ABSTRACT
Next we consider an in”uential model advanced by Blanchard (1981), in which he extended Keynesian IS…LManalysis by taking account of a richer array of “nancial assets. Besides money and short-term bonds, he also included longterm bonds and equities. The signi“cance of this generalization derives from the corresponding treatment of the real sector. Here it is assumed that investment demand I (or likewise consumption demand) varies with Tobin•s average q, instead of the real rate of interest. Consequently the share price dynamics feeds back on the real sector. The short-term interest rate plays a more indirect role, as it is involved in the determination of Tobin•s q on the “nancial markets via an arbitrage condition. Since, for simplicity, the model abstracts from in”ation, the nominal rate of interest coincides with the real rate and it is determined by a textbook LM schedule of money market equilibrium. Through this channel real output Y impacts on the “nancial sector. Economic activity, in turn, is in”uenced by the level of investment through a Keynesian (dynamic) multiplier channel that describes gradual output adjustment towards Keynesian aggregate demand. For a given price level the real…“nancialinteraction to be studied may thus be concisely summarized by the feedback loop Y → i → q → I → Y .
