The Keynesian System II

Money, Interest, and Income

Chapter 7

Professor Steve Cunningham

Intermediate Macroeconomics
ECON 219
Problems with the
Income-Expenditure Model
 What about prices?
– Don’t they change when AS and AD
conditions change?
– Don’t they have an influence?
 Are firms really indifferent to
changes in the real wage rate?
 These issues remain to be
addressed...
2
Money in the Keynesian Model
 Recall the classical model:
– Transactions motive: people hold
money only to make transactions
– Rejects the store of value theory of the
mercantilists, arguing that:
• Money bears no interest, and
• A rational person would not forego a
positive return by holding money unless
he/she planned to make a transaction.
– People do not hoard money.
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Liquidity Preference Theory
 Money is:
1. A Medium of Exchange
2. A Store of Value
3. A Unit of Account
 The first two create demands for
money.

4
Liquidity Preference Theory
 Transactions Motive—yields transactions
demand for money
 Store of Value—yields:
– Precautionary Motive—yielding precautionary
demand for money
– Speculative Motive—yielding the speculative
demand for money
 There are reasons why someone might
rationally hoard money!

5
Speculative Demand (1)
 Keynes considers a portfolio of
financial assets.
 All financial assets can be
considered as money or bonds:
– Money (M): yields no return
– Bonds (B): yield a return
 Wh = M + B

6
Speculative Demand (2)
 Example—Perpetuity (a bond that never
matures):
– Bond is issued at $1000
– Coupon rate is $50  50/1000=5%
– Later, market interest double to 10%
– How much can you sell the bond for?
– Ans: $500 because 50/500=10%
 When interest rates rise, bond prices fall
 capital losses!
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Speculative Demand (3)
People decide to hold money
r instead of bonds when interest
rates get so low that they cannot
possibly go lower. The move to
money to avoid capital losses.
There is a rational motive for
hoarding money!!!

Lp = Lp(r)
M d
r0 (-)
As interest rates fall,
Bd  0 and Md  .

M
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Precautionary Demand
 People hold money (“precautionary
balances”) for unforeseeable
expenses.
 These holdings (“balances”) tend to:
– Rise with income, and
– Fall with interest rates.
 Lp = Lp(Y,r)
(+) (-)

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Ambiguity in the Money Market
 In the classical model:
– Ms = M0 (exogenous)
– Md = Md(Y)
– We used these relationships to create the AD
curve.
 In Keynes’ model:
– Ms = M0 (exogenous)
– Md = L(Y,r)
– Ms = Md
– M0 = L(Y,r) is the money market outcome.
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Sidenote: Hicks’ Little Apparatus
 Sir John Hicks, 1939, “Mr Keynes
and the Classics, a Suggested
Interpretation”
 Introduces the IS-LM Model as a way
of making sense of Keynes’ General
Theory.

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Keynesian “Money Market”
 M0 = L(Y,r) is the equilibrium in the money
market.
 There is not one single variable that can
change to clear the market. There are two!
 The “money market” cannot tell us alone
what the supply and demand for money
will be.
 Money is not dichotomous.

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Hicks’ Interpretation: LM Curve
r LM Curve (L=M): all
LM those combinations of
real interest rates and
income which bring the
money supply equal to
money demand.

Y
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LM Curve Slopes Upward Because...
 Assumes Ms = M0 r Ms
(exogenous)
 If Y increases, transactions
and precautionary demand
increase. Md(Y1)
– There will be excess r1
demand in the money
markets r0 Md(Y0)
– Interest rates will be driven
upward
 So Y r, and the LM
M
Curve slopes upward.

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LM Curve Slopes Upward Because...

Liquidity Preference is:

L = L(Y,r)
Money Supply is:
Ms = M 0 = M
Ms = Md implies
M = L(Y,r)  LM Curve
Differentiating:
 L
dr Y  ()
  0
dY L ( )
r
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LM and the Money Market
r LM
r Ms

Md(Y2)

r1 Md(Y1)

r0 Md(Y0)

M Y0 Y1 Y2 Y
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Changes in Money Supply
r Ms Ms Ms

Ms
r*
M
s Md

M
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Capital Market
 Investment I = I(r,E) = I(r)
 But Saving S = S(Y) or S(Yd)
 So there is not a single “price variable” to clear the capital
market!
 I(r) = S(Y)  IS Curve: IS = IS(Y,r)
 IS: all those combinations of Y and r which make the
“capital market” clear.
 Equivalently, IS is all those combinations of Y and r for
which supply = demand in the loanable funds market.
 Thus the real sector cannot be resolved without
considering money market outcomes.
– Money is NOT dichotomous.

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IS Curve
r

Slopes downward because

r I Y

IS

Y
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IS Curve Slopes Downward Because...

Recall that:
I+T=S+G
or
I(r) + T0 = S(Y) + G0
Differentiate implicitly with respect to Y and r:
ds
dr dY ()
  0
dY dI ()
dr
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 r S
S
I0 = S0
r2

r1 I1 = S1

r0 I I2 = S2

I2 I1 I0 I Y2 Y1 Y0 Y

r2
r1
r0 IS
Y2 Y1 Y0 Y 21
Money and Investment
The interest rate is
determined in the
money market.
Decision makers in
r r firms compare this
Ms rate to the MEC and
make the decision
regarding
investment.
r*
Md I

M* M I* I
The real and monetary sectors are
linked. Money matters! 22
IS-LM
 Note that the real
r and monetary
LM
sectors of the
economy are
resolved together.
r*  Money matters to
real sector
outcomes.
IS
 There is no
Y* Y dichotomy.
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Money-Income Transmission
The Keynes Effect (Money Income Transmission Mechanism):

 I 
M s  B d   PB   r      AD   P 
Cdurables  
• Money is not neutral (in the short run), and there is no
dichotomy.

• Some modern Keynesians argue for long-run neutrality, but

short-run nonneutrality.

• Changes in the money supply affect the real sector through

the interest rate channel.
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Notes on IS-LM
 LM is a stock equilibrium (beginning of period. IS is
a flow equilibrium (end of period).
 The equilibrium is an equilibrium of flows
constrained by stocks. It is a cash-flow equilibrium.
 The time frame is long enough for full adjustment of
real income and interest, short enough so stocks do
not change.
 IS-LM equilibrium is not permanent. S>0 implies that
wealth (allocations) are increasing over time.
Therefore LM is shifting due to the stock of bonds. If
net investment is positive, then the capital stock
grows.
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Linearized IS-LM

M
LM :  kY  r IS : I  G  S  T
P
I  I0  r
M
 r   kY S  S0  (1  c )(Y  T )
P
M k I0  r  G0  S0  (1  c )(Y  T )  T
r   Y
P   r  (S0  I0  G0 )  (1  c )Y  T  cT  T
 r  (S0  I0  G0  cT )  (1  c )Y
(I0  G0  S0  cT ) 1  c
r   Y
 

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Linearized IS-LM
r k

LM
I0  G0  S0  cT0

 (1  c )
r* 
IS

M
Y
Y*
P
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Classical Model? (=0)
r LM

I0  G0  S0  cT0

 (1  c )
r* 
IS

Y
Y*

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