The main goal of Chapter 8 was to describe business cycles by presenting the business cycle facts.
This and the following two chapters attempt to explain business cycles and how policymakers should respond to them. First, we must develop a macroeconomic model that we can use to analyze cyclical fluctuations and the effects of policy changes on the economy.
By examining the labor market in Chapter 3, the goods market in Chapter 4, and the asset market in Chapter 7, we already have identified the three components of a complete macroeconomic model. Now we put these three components together into a single framework that allows us to analyze them simultaneously. This chapter, then, consolidates our previous analyses to provide the theoretical structure for the rest of the book.The basic macroeconomic model developed in this chapter is known as the IS-LM model. (As we discuss later, this name originates in two of its basic equilibrium conditions: that desired investment, I, must equal desired saving, S, and that money demanded, L, must equal money supplied, M∕P) The IS-LM model was developed in 1937 by Nobel laureate Sir John Hicks,[150] who intended it as a graphical representation of the ideas presented by Keynes in his famous 1936 book The General Theory of Employment, Interest, and Money. Reflecting Keynes's belief that wages and prices don't adjust quickly to clear markets (see Section 1.3), in his original IS-LM model Hicks assumed that the price level was fixed, at least temporarily. Since Hicks, several generations of economists have worked to refine the IS-LM model, and it has been widely applied in analyses of cyclical fluctuations and macroeconomic policy, and in forecasting.
Because of its origins, the IS-LM model is commonly identified with the Keynesian approach to business cycle analysis. Classical economists—who believe that wages and prices move rapidly to clear markets—would reject Hicks's IS-LM model because of his assumption that the price level is fixed. However, the conventional IS-LM model may be easily adapted to allow for rapidly adjusting wages and prices.
Thus the IS-LM framework, although originally developed by Keynesians, also may be used to present and discuss the classical approach to business cycle analysis. In addition, the IS-LM model is equivalent to the AD-AS model that we previewed in Section 8.4. We show how the AD-AS model is derived from the IS-LM model and illustrate how the AD-AS model can be used with either a classical or a Keynesian perspective.Using the IS-LM model (and the equivalent AD-AS model) as a framework for both classical and Keynesian analyses has several practical benefits: First, it avoids the need to learn two different models. Second, utilizing a single framework emphasizes the large areas of agreement between the Keynesian and classical approaches while showing clearly how the two approaches differ. Moreover, because versions of the IS-LM model (and its concepts and terminology) are so often applied in analyses of the economy and macroeconomic policy, studying this framework will help you understand and participate more fully in current economic debates.
We use a graphical approach to develop the IS-LM model. Appendix 9.B presents the identical analysis in algebraic form. If you have difficulty understanding why the curves used in the graphical analysis have the slopes they do or why they shift, you may find the algebra in the appendix helpful.
To keep things as simple as possible, in this chapter we assume that the economy is closed. In Chapter 13 we show how to extend the analysis to allow for a foreign sector.
9.1