PJM6000Project Management PracticesWeek 5Deb Cote,.docx

PJM6000
Project Management Practices
Week 5
Deb Cote, MS, Professor Al Grusby, MBA, PMP®
1
Review Last Week
➢ Stakeholder identification and analysis
➢ Stakeholder register
➢ Communications planning
➢ Communications channels
➢ Communications tips – challenges, model, audience
analysis, bad news, clarity, brevity, listening
➢ Communication management plan
➢ Role of PM and project team in stakeholder and
communications planning and management
2

Lecture Overview
❑ Project execution
❑ Project monitoring and controlling
❑ Baselines
❑ Earned Value Management
❑ What is change?
❑ Change management
❑ Change control
❑ Change requests
❑ Team development
❑ Issues management
❑ Ethics
3
4
Project Management Processes
Initiating Planning Executing Monitoring and Controlling
Closing
Develop Project Charter Develop Project Management Plan

Direct and Manage Project Work
Manage Project Knowledge
Monitor and Control Project Work
Perform Integrated Change Control
Close Project or Phase
Plan Scope Management
Collect Requirements
Define Scope
Create WBS
Validate Scope
Control Scope
Plan Schedule Mgmt.
Define Activities
Sequence Activities
Estimate Activity Resources
Estimate Activity Durations
Develop Schedule
Control Schedule
Plan Cost Mgmt.
Estimate Costs
Determine Budget
Control Costs
Plan Quality Management Manage Quality Control Quality
Plan Resource Management

Acquire Resources
Develop Project Team
Manage Project Team
Control Resources
Plan Communications Manage Communications Monitor
Communications
Plan Risk Management Implement Risk Responses Control
Risks
ID Stakeholders Plan Procurement Conduct Procurements
Control Procurements
Plan Stakeholder Mgmt. Manage Stakeholder Engagement
Control Stakeholder Engagement
5
Closing

Define Scope
Create WBS
Validate Scope
Control Scope
Plan Schedule Mgmt.
Define Activities
Sequence Activities
Develop Schedule
Control Schedule
Plan Cost Mgmt.
Estimate Costs
Determine Budget
Control Costs
Acquire Resources
Manage Project Team
Control Resources
Communications

Risks
Project Execution
PMI Initiation Planning Execution, Monitoring, & Controlling
Closure
6
❑Direct and manage project execution
❑Perform quality assurance
❑Manage project team
❑Procure equipment, materials, resources
❑Manage stakeholder
expectations
❑Communicate project
information
7

Project Execution
8
Closing
Define Scope
Create WBS
Validate Scope
Control Scope
Plan Schedule Mgmt.
Define Activities
Sequence Activities
Develop Schedule

Control Schedule
Plan Cost Mgmt.
Estimate Costs
Determine Budget
Control Costs
Acquire Resources
Manage Project Team
Control Resources
Communications
Risks
Importance of Monitoring & Controlling –
Software Project
Scenario

• A project is highly visible and of utmost importance
to the customer. The project manager has been
providing status updates on a weekly basis indicating
green status.
• Two weeks before the scheduled implementation, a
significant amount of scripts do not pass user testing
• The customer issues a “Stop Work Order”.
• What happened? Was something missed?
9
Monitoring & Controlling
10
“You cannot manage what
you cannot measure."
Peter Drucker
Monitoring & Controlling
Communicating critical updates to stakeholders so that
expectations are met and/or managed.
11

• Data collected is determined by which metrics will be
used for project control. Typical key data collected
includes actual activity duration times; resource usage
and rates; and actual costs, which are compared against
planned times, resources, and budgets.
• Since a major portion of the monitoring system focuses
on cost/schedule concerns, it is crucial to provide the PM
and stakeholders with data to answer questions.
• Each project may require you to assess the control points
and measures if you have variability in scope
Gray & Larson
12
What Data Should be Collected?
13
Monitoring & Controlling Questions
What is the current
status of the
project in terms of
schedule and cost?
How much will
it cost to
complete the
project?

When will
the project
be
completed?
Are there
potential problems
that need to be
addressed now?
If there is a
cost overrun
midway in the
project, can
we forecast
the overrun at
completion?
What, who,
and where are
the causes
for cost or
schedule
overruns?
“How does the Pareto Principle apply to projects? In
project management, the Pareto Principle is used to
find the 20% of X that drives the 80% of Y.
14
Pareto Principle
For example, we could use the principle

to find the 20% of activities that are
responsible for 80% of the labor costs or
the 20% of materials responsible for 80%
of the material costs. We would then
adjust the project monitoring to
concentrate on those areas.”
Source: Project Monitoring and Control - techniques to control
budget, status
and planning https://www.stakeholdermap.com/project-
management/project-
monitoring-and-control.html
15 Sketchbubble.co
m
• Evaluate test results
– Do they meet our stated standards?
– What actions do we need to take?
• Refer to your Quality Management Plan
– What was acceptable? What were our standards?
• Take corrective action
– As defined in Quality Management Plan

16
Perform Quality Control
• Use key performance indicators (KPIs) that measure
the major single points of failure
• Have a blend of leading vs. lagging
▪ Month end financials – lagging
▪ Forecasted metrics – leading
Lagging indicators can tell you where you’ve been and how you
have performed. Leading indicators will tell you where you are
going and how you may perform.
17
Monitoring & Controlling Best Practices
• Planned vs. Actual
▪ Planned budget, schedule, and scope are the costs, dates, and
work agreed
upon by all project stakeholders
▪ Project manager baselines the budget, schedule, and scope –
all future
measurements will be compared against these
▪ Actual budget, schedule, and scope are the true costs, dates,

and deliverables
that occur
• Measure progress throughout the project
▪ Everyone wants to know:
➢ Are we on budget?
➢ Are we on schedule?
➢ Will we deliver what was promised?
▪ If wait to measure at the end, it’s too late; not enough time to
recover
▪ Gantt Chart is most common visual to show progress
• Can you re-baseline?
• Late or over budget if approved scope changes impact costs
and/or dates?
18
Gantt Chart
Measuring Progress
• Baselines help you identify variances to the plan
• Those variances may indicate that attention is
warranted, for example:
▪ After evaluating your cost baseline you note that, using the
actuals provided, you are projecting to exceed your
baseline by +20%

▪ You may see that the amount of approved change requests
impacting the scope of the project are numerous. This may
trigger a conversation with the sponsor.
19
Baselines are Critical
“I think the great part about what I do is that
there's a scoreboard. At the end of every week, you
know how you did. You know how well you
prepared. You know whether you executed your
game plan. There's a tangible score.”
-Tom Brady, New England Patriots Quarterback
Source:
https://www.brainyquote.com/quotes/tom_brady_807009
Monitoring
20
Talk about these topics as a team:
• How are we doing in this project?
• Is everything under control?
• What are our major risks?

• Are we progressing as planned?
• How are we doing on budget?
• How are we doing on schedule?
• Is our sponsor/customer happy with our progress so
far?
21
Monitoring & Controlling : What Questions
Need Answering?
• Monitor and control changes to the triple constraint:
Scope, Schedule, Cost
• Scenarios for a training development project
▪ Example: Selecting vendor took longer than planned
▪ Example: Course costs more than planned
▪ Example: Customer requested multiple changes in course
Implement change control procedures
• Validate scope
▪ Are we producing what we said we’d produce in a quality
acceptable to the customer?
• What changes might you make to
scope, schedule, cost?

22
Triple Constraint
Earned Value Management (“EVM”)
Background – Earned Value
• Basic concepts conceived in industrial context
• More fully developed during 1950s – 1960s
• Emerged as a tool to:
– Track costs
– Report progress
• “What did we get for the costs we incurred?”
Purpose
• Example Construction Project:
• Project details:
– Total Budget: $200,000
– Baseline Schedule: 5 months
– Assume costs equally spread over 5 months at

$40,000 per month
Purpose
• Current Status
– End of month 2
– Actual Cost to date: $100,000
Purpose
• What does this mean?
• Ahead of schedule?
• Over budget?
• Under budget?
• Behind schedule?
Overview of Terminology
• BAC – Budget at
Completion
• AC – Actual Cost
• EV – Earned Value

• PV – Planned Value
• CV – Cost Variance
• SV – Schedule Variance
• SPI – Schedule
Performance Index
• CPI – Cost Performance
Index
• ETC – Est. to Completion
• EAC – Est. at
Completion
How to Determine Earned Value?
• Imagine a simple project with four phases
• When deliverables or tasks are partially complete, you
estimate a percentage
Deliverable Budgeted
Amount
Phase 1 $100
Phase 2 $100

Phase 3 $50
Phase 4 $250
Earned Value
$100
$200
$250
$500
Earned Value
30
Earned Value Numbers
31
Title Value
Actual Cost $100,000
Planned Value $80,000
Earned Value $90,000

Earned Value Analysis
• Variances:
– Cost Variance (CV) = EV – AC (-$10,000)
– Schedule Variance (SV) = EV – PV ($10,000)
• Indexes:
– Cost Performance Index (CPI) = EV / AC (.90)
– Schedule Performance Index (SPI) = EV / PV (1.125)
32
Negative
number ->
over budget
Performance Indices
• CPI – Cost Performance
Index
– CPI = 1: project is on
budget
– CPI > 1: project is under
budget

– CPI < 1: project is over
budget
33
• SPI – Schedule
Performance Index
– SPI = 1: project is on
schedule
– SPI > 1: project is ahead of
schedule
– SPI < 1: project is behind
schedule
Earned Value Forecasting
• BAC = $200,000
• EAC = BAC / CPI = $222,222
• ETC = EAC – AC = $122,222
• VAC = BAC – EAC = -$22,222
34
Illustration
Title Value Title Value

BAC $200,000 Schedule Variance $10,000
Actual Cost $100,000 Cost Perf. Index .90
Planned Value $80,000 Sched. Perf. Index 1.125
Earned Value $90,000 Est. to Completion $122,222
Cost Variance -$10,000 Est. at Completion $222,222
• Results:
– Over budget
– Ahead of
schedule
Summary
• It is a project performance & measurement tool
– Gain insight into past project performance
– Understand the current project position
– Forecast the future performance & outcomes
• Accomplished through revealing the
relationship between actual cost, planned value,
& earned value

Limitations
• Understanding limitations creates realistic
expectations
• Doesn’t tell you how to correct variances
• Data can be manipulated
• Relies on accurate data
• Quality is not directly considered as part of
metrics
Reporting Best practices
• Do
– Summarize the data (use chart, table, etc.)
– Explain terms (SPI, CPI, etc) in understandable
language
– Explain why you are where you are
– Explain what next steps are
• Don’t
– Show calculations in body of report (put in an
appendix)
38

Class Exercise – Earned Value
• On day 51 a project has an earned value of $600,
and actual cost of $650, and a planned value of
$560.
– What is the Schedule Variance (SV) for the
project?
– What is the Cost Variance (CV) for the project?
– What is the Cost Performance Index (CPI) for the
project?
– What is the assessment for the project on day 51?
39
Project Management, The Managerial
Process, Larson, Grey
Class Exercise – Earned Value
• Schedule Variance (SV) = EV – PV
– SV = $600 - $560 = $40
• Cost Variance (CV) = EV – AC
– CV = $600 - $650 = -$50

• Cost Performance Index (CPI) = EV / AC
– CPI = $600 / $650 = .92
• The project is ahead of schedule and over budget
40
41
Project Changes
42
Change
Management
• Helping show the value of changes to
those impacted and ease the transition
Change
Control
• Approval of product/service
and agreed upon process to
control changes to it
Change
Requests
• Requests from stakeholders to

deviate from approved
deliverables
Configuration
Management
• Process for methodically
implementing and tracking
approved changes
Let’s Review What CHANGE is
• Planning process should include a defined
process for making changes to the plan:
– Who/how collects change requests?
– Who/how evaluates change requests?
– Who/how makes decision on change requests?
– PM updates plan and communicates change
• Change requests can originate from any
stakeholder
– Customers, end users, project team members,
sellers, sponsor, interested parties, etc.
43
Change Request Process

44
It documents the
process for:
▪ Who can submit change
requests.
▪ How change requests
submitted.
▪ How change requests
tracked
▪ What the approval
thresholds are
▪ How the change request
status is communicated
Change Control Form
45
Change Control Board

• Create a team culture of transparency
• Issues get raised; results in change request
• Why:
– Sponsor asks for a new feature
– If requirement not captured correctly, need to change scope
– Defect is detected
Project Change is Ongoing
46
As project managers
we should embrace
change…and then
assess the impact.
Change needs to be
assessed in relation
to the triple
constraint
Change should never
just be absorbed..but
documented fully
and evaluated.
47

Change is Inevitable
Kotter’s Stages of Change
48
• Used when variance indicates a need for change
• Defined in the Change Control Document
• Formal
• Result in re-baseline
Change Requests
49
Information needed on a Change Request
• What needs to be changed: Original task,
assignment, schedule, etc.
• What is the proposed change
• Reasons for the proposed change
• Analysis

– Impact of the proposed change
– Alternatives to the proposed change
50
Change Request Info
Integrated Change Control
• Why is it called “Integrated” Change Control?
– Changes that occur at any one part of a project
need to be understood with respect to the whole
project.
– What is the impact of the change?
• Avoid project surprises from changes that are
not well thought out.
51
Integrated Change
Control – Class Exercise
• You are the general contractor working with your
client on their kitchen remodel project.
• Just after completing the demolition of the
kitchen, the client decides they need to add a
trash compactor to the kitchen. No problem

right? You haven’t started re-building yet so the
added cost to your original quote should just be
the cost of the new compactor?
– Explain all the ways this probably isn’t the
case.
– How might performing Integrated Change
Control disappoint the client in the near
term but save a lot of problems down the
road?
– Work individually - 10 minutes.
– Get together in your groups and compare
results – 10 minutes.
52
Everybody likes each other until things get tough. Then
you will find out what kind of team you have, and I
understand that as much as anyone.
-Doc Rivers, Celtics Head Coach
Source:
https://www.brainyquote.com/quotes/doc_rivers_573362
A Common Phenomena
53

Stages of Team Development
• Bruce Wayne Tuckman (1938)
• Psychologist (Ohio State University)
• Developed five stages of team development
• Tuckman’s stages (1977)
54
55
Photo credit: www.toolshero.com
Stages of Team Development
www.toolshero.com
56
Issues Management
57
Issues Management Process

58
Sample Template
Issues Log
59
Ethics
Ethics are standards of beliefs and values that
guide conduct, behavior & attitudes…simply
doing the right thing”
From Managing for Dummies, Nelson, 2003
We each have a well-developed sense of what
the “right thing” is. We’re just putting our own
values into practice.
Standards, such as the Project Management
Institute’s (PMI) Code of Ethics & Professional
Conduct, help with details for our circumstances
60

Ethical Practices Paper
Lecture Review
✓ Project execution
✓ Project monitoring and controlling
✓ Earned Value Management
✓ Baselines
✓ What is change?
✓ Change management
✓ Change control
✓ Change requests
✓ Team development
✓ Issues management
✓ Ethics
61
What’s Next
• Secondary posts due by Saturday 11:59pm
• TWO written assignments (Ethics and Change) due

Sunday 12:00 noon.
• Week 6 readings:
• The PMBOK Guide - Part 1 105-120 Part 2 613-632
• Gray & Larson - Chapters 10 and 13
• IMPORTANT: Plan Ahead.
– Week 6 (Closing/Lessons Learned & Curriculum Map) also
has TWO written assignments, but because term ends on
Saturday, curriculum map is due 11:59pm Thursday, and
lessons learned is due 11:59pm Saturday, to get in before
end of course and grade by deadline.
62
PJM6000
Week 4
Professor Al Grusby, MBA, PMP®
Review Last Week
2
➢Activities within initiation

➢Developing a Project Charter
▪ Purpose, what else included, not a living document
➢ Project considerations
▪ Assumptions, dependencies, risks, constraints
➢ Project scope
➢Work breakdown structure (WBS)
➢ Estimating cost and work
▪ Accuracy, techniques, PERT formula
➢ Roles & responsibilities of PM, project team members
Lecture Overview
❑Class mid-point
❑Stakeholder identification
❑Stakeholder analysis
❑Communications planning
❑Communications Tips
❑Analyzing and assessing how the stakeholder register
informs the communication plan
❑Role of PM and project team in stakeholder and

3
Class Mid-Point
4
• How is the pace?
• Learning more or less
than expected, or had
no expectations?
• Any questions on
discussed topics?
• Is project management
what you thought?
• Is it a profession you’d
consider?
• Review some concepts
thus far – you tell me!
5
Closing

Define Scope
Create WBS
Validate Scope
Control Scope
Plan Schedule Mgmt.
Define Activities
Sequence Activities
Develop Schedule
Control Schedule
Plan Cost Mgmt.
Estimate Costs
Determine Budget
Control Costs

Acquire Resources
Manage Project Team
Control Resources
Communications
Risks
Project Planning
6
• Consider how you would feel if –
The classes and/or requirements in your CPS program major
changed next week and you were not told about them.
(Updating the program would be a project.)
• Many times we are assigned a project and want to
jump to:
▪ Creating the schedule
▪ Identifying the project team
▪ focusing only on sponsor or executive team needs

• Before all that - consider who the stakeholders are
and how they inform our communication plan
approach.
Stakeholder Definition
7
An individual, group, or organization, who may affect,
be affected by, or perceive itself to be affected by a
decision, activity, or outcome of a project.
PMBOK, p563
Identify
stakeholders
Analyze their
needs, wants,
and impact
Set
stakeholder
expectations
Establish
stakeholder
management
strategies

Stakeholder Planning & Management
8
How do we
communicate
with them?
How do we
identify
them?
Who is
Impacted?
9
As the project manager, part of
your role is thinking broadly about
impacted stakeholders….
Stakeholders
Identify Stakeholders
Stakeholder
Identification
External

Customers
Internal
Customer
Sponsor Project Team Project Office
Executive
Team
Management
Team
User Groups
10
Common Stakeholder Groups Can be positively or
negatively impacted…
• Internal Stakeholders
– Project Team, Sponsor, PMO, Senior Mgt., IT Dept., HR
• External Stakeholders
– Suppliers, Customers, Competition, Public, Legal, Political
11

12
Good Example of Bad Stakeholder Process
13
Stakeholder Register
Stakeholder
Stakeholder
Interest(s) in
the Project
Assessment of
Impact
Potential
Strategies for
Gaining
Support or
Reducing
Obstacles
Analyze Stakeholders
14

• Chart stakeholders by how much power and
influence they have over your project.
• Determine how to communicate and work
with stakeholders based on their grid
position:
Low interest / low power: Keep tabs on their
interest level as it may shift, but only update
them with critical information.
High power / low interest: Work to satisfy
them but don’t overwhelm them with too
much communication.
High interest / low power: The biggest thing
this group wants is information. Keep them
informed of the project’s process and update
them as it progresses. Let them know about
roadblocks and successes.
High interest / high-power: These are your
key stakeholders – fully engage them with
the process and do everything within your
abilities to satisfy their requirements.
Analyze Stakeholders
Responsibility Matrices
• Responsibility Matrix (RM)
• Also called a linear responsibility chart.
– Summarizes the tasks to be accomplished and who
is responsible for what on the project.
– Lists project activities and participants.

– Clarifies critical interfaces between units
and individuals that need coordination.
– Provides an means for all participants to view their
responsibilities and agree on their assignments.
– Clarifies the extent or type of authority that
can be exercised by each participant.
Responsibility Matrix for a Market Research Project
RACI Chart
• RACI - Clarifies roles and responsibilities wrt.
actions and/or decisions
18
From PMBOK, Sixth Edition
Class Exercise – RACI
Packing suitcases for a family trip
Family Members
• Mom
• Dad
• Sarah

• Jeffrey
Actions
• Pack suitcases
• Fuel car
• Load beach toys
• Cabin reservations
• Book flights
19
“What’s a RACI Chart and how do I use it?” Greg Sanker,
retrieved from:
http://itsmtransition.com/2014/07/basic-raci-chart/
❑ Individually assemble a RACI Chart – include justifications
for
how you assign letters (R, A, C, I) – 10 minutes
❑ Assemble in your groups to discuss and come to consensus
– 10 minutes
Stakeholder Management
• Stakeholders..
– Play a vital role in project success

– If not supportive of the project, may be impactful
in negative ways
– As the project manager, your role is to understand
the various stakeholders, their role, and their
impacts
• Brainstorm with project team to identify
• Connect with other PM’s in organization to leverage
their experience
• Discuss with Sponsor
20
Communicate
Seek input
Hold accountable to promised work / deliverables
Mitigate risks
Manage conflict
Deliver on expectations
Manage Stakeholders
21

Communication Plan
• Once we identify stakeholders, how do we
communicate and engage with them?
– Stakeholder satisfaction is a key objective of the
project team per the PMBOK
– The process is iterative
• you may gain (or lose) stakeholders over the course of
the project.
– The Communications Management Plan becomes
a key conduit for managing stakeholder
engagement and gaining support
22
Preliminary Stakeholder Register
• Ms. Deidre Jackson, the CEO of Acme Company
• Internal
• Implement a more formal or mature way to manage projects
with
professional project management teams and project managers.
• High
• Supporter
• Keep Ms. Jackson informed of project status and issues as

they come up.
23
24
What are Project Communications?
25
Communications Channels
26
Communications Formula
HOW MANY NOW?
HOW MANY?
n(n-1)
2
10(10-1)
2
= 45
14(14-1)

2
= 91
27
WHO is involved? WHAT should be
communicated? WHEN
and HOW OFTEN should
information be communicated? HOW
should information be shared? What TOOLS
should be used?
Communications Management Plan
28
All stakeholders are not created equal
Verbal communications are often the most
misunderstood
Sender and receiver must BOTH be responsible
Stakeholders need different information
Tools available and preferences
Challenges

29
Communications Model
30
Communicating Bad News
31
Not Listening
Pretend Listening
Partially Listening
Focused Listening
Interpretive Listening
Interactive Listening
Engaged Listening
The Seven Levels of Listening
32

Concentrate
Don’t think
ahead
Interact
nonverbally
Probe
Paraphrase
Don’t
interrupt
Remember
RepeatClarify
Listening Tips
• Timely and appropriate communication, over
communicate
• Present analysis and conclusions in PowerPoint or
other formal documents (avoid presenting data
embedded in e-mails, notes, or off the top of your
head)
• Use distribution lists
• Avoid multiple email chains
33

Good Communication Habits
• How does the stakeholder register inform the
Communications Management Plan?
34
Communication
Plan
Generates
Support
Creates
Engagement
Provide
Transparency
of Status
Establishes
Team Process
Stakeholder Register -> CommPlan
• Once we identify stakeholders, how do we
communicate and engage with them?
▪ Stakeholder satisfaction should be a key objective
of the project team per the PMBOK

▪ The process will be iterative, you may gain (or
lose) stakeholders over the course of the project.
▪ The communications management plan becomes
a key conduit for managing stakeholder
engagement and gaining support
▪ Typically created early in the project lifecycle
35
Communications Management Plan
What information needs to be
collected and when?
Who will receive the
information?
What methods will be used to
gather and store information?
What are the limits on who has
access to the information?
When will the information be
communicated?
How will it be communicated?
36
From Gray & Larson
C

o
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m
u
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ic
at
io
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P
la
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A
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s Th
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ttrib
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u

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Communication Management Plan
Comprehensive
• Applies to internal project team
• Sponsor is KEY stakeholder
• External stakeholders
• Typically created early in the project lifecycle

• Poor communication can lead to project demise
• Sponsor communication needs may be different than
other stakeholder communication needs
• Ensure you are aware of any regulatory agencies
that also require updates
37
Communication Management Plan
Communication Plan
•Team Members may
have established
customer relationships.
It is important that they
do not provide adhoc
updates to the
customer
•Be mindful of project
team members who
want to update their
functional management
of project issues
outside of the defined
process stated in the
communication plan
•Does your
sponsor have

specific
communication
updates based
upon executive
reporting
requirements?
• Does your
organization have
a defined project
update process?
Enterprise
Project
Management
Office
Executives
CustomersProject Team
38
Communication Plan Development
• Leverage Organizational Assets
• Ensure you know Organizational reporting
requirements
• How do you define how much is too much
information?

• Have a clearly defined escalation process to your
project sponsor.
• Recognize that brevity may be important within the
Project Status Report delivered to executives
39
• Develop a comprehensive plan
• Identify all critical components and ensure all team
members are well informed and understand plan
• Ensure you clearly define who is the lead for
transmitting updates, and have a backup plan
• Ensure you have sponsor agreement
• Execute against the plan. If you identify gaps in the
plan, ensure you incorporate needed enhancements
into the plan.
40
Role as PM and Project Team
Communication Plan Examples
• By Stakeholder:
• By the Message:
41

• Develop a communication plan for an airport security project.
The
project entails installing the hardware and software system that:
1. Scans a passenger’s eyes
2. Fingerprints the passenger, and
3. Transmits the information to a central location for evaluation.
• Capture all of the elements in a good communication plan:
what
information and when?, who will receive it? Methods to gather
and
store the information?, who has access to the information?
When is
the information communicated and how is it communicated?
• Have a clearly defined escalation process to your project
sponsor
• Get together in groups to discuss
42
From Gray & Larson
Class Exercise: Communication Plan
Lecture Review

✓ Class mid-point
✓ Stakeholder identification
✓ Stakeholder analysis
✓ Communications planning
✓ Communications Tips
✓ Analyzing and assessing how the stakeholder register
informs the communication plan
✓ Role of PM and project team in stakeholder and
43
What’s Next
• Next week: The project execution, monitoring & controlling
processes
• Reading:
– The PMBOK Guide - Part 1 pp. 82-86. Part 2 561-564
– Gray & Larson - Ch. 10-11
– Stakeholders in Project Management article – link in BB
– PMI Article: The Essential Role of Communications –
attached in BB
• Instructor Perspective: “Communication and Stakeholder

Management”
• Discussion Board responses, subject: “Communication,
Communication,
Communication”
• Individual Assignment Week4: Stakeholder Analysis and
Register
– include a one page written introduction that outlines the
process you utilized
to identify all stakeholders and why you selected those
approaches.
– Check formatting - no text wrap issues
• Recitation Addressing ambiguity in professional situations
(Intellectual
Agility).
44
PJM6000
Week 6
Deb Cote, MS, Professor Al Grusby, MBA, PMP®
1

Review Last Week
➢ Change management
➢ Integrated Change Control, Change Request Form
➢ Project execution
➢ Project monitoring and controlling
➢ Pareto Principle
➢ Leading vs. Lagging Indicators
➢ Baselines
➢ Earned Value Management (EVM)
➢ Team development
➢ Issues management
➢ Ethics
2
Lecture Overview
❑Project closure
❑Aspects of the closing phase
❑Closing an unsuccessful project

❑Lessons Learned
3
4
Closing
Define Scope
Create WBS
Validate Scope
Control Scope
Plan Schedule Mgmt.
Define Activities
Sequence Activities
Develop Schedule

Control Schedule
Plan Cost Mgmt.
Estimate Costs
Determine Budget
Control Costs
Acquire Resources
Manage Project Team
Control Resources
Communications
Risks
• Client / Sponsor processes

• Deliverables processes
• Stakeholder processes
• Project plan / file processes
• Project Team processes
Aspects of the Closing Phase
5
PMI Initiation Planning Execution, Monitoring, & Controlling
Closure
• Deliverables review
• Final acceptance
• Sign off to accept project as complete and
deliverables as acceptable
• Project feedback
Project Closure – Client/Sponsor
• Final inspections / review
• Hand off or exchange process
• Document acceptance

Project Closure – Deliverables
• Contract closeout
• Accounts payable
• Performance reviews
• Waivers
• Close procurements
Project Closure - Stakeholders
• Final updates to project file
• Document lesson learned
• Create project summary
• Archive file
9
Project Closure – Project Plan/File
• Team evaluations
• Re-assignments

• Team lessons learned
• Celebrate success - Take opportunity to thank those
that contributed (even if not a successful project)
1
0
Project Closure – Project Team
Team Re-assignments
• Have new assignments planned before the project ends
• Some team members may be re-assigned before the end of
the project
• Where do folks go?
– May follow the product to Operations
– Go on to other projects
– Start new project with derivative products (Program)
– End of contract
11
Types of Project Closure
• Normal

– Completed normally
– Transferred to Operations
• Premature
– Pressure to get to market may drive releasing a product before
it is ready
– May have a window of opportunity that is closing
• Perpetual
– Never ending project
– Focus on making it better instead of getting something out to
the market
12Project Management: The Managerial Process, Larson, Gray
Types of Project Closure
• Failed
– Easy to close down
– Many times not the fault of the project team
– Should understand/communicate the reason
• Changed Priority
– Business priorities change

– Some project put on hold or simply cancelled.
13Project Management: The Managerial Process, Larson, Gray
• What makes a project unsuccessful?
• Internal projects
– Work through issues with sponsor
• External projects
– Consult with company’s attorney
– Communicate carefully
– Cancel all work
14
Closing an Unsuccessful Project
15
▪ Confirm operational
handoff
▪ Complete contracts
and administration

▪ Perform lessons
learned
▪ Release resources
▪ Celebrate success
Project Closure – Reminders
Class Exercise – Project Closure
• You are completing an 18 month project building a new 10-
story building
in downtown NY. The building opens in 4 weeks and your team
will be
dissolved.
• Answer the following:
– What are some steps you, as the project manager, can take to
reduce the
anxiety of your team as you approach the end of the project?
– Why is this important to think about with respect to this
project?
• Think about your answer individually (10 minutes)
• Get together in your groups and agree on a plan (10 minutes)
16

17
At the most basic level, project lessons
learned are the tangible results of an executed
project review, taking the project experience and
breaking it down into actionable conclusions
about what went right, what went wrong, and
what could be done better.
Lessons Learned
18
-inventing the wheel
ining needs

Lessons Learned Benefits
19
I don’t want to
admit my
mistakes
People will
just blame
each other
The same errors
are repeated
every project;
nothing changesIt takes too
much time
The project is
done; I just
want to move
on
We don’t have
a knowledge
base to share
lessons

Lessons Learned Excuses
20
Short Projects Long Projects
All Projects
Closure Stage Stage Closure
Stage Stage Stage Stage Closure
Lessons Learned Timing
❑ Involve all relevant stakeholders
❑ Explain process to participants
❑ Emphasize no blaming
❑ Ongoing document/store
❑ Include all experiences
❑ Solicit final feedback
❑ Act quickly
❑ Identify lessons
❑ Archive lessons

❑ Make accessible
❑ Disseminate lessons
❑ Reuse lessons
21
Lessons Learned Guidelines
1. Collect
2. Analyze
3. Document
4. Communicate
5. Incorporate
22
Lessons Learned Approach
23
Lessons Learned
Log
Survey
1-on-1s

Sticky
Notes
Flip
Charts
Dedicated Team Meeting
Collect
Questions to ask
• What went well (Accomplishments/Wins)?
– What has the project Produced, Created, or Achieved.
• What could have gone better (Challenges)?
– What has the project NOT produced, created, achieved that
was
expected or needed?
– Project shortcomings
24
25
Analyze

26
Document
MANY organizations perform lessons
learned, but FEW use them.
27
SHARE!
Communicate
28
Incorporate
29
We didn’t have enough resources.
• Common feeling
• Doesn’t blame, but -
• What resources – Analysts, programmers, business experts?

• How could this be avoided next time?
Jack never attended our team meetings. That’s not fair!
• Shouldn’t call out one person; instead, suggest attendance
didn’t seem mandatory
• Instead of focusing on the behavior, should say what
happened, or didn’t happen, as
a result?
The interface rocks!
• Is this a lesson, or just an observation?
• Did the team do something to improve or create a great
interface?
Good or bad? When team members say –
Lessons Learned Examples
Class Exercise – Lessons Learned
• Hurricane Maria -
– In September 2017 Hurricane Maria struck Puerto Rico
leaving in it’s wake death and
massive destruction.
– Even today, many things on the island are not back to normal
including, power outages,
availability of clean water and food, shelter, communications,
etc.

• Based on what you know of this disaster and efforts to bring
relief to the citizens
of Puerto Rico perform Lessons Learned:
– What went well (Accomplishments/Wins)?
– What could have gone better (Challenges)?
• Analyze the root cause.
• Think about your answer individually (10 minutes)
• Get together in your groups and agree on 2 or 3 Lessons
Learned to discuss with
the class (10 minutes)
30
31
Release Resources
32
Project Recognition and Celebration
Lecture Review
✓ Project closure

✓ Aspects of the closing phase
✓ Closing an unsuccessful project
✓ Lessons Learned
33
What’s Next
• Reading Assignments
• Videos: Curriculum Maps (make sure to watch these!)
• Week 6 Secondary Discussion Dost due by Saturday 11:59pm
• TWO written assignments:
– Curriculum map due by Thursday, 11:59pm
• Can do it all in a spreadsheet.
– Closure/Lessons Learned paper due by Saturday at
11:59pm
• IMPORTANT: Plan Ahead. No assignments accepted after
Saturday so can grade by deadline
Thank you for a great semester! 34
Week 6 Paper: Project Closure & Lessons Learned

Grading Rubric
Failing Below
Average
Average Above Average Superior
0 - 60 (F
range)
70 - 79 (C
range)
80 - 89 (B
range)
90 - 93 (A-
range)
94 - 100 (A range)
Topical
Content &
Focus (75%)
Paper does not

sufficiently
address the
closure and
lesson learned
processes and
does not cite
the
appropriate
number of
external
sources (2)
Paper only
partially
addresses
some or all of
the closure
and lesson
learned

processes, and
only cites in-
class sources
supporting
case
Paper fully
addresses the
closure and
lesson
learned
processes in
a thorough
manner and
makes good
use of
research by
citing at
least two

relevant,
non-course
resources
Paper fully
addresses the
closure and
lesson learned
processes and
shows
thoughtful
consideration of
the integration
between the
related topics
from the course
readings and
student’s
independent

research,
including the
citation of two
peer reviewed
sources
Paper fully addresses
the closure and lesson
learned processes,
shows thoughtful
consideration of the
integration between
the related topics from
the course readings
and student’s
independent research,
including the citation
of two peer reviewed
sources, and evidences

a superior
comprehension of the
relevant processes
Personal
Competencies
(10%)
thinking
solving
onal
writing
Submission
reflects no
applicable
personal
competencies
Submission
reflects a

minimal
applicable
personal
competencies
Submission
reflects both
applicable
personal
competencie
s in an
acceptable
manner
Submission
strongly reflects
applicable
personal
competencies
integrated

throughout the
assignment
Submission reflects an
excellent use of
applicable personal
competencies
integrated throughout
the paper in a way that
synthesizes the
personal competencies
with the key topical
areas
Grammar &
Clarity (10%)
Writing
contains
numerous

errors in
spelling,
grammar,
sentence
structure, etc.
that interfere
with
comprehensio
n. The reader
is unable to
understand
some of the
intended
meaning.
Frequent
errors in
spelling,
grammar,

sentence
structure,
and/or other
writing
conventions
that distract
the reader.
Minimal
errors in
spelling,
grammar,
sentence
structure
and/or other
writing
conventions
but the
reader is

able to
understand
what the
writer
meant.
All work
grammatically
correct with rare
misspellings.
All work
grammatically correct
with rare misspellings.
Formatting
(5%)
NOTE: Gross
failure to
provide

PROPER
citations and
references –
particularly
with regard to
direct quotes –
will result in
sanctions as
outlined in the
academic
honesty policy.
Multiple
errors in
formatting,
citations, or
references.
Some errors
in formatting,

citations, or
references.
Rare errors
in
formatting,
citations, or
references.
Virtually no
errors in
formatting,
citations, or
references.
Virtually no errors in
formatting, citations,
or references.

Learning Connection:
This assignment is directly linked to the following key learning
outcomes from the course syllabus:
· Describing administrative project closure tasks
· Describing how to conduct a Lessons Learned and how to
work with the results of this process.
In addition to these key learning outcomes, you will also have
the opportunity to evidence the following skills through
completing this assignment:
· Critical thinking
· Problem solving
· Professional writing
Assignment Instructions:
For this assignment, you are to write a three page paper
describing the key elements of the project closure and lessons
learned process. In order to do well on the this paper, you need
to provide not only an overview of the key elements of the
closure process, but you need to address why these elements are
important and necessary, and you should also speak to how the
main elements should be completed. Within the content of your
writing on project closure, you should provide information on
how one should conduct a lessons learned, who should be
involved, how information might be gathered, and how the
results can and should be used in a consistent manner. Please
review the general guidelines below as well as the attached
rubric for information on how I will be specifically evaluating
your submission.
Here are some general guidelines for formatting:
· Make appropriate use of title and headers
· Paper should follow APA6 formatting guidelines throughout
· Paper should cite a minimum of two sources
· Paper should be no less than 3 pages and no more than 4 pages
in length (this is the body of the paper, and it does not include

the title page or reference page)
· Submit one copy of your paper to your instructor through the
appropriate Turnitin link below. Keep a copy for yourself and
send a copy to the entire group.
· All Assignment files are due by 11:59 pm, Saturday EST,
using the Turnitin link below.
ECON 1110: Intermediate Macroeconomics
Lecture Notes for Topic 4: Economic Growth
James R. Maloy, Department of Economics, Spring 2020
Readings: Froyen, Chapter 20 (8th Ed. Ch. 5) has a basic form
of
the Solow model. These lecture notes present a simplified
version
of a very detailed presentation of the Solow model from David
Romer’s Advanced Macroeconomics postgraduate textbook.
1 Introduction
The purpose of this section is to understand the determinants of
long-run
economic growth. Economic growth is the change in output
(GDP) over
time. Long-run growth theory is concerned with what is

typically called
trend or potential GDP, not short-run business cycles which are
simply
fluctuations around this trend. Long-run growth is due to
changes in supply
factors which affect the production abilities of societies (recall
the vertical
long-run AS from the classical model–most growth theories are
founded in
classical theory). The focus in long-run growth is usually per
capita; it is
true that more population will allow more total GDP, but
economic growth
theorists are typically more interested in the factors that affect
output per
capita, which is known as labour productivity.
There are many important questions in growth theory, which
typically
centre around two key ways of looking at growth: inter-
temporally or cross-
sectionally. The first is to look at a particular society over a
period of
time–why does a particular nation have more per capita output
today than

in, say, 1872? The second approach asks why GDP (and GDP
growth rates)
1
differ amongst nations at the same time–why is the US
relatively affluent
while India is relatively poor? And furthermore, will India be
able to catch
up in the future? The basic way to start answering these types of
questions is
determine the factors which affect economic growth. Many of
the much older
theories of economic growth focused on variables such as
savings and capital
formation as the driving factors. However, the Solow Model,
developed
in the 1950s and the original model behind much modern growth
theory,
actually argues that such factors are not the most important
things.
2 Assumptions and Variables in the Solow Model
Let us begin by identifying some variables:

Y = output
K = capital stock
N = labor
A = effectiveness of labour. This is basically a variable that
encom-
passes all factors that determine how effective labor is, such as
knowledge,
technology, etc. Often this is just simplified to technology only.
AN = effective unit of labor
y = Y
AN
: This is defined as output per unit of effective labor.
k = K
AN
: This is a similar measure of capital per unit of effective labor.
Note the difference between Y and y, and K and k. They are
distinct
items; do not get them confused. Now that we have some basic
ideas, let us
define an aggregate production function:
Y = F(K,AN) (1)

Output is a function of the capital stock and the amount of
effective
2
labour. More specifically, we can define a Cobb-Douglas
production function
as:
Y = Kα(AN)1−α (2)
Note that this production function has constant returns to scale
(the
exponents sum to 1). This greatly simplifies the model.
However, the model
relies not on the aggregate production function Y , but on the
intensive form
production function, y. Recalling our definition of y from
above, dividing
the above production function by AN yields:
y =
Y
AN
=
Kα(AN)1−α
AN

=
Kα
ANα
= (
K
AN
)α = kα (3)
Therefore, the intensive form production function is:
y = kα (4)
This production function gives output per unit of effective
labour. Graph-
ically, it looks like the familiar production function from topic
2, only note
that the axes are different; the vertical axis is y and the
horizontal axis is k.
To make this a model of growth, we must introduce time into
the model.
Specifically, all of our variables in the original production
function (for total
output Y ) are functions of time (t):
Y = [K(t)]α[A(t)N(t)]1−α (5)
Therefore, output at time t depends on that period’s capital

stock, labor
force, and the level of technology and other factors that
determine labour
effectiveness. In order to finish building the model, Solow
makes some as-
sumptions about the growth rates of these items. The growth
rate is calcu-
lated by taking a time derivative, i.e. a derivative of each item
with respect
3
to time. A time derivative is symbolised by placing a dot over
the variable.
Much of this math involved in this requires some knowledge of
differential
equations, which if you have not taken Calc II you will not
know how to do,
so don’t get bogged down in worrying about where these
equations come
from as it really isn’t necessary to understand the model.
1. Assumption 1: The labor force N grows at a constant,
exogenously
given rate n.

2. Assumption 2: The level of effectiveness of labor A grows at
a constant,
exogenously given rate g.
3. Assumption 3: Investment in each period is some fraction of
output.
We can assume that investment is equal to the fraction of output
that
is saved, e.g. all savings are channelled to investment (like in
the
classical loanable funds theory with a balanced government
budget).
This can be expressed as I(t) = sY (t). Therefore, the amount
invested
each period is determined by the savings rate s, where 0 ≤ s ≤ 1.
The
savings rate s is also assumed to be constant and given
exogenously.
4. Assumption 4: Finally, we must indicate how the (total)
capital stock
K changes over time, i.e. the value of K
̇ . It is assumed that the
rate
of change of the capital stock is a function of the level of
investment

(from assumption three) and the depreciation of the existing
capital
stock. This can be given by K
̇ (t) = sY (t) − δK(t)
Therefore, the rate of change of the capital stock over time is
the
level of investment minus the amount of depreciation, δ. Note
that
0 ≤ δ ≤ 1. It is also taken exogenously.
4
3 The Solow Equation and the Solow Diagram
We are now ready to formulate the “Solow equation”. The key
to the Solow
model lies with the time derivative of k (capital per unit of
effective labor).
Specifically, this is given by
k̇ (t) =
˙
(
K(t)
A(t)N(t)
) (6)

This is solved by differentiating and plugging in values for the
variables.
The mechanics are given by Romer but rather than working it
out, which
makes no one happy except for the one person in this course
who actually
enjoys the chain rule, I will save us a headache and simply
assert that this
will yield the key Solow equation. Using the Cobb-Douglas
intensive form
production function from equation 4 above, this is given by:
k̇ (t) = skα − (n + g + δ)k (7)
This equation has two components. The first component
indicates that
savings increases the rate of change of capital per unit of
effective labor over
time. Recalling assumption three above, this is because savings
is channelled
into investment in new capital goods. The second component
(which is
subtracted) indicates that the growth of labor n, labour
effectiveness g, and
depreciation δ (see assumptions 1, 2 and 4 respectively) all
decrease the rate

of change of capital per unit of effective labour. Showing each
of these parts
of the equation separately on a graph (the Solow diagram) will
help this to
make sense.
The Solow diagram shows capital per unit of effective labor k
on the
horizontal axis and investment per unit of effective labor on the
vertical
axis (which is a fraction of output per unit of effective labor y,
as noted
5
above in assumption 3). Recalling our production function, we
note that
the first term in the Solow equation is just a fraction s of the
production
function. Therefore, it is sloped just like the production
function. The
second component is a linear function, since we assumed that n,
g and δ
are constant. Note that the two lines intersect. We shall call the
value of k

where the curves intersect k∗ .
It is now necessary to explain these curves in more detail. The
curved
line, skα, is the actual level of investment. Since we assumed
that all savings
are chanelled into investment, the fraction s of output that is
saved must
be the level of investment by definition. The straight line, given
by (n +
g + δ)k is what is called break-even investment. It is the level
of investment
needed simply to maintain k at its current level. What does that
mean?
Well, suppose initially that there are 5 units of capital K and 5
units of
effective labour AN. Therefore, k is equal to 1. Now suppose
that you have
population growth n. Specifically, suppose that now AN = 6 due
to this
increase in N. In order to maintain k = 1, you must invest in one
more
unit of K to make K also equal to 6. This is why it is called
break-even

investment. It is the amount of investment that is needed to
maintain k at
its current level. Looking back at the Solow diagram, note that
at values
of k below k∗ , actual investment exceeds break even
investment. Therefore,
the amount of capital per unit of effective labour is growing,
e.g. k is getting
bigger. Looking back at the Solow equation, note that the first
term is bigger
than the second term so the rate of change of k is positive. If k
is greater
than k∗ , then actual investment is below break even investment,
and k is
getting smaller; from the Solow equation, the second term is
larger then the
first term and the rate of change of k is negative. The model
thus implies
that k converges to k∗ , and k will be constant at that point.
This is what
6
is known as the steady state or balanced growth path. The actual
value of

k∗ can be calculated by setting the Solow equation equal to
zero (since k
is constant at the steady state so its rate of change is zero) and
solving for
k. Note that just because the economy reaches a steady state in
which k
becomes constant does not mean the economy as a whole is not
growing;
it just means that, in the steady state, all of the variables are
growing at
a constant rate. The implication is that regardless of its initial
starting
position, the economy will move to a long-run steady state, with
constant
growth. We will now turn to a description of the steady state,
and also
discuss how changes in the values of savings and other
variables will cause
the economy to converge to a new steady state.
7
It was mentioned above that all variables grow at a constant rate
in the

steady state. Some simple calculations can show that these
growth rates
are:
Variable Growth Rate
N n
A g
K n + g
AN n + g
Y n + g
K/N g
Y/N g
k 0
y 0
The most interesting conclusion is that output Y is growing at a
constant
rate n + g. This indicates that in the steady state, the growth
rate of
output depends on the growth rate of population and labour
effectiveness.
Furthermore, the growth rate of output per worker Y/N depends

only on
the growth rate of labour effectiveness A. This may come as a
surprise; it
is often thought that the level of savings determines the growth
rate of the
economy. The Solow model indicates that savings do not affect
the growth
rate of output in the steady state. What we will see is that
saving levels do
effect the level of output, but not the rate of growth of output in
the steady
state.
Changes in savings will only affect growth rates in the short run
transi-
tion period. If output was growing at 5% before the increase in
savings rates,
it will be growing at 5% once the new steady state is reached.
This does not
8
mean that savings does not affect the economy—quite the
contrary. During
the transition period, variables will be affected. This temporary

change has
permanent effects on the level of variables. To think of an
example, suppose
that every year you get a 10% raise on the previous year’s pay,
which we say
is $100 in 2015. Now suppose that in 2016 you get a special
bonus that dou-
bles your income to $200. The next year, you go back to getting
10% raises,
but this is now 10% of a much bigger value than it would be
otherwise—it
is 10% of $200 instead of $110! Therefore, although after the
transition
period the growth rate is back to 5%, you are at a higher level
of income
thanks to the bonus. A similar type of thing is occurring with
savings in the
Solow model. The Solow model indicates that, once the new
steady state is
achieved, output will be growing at the same rate as before, say
5%, but the
change in savings will affect the level of output, and an increase
in savings
means that we are now taking 5% of a larger level of output

than we would
have had if savings had not increased. A few simple graphs can
capture the
essence of a change in the savings rate. Suppose initially the
economy is in
the steady state, and at time t0 there is a permanent increase in
the savings
rate. This can be shown as:
We know from the Solow diagram that capital per unit of
effective labour,
k, increases to the new steady state. Once the new k∗ is
attained, the rate
of change of k is again zero.
9
The effects of the increase in savings on the natural logarithm
of Y/N
can now be seen. Output per unit of labour climbs until the new
steady
state is reached, when it becomes parallel to the original growth
path, once
again growing at a rate of g.

4 Conclusions of the Solow Model
We have spent considerable time deriving and working with the
Solow model,
but have yet to draw any fundamental conclusions. By going a
bit deeper
than we have here, it can be shown that the Solow model
indicates two
main sources of differences in output per worker Y/N over time
(or across
nations). Differences in capital per worker K/N and differences
in the ef-
fectiveness of labour A will affect the value of output per
worker Y/N.
Furthermore, the model indicates that only growth in the
effectiveness of
labour can cause a permanent change in growth rates. Before
Solow, many
theorists had suggested that differences in capital stocks per
worker were the
reason why some nations are rich and others poor; the Solow
model indicates
that different capital stocks alone can not account for
differences between
nations, or for that matter differences in a particular nation over

time. The
key seems to rest with differences in the effectiveness of labour.
However,
the Solow model assumes that the value of A and the growth
rate of A are
exogenous and constant; therefore, it takes as given the very
thing which
10
causes economic growth! Furthermore, Solow just treats A as a
catch-all
phrase that incorporates everything except capital. A can
include knowl-
edge, technology, human capital, property rights, attitudes
towards work, or
anything that can determine labour effectiveness; often it is just
simplified
to technology (Froyen does this) although Solow was not that
specific. This
is a key weakness in the model; the model indicates that growth
depends
on A but does not give any indication of what A is or how it is
determined,

which has led to later theories that expand on this concept.
11
ECON 1110 Lecture Notes 5
ECON 1110 Intermediate Macroeconomics
James R. Maloy
Spring 2020
Lecture Notes for Topic 5: Keynesian Macroeconomics (I)
Readings: Froyen Ch. 5 (8th Ed. Ch. 6)
I. The Foundations of the Keynesian Revolution
The Great Depression of the 1930s and the enormous long-term
persistency of high unemployment and low output could not be
explained by the classical model. In the classical framework,
recessions were possible but were expected to be of relatively
short duration and would correct themselves. A depression that
lasted for years with no sign of recovery was unfathomable.
According to the classical model, output was entirely
determined by supply factors, and no change in aggregate
demand, and no government policy, could be effectively used to
alleviate the problems. Indeed, many of the policies undertaken
at the time, such as tax and tariff increases, were exactly
opposite of those we typically expect to see from government
policy in a recession. For example, governments at the time
faced falling tax revenues due to the high level of
unemployment. To close the resulting budget deficit,
governments raised taxes. Under the classical analysis, such tax
increases should not affect the economy, but in reality caused
great harm. Indeed, it is generally agreed that governmental

mistakes greatly lengthened the Depression. However, we shall
see in this course that there is considerable disagreement on
precisely what was wrong about these policies and what (if
anything) should have been done instead.
The fundamental problem was that the assumptions of the
classical model were not realistic in describing the state of the
US economy in that period. Two main approaches emerged.
One, espoused by some such as Mises, centered on interferences
with market mechanisms that prevented efficient, market-
clearing outcomes. These arguments varied but typically
centered on market imperfections and interventionist policies in
the 1920s that created an economic bubble, which collapsed in
the 1930s, which were in turn made worse by more
interventionist policies. These ideas argued that markets work
properly but the conditions for them to do so were impeded
during this entire time period, such as by rampant expansionary
monetary policy in the 1920s or Hoover's policies on preventing
wage cuts in the misguided belief that high wages cause
prosperity.
An alternative approach centered on free markets being
fundamentally inefficient. Some were fundamental criticisms of
the system, such as Marxism or economic fascism
(corporatism), the latter of which was proposed by Mussolini as
a "third way" between the extremes of capitalism and
communism, and was a major influence on Hoover and FDR's
market intervention policies.
Many of these types of communist and corporatist policies
involve micro-level intervention, e.g. controlling production,
wages, etc. (often via government-managed cartels) in
individual firms or industries.
Keynes too looked at markets and viewed them as
fundamentally inefficient, but developed a radical new way of
looking at the problem. Rather than focusing on micro-
management of individual industries, he proposed macro-

management that focused on macro aggregates without
consideration for what was actually being done at the micro
level. This is simultaneously a strong point and weak point of
his model. He correctly noted a fundamental flaw of micro-
intervention that has led to extreme inefficiency and eventual
collapse of all such attempts: lack of information. Central
planning of micro-level production decisions requires an
amount of information and co-ordination that simply does not
exist. For example, if you order your automobile industry to
produce a certain amount of cars, you must ensure that all
industries that produce components such as steel or tires also
produce the correct amount. One of the key strengths of private
markets is that efficiency does not require much information: all
that you need to know are your own costs and revenues. If
there is a shortage of tires, the price will rise and supply will
follow!
Heavily influenced by mercantilism
, he argued that aggregate demand, not aggregate supply, was
the factor that determined output. He asserted that the
Depression was the result of aggregate demand being too low;
the economy had become stuck in a sub-optimal equilibrium
with low demand causing low production, which in turn causes
low levels of employment, which of course leads to low
demand. At a micro level this behavior was optimal: if you own
a firm and no one is buying your product, the optimal strategy is
to lay off workers and cut back production. However, at a
macro level this leads to poor economic outcomes, contradicting
the classical view that micro optimality leads to macro
optimality. He argued for a positive role for government to
intervene in markets: to ensure that aggregate demand was
sufficient to achieve full employment levels of production.
Essentially, this is macro-planning: the job of the government is
to ensure that total demand is at a sufficient level, but let the
private sector decide which products are actually produced.
This reduces the inefficiencies of micro-planning; Keynes

recognised that the private sector, not the government
policymaker, was best placed to make individual production
decisions. However, this strength is also a weakness: his model
therefore does not distinguish between $1tn on infrastructure
such as roads and rail and $1tn on worthless gadgets at
Walmart. Indeed, Keynes wrote that in the extreme, a
government could create the necessary aggregate demand by
burying a big pile of money and then letting the private sector
decide how to dig it back out again. In reality, the long-run
effects are very much dependent on what is bought-and how it is
paid for, e.g. borrowing the money and then burying it, which
leaves future generations with a bill for the $1tn that was
buried. Keynes ignored these long-run effects; his model was a
short-run model and only was concerned about the jobs created
today by burying money, not the long-run effects of such a
blatant misallocation of scarce resources. This is a key problem:
Keynesians argue that these policies are socially optimal but do
not properly account for long-run costs and benefits in their
analysis.
Keynes' model was fundamentally a disequilibrium model
designed to explain how the economy
operates when it is not in the full-employment classical
equilibrium. He did not really argue that the classical model
was "wrong"--he argued that it was a special case of the
economy operating the way we'd like it to behave, i.e. the ideal
state, akin to the physics assumption of being in a vacuum.
However, he argued that this special case was not realistic as
the real world was not characterized by perfect information and
fully flexible wages and prices. This is expressed in the title of
his General Theory: how the economy operates in general, such
as during the disequilibrium that classical economists largely
ignored as a transitory, self-correcting event, or times when the
economy is in an equilibrium, but it is a sub-optimal one. He
and his followers produced a model that made aggregate demand
the major determinant of output, and argued that aggregate

demand was not stable and required government intervention to
stabilise it.
It is interesting to note Keynes' rationale for his new model. As
one observer of economic thought put it: "The liberal capitalism
of the modern age, which Smith had heralded, whose victory
Ricardo had proclaimed, and which Marx sought to destroy, was
transformed by Keynes and given a new life."
During the apparent collapse of capitalism during the 1930's
and greater adherence to communist and fascist ideology
(although there is some debate about what Keynes actually
thought of fascist economics), Keynes decided that his task was
to save capitalism--although some opponents of Keynes argue
that his system actually destroys it
. Keynes was most closely associated with the old UK liberal
party, which was mostly centrist, and was not a proponent of
socialism/communism/fascism.
The model considered here is VERY incomplete and is not
remotely realistic. In the next topic, we will add the effects of
money and interest rates. In later topics, we will also look at
the role of aggregate supply. For now, we assume that there is
no money or interest, prices are constant and the quantity of
output demanded will be supplied at that price (e.g. a horizontal
AS curve at that price level). In the Keynesian model demand
determines output, not supply.II. Conditions for Equilibrium in
the Simple Keynesian Model
The simple Keynesian model hypothesised that equilibrium
required aggregate supply (output, Y) to be equal to aggregate
demand (E).
Y = E
Assuming that the economy is closed with no imports or
exports, aggregate demand (E) consists of three components:

consumption (C), investment (I), and government purchases (G).
So in equilibrium we have:
Y = C + I + G
Recalling some of the simplification to national income
accounts discussed in the first week of lectures, we know that
we can define Y as both national income and national product.
Defining Y as national product implies that:
Y ≡ C + Ir + G
where Ir is realised, or actual, investment. The difference
between realised and planned investment (I) lies in the
inventory component of investment. A firm will plan to have a
certain quantity of goods in inventory at the end of the year, but
unexpectedly high or low sales may leave them with more or
less inventory than the management had planned.
So in equilibrium, it must be that:
C + I + G = Y ≡ C + Ir + G
Or that there are no unplanned changes in inventories:
I = Ir
Now defining Y as national income implies that:
Y ≡ C + S + T
since national income is divided among consumption, savings,
and taxes.
Therefore, in equilibrium:
C + I + G = Y ≡ C + S + T
Simplifying gives another way to state equilibrium for the
model:

I + G = S + T
So the three ways of stating equilibrium are:
Y = E = C + I + G (aggregate demand equals aggregate supply)
I + G = S + T (government spending and investment must be
paid for by savings and taxes)
I = Ir (no unexpected changes in inventory)
Note that in this model it is aggregate demand (C + I + G)
driving aggregate supply—the reverse of the Classical model
and Say’s Law. Unlike the classical theory, aggregate demand
in Keynes’ model is neither neutralnor stable. Keynes therefore
had to throw out the entire classical model—the vertical AS
curve which leads to AD shocks affecting only prices, as well as
classical demand theory—the loanable funds framework and the
quantity theory of money. Keynes’ attack centered on the role
of interest rates in creating the self-balancing and stable
classical aggregate demand curve as well as the stability of
velocity in the quantity theory. Much of this will be covered in
later topics—right now, we will start by analyzing the factors
that drive consumption, investment and government spending as
a starting place to understanding Keynesian AD theory.
III. The Components of Aggregate Demand
Again, assume a closed economy with no imports or exports.
Consumption:
Unlike classical loanable funds theory which argued that
interest rates drove savings and consumption, Keynes argued
that consumer expenditures was a stable function of disposable
income, where disposable income (YD) is the difference
between national income and taxes (Y – T).
Keynes proposed the following consumption function:

C = a + b YD a > 0, 0 < b < 1
Or:
C = a + b(Y – T)
The intercept a is autonomous consumption (the amount people
would consume if they had no income), and b is the slope of the
consumption function, or the marginal propensity to consume
(MPC). It gives the percentage of a change in disposable
income that will go toward consumption. The MPC can be
defined as the derivative of the consumption function with
respect to disposable income (dC/dYD).
The Saving Function
Recall that disposable income can be divided into consumption
or savings:
YD = Y – T = C + S
Or
S = YD – C
Substituting for C yields:
S = YD –(a + bYD)
S = -a + (1 – b)YD
Why is the intercept of the savings function (-a)? Because
remember that if disposable income is zero, consumption is a.
So people are therefore dissaving a, and saving is negative at
zero income. As disposable income increases, we eventually
reach a point where people earn enough to stop borrowing and
start saving.
The Keynesian consumption function was a direct result of

Keynes' view of the psychology of the consumer from the
General Theory:
The fundamental psychological law, upon which we are entitled
to depend with great confidence both a priori from our
knowledge of human nature and from the detailed facts of
experience, is that men are disposed, as a rule and on the
average, to increase their consumption as their income
increases, but not by as much as the increase in their income.
The Keynesian consumption function therefore does not show a
proportional relationship between consumption and income
because of the autonomous consumption (a) term. The ratio of
consumption to income is given by the average propensity to
consume (APC):
b
Y
a
Y
C
APC
D
D
+
=
=
APC is therefore greater than the MPC and decreases as
disposable income increases, just as Keynes' statement above
implies. This Keynesian consumption function is also known as
the absolute income hypothesis. Consumption reacts to actual
current income. Any change in current disposable income will
yield a change in consumption.

Empirical tests of the Keynesian function have yielded mixed
results. An example of one estimated for the period 1929-41 for
the United States is:
D
Y
75
0
5
26
C
.
.
+
=
Thus for short-run periods, the Keynesian theory appears to be a
plausible description of reality.
The idea that APC declines (and corresponding APS, the
average propensity to save, rises) as income increases worried
early Keynesian economists, who feared that the economy might
stagnate as national income grew. As it turns out, studies have
shown that, even as national income has grown over the past
century, the estimated values of APC for any given decade do
not change by very much. It is obvious from these studies that
in the long run the relationship between consumption and
income is proportional, indicating that the original Keynesian
theory is not a good explanation of this long run phenomenon.
New models had to be devised to explain why APC is
proportional to income in the long run, but not proportional in

the short run..
Another empirical failing of the Keynesian model is that
quarterly changes in consumption were not explained by
changes in income; the idea of Keynes' absolute income
hypothesis that consumption changes when current income
changes is not well supported by data. Two newer models were
developed to correct these failings of the Keynesian theory, the
life cycle hypothesis and the permanent income hypothesis (see
appendix to these notes).
Investment
Keynes believed that changes in investment were a major source
of the instability of aggregate demand and national income.
Indeed, evidence has shown that investment is by far the most
variable component of aggregate demand. Consumption
generally changes only as a result of changes in income (hence
Keynes argument that it was a stable function of income), but
investment seems to change wildly over time. This observation
becomes the key to the Keynesian explanation of business
cycles.
Keynes listed two sources of changes in investment. The first,
as in the classical model, is the interest rate (MC of
investment). Keynes also expected a negative relationship
between investment and the interest rate, although he argued
that this relationship was weaker than in classical theory.
The simple Keynesian model of this topic does not include
interest rates, so we’ll ignore this until a later topic when
interest rates are introduced. The other source was business
expectations (MR of investment). Keynes was heavily
influenced here by his work in financial markets, which he
viewed as fundamentally inefficient and prone to volatility
induced by herd mentality. Buying shares of stocks and

building a factory have the same decision-making environment:
uncertainty regarding the future. Long term investments have
to be decided on with very little knowledge of future events.
An individual will not possibly be able to predict the future
(psychics aside), so the decision-maker will make decisions
based on past experiences or simply see what everyone else was
doing and follow their lead. The latter was the primary factor
in the instability of investment. Investment decisions would
follow a herd mentality, and changes in information or changes
in the behaviour of others would have drastic effects on
investment decisions. Note that this is a fundamentally
different view of human behavior than the classical theory.
Rather than rational, optimal individuals, people are part of a
collective herd which is prone to irrational, inefficient behavior.
Keynes’ model therefore used early versions of social
psychology. If the crowd believes that the future is awesome,
expected returns on both financial and real assets will be
inflated; both financial markets and business investment will
thus increase drastically in a bubble. In a panic, the opposite
occurs.
We have now established that factors other than current income
(Y) influence investment—it is driven by expectations of future
income. Therefore, we can take investment as exogenous for
now in our calculation of national income. The investment
function for now will just be I, and it is independent of the
current level of income. However, it is fundamentally volatile
and can suddenly change. We will expand our study of
investment in the next topic.
Government Spending and Taxes
Like investment, government spending is not considered to be
directly influenced by the level of income, but rather by the
decision-making of politicians, who may or may not take
economic factors in their budget decisions. For now, we will

leave government spending as G. To simplify things, we will
assume that the government just sets taxes as a fixed lump-sum
amount (T), and taxes do not vary with income. Therefore, the
only component of national income which is itself dependent on
national income (Y) in the simple Keynesian model is
consumption.
IV. Determining Equilibrium Income (or Output)
Recall that equilibrium is where aggregate demand and
aggregate supply are equal:
Y = C + I + G
Y is the endogenous variable we are trying to calculate. I and
G, as well as T, are determined exogenously, as well as the
autonomous part of consumption, a. The other component of
consumption is income-induced expenditure which is dependent
on the level of income. Recalling that we defined consumption
as:
C = a + b(Y – T)
substituting yields:
Y = a + bY – bT + I + G
Solving for equilibrium Y:
Y – bY = a – bT + I + G
Y(1 – b) = a – bT + I + G
Y = [1/(1 – b)][(a – bT + I + G)]
We therefore have solved for equilibrium output in this
economy. The first term, 1/(1-b), is called the autonomous
expenditures multiplier. Note that b is the MPC, and that 1-b is
the marginal propensity to save (MPS). Multipliers will be
discussed in more detail below. The second term is called

autonomous expenditures; that is, the expenditures that do not
depend on the level of income. We have already discussed a,I,
and G. The other component, bT, shows the (negative) effect of
taxes on income.
Changes in Equilibrium Income: The Multiplier
A feature of the Keynesian system is that changes in
autonomous components of national income generate even
larger changes in equilibrium income. Note that this is very
different from the classical model—rather than self-correction,
demand is wildly volatile. This is known as the multiplier
process. Basically, a change in one component of national
income yields an initial increase in income. The person who
receives this income saves a portion (MPS) and spends the rest
(MPC). This portion that is spent becomes the income of
another, and the process continues.
Multipliers in the Keynesian model are calculated by taking
partial derivatives of the equation for equilibrium income:
Y = [1/(1 – b)] [(a – bT + I + G)]
For example, the investment multiplier is ∂Y/∂I = 1/(1 – b),
which is 1/MPS. If MPC (b) is 0.8, then MPS is 0.2.
Therefore, the value of the multiplier is 1/(0.2) = 5. A $1
increase in investment increases income by $5. Since Y = C + I
+ G, and Y has increased by $5, the right-hand side of the
equation must also increase by $5 to maintain equilibrium. We
already know that $1 of this $5 increase in income is because of
the change in investment. How do we account for the other $4?
The other $4 represents an increase in consumption—remember
that if b, the MPC, is 0.8, it means that 80% of any change in
income will go towards consumption. Therefore, when income
increased by $5, consumption increased by $4. The other 20%
of the increased income $1) was saved—and channelled to
investment, hence the original $1 increase in investment! Now

our equation is in balance and equilibrium is attained. This
result must be true because of the one of the other conditions
for equilibrium:
I + G = S + T
Since nothing has happened to G or T, the increase in
investment must be matched by an increase in savings.
Therefore, this $1 increase in investment has increased income
by $5, consumption by $4, and savings by $1.
Similar multipliers can be found for other components of
national income. The government spending multiplier, ∂Y/∂G,
is also 1/(1 – b). The tax multiplier, ∂Y/∂T, is -b/(1 – b). Note
that the simplicity of this model makes the multipliers very
similar--this is not realistic. Also, this model greatly overstates
the magnitude of the multiplier. The multipliers in the more
complete IS/LM model in the next topic will be smaller.
Fiscal Stabilisation Policy
We have established that fiscal policy—changes in taxes and
government spending—can indeed influence aggregate demand
and output in the Keynesian economy. Keynes argued that the
government not only could influence output, but that it would
be necessary to use policy to smooth out the fluctuations in
aggregate demand that are caused by volatile investment. If the
output is too high or too low, the government can use policy to
bring the economy back to where it should be.
Appendix: Life Cycle and Permanent Income Hypotheses of
Consumption
I. The Life Cycle Hypothesis of Consumption
The idea behind that life cycle theory is that consumption does
not just depend on current income as it did in the Keynesian
theory, but rather on expected earnings over one's entire

lifetime. People do not want to live in a mansion one year and a
cardboard box the next; rather the person does what is
commonly known as consumption smoothing and tries to
maintain a relatively constant consumption level throughout his
lifetime. The person therefore saves during periods of high
income and dis-saves or borrows during periods of low income.
A simple graph can capture the essence of the life cycle
hypothesis. Assume the person lives for T years. When the
person is young, and still a student, income is very low.
Although it may not feel like it at times, the average student
lives above his means; rather than starving and having no
clothes during their education, you buy your necessities and
spend far in excess of your income. This is done by dis-saving.
If you had some wealth given to you earlier in life, you spend
it; or you take out a loan, or you resort to begging from your
parents and other family members, but you are willing to do so
to maintain an adequately high level of consumption. After
graduation, you enter the workforce, eventually make enough to
consume less than your income, and pay back your loans and
save for retirement. After retirement, your income falls and you
now dis-save again, by spending the wealth you accumulated
while working. There is some disagreement on whether
consumption will stay constant or gradually increase over the
lifetime, but either way it is obvious that consumption is being
smoothed.
The life cycle hypothesis can also be expressed more
completely by using some simple mathematics. Assume again
that the person lives for T years, and for simplicity assume that
he wants to consume the same amount each period. Therefore,
during each period t, he consumes 1/T of his expected lifetime
resources. Further assume that the person wants to leave no
bequest for his heirs; he wants to spend the total amount of his
current wealth and future earnings. Also assume that there is no
interest paid on assets; this greatly simplifies the equations.

Therefore, consumption in each period t,
[
]
(
)
T
1
t
,
Î
, is given by:
(
)
[
]
t
e
1
1
t
t
A
Y
1
N
Y
T
1
C

+
-
+
=
where
1
t
Y
is the individuals labour income in the current period, N is the
remaining number of years before retirement (i.e. if the person
plans to work for 10 more years then N = 10),
e
1
Y
is the average annual labour income expected over the future (N
– 1) years of employment, and A is the value of presently held
assets. Basically, the first term in brackets is how much he is
currently earning, the second term is how much in total he plans
to earn in the future, and the third term is the amount of assets
saved, i.e. wealth, from previous periods.
Consumption depends not just on current income, as it did in
the Keynesian model, but also on expected future income and
current wealth. The life cycle hypothesis, however, argues that
consumption is generally unresponsive to a change in current
income that does not affect future income. For example, the
effect of a temporary change in income can be calculated by
taking the derivative of the consumption function above with
respect to the change in current income:

T
1
Y
C
1
t
t
=
¶
¶
If the increase in current income is expected to be permanent,
the total change in current consumption is significantly higher:
T
N
T
1
N
T
1
Y
C
Y
C
e
1
t
1
t
t

=
-
+
=
¶
¶
+
¶
¶
Therefore, unless the individual is extremely close to retirement
(N is small), the effect of a permanent change in income on
consumption today is much greater. Therefore, we can conclude
that current consumption is not very responsive to temporary
changes in income but is much more responsive to permanent
changes in income. This should make sense. If you are 30
years old and wish to smooth consumption, you will not go out
and blow a one-time $100,000 windfall all today; you will want
to save it and divide it up over future periods. Current
consumption will not change by very much. If you expect to get
the same $100,000 bonus for the rest of your working life, then
you will spend a much greater proportion of today's $100,000
right away; after all, you will get another similar amount every
year so there is no need to save it to smooth consumption.
Empirical studies have given some support to these ideas,
indicating that a person spends a much larger portion of a
permanent change in income right away than of a one-time
increase in wealth. The textbook discusses some of these
studies.
Note that relaxing our initial assumptions will make the
equation given above more difficult. Therefore, it is useful to
express the general form of the above consumption function as:

t
3
e
1
2
1
t
1
t
A
b
Y
b
Y
b
C
+
+
=
Again, consumption depends not just on current income, but on
future income as well as the level of wealth. The strongest
change on current consumption comes from a change in
expected future labour income.
It should now be evident that this model provides an
explanation why empirical studies have found little relationship
between quarterly changes in income and consumption. If the
change in income is considered temporary, then it should not
have much impact on consumption.
II. The Permanent Income Hypothesis of Consumption

The permanent income hypothesis is an alternative theory of
consumption (although in many ways it is very similar to the
life-cycle hypothesis) developed by Milton Friedman. Like the
life-cycle hypothesis, Friedman proposes that consumption
depends on the long-run average of income, but the permanent
income hypothesis offers a different explanation. Friedman
postulates that consumption is some proportion (κ) of
permanent income (Yp):
C = κ Yp
Permanent income is defined as expected average long-run
income from labour and asset holdings. However, income in
any given period is not necessarily going to be at the long-run
average; there is a random component called transitory income
(Yt) that will be positive in a "good" year and negative in a
"bad" year. Actual income is given by:
Y = Yp + Yt
Basically, transitory income is the deviation of current income
from the expected long-run average. The key to the permanent
income hypothesis is that consumption depends only on
permanent income, not transitory income, as shown in the above
consumption function.
Friedman theorised that people used backwards looking (or
adaptive) expectations to determine permanent income, and that
this expectation was revised after each period:
(
)
,
p
1

t
t
p
1
t
p
t
Y
Y
j
Y
Y
-
-
-
+
=
0 < j < 1
Basically, people expect some proportion j of the difference
between actual income and last period's expectation of
permanent income to represent a change in permanent income.
For example, if this deviation in income this year (the deviation
between actual income and expected permanent income) is
$20,000 and j = 0.2, then the consumer believes that 20% of this
change in income is a change in permanent income and will
increase his expectation of permanent income by $4,000. The
remaining 80% is considered transitory income. Since
consumption only depends on permanent income, consumption
will increase by
(

)
(
)
000
4
Y
p
,
k
k
=
D
, not by κ(20,000). Consumption is therefore smoothed, as it
was in the life-cycle hypothesis. Like the life-cycle hypothesis,
the permanent income hypothesis shows that in the long-run,
consumption is some proportion (κ) of actual income (since in
the long run, expectations are correct and expected permanent
income is equal to actual income). In the short run,
consumption is not proportional to income, since during periods
when transitory income is high, people will save more and thus
APC will be lower during periods of high income. The opposite
will happen during periods of low income. This result is
consistent with the empirical studies that first shed doubt on the
viability of the original Keynesian consumption function for
long-run analysis. The model also explains why there is little
connection between actual quarterly changes in income and
consumption levels. Transitory changes in actual income will
not affect consumption, in contrast to Keynes' theory.
� Note that, despite the completely historically inaccurate and
frankly baffling urban myth that Hoover was laissez-faire and
believed in the classical model, Hoover was actually a staunch
interventionist and many of his policies and FDR's policies were
similar.)

� Recall that mercantilism argued for government policy to
direct a nation's consumption towards a desirable macro
outcome. Keynes' monetary theory also re-introduced a link
between money and wealth, which will be covered in Topic 6.
� A key issue, which was (and still is) largely ignored as US
economists quickly adopted Keynes' ideas, was that Keynes'
model was developed to explain the UK economy of the 1920s-
30s. The UK situation was in many respects very different from
the US and other nations. Some have argued that using Keynes'
ideas as a general theory of all economies at all time periods is
fundamentally flawed. Note that this is a different argument
than the more common one that Keynes' model is simply wrong
altogether.
� Spiegel, H. W. The Growth of Economic Thought, 3rd ed.
(Durham: Duke University Press, 1999), 607.
� This logical absurdity of saving something by destroying it is
best expressed by the quote from a US officer regarding the
destruction, with many civilian casualties, of the city of Ben
Tre during the Vietnam war: "It became necessary to destroy the
town to save it [from the communist Viet Cong]".
� Note that this argument indicates that the counter-balancing
we saw in the classical model that kept AD stable no longer
occurs!
� Again, this reduces or eliminates the counter-balancing we

saw in the classical demand theory--AD is therefore not
fundamentally stable in the Keynesian model!
1
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Spring 2020
Instructions for Essay
Due: Beginning of your scheduled lecture on Thursday 2nd
April. A hard copy must be submitted to me—no emailed
attachments.
Please read all of these instructions carefully as your grade
depends on it.
The purpose of the essay is to use the techniques and concepts
learned in class to analyse a particular issue. The ideal essay
should be about 2500 words. (Please worry more about making
it complete than whether or not it is exactly 2500 words!) You
must include a reference list at the end AND appropriate in-text

documentation (footnotes, endnotes, or parenthetical
documentation). Failure to include references constitutes
plagiarism and will not be accepted. It must be typed with 12
point font and 1.5 line spacing. Please include page numbers.
You are of course permitted to include charts or graphs (which
may be drawn by hand). Outside reading and research on the
chosen topic are essential. Possible sources of information are
the Internet and Pitt libraries. Another valuable resource for
economists is the Journal of Economic Literature, which is
available in the library. This quarterly publication compiles a
list of all economics books and journal articles and organises
them by subject. So if you are looking for recent journal
articles about monetary economics, you simply have to look at
the newest JEL under the topic “monetary economics” and you
will find a list of all recent publications. Obviously, if you look
at older copies of JEL you will find past publications. Only
certain editions list book publications. Perhaps more handy is
to use is EconLit, which is an online search engine for
economics publications, which should be available to you from
a Pitt computer at search.ebscohost.com (click on the EconLit
link). You can access many full articles directly from the search
engine, depending on whether Pitt has access to that particular
publication. You should also note that you can access JSTOR
from a Pitt computer (www.jstor.org). JSTOR is a collection of
online files of hundreds of different journals from many
subjects and is a valuable resource for finding full articles. Due
to copyrights articles from the past few years are not yet
available on JSTOR, but you can find most common journals at
Pitt’s libraries anyway if you require a recent edition.
Essay Topic:
Choose ONE of the following topics for your essay (if you
previously wrote an essay for me or for another class, you may
not turn in the same or a very similar essay for this class). Note
that I give you some suggested questions that you can address in

each essay. You should not feel restricted to answering just
these questions—just make sure that it flows coherently and is
complete. Most of these essays leave you plenty of room to
discuss the ideas that you find most interesting. I am mostly
looking at your ability to conduct research, write coherently,
and analyse issues and policies using proper economic
techniques. It is much more advisable to pick a relatively
narrow topic and do a more thorough discussion than to do a
superficial treatment of a broad topic.
1. The US federal government has run deficits for the majority
of recent history. There have been proposals in the past for
requiring government’s to balance their budget, such as
proposals for a balanced budget amendment or similar policy
rules. What are the benefits of a balanced government budget?
What are the potential problems? How do different schools of
macroeconomic thought view this situation? You could also
look at state-level analysis, as most US states do have some sort
of balanced budget rule. A similar topic is the European
Union’s Stability and Growth Pact (SGP) for eurozone nations,
which requires them to maintain a budget deficit of less than 3%
of GDP, except during times of economic turmoil (which has
been ignored by some members and also be aware the SGP has
been changed over time; the current version is different than the
original). You could explain the purpose and goals of this act,
the benefits and costs of fulfilling these requirements, and the
problems that have occurred in under the SGP.
2. The Bretton Woods system provided a system of fixed
exchange rates from the end of WWII until the early 1970s.
Write an essay discussing some aspect of the international
experience of under Bretton Woods. What are the benefits/costs
of fixed exchange rates? How did the system operate? What
difficulties were encountered that led to its eventual
abandonment?

3. After the breakdown of Bretton Woods, some European
nations decided to form their own system of fixed exchange
rates called the Exchange Rate Mechanism (ERM) (which was a
part of the European Monetary System, EMS). What were the
motivations for its creation? How did it operate? Which
nations had the most influence? What difficulties were
encountered? There are many interesting essays that you can
write on this situation, such as the exit of Britain from the ERM
in 1992 or the role of West Germany in this system.
4. During the 1970s and early 1980s, many industrialized
nations had massive inflation problems. There are many
possible explanations: monetary policy, the breakdown of the
Bretton Woods system, the oil embargoes launched by OPEC
nations, or fiscal policy actions (excessive government deficits).
These factors could affect aggregate demand or aggregate
supply and thus create inflation. Possible essays in this area
could focus on the supply shocks created by the oil embargoes,
the breakdown of Bretton Woods and the resulting exchange
rate volatility/monetary policy volatility in these nations,
government budget problems. An effective essay could be an
analysis of various attempts by governments to reduce inflation
during the 1980s, or explaining why West Germany had such
superior inflation performance relative to most other economies.
5. The Great Depression of the 1930s was a time of monumental
change in many nations. Key industries such as manufacturing
and agriculture were in massive slumps. Unemployment
reached record heights. There are two approaches that you can
take to this essay. You can analyse some of the causes of the
Great Depression (it would be best to pick a few related ones
since if you attempt to cover them all then you will not have a
very in-depth discussion of any). Alternately, you can look at

some of the economic policies used by governments to deal with
the Depression. You can do this for any particular (more or
less) capitalist nation, such as the US. Be cautious with this
topic—there are many low-level history-type sources out there,
most of which are dubiously accurate (e.g. falsely claiming
Hoover was laissez-faire, etc.) and lack proper economic
analysis. You could also analyse the policies taken by nations
that explicitly abandoned capitalism for fascism or communism,
although you should be warned that such an essay will require
you to do some outside reading about non-capitalist economic
theory. One particular topic along those lines would be to study
Mussolini’s corporatist policies and how they influenced US
policy and economic thought in the 1930s.
6. In the 1950s and 60s unemployment rates in Western Europe
were substantially lower than unemployment rates in the US.
By the 1980s the situation had reversed in many of these
nations. Economists have done considerable research to explain
this phenomenon. What factors caused high European
unemployment? What is the effect of this unemployment on
these nations? What policies have been tried/could be tried to
reduce unemployment? (Hint: Charles Bean has a very good
survey article on European Unemployment, which you can
search for on JSTOR).
7. Central Banking and Monetary Policy: You can write an
essay analysing the policies taken by the Fed or another central
bank in a specific situation, such as during the Great
Depression, the stock market crash of 1987, the East Asian
financial crisis, etc. There is much debate about what central
banks should be doing to deal with the current financial market
instability—you could write a very good essay comparing the
events of today with the actions taken by central banks in
response to previous financial market problems. You should
investigate the actual policies that were taken, their effects, and
any problems that were encountered.

8. The Austrian model developed by Mises, Hayek and others
has proven to have some value in predicting the recent
economic situation. Write an essay on some aspect of Austrian
theory. One example would be to investigate the Austrian
explanation of the 1930s depression and discuss its application
to today. Another example would be to compare the ideas of
Hayek and Keynes (who had a spirited correspondence with
each other) on the macroeconomy. The best source on Austrian
theory is mises.org, which has many full-text books and articles
available for free.
9. There have been numerous instances of hyperinflation
through modern history, such as what is presently occurring in
Zimbabwe. Perhaps the most famous example of hyperinflation
is what occurred in 1920s Germany, although other nations as
diverse as Turkey and much of South America have also
experienced massive inflation problems. What factors caused
these hyperinflationary episodes? What economic theories can
be used to explain hyperinflation? What were the consequences
of these inflationary periods on the economies of these nations?
10. An analysis of economic growth could provide an effective
essay topic. You could analyse the causes of economic growth
and then apply them to a particular nation (e.g. explaining the
causes of US growth in the post-Civil War period, the growth in
Japan after WWII or China since the 1980s, for example), or
you could compare the economic performance of different
countries today, e.g. explaining different productivity levels
internationally. Many of these topics cross over into aspects of
development economics, which is fine as long as you
concentrate on macroeconomic issues.
11. Alternatively, you can select your own topic in
macroeconomics, subject to the following:

a) You must pick something suitable for an upper-level
undergraduate student. Very basic topics or topics not related
to the course are not acceptable. Pick something feasible about
which you can find information. Do not pick something that is
too complicated—an essay on a complex subject that you do not
understand very well is not conducive to a higher grade,
contrary to popular belief. Also, try to be specific in your
topic—writing on “the Fed’s monetary policy” is very vague
and will not allow you to show much in-depth research, whereas
writing on, for example, how the Fed responded to the oil price
shocks will allow a much more detailed discussion.
b) You may select a topic that we do not explicitly cover in
class provided that it is sufficiently related to macroeconomics
c) If you choose your own topic, you must have it approved by
me BEFORE you start. Please email ([email protected]) me
with your proposed topic so that I can check it and provide any
advice/warning about your topic. If you wait until two days
before the essay is due to ask me to approve a topic you should
expect to get a sarcastic email in reply.
A few notes on writing techniques:
You should put considerable effort into the structure and
coherency of your essay. You should include an introduction
and conclusion. Your introduction should introduce your paper
and should clearly indicate the purpose of your paper. Be
particularly careful to ensure that your conclusion is a summary
of your key points and does not bring in a bunch of new
information. When writing the main body, pay attention to the
organisation of your discussion. Make effective transitions
between paragraphs; in other words, make sure that your
discussion flows coherently from section to section.
This essay must be written in the third person. The word ‘I’
should NOT be in this essay. I especially do not want to see the
phrases “I think” or “I believe” anywhere; in my experience

such phrases are typically followed by some pre-conceived
opinion that has nothing to do with the evidence you have
presented. Any conclusions you draw should be the result of
the evidence and theories you have discussed and your
economic analysis of the strengths and weaknesses of issues,
not on random personal opinions about how you think
butterflies are pretty with no factual foundation. You should
give the impression that your views and conclusions are the
direct result of what you have learned. Any opinions should be
supported by evidence.
Please ensure that you are writing an economics essay, not a
history or a politics essay. Although such issues are important
and can be brought into your essay where appropriate, you are
expected to concentrate on economic issues and use economic
analysis in your essay.
Try to include economic theory and relate it to the issue at
hand, rather than just writing a summary of events. For
example, if you were writing about monetarism in the US during
the 1980s then you should include monetarist theory to
supplement your summary of the policies taken by the Fed. In
other words, you should be using theory to explain the
evidence.
Please consult outside sources and research your topic
thoroughly. Just reading the textbooks and some random
articles from the National Enquirer does not constitute research.
Make sure that your sources are at an appropriate level for this
class. This is particularly important for internet sources: just
because something is on the internet does not make it true! For
example, something found on the European Central Bank’s
website should be fine, but something from some random blog
may be, but is not necessarily, accurate. However, keep in mind
that good sources may be factually correct but biased towards a
particular point of view, e.g. you probably will not find much

effective criticism of Fed policy on the Fed's own website.
At the university level you should not be using an
encyclopaedia as a primary reference for the bulk of your essay.
However, if you do consult one do make sure that it is a
properly-edited one, not something where anyone with internet
access and an IQ of 60 can post random things. Wikipedia is
not an acceptable reference for a university-level student. YOU
MAY NOT USE WIKIPEDIA OR ANY SIMILAR TYPE OF
NON-REFERENCE. The use of inappropriate sources will
result in a significantly lower grade.
Also, you MUST include appropriate documentation, including
both references in the text (parenthetical or footnotes/endnotes)
AND a full, alphabetized reference list at the end. Failure to
use appropriate documentation constitutes plagiarism and will
not be accepted. Use an appropriate format for references.
You should purchase a guidebook that shows you an appropriate
style, such as MLA. Most such books show methods of both
parenthetical documentation and footnote documentation.
Usually, parenthetical documentation is used in economics but I
will accept footnotes/endnotes as well. Any style is acceptable
as long as you are consistent (i.e. don’t switch from footnotes to
parenthetical halfway through the essay), with the exception
that using numbered parenthetical references such as [3], with
the [3] referring to “source 3” in a numbered bibliography at the
end is complete rubbish; no proper academic papers use such a
style.
As for WHEN to use documentation:
The basic rule is that you must give the source of anything that
is not common knowledge. What is common knowledge?
Basically, anything that should be known by a student at your
level is common knowledge. For example, you do not have to
give credit to Adam Smith if you start talking about supply and
demand. However, any figures or advanced theories must be

referenced. If you say that some country had inflation of
4.5654 percent in 1984 or discuss Friedman’s theory of the
velocity of money, you MUST provide documentation crediting
your sources. Any fact, figure, or theory you mention must be
referenced in the text by using a parenthetical
reference/footnote. As a general rule, in an essay of this type
where most of what you write will be other people’s ideas,
probably almost every paragraph should have at least one
reference in it. Exceptions are introductions/conclusions or
transition paragraphs between sections. Also, any charts/graphs
that use data must have the data source referenced. If you are
in doubt about how/when to use documentation, please ask!
Improper documentation constitutes plagiarism. My general
advice if you are unsure if you should document something is to
go ahead and put in the citation—simple cost/benefit analysis
indicates that excessive documentation is less costly than
inadequate documentation (aka plagiarism).
Finally, do not cheat or plagiarise on your essay in any way,
shape or form. Do not turn in an essay identical to one that you
have done for another class. Any formal complaints I receive or
evidence I find of a student cheating, plagiarizing or attempting
to free-ride off the work of another student will be treated as an
academic integrity offense. This assignment is subject to the
University’s policies on academic integrity, as specified here:
http://www.cfo.pitt.edu/policies/policy/02/02-03-02.html
2

James R. Maloy
Spring 2019
Lecture Notes for Topic 3: Classical Macroeconomics (II)
Readings: Froyen Ch. 4
This section discusses the determination of prices in the
classical model. The roles of money and the classical quantity
theory of money are discussed. The classical aggregate demand
curve is derived and equilibrium prices and output are
determined by the intersection of aggregate demand and
aggregate supply. The determination of interest rates and the
role of interest rates in stabilisation are analysed, as well as the
role of government policy.
I. The Quantity Theory of Money
There are two main versions of the classical quantity theory of
money—Fisher’s quantity theory and the Cambridge quantity
theory. Both models are similar and draw basically the same
conclusions, but the techniques and analysis are a bit different.
One of the oldest economic theories still in use today, the
quantity theory of money traces its origins to theorists who
were trying to determine the effects of an increase in the gold
supply.
At that time, most of the world was on a gold standard, so the
quantity of gold in the nation determined the quantity of money.
When new gold supplies were discovered (i.e. in the New
World) it increased the quantity of money in the economy.
Under mercantilist theory, the increase in gold would make the
country more affluent, but theorists such as David Hume and
some of his contemporaries disagreed. They developed a theory
which is familiar today—the idea that increases the money
supply only cause inflation. The quantity theory shows a
relationship between the quantity of money (the independent

variable) and the price level (the dependent variable). Hume
wrote that in the long run the absolute size of the money stock
was insignificant because the price level would eventually
adjust to match it. This idea became known as the neutrality of
money, as mentioned in the last topic. If the money stock were
to double, for example, prices would eventually double and
employment would be at the normal level. The classical
economists argued that monetary policy would only cause
inflation in the long run, although there was some room for
short-run non-neutrality due to lags in the adjustment process.
Therefore, early quantity theorists suggested that in the short
run it may be possible to experience an increase in output as a
result of an increase in the money supply, but this would be a
transitory effect. Hume even suggested that output could be
continually increased, but at the cost of ever-increasing
inflation.
Fisher’s Quantity Theory
Fisher greatly advanced the quantity theory by coupling it with
the equation of exchange
.
MV = PY
M is the money supply, V is the velocity of money, P is the
price level, and Y is the real level of output. PY is of course
nominal output. Velocity measures the turnover rate of money
(money being currency and demand deposits) in the economy,
i.e. how many times on average a pound coin changed hands in
a year. For example, if nominal output PY was $100 and the
money supply M was $20, it means that each dollar was used an
average of 5 times.
The equation of exchange is true by definition, but Fisher and
other quantity theorists went further by attempting to explain
the determination of each component. The equilibrium level of

output Y is determined exogenously by the factors considered in
the previous chapter; a change in the money supply is not a
factor that affects equilibrium output. Velocity is dependent
on the paying habits of society. An increase in credit
transactions, for example, would increase velocity, since things
could be bought immediately without needing up-front payment.
Shorter pay periods yield smaller paychecks, which would cause
a decrease in the amount of money held at any given time and
therefore increase velocity. These factors, however, are
assumed to be relatively stable in the short run and would
therefore generate constant velocity. It is important to note that
many classical economists did not believe that velocity was
necessarily stable; they only believed that in equilibrium,
velocity (like output) was independent of the money supply, and
could therefore be treated as an exogenously-given constant. In
other words, a change in the money supply would not affect
equilibrium velocity. Therefore, for simplicity, we will treat
velocity as a constant. In summary, the changes in the money
supply do not affect equilibrium values of V and Y.
The equation of exchange can be used to determine the price
level. Holding Y and V constant, an increase in the money
supply must be met by an equal increase in the price level for
the identity to hold, ceteris paribus. Fisher wrote in his work
The Purchasing Power of Money that doubling the quantity of
money will initially decrease velocity by fifty percent, and the
person will be left with “double the amount of money and
deposits which his convenience had taught him to keep on
hand…and there cannot be surplus money and deposits without
a desire to spend it, and there cannot be a desire to spend it
without a rise in prices.” P will therefore double and V will
return to its original level. In other words, an increase in the
money supply increases demand for goods, but does not increase
the productive capacity of the economy to produce more
goods—it is demand without production to match it; prices
simply increase. Thus Fisher’s quantity theory of money

(sometimes called the transactions quantity theory): the quantity
of money determines the price level. Note that in the short run,
before prices double, there may be some non-neutrality of
money, and velocity and output can be affected. Thus we have
an important conclusion: although the economy can move away
from full employment output, any change in output is only
temporary and the economy, through natural behaviour in the
"perfect system," will correct itself. Laissez-faire should be
maintained because firstly, any fluctuation in output will correct
itself without government interference and secondly, any
attempts to use monetary policy to artificially increase output
will only cause inflation.
The Cambridge Quantity Theory
The Cambridge approach is named for two famous classical
economists from Cambridge University, A.C. Pigou and Alfred
Marshall. They arrived at the same conclusion as Fisher, but
unlike the Fisher version, which said that by definition changes
in the money supply generate changes in prices, the Cambridge
economists developed a model of money demand to analyse how
people decide how much money to hold, and therefore how
changes in the money supply will affect their optimum money
holdings. They thus generated an economic rationale for the
link between money and prices.
The Cambridge economists argued that people would hold
money for transactions or for unexpected expenses. But,
holding wealth in the form of money would entail an
opportunity cost, namely the foregone interest that could be
obtained from holding bonds. There is therefore an optimum
level between the desire to hold money for transactions or
emergencies and the desire to not hold money and hold interest-
bearing bonds instead. Interestingly they veer towards the
foundation of Keynes’ monetary theory—their model treats
money as an asset rather than just a means of transactions, but

they do not explore the full implications. Marshall and Pigou
theorized that the demand for money (MD) would be a
proportion, k, of nominal income (PY):
MD = kPY
Since in equilibrium money demand must be equal to money
supply (M), we have:
M = MD = kPY
Marshall and Pigou also expected k and Y to be fixed
exogenously, thus generating another model that shows that
changes in the money supply generate identical changes in the
price level. Indeed, if k = 1/V, the Fisher and Cambridge
equations are identical.
Therefore, both versions generate the same results, but the
Cambridge approach generates a more economics-oriented
argument by deriving the quantity theory as a money demand
theory, not just a mathematical identity.
II. The Classical Aggregate Demand Curve
The quantity theory is an implicit theory of aggregate demand,
and can be used to build the aggregate demand (AD) curve.
Using the equation of exchange:
MV = PY (or M = kPY)
the AD curve is derived by plotting different combinations of P
and Y for a fixed money supply (M). For example, if V is a
constant 2.0 and M = 600, we know that PY = 1200. Supposing
P=2.0 and Y = 600 gives us one point on the AD curve. Now
suppose P = 3.0 and Y = 400. We have another point on the AD
curve. Continuing with different combinations of P and Y that

generate a product of 1200, we find a downward sloping AD
curve: the aggregate quantity demanded increases as the price
level decreases for a given quantity of money. This should
make sense: if you have 50 pounds in your pocket, you will
demand more goods the cheaper the goods are!
We note that an increase in the money supply (holding V
constant) will generate an equal change on the other side of the
equation. Therefore, we can plot a new AD curve with different
combinations of P and Y for the new quantity of money. An
increase (decrease) in the money supply shifts the AD curve to
the right (left). Any point on the AD curve is a point of
equilibrium in the money market—where money supply equals
money demand. That is,
M = MD = kPY
Furthermore, any point on the AD curve is a point where P and
Y are at levels where their product PY corresponds to the
quantity of money M. If MV does not equal PY, we are at a
point off the AD curve for money supply M. In summary, for
any point on the AD curve for quantity of money M, it must be
that M = MD and MV = PY.
Aggregate Demand and Supply in the Classical System
Combining the classical AD and AS curves gives equilibrium in
the output (or product) market. The vertical AS curve shows
that output is independent of the price level. Changes in the
money supply generate shifts in the AD curve, which in turn
generate changes in the price level. Therefore, only the real
factors from the last topic determine the equilbrium level of
output; changes in these variables shift AS and affect prices and
output. The quantity of money determines the AD curve, which
in turn determines the price level. Note that a change in the
money supply leads to a change in prices but not output via the
quantity theory.

III. The Classical Theory of the Interest Rate—The Loanable
Funds Theory
In the classical model, the interest rate played a critical role in
maintaining the stability of aggregate commodity demand. The
classical model argued that any change in any component of
aggregate demand—consumption, investment, and government
spending—would be matched by a counterbalancing change in
one of the other components, and the interest rate was the
mechanism that ensured this result.
The equilibrium interest rate is determined by the amounts of
borrowing and saving (saving = lending). All transactions were
assumed to be in the form of bonds. If a firm wished to borrow
money, it would issue a bond. The saver would then buy the
bond, giving the firm money in exchange for it. The bond
would bear an interest rate (r), as determined by the interaction
of demand for bonds (lending) and supply of bonds (borrowing).
The demand for bonds is called supply of loanable funds in
classical terminology. Likewise, the supply of bonds by
borrowers is termed demand for loanable funds. The supply of
loanable funds is expected to be a positive function of the
interest rates. Recall that individuals can either consume or
save their income. At higher interest rates, the opportunity cost
of consumption increases and people are more willing to forego
current consumption to take advantage of higher interest rates.
Therefore, the supply of loanable funds curve is upward
sloping.
The demand for loanable funds is the level of investment by
businesses plus the amount of government borrowing, i.e. the
government budget deficit (g-t). The amount of investment
undertaken is expected to increase as the interest rate decreases.
This is because firms invest up to the point where the interest

rate equals the expected return of the project (i.e. MC=MR), and
as interest rates decline, more projects become profitable and
investment increases. Therefore, the demand for loanable funds
for investment is a downward sloping function of the interest
rate. The level of the government deficit (g-t) is assumed to be
independent of the interest rate, so the total demand for
loanable funds curve is shifted to the right by the amount of g-t.
Equilibrium is where the supply and demand of loanable funds
curves intersect. At that intersection, the equilibrium interest
rate is set, and demand and supply of loanable funds intersect,
i.e. s = i + (g-t). (Recall that this is the same identity as the
relationship derived in Topic I: I + G = S + T).
Why does the interest rate ensure that desired commodities
demand (C+I+G) remains at a constant level? Assume that G is
constant. Suppose that there is an increase in autonomous
investment. The firms need money for the new investment, so
the demand for loanable funds curve shifts right. At the new
equilibrium, the interest rate has increased and the quantity of
funds loaned out has increased. Therefore, more investment has
taken place and people save a greater quantity of money to take
advantage of the higher interest rates. We see that the increase
in investment is exactly equal to the increase in savings. But
recalling that people either consume or save their income, the
increase in savings must yield an equal decrease in
consumption. Therefore, investment and consumption have
changed by equal and opposite amounts, and the net change in C
+ I + G is zero! Therefore, the interest rate in the classical
model works to smooth out and eliminate any changes in desired
demand.
IV. Government Policy in the Classical Model
Note that monetary and fiscal policy are known as demand
management. The goal of these policies is to alter aggregate

demand. We know that output in the classical model is
determined by aggregate supply, not aggregate demand, so even
if these policies succeed in shifting AD, output will be
unchanged. However, it will also be shown that fiscal policy is
generally ineffective even in adjusting AD, since only changes
in the money supply shift AD.
Monetary Policy
We have seen that money is neutral in the classical model.
Only real factors determine the level of aggregate supply and
output. A change in the money supply only changes aggregate
demand and the price level. Therefore, monetary policy does
not cause real changes; it only affects inflation and prices. The
quantity theorists argued that any short run non-neutrality of
money that caused a recession and potential use of a monetary
expansion was so short-term that it was not worth the long run
cost of higher inflation.
It should be noted that money can be considered insignificant in
the sense that it does not determine long-run output. However,
money is significant in its use as a medium of exchange, and
stable money is a requirement for stable prices. As John Stuart
Mill wrote,
There cannot be intrinsically a more insignificant thing, in the
economy of a society, than money; except in the character of a
contrivance for sparing time and labour. It is a machine for
doing quickly and commodiously, what would be done, though
less quickly and commodiously, without it; and like many other
kinds of machinery, it only exerts a distinct and independent
influence of its own when it gets out of order.
Fiscal Policy

There are two types of fiscal policy—changes in government
spending and changes in taxes. Assuming that taxes remain
unchanged, the effects of a change in G can be analysed. An
increase in government spending (fiscal expansion) will alter
the government budget deficit g-t. Therefore, the government
will have to finance this increase in the deficit by borrowing,
thus shifting the demand for loanable funds curve to the right.
What happens is similar to the case of an increase in
investment. At the original level of interest, there is excess
demand for loanable funds, so the interest rate increases. As
the interest rate increases, some investment projects cease to be
profitable, so investment declines. The increase in the interest
rate causes savings to increase and consumption to decrease.
Therefore, the increase in government spending is completely
offset by the decreases in consumption and investment, and the
sum of C + I + G is unchanged. The government spending
crowds out private expenditures, and the fiscal policy is
ineffective. Recalling that we constructed the AD and AS
curves without mention of government, it is evident that a bond-
financed increase in government expenditures will have no
impact on prices or output. If, alternatively, the government
finances the increased spending through the printing of more
money, it is obvious that the increase in the money supply will
only increase the price level.
Tax Policy
Suppose the government chooses to expand the economy by a
tax cut. On the demand side, a tax-cut could stimulate
consumer demand. However, if the government sells bonds to
finance the tax cut, the interest rate will adjust to ensure that
the level of AD remains unchanged. The increased demand for
loanable funds (g-t becomes larger) will increase the interest
rate and cause saving to increase, thus partially eroding the
initial increase in consumption stimulated by the tax cut. The

higher interest rates would also cause investment to decline.
The same crowding out effect as before would occur, with C + I
+ G unchanged. Likewise, paying for the cut by printing new
money will just increase the price level. Therefore, tax policy
is ineffective in changing AD.
However, if the tax cut is not lump sum, but a decrease in
marginal tax rates, the change can have important impacts on
supply decisions. A decrease in marginal income tax rates, for
example, will make people more willing to work for a given real
wage, since the worker gets to keep a larger percentage of his
earnings. The labour supply curve will increase, generating an
increase in the equilibrium quantity of labour and thus
aggregate supply. Therefore, changes in marginal tax rates can
have real effects on the economy. However, this affect is
typically considered detrimental, as it simply distorts the
market---note that employment (and thus output) are the highest
when there is no income tax, and changes in the policy cause
fluctuations, rather than cure them. Classical economists
therefore viewed taxes as having either no effect or a
detrimental effect, based on the case. Taxes were simply ways
to pay for necessary government expenditure rather than a tool
to manage the economy. In any case, there was no need for tax
policy to stimulate the economy in the Keynesian sense due to
self-correction. In the classical era there typically was no such
thing as an income tax, or where it existed the rate was very
low. Therefore, classical economists usually did not pay much
attention to this type of situation---it is with hindsight that we
can apply their theory to income taxes. Modern supply-side
economics theories centre around this classical concept.
� The first known mention of the quantity theory is actually in
the writings of Copernicus in the 1520s, although the
development of the theory happened much later as a response to
New World gold entering Europe.

� Fisher's version actually looked at total transactions T such
that MV=PT, not just transactions related to current production
Y. If the proportion of transactions related to current
production is stable, then replacing T with Y works—if not, it is
a problematic assumption. Interestingly he also distinguished
financial transactions, an idea which has been largely lost. See
Fisher (1911)
1
James R. Maloy
Spring 2020
Lecture Notes for Topic 6: Keynesian Macroeconomics (II)
I. Interest Rates and Aggregate Demand
Recall that in the Classical system interest rates were
determined by the interaction of the supply of and demand for
loanable funds. Interest rates were seen to be the mechanism
that ensures the stability of aggregate demand. The Classical
economists theorised that a change in one component of
aggregate demand would generate a change in the interest rate,
and that the change in the interest rate would generate a change
in other components of aggregate demand that would cancel out
the initial change, thus keeping aggregate demand at the
original level. Money, since it did not bear interest, was not a
factor in determining interest rates, nor did money affect the

real level of income or output (neutrality of money).
Keynes had a different way of looking at the situation. He
argued that changes in the interest rate would indeed cause a
change in aggregate demand, since the classical theory ignored
factors such as a direct link between consumption and the
interest rate. He also derived the interest rate not as a function
of demand and supply of bonds, but rather demand and supply
of money. This is Keynes’ attack on the classical system—
changes in money yield changes in the interest rate, which in
turns yield changes in aggregate demand. Recalling that in the
Keynesian system output and income was demand-determined,
we see that changes in the demand and supply of money will
generate changes in income.
We have already discussed how aggregate demand affects
income in the last chapter. We now must see how interest rates
affect aggregate demand, and how money affects the interest
rate, to have a full picture of the Keynesian model.
Keynes, like the classical economists, saw a negative
relationship between investment and the interest rate. However,
he also saw that a decrease in the interest rate could have a
positive impact on consumption as well. Many consumer
durable goods, such as cars, are purchased on credit. A
decrease in interest rates will reduce financing costs and will
boost consumption. Likewise, the lower mortgage costs will
boost demand for homes, which will increase new housing
starts, a component of investment. Keynesians also argue that
lower interest rates might boost government expenditures that
require financing, especially for local governments with lower
funds. Therefore, the forces causing increases in aggregate
demand from a decline in the interest rate outweigh the forces
causing decreases in aggregate demand—and thus self-
correction does not occur.

I. The Keynesian Theory of the Interest Rate
To develop the Keynesian interest rate, some assumptions will
be used. First, assume that all financial assets are classified as
either money or bonds. Money consists of currency and demand
deposit accounts. Money is assumed to not bear interest (if we
adjust the model to allow interest on money accounts, we get a
similar result as money earns less interest than other assets).
Bonds are homogenous perpetuities, which pay a fixed amount
at fixed intervals with no repayment on the principle.
Keynes hypothesised that wealth (Wh) could be divided into
holdings of bonds (B) and money (M).
Wh = B + M
The equilibrium interest rate is the rate where the demand and
supply of bonds are equal. This implies that the bond market is
in equilibrium—since the person is satisfied with how much he
is holding in bonds at the current rate of interest, there is no
excess supply of or demand for bonds. However, if a person is
satisfied with the percentage of wealth held as bonds, he must
also be satisfied with the percentage held as money. Using the
same logic, it is evident that money supply and demand are at
equilibrium too. If the person is happy with their bond-money
combination, so there can be no excess demand or supply of
money. This can be proven by contradiction: suppose that the
bond market is in equilibrium but there is excess demand for
money. This means people want to hold more money than they
currently hold, which means that they want to sell bonds, so
there is excess supply of bonds at the current interest rate—
which implies that the bond market could not be in equilibrium!
When one market is in equilibrium, so is the other. Keynes
wanted to emphasise the role of money in the system, so he uses
the money market rather than the bond market for determining
interest rates.
II. The Keynesian Theory of Money Demand

Since bonds bear interest and money does not, there is
obviously an opportunity cost of holding money. So why would
someone want to hold any money at all when interest-bearing
bonds are available? What factors determine how much of the
non-interest bearing asset, money, a person chooses to hold?
Keynes listed three motives for money demand: transactions,
precautionary, and speculative demand for money. The
transactions motive is essentially the same as in the classical
model. Money is a liquid asset and can be easily converted into
other goods. Changing back and forth from bonds to money has
associated transaction costs, and it makes little sense to incur
them for short-run interest gains if the wealth is going to be
spent soon anyway. Like the classical economists, Keynes
expected the transactions demand for money to increase as
income increases.
Keynes’ second motive, precautionary demand, is similar to
transactions motive. Keynes felt people would keep some
wealth as money in case of unexpected events, such as
unemployment or injury. Again, Keynes expected precautionary
demand to be directly related to income. One can think of
precautionary demand as simply the demand for unexpected
transactions.
The third motive, speculative, is more original. Bonds
command a price on the open market, and it is a fact of finance
that the price of bonds is inversely related to the interest rate
(this relationship can be proven rather easily but it is not
particularly relevant to the course so it will not be taken up
further). Therefore, when interest rates increase, the value of
the bond declines, which is a capital loss for the bondholder
(and vice versa). Keynes theorised that people formed some
judgment as to what was the “normal” rate of interest. If
interest rates are above this level, they are expected to fall and

the value of the bonds is expected to increase, thus generating
both interest and a capital gain for the bondholder. If interest
rates are below this level, they are expected to rise, generating a
capital loss. Since the net return on a bond is the interest
payment plus the capital gain or loss, there is some critical
value below the normal rate of interest such that for any point
below the critical value, the capital loss outweighs the interest
gain and the net return on the bond is negative. Above the
normal rate, the expected return is positive since there is a
capital gain as well as the interest payment. Between the
normal and critical value, the interest payment outweighs the
expected capital loss, and the net return is positive. Therefore,
speculative demand for money is zero above the critical value,
since there is a positive return from bondholding. (Money,
remember, bears no interest.) The only money that will be held
will be for transactions or precautionary purposes. Below the
critical value, people will hold only money and no bonds, since
the expected return on bonds is negative.
The aggregate speculative demand for money is the compilation
of the individual curves. It is downward sloping since at low
interest rates people expect rates to start increasing and will
hold more money to prevent a capital loss. The curve is smooth
since each person has their own idea of a “normal” interest rate.
Total Money Demand in the Keynesian System
Therefore, we have three motives for money demand. Keynes’
first two (transactions and precautionary) give money demand
as a function of income, while speculative demand is assumed
to be a function of the interest rate and income. These concepts
were later revised by other economists. William Baumol
demonstrated that transactions demand is also inversely related
to the interest rate, while James Tobin improved Keynes’
speculative demand theory.
Using all of these ideas, we can now express the Keynesian
demand for money as

Md = L (Y, r)
Money demand for transactions is positively related to income
and negatively related to interest rates. The money demand
curve, when plotted against the interest rate, is a downward
sloping function.
A typical linear version of this function is:
Md = c0 + c1Y – c2r c1 > 0,
c2 > 0
The parameter c1 is the sensitivity of money demand to changes
in income, and c2 is the sensitivity of money demand to changes
in the interest rate.
Money Supply and Equilibrium: The Liquidity Preference
Model
Again, we are assuming that the money supply is fixed by the
central bank and is independent of the interest rate; i.e. a
vertical line at the fixed money supply (this assumption is
actually not correct, and is the topic of a later lecture on the
money supply process). Equilibrium in the money market and
the equilibrium interest rate are determined by the intersection
of money demand and supply. Note that income (Y) is held
constant when deriving the demand curve; an increase
(decrease) in Y will lead to an increase (decrease) in money
demand; the curve will shift right (left) and interest rates will
increase (decrease). Interest rates are thus procyclical: they
move with the business cycle. Note also that monetary policy
(changes in the money supply) will shift the curve; a monetary
expansion leads to lower interest rates while a monetary
contraction leads to higher rates.
However, what is the relationship between the money market

and the goods market (for output)? How do changes in the
money market affect the goods market, and vice versa? The
IS/LM model shows these ideas by combining the simple
Keynesian model with the Keynesian liquidity preference
model. Note: The IS/LM model is a demand-side model; both
the simple Keynesian model and liquidity preference model are
AD-side concepts. The IS/LM model thus assumes that firms
automatically supply whatever level of output is demanded at a
fixed price (essentially, a horizontal AS curve whereby AD
determines Y*). This will be discussed in more detail in a later
topic.
III. Money Market Equilibrium: The LM Curve
We have said that money demand is a function of the interest
rate and income:
Md = L(Y, r)
or in linear form:
Md = c0 + c1Y – c2r c1 > 0,
c2 > 0
The signs indicate that money demand increases as income
increases (due to the transactions/precautionary motives) and is
negatively related to the interest rate. We have seen that the
money demand schedule is downward sloping when plotted
against the interest rate. A change in income causes a shift in
the money demand schedule (not the money demand function).
Why? As income increases, you are demanding more money for
transactions at any given interest rate. An increase in the
quantity of money demanded for a fixed money supply will
naturally cause a rise in the equilibrium interest rate (think of
the interest rate as the price of money). Therefore, we note that
there is a positive relationship between interest rates and

income. This positive relationship is called the LM curve. The
LM curve shows all combinations of the interest rate and
income that generate equilibrium in the money market, i.e.
money supply equals money demand.
The LM curve can be derived graphically by calculating the
interest rate for different levels of income (and thus money
demand) and plotting this relationship.
The LM curve can also be derived algebraically. The LM curve
shows money market equilibrium where money supply and
demand are equal. This can be calculated by setting money
demand and supply equal and solving for r (alternatively, you
can solve for Y but solving for the interest rate is the more
common method).
Ms = Md = c0 + c1Y – c2r
r = c0/ c2 – Ms/ c2 + (c1/c2)Y
IV. The Slope of the LM Curve
The slope of the LM curve can be calculated by calculating the
change in interest rates from a change in income. This partial
derivative is:
∂r/∂Y = c1/c2
Therefore, two things influence the slope of the LM curve. c1
measures the increase in money demand from an increase in
income. The higher the value of c1, the steeper the curve. c2
measures the interest elasticity of money demand. The higher
the interest elasticity of money demand, the flatter the money
demand curve. There is little disagreement about the value of
c1 but there is considerable argument about the value of c2.

V. Factors That Shift the LM Schedule
There are two factors that cause a shift in the LM curve. The
first is a change in money supply. An increase in money supply
will shift the LM curve to the right. The second is a change in
the money demand function itself, i.e. a change in the c0
parameter. Basically, this change in anything that affects
money demand other than changes in income or interest rates.
A shift in the variables of money demand—income and interest
rates—doesnot shift in the LM curve—it causes a movement
along the curve, but a change in anything else that affects
money demand does shift the LM curve. (Remember your rules
of graphing—r and Y are endogenous changes.) An increase in
money demand for a given interest rate and income will shift
the LM curve to the left, and vice versa.
VI. Product Market Equilibrium: The IS Curve
We have stated two equivalent ways to describe product market
equilibrium:
Y = C + I + G
or
I + G = S + T
The IS curve can be derived from either of these equations. The
second one will be used to derive the IS curve graphically.
First, ignore the government sector, i.e. G and T are zero. Now
that we have developed the Keynesian interest rate, we can
express investment as a function of the interest rate. Again,
this is a negative relationship. Again, saving is a positive
function of income.

Now add the government sector. The government is assumed to
not be concerned about the interest it has to pay for its
borrowing. Therefore, adding government spending to the
investment function and taxes to the saving function will be a
parallel shift of these functions. Adding government spending
will shift the investment function to the right, and the saving
function will shift to the left since taxes will decrease the level
of disposable income and thus savings. Combining these two
functions will give us the IS curve. The IS curve shows all
possible combinations of output and the interest rate that
generate equilibrium in the product market. It shows an inverse
relationship between interest rates and output.
The IS curve can also be derived algebraically, using either of
the two conditions for equilibrium. From the first condition,
I + G = S + T
we can express investment as a linear function of the interest
rate
r
i
I
I
1
-
=
0
1
>
i

The savings function is again:
)
)(
1
(
T
Y
b
a
s
-
-
+
-
=
Taking government spending and taxes as exogenous, we have
T
T
Y
b
a
G
r
i
I
+
-
-
+

=
+
-
)
)(
1
(
1
Rearranging and solving for Y yields an expression for the IS
curve: (Usually, the LM curve is solved for r. The IS curve is
solved for Y.)
[
]
b
r
i
bT
G
I
a
b
Y
-
-
-
+
+
-
=
1
1
1

1
We can also find the IS curve by using Y = C + I + G.
Substituting our equations for investment and consumption and
solving for Y gives an identical expression for equilibrium.
Factors That Determine the Slope of the IS Curve
As for the LM curve, the slope of the IS schedule is calculated
by taking the partial derivative of the IS curve equation, ∂r/∂Y.
This yields:
∂r/∂Y = - (1-b)/i1
This slope is negative, as previously mentioned. Two factors
influence the slope of the IS curve. 1 – b is the marginal
propensity to save (MPS), which is the slope of the savings
function. The IS curve is steeper the higher the MPS. We will
not consider saving in more detail until next term.
The second factor that influences the slope of the IS curve is i1,
the slope of the investment function and more commonly called
the interest elasticity of investment. The higher the interest
elasticity of investment, the flatter the investment function. In
this case, there are large changes in investment with small
changes in interest rates, and since investment is a component
of income, small changes in interest rates therefore yield large
changes in income; thus the flatter the IS curve. Conversely,
low interest elasticity of investment will yield a steep IS curve.
VII. Factors That Shift the IS Curve
The factors that shift the IS curve are the same factors that
cause a shift in the simple Keynesian model from the last
chapter. Changes in government spending, taxes, and
autonomous investment and consumption will shift the position
of the IS curve. The magnitude of this change can again be
calculated by using the multiplier, which are again calculated

by taking partial derivatives. These multipliers are unchanged
from the last section—the multiplier is 1/(1 – b) for changes in
G, I, and a; and –b/(1 – b) for changes in T.
We can graphically show the effects of changes in government
spending, investment, consumption, and taxes. An increase in
autonomous investment or government spending will shift the IS
curve to the right.
An increase in autonomous consumption will shift the savings
function and thus the IS curve will shift right. An increase in
taxes, again, reduces aggregate demand and the IS curve will
shift left. Decreases in any of these factors will yield opposite
effects. Note that if the interest rate is unchanged, output will
change by the full amount of multiplier, as in the simple
Keynesian model. If the interest rate changes at all, output will
not increase by the full amount.
VIII. The IS and LM Curves Combined
The point of intersection between the IS and LM curves gives
the interest rate and output level at which the money market and
product market are simultaneously in equilibrium.
Again, the equilibrium values of the interest rate and income
can be calculated algebraically. Since in equilibrium Y and r
must be the same in both the IS and LM curves, substituting the
LM curve into the equation for the IS curve and solving for Y
gives equilibrium income:
Substituting this value of Y into the equation of either the IS or
LM curve and solving for r yields:
The point of the IS/LM model is to improve the simple
Keynesian model by acknowledging the fact that money and

interest will affect output levels and vice versa—the goods
market and money market are interrelated. For example,
suppose that there is an increase in autonomous investment,
which shifts the IS curve to the right. The new equilibrium
occurs at higher interest rates and higher output levels. We
know what causes the higher output—higher investment means
higher AD which means higher output, as in the Keynesian
cross diagram. However, more output (income) leads to more
money demanded for transactions and as a store of wealth—the
money demand curve shifts upward and to the right, hence
higher interest rates. IS/LM shows both of these effects on a
single diagram. A similar thing occurs due to LM shifts. An
increase in the money supply lowers interest rates; lower
interest rates boost I, and thus AD and output, Y, as shown by
IS/LM.
15
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_1251624164.unknown
James R. Maloy
Spring 2020
Lecture Notes for Topic 7: Keynesian Macroeconomics (III)
In this section, we will discuss the role of demand management
in the Keynesian system, i.e. the use of fiscal/monetary policies
to adjust aggregate demand and output. The overall goal of

such policies in the Keynesian system is to stabilize output,
employment and prices—i.e. keep AD stable—by
counterbalancing any AD shifts (due primarily to volatile
investment), thus eradicating the business cycle. Note that this
is IS/LM analysis, which assumes prices are fixed—more on
price volatility in a later topic.I. Monetary Policy in the IS-LM
Model
In the last topic we discussed factors that cause a shift in the
LM curve—changes in money supply or money demand.
Monetary policy is the manipulation of the money supply to
change equilibrium income. Suppose the central bank wants to
increase equilibrium income. They will increase the money
supply (the methods and tools of the central bank will be
discussed in the spring term), thus shifting the LM curve to the
right. At the new equilibrium, output has increased and the
interest rate has fallen.
How does monetary policy work? Why does increasing the
money supply increase output? There is some disagreement
about how monetary policy actually works. In the Keynesian
system, monetary policy works through what is known as the
indirect transmissionprocess. In economic terms, the increase
in the money supply creates an excess supply of money at the
current interest rate, which causes the interest rate to fall.
(Remember the money market analysis from the last chapter.)
As the interest rate falls, investment will increase, and thus
income will rise. The rise in income will boost consumption
through the multiplier effect. Both of these factors will then
boost the quantity of money demanded, since money demand is
a positive function of income. At the new equilibrium, income
is higher and interest rates are lower. This is where the new
LM curve intersects the IS curve. Hence the indirect
transmission process—changes in money yield changes in
interest rates, which in turn cause changes in consumption,

investment, and output. Monetary policy works indirectly via
the interest rate.
A monetary contraction is a decrease in the money supply, and
has the opposite effects.
II. Fiscal Policy in the IS-LM Model
Fiscal policy is the manipulation of government spending and
taxes to change the level of equilibrium income. An increase in
government spending and/or a decrease in taxes will shift the IS
curve to the right, and a decrease in government spending
and/or an increase in taxes will shift the IS curve left. For an
expansionary government policy (G up and/or T down), a new
equilibrium will be attained with increased output and higher
interest rates.
The economic reason for this occurrence is also straightforward.
Since government spending adds to aggregate demand (Y= C + I
+ G), an increase in government spending will place upward
pressure on output. Likewise, a decrease in taxes will boost
consumption. If the interest rate remains unchanged, output
will increase by the amount of the expansion times the
multiplier, just as in the simple Keynesian model from Topic 4.
However, the simple Keynesian model did not include the
money market. The increase in income from the fiscal
expansion will increase the quantity of money demanded. As
the quantity of money demanded increases, the interest rate will
rise. The increase in the interest rate will in turn cause a
decrease in investment. The decrease in investment will
partially offset the fiscal expansion. Therefore, the equilibrium
output is at a lower level than in the simple Keynesian model—
there is partial crowding out because the increase in government
spending drives up interest rates. Note that this result is

between the two extremes of the Classical model and the simple
Keynesian model. In the Classical model there was complete
crowding out and the fiscal policy was useless. In the simple
Keynesian model without the money market there was no
crowding out at all. In the complete Keynesian model the fiscal
policy is partially effective. Again, the new equilibrium occurs
where the new IS curve intersects the LM curve.
III. Policy Effectiveness and the Slope of the IS Schedule
Recall that we calculated the slope of the IS schedule to be
1
i
b
1
Y
r
-
-
=
¶
¶
. Therefore, the higher the value of (1 – b), which you should
recall is the marginal propensity to save (MPS), the steeper the
IS curve. (Alternatively, you could say that the lower the value
of the marginal propensity to consume, b, the steeper the IS
curve.) Also, the lower the absolute value of the interest
elasticity of investment (i1), the steeper the IS curve. A low
value of b (i.e. a high value of 1 – b) and/or a low value of i1
will make a steep IS curve, and vice versa. The interest rate
sensitivity of investment demand (i1) is the more interesting
case, and is the source of much disagreement among economists
over the slope of the IS curve.

So what are the policy effects of having a steep IS curve
because of low interest rate sensitivity of investment?
Assuming a “normal” upward-sloping LM curve, we can easily
show that fiscal policy will be relatively more effective than
monetary policy in changing output. What is the economic
intuition for this result? If investment is not very sensitive to
changes in the interest rate, it will take a large change in
interest rates to change investment. An increase in G, for
example, will cause a rise in the interest rate, but since
investment is not sensitive to this change, the increase in
interest rates will not cause a large fall in investment—there is
very little crowding out. Therefore, fiscal policy is very
effective. Monetary policy, remember, works by influencing
investment via the interest rate, but since investment is not very
sensitive to the interest rate, monetary policy will not work very
well.
Conversely for a flat IS curve, due to high interest rate
sensitivity of investment, monetary policy will be relatively
more effective than fiscal policy, for the exact opposite reason
as the low interest rate elasticity case. These results can easily
be viewed graphically. It is also possible to demonstrate this
mathematically. The homework will show some examples of
economies with different values of i1 and b, and your
assignment will be to calculate the effect of monetary and fiscal
policies for these economies using the same procedures from the
previous homework. Consult the appendix to chapter 7 if you
need help on this before the seminars.
IV. Policy Effectiveness and the Slope of the LM Schedule
Recall that we calculated the slope of the LM schedule to be

2
1
c
c
Y
r
=
¶
¶
. Therefore, the higher the value of c1, (the increase in money
demand from an increase in income, i.e. the percentage of
income that is demanded as money), the steeper the LM curve.
Likewise, the lower the value of c2, (the interest elasticity of
money demand), the steeper the LM curve, and vice versa.
Again, the more interesting case is the interest rate sensitivity
of money demand, c2. Keynesians typically believe that c2 is
relatively high and thus the LM curve is relatively flat.
The policy implications for LM curves of different slopes can
be seen graphically. For a flat LM curve, we can easily see that
fiscal policy will be relatively more effective than monetary
policy for changing equilibrium output. Why?
If there is an expansionary fiscal policy, for example an
increase in G, output will increase, thus boosting transactions
demand for money and throwing the money market out of
equilibrium at the current interest rate (more money demanded,
same quantity of money). Interest rates will therefore rise. If
money demand is very sensitive to changes in the interest rate,
it will not take much an increase in interest rates to restore
equilibrium (very small change in interest rates will cause a big
change in money demand and thus equilibrium quickly

restored). Since interest rates only rise by a small amount,
there is not much crowding out and the policy is very effective.
Monetary policy with a flat LM curve will not be very effective
because the increase in the money supply will only yield a small
fall in interest rates (again, it only takes a small change in
interest rates to cause money demand to match the larger money
supply). Since interest rates only fall a little, there will not be
much increase in investment and thus only a small change in
output.
Conversely, monetary policy will be relatively more effective
than fiscal policy for a steep LM curve. Keynesians typically
believe the previous case to be true, i.e. fiscal policy more
effective.
4
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PJM6000Project Management PracticesWeek 5Deb Cote,.docx

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