ECO 209Y MACROECONOMIC THEORY AND POLICY LECTURE 11: THE IS-LM MODEL AND EXOGENOUS/ENDOGENOUS MONEY

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1 ECO 209Y MCROECONOMIC THEORY ND POLICY LECTURE 11: THE IS-LM MODEL ND EXOGENOUS/ENDOGENOUS MONEY Gustavo Indart Slde 1

2 KEYNESIN MONETRY THEORY EXOGENOUS MONEY SUPPLY Gustavo Indart Slde 2

3 Keynes treated real money supply (M S ) as an exogenous varable determned by the central bank M S = M/P For hm, real money demand was determned by the nomnal nterest rate (yeld) on bonds (), the level of real ncome (Y), and the state of bearshness (X) M D = M (, Y, X) For a gven Y and X, changes to equate the real money supply and the real money demand (or lqudty preference) M (, Y 1, X 1 ) = L (Y 1, X 1 ) M/P = L (Y 1, X 1 ) KEYNESIN MONETRY THEORY Gustavo Indart Slde 3

4 KEYNESIN MONEY MRKET EQUILIBRIUM M/P The money supply M S = M/P s exogenously determned,.e., ndependent of, Y and X. t the level of ncome Y 1 and state of bearshness X 1, the correspondng lqudty preference curve s L(Y 1, X 1 ) and equlbrum nterest rate s 1. 1 M D = L (Y 1, X 1 ) L(Y 1, X 1 ) M 1 /P 1 M/P Gustavo Indart Slde 4

5 KEYNESIN MONEY MRKET EQUILIBRIUM ND THE LM CURVE Money Market M/P LM Curve Y 2 > Y 1 LM (X 1 ) B B 2 2 L(Y 2, X 1 ) 1 1 L(Y 1, X 1 ) M 1 /P 1 M/P Y 1 Y 2 Y Gustavo Indart Slde 5

6 N INCRESE IN EXOGENOUS MONEY SUPPLY ND THE LM CURVE Money Market LM Curve M/P (M/P) 1 1 LM (X 1 ) LM (X 1 ) B 2 2 B (M/P) L(Y 1, X 1 ) M 1 /P 1 M 2 /P 1 M/P Y 1 Y Gustavo Indart Slde 6

7 IMPCT OF N INCRESE IN EXOGENOUS MONEY SUPPLY LM (X 1 ) LM (X 1 ) ' B C n ncrease n M S causes the LM curve to shft down and to the rght,.e., t causes to fall at each level of Y. IS (X 1 ) Y 1 Y 2 Y Gustavo Indart Slde 7

8 IMPCT OF N INCRESE IN EXOGENOUS MONEY SUPPLY (CONT D) Money Market LM Curve M/P (M/P) 1 1 C 3 B 2 2 L(Y 2 ) B (M/P) L(Y 1 ) 3 LM C LM IS M 1 /P 1 M 2 /P 1 M/P Y 1 Y 2 Y Gustavo Indart Slde 8

9 NEO-KEYNESIN MONETRY THEORY MONEY SUPPLY RULE Gustavo Indart Slde 9

10 NEO-KEYNESIN MODEL WITH MONEY SUPPLY RULE The Bank of Canada controls the stock of hgh-powered money or monetary base (B) but not the money supply The money supply (M S ) s determned by the monetary base (B) and the money multpler (mm) M S = mm B B s consdered exogenous but mm s endogenous mm depends on the desred cash-reserve rato (re) and the desred currency-depost rato (cu) For a gven B, for nstance, as rses banks provde more rsky loans and re falls and mm ncreases Therefore, the real supply of money (M S ) ncreases wth the nterest rate (),.e., B s exogenous but M S s endogenous Gustavo Indart Slde 10

11 NEO-KEYNESIN MONEY SUPPLY RULE ND THE LM CURVE Money Market LM Curve Keynesan M S Y 2 > Y 1 Neo-Keynesan M S B B C 3 L(Y 2, X 1 ) 1 1 Keynesan LM Neo-Keynesan LM L(Y 1, X 1 ) M 1 /P 1 M 2 /P 1 M/P Y 1 Y 2 Y Gustavo Indart Slde 11

12 IMPCT OF N INCRESE IN ENDOGENOUS MONEY SUPPLY Money Market LM Curve M/P (M/P) 1 1 C 3 B 2 2 L(Y 2 ) B L(Y 1 ) 3 LM C LM IS M 1 /P 1 M 2 /P 1 M 3 /P 1 M/P Y 1 Y 2 Y Gustavo Indart Slde 12

13 THE MONETRY BSE ND THE MULTIPLIER Inflaton Monetary Base Money Multplers Perod verage rate of nflaton below 2% Monetary base trpled Money multplers plummeted Source: John C. Wllams, Monetary Polcy, Money, and Inflaton, FRBSF Economc Letter , 9 July Gustavo Indart Slde 13

14 NEO-KEYNESIN MONETRY THEORY INTEREST RTE RULE Gustavo Indart Slde 14

15 NEO-KEYNESIN MODEL WITH INTEREST RTE RULE In ths case the Bank of Canada targets the rate of nterest (not the money supply) The money supply (M S ) s assumed horzontal at the target nterest rate ( 1 ) = 1 The real money stock s thus determned by the real money demand The Bank of Canada must change the monetary base as needed to keep the rate of nterest at ts target Thus the monetary base becomes endogenous Gustavo Indart Slde 15

16 NEO-KEYNESIN INTEREST RTE RULE ND THE LM CURVE Money Market LM Curve 2 < 1 1 M S 1 LM B C C 2 M S 2 LM B L(Y 2 ) L(Y 1 ) IS M 1 /P 1 M 2 /P 1 M 3 /P 1 M/P Y 1 Y 2 Y Gustavo Indart Slde 16

17 POST-KEYNESIN MONETRY THEORY ENDOGENOUS MONEY SUPPLY Gustavo Indart Slde 17

18 POST-KEYNESIN THEORY OF ENDOGENOUS MONEY Ths theory s n opposton to tradtonal Keynesan theory but, most partcularly, to monetarsm, for whch money supply s also exogenous We ll examne two dfferent Post-Keynesan approaches to money supply determnaton: horzontalsm and structuralsm Both approaches subscrbe to the core proposton that bank lendng drves money We wll focus on smple versons of the horzontalst and structuralst models of endogenous money supply Gustavo Indart Slde 18

19 MIN FETURES OF POST-KEYNESIN ENDOGENOUS MONEY MODELS Loans create deposts That s, money creaton s not the result of an ncrease n banks reserves The money multpler s an after-the-fact phenomenon It s not a drver of money supply creaton The determnaton of the money supply (M S ) reflects a loan multpler Money s created by bank lendng Gustavo Indart Slde 19

20 POST-KEYNESIN MONETRY THEORY HORIZONTLIST MODEL Gustavo Indart Slde 20

21 SSUMPTIONS OF THE POST-KEYNESIN The banks lendng nterest rate () s set as a mark-up over the bank rate (*) set by the central bank = (1 + m) * The supply of loans (L S ) s horzontal at the level of The demand for loans (L D ) decreases wth and ncreases wth Y The monetary base (B) equals the banks reserves (R) Therefore, CU P = 0 (and thus CU B = 0 as well) Therefore, M = D (only depost money) HORIZONTLIST MODEL Banks reserves (R) are a fracton (k) of the money supply (M) R = km so M = R/k and mm = 1/k Gustavo Indart Slde 21

22 Banks assets consst of loans (L) and reserves (R) whle banks labltes consst only of deposts (where D = M) Thus the bankng sector s balance sheet s: where E s banks equty L + R = M + E Snce R = km, the supply of money s: L + km = M + E (1 k)m = L E M S = E/(1 k) + L/(1 k) POST-KEYNESIN HORIZONTLIST MODEL Note that there s no demand for money n ths model Gustavo Indart Slde 22

23 POST-KEYNESIN HORIZONTLIST MODEL (CONT D) Gven M S = E/(1 k) + L/(1 k), the soluton for the model s as follows: L s determned by the demand for loans (L D ) at Gven L, we thus fnd M S Gven M S, we fnd R R = km nd gven R, we fnd B (the monetary base) Therefore, the monetary base s also endogenous B = R The Bank of Canada creates as much B as the banks demand Gustavo Indart Slde 23

24 ENDOGENOUS MONETRY BSE IN THE HORIZONTLIST MODEL M M S = E /(1 k) + L/(1 k) M M = R/k M S M 1 M 1 L 1 L R 1 R L S = L D B B = R 1 = (1 + m)* L S B 1 Ths mples that the supply of B s horzontal at *. L D (Y 1 ) L 1 L Gustavo Indart Slde 24 R 1 R

25 POST-KEYNESIN MONETRY THEORY STRUCTURLIST MODEL Gustavo Indart Slde 25

26 POST-KEYNESIN STRUCTURLIST MODEL Lke horzontalsm, structuralsm also embodes the core logc of loans creatng money Structuralsm addresses two man shortcomngs of the horzontalst approach The absence of money demand The exogenety of long-term (bond) nterest rate Structuralsm ntroduces money demand and restores Keynes s theory of long-term nterest rate determnaton Gustavo Indart Slde 26

27 SSUMPTIONS OF THE POST-KEYNESIN There s no nterest pad on deposts STRUCTURLIST MODEL There are three nterest rates n the fnancal sector: The short-term polcy or bank rate (*) exogenously set by the monetary authorty The lendng rate of nterest ( L ) set by the banks as a mark-up over the polcy rate L = (1 + m) * The long-term bond rate () determned by the money demand (.e., lqudty preference) Gustavo Indart Slde 27

28 SSUMPTIONS OF THE POST-KEYNESIN STRUCTURLIST MODEL (CONT D) The demand for money depends on (bond rate), Y (real ncome), and X (state of bearshness) M D = M(, Y, X) where M < 0, M Y > 0, and M X > 0 The supply of loans (L S ) s horzontal at the level of L The demand for loans (L D ) decreases wth L and ncreases wth Y The monetary base (B) equals the banks reserves (R) whch consst of borrowed (R B ) and non-borrowed (R N ) reserves B = R B + R N = km Gustavo Indart Slde 28

29 POST-KEYNESIN STRUCTURLIST MODEL Banks assets consst of loans (L) and reserves (R = km) whle banks labltes consst of deposts (M) and borrowed reserves (R B ) Thus the bankng sector s balance sheet s: where E s banks equty L + km = M + R B + E Therefore, the supply of money s: M S = (R B + E)/(1 k) + L/(1 k) Gustavo Indart Slde 29

30 POST-KEYNESIN STRUCTURLIST MODEL (CONT D) Gven M S = (R B + E)/(1 k) + L/(1 k), the soluton for the model s as follows: L s determned by the demand for loans (L D ) at L Gven L, we thus fnd M S Gven M S, we fnd R R = km nd gven M S = M D, we fnd Therefore, the money supply and monetary base are both endogenous Banks lendng creates money, and banks borrowng creates hgh-powered money Gustavo Indart Slde 30

31 ENDOGENOUS MONEY SUPPLY IN THE STRUCTURLIST MODEL M M S = (R B + E) /(1 k) + L/(1 k) M S M M 1 M 1 45 L 1 L M 1 M L L S = L D M D = L (, Y 1, X 1 ) L1 L S 1 Therefore, f Y = Y 1, the fnancal sector s n equlbrum at and = 1. L D (Y 1 ) M D L 1 L Gustavo Indart Slde 31 M 1 M

32 POST-KEYNESIN MONETRY THEORY THE STRUCTURLIST MODEL ND THE LM SCHEDULE Gustavo Indart Slde 32

33 THE LM CURVE IN THE POST-KEYNESIN STRUCTURLIST MODEL Suppose the fnancal sector s ntally n equlbrum as shown n slde 31 t Y = Y 1, = 1 Ths s one pont on the LM curve Consder now the mpact of an ncrease n Y to Y 2 The loan demand curve shfts to the rght to L (Y 2 ) and L ncreases to L 2 s L ncreases, deposts (.e., the money supply) ncrease along the M S curve to M 2 s Y ncreases, the lqudty preference curve also shfts to the rght to M(Y 2, X 1 ) Gustavo Indart Slde 33

34 THE LM CURVE IN THE POST-KEYNESIN STRUCTURLIST MODEL Gven the new M 2 and M(Y 2, X 1 ), the bond rate changes to 2 Ths s another pont on the LM curve But s t 2 > 1 or 2 < 1? That s, s the slope of the LM curve postve or negatve? The sgn of the slope of the LM curve s determned by the relatve ncome elastctes of the demand for loans (Ɛ L ) and the demand for money (Ɛ M ) If Ɛ M > Ɛ L 2 > 1 and LM has a postve slope If Ɛ M < Ɛ L 2 < 1 and LM has a negatve slope Gustavo Indart Slde 34

35 THE DERIVTION OF THE LM CURVE IN THE STRUCTURLIST MODEL M M S = (R B + E) /(1 k) + L/(1 k) M M S M 2 M B 2 M 1 M 1 Here we assume Ɛ M > Ɛ L and thus the LM has a postve slope. 45 L 1 L 2 L M 1 M 2 M L L S = L D M D = M ( B, Y, X) L1 B L 1 L 2 L D (Y 2 ) L D (Y 1 ) 2 L S 1 L Gustavo Indart Slde 35 M 1 B M (Y 2, X 1 ) M (Y 1, X 1 ) M 2 M

36 THE DERIVTION OF THE LM CURVE IN THE STRUCTURLIST MODEL (CONT D) M M S = (R B + E) /(1 k) + L/(1 k) M M S M 2 M B 2 M 1 M 1 Here we assume Ɛ M < Ɛ L and thus the LM has a negatve slope. 45 L 1 L 2 L M 1 M 2 M L L S = L D M D = M ( B, Y, X) L1 B L 1 L 2 L S L D (Y 2 ) L D (Y 1 ) L Gustavo Indart Slde B M (Y 2, X 1 ) M (Y 1, X 1 ) M 1 M 2 M