1. UNIT 2 NEOCLASSICAL SYNTHESIS
structure
2.0 Objectives
2.1 Introduction
2.2 InvestmentFunction
2.3 Demandsfor andSupplyofMoney
2.4 EquilibriuminReal Sector-ISCurve
2.5 EquilibriuminMonetarySector-LMCurve
2.6 SynthesisofRealand Monetary Sectors
2.7 LetUs Sum Up
2.8 Key Words
2.9 SomeUsell Books
2.10 AnswersIHints to CheckYourProgressExercises
2.0 OBJECTIVES
AAergoingthroughthisunityoushouldbeinapositionto
explaintheequilibriuminrealandmoneymarketsinaneconomy;
explaintheunderlyingideasbehind IScurve;
explaintheunderlyingideasbehindLMcurve;
explainthe interactionofISandLMcurve;and
apprisetheeffectivenessofmonetaryandfiscal policiesinaneconomy.
2.1 INTRODUCTION
In the previous Unit we discussed the classical and Keynesian views on the
determination of output and prices in an economy.According to the classical
economists supply creates its own demand and full employmentprevailsthrough
adjustments in prices and wage rate. TheKeynesianview,however,assumesthat
price level and wage rate are sticky in an economydue to various factors such as
labourcontracts and labourlaws sothat adjustmentto demand shockstakes place
not through adjustmentsinprices andwage rate but through changesin outputand
employment levels. In fact, Keynesianeconomicspresents a view oppositeto the
classicaleconomiststhat demandcreatesitsown supplyso longasunemployment
existsinthe economy.
Theclassicaleconomistsassumedadichotomybetween therealandmonetarysectors
ofaneconomy.Accordingtothemanincreaseinmoney supply(M, )inaneconomy
with output and employmentlevelsunchanged,will translateinto a proportionate
increase in prices. Therefore, through increase in price level and wage rate the
adjustmentprocesswillbeginandfullemploymentwill be maintained.
711edifferenceinviewsbetyee~classicalandKeynesianeconomistsisdueprimarily
to thetimehorizon considered.In the Keynesianviewinthe longrunprice leveland
2. Traditional*ppmaehe~toA~~ wage rate will adjust to - , .A,, rum levels. But in the short run due to price and
Macroeconomics wage rigiditiesful' ,iilployment equilibriumwill not be realised.The neocl-xical
economists, particularly Sir John Hicks, have attempted to combine the ideas
containedin both the schoolsof thoughtand to bring a synthesis between the real
sectorand the monetarysector of the economy. 1
We shouldrememberthat theclassicaleconomistsdid not botheraboutthe quantity
of money supplied,as it did not affectoutput and employmentaccordingto them.
The Keynesian economists,however,projected an activerole for money supplyas
it can influencethe levelsof outputand employment.
In continuation of the basic ideas presented in the previous Unit we discuss the
behaviourofinvestmentfunctionbelow.
2.2 INVESTMENT FUNCTION
The classicaleconomistsdid not pay much attentionto the increasein capital stock
dueto investmenttakingplace in aneconomy.We knowthat investmentresults in
atl increase in the level of capital input. In the production process the inputs are
transformedto outputwiththehelp oftechnology.It isan important featdreofcapital
input that it is durable in nature, that is, it does not get exhausted in a single use
Ilowever, certaindepreciation (that is, wear and tear) to capital stock is involved
when production takes place.
TL- I + . . ~ I. l , , , L cf cqital stock increaseswhen net investment(gross investmentminzls
depreciation)isincurred.We will look intothe growthofcapitalstockandconsequent
rise in output in Block 2.
Investment takes place in an economy because it provides certain returns to the
investor and there is a profit motive involved. The return to investment can be
measuredbythemarginalproduct ofcapital(MPK), which isdefined asthe increase
in output when capital stock increases by a single unit. Simultaneously,business
firms or households have to borrow by paying certain rate of interest in order to
undertake investment. Even in cases when a household or business firm do not
requireborrowing,the implicitcost ofthe investmentisthe interest foregone.For
example,if I construct anew house (that is, I undertake some investment), Ihave
the option of taking a loan from a bank on the condition that I repay the principal
alongwithinterest.Similarly,businessfirmsundertakeinvestmentsto produce goods
and services. In doing so they take intd account two factors: i) the return from
investmentwhich isdeterminedby MPK,andii)prevailingrate ofinterest.If return
to investment is higher than interest rate they undertake the investment project,
otherwise it isnot profitableto them. The equilibrium levelof investment will be
achievedwhen the ratesf interestisequalto the rate of return from investment.
It isa commonfeatureofthe aggregateproduction functionthat as we increqsethe
levelofcapitalinputthemarginalproductivityofcapitaldecreases.Thusasmerit
increasesthereturnto investmentdecreases.Increased levelofbvestment, thereibre,
canbe undertakenonlywhen therate of interest isrelatively lower.
In Fig. 2.1 we presentthe investmentfuhctionasa downward slopingstraight line.
We measurethe levelof investmefit(I)on x-axisand the rate of intereston y-axis.
Whentherate of interestisr, the levelof investment isI,. In casethe rate of interest
declinesto r2the level of investment increasesto 12.
3. Neoclassical Synthesis
I, 1 2
Fig.2.1: InvestmentFunction
Apart from theprevailing rateof interest(r)thedecisionto invert dependsto a great
extant an expectations about future movements in prices, resources availability,
governmentpolicy, competitionfromrivalfirmsandproduct, etc. Sinceinvestment
involves creation of capital stocks which remains in use for a longer creationof
capital stocks which remains in use for a longer period of time, the element of
uncertainty playsa vitalrole in investmentdecisions.
Economistshavefounditquitedifficulttoexplainthepatternofinvestmentspending.
Thereareseveralecononletricmodelstoexplain investmentbehaviourandnoneof
the models have been proved to be superior over others.
The accelerator model of investment short that rate of investment depends upon
changesinaggregateoutput.It statesthatdesiredlevel ofcapitalstockinthe economy
isa constantfractionof output level,that is, k =h Q. Thus,asoutput level changes
capitalstockalsochanges.In periodsof increasingeconomicactivity,when growth
ratein GDPishigher, thereis a senseof securityinthe minds of entrepreneursand
they undertake investments. Onthe otherhand, inperiodsofrecession,there in not
much increase in investment. Thus investment not only influences output (recall
multipliermodel),it is influencedby thechanges in output.
I
?'headjustmentcost model statesthata firmundertakesfeasibilitystudies,machines
analysisand financial arrangementsbefore implementingas investment decision.
Secondlythereisacostinvolvedininstallationofnowmachinery,trainingofworkers
to operatethe new technologyanddisruptionofproductionchain. Thesecostsare
calledadjustmentcostsandrise ifthechangeisdoneina shortperiod oftime. Thus
i firms make gradual changes in theircapital stock even though the requirementis
I much higher.Accordingto adjustmentcostmodelsof investment,there isalwaysa
gapbetween desired level of capital stock and actual level of capital stock.
I
4. TraditionalApproaches to
Macroeconomics 2.3 DEMANDFORAND SUPPLYOFMONEY
Money servesthree importantfunctionsin an economy,viz., mediumof exchange,
unit of account, and store of value. In an economy without money it would be
extremelydifficult to exchangegoodsand servicesthrough 'barter' aswas the case
before 'paper money' was invented.Modemmoneyhassignificantlyeasedthemode
of exchange -we can go to the market and buy or sell goods and services in
exchangefor money. Secondly,money servesasa unit of accountinthe sensethat
the value of goods and servicesare measured in terms of money. Thirdly,paper
money although doesnot have anyintrinsicvalue it is storedbecause it commands
certainpurchasing power in the market.
Demandformoney(M,,)arisesasitperformstheabove-mentionedhctions-allof
us want tohave moremoney. Theclassicaleconomistsput more importanceon the
medium ofexchangefunctionofmoneyandsuggestedthatpeopledemandformoney,
as it isrequired to carryout transactionsin the market.We receive our income on a
monthlyorweekly basis (itcanbehighlyirregularalso)whilewe makepurchasesina
routinemanner.Thusthereisnosynchronisationbetweenthetimewereceiveourincome
andwe carryoutmonetarytransactions'.
Keynesrecognisedthat therearethreetypes ofdemandfor money,viz., transaction
demand, precautionary demand and speculativedemand. People store money as a
precautioninordertomeetexigenciesinday-to-daylife,whichisdifferenth mtransaction
demand.Precautionarydemand formoneydependsupontheperception oftheperson
concernedwithrespecttoperiodicityofincome,stabilityinincomeflowanduncertainty
infutureincomestream.Letusdenotethe sumoftransactiondemandandprecautionary
demand for money as M; .We assume that Mf;is a constant proportion of total
income.
Thethirdtypeof demand formoney, accordingto Keynes,isthe speculativedemand
(M ; ), which is used largely for purchase of financialassets.Theseassets couldbe
interest-yieldingbondsordividend-yieldingshares(ofafm).Thespeculativedemand
formoney dependsupon the portfolioofassetsthat we need to maintain. If we hold
moneyinthe formofcashthereturnto money iszero.Moreover,ifthereisinflationin
theeconomythenthereisadeclineinpurchasingpower.However,ifweput it instocks
(that is,shares)thereisconsiderablerisk involvedasstockpricesvary andwe losepart
ofourmoneywhen stockpricesdecline.Wecankeepmoney in somefixeddepositor
fixedincome-yieldingasset,butinthatcasewehavetocompromisewithliquidityinthe
sensethat itmay notbepossibletogetback cashimmediately.
Accordingtoclassicaleconomists,whenthereisexcessoflonablefunds(thatis,saving ,
available-forinvestment)inthe marketcomparedtodemand for it(thatis, investment
requirement)thenthereisadeclineintherateof interest. The increaseinmoneysupply
bythecentralbank (forexample,ReserveBank of India)increaseslonablehnd inthe
economy.If there isnocorrespondingincreaseindemandformoney, equilibriumin
money marketcanbeachievedonlythroughadeclineintherateof interest.In fact,the
classicaleconomistsassumedflexibilityininterestrateforrealisationofequilibriumin
moneymarket.
I
'The demand for money according to classical economists was determined by the 'quantity 1
theoryof money', accordingto which MV =PY, where M ismoney supply,V isvelocity ofmoney,
P isprice level and Y is output level. When V and Y are given,P is proportional to M. Thuswhen
money supply increasesthere is a proportional increase in price level.
5. Neoclassical Synthesis
1,
Fig.2.2: LiquidityTrap
Theprecautionary andtransaction demand for money may be a fixedproportionof
incomeanddependantupon certainpsychologicalfactorsapartfrombasicrequirement.
The speculativedemandformoney ( M i), on the otherhand, dependsupon rate of
interest.When rateof interestishigh, peoplekeeparelativelyloweramountintheform
ofcash,astheywouldbelosingoutinterestotherwise.Ontheotherhand,whentherate
of interestislowpeople preferto keepa relativelyhigher amountofcashwith them.
Thusspeculativedemandformoneyisaninversefunctionofinterestrate(seeFig.2.2).
AccordingtoKeyneswhenrateofinterestissufficientlylow(sayr, inFig.2.2)people
prefer to keeptheir incomeinthe formof cashwith themselvesinstead of financial
assets.Thelossdueto interestthattheir incomecould haveearnedisminimal when
interestrateisverylow.
In terms of Fig. 2.2 the curverepresenting speculativedemandfor money becomes ,
infinitelyelastic(horizontal)whenrateofinterestislow.Thissegmentiscalled'liquidity
trap' becausepeopleprefer liquiditytokeepingtheirmoneyinfinancialassets.
Rccall fromUnit 1that incomeservestwo purposes: it is eitherconsumedor saved.
Thmfore, itisimplicitlyassumedthatwhateverisnotsavedisconsumed.Thusahigher
savingmeansreduced consumption. Unlessthehigher savingtranslatesintohigher
investmenttherewould be a declineinaggregatedemandand consequentlya fall in
outputlevel. When Keynestalks ofliquiditytraphemeansthatthereisan increasein
savingbutthereisnocorrespondingincreasein investment.Thusgovernmentpolicy of
injectingmoneyintothesystemori n m i n gincomeofpeopledoesnothawanyimpact,
asitisdivertedtowardssavingwithoutincreaseinconsumption.
Youmaybewonderingwhethersuchsituationstakeplace inreality.Duringlate 1990s
Japaneseeconomywentthroughsevererecessionwith declinein output,pricesand
interestrate.Forquitesometimeintheyear2003therate ofinterestwas0.03per cent
perannum.Insuchsituationsmonetarypolicybecomesineffective.
The supplyofmoney constitutesthe currency in circulationand deposits in banks.
Money is usually supplied by the central bank.of a country andthere are various
measures of money supply dependingupon its liquidity. In Indiafor example we
6. TraditionalApproachesto
Macroeconomics have money supplymeasuressuchas MI,M2 andM3 which aredistinctfromeach
other.
CheckYourProgress 1
1) What are the types of demand for money? What are the factors on which the 1
demandformoneyisdependentupon? ~
2) Explaintheconceptof'liquiditytrap'? Whydoesmonetarypolicybecomeineffective
iftheeconomyisonpassingthroughaphaseofliquiditykip? I
2.4 EQUILIBRIUMINREALSECTOR-ISCURVE
InFig. 1.4inUnit 1wehaveshowntheequilibriumoutput at a levelwhen aggregate
demandequalsaggregatesupply.Inasimplemodel-gate demand(AD) comprises
C+I,herewe clubgovernmentexpenditureinvestmentforsimplerexposition,while
aggregatesupply(AS)comprisesCandS.ThusattheequilibriumlevelofoutputI=S.
In Fig. 1.4 we assumethe level of investmentto be fixed so that it is depicted as a
horizontalstraightline.InFig.2.3 wepresenttheinWactionofsaving(S)andinvestment
(I) functions. When investment is I, and savingfimctionisrepresentedby S,then
f
equilibriumoutputisY,.
Wenotice abasic differencebetween exFig. 2.1 and Fig. 2:3. In Fig. 2.1 investment
dependsupontherate ofinterest (r)suchthatmoreisinvestedwhen a lowerinterest
rateprevailsintheeconomy.InFig.2.3 investmentisshowntobeafunctionofY. Both
thesaving4investmenth t i o n scanheintegr-dedsothatweobtainequilibriumlevels
ofr andY. TheIS curvebased onneoclassicalideasshowsthe cquilibriurninthe real
sectoroftheeconomy(see Fig.2.4)
7. Saving. investnient
Fig.23: EquilibriumOutputLevel
Inorderto explainFig.2.4 letus beginwiththe secondquadrant(north-westcomerof
thediagram).ThisrepresentstheinvestmentcurvepresentedinFig.2.1. Theonlychange
hereisthatwe measureinvestmentonx-axis inthe oppositedirection.The farthera
pointtothe leftfromtheorigin,higher isthelevelofinvestment.Inthethird quadrant
(thatis, south-westcomer)we measureI on x-axisand Son y-axis.Wehave drawna
45Olinesothat S=I(impliesequilibriumlevelofoutput)alongthisline.Inthe fourth
quadrantx-axismeasuresincome(Y) andy-axismeasuressavings. ered h a v eh w n
the savingfunction(Fig. 2.3 in invertedposition) and itgivesthe level of savingfor
differentlevelsofin&e @member thatx-axismeasuresincomehere). Thusoncewe
knowtherequiredlevelofsavingweknowthelevelofincomefkomthesavingfunction. 4
Inthefirstquadrant(north-eastcomer)wehavetheIScurve,whichwe derivebyusing
theinformationcontainedinotherthreequadrants.Inthefirstquadrantwehavetherate
ofinterestony-axisandincomeonx-axis.
S = I
Fig. 2.4: ISCurve
Neoclassical Synthesis
8. TraditionalApproaches
Macroeconomics
to NowletusexplainhowweobtainedtheIScurve.Letusassumethat investmentisgiven
tous (seesecondquadrant).Bylookingintothethirdquadrantwe findtheequilibrium
levelof saving(sinceSshouldbeequal to Iatequilibrium).Next, ifwe look intothe
fourthquadrant,giventherequiredlevelofsaving,weobtainthcequilibriumlevelof
homebydrawingaperjmdicularlinefromthesavingfimctiontoihex-axk.Byc o m b i i
differentlevelsofinvestmentandsavingwederivetheIScurve.Thuseverypointonthe
IScurverepresentsequilibriumlevelsofincomeandinterestrate
Whenthereischangeinthelevelofinvestmentthereisawholese~,,ie;lce ofclianges-
therequiredlevelofsavingwill change,therequiredlevelof incomewill change.An
implicationoftheIScurveisthatthegoodsmarket(realsector)canbeatequilibriumin
anycombinationoflowerinterestrateandhigherincome,orahigherinterestrateand
lowerincome.
2.5 EQUILIBRIUM IN MONETARY SECTOR - LM
CURVE
?'hederivationof LMcurveutilisesthe Keynesianviewthat speculativedemand and
transactiondemandformoneyare separate.TheLMcurveispresentedinFig. 2.5.
nordertoexplainFig.2.5 we againbegin withthe secondquadrant.Herewemeasure
interestrateony-axisandspeculativedemandformoneyonx-axis.Itisare-presentation
of Fig. 2.2with the differencethat M: ismeasured in the oppositedirection. Thus
W e rapointh mtheoriginhigheristhelevelofspeculativedemandformoney. From
thespeculativedemandhction, giventheprevailingrateofinterest,wecanf i doutthe
quantityofspeculativedemand.Thethirdquadrantshowsthatequilibriuminthemoney
marketcanbeachievedwhendemandformoneyisequalto supplyofmoiiey.Herewe
measure M; ony-axisand onx-axis. Weknowthattotal demand formoney is
M:,Y
Fig.2.5: L&lCurve
9. given by Mf:+M,';.For equilibrium in the money market to be realised (that is, Neoclassical Synthesis
M , =M , )we have drawna straightline, whichtouchesy-axisat M; (since MI: =
0atthispoint) andtouchesx-axisat M; (since M ; =0atthispoint).Ifrateof interest
islowmoremoney isdemandedforspeculativepurposes, which implieslessmoneyis
leftfortransaction demand. Recall thattransaction demandformoney isaconstant
proportionof income.Thushigherlevelof M ; correspondstohigherlevelofY.This
behaviourisrepresentedinastraightlineinthefourthquadrant.
In thefirstquadranttheLMcurveisgivenwhichisupward sloping.Alongy-axis we
measuretherateof interestwhile incomeismeasured onthe x-axis.Rememberthat
eachpoint ontheLM curverepresentsequilibriuminthemoneyrnarket.Animplication
oftheLM curveisthatmoneymarketequilibriumcombineslowerrwith loweryand
higherrwithhigherY
2.6 SYNTHESIS OF REAL ANDMONETARY
SECTORS
Now letus combineISandLMcurvesasshowninFig.2.6.SuchintegrationofIS-LM
givesauniquecombinationofrandY,whichrepresentsequilibriuminbothxalmarket
andrponeymarket.In Fig.2 6wefindthatr, andY,issuchacombinationfortheISand
LMekes.Rememberthat we havemaintained fixedpricesin themodel, which is
simplisticbut convenient.Inthismodelitisnot necessarythatequilibriumincomeand
interestrateguarantee111employment.Insuchacasethegovernmentneedstointervene.
Therecouldbetwopolicy instrumentsforinterventionbythegcivernrnent:fiscalpolicy
andmonetarypolicy. Fiscalpolicyreferstotaxationandexpendituremeasuresbythe
government.When the governmentincreasesitsexpenditurethere isan increasein
investments,whichresultsinanupwardshiftintheinvestmentschedule.weh&e shown
in Fig. 2.4 a shiftin the investment scheduleby a dottedline. Dueto the shift inthe
investmentschedulethereisanoutwardshifiintheIScurvealsoandequilibriumlevelof
output increases.Wehave shownsuchashift intheIScurveinFig.2.4byadottedline.
Anothermeasure under fiscal policyisthereduction of taxrateson income.Sucha
measurewillchangethenatureofconsumptionhction(alsosavingfunction)andleave
peoplewith moreincome. SuchameasurewillshifttheIScurveupward.Theopposite
effecttakesplacewhen governmentexpenditureiscurtailedortaxratesareincreased.
Rememberthatchangesin fiscalpolicyaffectsIScurve.
Monetarypolicyreferstochangesinmoneysupplyintheeconomybythecentralbank
(forexample,ReserveBankofIndia).Itwilleffectashiftinthe LMcurve.Whenthere
isanincreaseinmoneystipply,anincreaseinreal balancestakesplace,whichdecreases#
rateofinterest.Whenrateofinterestdeclinesforeachlevelofincomethereisadownward
shift in the LM curve (dotted line in Fig. 2.6)accordinglytherewill be a changein
equilibrium levelsofrandY(notshowninthefigure).
'
Throughappropriatechangesinfiscalpolicyandmonetpypolicythegovernmentcan
I interveneandsteer theeconomytowardsfullemploymentequilibriumlevel.
I
Wehavementioned earlierin Section2.3that monetarypolicy becomesineffective
i
whentheeconomyispassingthroughaliquiditytrap. Infact,thedifferencebetweenthe
classicalandKeynesianpositionscanbeshownthroughtheIS-LMmodel.
I
11. Now letuslookintotheotherexbremewhentheeconomyisoperatingatincomelevelof Neoclassical Synthesis
Y,.Atthis levelan increaseingovernmentexpenditureresultsinashiftintheIScurve
from IS, to IS',. Seethat at this leveltheLM curve isperfectlyinelastic,the rate of
interestisalreadyveryhigh,andrealbalancesintheeconomyislow.Whengovernment
borrowsfromthemarket,itcompeteswithprivateinvestmentandthereisanincreasein
interestrate-incomeleveldoesnotincrease.Thisistheclassicalrange.
Inpractice,however,the economyusuallyoperatesatamoderatelevelofincome,Y,.
Atthislevel,theeconomyhasnotreachedfullemploymentequilibriumlevel.Whenthe
governmentborrowsfromthemarketitcompeteswithprivateinvestmentbutitdoesnot
'crowd out' private investmentcompletely.As a result of increase in government
expendituretheIScurveshiftsfromIS, toIS',. Thereisanincreaseintherateofinterest
aswellasthe income.
CheckYourProgress2
1) Explaintheprocessofdetaminationofequilibriumintherealsectoroftheeconomy.
2) WhatdoestheLMcurvesignify?Whyisitupwardsloping?Explainthroughsuitable
d i m .
3) ExplainthroughIS-LMcurvetheineffectivenessofmonetaryandh a 1policies.
12. lkaditionalApproachesto
Marrrrpcnnnmirr . 2.7 LETUS SUMUP
Therearethreetypesofdemandformoney:transactiondemand,precautionarydemand I
andspeculativedemand.While&insactionandprecautionarydemandareconsidered
to be dependentuponlevelof income,speculativedemand formoneydependsupon
prevailingrateofinterest.Whenrateofinterestistoolow,speculativedemandisperfectly
elasticandadditionalincomein thehandsofpeople inthe formof idlecashbalances
withoutanyincreaseinconsumptionexpenditure.Suchasituationiscalledliquiditytrap
resort toappropriatefiscalpolicy.
Iandinterventionthroughmonetarypolicybecomesineffectiveandgovernmentshould 1
ThroughtheIS-LMmodelwedetermineauniquecombiionofinterestrateandincome
intheeconomywherebothreal sectorandmonetarysectorareinequilibrium.However,
suchequilibriummaynotbeat111employmentlevel.Inordertobringin111employment
.thegovernmentshouldintervenebyincreasingitsexpenditure. I
I
2.8 KEYWORDS I
Liquidiih p A situationofverylowrateofinterestwhenpeopledo
not increaseconsumptionexpenditureandadditional
I
moneyincomeissaved. I
SpeculativeDemand That part of demand for money which dependsupon
rateofinhestandused forinvestmentinfinancialassets.
Inflation Aperiodofsustainedriseinoverallprices.
ProductionFunction Thetechnicalrelationshipbetween iriputsandoutput.
2.9 SOMEUSEFULBOOKS
Mankiw,N. G,2000,Macroeconomics,FourthEdition,Macmillan,New Delhi.
Samuelson,P. A. and W. D. Nordhaus, 2005,Economics, Eighteenth Edition,Tata
McGrawHill,Delhi.
2.10 ANSWERShXINTSTOCHECK YOUR
PROGRESSEXERCISES
checkYourProgress1
. 1) Gothrough Section2.3. Discusstransation,precautionaryandspeculativedemand
formoney.
2) SeeSection2.3 andanswer.
CheckYourProgress2
1) s is cussthemethodthroughwhichweobtaintheIScurve. SeeSection2.4.
2) LMcurvesignifieequilibriuminthemoneymarket.ExplainFig.2.5.
3) GothroughSection2.6 andExplainFig.2.7.
