An Integration of CAPM with IS-LM Analysis into a Unified Theory of Aggregate Demand

Abstract

Ever since James Tobin [23] explained the demand for money in a portfolio context economists have been aware of the relation between portfolio behavior and aggregate demand. On a most basic level, since the demand for money is at least partly dependent on portfolio behavior, the LM and aggregate demand schedules are also dependent. Nevertheless, formal derivations of aggregate demand schedules (e.g., from IS-LM schedules) have not as yet taken portfolio considerations fully into account.' Likewise, the vast literature on capital market theory emanating out of the Sharpe [22]-Lintner [18]-Mossin [19] mean-variance capital asset pricing model (CAPM) assumes that the level of aggregate demand (or income) is exogenously determined. Two of the most important literatures in macroeconomics, aggregate demand theory and capital market theory, have been largely developed along separate paths. The purpose of this paper is to unify the relationship between aggregate demand theory and capital market theory by explicitly incorporating the CAPM into an IS-LM framework.2 In this way we can examine the effects of shocks to the IS and LM schedules upon the returns to riskless and risky securities and the feedback effects upon aggregate demand. The influence of these shocks on aggregate demand (i.e., the monetary and autonomous spending multipliers) will be shown to depend on the amounts of security risk (beta coefficients) as well as upon investors' risk-return attitudes.3