Up until the Great Depression, laissez-faire and classical doctrines were widely embraced by economists and decision-makers. The industrialized world experienced protracted and widespread unemployment during this time, which made the ability of the classical model to forecast the economy into question. Maynard John Keynes, who developed the Keynesian model, was the biggest opponent of the classical model. Keynes and classical economists had reached an understanding that economies tended toward equilibrium, but they disagreed on whether current levels of production allowed for full employment. Therefore, in the Keynesian model, the economy will tend towards the equilibrium and not at full employment as the classical model asserts. On Keynes, wages and prices would tend to be rigid when the demand falls. Therefore, a decrease in aggregate demand rapidly translates into lower GDP and decreased employment. Any efforts to buy more than the full output of employment leads to inflation without possible increments on GDP. The Cambridge emphasized on the imperfect competition at the micro level. The main idea around the emphasis was that the seller sells different goods in a market, where he/she raises prices and earns profits. These profits entice other sellers into the market where those selling at loss exit the market (Matthew Luzzetti).
Hicksian IS-LM Model
IS-LM Model is a macroeconomic model, which uses graphs to represent the intersection of two curves. The IS curve stands for the variation in the income-expenditure models that incorporate interest rates in the market (demand) whereas the money supply equilibrium/liquidity preference curves represent the available amount of money for investing (supply). Keynes’s support of Hicks’s work was grounded in the idea that IS-LM model enabled the capturing of the significance of effective demand, fiscal policies and the probabilities of underemployment equilibrium. During the Great Depression, Hicks’s model started from the Keynes’s objection of the classical dichotomy concept, which supported the neutrality of spending. Keynes’s had argued that alteration to the quantity of money affects employment, income and the quantity of output. Hicks’s model then attempted to solve real markets and money simultaneously. Thus, the model IS-LM that constituted two curves where LM derivation was from money markets while IS stood for goods markets. The equilibrium situation within the goods markets was S=I where S is savings, and I is investments. The equilibrium situation in the money markets was L=M where L is money demand and M is money supply. The original equations of IS-LM model are as follows:
S=a+bY+ci
I=d+eY+fi
L=A+BY+CI
M=Mo
Where;
a: autonomous savings (a0)
c: interest elasticity of savings (c>0)
d: autonomous investment (d>0)
e: marginal propensity to invest (e>0)
f: interest elasticity of investment (f0)
B: transactions demand for money (B>0)
C: speculative demand for money (CY, prices then shift LM curve upwards. Prices rise as firms produce more than profit maximization levels of output in the long term. Four decades after Hicks had come up with the IS-LM model, he critiqued it. He admitted that the model lacked the labor market. This is where he invented the pseudo-deterministic model to fix the weakness of IS-LM model (Romer).
The Heckscher-Ohlin Model
This model is accredited to Eli Heckscher and Bertil Ohlin. HO is different from the Ricardian model in two ways. Firstly, the model is more realistic as it allows capital to be the second factor of production. Secondly, comparative advantages are determined through the distinctions in the endowment of factors internationally rather than technological differences. Thus, HO model assumes that all countries have similar technology for production. The first idea assumes that production capacity frontier will be concave leading to increased opportunity costs. Consequently, ultimate specialization as the Ricardian model had suggested is unlikely. Moreover, trading will result in a redistribution of incomes between capital and labor factors. The second idea is that the model assumes that countries will export commodities with that make use of the plentiful factors intensely. For instance, Canada has plenty of lands that makes it export forestry, petroleum and agricultural products. Western Europe, U.S., and Japan constitute a very skilled population and capital and thus exports complex manufactured goods and services. Asian countries and China constitute a vast number of workers who are unskilled and little capital and thus exports less complex manufactured commodities. When a country has an endowment of more than two commodities, it becomes difficult to examine factor abundance and intensity. This is where Leontief’s test comes in. The test operates by multiplying Leontief’s numbers with the actual value of a country’s exports and imports. The result is the values for total exports and imports. Such values are referred to as factor content of exports and factor content of imports. They are used in measuring amounts of capital and labor that has been used in the production of exports and imports. Differences between factor contents of exports and imports give the net exports (Giri).
IS-LM-BP Model
This model was introduced to extend the existing IS-LM model. The formulation of this model is accredited to Mundell Robert and Fleming Marcus. The two came up with simultaneous analysis of open economies immediately after World War Two. In Mundell’s paper, “Capital Mobility and Stabilization Policy under Fixed and Flexible Exchange Rates” (Robert), there are attempts to offer an analysis of cases of perfect capital mobility. Flemming model in the article, “Domestic Financial Policies under Fixed and Floating Exchange Rates” (Marcus), there is a more realistic standpoint. Fleming’s model assumes an imperfect mobility of capital making it more comprehensive and rigorous model.
IS curve stands for equilibrium in the goods market, LM curve for equilibrium in money markets and BP curve for equilibrium in the balance of payments. Post-WWII, equilibrium situation for open economies in the marketing of goods was that production Y was equivalent to demands for the goods that was the total of investment, consumption, net exports, and public spending. This was referred to as IS. If definition of consumption (C) was C=C(Y-T) and T corresponded to taxations, the equilibrium would be;
Y=C(Y-T) +I+G+NX
The LM curve represented the connections between money and liquidity. In an open economy, interest rates were determined using the equilibrium of demand and supply for money, M/P=L (i, Y) when M-amount of money offerings, Y-real income, i-real interest rates, and L-demand for money and a function of Y and i. The money markets equilibria implied that money amounts and interest rates were incremental functions of the overall output. Thus, when output increased, demands for money increased and the money was supplied. Thus, the rates of interest could rise until opposite impacts that acted on the demand for money were canceled. The BP curve indicated a point where the balance of payments was in equilibrium. It showed interest and production rates combined that acted as a guarantee for financing the balance of payments. This meant that the net export volumes that had an effect on total production were to be consistent with volumes of net capital outflows. IS-LM-BP model offered a distinction between imperfect and perfect competition and flexible and fixed exchange rates (Zammit).
References
Giri, Rahul. The Heckscher-Ohlin Model. Mexico: Centro de Investigacion Economica, Instituto Tecnologico Autonomo de Mexico (ITAM), 2011.
Kaboub, Fadhel. IS-LM Model. Granville, Ohio, United States: Denison University , 2010.
Marcus, J. Fleming. "Domestic Financial Policies under Fixed and under Floating Exchange Rates." Staff Papers (International Monetary Fund) 9.3 (1962): 369-380.
Matthew Luzzetti, Lee Ohanian. "Macroeconomic paradigm shifts and Keynes’s General Theory." Research-based policy analysis and commentary from leading economists 31 January 2011. .
Robert, A. Mundell. "Capital Mobility and Stabilization Policy under Fixed and Flexible Exchange Rates." The Canadian Journal of Economics and Political Science 29.4 (1963): 475-485.
Romer, David. "Keynesian Macroeconomics without the LM Curve." Journal of Economic Perspectives 14.2 (2000): 49–169.
Zammit, Nick. The Open Economy (IS-LM-BP). UK: University of Warwick, 2016.
