Keynesian vs. Classical Income Model
Keynesian vs. Classical Income Model
Keynesian vs. Classical Income Model
MIC MODELS
DR. SEEMA SHARMA
DEPARTMENT OF MANAGEMENT STUDIES
IIT DELHI-110016
Introduction
What is Economics?
Economic Problems in Long Run
Economic Problems in Short Run
Economic Systems
Business Cycles
Stabilization Policies
History of Economic
Thought
Mercantilism
Classical
School of Thought
Keynesian School of
Thought
Classical Model
Classical economists believed that because of the following:
Say’s Law
Flexible interest rates
Flexible prices
Flexible wages
P0
Multiplier
mpc of poor people is high hence, in depression, purchasing
power of poor people should be increased.
IS LM Framework
IS LM Analysis
Y = C+I+G
C+I+G = C+S+T
Hence S = I (Desired S and I)
IS Curve: There is
negative relationship
between r and output.
Changes in Y caused
by changes in r are
reflected as
movements along the
IS curve. When
interest rates
decrease, spending
rises and as a result,
output increases as
well. When interest
rates increase,
spending falls and as
a result output
decreases as well.
Shifts in IS curve: Changes in Y due to factors
other than r
Change Shift
Increase in investment right
M
Money Supply is assumed fixed as set by RBI in India and
Federal reserve in US
LM curve shows all combinations of r & Y at which demand
for money and supply of money is equal.
Shifts in LM curve
Change Shift
Open Market Operations: The Central Bank buys G-Secs & increases the money supply.
This injection of liquidity lowers the interest rate in the money market. The reduced
interest rate induces increased investment, and equilibrium output consequently
increases. The LM curve shifts to the right and equilibrium output increases. Because of
the increased income demand for money increases (transactions), and this increases the
interest rate. The economy eventually settles down at a new simultaneous equilibrium.
Y = C(Y-T) + I + G + NX
If ER decreases (An appreciation under flexible exchange rates or a revaluation under fixed
exchange rates), then we’ll be able to buy more foreign currency with less of our own currency.
Therefore, when ER decreases domestic residents have more purchasing power, thus being able to
buy the same amount of goods using less domestic currency. Hence Net Exports will come down.
If ER increases (depreciation under flexible exchange rates or a devaluation under fixed exchange
rates), the net exports will increase.
In case of increase in ER, IS curve shifts to the right, and in case of decrease in ER causes net export
to decrease and hence the IS curve shifts to the left.
The Money Market
The equilibrium of the money market implies that, given the amount of
money, the interest rate is an increasing function of the output level. When
output increases, the demand for money raises, but, as we have said, the
money supply is given. Therefore, the interest rate should rise until the
opposite effects acting on the demand for money are cancelled, people will
demand more money because of higher income and less due to rising
interest rates. The slope of the curve is positive, contrary to what happened in
the IS curve. This is because the slope reflects the positive relationship
between output and interest rates.
IS-LM-BP Model: BP Line
The Balance of Payments
Shift in BP Curve
Equilibrium in IS-LM-BP Model
Scenario 1: Fixed Exchange Rates, Perfect Capital Mobility, Increase in
Money Supply