Keynesian IS-LM The Keynesian System (II): Money, Interest, and Income
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...
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.
Money is: The first two create demands for money.
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!
Speculative Demand (1) Keynes considers a portfolio of financial assets. All financial assets can be considered as money or bonds: Wh = M + B
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!
Speculative Demand (3)
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) (+) (-)
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.
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.
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.
Hicks’ Interpretation: LM Curve
LM Curve Slopes Upward Because... Assumes Ms = M0 (exogenous) If Y increases, transactions and precautionary demand increase. - There will be excess demand in the money markets
- Interest rates will be driven upward
So Y r, and the LM Curve slopes upward.
LM Curve Slopes Upward Because...
Changes in Money Supply
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.
IS Curve
IS Curve Slopes Downward Because...
Money and Investment
IS-LM
Money-Income Transmission
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.
Linearized IS-LM
Linearized IS-LM
Classical Model? (=0)
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