In the second half of the 19th century neoclassical economists emerged as a revolt against the school of classical economic thought. Neoclassical economics sought to explain the maximisation of utility with an underlying theory of rational choice theory. In the post war period a movement occurred that sought to synthesis the macroeconomic, long run theories of John Maynard Keynes with the microeconomic, short-run theories of neoclassical economics. This essay will explore how John Hick’s ISLM synthesis of Keynes is related to the neoclassical growth model. In addition it will explore how both the growth model and theory of capital reproduce problems inherent in the explanation of ...view middle of the document...
However, it was Samuelson who sought to present Hick’s model as the totality of Keynesian thinking (Yaroufakis, Halevi, & Theocarakis, 2011). Keynes’ argument that the economy operated with complex agents who acted on “animal spirits” precluded the existence of a mathematical model that would accurately reflect his work.
The ISLM model shows both the equilibrium between interest rates and real GDP as well as the preference to hold cash balances (in lieu of securities). The upward sloping IS curve shows the real output of an economy at various interest rates (which are the fixed variable). The downward sloping LM curve expresses equilibrium in the money market as a relation between real interest rates (r) and real output (Y). The LM curve shows a positive correlation between real output and interest rates. The ISLM is used to show the theoretical outcomes of short-run changes to fiscal and monetary policy. Adjustments are made through changes to interest rates.
The neoclassical growth model was developed, independently by Robert Solow and Trevor Swan as an extension of the Harrod-Domar model. The Harrod-Domar growth model was created with the intention of applying Keynesian interpretations of macroeconomics to the long run (Pasinetti, 1974) . The Harrod-Domar model expressed growth as the sum:
Where g = growth rate, s = savings ratio and v = capital output ratio.
Here we have been presented with three values, however, Harrod did not to specify which should be taken as the unknown (Pasinetti, 1974). Several economists sought to define the unknown and to extend the model. Here we shall concentrate on Solow’s attempt. Solow sought to set the capital-output ratio as the unknown. Solow posited that v would return s/v to equality with the natural rate of growth (The New School for Social Research). Taking v as the unknown variable allows us to consider the role played by technological advancement in generating economic growth. Where the Harrod-Domar model was highly unstable, this new model allows for “the possibility of substituting labour for capital in production” (Solow, 1956). By doing so Solow was able to show that for any given savings ratio it was possible for the economy to approach full employment (Halevi, 2007). The Solow-Swan model relies on the neoclassical production function, whereby income (or total output) is shown to be a product of both labour and capital inputs. We see that the neoclassical theory of growth is underpinned by the assumption that each good can be produced by infinite combinations of labour and capital.
There are extensive connections that we can see between the ISLM neoclassical synthesis and Solow’s growth model. Indeed both models are consistent with one another and changes in one are transmitted to the other. Underpinning this connection are crucial assumptions. The ISLM model reflects a Keynesian’s assumption that the propensity to save is given. The Solow-Swan growth model shares this assumption...