10 Keynesian Economics and IS-LM Analysis

Lecture from: 18.11.2025 | Video: Video ETHZ

Finishing Lecture 9: Business Cycle Theories

The transition to short-run analysis continues with a closer look at the competing theories explaining fluctuations.

Classical vs. Keynesian: The Divide

The fundamental difference lies in the assumption about market clearing.

Classical Models (Imperfect Information)

Assume markets clear, but imperfect information confuses agents.

• Labor Market: If inflation is unanticipated, workers may mistake a nominal wage rise for a real wage rise (“inflation fallacy”) and work more. Result: Boom driven by confusion.
• Product Market: Firms may mistake general inflation for higher demand for their specific product and produce more.

Result

An unexpected price rise leads to a temporary output boom.

Keynesian Models (Stickiness)

Assume markets do not clear instantly because prices/wages are “sticky.”

• Sticky Wages: Contracts fix nominal wages. If prices rise unexpected, real wages ($W/P$) fall. Labor becomes cheaper $\to$ Firms hire more $\to$ Boom.
• Sticky Prices: Menu costs prevent instant price updates. If demand rises, firms with fixed prices become relatively cheap $\to$ Sales surge $\to$ Production increases.

Real Wages: Procyclical or Countercyclical?

• Keynesian/New Classical: Predict countercyclical wages (Recessions = High Real Wages).
• RBC (Real Business Cycle): Predicts procyclical wages (Boom = High Productivity = High Wages).

Switzerland’s high-inflation episode (2022-2023) supported the countercyclical view: nominal wages lagged, so real wages fell while the economy was active.

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Keynesian Economics and the IS-LM Model

The primary tool for short-run analysis is built here. Rooted in John Maynard Keynes’s General Theory (1936), it was a response to the Great Depression.

Keynes’s Insight: Recessions can result from inadequate aggregate demand. Core Assumption: Prices are fixed in the short run.

The Keynesian Cross

The simplest model, illustrating income determination.

Distinction:

• Planned Expenditure ($E$): What agents intend to spend ($C+I+G+NX$).
• Actual Expenditure: What is actually spent (equals Output $Y$).
• Difference: Unplanned inventory accumulation.

Equilibrium: Where Planned Expenditure = Actual Output. Graphically, where the Expenditure Function crosses the 45-degree line.

Gaps and the Multiplier

The equilibrium output ($Y$) might not match full-employment output ($Y_f$).

• Deflationary Gap: $Y<Y_f$. (Recession). Demand is too low.
• Inflationary Gap: $Y>Y_f$. (Boom). Demand is too high.

The Multiplier Effect: An initial injection of spending (e.g., Government spending $G$) becomes income for someone, who spends a fraction of it, creating more income, and so on.

$\text{Multiplier}=\frac{1}{1-\text{MPC}}=\frac{1}{\text{Marginal Propensity to Withdraw}}$

Leakages

In open economies like Switzerland, the multiplier is smaller because income “leaks” into Savings ($MPS$), Taxes ($MPT$), and Imports ($MPM$).

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The IS-LM Model

The Keynesian Cross is too simple because it treats Investment ($I$) as fixed. The IS-LM Model endogenizes investment by introducing the interest rate ($i$).

It finds the specific pair of $(Y,i)$ where both the Goods Market and Money Market are in equilibrium.

1. The IS Curve (Goods Market)

• IS = Investment-Savings.
• Derivation: A lower interest rate makes borrowing cheaper $\to$ Investment ($I$) rises $\to$ Planned Expenditure rises $\to$ Equilibrium Output ($Y$) rises.
• Shape: Downward sloping. (Low $i$ leads to High $Y$).

Intuition

Think of $r$ as the “price tag” on borrowing. When borrowing is cheap (Low $r$), firms build factories (High $I$), creating income (High $Y$).

2. The LM Curve (Money Market)

• LM = Liquidity-Money.
• Theory: Liquidity Preference. The interest rate adjusts to balance money supply and demand.
• Derivation: Higher Income ($Y$) $\to$ More transactions $\to$ Higher Money Demand. With fixed Money Supply, the “price” of money ($i$) must rise to convince people to hold less cash.
• Shape: Upward sloping. (High $Y$ leads to High $i$).

General Equilibrium

Intersection of IS and LM determines the short-run equilibrium ($Y_e,i_e$).

Policy Analysis

Who Moves Which Curve?

• Fiscal Policy (Govt): Change $G$ or $T$. Shifts IS Curve.
• Monetary Policy (Central Bank): Change $M$. Shifts LM Curve.

Fiscal Policy (Expansion)

• Action: Increase $G$ or cut $T$.
• Shift: IS shifts Right.
• Result: Income ($Y$) rises, but Interest Rate ($i$) also rises.
• Side Effect: The higher interest rate reduces private investment (Crowding Out).

Monetary Policy (Expansion)

• Action: Increase money supply $M$.
• Shift: LM shifts Right (Down).
• Result: Income ($Y$) rises, and Interest Rate ($i$) falls.
• Mechanism: Lower rates stimulate investment.

The Liquidity Trap

If interest rates hit zero, people become indifferent between cash and bonds. Money Demand becomes horizontal.

• Result: LM curve is flat at zero.
• Implication: Monetary policy is powerless (cannot lower rates further). Fiscal policy becomes the only effective tool.

Deriving Aggregate Demand

Relaxing the fixed price assumption derives the AD curve.

• Action: Price level ($P$) rises.
• Effect: Real Money Supply ($M/P$) falls $\to$ LM shifts Left $\to$ $i$ rises $\to$ $Y$ falls.
• Result: Inverse relationship between $P$ and $Y$ $\to$ Downward sloping AD curve.

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Continue here: 11 Aggregate Demand and Aggregate Supply