand if they receive support from the
monetary sector. In this case, the velocity or demand of money determines aggregate
demand. If the velocity of money remains unchanged at the initial level of output, so does
aggregate demand. Essentially, the monetary sector is the source of any shift that
occurs.[6] From the monetarist perspective, money velocity is stable, but, from a
Keynesian point of view, an increase in aggregate demand can increase the velocity of
money and lead to higher output.

The graph indicates one of the major criticisms of deficit spending as a way to stimulate
the economy: rising interest rates lead to crowding out – i.e., discouragement – of private
fixed investment, which in turn may hurt long-term growth of the supply side (potential
output). Keynesians respond that deficit spending may actually "crowd in" (encourage)
private fixed investment via the accelerator effect, which helps long-term growth.
Further, if government deficits are spent on productive public investment (e.g.,
infrastructure or public health) that directly and eventually raises potential output.
Whether a stimulus crowds out or in depends on the shape of the LM curve. A shift in the
IS curve along a relatively flat LM curve can increase out substantially with little change
in the interest rate. On the other hand, an upward shift in the IS curve along a vertical LM
curve will lead to higher interest rates, but no change in output (This case represents the
Treasury View).

The IS/LM model also allows for the role of monetary policy. If the money supply is
increased, that shifts the LM curve to the right, lowering interest rates and raising
equilibrium national income.

Usually the model is used to study the short run when prices are fixed or sticky and no
inflation is taken into consideration. To include these and other crucial issues, several
further diagrams are needed or the equations behind the curves need to be modified.

References
This article's citation style may be unclear. The references used may be clearer
with a different or consistent style of citation, footnoting, or external linking.

1. ^ Robert J. Gordon, Macroeconomics eleventh edition, 2009

2. ^ Hicks, J. R. (1937), "Mr. Keynes and the Classics - A Suggested Interpretation",
Econometrica, v. 5 (April): 147-159.
3. ^ Hicks, John (1980-1981), "IS-LM: An Explanation", Journal of Post Keynesian
Economics, v. 3: 139-155
4. ^ (Hicks 1980-1981)
5. ^ "The General Glut Controversy", History of Economic Thought, New School
(on line).
6. ^ Spector, Lee C. and T. Norman Van Cott. "Textbooks and Pure Fiscal Policy:
The Neglect of Monetary Basics" (Jan 2007). [1]

Related Models
• AD-AS Model
 • AD-IA Model
• Mundell-Fleming model

See also
• Policy-mix
• Money demand

External links
• Elmer G. Wiens: IS-LM Model - An On-line, Interactive IS-LM Model of the
Canadian Economy.
• The Hicks-Hansel IS-LM Model: [2] in-depth comment and explanation.
• Krugman, Paul. There's something about macro - explaining the model and its
role in understanding macroeconomics
• Weerapana, Akila. [3] - Lecture Notes explaining the IS Curve and the LM Curve

Retrieved from "http://en.wikipedia.org/wiki/IS/LM_model"

Categories: Macroeconomics | Economics models | Economics curves
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THERE'S SOMETHING ABOUT MACRO

It's holiday season, and my thoughts have turned to ... course preparation. Classes don't
begin until February, but books must be ordered, reading packets must receive copyright
clearance and go to Graphic Arts, and background notes must be prepared.

This spring I have a new assignment: to teach Macroeconomics I for graduate students.
Ordinarily this course is taught by someone who specializes in macroeconomics; and
whatever topics my popular writings may cover, my professional specialties are
international trade and finance, not general macroeconomic theory. However, MIT has a
temporary staffing problem, which is itself revealing of the current state of macro, and I
have been called in to fill the gap.

Here's the problem: Macro I (that's 14.451 in MIT lingo) is a quarter course, which is
supposed to cover the "workhorse" models of the field - the standard approaches that
everyone is supposed to know, the models that underlie discussion at, say, the Fed,
Treasury, and the IMF. In particular, it is supposed to provide an overview of such items
as the IS-LM model of monetary and fiscal policy, the AS-AD approach to short-run
versus long-run analysis, and so on. By the standards of modern macro theory, this is
crude and simplistic stuff, so you might think that any trained macroeconomist could
teach it. But it turns out that that isn't true.

You see, younger macroeconomists - say, those under 40 or so - by and large don't know
this stuff. Their teachers regarded such constructs as the IS-LM model as too ad hoc, too
simplistic, even to be worth teaching - after all, they could not serve as the basis for a
dissertation. Now our younger macro people are certainly very smart, and could learn the
material in order to teach it - but they would find it strange, even repugnant. So in order
to teach this course MIT has relied, for as long as I can remember, on economists who
learned old-fashioned macro before it came to be regarded with contempt. For a variety
of reasons, however, we can't turn to the usual suspects this year: Stan Fischer has left to
run the world, Rudi Dornbusch is otherwise occupied, Olivier Blanchard is department
head, Ricardo Caballero - who is a bit young for the role, but can swallow his distaste if
necessary - is on leave. All of which leaves me.
Now you might say, if this stuff is so out of fashion, shouldn't it be dropped from the
curriculum? But the funny thing is that while old-fashioned macro has increasingly been
pushed out of graduate programs - it takes up only a few pages in either the Blanchard-
Fischer or Romer textbooks that I am assigning, and none at all in many other tracts - out
there in the real world it continues to be the main basis for serious discussion. After 25
years of rational expectations, equilibrium business cycles, growth and new growth, and
so on, when the talk turns to Greenspan's next move, or the prospects for EMU, or the
risks to the Brazilian rescue plan, it is always informed - explicitly or implicitly - by
something not too different from the old-fashioned macro that I am supposed to teach in
February.

Why does the old-fashioned stuff persist in this way? I don't think the answer is
intellectual conservatism. Economists, in fact, are in general neophiles, always looking
for something radical and different. Anyway, I have seen over and over again how young
economists, trained to regard IS-LM and all that with contempt if they even know what it
is, find themselves turning to it after a few years in Washington or New York. There's
something about primeval macro that pulls us back to it; if Hicks hadn't invented IS-LM
in 1937, we would end up inventing it all over again.

But what is it that makes old-fashioned macro so compelling? To answer that question, I
find it helpful to think about where it came from in the first place.

Afficionados know that much of what we now think of as Keynesian economics actually
comes from John Hicks, whose 1937 article "Mr. Keynes and the classics" introduced the
IS-LM model, a concise statement of an argument that may or may not have been what
Keynes meant to say, but has certainly ended up defining what the world thinks he said.
But how did Hicks come up with that concise statement? To answer that question we
need only look at the book he himself was writing at the time, Value and Capital, which
has in a low-key way been as influential as Keynes' General Theory.

Value and Capital may be thought of as an extended answer to the question, "How do we
think coherently about the interrelationships among markets - about the impact of the
price of hogs on that of corn and vice versa? How does the whole system fit together?"
Economists had long understood how to think about a single market in isolation - that's
what supply-and-demand is all about. And in some areas - notably international trade -
they had thought through how things fitted together in an economy producing two goods.
But what about economies with three or more goods, where some pairs of goods might be
substitutes, others complements, and so on?

This is not the place to go at length into the way that Hicks (and others working at the
same time) put the story of "general equilibrium" together. But to understand where IS-
LM came from - and why it continues to reappear - it helps to think about the simplest
case in which something more than supply and demand curves becomes necessary: a
three good economy. Let us simply call the goods X, Y, and Z - and let Z be the
"numeraire", the good in terms of which prices are measured.
Now equilibrium in a three-good model can be represented by drawing curves that
indicate combinations of prices for which each of the three markets is in equilibrium.
Thus in Figure 1 the prices of X and Y, both in terms of Z, are shown on the axes. The
line labeled X shows price combinations for which demand and supply of X are equal;
similarly with Y and Z. Although there are three curves, Walras' Law (if all markets but
one are in equilibrium, that market is in equilibrium too) tells us that they have a common
intersection, which defines equilibrium prices for the economy as a whole. The slopes of
the curves are drawn on the assumption that "own-price" effects are negative, cross-price
effects positive - thus an increase in the price of X increases demand for Y, driving the
price of Y up, and vice versa; it is also, of course, possible to introduce complementarity
into such a framework, which was one of its main points.

This diagram is simply standard, uncontroversial microeconomics. What does it have to

do with macro?

Well, suppose you wanted a first-pass framework for thinking coherently about macro-
type issues, such as the interest rate and the price level. At minimum such a framework
would require consideration of the supply and demand for goods, so that it could be used
to discuss the price level; the supply and demand for bonds, so that it could be used to
discuss the interest rate; and, of course, the supply and demand for money.

What, then, could be more natural than to think of goods in general, bonds, and money as
if they were the three goods of Figure 1? Put the price of goods - aka the general price
level - on one axis, and the price of bonds (1 divided by 1+i, if they are one-period
bonds) on the other; and you have something like Figure 2 - or, more conventionally
putting the interest rate instead of the price of bonds on the vertical axis, something like
Figure 3 . And already we have a picture that is essentially Patinkin's flexible-price
version of IS-LM.

If you try to read pre-Keynesian monetary theory, or for that matter talk about such
matters either with modern laymen or with modern graduate students who haven't seen
this sort of thing, you quickly realize that this seemingly trivial formulation is actually a
powerful tool for clarifying thought, precisely because it is a general-equilibrium
framework that takes the interactions of markets into account. Here are some of the
things it suddenly makes clear:

1. What determines interest rates? Before Keynes-Hicks - and even to some extent after -
there has seemed to be a conflict between the idea that the interest rate adjusts to make
savings and investment equal, and that it is determined by the choice between bonds and
money. Which is it? The answer, of course - but it is only "of course" once you've
approached the issue the right way - is both: we're talking general equilibrium here, and
the interest rate and price level are jointly determined in both markets.

2. How can an investment boom cause inflation (and an investment slump cause
deflation)? Before Keynes this was a subject of vast confusion, with all sorts of murky
stuff about "lengthening periods of production", "forced saving", and so on. But once you
are thinking three-good general equilibrium, it becomes a simple matter. When
investment (or consumer) demand is high - when people are eager to borrow to buy real
goods - they are in effect trying to shift from bonds to goods. So as shown in Figure 4 ,
both the bond-market and goods-market equilibrium schedules, but not the money-market
schedule, shift; and the result is both inflation and a rise in the interest rate.

3. How can we distinguish between monetary and fiscal policy? Well, in a fiscal
expansion the government sells bonds and buys goods - producing the same shifts in
schedules shown in Figure 4. In a monetary expansion it buys bonds and "sells" newly
printed money, shifting the bonds and money (but not goods) schedules as shown in
Figure 5 .

Of course, this is all still a theory of "money, interest, and prices" (Patinkin's title), not
"employment, interest, and money" (Keynes'). To make the transition we must introduce
some kind of price-stickiness, so that incipient deflation is at least partly translated into
output decline; and then we must consider the multiplier impacts of that output decline,
and so on. But the basic form of the analysis still comes from the idea of a three-good
general-equilibrium model in which the three goods are "goods in general", bonds, and
money.

Sixty years on, the intellectual problems with doing macro this way are well known. First
of all, the idea of treating money as an ordinary good begs many questions: surely money
plays a special sort of role in the economy. Second, almost all the decisions that
presumably underlie the schedules here involve choices over time: this is true of
investment, consumption, even money demand. So there is something not quite right
about pretending that prices and interest rates are determined by a static equilibrium
problem. (Of course, Hicks knew about that, and was quite self-conscious about the
limitations of his "temporary equilibrium" method). Finally, sticky prices play a crucial
role in converting this into a theory of real economic fluctuations; while I regard the
evidence for such stickiness as overwhelming, the assumption of at least temporarily
rigid nominal prices is one of those things that works beautifully in practice but very
badly in theory.

But step back from the controversies, and put yourself in the position of someone who
must reach a judgement about the likely impact of a change in monetary policy, or an
investment slump, or a fiscal expansion. It would be cumbersome to try, every time, to
write out an intertemporal-maximization framework, with microfoundations for money
and price behavior, and try to map that into the limited data available. Surely you will
find yourself trying to keep track of as few things as possible, to devise a working model
- a scratchpad for your thoughts - that respects the essential adding-up constraints, that
represents the motives and behavior of individuals in a sensible way, yet has no
superfluous moving parts. And that is what the quasi-static, goods-bonds-money model is
- and that is why old-fashioned macro, which is basically about that model, remains so
useful a tool for practical policy analysis.