How can a government be sure that its increase in spending would not be offset by a decrease in private saving? Keynes was unable to answer this question during his presentation in front of the Macmillan committee. In order to find answers, Keynes expanded his Keynesian cross model to include the rate of interest. Keynes argued that interest rates affected the quantity of production. Just as individuals save more when incomes are high, businesses invest more when the rate of interest is low. In order to make this argument he assumed that there was only one interest rate in the whole economy.
Keynes called the demand curve for investment as a function of the interest rate the marginal efficiency of capital. Lower interest rates encourage businesses to invest in themselves while high interest rates do not. A lower interest rate leads to an increase in national income. Keynes made three major breakthroughs. The first was the consumption function. The second was the marginal efficiency of capital. Keynes third breakthrough answered the question, “If the amount of total spending in the economy was determined by the balance between savings and investment at any interest rate, what determined the interest rate?” To answer this, he had to clarify the role of the quantity of money in the economy. The supply of money is determined by the central banks and they can change the supply by buying or selling bonds. When the central bank buys bonds it increases the supply of money and when it sells bonds it decreases the supply of money. Interestingly the price and yield of bonds move in opposite directions. Keynes describes a new use for money that he refers to as liquidity preference: a wish to hold assets in “liquid” form (money) in order to use this money to speculate by buying bonds when the time seems right to do so. The interest rate is determined by the need to make the demand for money equal to the supply of money.
In a time of crisis, the risk of failure makes the value of bonds decline and leads to bondholders to sell their bonds to get cash. The 2008 financial crisis is a good example of this. When bondholders sell their bonds, the interest rate rises. Those who borrow to invest must now borrow at higher interest rates and therefore will invest less leading to a decrease in output and employment. This is one of Keynes most important findings.
The demand for money is a function of both the interest rate and GDP. In order to maintain equilibrium in the money market where the supply and demand for money are equal, GDP and the interest rate must rise and fall together. The IS curve refers to the savings and investment curve. It shows different combinations of the interest rate and national product where savers and investors are content, and at which firms do not wish to change their level of production. The LM curve shows the interaction between liquidity preference and the money stock. It shows different combinations of the interest rate and national income where wealth holders are content to hold a give quantity of money In the IS-LM diagram, where the curves cross is a point in which both groups are content, and there is no pressure to change either the interest rate or GDP.
The interest rate must rise to crowd out private investment and the amount of crowding out is determined by the extent to which the interest rate rises (slope of the LM curve). Only if the LM curve is vertical is crowding out complete.