Answer to Question #46759 in Microeconomics for Rahul Kumar

Question

With the help of Is-Lm technique, explain the process of integrations of money market and goods
market by way of Keynesian approach. What are the policy implications of Keynesian approach?

Answer 1

In this particular aspect of macroeconomics we will discuss about the theory of product market equilibrium and with the theory of money market equilibrium and interest rate determination. Keynes had analysed the product market and money market equilibrium in isolation of one another. This is considered to be a serious flaw in the Keynesian approach because, in reality, functioning of both the sectors is interrelated and interdependent. Therefore, unless both the markets reach equilibrium simultaneously at the same rate of interest and the same level of income, none of these sectors can attain a stable equilibrium. It was John R. Hicks who integrated the Keynesian analysis of the product and money markets and developed a model, called IS-LM Model, to show how both the markets can attain equilibrium simultaneously at the same interest rate and national income. The post-Keynesian developments in macroeconomics do not end with Hicks’ IS-LM Model. The economists of later generations have also constructed theories that integrate classical and Keynesian economics, and have developed different kinds of aggregate demand and supply models. This was followed by other developments with altogether new approach to deal with macroeconomic issues. This part of the book presents a detailed discussion on the Hicksian IS-LM model and a brief discussion on the other post Keynesian developments in macroeconomics.
Therefore, changes in the variables of one sector affect the activities of other sector. In simple words, changes in the product market affect the money market equilibrium and vice versa. The Keynesian theory ignores the effect of changes in the product market on the money market. Therefore, his theories related to the product and money markets are considered to be partial and incomplete. Fiscal operations of the government affect the first and foremost, the market by changing the aggregate demand. Therefore, changes in money demand and supply are linked to the money market represented by the LM curve. To begin with we will first discuss the effect of government expenditure and taxation on the product market and derive the IS curve. The effect of change in money supply and demand on the monetary sector and the derivation of the LM curve will also be discussed.