April 08, 2004
The Keynesian IS/LM Model
The IS/LM Model links the long-term interest rate, the short-term interest rate, and the level of output, which equals income. This model improves on the Simple Keynesian Model by making explicit the role of the long-term interest rate in determining the level of investment.
Shown is a business cycle caused by a shock to investment. Please note that, due to time considerations, we did not finish the analysis by showing the changes in the right-hand diagram caused by the changes in the interest rate and income.
The Simple Keynesian Model
The (over) simplified Keynesian Model illustrates the important point that small changes in investment can cause large changes in output.
The Classical Model of Production and Employment
Flush with their successes explaining things with supply and demand, the classical economists attempted to explain business cycles with a model based on the supply and demand for labor. The central concept in this model is a production function that determines the quantity of output in terms of capital and labor. The amount of capital is taken as fixed in the short run.
At this point, we can determine the level of output.
Any unemployment that is observed should disappear quickly as the real wage rate adjusts.
Two additional diagrams account for the nominal price level and the nominal interest rate.
The left-hand diagrams above show a business cycle caused by a bad year for the production function.
The Transactions Demand for Money
The classic parable about the transactions demand for money involves a tradeoff between interest on bank deposits and the shoe leather cost of repeated visits to the bank.
