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 Slide 1

2 KEYNESIN MONETRY THEORY EXOGENOUS MONEY SUPPLY Gustavo Indart Slide 2

3 Keynes treated real money supply (M S ) as an exogenous variable determined by the central bank M S = M/P For him, real money demand was determined by the nominal interest rate (yield) on bonds (i), the level of real income (Y), and the state of bearishness (X) M D = M (i, Y, X) For a given Y and X, i changes to equate the real money supply and the real money demand (or liquidity preference) M (i, Y 1, X 1 ) = L (Y 1, X 1 ) M/P = L (Y 1, X 1 ) KEYNESIN MONETRY THEORY Gustavo Indart Slide 3

4 KEYNESIN MONEY MRKET EQUILIBRIUM i M/P The money supply M S = M/P is exogenously determined, i.e., independent of i, Y and X. t the level of income Y 1 and state of bearishness X 1, the corresponding liquidity preference curve is L(Y 1, X 1 ) and equilibrium interest rate is i 1. i 1 M D = L (Y 1, X 1 ) L(Y 1, X 1 ) M/P Gustavo Indart Slide 4

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

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

7 IMPCT OF N INCRESE IN EXOGENOUS MONEY SUPPLY i LM (X 1 ) LM (X 1 ) i 1 i 2 i 1 ' B C n increase in M S causes the LM curve to shift down and to the right, i.e., it causes i to fall at each level of Y. IS (X 1 ) Y 1 Y 2 Y Gustavo Indart Slide 7

8 NEO-KEYNESIN MONETRY THEORY ENDOGENOUS MONEY SUPPLY Gustavo Indart Slide 8

9 NEO-KEYNESIN MODEL WITH MONEY SUPPLY RULE The Bank of Canada controls the stock of high-powered money or monetary base (B) but not the money supply The money supply (M S ) is determined by the monetary base (B) and the money multiplier (mm) M S = mm B B is considered exogenous but mm is endogenous mm depends on the desired cash-reserve ratio (re) and the desired currency-deposit ratio (cu) For a given B, as the rate of interest rises (i), banks provide more risky loans and re falls and mm increases Therefore, the real supply of money (M S ) increases with the interest rate (i), i.e., B is exogenous but M S is endogenous Gustavo Indart Slide 9

10 NEO-KEYNESIN MONEY SUPPLY RULE ND THE LM CURVE i Money Market i LM Curve Keynesian M S Y 2 > Y 1 Neo-Keynesian M S B B i 2 i 2 i 3 C i 3 L(Y i 2, X 1 ) i 1 1 Keynesian LM Neo-Keynesian LM L(Y 1, X 1 ) M/P Y 1 Y 2 Y Gustavo Indart Slide 10

11 NEO-KEYNESIN MODEL WITH INTEREST RTE RULE In this case the Bank of Canada targets the rate of interest (not the money supply) The money supply (M S ) is thus horizontal at the target interest rate (i 1 ) i = i 1 The real money stock is thus determined by the real money demand The Bank of Canada must change the monetary base as needed to keep the rate of interest at its target Thus the monetary base becomes endogenous Gustavo Indart Slide 11

12 NEO-KEYNESIN INTEREST RTE RULE ND THE LM CURVE i Money Market i LM Curve i 2 < i 1 i 1 M S i 1 LM B C C i 2 M S i 2 LM B L(Y 2 ) L(Y 1 ) IS M/P Y 1 Y 2 Y Gustavo Indart Slide 12

13 POST-KEYNESIN MONETRY THEORY ENDOGENOUS MONEY SUPPLY Gustavo Indart Slide 13

14 POST-KEYNESIN THEORY OF ENDOGENOUS MONEY This theory is in opposition to traditional Keynesian theory but, most particularly, to monetarism, for which money supply is also exogenous We ll examine two different Post-Keynesian approaches to money supply determination: horizontalism and structuralism Both approaches subscribe to the core proposition that bank lending drives money We will focus on simple versions of the horizontalist and structuralist models of endogenous money supply Gustavo Indart Slide 14

15 MIN FETURES OF POST-KEYNESIN ENDOGENOUS MONEY MODELS Loans create deposits That is, money creation is not the result of an increase in banks reserves The money multiplier is an after-the-fact phenomenon It is not a driver of money supply creation The determination of the money supply (M S ) reflects a loan multiplier There is no money supply schedule per se (relating M and i) Money is created by bank lending Gustavo Indart Slide 15

16 POST-KEYNESIN MONETRY THEORY HORIZONTLIST MODEL Gustavo Indart Slide 16

17 SSUMPTIONS OF THE POST-KEYNESIN The banks lending interest rate (i) is set as a mark-up over the bank rate (i*) set by the central bank i = (1 + m) i* The supply of loans (L S ) is horizontal at the level of i The demand for loans (L D ) decreases with i and increases with 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 deposit money) HORIZONTLIST MODEL Banks reserves (R) are a fraction (k) of the money supply (M) R = km so M = R/k and mm = 1/k Gustavo Indart Slide 17

18 Banks assets consist of loans (L) and reserves (R) while banks liabilities consist only of deposits (where D = M) Thus the banking sector s balance sheet is: where E is banks equity L + R = M + E Since R = km, the supply of money is: L + km = M + E (1 k)m = L E M S = E/(1 k) + L/(1 k) POST-KEYNESIN HORIZONTLIST MODEL Note that there is no demand for money in this model Gustavo Indart Slide 18

19 POST-KEYNESIN HORIZONTLIST MODEL (CONT D) Given M S = E/(1 k) + L/(1 k), the solution for the model is as follows: L is determined by the demand for loans (L D ) at i Given L, we thus find M S Given M S, we find R R = km nd given R, we find B (the monetary base) Therefore, the monetary base is also endogenous B = R The Bank of Canada creates as much B as the banks demand Gustavo Indart Slide 19

20 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 i L S = L D B B = R i 1 i = (1 + m)i* L S B 1 This implies that the supply of B is horizontal at i*. L D (Y 1 ) L 1 L Gustavo Indart Slide 20 R 1 R

21 HORIZONTLIST MODEL WITH POSITIVELY SLOPED SUPPLY OF LONS Palley adjusts the horizontalist model by incorporating an upward sloping loan supply schedule Palley gives two possible reasons for this schedule: Banks raise the mark-up as lending increases (e.g., because of greater risk) The central bank increases the bank rate as the money supply increases Therefore, the supply of monetary base is not horizontal In any case, L S = L D at the set interest rate (i) Gustavo Indart Slide 21

22 HORIZONTLIST MODEL WITH UPWRD SLOPING LON SUPPLY CURVE 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 i 1 i L S = L D L D L S i = [1 + m(l)] i* B B 1 B = R This implies that the supply of B could be horizontal at i* (if i* fixed) or an increasing function of i* (if i* variable). L 1 L Gustavo Indart Slide 22 R 1 R

23 POST-KEYNESIN MONETRY THEORY STRUCTURLIST MODEL Gustavo Indart Slide 23

24 POST-KEYNESIN STRUCTURLIST MODEL Like horizontalism, structuralism also embodies the core logic of loans creating money Structuralism addresses two main shortcomings of the horizontalist approach The absence of money demand The exogeneity of long-term (bond) interest rate Structuralism introduces money demand and restores Keynes s theory of long-term interest rate determination Gustavo Indart Slide 24

25 SSUMPTIONS OF THE POST-KEYNESIN There is no interest paid on deposits STRUCTURLIST MODEL There are three interest rates in the financial sector: The short-term policy or bank rate (i*) exogenously set by the monetary authority The lending rate of interest (i L ) set by the banks as a mark-up over the policy rate i L = (1 + m) i* The long-term bond rate (i) determined by the money demand (i.e., liquidity preference) Gustavo Indart Slide 25

26 SSUMPTIONS OF THE POST-KEYNESIN STRUCTURLIST MODEL (CONT D) The demand for money depends on i (bond rate), Y (real income), and X (state of bearishness) M D = M(i, Y, X) where M i < 0, M Y > 0, and M X > 0 The supply of loans (L S ) is horizontal at the level of i L The demand for loans (L D ) decreases with i L and increases with Y The monetary base (B) equals the banks reserves (R) which consist of borrowed (R B ) and non-borrowed (R N ) reserves B = R B + R N = km Gustavo Indart Slide 26

27 POST-KEYNESIN STRUCTURLIST MODEL Banks assets consist of loans (L) and reserves (R = km) while banks liabilities consist of deposits (M) and borrowed reserves (R B ) Thus the banking sector s balance sheet is: where E is banks equity L + km = M + R B + E Therefore, the supply of money is: M S = (R B + E)/(1 k) + L/(1 k) Gustavo Indart Slide 27

28 POST-KEYNESIN STRUCTURLIST MODEL (CONT D) Given M S = (R B + E)/(1 k) + L/(1 k), the solution for the model is as follows: L is determined by the demand for loans (L D ) at i L Given L, we thus find M S Given M S, we find R R = km nd given M S = M D, we find i Therefore, the money supply and monetary base are both endogenous Banks lending creates money, and banks borrowing creates high-powered money Gustavo Indart Slide 28

29 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 i L L S = L D i M D = L (i, Y 1, X 1 ) i L1 L S i 1 Therefore, if Y = Y 1, the financial sector is in equilibrium at and i = i 1. L D (Y 1 ) M D L 1 L Gustavo Indart Slide 29 M 1 M

30 POST-KEYNESIN MONETRY THEORY THE STRUCTURLIST MODEL ND THE LM SCHEDULE Gustavo Indart Slide 30

31 THE LM CURVE IN THE POST-KEYNESIN STRUCTURLIST MODEL Suppose the financial sector is initially in equilibrium as shown in slide 29 t Y = Y 1, i = i 1 This is one point on the LM curve Consider now the impact of an increase in Y to Y 2 The loan demand curve shifts to the right to L (Y 2 ) and L increases to L 2 s L increases, deposits (i.e., the money supply) increase along the M S curve to M 2 s Y increases, the liquidity preference curve also shifts to the right to M(Y 2, X 1 ) Gustavo Indart Slide 31

32 THE LM CURVE IN THE POST-KEYNESIN STRUCTURLIST MODEL Given the new M 2 and M(Y 2, X 1 ), the bond rate changes to i 2 This is another point on the LM curve But is it i 2 > i 1 or i 2 < i 1? That is, is the slope of the LM curve positive or negative? The sign of the slope of the LM curve is determined by the relative income elasticities of the demand for loans (Ɛ L ) and the demand for money (Ɛ M ) If Ɛ M > Ɛ L i 2 > i 1 and LM has a positive slope If Ɛ M < Ɛ L i 2 < i 1 and LM has a negative slope Gustavo Indart Slide 32

33 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 positive slope. 45 L 1 L 2 L M 1 M 2 M i L L S = L D i M D = M (i B, Y, X) i L1 B L 1 L 2 L D (Y 2 ) L D (Y 1 ) i 2 L S i 1 L Gustavo Indart Slide 33 M 1 LM B M (Y 2, X 1 ) M (Y 1, X 1 ) M 2 M

34 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 negative slope. 45 L 1 L 2 L M 1 M 2 M i L L S = L D i M D = M (i B, Y, X) i L1 B L 1 L 2 L S L D (Y 2 ) L D (Y 1 ) L Gustavo Indart Slide 34 i 1 i 2 B LM M (Y 2, X 1 ) M (Y 1, X 1 ) M 1 M 2 M