LECTURE NOTES. Chapter 6: The Keynesian System (II): Money, Interest, and Income. 1. Money in the Keynesian System

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1 LECTURE NOTES Chapter 6: The Keynesian System (II): Mney, Interest, and Incme 1. Mney in the Keynesian System Interest rates and aggregate demand AD cmpnents affected Investment Durable gds Gvernment spending (i.e. infrastructure investment) If interest rate falls, then investment increases. Because investment is an autnmus cmpnent f Y, utput increases. AD increases by Y increases by See Figure 6-1 Page 1 f 15

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3 2. The Keynesian Thery f the Interest Rate Imprtant simplificatin: Wealth (Wh) can be divided int tw grups, (1) mney (M) and (2) al nnmney assets and nnmney asseta are bnds (B). Mney is a shrt-term liquid asset Bnds are lng-term less liquid assets Nte that there are n cnsumptin gds Mney demand (hw much mney t hld with respect t bnds) depends n the liquidity preference Liquidity preference determines M when W is fixed. Therefre, it indirectly determines B as well Mney supply Exgenusly fixed by the mnetary authrity (i.e. the central bank) Hw t allcate wealth between M and B? Recall that the price f the bnd: ( ) r if the bnd is a perpetuity bnd Then, there exists and interest rate i that equilibrates the demand and supply f bnds Example 1: Excess f mney supply Ecnmic agents sell the mney and buy bnds The price f bnds rise Interest rate falls Example 2: Shrtage f mney supply Ecnmic agents buy mney by selling bnds The price f bnds fall Interest rates rise Therefre, by cnstructin The equilibrium interest rate is the ne that equilibrates supply f and demand fr bnds, and The equilibrium interest rate is the ne that equilibrates supply f and demand fr mney VERY IMPORTANT: INTEREST RATE IS NOT THE PRICE OF MONEY If individual A lends 10 units f x (apples) t individual B with the cnditin that ne year after he shuld return 11 units, there is a 10% interest rate but n mney invlved If interest rate is nt the price f apples, then it is neither the price f mney Interest rate is the price f time (credit), whether this cmes in the frm f mney r apples. Interest rates is nt a mnetary phenmenn, it is a time (preference) phenmenn Page 3 f 15

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5 3. The Keynesian Thery f Mney Demand Three mtives t hld mney: (1) Transactins demand Cash-in-advance (CIA) requirements t perfrm transactins Higher incme implies mre transactins and therefre a higher demand t hld mney Fr large amunts, interest rates is inversely related t mney demand (shrt-term investment in bnds) (2) Precautinary demand Fr a rainy day (unexpected medical r repair bills, etc.) (3) Speculative demand If interest rates are expected t rise and if the capital lss is larger than gain frm interest rates, then sell bnds and buy mney If interest rates are expected t fall and if the capital gain is larger than the utility lss frm hlding cash, then buy bnds t re-sell when capital gains are high enugh Keynes assumes ecnmic agents wrk with a given level f what is cnsidered t be a nrmal interest rate ( ). When the market interest rate deviates frm the nrmal interest rates, then there are changes in mney demand due t speculatin There is a critical interest rate level ( ) at which capital gains > interest rate gains Because ecnmic agents have different cnsideratins f what is and therefre mney demand changes smthly with changes in (Figure 6-3) Liquidity trap: If r is lw enugh, then the fr all ecnmic agents. At this pint, any increase in mney supply is hld as mney demand Nthing ges t investment/cnsumptin thrugh bnds Ttal demand fr mney Psitively related t incme Negatively related t interest rates ( ) In Classical macrecnmics mney demand is functin nly f incme: ( ) The fact that yu can graph decreasing quantity f mney demand against the interest rate des nt make the interest rate the price f mney similarly t the fact being able t graph a lwer quantity demanded f an inferir incme rises des nt make incme the price f the inferir gd (see Figure 6-4) Page 5 f 15

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8 4. The IS-LM Mdel Tw markets: Mney market (LM) Cmmdity (gds) market (IS) Bth markets shuld be in equilibrium Relatinship between r and Y Mney Market Equilibrium: The LM Schedule (equilibrium cnditin) ( ) ( ) is upward slping Level change nly Slpe change nly Level and slpe change Liquidity trap: The lwer the interest rate, the larger. If is large enugh changes in d nt prduce a change in Y (see Figure 6-8) If then depends nly n incme and Keynesian mney demand is similar t Intuitin: mney demand in Keynesian macrecnmics 1 st : Incme increases 2 nd : Mney demand fr transactin increases 3 rd : Sell f bnds increases (t buy mney) 4 th : Price f bnds fall 5 th : Interest rates rise Page 8 f 15

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10 Prduct Market Equilibrium: The IS Schedule Equilibrium cnditins [incme equals aggregate demand] [simplificatin: assume n gvernment sectr: I = S] Let ( ) ( ). Investment depends n interest rates but savings depend n incme Then there is a cmbinatin f r and Y that makes ( ) ( ) Higher incme implies higher savings. Higher savings imply lwer interest rates. Lwer interest rates imply higher investments. Therefre there is an inverse relatinship between r and Y in the IS schedule Slpe Depends n the sensitivity f investment t changes in the interest rate Level Depends n autnmus expenditures (a, I, G, and T) Page 10 f 15

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14 The IS and LM Schedules Cmbined Remember: IS and LM are nt demand and supply lines, but equilibrium pints in tw different markets Where IS and LM crss each ther there is general equilibrium Disequilibriums: Cnsider disequilibria (see Figure 6-17): (1) Cnsider pints abve the LM schedule: Interest rate is t high. The price f bnds is expected t rise. Ecnmic agents sell mney and buy bnds reducing the interest rate level (2) Cnsider pints belw the LM schedule: Inverse case than abve (3) Cnsider pints abve the IS schedule: Output exceeds AD. Inventries increase beynd the desired level ( ). Investment falls until utput matches AD (4) Cnsider pints belw the IS schedule: Inverse case than abve Page 14 f 15

15 METROPOLITAN STATE UNIVERSITY OF DENVER 5. Mdel Example LM schedule IS schedule (1) ( ) (2) (3) Replace (1) and (2) in (3) and d sme math ( )( ) In equilibrium [ ] ( ) Then ( ) [ ] ( ) Shcks (try it yur-self) ( ) ( ) ( ) ( ) ( ) Page 15 f 15